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Klarman Notes from CFA Conference (May 18th, 2010)

The following is a great transcript of questions to Seth Klarman from Jason Zweig (of WSJ) at the recent CFA Conference:
http://www.scribd.com/doc/31684724/Notes-from-Seth-Klarman-s-discussion-at-the-CFA-Institute-s-Annual-Conference

Kudos to Cameron Wright for putting this together.

There are many good questions, but the one idea that stood out for myself is Klarman's opinion on gold. It's hard to believe that value investors are talking about the shiny metal nowadays, but well-respected guys from Grantham to Einhorn are on the bandwagon. Given this, Klarman is probably next best to Buffett in giving his opinion on what really shouldn't even be an option for a true value investor.

This is from the transcript:

JZ: Graham stated that an investment is anything you analyze, has safety of principle and an adequate return, and all else is speculation. But he speculated…

SK: Graham wasn’t thinking about currency devaluation. If you want to short the dollar, you need to short it against something, what is that something? No other currency makes sense. Gold is an expensive hedge to protect against severe erosion in purchasing power, but it’s something we feel is worth it. We are looking to protect tail risks that could be catastrophic, one of which is hyperinflation. We don’t like TIPS since the government keeps the inflation data. It’s more likely the Bond Market would call the government on inflation before it shows up in government data. So what we did is buy way out of the money puts on bonds. We lose 100% if rates go to 5% or 6%. However, if rates get to double digits, we’ll make 10, 15, 20 times our money. If they get to 20-30%, we’ll make 50-100x. And there’s way less than a 50/50 chance this would happen in 5 years or less. But we view it as very cheap insurance and it’s worth risking our capital to buy that insurance.

JZ: How do you protect your clients against inflation/falling US Dollar?

SK: I mentioned the OTM puts on bonds, I don’t feel comfortable mentioning anything else and having 1600 people call up their brokers and over pay for protection. But you need to think about and consider gold going down, the US Dollar not being the reserve currency (or continuing to be the reserve currency). It’s more art than science, and what we’re doing could very well have a negative NPV, but we think it’s a good idea to try to protect client purchasing power if the world gets really bad.

Combine this with his quote from Jason Zweig's followup piece on WSJ:

You could have heard a pin drop as Mr. Klarman proclaimed, "I am more worried about the world, more broadly, than I ever have been in my career." That's because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

"Will money be worth anything," asked Mr. Klarman, "if governments keep intervening anytime there's a crisis to prop things up?"

To protect against that "tail risk," said Mr. Klarman, Baupost is buying "way out-of-the-money puts on bonds"—options that have no value unless Treasury bonds plummet. "It's cheap disaster insurance for five years out," he said.

Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.

"All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive," he warned.

Especially gold. "Near its all-time high, it's a very hard moment to recommend gold," said Mr. Klarman.

Mr. Klarman pointed out that his own ideas "on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what's going to happen in the world at large." In other words, while you might want to insure against a disaster scenario, you shouldn't bet the ranch on it.

And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is "out of favor, loathed and despised." So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors' stomachs. Then you can pounce.

As Mr. Klarman put it, "Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."

I've looked at LEAPs on the GLD as an insurance play and can't get comfortable with it. While it's tough to know what the "right" value of these options should be, they seem to be expensive. At least I can take comfort in not being completely wrong with my perception.

The conclusion is that it's best to simply get back to work analyzing companies and not waste any more time thinking about how to put together the hedge against armageddon (unless there is some way to replicate his basket of puts as a small investor). I've been leaning in this direction over the past few weeks, but Klarman's comments are enough to push me over the edge.

RDSI Spinoff - Bad News

I've been following the spinoff of RDSI Banking Systems (RDSI) from Rurban Financial (RBNF) for a while now. It looked to have great potential: tiny and underfollowed, complex, and lots of insider participation. You can read the details here. The biggest risk was not structural, but business related. As part of the spin they had to break their contract with Fiserv and convince the existing client base to switch over to their new software. Well, so far that hasn't gone very well as noted in their recent 10-Q:

RDSI has lost or will lose a significant number of its existing data processing customers in connection with the transition to Single Source™.  As of May 14, 2010, 53 of RDSI’s 74 customers had notified RDSI of their intentions to move their processing away from RDSI, with 29 of these customers having already de-converted from RDSI.  While RDSI currently has 10 contracts from existing RDSI customers (excluding State Bank) to convert to the Single Source™ software and remain with RDSI, and New Core has six contracts with non-RDSI customers to convert to Single Source™, it is currently uncertain as to if and when these customers will be converted to Single Source™ and/or begin to generate revenue for RDSI.

OK, well, we expected them to lose some customers. In fact, they've alluded to the fact that they might lose a majority of customers in the short-term but that this would be necessary for long-term success. Here's the really bad stuff (bolding mine):

·

RDSI and New Core have encountered significant challenges in converting RDSI’s first customer, State Bank, to Single Source™ due to the fact that the Single Source™ core system is untested in a bank environment of the size and complexity of State Bank.  RDSI has been running Single Source™ as the primary data source for State Bank since the conversion of State Bank to this new core system on March 19, 2010, with State Bank’s previous data processing system also running essentially parallel to the Single Source™ system since the conversion.  Since the conversion of State Bank, RDSI and State Bank have determined that the Single Source™ system needs further enhancements to operate in a number of complex areas.  As the alternatives and necessary enhancements to the Single Source™ software system are considered and addressed by RDSI and New Core, the Boards of Directors of State Bank and RDSI have agreed that State Bank will go back to its previous data processing system operated at RDSI.  It is expected that this transition of State Bank back to its previous data processing system will take approximately 60 days.  No assurances can be given as to if or when State Bank will convert back over to the Single Source™ system.  RDSI is communicating this development to the client banks that have contracted for the installation of Single Source™ software, and this development may delay their conversion dates or result in some or all of these banks electing to seek other processing alternatives.

 

·

In view of the expected loss of customers and associated revenue by RDSI in connection with its transition to providing Single Source™ software, together with the increased expenses associated with this transition and the contemplated spin-off of RDSI from Rurban and merger of RDSI with New Core, it is anticipated that RDSI will experience a significant net operating loss in 2010, and possibly beyond.  As a result, RDSI has agreed with regulators to seek additional equity and/or debt financing from outside sources unaffiliated with Rurban and State Bank to provide funding to support ongoing operations and business development of RDSI over the short-term and long-term through the end of 2011.  RDSI has further agreed that it will not convert any additional financial institution customers to the Single Source™ until it has secured this additional financing.  No assurances can be given as to if or when RDSI will be able to secure this additional financing on terms acceptable to RDSI.  As a result, it is currently uncertain as to if and when additional customers will be converted to Single Source™ and/or begin to generate revenue for RDSI.

Let's remember that State Bank is a relatively tiny institution in the grand scheme of things - this ain't no Bank of America. If they can't get the software to work on their own system, it is unlikely that they'd be able to get it installed anywhere. It was going to be hard enough to get clients to move beforehand, now it might be impossible.

I'm guessing that this kills the idea, but I'm not ready to remove this from my watchlist just yet. I'll keep following until there is some finality to the situation. 

Rosenberg: S&P 500 Now 35% Overvalued

From David Rosenberg this morning, bolding mine:

According to the Shiller P/E ratio, the S&P 500 is now 35% overvalued — a full one standard deviation event.

The April data was just updated and showed the inflation-adjusted normalized P/E, premised on “bird-in-the-hand” (as opposed to consensus earnings forecasts, which is historically more than 20% higher than we actually get — one reason why Wall Street banks are dubbed “the sell side”) 10-year trailing profits, expanded to over 22x from 21x in March.

This is not nosebleed territory, but it is expensive; the historical average is 16.4x. So, this implies that the market is currently 34.7% overvalued benchmarked against the historical norm. It would be nice to say that a higher-than-normal P/E is justified by low inflation and low interest rates. But frankly, real bond yields are not that far from their long-run averages; however, equity valuation is, and something is going to give at some point.

Valuation metrics are not meant to be timing devices. Assets, securities, and currencies can stay overvalued for extended periods of time, but inevitably Bob Farrell’s rule number one on the concept of “mean reversion” will come into play. The operative strategy is to buy low and sell high, not the opposite; and to be paid to take on risk as opposed to be paying for taking on the risk.

Defensive income-oriented strategies, at this point, make perfect sense from our lens.

Source: https://ems.gluskinsheff.net/Articles/Coffee_with_Dave_042110.pdf

Monish Pabrai Interviewed by Steve Forbes

Monish Pabrai was interviewed by Steve Forbes in his Intelligent Investing series. The actual publication date of the interview was April 9th, 2010.

The original video is here:
http://www.forbes.com/2010/04/09/pabrai-buffett-munger-intelligent-investing-video.html

All notes are paraphrased. Also, I have left on any comments from Pabrai that he's made repeatedly in the past. For more background, see my notes from his lecture at Columbia as well as Pabrai's recent Bloomberg interview.

• He doesn't invest in tech because he spends time in it and there are no moats in tech.
• His biggest edge is attitude, the only advantage an investor has is waiting.
• Entrepreneurs aren't actually big risk takers. The are great at living with uncertainty and making low risk bets with high potential returns. Bill Gates is a great example given that Microsoft never had more than $50k worth of capital invested in it.
• He made the mistake of thinking he could build a better company just by putting in more capital. His first company was no capital, but had huge returns. He put in a lot of dough into his second company, but had no results. Now, Pabrai funds has next to no capital, so essentially no risk.
• Best quote: he asked Warren if he had a nap room. Answer was yes. 
• Chinese companies have 3 sets of books: one for the government, one for the owner's wife, and one for the owner's mistress. Problem is that you don't know what set you are looking at.
• Nowadays he is just twiddling his thumbs. He is happy that he plays racquetball and bridge. He has his eye on the market, but there is not a whole lot of value. He's waiting for the game to come to him.
• Delta Financial went to zero, 100% loss for Pabrai Funds. Lesson: company was highly levered and depended on securitization market. Should learn from this mistake through his checklist.

Pabrai Interview on Bloomberg

Monish Pabrai had a good interview on Bloomberg radio recently. It's great that Bloomberg actually does an in-depth interview and gives more than a 30 second soundbit (unlike some business networks).

Archive is here:
http://media.bloomberg.com/bb/avfile/Markets/Analyst_Calls/vUaHTa9aFj6Q.mp3
(you have to fast-forward about a fifth of the way in)
 
Here are my notes:

On Management
-Meeting management doesn't help make better investments. Realize that CEOs are all great salespeople and you'll always have a good feeling about the company after talking to a good CEO.
-It's not that CEOs are willingly deceitful. It's just that they are are always optimistic about their company. While this is a good leadership quality, it doesn't help the investor.
-Rules are 1) never meet management, and 2) just look at their track record

On Checklists
-He spends a bunch of time on the aviation example. He's given this example many times...
-Read The Checklist Manifesto.
-Pabrai has found that his big mistakes usually are obvious in hindsight. Not only is it obvious, but the information was public at the time of investment. This is the case for both himself and the investing greats. He's spent a lot of time collecting mistakes from the greats and analyzing them.
-His checklist has 80 items. Reviewing it after wanting to move forward with an idea only takes around 30 mins
-All investments have red flags, it's not so much finding the perfect company as much as it is being aware of the risks and not making the same mistake twice.
-There are 7-8 questions in his checklist that are related to leverage
-One interesting question: Is the investment a "win win" for all stakeholders involved.

Great Michael Burry Summary

Street Capitalist has a great writeup on what we can learn from Michael Burry. If you haven't heard of Burry, he's another one of the guys that made a fortune betting on the housing collapse. He's unique in that he was just a small time guy who attracted money from Greenblatt largely based on his writings online. 

Rather than spending dozens of hours combing through old posts on SiliconInvestor.com, the post by Street Capitalists has most of what you need to know:

http://streetcapitalist.com/2010/03/24/learning-from-michael-burry/

Must Read: James Montier - 10 Lessons Not Learnt

James Montier is simply brilliant. I started making notes on his latest piece, but then had too much to put in a post. The doc is long, but is well worth the time.

I can't find the original on GMO, so here is the summary and PDF via Zerohedge:

• Lesson 1: Markets aren’t efficient.
• Lesson 2: Relative performance is a dangerous game.
• Lesson 3: The time is never different.
• Lesson 4: Valuation matters.
• Lesson 5: Wait for the fat pitch.
• Lesson 6: Sentiment matters.
• Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!
• Lesson 8: Over-quantification hides real risk.
• Lesson 9: Macro matters.
• Lesson 10: Look for sources of cheap insurance.

http://www.zerohedge.com/sites/default/files/bad%20dream.pdf

Hagstrom: Who's Afraid of a Sideways Market?

Robert Hagstrom, portfolio manager at Legg Mason and author of The Warren Buffett Way, wrote an excellent article recently. It was featured on Morningstar, but the original PDF is available here:

http://www.lmcm.com/pdf/Point_of_View/POV_Who%27s%20Afraid%20of%20a%20Sideways%20Market.pdf

In the article he looks at the 1975-1982 period, which was a sideways market, and examines the portfolios of Buffett and Bill Ruane. To simplify, his point is that even though the market went sideways, there were still plenty of ways to make money, as proven by the 34% and 28% annual returns of Buffett and Ruane.

The summary of the article is as follows:

Whether we are in for a sideways market for the next several years is open for discussion. However, the central point of this research is to remind investors, despite the average returns of a broad index, there are significant opportunities and profits to be made by those who understand the variations within the system. No matter how the stock market behaves, or how the underlying economy performs, there will be, in the words of Stephen Jay Gould, a “spread of excellence.” In financial ecology, there are always changing patterns and trends to improvement. As such, the investment landscape favors the stock picker – perhaps now more than ever.

Hagstrom makes some excellent points. While macro forces are important, a sideways market doesn't necessarily mean that great companies can't be found. The limitation however of looking at one time period is that we extrapolate too much from a very specific situation. There are certainly time periods where there are few opportunities (if any). While '75-'82 was great for Buffett, it was only in 1969 that he returned capital to his partners because he couldn't find any good ideas.

Given this, the question is whether the market today more resembles 1969 or 1975?

Complicated and Tiny Canadian Spin (MGA and UWE)

A complex deal just hit the wires this morning. Here is the bit right from the press release:

U3O8 Corp. (TSX VENTURE:UWE) and Mega Uranium Ltd. (TSX:MGA) ("Mega") are pleased to announce that they have entered into a definitive agreement under which U3O8 Corp. will acquire all of Mega's South American uranium properties and $4 million in cash in exchange for 30,564,858 common shares of U3O8 Corp. (the "U3O8 Shares"). The acquisition will provide U3O8 Corp. with an expanded portfolio of projects at various stages, from National Instrument 43-101 ("NI 43-101") compliant resources in Guyana, to significant historical resources in Colombia and near-resource and discovery potential in Argentina. U3O8 Corp. will emerge as a well funded dominant explorer with a strong platform for growth in South America – one of the world's promising new frontiers for uranium exploration and development. 

I'm not a huge Uranium fan, but it's the details of the transaction that make it interesting:

As currently proposed, U3O8 Corp. will issue the U3O8 Shares to Mega, in exchange for all of the outstanding shares of a wholly-owned subsidiary of Mega, which will indirectly hold Mega's South American properties and $4 million in cash. Following completion of the sale, it is expected that Mega will distribute the U3O8 Shares to its shareholders as a dividend-in-kind paid on its common shares (the "Dividend").

A "dividend in kind" is the same as a spinoff. For whatever reason, the term is often used in Canada and Israel.

Now, this doesn't make a ton of sense. Why would a company exchange a division for stock, only to then take that stock and spin it off? Why wouldn't you just sell the division? My hunch is that the next paragraph provides some clues:

No U3O8 Shares will be delivered to Mega shareholders who are, or are deemed to be, non-residents of Canada. Instead, these shares will be aggregated and sold in the open market, in an orderly fashion, on behalf of the non-resident shareholders who will receive a pro-rata share of the cash proceeds from the sale, net of applicable withholding taxes and brokerage fees.

I've seen this with other Canadian spinoffs where the are structured so that Canadian residents are the only ones that get the stock. Non-residents have their shares automatically sold off. Depending on the amount of foreign ownership, this could obviously create significant downward pressure. Given that U308 Corp is an $11M company and Mega Uranium is a $162M company, it's easy to see how some forced selling would crater the stock. 

Finally, perhaps the most important point:

Prior to the transaction, there are 23,057,700 issued and outstanding common shares of U3O8 Corp. After the completion of the transaction, there will be 53,622,558 common shares outstanding of U3O8 Corp. (approximately 57% of which will be held by Mega shareholders without consideration of U3O8 Shares to be sold on behalf of non-residents and treatment of fractional shares).

It will be interesting to find out how much insiders own after "consideration" of the shares to be sold. The guy behind Mega is named Sheldon Inwentash, who runs a company called Pinetree Capital Ltd. The key will be to watch what he does. It could get interesting if the insiders like Inwentash are scooping up shares that are automatically sold.

No position currently, but this could change at any time.

The Little Guide to Prudent Investing

Valuehuntr.com put out a good presentation they call "The Little Guide to Prudent Investing". It's a decent primer on the basics of value investing. PDF is here.