Tag Archives: defining risk

Notes – Doing The Hugh Hendry (#debt, #diversification)

Below is some commentary from Hugh Hendry I found in an FT.com editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.


Review – The Intelligent Investor (#valueinvesting)

The Intelligent Investor: A Book Of Practical Counsel; The Definitive Book On Value Investing (buy on Amazon.com)

by Benjamin Graham, published 1973, 2003, 2006

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library.

All you need to know about intelligent investing

Graham’s layman’s manual for thoughtful investing in common stocks and bonds is a long book, chock full of useful theory and wisdom-gained-by-experience as well as numerous “case studies” which serve to illustrate Graham’s points. While it’s all worth considering, the truth is that certain parts of the book shine more brightly than others and, following the 80/20 principle, are clearly more valuable overall. Having earlier posted a reference item containing a summary of the major points made in the outstanding commentary by Jason Zweig which covers the entire breadth of the book, my purpose this time is to hone in on that key info at the expense of the totality of the book.

Starting out

The Intelligent Investor is of course a practical guide to sound investment, but it is also a work of philosophy. Buried throughout the book are invaluable caveats that are easy to overlook yet deserve to get full billing because they can spare an amateur a lot of headaches down the road. In the book’s introduction, there are two such provisos quite nearby one another, the first being,

be prepared to experience significant and perhaps protracted falls as well as rises in the value of [your] holdings

and the second being,

while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster

Subtle, but profound, these two warnings are Graham’s opening salvo on the subject of investor psychology, or more accurately, the investor’s own psychology. It will be a common thread running throughout TII– your biggest risk in investing is yourself and your psychological reaction to events impacting your portfolio.

Translating the first message, Graham is trying to gird the investor for the inevitabilities of the market, where volatility is constant in both directions. The key, as you will see, is to master volatility by recognizing that the upward variety is not necessarily proof of a good decision and the downward variety is not punishment but an opportunity to buy at bargain prices.

The second message is even more important– successful investing requires an even-keeled temperament and reasonable expectations about long-term success. The game is about expecting little and learning to be pleasantly surprised, rather than expecting a lot and constantly being disappointed. Most of your fellow market participants are excitable folks and their optimistic expectations will work with yours to crowd out any chance at realizing value, while you’ll always have plenty of room to maneuver on your own if you seek out the waters everyone of which everyone else has become bored.

The last warning is to be consistent and disciplined, to never abandon your principles in dire times because that is in fact when they become most valuable:

Through all their vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results

This is again a psychological appeal. When everyone else is losing their shirts, and their minds, forgetting what they’re doing and why, it will pay the long-term investor great dividends to be mindful of who he is and by what principles he invests as his conservatism is always in due time rewarded.

Security analysis 101

While the best treatment of Graham’s principles of security analysis are given in great detail in his treatise of the same name, Security AnalysisThe Intelligent Investor does come with several basic recommendations on how to perform basic security analysis for issues under consideration for inclusion in one’s portfolio.

Bond analysis

The key to bond investing is interest coverage, as without it a bond is in default and its principal value is imperiled. Therefore, the primary analytical factor is the number of times total interest charges have been covered by available earnings in years past. Typically two values are consulted:

  1. average coverage for a period of years (7)
  2. minimum coverage in the poorest year

Graham recommends 4x for public utilities, 5x for transportation companies, 7x for industrials and 5x for retail concerns, before income taxes on an average of 7 years basis, and 3x, 4x, 5x and 4x, respectively, measured by the poorest year.

On an after-tax basis, Graham recommends 2.65x for public utilities, 3.2x for transportation companies, 4.3x for industrials, and 3.2x for retail companies on an average of 7 years basis, and 2.1x, 2.65x, 3.2x and 2.65x, respectively, measured by the poorest year.

Additional factors for consideration are:

  1. size of the enterprise – something large and robust, so that depletions in revenue do not imperil the business as a whole
  2. equity ratio – the market price of equity versus the total debt, which shows the amount of “cushion” for losses standing in front of the debt
  3. property value – this is the asset value on the balance sheet, though “experience has shown that in most cases safety resides in the earning power”

Stock analysis

Some basic principles of stock selection and analysis are considered in more detail below, based upon whether one is determined to be a defensive or an enterprising investor. For now, it is sufficient to quote Graham on the subject in the following manner:

The investor can not have it both ways. He can be imaginative and play for the big profits that are the reward for the vision proved sound by the event; but then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities for gone

In essence, Graham is outlining the philosophy of “growth” versus “value” investing and stock analysis– attempting to forecast the future, or being content one is not paying too much for what he’s got based on an assessment of the past.

Keeping the shirt you have: the defensive investor

In Graham’s mind, there are two kinds of investors– the defensive investor, who is passive and seeks primarily to protect his capital, and the enterprising investor, who treats his investing like a professional business and expects similarly profitable results for his efforts. First, let’s talk about the defensive investor.

The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition

Specifically, Graham lists 4 criteria for selecting common stocks for the defensive investor’s portfolio:

  1. diversification – minimum of 10, maximum of 30 separate issues
  2. standing – companies which are large, prominent and conservatively financed (over $10B mkt cap and in the top third or quarter of their industry by market share or some other competitive metric)
  3. dividends – a long record of continuous payments
  4. price – no more than 25x avg earnings of past 7 yrs, nor 20x LTM earnings

Additionally, Graham warns against excessive trading or portfolio turnover:

if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes

Graham also defines risk early on, saying,

the risk attached to an ordinary commercial business is measured by the chance of its losing money

and that further, a defensive investor should never compromise their standards of safety and quality in order to “make some extra income.” Safety first, income/returns second, or you’re likely to wind up with neither in the long run.

In terms of selecting individual stocks for the defensive investor’s portfolio, Graham suggests 7 criteria:

  1. adequate size of enterprise – generally speaking, small companies are excluded and medium size companies are included if their market/industry position is robust
  2. sufficiently strong financial condition – 2:1 current ratio, and LT debt < net current assets (working capital)
  3. earnings stability – some earnings for the common stock in each year over the past decade
  4. dividend record – uninterrupted payments for the past 20 years
  5. earnings growth – minimum of 1/3 increase in per-share earnings in the past ten years using three year average at the beginning and end
  6. moderate P/E – no more than 15x avg earnings of past 3 years
  7. moderate P/A – price should be < 150% of TBV, though may be higher if earnings multiplier is below 15, never to be greater as a combined ratio than 22.5 ( P/E * P/B <= 22.5)

The purpose is to eliminate companies which are: too small, with a weak financial position, with earnings deficits or with inconsistent dividend histories. In general, these factors should combine to create a stock portfolio which, in the aggregate, has an earnings yield (earnings/price) at least as high as the current high-grade bond rate.

At all times, remember that the defensive investor is

not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand

and that, generally speaking, rather than emphasizing the “best” stocks,

let him emphasize diversification more than individual selection

Making more and better shirts: the enterprising investor

Like the defensive investor, Graham counsels the enterprising investor to think firstly of not losing what they’ve got. But in this sense, the enterprising investor has a new tool in his kit that expands his realm of possible investment options while still maintaining safety of principal– the search for “bargain” priced opportunities, the idea here being that the price being offered for a security is a steep discount (generally 30% or greater) than the indicated “intrinsic” or underlying value of the security itself based upon its asset or earnings power fundamentals (with any luck, both).

About bonds and preferred stocks, Graham suggests that preferreds never be bought without at least a 30% discount, and a similar discount on a high-yield bond. More importantly,

experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate security merely because the yield is attractive […] it is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income

About IPOs, Graham says to never touch them, however, busted IPOs can present interesting opportunities later on down the line:

Some of these issues may prove excellent buys– a few years later, when nobody wants them and they can be had at a small fraction of their true worth

With regards to selecting equity securities, Graham lays out three “recommended fields” for enterprising investors:

  1. large cap contrarianism
  2. “bargain” issues
  3. special situations

Digging in further, let’s take a closer look at large cap contrarianism. The idea here is to focus on companies that are well-known but are currently experiencing an earnings hiccup or some other negative news or general investor boredom that leaves them unpopular and trading at a lower than average multiple. The value in these companies are that,

they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base [and] the market is likely to respond with reasonable speed to any improvement shown

A good example of this principle in practice would be a situation such as buying well-known, large cap companies whose shares had strongly sold off during the financial panic of late 2008, early 2009.

According to Graham, a bargain issue is one in which the indicated value is 50% higher than the current price. Bargains can be detected one of two ways, either by estimating future earnings potential and applying an appropriate multiple and comparing this to current trading price for shares, or else by studying the value of the business for a private owner, which involves particular emphasis on the value of the assets (or the tangible book value of the shares).

For an earnings-based bargain, Graham adds some further criteria, such as:

he should require an indication of at least reasonable stability in earnings over the past decade or more — ie, no year of earnings deficit — plus sufficient size and financial strength to meet possible setbacks in the future

with the ideal being a large, prominent company selling below its past average price and P/E multiple.

Special situations encapsulate a range of investment activities, from liquidations (workouts), to hedging and merger arbitrage activities. While Graham sees this area as one offering special rewards to dedicated and knowledgeable investors, he advises that the trend is one towards increasing professionalization and thus even the enterprising investor is best to leave this area alone unless he has special confidence and competence in the area.

Of special emphasis is the idea of focus and dedication, that is to say, one is either an enterprising investor or a defensive one, but not some of both:

The aggressive investor must have a considerable knowledge of security values– enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement

When considering individual stock selections for the enterprising investors portfolio, Graham reminds the reader that

Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction

To the last point, it is fascinating to see in the footnote commentary by Jason Zweig how many of Graham’s various example companies used throughout the book disappeared not due to bankruptcy, but because they were at some point acquired and absorbed wholesale into the operations of another business.

Several categories of equity selection stand out as particularly valuable for the enterprising investor in Graham’s eyes:

  1. arbitrages – purchase of one security and simultaneous sale of one or more other securities into which it is to be exchanged under a plan of reorganization, merger or the like
  2. liquidations – purchase of shares which are to receive one or more cash payments in liquidation of the companies assets; should present a minimum of 20% annual return w/ 80% probability of working out or higher
  3. related hedges – purchase of convertible bonds or convertible preferred shares and simultaneous sale of the common stock into which they are exchangeable
  4. NCAV – 2/3 or less of net current asset value (current assets – TOTAL liabilities); portfolios should have wide diversification, often of 100 securities or more, and require patience
  5. contrarian cyclical investing – buying important cyclical enterprises when the current situation is unfavorable, near-term prospects are poor and the low price fully reflects the current pessimism

Graham also recommended a special set of 5 criteria for selecting “bargain” issues of small or less well-known enterprises, which can be generated from lists from a stock guide or a stock screen beginning with companies trading for a P/E multiple of 9 or less:

  1. financial condition – current ratio of 1.5:1 and debt <= 110% of working capital
  2. earnings stability – no deficit in the last five years
  3. dividend record – some current dividend
  4. earnings growth – last year’s earnings greater than 5 years ago
  5. price – less than 120% of TBV

Graham notes that diversity is key to safety in these operations and such companies should be bought on a “group basis”.

A balancing act: the portfolio

As a broad strategic principle, Graham recommended that defensive and enterprising investors alike seek to allocate a minimum of 25% and a maximum of 75% of their portfolio into stocks and the remaining amount into bonds. In most cases, an even 50-50 split is recommended. The rule of thumb used to guide allocations above or below 50% is that, as the investor determines the “general price level” of the market to be higher than is prudent, he should allocate toward 75% bonds and 25% stocks, whereas when he determines this price level to be much lower than is reasonable (say, in the midst of a bear market), he should allocate toward 75% stocks and 25% bonds.

As Graham says on page 197,

the chief advantage, perhaps, is that such a formula will give him something to do

Remember, you are your biggest risk. Graham was concerned that without “something to do”, an investor might “to do” his portfolio to death with over activity, over-thought or over-worry.

This is a useful insight, but is Graham’s portfolio balancing technique still valid in today’s era of higher inflation risks?

Without stepping on the maestro’s toes too much in saying this, my thinking is that it is increasingly less valid. As Graham himself warns throughout the book, bonds provide no protection against inflation and, while inflation is not “good” for stocks in real terms, the ability to participate in increased earnings is at least better than having a fixed coupon payment in an inflationary environment.

In this sense, an allocation toward 100% stocks makes more sense, assuming we are entering a period of protracted inflationary pressures such as we are.

That being said, Graham’s warning about having something to do is still worth considering. Having kicked the legs out from under the “rebalancing act(ivity)”, perhaps a good substitute would be a continual turning over of rocks in the search for new investment ideas for the enterprising investor. For the defensive investor, the best course of action may be to enjoy the benefits of doing something through dollar-cost averaging, that is, making a little bit of his total intended investment each month or quarter rather than all at once. Another idea might be to allocate 10 or 15% of his portfolio into a MMF or equivalent when he feels the market is rising beyond prudent levels. But the thing that has never sat right with me about Graham’s reallocation technique is that, while in principle it makes sense, in practice it comes down to base attempts at market-timing that always end up generating unsatisfactory results.

Better to focus on Graham’s other major portfolio strategy tenet, which is diversification. While poo-poohed at times on this blog, Graham is a supporter of diversification for defensive and enterprising investors alike, mostly because it can serve to shield them from their own ignorance or over-enthusiasm. More specifically, many of Graham’s favored techniques (such as special situations, net-nets and bargain securities), while bearing overall pleasing risk/reward balances, nevertheless never bring certainty of either one and for this reason he believes developing a diversified portfolio of such opportunities is the best way for an investor to protect themselves from permanently losing a large part of their capital on one idea.

Saving the best for last: Mr. Market and the Margin of Safety concept

Mr. Market-mania

Markets are made up of people, and people are emotionally volatile. As a result, financial markets are volatile as well. While the vast majority of the time prices tend to move slightly above and slightly below an established trend line, at other times they can swing wildly off course in either direction:

the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one third [ X * 1.5 * .66 = ~X] or more from their high point at various periods in the next five years

Graham also warns against what might be termed the Paradox Of Market Goodwill:

The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value–ie, the more this “value” will depend on the changing moods and measurements of the stock market

In Graham’s mind, the solution is to

concentrate on issues selling at a reasonably close approximation to their tangible-asset value– say, at not more than one-third above that figure [130% of TBV]

as a general principle of careful investing for the defensive investor. But there is more. Graham represents additional criteria based on the consideration of the firm’s earnings power, outlining what value-blogger Nate Tobik of Oddball Stocks likes to call the “two pillar” method:

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years

In terms of mastering an investor’s own psychology when facing the market, asset values reign supreme, however, because

the investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets. As long as the earnings power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high

By Graham’s reasoning, buying a stock close to book value puts him in the same position as an individual offered an opportunity to buy into a private business’s book. Because he has paid a fair, businessman’s price, he doesn’t have to worry about what someone else thinks of his ownership stake, only the operating performance and financial strength of his chosen enterprise.

From a psychological standpoint, it is the high ground and much sought after.

But what is this “master game” of which Graham speaks? It is nothing more than the most masterly metaphor of the entire investing world, Mr. Market.

The idea of Mr. Market is that of a manic depressive business partner who on any given day may offer to buy your stake in the joint business for far more than you think it’s worth, or to sell you his stake for far less than you think it’s worth. The key to taking advantage of Mr. Market is to avoid trying to guess and anticipate why his mood ever suits him, instead relying on your own judgment and thinking about the value of the underlying enterprise regardless of Mr. Market’s various mood swings.

It’s worth quoting Graham at length on this subject:

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement

Further:

the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source [such as his own study of the fundamentals]

[…]

price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies

In other words, once you have made your investment, the only value of further quotations is to be appraised of another opportunity to buy (if prices decline sharply from that point) or of an opportunity to sell at a profit (if prices rise sharply from that point).

The rest of the time, you can judge the soundness of your decision by studying whether the operating performance of the business plays out according to your expectations. If the underlying business performs as you anticipated over a long period of time, you only need wait for the market to recognize your good judgment. However, if the business steadily deteriorates in a surprising fashion, you may have a basis upon which to second-guess your original judgment. But a falling stock market price would not be the primary indicator in such a situation, nor would a rising one signal you have done well.

Margin of Safety, the central concept of investment

The intellectual principle of the margin of safety involves “inverting” a stock and thinking about it like a bond.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt

For example, if a business owes $X, but is valued at $3X, the business could shrink by 2/3rds before imperiling the position of the debt holders.

Similarly,

when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power

the common stock can be considered to enjoy a margin of safety as large as that of a good bond.

Broadly, margin of safety can be thought of as the consistent earnings power of the equity, wherein

the margin of safety lies in an expected earning power considerably above the going rate for bonds

A proxy measure here would be to look at the earnings rate, or earnings yield (earnings/price) and compare this to the going rate on a similar bond.

Another, more general way to think about Margin of Safety is that it is the difference between how much you pay for something versus the calculated intrinsic value you determine that thing to have. In this sense, the Margin of Safety is always price dependent and will be higher at lower prices and lower at higher prices, relatively speaking.

And the Margin of Safety works in tandem with the principle of diversification:

Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for a profit than for a loss– not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business

The emphasis is always on finding an adequate margin of safety in order to protect your principal because if you do that, the returns will tend to take care of themselves:

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Special note on market-timing

There isn’t much more to it than this:

if he places his emphasis on timing, in the sense of forecasting, [the investor] will end up as a speculator and with a speculator’s financial results

In case you’re wondering, that’s a bad thing in Graham’s mind because he is convinced that all but the most talented and luckiest speculators lose out in the end because they do not pay attention to safety of principal.

Post-Mortem: KVPHQ Capital Structure Arbitrage Trade ($KVPHQ, #CapArb)

A “valueprax” investment post-mortem explores the aftermath of a portfolio investment, successful or unsuccessful, with the intent of acknowledging the good, accepting the bad and attempting to find humor in the ugly. Success and failure alike carry valuable lessons; in support of the constant effort needed to avoid cognitive bias, the post-mortem is the table upon which all cards are laid and reality is fully embraced, rather than selectively avoided.

The Thesis

The thesis for this trade was elaborated upon in some detail in a series of posts over at CreditBubbleStocks.com. Essentially, KV Pharmaceuticals, the maker of an orphan drug called Makena which is used to treat pregnant women who have previously had complicated pregnancies, was the victim of a poor business model. They endeavored to charge $1,500/shot for a drug that could be easily replicated by pharmacists with generics for $10/shot. Physicians, the FDA and the government healthcare (Medicare/Medicaid) system all frowned on this behavior by the company by avoiding their products in favor of the generic alternative.

The result was a cash and earnings shortfall which left KV Pharmaceuticals with a challenged capital structure, summarized in an early post at CreditBubbleStocks.com:

There are two classes of common stock. The A class has a higher dividend but much smaller voting rights than the B class. The fully dilluted A+B share count is ~90 million, giving the company a $90 million market capitalization. Meanwhile, there are $225 million of senior secured notes due 2015 trading at 60 (market value $135mm) and $200 million of convertible notes due 2033 trading at 16 (market value $32mm). [In addition to various other obligations including payments owed to the previous owner of Makena.]

The nature of capital structure pricing and the legal force of competing claims within the capital structure dictate that discrepancies involving discounted debt and greater than de minimis common equity valuations can not be sustained over the long-run and the prices of these securities should eventually converge toward a common, non-contradictory narrative of the state of the business. Corporate debt trading at a significant discount to face value in the markets implies financial distress and a risk of insolvency, which further implies that common equity has no value, as the financial claims of debtholders are superior to those of preferred and common equity holders. Debt holders are due their principal at time of maturity, so if the bond market is saying they aren’t going to get all of their principal back it implies the equity holders have claims with zero economic value.

The Research & Analysis Process

Unlike an earlier cap-arb trade I did involving the securities of the now-bankrupt Energy Conversion Devices where I performed fairly extensive due diligence work on my own, in the case of KV Pharmaceuticals I simply grabbed the coattails of CBS and held on for dear life. “Research” involved following the postings on KV at the CBS website. “Analysis” involved considering what the posts were about and coming to terms with the argument for the cap-arb trade.

When I felt sufficiently comfortable with the thesis, I decided to place my bet.

The Execution

As with the previous cap-arb I did, the trade itself was theoretically simple but turned out to be technically complex. To set up the capital structure arbitrage the investor wants to buy the distressed bonds and synthesize a short on the equity. The belief here is that the equity is over-valued (assuming it’s worth zero) and the debt is under- or fairly-valued.

If the equity turns out to be worth something, the investor will lose on the equity short but gain on the debt long due to a full recovery. If the company is in fact insolvent and seeks bankruptcy protection with a zero equity value, the investor will gain on the equity short and could potentially lose on the debt long, though in practice it’s more common for the debt, already trading at distressed prices, to not lose a whole lot more in that situation.

I faced a couple challenges particular to this investment, the first being that the particular issue of debt I was looking for wasn’t widely available and took some time to come by. The second challenge was that the company was not that liquid and the options issuance (I wanted to synthesize a short by buying puts) available had wide bid-ask spreads and low volume and open interest.

This second aspect of the technical execution of the trade proved to be my folly.

The Experience & Lessons Learned

I didn’t double check this but I think I put the trade on originally back in May. I finally sold my puts (Sep 22 2012 2.50s) today. I still own the bonds, which are now trading at essentially a de minimis value, having lost approximately 90% of their value. Overall, the trade lasted about four months.

At the time I was placing the trade, I was traveling and not near a reliable internet/computer connection. That made researching securities and placing the trades incredibly challenging and stressful. In the future, I would not advise myself (nor anyone else) to attempt to place anything but the simplest of trades under such circumstances. It ended up resulting in me making a poorly informed decision (explained more below) and stressed me out during what was an otherwise enjoyable trip.

Another issue I faced is that I did not understand the technical details involved in pricing the option securities involved. I had trouble determining how many and which options I needed to buy to properly hedge my bond exposure and create the cap-arb. This is a limitation of my own understanding of option pricing theory which could have been remedied by intensive study of options reference materials which I decided I did not have time to engage in before or since I placed the trade. This is a behavioral issue– I admittedly did not understand the technical details of professionally executing this trade but assumed it would not be a big issue (probably, in my mind, relative to all the imaginary profits I’d be making when this thing went off with a bang).

The experience of being invested, itself, was fairly easy to endure in this case. KV’s business situation continued to deteriorate over the course of the trade. The company went through all the tell-tale signs of continuing, aggravated distress, including: falling share price, falling bond price (!), odd IR boilerplate related to trading activity, unfavorable announcements and news developments from regulators, etc., all the stuff you’d imagine would not be happening at all, especially not simultaneously, with a healthy company.

However, I again faced execution challenges when the company delisted its stock. I wasn’t sure if this was an appropriate time to “cover” and sell my puts, or if I should hold on, imagining they’d become even more valuable once the company delisted as I anticipated the stock price, already nothing more than a bloody stump, would be completely demolished following delisting.

In short, my lesson was that while I can follow the logic of a cap-arb thesis, I have real and continued shortcomings in terms of my knowledge of how to technically execute on the thesis which introduce significant risk into the equation. It is not the trade which was risky, it was me doing the trading.

That being said, I did come away with the sense that, while I am the right “scale” for opportunities like this (these inefficiencies exist because larger players won’t bother with them), without significant leverage, which may in fact be available through careful, expert use of options, these trades represent the opportunity to pick up pennies in front of a steamroller. If things go right and you’re not leveraged, you make a little money, but if you screw something up you can cost yourself even more.

The Outcome

In the end, the thesis was absolutely correct. KV Pharmaceuticals filed for bankruptcy protection in order to restructure their financial obligations. Their market cap fell from an initial ~$90M to the current ~$3.5M and the stock was delisted. Unfortunately, the debt I purchased also fell dramatically in value and right now it looks like the recovery on it will be pretty pathetic, if anything.

The trouble is, I didn’t technically execute well. I bought some in-the-money puts that were earlier dated (Sep 2012). I sat and watched my bonds get eviscerated even as it became clear there was no benefit in being hedged because the company was essentially a one-way trade (short) as they faced a going-concern issue. Meanwhile, the puts just didn’t perform because of what I paid for them– as they traded up a bit I didn’t receive much benefit because I bought at such a wide initial bid-ask spread. I probably could’ve more intelligently bought the puts so as to make a killing at this point in the game, but I didn’t know how to, that was beyond my expertise then and now.

Additionally, there were numerous points at which the puts were worth substantially more than what I ultimately paid for them (40-60% more at various points) but I never took advantage because I was greedy and assumed the share price would keep going down as everyone realized it was hopeless and the puts concurrently traded higher. Instead, volume dropped on the puts as people closed out their trades and the value of the options dwindled as they neared expiration (which is tomorrow). Fearing a total wipeout on the puts, I threw them into the market at market price this afternoon, happy to be rid of them and at a 20% profit.

Unfortunately, this was a fraction of what they had been worth at various points and was not enough to compensate for the loss in the bonds, such that even though the thesis played out as anticipated, I lost money on this trade.

I’ve learned my lesson now. I have one more cap-arb that’s ongoing and I’ll let it play out before selling. But I’ve realized I’m in over my head on this stuff and I don’t have the time and knowledge to get myself up to speed. I am my own worst enemy on this stuff, truly the biggest risk of permanent loss of capital lies within me.

With respect to that, I just won’t touch these kinds of trades anymore.

The Free Capital Blog Digest (@guy_thomas, #valueinvesting)

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012.  Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How important is analytical intelligence in investing?

  • Equity trading is not as reliant on raw mental strength (IQ, analytical ability) as fixed-income trading; instead, equity trading is more dependent upon mental characteristics such as:
    • Actively seeking information from dis-confirming sources
    • Adjusting for one’s biases
    • Accepting uncertainty for long periods
    • Deferring decisions for as long as possible
    • Calibrating your certainty to the weight of evidence
    • Responding unemotionally to new information
    • Indifference to group affiliation
  • The mental characteristics which are helpful in investing are not universal positives and may be useless or negative characteristics in other endeavors

Max, min and average payoffs

  • Most activities can be categorized as max payoff, min payoff or average payoff
  • Max payoff means the activity is “positive scoring”, your payoff is your highest or best result and failure carries no lasting consequences
  • Optimal traits for max payoff are:
    • high energy
    • irrational optimism
    • persistence
  • Examples of max payoff activities include:
    • selling
    • leadership
    • most sports
  • Min payoff means the activity is negative scoring, your payoff is your lowest result and even a single failure may have lasting consequences
  • Optimal traits for min payoff are:
    • meticulous care
    • good judgment
    • respecting your limitations
  • Examples of min payoff activities include:
    • flying a plane
    • driving a car
    • performing brain surgery
  • Average payoff activities combine elements of both max and min; investing is an average payoff activity, with particular emphasis on the min aspects
  • A lot of success in investing comes from simply avoiding mistakes (min payoff)

Discussion of diversification (posts 1, 2, 3 & 4)

  • Diamonds and flower bulbs
    • Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years
    • Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value
    • Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach
    • “Investing is a field where knowing your limitations is more important than stretching to surpass them”
  • How many shares should an investor hold? Some theory…
    • The optimal number of stocks to hold, N, is a function of…
      • quality of knowledge about return dispersions (decreasing)
      • $ size of portfolio (increasing)
      • volatility of shares (increasing)
      • capital gains tax rate (decreasing)
    • Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually
    • With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position
    • If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity
    • If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer
  • How many shares should an investor hold? Some practicalities
    • There is clearly a trade-off between the number of positions you have and your quality of knowledge
    • A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy
  • Concentrated investors often “come a cropper”
    • Many investors eventually disappoint because they have concentrated their bets on companies the world turns against
    • This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)
    • The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

Meeting management

  • Opportunity cost of time: is it better spent speaking to management or investigating other ideas?
  • Getting an edge: sometimes speaking with management helps to understand the picture in a way that gives you an edge
  • Buffett: if you need to talk to management, you shouldn’t own the stock
  • Don’t be schmoozed

Analytics versus heuristics; why I don’t use DCF models

  • Time is precious and DCF models take too long
  • A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close
  • Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it
  • Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off

Review – Nintendo Magic ($NTDOY, #videogames, #business)

Nintendo Magic: Winning the Videogame Wars (buy on Amazon.com)

by Osamu Inoue, published 2009, 2010 (translated from Japanese)

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer.

Two Nintendo legends no one seems to know about

The original Nintendo started out as a manufacturer of playing cards and other toys, games and trinkets near the end of the Shogunate era in Japan, but the modern company we know today which gave the world the Nintendo Entertainment System, the Game Boy, the Wii and characters like Mario & Luigi and Pokemon, was primarily shaped by four men: former president Hiroshi Yamauchi, lead designer Gunpei Yokoi, the firm’s first software designer Shigeru Miyamoto and the first “outside hire” executive and former software developer, Satoru Iwata.

A family member of the then privately-held Nintendo, Yamauchi took the presidency in 1949 when his grandfather passed away. He tried adding a number of different businesses (taxis, foodstuffs, copiers) to Nintendo in true conglomerate fashion, managing in one 12 year period to grow sales by a factor of 27 and operating profits by a factor of 37.

But his most influential mark on Nintendo’s business came with his fortuitous hiring of Gunpei Yokoi, an engineer, who would head up hardware development for Nintendo’s game division. It was this strategic decision to concentrate Nintendo’s efforts on game development that would lead to the modern purveyor of hardware and software known around the world today.

Hardware engineer Gunpei Yokoi is not a well-known name outside the world of hardcore Nintendo fandom, which is not altogether surprising because most Nintendo fans alive today were not users of some of his first toy gadgets such as the “Love Detector” and the “Game & Watch” handheld mini-game consoles. On the other hand, it’s a shock that the man’s reputation is not larger than it is because he essentially single-handedly created the company’s hardware development philosophy in the 1960s which has remained with it today and continues to influence Nintendo’s strategic vision within the video game industry.

That hardware philosophy was summed up by Nintendo’s first head of its hardware development section as “Lateral thinking with seasoned technology”. In concrete terms, it is the idea of using widely available, off-the-shelf technology that is unrelated to gaming in new and exciting ways of play, for example:

  • Yokoi’s “Love Detector” game, which used simple circuitry and electrical sensors to create an instrument that could supposedly detect romantic chemistry between two users when they held hands and held the machine
  • A blaster rifle toy that used common light-sensing equipment to deliver accuracy readings of the users target shots to the rifle, registering hits and points
  • More recently, the Nintendo “Wiimote” concept, which was simply the idea of repurposing the common household TV remote into a tool for play

Yokoi’s lasting impact on the hardware (and software) philosophy at Nintendo is best captured by current president Satoru Iwata who once said,

It’s not a matter of whether or not the tech is cutting egde, but whether or not people think it’s fun

Similarly, this focus on repurposing existing technology for fun rather than investing in brand new technology helps to explain why many of Nintendo’s systems have been knocked for their not-so-hardcore hardware (think non-HD Wii vs. HD-enabled Sony PS3 and Microsoft Xbox 360) but nonetheless became massive consumer hits– the focus was on fun, not flash.

The Wii particularly was the response to the failure of two systems which preceded it (Gamecube and N64), which were extremely technologically advanced for their era and which departed as swiftly from Yokoi’s philosophy as they posed monumental development challenges for software developers due to their complex, proprietary nature. Instead of creating yet another whizbang console, Nintendo decided that if Wii’s costs were kept down and developers were free to focus on things like a new, intuitive controller and built-in connectivity functions, fun and market success would follow.

Essentially, the game hardware is a commodity with zero barriers to entry. Anyone can have the latest, greatest technology if they’re willing to pay for it. There is no way to establish a competitive advantage on the basis for hardware sophistication alone. It must come from design, or, as Yokoi put it,

In videogames, these is always an easy way out if you don’t have any good ideas. That’s what the CPU competition and color competition are about

Nintendo’s two leading lights: Satoru Iwata and Shigeru Miyamoto

Rounding out the Fantastic Four are Satoru Iwata, the company’s current president, and Shigeru Miyamoto, the star software developer.

Iwata came from relative privilege and studied computer programming in school. He had a passion for making and playing games from an early age. He joined a software developer, HAL Laboratory, early on. He successfully turned around the flagging HAL Lab before it was acquired by Nintendo.

Meanwhile, Miyamoto first came to fame through development of his Donkey Kong arcade game, which introduced the characters Donkey Kong and Mario and which was originally based off of Popeye until the IP could not be acquired for licensing. As a small boy he spent hours running around the hills, forests and mountains outside his home, which inspired many of his later game creations such as Pikmin, Animal Crossing, The Legend of Zelda, etc. He was the first designer Nintendo had ever hired. Miyamoto often utilizes his “Wife-o-meter” to help him understand how to make games that are more broadly appealing.

Miyamoto’s design ethic is best synthesized as populist-perfectionist:

When creating a game, Miyamoto will occasionally find employees from, say, general affairs who aren’t gamers and put a controller in their hands, looking over their shoulder and watching them play without saying anything

He creates game characters, game designs and immersive environments that appeal to everyone, not just the archetypical “hardcore gamer.” But this desire to serve a mass, unsophisticated audience does not mean that Miyamoto considers quality as an afterthought. Miyamoto will “polish [an idea] for years, if he has to, until it satisfies him” and “shelving an idea does not mean throwing it away. Those huge storehouses are full of precious treasure that will someday see the light of day.”

This is part of the value of Nintendo– they have many unrealized ideas waiting to be turned into hardware and games and the only thing preventing them from seeing the light of day is someone like Miyamoto who wants to make sure that when they eventually emerge into the light, they don’t just shine but sparkle.

And this thinking carries over to the company’s hardware efforts, as well. According to a lead engineer, the DS

had to work consistently after being dropped ten times from a height of 1.5 meters, higher than an adult’s breast pocket

Nintendo is “obsessed about the durability of their systems due to an overriding fear that a customer who gets upset over a broken system might never give them another chance.”

“Nintendo-ness”: how Nintendo competes by not competing

In 1999, then-president Yamauchi saw a crisis brewing for video game developers:

If we continue to pursue this kind of large-scale software development, costs will pile up and it will no longer be a viable business. The true nature of the videogame business is developing new kinds of fun and constantly working to achieve perfection

The solution was to adhere ever more closely to “Nintendo-ness”. Nintendo picks people with a “software orientation.”

“Nintendo-ness” is the company’s DNA, once someone has grasped Nintendo-ness, it is rare for them to leave the company. That tendency protects and strengthens the company’s lineage and makes employees feel at home

Manufacturing companies create hardware which are daily necessities, which compete based on being better, cheaper products. Nintendo is in an industry of fun and games, software, where polished content is the goal. Compare this to rival Sony, where hardware specs are key and the software is to follow.

According to Iwata,

Do something different from the other guy is deeply engrained in our DNA

Similarly, Nintendo-ness means delighting customers through creation of new experiences because

if you’re always following a mission statement, your customers are going to get bored with you

This way of thinking goes back to Hiroshi Yamauchi, president of Nintendo for 50 years, according to Iwata:

He couldn’t stand making the same kind of toy the other guy was making, so whatever you showed him, you knew he was going to ask, ‘How is this different from what everybody else is doing?’

For some reason, Nintendo observers and critics don’t get this– why isn’t the company doing what everyone else is doing? Why are they making a console with a TV remote instead of HD graphics (the Wii)?

To Nintendo, the risk is in not trying these things and trying to do what everyone else does. Iwata sums it up nicely:

Creators only improve themselves by taking risks

Of course, not all risks are worth taking. Iwata as a representative of Nintendo’s strategic mind makes it clear that the company is keenly aware of its strategic and financial risks:

The things Nintendo does should be limited to the areas where we can display our greatest strengths. It’s because we’re good at throwing things away that we can fight these large battles using so few people. We can’t afford to diversify. We have overwhelmingly more ideas than we have people to implement them

For example, Nintendo considers the manufacturing of game consoles to be outside its purview, a “fabless” company.

Then there’s the reason for the huge amount of cash on the balance sheet:

The game platform business runs on momentum. When you fail, you can take serious damage. The risks are very high. And in that domain, Nintendo is making products that are totally unprecedented. Nobody can guarantee they won’t fail. One big failure and boom– you’re out two hundred, three hundred billion yen. In a business where a single flop can bankrupt you, you don’t want to be set up like that… To be completely honest, I don’t think that even now we have enough [savings]… That’s why IBM, or NEC, or any number of other companies are willing to go along with us. We’d never be able to do what we do without being cash-rich

That being said, Iwata has not been shy about his policy toward dividends and acquisitions. He has stated that assuming Nintendo’s savings continue to accumulate, passing 1.5T or 2T yen, a large merger or acquisition may become a possibility. Otherwise, excess capital will be distributed as dividends.

The next level

Nintendo’s philosophy is to avoid competition. It sees the hardware arms race as an irrelevant dead-end. The key is to create new ways to interact with game consoles and software that keeps game players on their toes and brings smiles to their faces. According to Iwata,

We’d like to avoid having players think they’ve gotten a game completely figured out

Thus, for Nintendo the next level logically is integration of  User-Generated Content into their software environments, which would have inexhaustible longevity. First they sought to increase the gaming population, now they’re looking at how to increase the game-creating population.

The company’s true enemy is boredom. Whatever surprise you create today becomes your enemy tomorrow.

In the end, Iwata says,

Our goal is always to make our customers glad. We’re a manufacturer of smiles

This is what the company calls “amusement fundamentalism” and it’s what sets them apart from their perceived competition, especially comparisons or criticisms aimed at the company in terms of how it stacks up against a company like Apple. To Iwata, this just doesn’t make sense:

We’re an amusement company and Apple’s a tech company