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Joel Greenblatt's special situations class at Columbia Business School featuring Rob Goldstein, partner at Gotham Capital on Moody's

6/28/2015

Joel Greenblatt literally wrote the book on special situation investing, so it's fitting that he teaches the Value & Special Situation Investment class at Columbia Business School.

This particular lecture is interesting because it encompasses a wide spectrum of the value framework; a special situation (spin-off) and a wonderful business (Moody's). It is also caught my attention because it features Rob Goldstein, partner at Gotham Capital. Before this lecture I was familiar with just one-half of Gotham's high performing investment partnership.

Goldstein does a case study of Moody's (MCO), which went public via spin off from Dunn & Bradstreet (DNB) in September 2000. The challenge is paying up for quality. To find a comp., the Gotham team used Buffett's 1988 Coke (KO) investment as an example of paying a premium for quality.

I have a fond opinion of Moody's as when I was a credit analyst, Moody's was was the more conservative of the rating agencies, and I used the "Moody's medians" as the benchmark for much of my coverage ratios.

The second half of this 2 hour+ video is Greenblatt lecturing on "The Little Book" to his CSB class. That will be the second of two posts from this video.

As usual, if you don't want to watch an hour of video, my notes are below. All the charts I've included go to the time of the lecture November 2006, for proper perspective.

My Notes:

Gotham came across Moody's in 2000 when spun off.
It is one of the greatest business they've ever seen, but its not cheap.
Moody's was spun off at 21x forward earnings, 24x trailing earnings. They typically bought at 10x earnings at that point.

Coke as a comp:

Q: Why compare Moody's to Coke? A: One of the best franchises ever, Buffett bought at a high price but it continued grow and was cheap in retrospect. It's a high hurdle.
Buffett bought Coke (KO) at 13x forward earnings, 15x trailing earnings. Turned $600m in $7B in 12 years, about 23% annually. Reasons include price increases, buy backs, dividends, P/E expansion.
Q:What was so great about coke? A: High ROIC, great brand name, safety of franchise, easy to understand, predictable business.
Three important things about Coke: organic growth, high ROE, lasting competitive advantage.

Moody's:

Moody's: founded in the 1900's, originally charged investors for bond ratings, but ratings became so important, that debt issuers began paying for the ratings (1970s). Pay for rating or face higher borrowing costs.
Moody's and S&P each have 40% market share, and most issuers pay both.
Over past 19 years before 2000 spin off, Moody's revenues grew at 15%, operating profits grew at 17%. Revenue grew almost every year (with one exception).
Can we extrapolate this forward? What is the BTE? Goldstein believes that there is no chance of a 3rd major player.
Student brings up Fitch. Goldstein says they are a niche player. They are a big part of the other 20%. No one likes two dominant players but there is nothing they can do about it. Various solution suggested. There is not a practical solution to problem. Also one would be messing with the balanced workings with financial markets.
Revenue model: Fee on issuance, fee to maintain rating. but fee's are very low relative to face value of debt. Emory's note: This is like the path critical, low cost relative to value, ideal business as mentioned by Jeffrey Ubben of ValueAct.
Concluded Moody's is a great business.
Moody's did very well over time due to the rise of bond issuance globally, securitization.
Moody's was spun-off from Dun and Bradstreet. Pre-spinoff D&B traded at $27.75, post spinoff D&B component was worth $7.50 a share, implied Moody's price was $20.25. Moody's expected to earn $0.95 a share, this is roughly 21x earnings.

ROE's and Growth Rates:

Growth Rate (GR)/Reinvestment Rate (RR)= Return on Equity (ROE). For Coke this works out to 12%/20%=60%
For Moody's: What growth rate can we assume? Make assumptions about volume and price.
We can expect volume to grow, based on Asia demand, ect. They settled on 12% operating earnings growth rate, based on historical performance, and they don't see the drivers changing. This also matches Coke, for an easy comp.
What is the return on capital? Since Moody's gets paid on time or in advance of delivering service, and there is no physical good to deliver, the return on capital is higher than Coke. In fact, it is infinite (denominator is zero), due to the pre-paid nature. Very few businesses can claim to have infinite ROC.
Coke needed to spend 20% of its earnings on reinvestments, while Moody's needed to reinvest none of it. Coke produces $0.80 on revenue, Moody's produces $1.00.
Question: Does that mean Moody's is worth 25% more than Coke (all things being equal)? Answer, yes, at this time, but as growth rates decline the story changes.
For Coke: Rearrange GR/RIR=ROE to GR/ROE=RIR if growth declines to 5% --> 5%/60%=8.3% Reinvestment Rate has declined from 20% to 8.3% as a result of lower growth.
So to split the difference they decided Moody's was 15% better than Coke (not 25%). This is a more conservative assumption.
Coke's P/E when Buffett bought it was 13x. If Moody's is 15% better that is a P/E of 15x (13*1.15=14.95)
They were very comfortable with management. Management were good, and didn't think they were going to screw it up. Buffett owned it, management spoke with him.
Management compensation was in line, and they said they would return all excess capital through buy backs.
So to re-cap: Moody's vs Coke: Same growth rate, better ROE, comparable competitive advantage
What if Buffett paid 18x earnings? He would have still made 20% annually. This is roughly 40% more (18/13=1.385). Goldstein concluded Buffett could have paid a 40% premium and still done great.
How to justify 21x earnings for Moody's? Buffett's Coke P/E, factor in 15% premium for ROE, and 40% premium to target that reduced 20% compounded annual return rather than 23%. (13*1.15*1.4=20.93)

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A note on interest rates: They declined from 9% to 6% from Buffetts Coke 1998 purchase to the Moody's 2000 spin-off. A bond would have gone up 42% over this time, which matches that 40% premium we factored in before.

Buffett made 185% in the first 3 years after Coke purchase, afterword made 18% annually
In the first year after spin off Moody's was up 50%. Gotham sold too early, but it was 30x earnings. Holding on looks easy after the fact.
In 2001, profits were up 40%, and the next few years were up 25%. Drove shares higher.
Greenblatt: We did learn something from selling too early. When we have one of the top five businesses of all time, we need to think three or four more times before we sell, after you've bought it well.

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Is Chicago the next Detroit for municipal bond investors?

6/22/2015

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My career in asset management started with Federated Investors' municipal bond group. As an analyst, I reported to the Sr. Analysts and Portfolio Managers. The talented team at Federated has a deep expertise in municipal credit.

Therefore, Lee Cunningham is the best person I know to answer the question "Is Chicago the next Detroit?" As Sr. Portfolio Manager, he runs Michigan focused and High Yield municipal bond funds for Federated Investors.

If you want to learn more about muni bonds, I recommend this book (link).

Also, if you are on twitter, I recommend followingCate Long (@cate_long) for all muni bond news.

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Seth Klarman's presentation to Bruce Greenwald's Columbia Business School class

6/18/2015

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I hope you enjoy Klarman's presentation as much as I did. It's is a bit long but worth the time.

Like Greenwald says in the beginning, the founder of Baupost Group needs no introduction. Klarman's remarks begin around the five minute mark. If you aren't familiar, he also wrote this book (link).

As usual, my notes are below. You may find Baupost Group 13F here, but it represents only a fraction of total firm AUM.

My Notes:

Baupost Group started with $27 million, three families as clients in the summer of 1982, met them at HBS.
Came to value investing while working for Michael Price before business school.
Believes people are naturally risk adverse, Greenwald said in the intro he is among the most risk adverse investors.
The invest business has a herding behavior. The benefit of swinging for the fences does not outweigh the risk of under performance.
He believes in absolute performance, not relative performance. He wants to make absolute dollars. Note from Emory: You can't spend your Sharpe Ratio.
He believes it is impossible to be successful in a Top Down approach to investing.
Focus on Risk before Return. Risk is not price volatility, not beta, not VaR. Most people focus on return.
It is hard to measure risk. It's easy to measure return.
He doesn't really short stocks too much, does not seek to be market neutral.
His team hunts for opportunity. Two things are scarce: Capital and Time. Focus capital in the best values, and reduce time spent on bad opportunities.
Mispricings caused by: Emotion, fear, surprise, complexity, stigma. For example a major bankruptcy, or disaster.
Example for bonds: bankruptcy, rating downgrade can result in non-economic sellers.
Example for equities: removed from index, spin offs can result in non-economic sellers.
Psychology is really important. Investing is the intersection of economics and psychology.
You must be emotionally conditioned to be a good investor. People are relative performance oriented.
"Relative Performance Gun to Your Head" - you will do the wrong thing every time.
"We like to pretend we are Warren Buffet."
"The only way to do well in the long term is to ignore the short term."
"We don't time the market by holding cash, we time opportunity by holding cash."

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Today's opportunity set will soon be gone and tomorrow, the next day there will be new ones.
Uses no leverage, with the exception of non-recourse debt in real estate investments.
We put 100% of employees net worth in the fund.
Part of his edge are great clients. Wealthy individuals and US Endowments/Foundations, not sovereign wealth.
Sometimes you lose money on a mark-to-market basis to make money by buying a lower price.
A very flexible mandate is part of his edge. His portfolio has gone from equities and distressed debt to many different asset classes.
Doesn't silo capital, we may allocate all money into the best opportunity/asset class.
At the time of this presentation (2010) one could buy a building at 1/3 to 1/2 the value of a REIT.
Firm structure and culture is part of his edge.
Relationships with people who source investments are part of his edge.
Flow of an investment idea within Baupost: Broker calls trader, who forwards it to the head of the group, hands it to analyst, analyst delivers research back to head of group, who hands it to Klarman for approval.
Build broker relationships when times are good, so that they come to you in times of market stress.
Example of real estate investment: Troubled properties, rents falling below debt coverage levels, debt is coming due and can't be rolled, tenants moving out, tried to convert apartments to condo's and failed.
Just as stock can be over or under valued, so can a building.
Our reputation helps us get real estate deals. If we say we are going to do it, we do it.
We try stay out of the press, as a risk management tool.
He sees that much of the excesses of pre-credit crisis are back with different structures.
Mutual fund managers: "Monkeys with money looking to put it to work in the least objectional way"
Need to aware of outcomes that we've never seen before.
At time of presentation he had 8% in equities, 12% Real Estate, 5% in private deals, 30% in cash.

Q&A:

On catalysts:He doesn't need a catalyst to unlock value but he likes catalysts.
He likes to get out before fully valued: 85% to 90% on the dollar.
Catalyst help investor psychology. You can wait for the catalyst.
Equity doesn't naturally have a catalyst like debt does, maturity, debt covenants, ect.
If he wrote a new book: he would write about the new asset classes he is involved with, not just stocks and bonds.
He believe value investing applies to all asset classes even venture capital.
How do invest as an individual or small fund manager: Narrow your focus, specialize, go smaller (microcap), look non-US.
On inflation: Invest bottom up, worry top down. You can't trust TIPS. Bought way out of money interest rate Puts. Have lost money so far.
How to approach a new investment opportunity: Impossible to value a company precisely. Look at many metrics, should be cheap on many metrics that are applicable to that business.
However one valuation approach they focus on is DCF, but they don't get fancy with the discount rate. They run sensitivity/scenario analysis.
The work they do is not hard, but the discipline and patience is hard.
Advice on clients to someone starting a firm: Go to people you know, our fee's are below average. If your client is a bad person, you going to have trouble.
How to do the right thing: WSJ cover test, Football field test (don't run near sidelines, might go out of bounds)
How do you think about discounts: if the discount never closes you don't make money, we don't have a discount level we target, we like to think about potential returns.
Attributes of a good investment process: Teamwork, putting team ahead of you, playing for results not statistics. Do the best you can possibly do, and the results will be good.
During the crisis: We were buying every single day, and the office was calm. That was the outcome of our process.

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Ethan Berg worked for Michael Porter. This is how he analyzes Economic Moats with the Five Forces.

6/16/2015

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Ethan Berg is a management consultant turned investment partnership manager. He worked for six years at Michael Porter's Monitor Group. Of course, Porter is best known for his Five Forces analysis. As a management consultant Berg brings a unique perspective, a certainly a different methodology to value investing.

If you've ever worked with a management consultant, you know they have buzzwords and terminology that can be foreign to an investment manager. This interview is no different. "Assets and Activities", and "Activity Webs" are discussed at length. However, don't be deterred by this seeming foreign language, these are simply tools to gain a deeper understanding of Economic Moats. Listen below, and check out my notes further down the page.

This interview comes to us from the must-listen Value Investing Podcast by John Mihaljevic, CFA, author of The Manual of Ideas. More about Berg from The Manual of Ideas:

Ethan Berg is the founder and chief investment officer of G4 Partnership, an investment partnership dedicated to the implementation of the investment discipline of Ben Graham, Warren Buffett and Seth Klarman. Prior to founding G4 Partnership in 2000, Ethan was a management consultant at Monitor Group for six years, including two years of working directly for Michael Porter.

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My Notes:

Moats are "assets and activities" that give an edge.

Management consultants dive deeper than typical investors, it is a function of time. While investors must look at several companies a day from the outside, consultants spend months inside one company.
Porter has published several books but also many unpublished manuscripts.
Porter's firm used many different analysis, but best known is Five Forces. Also used nationwide analysis. Berg developed Advantage Curves analysis.

They dove deep into customers relationship with companies and brands.
Southwest Airlines (LUV) competitive advantage was based around one type of airplane. Bought airtran and eroded their competitive advantage. No longer one airplane type. Comprising Moats to grow is a difficult trade-off.
For reference, here is a chart of Southwest's ROIC over time, the Airtran deal closed May of 2011.

Activity system defined: Key activities that provide lower cost structure
Berg likes to read founder biographies, it gives him a sense of company culture.
As a management consultant, he cold called people at a companies. Asking questions was very valuable, investors don't typically do this, spend more time with IR.
What is strategy: Where and how do we compete? On what attributes do we win?
Steinway Piano: 90% market share of professional pianists for over 100 years. Pianist talk about the "Voice" of a Steinway piano.
Pianist have a emotional connection to the brand. The customer experience is built around supporting pianists in extraordinary ways.
They have a single source of wood that is a competitive advantage.

Note from Emory: I was recently a jazz show. Yamaha was the piano sponsor. Not to be outdone, Steinway provided the chairs.
No pianos are given away. Even official Steinway pianists pay for their piano.
Steinway sold to PE firm in 2013. Berg cautions the existing factory, facilities, and people are the competitive advantage. If these were changed, all that remains is the brand.
Compare Operation effectiveness vs competitive/strategic advantage:
Operational effectiveness: tweaking existing operations for small gains. Strategic Advantage is doing something different than competitors. Steinway operates very different than other piano manufacturers.
Google (GOOG): He generally doesn't invest in technology companies. Noticed Google because trading at 10x FCF. Had 70% market share in search. "Free options" on Android, G+, Google Wallet. These are all deepening the moat.

At the time, Google was the preferred employer for talent. Microsoft was a second tier.
Porter's Five Forces, can be helpful to managers inside of the company. "Activity systems" or "Activity Webs" are more useful for investors assessing strategy.
Assessing competitive advantage internally can be very uncomfortable for companies.
Can you price above competition? If not do you really have a competitive advantage?
Merrimack Pharmaceuticals (MACK): Can pay below industry salaries because so attractive to top tier talent.
Merrimack has a unique culture and operation structure that makes it very attractive . They do things differently. Cross functional teams organized by product, not by function.
Like local business journal, as they provide anecdotal information about the companies.
Read the HBS case studies if there is one on your company.
Make a hypothesis about the company. Ten things. Then check your hypothesis against feedback from those familiar with the company such as employees, competitors, suppliers, customers, and management consultants.
It all begins with the customer. AT&T was focused what they can do, not what the customer wants. They is a function of its long time monopoly status. Investors often thing of what a company does, has, market share. However investors should focus on what customers want.
The ideal company can deliver what the customers want and a strategically advantaged way.
Costco (COST) may deliver what customers want in a less expensive and fundamentally different way.
Five Forces is very applicable to assessing long term strategic advantage. What are the threat of new entrants? Will new technologies disrupt my long term competition advantages? For example he believes genetic testing does not have a long term competitive advantage.
What sets of analyses are most applicable from Monitor management consulting to Investing? Who are the customers, what do they value, and how does the company deliver that value? Easier to do in pure play companies than conglomerates.
Biggest mistake investors make when it comes to competitive advantage? The low bar they set for competitive advantage. Its not just taking market share or having a high ROE.

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Long form Interview with ValueAct's Jeffrey Ubben

6/15/2015

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The common perception of activist investing is personified by Carl Icahn. Activists are known for using PR campaigns to exert pressure and affect change at target companies.

However Jeffrey Ubben of ValueAct is among the world most successful activist investors, and rarely goes public. In fact, he says public campaigns are less effective in unlocking value than his collaborative approach.

Ubben recently made waves in pharma/biotech when he sold part of his long time Valeant ($VRX) stake.
Enjoy the 25 minute interview below, in two parts. It is courtesy of the amazing OpalesqueTV YouTube channel.

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My Notes:

On concentration: according ValueAct's most recent 13F their portfolio has 15 holdings with 89% in the top 10
Approach in summary: buy undervalued companies at a discount in public markets, get board seat/control, affect change and improve operations from the inside, sell to private equity at a premium.
Other activists seek a short term exit, and it's often too soon. They are outsiders, and there is an informational disadvantage vs inside, collaborative approach.
No-media approach is a competitive advantage vs typical activists.
"We spend a year before we are fully invested". After 3 months of research they might buy some shares.
Typical company: Has recent under-performance, has concentrated industry structure with a dominant player so the customers don't want them to go away.
Won't buy 10% of a company without engaging management, if management is not interested in suggestions they back off.
Activist becoming directors solves much of the agent/principal problem.
Suggests Enron/Worldcom/ accounting scandals has been caused by boards that were asleep at the wheel and insulated by the board structure and poison pills.
Having liquidity at the hedge fund level creates short term pressures, and short term activist investors. So having the right investors in your fund is critical.
Many of their companies have core business, which in the past grew at high rate with large margins, however profits were re-invested poorly. "Turn off loss makers". Get back to core competencies. Become a pure play. Use cash from divestitures to buy back stock.
They like companies where product is a small part of customers cost structure but it is a critical path, so pricing is on value not cost.
Industries they are interested in: technology, software, healthcare, business services and information services only.
First move is usually sell off assets, it usually requires management change.
"There are 5000 stocks and we only need 3 or 4 new ideas a year"

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hedgeroll

Joel Greenblatt's special situations class at Columbia Business School featuring Rob Goldstein, partner at Gotham Capital on Moody's

Is Chicago the next Detroit for municipal bond investors?

Seth Klarman's presentation to Bruce Greenwald's Columbia Business School class

Ethan Berg worked for Michael Porter. This is how he analyzes Economic Moats with the Five Forces.

Long form Interview with ValueAct's Jeffrey Ubben

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hedgeroll

Joel Greenblatt's special situations class at Columbia Business School featuring Rob Goldstein, partner at Gotham Capital on Moody's

Is Chicago the next Detroit for municipal bond investors?

Seth Klarman's presentation to Bruce Greenwald's Columbia Business School class

Ethan Berg worked for Michael Porter. This is how he analyzes ﻿Economic Moats with the Five Forces.

Long form Interview with ValueAct's Jeffrey Ubben

Categories

Archives

Ethan Berg worked for Michael Porter. This is how he analyzes Economic Moats with the Five Forces.