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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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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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biotech as buffett's wonderful business

4/28/2014

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Most people would say Warren Buffett, the famously tech-adverse investor who seeks "Wonderful Businesses", would never touch the biotechnology sector. However I believe this is simply a function of his circle of competence principal. Simply, if he doesn't fully understand a business, he won't allocate it his capital.

Do some investor's circle of competence include biotech? Of course, but does the biotech sector contain "Wonderful Businesses"? Let's find out.

Time is the friend of the wonderful business, the enemy of the mediocre.
-Warren Buffett, 1989 Chairman's Letter

So what is a Wonderful Business? Investopedia has a nicesummary of Buffett's wonderful business criteria:

Buffett's criteria for "wonderful businesses" include, among others, the following:

They have a good return on capital without a lot of debt.
They are understandable.
They see their profits in cash flow.
They have strong franchises and, therefore, freedom to price.
They don't take a genius to run.
Their earnings are predictable.
The management is owner-oriented.

For the purposes of this post, I am going to focus on the factors we can easily quantify, specifically items one and three. Return On Invested Capital, item one, is certainly the most important. It's also worth noting that this criteria works.

"Leaving the question of price aside, the best business to own is one that over an
extended period can employ large amounts of incremental capital at very high rates
of return. The worst business to own is one that must, or will, do the opposite - that
is, consistently employ ever-greater amounts of capital at very low rates of return."
-Warren Buffett, 1992 Chairman's Letter

There are many "cheap" companies, but not many that earn high returns on capital. Let's look at Berkshire Hathaway's publicly traded holdings to see what Buffett considers an acceptable ROIC.

For those who completely dismiss The Oracle's interest in biotech, I will point to Berkshire Hathaway's quarterly 13F filing. As of December 31, 2013 Bershire owned shares in Sanofi Aventis and Johnson & Johnson. Although these are "pharma" and not "biotech", the truth is that the distinction between the two sectors has been getting blurrier every year. Biotech is simply next-generation pharma. Case in point, J&J is the world's fifth largest biologics company, and Sanofi's Tuberculin for diagnosis of tuberculosis is a Purified Protein Derivative.

Let's check out the ROIC's of Berkshire Hathaway's healthcare companies. (Yes, I know DaVita is not Buffett's position, but rather Ted Weschler's) Also, they recently sold out of GSK, but it's worth noting for our purposes.

So we've established that Berkshire Hathaway, and by extension Buffett, has invested (to a limited extent) in companies that sell biotechnology products. But what about the criteria outlined above? What about a pure play biotech company?

Gilead Sciences is the second largest component of the NASDAQ Biotechnology Index at 8.4%. This maker of Hepatitis and HIV antiviral drugs was founded in 1987 and then went public in January 1992.

Gilead has followed the path of many growing companies, operating at a loss for the first several years before finding success. It wasn't until the second quarter of 2002 that Gilead earned a profit, and since then it has earned an excellent average ROIC of 26.9% over the past five years, nearly as much as Buffett's fourth largest holding IBM.

Below I've shown regular ROIC, and Cash Return on Capital Invested, to smooth out some accounting charges that do not impact cash.

What about criteria number three, profits as cash flow? Turns out Gilead is pretty good there too, with the same exceptions of some accounting write downs, Earnings and Cash Flow from Operations have tracked each other very closely.

So we've established that biotechnology can, quantitatively, meet the definition of a "Wonderful Business".

Interesting side notes:

Michael L Riordan, Gilead Founder attempted to recruit Warren Buffett as a board member in 1988. Buffett quipped "Sorry, but I would bring nothing to this enterprise except my name".

To further illustrate the blurring lines between pharma and biotech, Gilead's antivirals are small molecule drugs, which are typically associated with pharmaceutical companies.

Since Gilead started earning a profit in 2002, the stock has gone up. See below. Like I said earlier, this stuff works.

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
-Warren Buffett, 1989 Chairman's Letter

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All data from ycharts.com

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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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

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

biotech as buffett's wonderful business

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