HedgeRoll

Is Chicago the next Detroit for municipal bond investors?

6/22/2015

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

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.

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

6/16/2015

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.

Long form Interview with ValueAct's Jeffrey Ubben

6/15/2015

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"

Who are the best biotech investors?

5/26/2015

I recently published a report over at Chimera Research Group titled 13F Analysis of Best Performing Healthcare Hedge Funds (Q1 2015).

As free preview to the Chimera article, below is a list of the best performing healthcare specialists, judged by replicating the holdings disclosed in their 13F filings. For details on how these portfolios were constructed, see the geek notes below.

As implied by the article title, I identify the best performing healthcare focused hedge funds from the list of 35+ 13F filers I track. From this list I created a "best ideas" portfolio by looking for stocks that multiple managers own. The intuition is this: if two biotech specialists with great track records, who are presumably competitors, are both in the same stock, its worth a look. The entire article, including stock picks, is available over at Chimera Research Group.

To be perfectly clear: These are the not returns of the funds listed, rather they are the returns of buying the stocks listed on the fund's 13F filing.

Portfolio Construction Notes:

All data pulled from 13F filings.
Top 20 holdings, equally weighted, long only.
Healthcare stocks only.
Portfolio rebalanced 46 days after quarter end, as filings are due 45 days after quarter end.
Backtesting all 35 healthcare hedge fund 13F by the criteria above, these are the best performing 13F portfolios over the past one, two, and three years. The data is from Whalewisdom.com.

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Motley Fool on American Express and Costco

4/1/2015

Motley Fool has an interesting conversation on American Express's split with Costco. In their view it's indicative of disciplined management from AXP.

As I previously discussed, American Express may be undervalued here.

Something for biotech investors to think about

3/23/2015

When it comes to #Biotech, this is something investors should be thinking about, from this book.

Biogen Idec exposure by ETF (BIIB)

3/19/2015

The market is buzzing about Biogen Idec ph1b BIIB-037 data for Alzheimer's disease tomorrow. The press release is coming out at 5:35 am EDT. BIIB represents a 9.72% holding for most common benchmark in biotech, the Nasdaq Biotechnology index, the ETF that tracks this index is IBB. Other ETF's with large exposure include BBH, and PBE.

The data are widely expected to be positive. Either way, it will move the sector. Best of luck.

Data above is from morningstar and etfdb.com

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The American Express Company (AXP) Valuation, Buffett Style

3/13/2015

A must read book for any value investor is The Warren Buffett Way by Robert Hagstrom. Now in it's 3rd edition, the book profiles Buffett, his process, and deconstructs his most well known investments. It provides a valuation framework and quantifies Buffett's famous Margin of Safety.

Unlike many of Buffett the books out there, this one is by and for investment practitioners. Robert Hagstrom is Chief Investment Strategist and Managing Director of Legg Mason Investment Counsel. The forward to the first, second, third editions are by Peter Lynch, Bill Miller, and Howard Marks, respectively. While it is not endorsed by Buffett himself , Hagstrom reports he was granted permission to quote extensively from Buffet's letters, after he had reviewed the book.

American Express is one of Buffett's best known investments, and it is well examined in the book. This is the first in a series wherein I'll review a valuation from the book, and then perform an updated valuation of the company with the same approach as the author.

AXP has under performed the market over the past year, among the reasons are the Costco deal, and the anti-trust case.

EDIT 3/16/15: Talking with some investors brought up other risks:

3rd place in network size (vs V/MC)leads to competitive disadvantages over time.
AXP could be a casualty of the disruption in the payment space, such as Applepay, ect.
We should be asking why does anyone still want an Amex card? Is it as prestigious as it used to be?

Are these problems actually a buying opportunity? Buffett recently opined on these issues on CNBC.

Buffett has actually gone several rounds with American Express, first with The Buffett partnership during the Salad Oil Scandal in the 1960's and then again with Berkshire in the 1990's when he infused AXP with capital via preferred shares during a cash crunch (sound familiar?).

Buffett converted his preferred to common in 1994, after AXP management sold off under performing divisions and began buying back shares. He bought more in 1995, owning almost 10% of AXP.

In The Warren Buffett Way, the Hagstrom uses a two-stage "dividend" discount model, however in lieu of dividends he substitutes "owners earnings" defined as:

	Owners Earnings Calculation
	Net Income
+	Depreciation, Depletion, and Amortization
-	Additional Working Capital
-	Capital Expenditures
=	Owners Earnings

In the 1990's American Express situation , it was approapriate to use net income, as non-cash charges roughly equal capex.

The author uses the following conservative assumptions:

10% owner earnings growth for 10 years, followed by 5% growth after. Management was guiding 12% to 15% net income growth at the time.
A 10% discount rate, at the time 30 year treasuries were yielding 8%

Based on these assumptions, he concludes that Buffett determined AXP had an intrinsic value of $43.4B while its market cap was only $13B. A whopping 70% margin of safety!

There are a host of qualitative factors to consider. The author goes into AXP's consistent operating history, and management rationality. You'll have to read the book if you want a discussion of those.

Of course, since 1994 AXP has performed very well.

To assess the current valuation we are going to carry forward the authors assumptions about owners earning's being equal to net income. Over the past few years, depreciation, depletion, and amortization has roughly equaled capital expenditures at AXP, so we are going to keep that simplifying assumption.

As for owners earning growth rate, AXP management is still targeting 12% to 15% long term growth, same as 1994. Now that is consistency!

We have been able to drive strong EPS growth within our 12% to 15% long-term target range. - Jeffrey Campbell, Chief Financial Officer- Q3 2014 earnings call, Oct. 16, 2014

To be conservative we are going to keep our model's growth of 10% for 10 years, and a terminal growth rate of 5% after 10 years.

As for discount rates, long term treasury rates are much lower today than 1994. However, I love building conservative assumptions into my models. This way, if your valuation work points to a screaming buy, you know its not because of your optimistic assumptions. For these reasons we are going to stick with a 10% discount rate.

One interesting take-away from the book is Buffett doesn't adjust his discount rate up or down to account for perceived risk. Rather, he demands a larger margin of safety. This is just another example of value iinvesting contradicting the approach taught in business school.

After re-running the two-stage "dividend" discount valuation model with 2014 earnings and the assumptions outlined above, the model concludes AXP is worth $179 a share. This figure is much higher than any sell side analyst price targets. This is an intrinsic value estimate, not a price target. It also implies a 56% margin of safety at the current market price of $79. Please note, this is the book's sheet, not mine. You can get a copy of the model from the books companion website.

It's worth noting a few take away's from this intrinsic value estimate:

The 56% margin of safety is less than the 1994 Buffett purchase margin of safety of 70%.
The assumptions in this model are arguably more conservative than the books 1994 calculation; the risk-free-rate is much lower today, but we used the same 10% discount rate.
To get a 70% margin of safety, AXP would have to trade at $53.
The current price per share of $79 implies a 3% growth rate in owner earnings for the next ten years, followed by 2% growth after ten years.
EDIT 3/16/15: bringing the discount rate down from 10% results in some very steep discounts to intrinsic value.

Is the Costco and anti-trust news important enough compress the earnings growth rate to 2% vs management's 12% to 15% target? That is the question investors should be asking themselves.

Tracking Biotech merger Arbitrage opportunities

3/5/2015

The biotech space is hot with merger activity right now. Last night, Pharmacyclics (PCYC) agreed to be acquired by Abbvie (ABBV), and a few days ago the Salix / Valeant (VRX) deal was announced. Merger arbitrage, or speculating on mergers & acquisition activity, can be a high risk game. However a lower risk variation of merger arbitrage has been practiced by Warren Buffett, and of course it fits nicely in the value investor's framework.

Note: if you just want the merger arb tracking sheet, scroll to the bottom. If you want to learn about how Buffett does it, read on.

Not much has been written about Buffett's approach to merger arbitrage. However, I have found two books:

Warren Buffett and the Art of Stock Arbitrage cites this study and a Forbes article that state Buffett has produced annualized returns of 80% to 90% on his merger arb investments, or "work outs" as he likes to call them.

Buffett practices long-only merger arbitrage, taking long positions in the company to be acquired. This contrasts with traditional merger arbitrage, in which one goes long the acquired and shorts the buyer. This approach hedges out market risk and some other factors. However some criticize it as twice the risk for half the return.

Here is Warren Buffett in his 1988 letter writing about arbitrage:

Below is a summary of the investment criteria in Warren Buffett and the Art of Stock Arbitrage and Trade Like Warren Buffett.

Must be a friendly deal, no large shareholders should oppose it. Buffett doesn't wager on hostile takeovers.
Must be a strategic deal rather than financial. Prefer deals by competitors rather than private equity.

How likely is deal to close? On average greater than 90% of all deals close. Important for risk adjusted returns calculation.
How long until the deal closes? This is critical to calculate the annualized return.

What are the chances the deal falls apart?

Due diligence risk. Check out the break-up fee to see how serious the parties are about the transaction.
Regulatory: do the two companies together now control a certain market. Check out the Herfindahl-Hirschman Index.
What are the chances of a higher bid? Good for long only merger arb, risky for traditional merger arb.
If the deal does fall apart, how low will it trade?

With these factors in mind, Warren Buffett and the Art of Stock Arbitrage describes a model that incorporates these factors. One of my pet peeves is investment calculations in paragraph form. So I built the model below for you, and loaded it with my best estimates for PCYC and SLXP.

The entire sheet doesn't fit into this web page well, so you may just want to look at it here. I should mention this model is only good for all cash deals. If there is interest, I may build one for a mix of cash and stocks. My take away at time of publication: there is some opportunity in PCYC, but not much in SLXP.

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