Energy Recovery – $ERII – Insider Buying and The Fear of Missing Out

Energy Recovery

ERII_YFinance

Energy Recovery (ERII) was incorporated 1992 and went public in 2008. The company produces energy saving solutions for desalination plants. Over the past few years it has been developing a number of products to address the needs of other fluid intensive industrial processes, mainly related to the oil and gas.

Legacy Business

The companies legacy business and initial reason for existence, was to provide energy saving devices for desalination plants. My admittedly simplistic understanding of the companies products is that they allow for the conservation of pressure that would otherwise be wasted as pressurized waste water flows out of plant.

Here is a nice video explaining the product better than I can: https://www.youtube.com/watch?v=Y4Yk2Srs4XM

The company went public at an unfortunate time. As the global financial crisis caused its customers to cut capex, ERII’s operating leverage worked against them and the company floundered. In 2011, ERII got a new CEO and was able to recover its revenue and operating margins within a few years. Today it claims 90% to service 90% of the desalination market for its products.

Though it has managed a strong comeback from the dark-days of 2011, the desalination business only generates $50 million in annual revenue and little to no profitability.

ERII_Opps_13-11ERII_Opps_11_09

Product Portfolio

The vast majority of ERII’s value is related to several product initiatives that the company is pursuing. All of these products involve applying its pump and conversion technologies to some stage of the oil and gas industry.

ERII’s most promoted product is called VorTeq. It was developed for the hydraulic fracturing industry (AKA fracking). Fracking involves blasting sand and various chemicals into rock formations underground in order to liberate fuel. The the problem for fracking companies is that the materials used to blast apart the rocks also cause a lot of wear and tare on the pumping infrastructure. As a result, fracking operations have many expensive pumps on site so that when and if one goes down, the company doesn’t have to stop work entirely.

ERII wanted to use their fluid engineering expertise to create a solution to this problem and that is the VorTeq. As you can see from the diagrams below, the company’s vision is for the VorTeq to replace the “missile” as a go between for the pumps, water and the blender. The ideal result being that by using the VorTeq, fracking companies will save money by employing fewer pumps, less water, and less money/time fixing damaged pumps.

The company has produced a working prototype of the VorTeq and in a partnership with Liberty Oilfield Services, they plan to test it in the field over the next 6 -12 months. If the product is fit for commercialization, the company expects to lease the VorTeq for $1.5 million annually and thinks there is a $1.3 billion total addressable market for the product.

FrackingWIthoutVorteqFrackingWithVorTeq

The second major product in ERII’s portfolio is the IsoBoost System. The IsoBoost System is designed to be placed into gas processing facilities. Gas processing facilities typically use three or more pumps to pressurize the fluid used to breakdown unpurified gas. ERII’s value proposition is that by using the IsoBoost system, gas processors could remove two of the three pumps. This would save, one, money from having to purchase and maintain the pumps and two, the energy recovered by running the depressurized fluid through the IsoBoost.

What the company failed to anticipate before marketing the IsoBoost is that plant managers are really more focused on downtime risk than energy savings. I.E. the risk that losing pumping capacity will shut down their entire plant. ERII estimates that it costs the “average” plant about $2.5 million per day to be shutdown. So even though the IsoBoost system may have been equal in redundancy to the standard three pump system, and save energy, plant managers were very hesitant to sign up because it is a career risk if the you buy the IsoBoost and it causes a shutdown but only a kind of accepted operational risk if all three of your pumps break. As Keynes said, “It is safer to fail conventionally then to succeed unconventionally.”

This may not be an insurmountable obstacle. A large customer recently informed ERII that they’d crunched the numbers, and that the IsoBoost system is actually more redundant than the current industry standard three pump system, and moreover that this can be proven statistically. To that end, ERII has hired a third party to analyze the data and plan to present their findings at the Turbocharge conference in mid 2015. If the companies can convince plant managers that their product actually increases uptime, and saves money, it should dramatically increase sales of the IsoBoost system. ERII estimates the total addressable market of this product is about $1.5 billion, which includes gas processing and the ammonia market.

ERII_ISOBOOST

The final major product in the companies pipeline – no pun intended – is the IsoGen. The IsoGen was created to harvest energy from oil and gas pipelines. Basically, when oil or gas goes downhill it can build more speed / pressure than is safe for the pipes or plants receiving it. What the pipeline companies do is create choke valves to slow the flow of fluid through the pipes. The energy lost from slowing down a massive amount of fluid is essentially wasted money. The IsoGen generates electricity by taking the energy in the fluid and converting it into usable electrical power. The company puts the TAM of this product at around $1 billion.

Iso_GEN

The Pros – Track Record – Balance Sheet – Insider Buying

It is great to see that ERII has a track record of delivering at least tangentially similar devices to real industrial customers in the desalination market. Recent contracts for the IsoBoost by Conoco Philips and a purchase of the IsoGen by Aramco show that big players take the company seriously enough to do business with them.

ERII’s balance sheet is reasonably intact as well. With ~ $34 million in cash on the balance sheet and zero long-term debt, the company is not in any immediate danger of going bankrupt.

Recent insider buying, and share repurchases is among the most compelling things about ERII. Over the last year former board member Peter Lorentzen has doubled his indirect stake in the company from ~6% to ~12%. Board member Mao Robert Yu Ling also purchased ~$250,000 worth of stock in the open market last year. Perhaps more importantly, the CEO, Thomas S. Rooney is also getting in on the action. In 2014 he requested that the board pay his bonus in stock options in lieu of cash. ERII awarded him options for 440,000 shares a strike price of $4.96 per share. The company itself has also purchased shares. Since 2012 the shares outstanding have declined from 52.6 million to 51.8 million as of the last 10Q.

The Cons:

With only $35 million of cash on the books and little to no operating profit to speak of, it is possible that ERII will have to raise additional capital in the event that their products do become successful. Of course the terms of this capital raise may be much more or less advantageous then they are today but it is a risk.

The markets for these products may be much more competitive than the desalination space the company has previously operated in. Although the 90% market share the company purports to command suggests a less than commodity market place. The lack of profitability in the market they already dominate should be of concern to investors.

Valuation – No One Knows Anything

The company trades at market cap of roughly ~$250 million and has no debt. I would think that the desalination segment could be sold for 1x sales. So essentially, you are paying $200 million for the product portfolio – maybe $180 million if you want to count some of their cash towards an enterprise value.

To value ERII’s product portfolio with you have to make reasonable guesses about the following:

  1. The true size of the product(s) potential market – both recurring and one time
  2. The amount of market-share that the company’s product(s) will capture
  3. The amount of additional capital required to address the acquirable market share
  4. The profitability of the product or products that achieve any market share
  5. The timing of any achieved profitability

It is very tempting to take managements estimates of a ~$5 billion addressable market and the historical gross margins of the desalination products to create a scenario analysis for the product portfolio’s value. In fact I did just that, but even before I did, I knew it was a joke. As someone once said, “More fiction has been written on Microsoft Excel than Word.” Here’s some of my recent work:

ERII_Scenario_v3

Keeping investing simple is usually a good thing. If you pay $50 million for this product portfolio, you are likely getting a good deal. At $100 million it’s harder to say, and at $180 million plus, it is anyone’s guess.

Insider Buying – What to Make of It?

The only indication I have that these products may be worth more than the market is currently giving them credit for is the management and insiders monetary vote of confidence vis-à-vis their share purchases. Which begs the question, what is that worth? Unfortunately this is another tough question without an easy answer.

To try and handicap the informational content of their purchases it may be helpful to ask the following questions;

  1. What kind of access to information do they have?
  2. What if any record of capital allocation do they have?
  3. What percentage of their net-worth does this represent / what degree of confidence do they seem to have?

For instance, if the insider buying the shares is John Malone, you probably want to buy, buy, buy. On the other hand, Ron Johnson comes to mind. Ron Johnson, upon becoming CEO of J.C. Penny invested over $50 million of his own money in to the company thinking that he could transform into, well I don’t know but it didn’t work and he’s probably going to lose it all. Management’s confidence in their firm certainly counts for something, but it doesn’t mean you should always invest alongside them.

Here’s my very simplistic breakdown of ERII’s recent insider purchases:
ERII_Insider_V2

6.4! Yes, 6.4, another meaningless number but a fair meaningless number in my estimation. The takeaway is that management buying isn’t something you can take to the bank or even effectively quantify but it is encouraging and should be monitored.

Conclusion – The Fear of Missing Out

To pay $50 million for a cyclical business and $200 million portfolio of unproven products is not the certainly not the dumbest thing anyone has ever done in the stock market. At the same time, you would need a lot more information than I have to say there is a demonstrable margin of safety here. But here’s the thing, I want to be invested in this company and I know exactly why; the fear of missing out.

If this company generates even a little traction with it’s VorTeq product the stock could easily double or triple, and I am going to be sitting here telling myself, “all the signs were there, (mostly management buying really) and you didn’t buy it, you’re an idiot.” And this is the motivation for a ton of behavior on Wall Street; the inherent ambiguity of stock valuation (the future itself perhaps) means that there is nothing more dangerous than a plausible idea.

Truly great investors have both the intellect to parse the plausible from the probable and the discipline to act on that knowledge accordingly. I aspire to be as cold blooded as Warren Buffett, but I still have a dose of the old animal spirits. So I took a very small tracking position for my personal account to quiet that evil optimist who hates to be left out of the big parade.

Disclosure: I am long shares of ERII. I may buy or sell ERII without notice. Something in this article is wrong! Please always do your own research. 

Holiday Readings

Some holiday reading links and video materials:

Ray Dalio at the NYT deal book conference:

Aswath Damodran writes a good note on the Oil price drop and its implications
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Tim Ferris Podcast with Dr. Peter Attia
<LINK>

More interesting Dr. Peter Attia Articles:

Is Sugar Toxic
<LINK> 

Success Versus Failure – (His thoughts on the epidemic of diabetes)
<LINK>

The fiction book I’m currently reading – The Martian – This book is very cool and it has over 6 thousand reviews on Amazon, amazing!
<LINK>

ALJ Regional – A Mini BRK In The Making?

Background

ALJ Regional holdings is a micro-cap holding company. The company’s largest shareholder, Jess M. Ravich owns 47% of the outstanding shares and is also the Chairman. Mr. Ravich has had a long career as an investment banker, and thus far it seems he is putting that experience to good use in assembling the holdings of ALJ. It is also perhaps worth noting that, according to this article, he is a longtime friend of legendary investor Seth Klarman.

In 2013, the ALJ used the proceeds from the sale of its primary asset, a steel mill, to purchase Faneuil, Inc for $53 million. It then purchased a stake in Floors-N-More, a retailer of carpet in the Las Vegas area. The most interesting aspect of both these transactions is that ALJ allowed the managers of each subsidiary to participate in the upside of the business through meaningful equity participation.

Fanueli, by far the larger of the two subsidiaries, provides enterprise consumer facing services (think call centers) to municipalities and businesses. Mainly these consist of toll collection, customer relationship management, healthcare exchange support and medical device tracking services. The business has exhibited strong profitability since its acquisition. I estimate return on tangible assets to be ~ 30%, return on assets to be 12% and return on equity ~ 20%. As mentioned previously, ALJ also incentivized the management of Faneuil by allowing Ms. Anna Van Buren (the CEO) to purchase 3.75% of the company, along with options for an additional 1% stake and a bonus of 10% over any EBITDA greater than $5 million.

In the spring of 2014, AJL acquired substantially all of the equity interest in Floors-N-More (Carpets) for $5.25 million. Carpets has five locations in the Las Vegas area. Roughly annualizing the results provided in the quarterly report ended June 30, 2014, indicates that Carpets earns a 12% return on assets and a ~18 return on equity. Of course, this estimate was derived from a very small sample but it is nevertheless encouraging. Also, similar to the Faneuli transaction, the CEO of the Carpets subsidiary has been granted incentive compensation in the form of 40,000 equity award units, which vest equally over a four-year period and represent ~6% of the Carpets subsidiary.

Other Assets

In addition to its two operating subsidiaries ALJ holds approximately $180 million in Net Operating Losses. These losses were accrued during its ownership of the steel plant, which was sold in 2013. Now that the company has subsidiaries producing taxable income, these should produce value for the shareholders going forward.

(Digression – Bellator Investments)

While looking over the financials of ALJ the name Bellator caught my eye. Bellator is a company that promotes, markets and develops Mix Martial Arts content. The most well known company in this space is the Ultimate Fighting Championships (UFC). In 2014, Forbes valued the UFC at $1.5 billion. In the most recent quarterly ALJ reports an investment in Bellator of $102 thousand under Other Assets. Digging a little deeper, it appears that ALJ made an investment of $212 thousand in Bellator Sport Worldwide in September of 2009. Since then the ALJ has invested a few more small sums into Bellator. Viacom paid $50 million for a majority stake in Bellator in 2011. Despite this, the ALJ has actually amortized its investment in Bellator down to the $102 thousand as of the last quarterly statement.

The company gives almost no details on the transaction, so it is difficult to say what has transpired to reduce the value of the investment ALJ made in 2009. And certainly anything is possible (dilution?), but it seems very strange that the investment should be impaired since the company was only formed in 2008, and so an investment in September of 2009 should theoretically have been for a much smaller valuation than what Viacom paid in 2011. In any case, the investment in Bellator is most likely immaterial to the valuation of ALJ but it is an interesting artifact that I wouldn’t mind knowing more about.

Risks

As the company’s largest current asset, the majority of the operational risks lies with the performance of Faneuli. I believe this is mitigated somewhat by the CEO’s ownership stake and incentives but only marginally.

Debt, the company owes roughly $25 million in debt. The majority of which is related to a sellers note used to fund the purchase of Faneuli. ALJ has a credit line of $5 million from M&T bank that is currently undrawn. It also has $13 million of cash and equivalents and ~$24 million in accounts receivable. With operating income of ~ $10 million at the current run rate ALJ should have very little trouble covering the payments it needs to make.

Valuation

At approximately 33 million fully diluted shares outstanding and a current price of $4.00 per share the company trades at a market cap of $132 million. That is roughly 3x book value and 13x TTM assumed annualized earnings. I think if all goes well the company could earn $12 million for FY 2015 and so that would be an and 11x forward multiple. But that is assuming all goes well. No matter how you slice it the company is not terribly cheap on an earnings or asset basis, it was at $2.00 a share but now not so much.

To buy the shares at this price you have to feel very confident in Mr. Ravich’s abilities as a capital allocator and the ability of the operating subsidiaries to continue to execute on that vision. Now, this does not strike me as a totally unrealistic assumption given, 1) his small track record over the past few years, 2) his ownership stake in the company and 3) his association with one of the greatest value investors of all time. Still, this does not qualify as a substantial margin of safety. So while I’ll continue to consider taking a small position on the basis of what Jeff Bezos would call a “regret minimization framework”. I appear to have missed the boat on the great value that ALJ offered only six months previous.

Before I sign off on this one, I would just like to mention that I think this may be one of the great examples of how a company trading at a relatively high / fair current multiple could end up being one of the great bargains in the stock market. Granted, as I mentioned before, you have to feel very confident about your assumptions of Mr. Ravich’s capital allocation abilities to make such a call but you would have also had to say the same thing about buying BRK during most of its operating history. Unfortunately, Mr. Ravich is not a young man who just finished working for Benjamin Graham but even the opportunity to invest with a middle-aged skilled capital allocator at this (small) level of assets could be a great thing.

As always, please do your own due diligence and thanks for reading.

Disclosure: No Position

Readings – Healthcare In America – The Bitter Pill

If the test of a great article is that it makes you realize how ignorant you are, then “The Bitter Pill” succeeds brilliantly. Published in 2013, in Time Magazine of all places, this piece was recommended to me by a friend who works in the health insurance business as “the best summary of what is wrong with the American Healthcare system, to date”.  And it is.
LINKS:

PDF Version:

http://www.uta.edu/faculty/story/2311/Misc/2013,2,26,MedicalCostsDemandAndGreed.pdf

Time Website Version: http://time.com/198/bitter-pill-why-medical-bills-are-killing-us/

Hellfire and Brimstone – Electromagnetic Swans and Some Thoughts On Hedging

John Knox, the fire and brimstone preacher key to the Protestant Reformation of Scotland

Electromagnetic Swans

Recently I have been re-reading Nassim Taleb’s Fooled By Randomness and The Black Swan. So I was primed when I saw the headline, “Elliot Warns of Greatest Danger in Electromagnetic Pulse”. Understanding my own bias, and the fact that at any given moment there will be at least ten different hedgefund manager’s warning about twenty different unforeseen dangers and/or once in a lifetime opportunities; I took a few minutes to try and guestimate the probability of there being an electromagnetic storm in my lifetime. And of course, I don’t have an exact answer of what the probability is. The best I can say is that I don’t have any reason to think it’s highly probable but I also don’t have any reason to think that it is totally negligible. The little facts I do have are as follows:

There was a near-miss in 2012, when what scientist called a “superstorm” came close to hitting our planet. The article makes it seem pretty scary but what does a near miss really mean? If you almost roll snake-eyes, (double 1’s with two dice), it does not mean that a snake eyes is a probable combination. Similarly the fact that a solar storm almost hit earth doesn’t really reveal much about the probability of us being hit in the future. As Taleb would say, “we cannot see the generator.”

Perhaps more worryingly, Elliot points out in their letter to investors that a large electromagnetic storm occurred in 1859, knocking out telegraph wires but otherwise leaving that much less electricity dependent time largely unscathed. So we know it can happen. Other than these tidbits, I couldn’t find any evidence of a reliable method of estimating the probability of such an event. Therefore all I can really comfortably say is that the probability is greater than zero and less than one.

Given this level of uncertainty, of my ignorance, it is tempting to drop the subject all together. Some “prudent” people will argue it’s not worth worrying about “once in a lifetime events”. On its face this attitude can seem reasonable, practical, even intelligent; why waste time worrying about something whose probability you can’t reliably estimate?

The flaw in this mode of thought is that it’s not just the probability of a given event – it’s the impact of the “rare” event weighted by its probability that should guide our decisions. Thus to the contrary, our ignorance about a given events probability makes the truly prudent course to be extra concerned, especially if the event would have a severely negative impact. This logic should seem particularly congruent to self-avowed value investors whose modus operendi is to protect against the downside, and let the upside take care of itself.

If such a storm were to happen tomorrow, scientists and Elliot management estimate that we would fare far worse than our ancestors. They predict that much of the developed world would be without power for potentially months, as the hard to replace electronics that enable our power grid would be destroyed by the storm. It does not require a highly developed imagination to see that this would have a profoundly negative impact on economic activity, and more disturbingly, day-to-day life itself.

Financial markets would not likely fare much better than the electrical grid, and probably worse. Hypothesizing for a moment, and assuming you could even find prices for any of these instruments without power; one safe bet is that equities would plummet. The credits markets would freeze and at least the front-end of really high-grade sovereign curves would rally. The U.S. dollar and gold would catch a bid along with a few other safe haven currencies, and from there it gets a little tricky. The long end of the Treasury bond curve might actually sell-off as investors worried about inflation from expected government policies to shore-up the economy. Commodities markets would likely suffer massive declines and the viability of the exchanges might come into question, as many people sought to either default on contracts or take delivery of more precious metals than could be physically settled. Suffice to say, it would be a shit-show.

You may think such statements hyperbole, and if you are confident that the probability of such an event is indeed very low then perhaps it is. But the point I am trying to make isn’t just about electromagnetic storms. It’s about how we should think about what we don’t know, and what that might mean for portfolio construction.

 Principles & Panacea

The most common method of guarding against the markets gyrations is to create a portfolio that is diversified among asset classes. To its credit, many versions of this strategy have served to reduce the volatility of a portfolio over course of the past century (in America). In fact, if you go into any private wealth manager in the United States, they will probably show you a chart like the one below and explain that it demonstrates you are better off investing in a mix of asset classes.

AMTABLE

A less common approach to achieving a portfolio that will protect against downside risk is to practice the art of value investing. The thinking being, that owning a portfolio of undervalued assets should create a margin of safety that can serve as a cushion against adverse developments.

I mention these strategies both because they are somewhat well known and contain elements of truth. Furthermore, either of them, if applied with skill, has the ability to achieve superior relative risk adjusted returns over the long-term. The danger to investors lies in mistaking the sound principles that underlie them, and the relative results that can be achieved by them, for an investing panacea.

Returning for a moment to the subject of our fallibility, consider that it does not require a catastrophe for markets to take dramatic and unforeseen directions. Consider the case of one Benjamin Graham, as Murray Stahl relates it in this excerpt from his wonderful essay Benjamin Graham: Investor and Person. There is perhaps no better example of how a fundamentally sound strategy can fail even the brightest star during a severe market dislocation.

Chapter 13 of the Graham memoirs relates his experience as an investor during the Great Depression. The chapter begins by comparing these experiences to Dante’s version of hell. As is well known, Graham was a conservative investor. He makes mention of selected long positions such as Plymouth Cordage. The shares were trading at a price of $70 with in excess of $100 of working capital. Such investments are classic value stocks. Graham mentions others such as Pepperell Manufacturing and Heywood and Wakefield.

The Graham Fund, then known as the Benjamin Graham Join Account, had the following positions in the middle of 1929, just prior to the stock market collapse. The fund had $2.5 million of capital. It owned $2.5 million of convertible preferred shares offset by an equal amount of equivalent common stock short sales. This arbitrage position is fairly common today. In 1929, such undertakings were considered to be very conservative and required very little margin. This was the case in the Graham Account.3 There were also $4.5 million of genuine long positions and $2 million of borrowings against these positions. According to Graham’s then computations this amounted to 125% margin (i.e., 4.5 long on 2 of borrowings, or exposure of 2.25x, for 125% leverage).

In the modern era the exposure would be calculated as follows:

$2.5M long convertible preferred

2.5M short common stock

4.5M long common stock

2.5M portfolio equity

$9.5M total exposure

$2.5M portfolio equity

380% total exposure

The investment performance results as reported by Graham were as follows.

1929 (20)%

1930 (50.5)%

1931 (16.0)%

1932 (3.0)%

1929 – 1932 (67.7)%

Of course, as is known, Graham managed, subsequent to the Great Depression, to rebuild his fortune and ultimately achieve a level of wealth that he probably could not have imagined in 1929. One factor in the recovery was that in January 1934 his investors generously consented to remove the high water mark and re-instate performance fees.5

However, another important factor is that the application of the principles of value

investing once again generated results in accord with the historical standard subsequent to the summer of 1932.

This brief summary of investment experience invites two questions. First, should

Benjamin Graham have anticipated the investment calamity of the Great Depression? Second, does there exist an inherent flaw in the philosophy of value investing such that the application of margin of safety principles does not always produce a margin of safety?

In answer to the first question, it would have been necessary for Benjamin Graham to have conceived in 1929 that the next four years would witness a circumstance in which production of goods and services for which there was evident demand in 1929 would become remarkably diminished in the ensuing years. Scholars still debate the causes of this phenomenon nearly 80 years after its occurrence. If Benjamin Graham failed to foresee the Great Depression, one cannot find many contemporaries who managed to foresee the calamity. Indeed, luminaries such as John Maynard Keynes or Irving Fisher fared no better than Graham.

In answer to the second question, it is perhaps sufficient to say that value investing is a technique that merely seeks to assess the worth of a given enterprise against its trading price at a given moment. It makes no claim to see the diminutions of value that are caused by economic crises….

Wow. One of the greatest investment minds of all time, the founder and master of his craft operating in conditions of market efficiency that would leave any of todays investment managers salivating uncontrollably, was brought to his knees by the great depression. The lesson, if there is one, is that if it can happen to him, it can happen to you (or me).

So what should investors do? If diversification and a margin of safety are insufficient for protecting against the vagaries of fate, what remedy is there? I don’t have an easy answer but I do have some thoughts:

Limit the use of Leverage

Obviously I’m not breaking new ground with this one. But I lead off with it because it is probably the most important, especially for young investors. I believe Warren Buffett has said he would never leverage himself by more than a quarter of his equity. I am certain he is familiar with the record of his teacher Benjamin Graham during the great depression, and has drawn a similar that very lesson from it. As usual, the admonition is easier proscribe than execute. Leverage has a way of creeping up on you. It is the temptation of scalability – the idea that more can be achieved with less. You have to consistently resist the little voice in your head that says this time is different, to allow that, this situation is unique and deserves to be exploited to its maximum.

Great investors are able to see past this temptation. They understand the dark side of leverage. That it erodes at whatever margin of safety you’ve accumulated, and leaves you exposed to the markets irrationality; the very thing that as an investor you are paid to exploit becomes a potentially fatal liability.

Beware Of Overestimating Your Diversification

Just as we should have humility about the outcomes that will affect our portfolios, the Black Swan concept (the limits of induction), teaches us to have humility about how our portfolio components will perform. For instance, people like to think that owning bonds is an effective hedge against deflation but what kind of bonds exactly? In a real economic catastrophe any bonds with credit risk exposure, not matter how strong, might actually decline in value. A truly devastating economic scenario could actually be viewed as stagflationary and thus one would expect a decline in the value of high duration bonds as well. The point is to think deeply about your positions; they may behave nicely under normal conditions and fail you when you need them most.

Consider Holding Cash

I was already writing this post when I started reading some of Seth Klarmans investor letters. So it struck me when I noticed that he was consistently referencing some of the ideas I had been kicking around with regard to value investing and hedging. One of Klarman’s claims to fame is achieving his amazing investing record whilst maintaining a substantial allocation to cash.

Cash, as an asset, has something of a reputation problem. Most of which can be attributed to its obvious lack of relative yield. To its further shame, many widely cited studies of asset returns have shown cash to be among the poorest performing asset classes in the modern era. The perception of cash as unattractive is so pervasive that even lay people are loath to see cash sitting their account, “not working for them”. And I must confess, at times I too find myself having thoughts along these lines.

As usual, the accepted wisdom is far from wise or at least incomplete. More enlightened investors such as Klarman see cash something akin to an option whose value will be realized when the next opportunity or cycle presents itself. Where the student sees the empty hand as weak without a weapon in it, the master sees the potential in a limb free of constraint.

Somewhat paradoxically, cash aversion is also common among professional managers and institutional investors. Klarman suggests the reason for this phenomenon is the institutional focus on relative performance. Managers think of themselves as investors and therefore feel it is their obligation to be invested, in something, anything. The institutional imperative to be doing something is too powerful for most to resist. As usual, Klarman said it better than I could. Here he is on adopting an absolute performance orientation. I find it very zen:

Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative- performance-orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market. Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Hold Antifragile Assets

Nassim Taleb defines something as antifragile if it gains from disorder. The most obvious incarnation of antifragile in the world of investments is an option. There is a good deal of debate over whether options are too expensive or worthwhile, and as with everything in investing, there will be exceptions to whatever generalization you arrive at according to the price being asked.

In an attempt at generalization, some have framed the question of options as akin to the age-old question of whether insurance is worth buying. In this context, my only observation is that market catastrophe insurance, though it may be expensive in most retrospective periods, has a unique value proposition because unlike most insurance outcomes that are designed to protect against a localized event – say your house burning down or car being stolen; market catastrophe hedges are virtually certain to provide you with cash during a systemic event. I.E. when everyone else’s house is on fire and they are begging to sell it to you.

As far as I can tell, Klarman held out of the money options to protect against market declines. Or at least he did in the years between 1995 and 2000 (which is all the letters I’ve been able to find – feel free to send me more nomeansum@nomeansum.com). Klarman also famously profited from buying put options on Japanese equities in the late 1980’s and subprime CDS preceding the housing collapse (nice work if you can get it). The below excerpt from his 1995 letter makes it pretty clear that, at lest in those days, he thought it was worthwhile to hold such antifragile assets:

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And here he says it again:

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And again:

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And again, with some more remarks on holding cash:

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It is worth mentioning is that the Market Hedges portion of the Baoupost (Klarman’s) portfolio usually ranged between 0.5-2% of assets, with Cash & Cash Equivalents of 15 – 35% of assets. I’d love to know how far out of the money Klarman was looking, and in what tenor, and why. Unfortunately that level of detail is likely beyond my reach. Even so, it’s interesting to see that he thought it worthwhile to invest up to 2% of his portfolio in what is commonly derided as an “expensive” or “wasting” asset. I wonder if he still does…..

Klarman Table2

Think Carefully About Short-Selling

As I understand it, short-selling put the hedge into hedge fund and thus it should come as no surprise that short selling is an integral part of many sophisticated investors approach to markets. The general expectation being that short-selling will be utilized as a method of generating alpha through a reduction of market risk and individual security selection. On the other hand, the potential for unlimited losses (asymmetric risk), the general proclivity for the markets to rise, and the overall difficulty of finding attractive positions, has lead many investors to shun the enterprise completely. Suffice to say, there is no shortage of opinions on the subject.

Having mixed feelings about it myself, I was keen to see what Klarman had said and done in this arena. Though, knowing he is an avowed value investor, it didn’t come as complete surprise when he voiced disinclination towards the practice:

We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect.

I should point out, Klarman is discussing short selling in regards to the specific market positioning of 1999. So while I do believe the quote reveals something about his attitude towards short-selling generally, it should not be read as Klarman forswearing short-selling totally. Klarman’s passage reminded me of a less famous but equally a credentialed Baoupost alumnus who has his made his opinion on short selling public. In the depths of the financial crisis, David Abrams made the following remarks at a conference on value investing hosted by Columbia Business School:

And the final thing too, within the whole industry is the long / short side. People have to, whether your managing a fund like that or investing in a fund like that, you have to be doing some fairly deep soul searching now because the government’s after you, politicians are after you, there’s no way to do it without taking counter-party risk, and how do you feel safe with counter-party risk? Maybe it will subside and it will be fine but you know, you’ve got to be doing some deep soul searching now.

To clarify that a bit, Mr. Abrams is making the point that short selling has two weaknesses. The first is what we might term regulatory risk; the risk that the government or relevant regulatory body will suspend the rights of institutions to sell short. This happened during 2008 when U.S. and U.K. regulators banned short selling on approximately ~800 financial firms. Thus Mr. Abrams seems justified in imploring investors to think deeply about the value of a strategy that has the possibility of being prohibited just when it is most desirable. His second point about “counterparty risk” is more technical. It refers to the fact that when you short securities you must necessarily borrow them from someone else – that someone else is your counterparty. Almost always this someone else has the right to demand the shares back on any given day and thus, you keep your short position at the pleasure of your counterparties.

Honestly, I don’t know what conclusions to draw from his points. They are tempting to dismiss as unlikely events, the kinds of things that happen to other people. Most likely he is correct in taking a middle ground by recommending one think very carefully about relying solely on short selling as a method of protecting against adverse market events. As usual, the risks of the method must be balanced against the potential rewards of the specific situation. It is not supposed to be easy.

Social Perspective & Conclusion

I once did a post on John Maynard Keynes and value investing. So I was delighted to find that Murray Stahl had achieved a superior treatment of the subject in one of his market commentaries. One quotation by Keynes stuck a chord with me when I read it. Here it is:

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Howard Marks talks about how second order thinking is required to be a great investor; that ability to look beyond the immediate, to consider the consequences of consequences. How few investors consider the affect of their actions on the broader functioning of the economy (except to say that it is positive), and less still of their potential impact on the psychology of their fellow investors? I think Mr. Marks would agree that Keynes had the right stuff.

Keynes’ observation is about more than just stoicism in the face of a market decline. It alludes to a hard reality that in the age of Alpha obsession people would often rather forget. That reality, as it pertains to hedging, is that as much as people can and should try to protect themselves from adverse market outcomes, it would be extremely difficult to maintain, let alone build wealth, in the face of a catastrophic event. No less especially because the vast majority of financial instruments are in one form or another, promissory notes against future economic activity; as much as we all want to be Ubermensch, and self sustaining scallop farmers, the truth is that what we call our economy is really just a social system, and to a much grater extent then many would care to admit, our wealth in any period of meaningful duration is more likely to be a function of Beta than Alpha. I think Dr. Franklin said it best when he proclaimed, “We must all hang together, or assuredly we shall all hang separately.”

Weak Shorts, Weak Longs – My Mistakes of 2013

Preface

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Charlie Munger

A lot of things went right in 2013. My portfolio handily beat the S&P’s stellar performance. But I don’t want to focus on that. This post is about the mistakes I made, and the lessons I’ve tried to learn. For those who don’t want to read the whole post, I’ve summarized the take always below:

1. Be careful not to let an edge turn into an ego trip. ONLY take a position when you have an edge.

2. Learn to do nothing. Never be afraid to walk away from an investment. As WB puts it, wait for the fat pitch!

3. Once you get what you were looking for from a catalyst, cover your ass!

4. Short selling is very hard.  Be very picky and never bet too much.

Meta Analysis Disclaimer

There is a lot of noise in any given year or even years investing results, so much so that even with the benefit of hindsight it can be difficult to say what was a mistake and what was correct. Acknowledging that, let’s just say I’m going to go over mistakes that fall into the known mistakes category, and ignore the unknown mistakes category – and even more troubling – I’ll ignore the possibility of these trades I label mistakes actually were correct ex-ante.

Debt Ceiling – Distinguishing Edge From Ego

This first mistake is a very clear example of how to behave when you have an edge and how not to behave when you don’t. When the S&P sold off in the fall of 2013 due to concerns about the government’s ability to pass the debt ceiling, (again) I was closely monitoring the situation. At one point it was 11pm EST and news stories began to appear on Twitter and the Wall St. Journal stating that the house was very close to reaching some sort of compromise. One look at the level of S&P futures told me that the market either hadn’t incorporated the information or chose to disbelieve it. Though I believed in congress’ ineptitude, the deadline for a deal was fast approaching and I judged it likely that there was some truth to the news reports. Realizing that a breaking story happening outside of regular trading hours actually offered a small investor such as myself an advantage, I felt I had enough of an edge to merit backing up the proverbial truck, and so I did. I bought as many S&P mini-futures as a safely could. Over the course of the next day the market rallied nearly 20 points and I made profits worth about 20% of my equity.

This entire rally happened on the back of no concrete deal. Merely the hint that something was close to being agreed upon. Now this is where I made my big mistake. Somehow, someway I got it into my head that this yet to be seen agreement would disintegrate due to the usual partisan squabbles. Now it’s one thing to conjecture something, but it’s another to make trade out of it. Honestly, and embarrassingly, I think that instead of attributing the money I had just made to a well timed play on shaky information, I started to believe that I was George Soros re-incarnate. So of course, I gave back all the money I had just made when the market continued to rally and I was stopped out.

What I’m trying to take away from this mistake is how easily edge can lead to ego and how dangerous that is. George Soros says the market is always wrong but that he’s always fallible too. To me those two statements are like an equation that has to balanced because if it doesn’t you wont be in the game for long. Taking a big position when you believe you have an edge is justified so long as the security is liquid and you can cap your downside. Taking a big position when you have no edge is just a road to ruin. In short, I need to be careful that I don’t let luck or even a brief edge creep into ego. Hopefully getting burned once will be enough.

HLF – Weak Shorts, Weak Longs

“ Cause it’s so hard to do and so easy to say, but sometimes, sometimes you just have to walk away.” – Ben Harper

Herbalife, oh herbalife, how many hours have fallen by thy name? They should use this stock as a case study at Harvard business school because I think everyone involved is crazy, myself included. I became interested in this stock like everyone else because of the controversy surrounding it. So I took the time to watch Mr. Ackmann’s presentations, read long and short opinions on the interweb, and looked at the financials. Net, net I came to the erroneous conclusions that it made sense to be short the stock going into the end of the year, and the firm’s audit report deadline. I lost money shorting the stock because of horrible position management. That said, I believe there is a broader lesson to be drawn from Herbalife, a lesson that is more about choosing the proverbial table you play at then how a given hand goes while your there.

I said I was intrigued by the controversy surrounding the stock, and what I’ve come to conclude is that the controversy was legitimate. The longs were vulnerable to the possibility of the marketing schemes collapse and increased government regulation (of whatever form), and the shorts were vulnerable to continuing profitability and squeeze pressure from both opportunistic investors and the company. The shorts also lacked both proof of fraud and a precedent of real government intervention. Of course anything can be an attractive at the right price but HLF was (hardly) ever there.

Herbalife is a case of weak shorts and weak longs. Everyone, both sides, are choosing to play a hard game, when the reality is I don’t have to. I think making things harder than they have to be is probably one more the most pervasive errors in investing. We, me, people, spend a lot of time, do a lot of research and as a result feel like we need to have a conclusion to show for it. So we make wagers that we don’t have to because we feel like we deserve to have an opinion based on all the work we’ve done.

People talk a lot about being unemotional about investments but not nearly as much about remaining unemotional about our investment candidates. Likewise, people often say investing is hard, but sometimes it’s the not investing that’s difficult. Stepping away from something you’ve put your time and energy into is hard. There is a huge psychological barrier against it.  To combat this tendency I’m going to start making a list of all the things I’ve learned while researching the stock. Then I’m going to look at that list and say to myself, even if I don’t invest now, these are all the new things I know that can help me with future investments. That way I’ll be able to feel like I haven’t wasted my time, and more importantly, stop myself from wasting my money.

JCP – Know Your Business

JC Penny was a situation where I didn’t understand the business well enough. My thesis was that with Ron Johnson out and Mike Ullman in, the company had enough cash and assets to get it through the turn around 2.0 without diluting current equity holders.  I believed I had done my research, I read financial statements, created an elaborate financial model of the capital structure and checked to see how others opinions compared with my own. I ended up being wrong about the capital structure, and the company had to raise equity because their business (suppliers) demanded it. This mistake was a result of not sufficiently understanding the stock and/or business. It was a small comfort to see that Kyle Bass and Hayman Capital were in the same boat I was. Sometimes even smart people with better access to experts get things wrong.

MUSA  – Using Leverage With Catalysts

“Bulls and Bears make money, but Pigs get slaughtered.” – Anonymous

“Experience is what you get when you didn’t get what you wanted.”  – Howard Marks

MUSA which has been previously profiled on this site was a recent spinoff trading at a significant discount to its peers. In addition, it had ethanol assets worth more than their carrying value that it was going to dispose of, and windfall income from the sale of RIN credits. My thesis was that the first earnings call would bring the Wall St’s attention and lead to the stock trading higher. Since I thought knew the timing of an event which would be the catalyst for a higher valuation, I decided to use options to increase my leverage. Lo and behold the stock did climb nearly ~20% to $45 in the run-up to and following the first earnings release. And of course, instead of congratulating myself on the windfall I had just made I decided to try and avoid paying taxes in 2013, and see if the stock could get to my price target of $51 per share. Now I did sell some options but not nearly enough and soon after J.P. Morgan put a price target of $45 on the stock, and a slight sell-off crushed the stock back down to ~40 per share turning my formerly spectacular profit into an abysmal loss.

I may have been wrong to buy those options in the first place. Spinoffs can take a long time to develop a following. Joel Greenblatt says you should give the market 2-3 years to correct a mis-pricing.  Assuming I was correct to have the position in the first place, I should have sold much more of it as we moved away from the “catalyst event” in question. Another lesson I’ve learned is that while options are great when they work for you, when you own illiquid options in a stock you believe in it is extremely painful to start caring about daily price fluctuations.

So two take always; one, only use options (or lots of leverage) when you are sure about a catalyst event, and two, once that catalysts delivers the juice you were hoping for, start selling down the position, cover your ass – don’t wait.

 The Wages of Sin – Pandora, Tesla, TTS, Et al.

“We don’t short stocks because we don’t like trading misery for money.” – Charlie Munger

2013 taught me that shorting stocks is very hard.  I think the most important lesson was to never short a company whose product you would actually use or want. I don’t care how overvalued, unless there is fraud, it’s probably not going to be a strong short. Whatever your conditions for being long a stock they should be doubly stringent for going short, and the position size greatly reduced because of the negative convexity shorts exhibit.

Timing is another important element of short selling that I can improve upon. As a small investor, it is fairly easy for me to get in and out of positions, and because shorting is so difficult (especially in a bull market), I think it would be wise to use that to my advantage.  This goes especially for weaker shorts where I believe I’ve identified a catalyst/trigger event. Using technical factors to try and position oneself into an event could very much help limit losses associated with a rising market or single name. Of course if the stock were pure scum with no discernable trigger you probably don’t want to play games jobbing around the position. But with more “event driven” short opportunities, I think this kind of positioning game could help performance. On the other hand, I’m sure it would also be a lot of work to implement.

In Sum

All in all, 2013 was a great year, and I can’t complain but I can try to improve.

Coattailing Sears Canada – $SCC

You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders. – Warren Buffett

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Sears Canada is an example of what Warren Buffett calls coattailing.  That is, putting other peoples ideas into your own portfolio. I came across this stock when reading the Horizon Kinetics Q4 investor letter.  You can and should read their excellent letter here - but essentially – their thesis is that based on recent transactions, the company has leases that could be monetized to the tune of  ~3.00 billion. Given that the company currently has a  ~ 1.3 billion market capitalization this represents a significant asset cushion, and a potentially attractive investment.

That said, intelligent investors will want to know, what are the assumptions going into that ~3 billion of asset? Here’s what the folks at Horizon said:

“So, if the company agreed to vacate six stores for $644 million, how much might the rest be worth? The annual report provides information that the average size of the full-line department stores is a bit over 128,000 square feet. In that case, the $644 million, for those 11 stores amounts to about $450 per square foot. Now some would say, and they’re probably right, that these were among the best-located, most valuable Sears Canada stores, and that the remaining 111 full-line stores are worth far less.

Ok. Our investigations suggest that merely to construct a mall store costs well above $100 per square foot. If we assume that the remaining full-line stores are worth only that much, then 111 stores x $100/sq ft x 128,800 sq ft/store = $3.03 billion, or $29.78 per share. That was over twice the market value of Sears Canada at the time.  Nor does that calculation include the 300-plus other properties. Nor does it include the top four full floors of the Toronto Easton Centre, the premier shopping center/office tower/hotel complex in Toronto, which the company did not vacate as part of the October transaction.”

Cynics might assume that any company selling so cheap must be up to its eyeballs in debt. That’s not the case here. With about ~230 million in cash on the books,  ~700 million in net current assets, ~50 million in debt, and ~412 million in retirement obligations – the company is well capitalized.

As for the operating business, it was cash flow positive for eight years up until 2013. Now however, the business, (like most other big box retailers) is under pressure. Cash from operations over the trailing twelve months has been -33 million. These losses are not devastating to the investment thesis so long as they are constrained to the present level but it is a risk. A mitigating factor is that Sears Canada has Sears Holdings and thereby Edward Lampert as a controlling owner. Bearing in mind that a considerable portion of Mr. Lamperts net worth is invested in Sears Holdings, it seems reasonable to assume he will take steps to maximize shareholder value should the losses mount.

Other Risks

Anything times zero is zero, Buffett said. A total loss is a “zero.” No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up. Long-Term, however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero. – Alice Schroder, The Snowball

At first glance SCC seems like a homerun; a well known brand with backed by significant asset coverage and an incentivized owner-operator is probably as much as an investor could wish for. What gives me pause is that this bet has aspects, which to me, make it a derivative of the Canadian real-estate market.

As some may be aware, there has been hypothesizing of a Canadian housing bubble for some time now.  Though skeptics have largely pointed at the residential market, I feel it’s safe to assume that a credit bubble lifts more than one boat.  The most obvious and important being the commercial being real-estate market. Any decline in said market would likely have negative impact on the realizable value of the real estate assets held be SCC. In addition, a declining housing market would likely have a profound impact on an already leveraged consumer base.  Considered together, these vulnerabilities conjure the vision of a declining real-estate market and weakened consumer eroding both the asset coverage and core business at Sears.

Of course, the question is not merely whether the scenario is possible, but rather how likely? The answer is unknowable, at least to me. Nonetheless, it seems likely enough to give any investor second thoughts about about loading up on Sears Canada.

Disclosure: Long SCC