Short Selling

by Amit Kumar

  I should have been much more demanding about the valuation in 2008 because I knew something bad was going to happen. I didn’t have enough cash. The bottom-up investor didn’t listen to the top-down investor in me.

  Q: As the Federal Reserve begins to taper bond purchases and consider raising rates, how should value investors prepare for a possible impact on valuation multiples in the market?

  The Federal Reserve and United States Congress have taken unprecedented steps in the wake of the financial crisis of 2008. As a result, we are in an undefined period and it is a new economic landscape, possibly. However, there will be more recessions and the economy will grow again consequently. I have the same kind of worries about the economy as I had during the crisis. We are very demanding on valuation right now about buying new stocks in our portfolio and there is no better time to focus on diversification.

  Seth is paying attention to the macro and he is worried about what will happen to the economy. I share the same worries about valuation. My successor shares the same belief. I don’t know if it is too early to raise more cash, but it is time to be more demanding about valuation because I don’t know if we are in the same economic landscape anymore. Whenever Ben Graham was asked about the expectations, he said the future was uncertain. He said, “Look, intrinsic value is important but things can happen and there is a need for diversification.”

  Q: You have often spoken about gold as calamity insurance as well as an inflation hedge. You have been critical of the Neo-Keynesian policies and believe that gold is also a hedge against failures of Keynesian policies.

  Today, people believe financial crises are a thing of past—low risk of inflation, low risk of financial crisis. The steps taken by central banks and the U.S. Congress in terms of increase in public debt and deficit are unprecedented. This is the biggest crisis since the Great Depression, possibly threatening a new economic landscape. Value investors were historically helped by recessions because they bought on the way down and sold on the way up. Many value investors took the attitude to spend no time on the top-down because they like to buy on the way down. Value investors were caught unaware. They didn’t realize that the profits for financial services, banks in particular, were fictitious. For two years, they made money. William White, the chief economist for Bank of International Settlement (BIS), wrote a paper that low inflation was not enough and talked about longer-term consequences of asset price bubbles and financial imbalances in the setting of current interest rates. He talked about the role of monetary policy in a Keynesian macroeconomic model in which financial imbalances play a role and where their subsequent unwinding may lead to a credit crunch or similar financial distress. The paper was interesting but I didn’t know when the bad times would arrive. We believe that buying gold is buying insurance against such bad times.

  Q: You mentioned that you owned BIS stocks. Why did BIS sell their stock to private investors and not central banks and sovereigns?

  Isolationists in the United States Senate did not want the [United States] to be a shareholder in an organization that was dominated by a majority of Europeans. The American tranche that was reserved for Americans was sold to the public, and so was the Belgian tranche because they refused to participate. We took ownership in 1980s because the BIS were self-satisfied bureaucrats. We looked at BIS stock as a combination of gold bullion and [a] money market fund. BIS owned gold bullions because the bank was capitalized with gold bullion at the time of creation and money market funds because 90 percent of the assets and liabilities would typically mature within a year.

  So, BIS would invest liabilities such as deposits from Central Banks in J.P. Morgan short-term paper. BIS stock was trading at 40–50 percent discount to the NAV adjusted for the price of gold. A French economist told me that he was visiting BIS and asked me if I had any questions for them. I was curious about a provision in their liabilities. The answer I received was that it was a provision for a highly unlikely event and it was equity for all good purposes. We hoped that BIS didn’t sell the gold and that they would continue to increase the dividends. Shortly after the turn of the century, when the IMF [International Monetary Fund] was discredited due to emerging markets crisis and World Bank loans were alleged to have ended up in the wrong pockets in Africa, I suspect, BIS believed they had a chance to become a major multinational institution that could displace World Bank and IMF in charge of preventing future financial crises. They did not want public shareholders anymore.

  Recap

  • According to Ben Graham, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”3

  • There are three core concepts for value investing—price versus value, Mr. Market, and margin of safety.

  • The way of pricing puts the investor in the shoes of a business owner, putting the focus on the intrinsic value of the business. Timing is not important unless it allows the investor to buy stocks below intrinsic value.

  • Mr. Market, the fabled character, changes his mind every day on the price of stocks, and he is also subject to wild mood swings that can result in large fluctuations and create opportunities.

  • The investor can determine a sound purchase price at a discount to intrinsic value by applying the concept of margin of safety based on the stock’s earning power or value of asset.

  Key Takeaways from the Interview with Jean-Marie Eveillard

  • When you lag on the market for six to twelve months, the investors begin to leave and then they completely desert you if you continue to lag on the market for more than two years. Conversely, the investors do not start believing in your performance until you have a good run for one year.

  • If the business begins to deteriorate and stock is modestly overvalued, the stock can fall a lot very quickly. You have to be quick to determine if the weakness is temporary or not.

  • One should be quick to sell the stock, acknowledge the mistake to avoid a permanent loss of capital, and move on to something else.

  • Conversely, one should be very slow to sell if the company appears to have a competitive advantage.

  • In general, cash is an important tool for the value investor.

  7

  Activist Investing

  Shareholder activism won’t go away and scares the hell out of all of our managers.

  —WARREN BUFFET

  THIRTY YEARS AFTER BEN GRAHAM tried shareholder activism with Northern Pipelines, Warren Buffett (Graham’s protégé) had his first tryst with shareholder activism. In the 1950s, Buffett took a large stake in Sanborn Map and forced the company to separate its investment portfolio from its core business. Sanborn stock had been trading significantly below the value of its investments and management had not exhibited interest in closing the gap.

  In the 1960s, Buffett acquired a large stake in Berkshire Hathaway, then a textile business, and he received a verbal agreement for a tender offer of $11.5 per share. Buffett felt slighted when Berkshire tried to shortchange him by offering $11.375 per share. He bought the entire company and fired the chief executive officer (CEO). Berkshire’s textile business kept dying and Buffett admitted that he made a mistake by buying Berkshire.

  His stance on activist investing changed over the next few years when he bought nearly ten percent of Washington Post in 1973. Warren Buffett reached out to Katherine Graham and pacified her concerns about his stake. They became friends and Buffett joined Washington Post’s board. Warren Buffett has since engaged in friendly acquisitions.

  However, the 1980s saw the rise of corporate raiders as leveraged buyouts (LBOs) flourished, marking the beginning of the credit boom. This era is famously portrayed in some iconic scenes of the movies Wall Street and Barbarians at the Gate. Some executives of the targeted conglomerates were forced to break up their companies to unlock value, while others fended off raiders by introducing poison pills (issuing more stocks and diluting the raider’s stake) a
nd golden parachutes (extraordinary severance benefits in the event of a takeover). This era ended with the bankruptcy of Drexel, the investment bank involved in LBO financing, and it financed a number of mega deals including the maiden LBO of RJR Nabisco by KKR as well as Phillips 66 by Carl Ichan and MGM by Ted Turner.

  Drexel was mired in illegal junk bond market dealings led by Michael Milken, and the bank was investigated by multiple U.S. regulators, threatening it with indictment under RICO (the Racketeer Influenced and Corrupt Organizations Act). While Drexel was able to settle the charges, it was faced with the collapse of the junk bond market when the LBO of United Airlines fell through on Oct 13, 1989. Drexel was forced into bankruptcy and the booming LBO market came to a halt. Some corporate raiders from the LBO era morphed their role over the next decade into activist investors.

  A new generation of activist investors also arrived on the scene at the turn of the twenty-first century. These investors buy stocks in undervalued companies and pressure company boards to unlock value by buying back shares, taking steps to improve operating profits, or shaking out management ranks. In general, when an activist investor gets involved, the target stocks tend to rise because of the successful track record of the activist. Short sellers in such companies face headwinds from a push by the activist to introduce changes in favor of the stock.1

  An Interview with Bill Ackman

  Bill Ackman is a uniquely successful activist investor who has not only pushed for changes through his long investments but also shined a spotlight on troubled companies through his activist short positions. His prolonged battle with MBIA as a result of his short position in the company is captured in the book Confidence Game. Eventually, Bill was proven correct, and he stuck to his guns on his short thesis on MBIA for six years. Bill Ackman is a value investor as well; however, he takes a concentrated approach in his investments. He agreed to provide an interview for the book and share his insights on investing here.

  Q: Can you talk about accounting and liquidity considerations in your public equity investments today?

  During my first two years of employment, I worked for a real estate service firm that arranged financing for developers. I saw some successful and unsuccessful investors in real estate. The smart ones did not care about GAAP [generally accepted accounting principles] but used cash flow to assess value. Accounting is an imprecise language. How much cash a business generates over its life will determine its value, so learning how to translate GAAP accounting to economic earnings was an important learning for me.

  What is remarkable about the public markets is the ability with minimal frictional cost to buy and sell securities even at an enormous scale. The option to abandon a good investment for a better one is a great aspect of the public markets. If you take a company private by buying 100 percent of the equity, you cannot buy more of it. In the public markets, every one of your holdings is priced every day, and you can add more to your position and vice versa. You don’t need to hire an investment bank to sell your company. The ability to switch seats is a very valuable one.

  Q: How do you find the research approach to find long investments different from that of short investments?

  I find [the] Graham and Buffett approach about margin of safety (i.e., a wide spread between the price you pay and value) to be a very useful construct. We concentrate our capital in a handful of high-quality businesses. We prefer simple, predictable, free-cash-flow-generative businesses with dominant characteristics, which Buffett describes as companies with moats around them. We look for stock prices that allow one to buy a business at a significant discount to its intrinsic value as is, and at an even greater discount if the business can be optimized. We look to understand the factors that cause these discounts, factors that we can influence by being a shareholder in the company. If we believe we can catalyze the necessary changes, and the discount to intrinsic value is large enough, we invest. That’s the long approach.

  The short approach is equivalent in some sense—the analogy to a margin of safety is what we call a “ceiling on valuation.” By “ceiling on valuation,” we mean an estimate of the reasonable worst-case outcome if the market were to ignore our negative views on a company. There are some businesses where it is easier to determine a ceiling on valuation than others. If you are shorting an internet-based business model with rapidly growing revenues without any cash generation, the stock market can assign an extremely high valuation without any meaningful upward-bound growth because it is difficult to precisely value this kind of high-growth business. You can short the stock and it can double or triple from there because the value is tied to hopes and dreams.

  We don’t short those types of companies; in fact, we short very few stocks at all. We have shorted a handful of stocks over the twelve-year history of the firm because of the inherent risk-reward equation (i.e., downside is unlimited). Short selling can be much more treacherous on the downside. We look for cases where a business can disappear (e.g., financial institutions with inadequate reserves that can be deemed insolvent by regulators or the market). We also look for companies that are violating the law—Herbalife violating the anti-pyramid and anti-deceptive marketing laws of the FTC [Federal Trade Commission]. We look for cases where a company is violating securities laws; cases where regulators will take down the company.

  Q: Can you explain some of the inefficiencies in corporations that lend to your style of investing activism?

  Companies for which cost control, strategy change, management change, better allocation of capital, monetizing hidden assets, or helping the market rethink the nature of the business can contribute meaningfully to unlocking value.

  Q: When you started in the business, what caused you to pursue an activist investing style?

  It is probably my personality and my frustration with being a passive investor when I see a huge opportunity that is not exploited by a company. It is a large competitive advantage to not be limited to the status quo in selecting investments.

  Q: Can you talk about your capital allocation approach, position sizes, and how you manage risk at a portfolio level?

  We manage risk first by not using margin leverage. Margin leverage is a dangerous source of capital because you can be wiped out when the market crashes. Without margin leverage, we can afford to think about each investment as a stand-alone investment with particular risks and opportunities for rewards. We prefer large-cap North American companies that generate simple, predictable cash flows that have limited exposure to extrinsic factors we cannot control.

  While nearly every company is exposed to GDP [gross domestic product], our companies are generally very stable businesses that will not be materially impaired by negative GDP growth. We do not like businesses where commodity prices can have a huge impact. Beyond investment selection, buying at a discounted price is one of our greatest risk-management devices.

  Q: Is it true that you avoid leverage at the portfolio level, as well as pass-through leverage in your portfolio companies?

  We generally prefer investment-grade companies, but they are rarely debt free. Occasionally, we have invested in highly leveraged companies. For example, General Growth Properties was highly leveraged, with $200 million in equity and $27 billion in debt. We sized our position smaller in General Growth for this reason.

  Q: Could you talk about some of your past research that you consider to be your best?

  General Growth is probably our best investment, not just because we made a fortune on the investment (i.e., a more than 130-fold return compared to the initial purchase cost and about 60 times our average cost), but also because our involvement enabled us to maximize value for all stakeholders.

  General Growth stock would very likely have gone to zero had we not bought 25 percent of the company, convinced the board to file for Chapter 11, joined the board, and led a restructuring with creditors. We worked with management and the company’s advisors to implement a restructuring that benefited all of the creditors—creditors got par p
lus accrued interest and shareholders have recovered nearly all of their investment. We brought in a new management team and came up with the idea of spinning off Howard Hughes, which we executed. We hired a new management team for Howard Hughes and I currently chair the board. You could call it our magnum opus.

  I think Herbalife on the short side rivals MBIA in the quality and level of research we have done. It has not yet been profitable. Herbalife has been levering up and buying the stock, which has propped up the stock, but the leverage is also putting them in a weaker position. Their buybacks will end in June 2015, so we will see then.

  Q: Do you think it is inherently difficult to generate alpha on shorts than longs?

  It is harder and creates more brain damage than you can imagine. Will we do it again? I will give the same answer I gave the last time. We waited five years after closing the MBIA short investment before we built our Herbalife position. We may wait another five, ten, or twenty years to do the next one. Who knows, we may never get involved in shorts in the future. If and when Herbalife plays out the way we expect, perhaps the next time we will just say the name of the company without taking a short position and wait for it to go to zero.

  Q: What are your thoughts about short sellers and their role in the market?

  Short sellers play a very important role in the market. Collectively, short sellers have a lot more resources than government regulators. They can devote a lot of time and attention to one company and do a lot of research to uncover frauds. That is a very helpful thing for the market. They can also help cushion volatility in the market as the buyer of last resort when stocks crash.