by Amit Kumar
Q: Back to your sleep-at-night test: how do you handle stress?
I am an inherently stable, healthy, and resilient person and I am economically well-off. I also don’t have 100 percent of my net worth invested in the funds. It is important in investing to not let volatility affect your judgment. It is easier to behave that way when all of your resources are not committed to your investment fund. It is better for your investors as well because people can act irrationally when they have too much of their capital in their fund. I have the vast majority of my liquid net worth in my fund, but I have enough outside that I can live without worrying about market volatility.
I don’t find investing stressful because we do our homework and know what we own. Our portfolio is comprised of the highest quality businesses in the world, and we purchased these companies at attractive prices. This is inherently a relatively low-risk strategy.
Q: How do you remain confident throughout your trades, even when the market does not respond as you anticipate?
People and markets constantly judge you over short periods. In the Herbalife [trade], eighteen months into our short position, the stock is up 30 percent above where we shorted. It’s noise. [chuckles] Stock markets can be wrong for a long time, but you have to be able to survive that period.
Q: You spotted a systemic issue with monolines before anyone else. Why did you decide to begin shorting MBIA alone and not some of the other monolines as well?
We ultimately shorted MBIA, FSA, Ambac, and others. Our approach requires deep, fundamental research, and it takes an enormous amount of time to research any one of these companies. Our timing was terrible on MBIA, but it eventually paid off. By contrast, our timing was very good on the other mortgage and bond insurers such as Radian, PMI, Ambac, and FSA. Experience is learning from mistakes.
Q: Have you seen that regulators are now more open to looking at criticisms from short sellers in the last few years?
Regulators do not have an easy job, especially with limited resources, and they have to focus on their priorities. I was a little disappointed with how long it took the regulators to see some of the issues that we had identified with MBIA. I think they have been much more responsive in the case of Herbalife. It did seem like a century between the time we shorted MBIA and when the SEC launched a formal investigation of the company. Their timeframes on these cases are not as aggressive as the private sector because they have to be careful. That is OK. I have a lot of respect for the SEC and FTC. I think they will ultimately get to the right answer on Herbalife.
I think the SEC has a lot of respect for the short sellers. As long as you disclose your interests (i.e., that you are shorting the stock), they have no issues in taking information from short sellers. They will use it to point them in the right direction in their investigations.
Q: When do you prefer to make a short bet using derivatives over cash equity?
The problem with short selling is that the upside is limited and the downside is unlimited. Derivatives are a good way to mitigate that risk. I would rather buy CDS than short a stock. You risk much less capital and you can make much more money.
Q: Is your investment horizon shorter with long-term puts than the CDS?
We can extend them so they are not necessarily shorter term. Of course, there is a cost to extend options.
Q: Can you describe the series of events in your research process that changed your investment outlook on Fannie Mae and Freddie Mac from bear to bull?
The stock prices declined and basically went to zero. [chuckles] They have a dominant market position and they offer a valuable service. The world has changed meaningfully in last six years since the depths of financial crisis. Housing markets have recovered. Interest rates are still very low. Their losses have declined. In fact, they over-reserved by $140 billion, and these reserves are in the process of being reversed. There are a number of proposals to wind down Freddie and Fannie. They were government agencies whose profits were taken away in an illegal action. There was no one single event that changed our minds. We became bullish after the facts changed.
Q: Is it easier to get the attention of Congress and regulators as a bull to your potential solutions on bringing Fannie and Freddie out of conservatorship?
We have made no effort to get their attention or to lobby them. We floated some thoughts in a 110-page presentation at the Ira Sohn Conference. It has made its way to the Congress and people are looking at it. The best solution to the problem will hopefully drive a favorable outcome for shareholders.
Q: How significant are macroeconomic indicators and cycles in your investment decisions?
We try to minimize macro risks in selecting the companies we invest in. As a result, we don’t need to pay as much attention to macro factors in determining the likely outcome for the companies we own.
Q: Could you talk about some value traps that you decided to pass as an investment idea?
We have seen value traps that result from the inability to influence management as a result of a control shareholder who behaves economically irrationally.
Q: Do you look think troubled industries can be value traps (something like coal)?
The coal industry is likely in long-term secular decline because of its environmental impact. We generally try to avoid businesses that are similarly disadvantaged.
Q: What advice would have for a recent graduate or an aspiring professional investor?
I would say you should find a job at a firm whose investment philosophy and principles you respect. You should try to work with people you can trust and admire and learn from your and their mistakes. Good will come from that.
Recap
• Bill Ackman has adopted Graham and Buffett’s approach about margin of safety—that is, a wide spread between the price you pay and value. Beyond that, the key element for him is very high quality of the business.
• When passive investors think the status quo will not change, an active investor can buy the company where he or she can change things and have a competitive advantage.
• Margin and leverage are dangerous sources of capital because you can be wiped out when the market crashes.
• The problem with short selling is that the upside is limited and downside is unlimited. Derivatives are good way to mitigate that risk.
8
Papa Bear
Coattailing Marquee Investors or Betting Against Them?
Be neither a conformist nor a rebel, for they are really the same thing. Find your own path, and stay on it.
—PAUL VIXIE
YOU JUST HEARD A FAMOUS investor announce a short position at a conference or on television. Congratulations, you found a short thesis along with a catalyst—but so did the rest of the market. The stock takes a quick dive and easy profits are probably off the table. You may not even be able to short the stock at this point if it falls more than 10 percent, which would prompt the exchange to impose a short sale restriction on the stock. If you are able to short the stock at this point, you face the risk that the stock snaps back. The famous investor is probably exiting at this point, and new bulls are probably stepping in.
Typically, well-publicized shorts become crowded trades; it is extremely hard to make long-term bearish bets on such stocks, even if you agree with the bear. Increased borrowing costs, short sale restrictions, and stock volatility are some of the key impediments to coattailing short trades. Such shorts can get even more complicated with public outrage from regulators, promoters, and other bulls.
If you want to coattail the marquee investor, it may be a wise idea to do your own research in addition to understanding his or her short thesis. If you find yourself on the other side of this trade after your initial research, you also want to double-check your facts because you are up against a smart investor with great financial resources and research ability. Your ray of hope in a contrarian bet is that the smart investor is human and may not be right 100 percent of the time.
This chapter presents a few well-pub
licized short stories to provide great insight into the research presented by reputed short sellers. I begin with the example of Herbalife, a highly controversial stock, where coattailing the bear would have been rough. Next, I argue how it made sense to bet against the long case for Banco Popular. I also cite an example of a short that did not work for the bear and an example where it made sense to bet with the bears. The chapter concludes with a brief discussion of analyst downgrades.
CASE STUDY:
HERBALIFE (HLF)
Act I: Bear attack on Herbalife
Herbalife is a multilevel marketing company that sells weight management and nutrition products. Herbalife became public at the end of 2004 at $14 per share and hit an all-time high of $50 in 2008, but the Lehman Brothers crisis pushed the stock back to its initial public offering price levels. However, Herbalife stock had enjoyed a great streak since 2009, rising 4.5× to hit a new all-time high of $72.23 on April 26, 2012. During this second act of the stock, the revenues (excluding shipping and handling charges) increased from $2.3 billion to $3.4 billion, and the gross profit increased from $1.8 billion to ~$2.8 billion.
Five days later, on May 1, 2012, David Einhorn of Greenlight Capital appeared on Herbalife’s earnings call to quiz management on its hierarchy of distributors and why the company stopped breaking out figures categorizing its lower-end distributors as self-consumers, small retailers, or potential sales leaders. “We can easily provide the exact same breakout going forward if you would like that sent to you and our investors,” replied John DeSimone, Herbalife’s chief financial officer (CFO). “Our objective is to be completely transparent.”1
A full decade earlier, Einhorn had announced his short position on Allied Capital at the Ira Sohn Conference. After a long battle with Allied Capital and an ensuing investigation by the SEC, Einhorn was proved right. He already had a successful record short selling financial firms—a streak he continued with his successful short on Lehman Brothers in 2008. It is no wonder that the market’s reaction to Einhorn’s questioning on Herbalife was imminent; the company’s shares fell three days in a row by 20 percent, 6 percent, and 12 percent, from $70.32 to $46.20.
However, Einhorn had not yet announced any short position on Herbalife; it was widely speculated that he would disclose his short position at the upcoming Ira Sohn Conference. However, he did not even mention Herbalife at the conference on May 16, 2012, ending the speculation on Herbalife to be his short idea. The stock rose 17 percent that day to $49.51, but then fell 10 percent the next day. Over the next three months, Herbalife stock crept back to over $50, as the company beat street estimates and raised guidance in its July 31 earnings release.
In its September 18, 2012, article, “You Have Been Einhorned,” the Wall Street Journal suggested that Einhorn’s bearish calls moved markets more significantly than his bullish ones. While Einhorn had still not publicly announced a short position in Herbalife, the stock began sliding for four days, down 10 percent from $52.53 on September 14 to $47.10 on September 20.
Act II: New bear attacks Herbalife
The Ira Sohn Conference on December 19, 2012, was a different story. Bill Ackman made a 334-page presentation, “Who Wants to be a Millionaire,” making a detailed bear case for Herbalife. Ackman’s thesis alleged that Herbalife was a pyramid scheme, where money at the top was made from losses suffered by people at the bottom of the pyramid.
FIGURE 8.1 HLF short interest and stock prices. Source: Bloomberg.
Bill Ackman is a reputed activist investor who questioned the AAA rating of MBIA in 2002 (see chapter 7). His firm wagered a short bet on MBIA stock, bought credit default swaps on MBIA bonds, and stuck to their guns on the MBIA short for six years. During this time, his firm was also investigated by the New York Attorney General and the Securities and Exchange Commission (SEC); however, his thesis eventually was proven right in December 2007, when MBIA disclosed $8.1 billion of collateralized debt obligation exposure backed by risky home loan securities.2 His short bet on MBIA made millions in profits.
Ackman’s bear thesis on Herbalife argued that pyramid schemes are inherently fraudulent and must eventually collapse. His firm hosted a website to support his thesis (http://factsaboutherbalife.com). Herbalife stock went into a tailspin as Ackman doubted the legitimacy of their business model. The stock fell 12 percent on his announcement and continued to fall three days in a row by 9.75 percent, 19.08 percent, and 4.44 percent, from $42.50 to $26.06.
Act III: Bulls plow in, tug-of-war ensues, shorts squeezed
Herbalife stock rose 12 percent on December 31, 2012, and continued to rise another 10 percent as Herbalife’s chief executive officer (CEO) defiantly presented his case during an analyst meeting on January 3, 2013. Shorts had little idea what brewed behind the stock rebound. A week later, Dan Loeb of Third Point announced an 8.24 percent stake in Herbalife; soon after, traders speculated that Carl Icahn had taken a large stake in Herbalife. The stock found life support with potential involvement of two reputed activist investors, rising another 15 percent.
On January 24, 2013, the Wall Street Journal reported that Einhorn had covered his short position on Herbalife for a profit, but the stock did not react much to the report. On the same day, Carl Icahn said in an interview with Bloomberg that he did not respect Ackman and did not like how Ackman had publicly attacked Herbalife; however, he did not disclose a stake in Herbalife. Icahn and Ackman both called in to a CNBC show during the next trading day to lash out at each other. The stock ended up by 5.7 percent that day.
In another twist, rumors of an Federal Trade Commission (FTC) conference call on pyramid schemes surfaced the following week, sending Herbalife stock down 10 percent. Herbalife continued to fall another 10 percent for the next week until the New York Post reported on February 4, 2013, that the FTC was investigating claims of pyramid schemes. The stock dropped 13 percent in premarket trading on the news, but recovered losses as Herbalife said it was not a subject of FTC investigation and demanded a correction from the New York Post.
A tug of war between bulls and bears ensued as Carl Ichan disclosed a 12.8 percent stake in Herbalife on February 14, sending the stock up 22 percent in after-market trading. CNBC reported on July 31, 2013, that Soros Funds Management took a large stake in Herbalife. Bill Ackman filed a complaint with the SEC against Soros Funds, alleging that it broke insider trading laws. Herbalife stock nearly doubled by August 18, 2013. However, I believed that the jury was still out on Herbalife stock as Ackman is known to have bounced back in the past by holding on to his position.
Act IV: Ackman replaces short position with puts, federal investigations are opened
Bill Ackman cut his short stock position by more than 40 percent around September 2013 and replaced it with long-term, over-the-counter put options while vowing to take his Herbalife bet “to the end of the world.” On March 12, 2014, Herbalife announced that FTC had opened an investigation into its operations. Herbalife was down 10 percent on the news. A month later, Financial Times reported that the U.S. Department of Justice and the FBI had opened a criminal probe into Herbalife. The stock fell 15 percent on the news to the low 50s and traded down to the low 40s at the time of publication of this book.
Takeaway
The Herbalife story shows many things that can go wrong in coattailing smart investors. Shorts with the public involvement of activist investors become a hotbed for traders and often result in violent movements in the stock price. Tactical short-term trading in such stocks may bring swift profits, but regular trading in such stocks can also be a recipe for disaster.
Smart Investors Are Human: Contrarian Bets
While only a handful of investors publicly announce their short positions, a much larger number of long investors often publicly advocate their long positions. Every once in a while, long investors tend to underestimate or overlook the risks to their thesis, begging a closer scrutiny of the risks. Banco Popular (BPOP) seemed to be such a case in April 2010, when some hedge funds held a large p
osition and mentioned the stock favorably at an investor conference. After a quick glance at the loan quality of BPOP, I became curious to look more closely at BPOP’s public filings.
CASE STUDY:
BANCO POPULAR (BPOP)
BPOP was trading at 1.1× book value while its asset quality (table 8.1) continued to deteriorate. A few things stood out as I looked further into the company’s assets: 70 percent of BPOP’s assets were in Puerto Rico, where the local governments were under great budget constraints. Level III assets, or thinly traded assets with no observable market, constituted a relatively high proportion (~4 percent) of BPOP’s assets. During the financial crisis, banks had come under severe pressure for overestimating the value of their Level III assets.3
Table 8.1
Source: BPOP SEC filings.
FIGURE 8.2 BPOP loan composition. Source: BPOP SEC filings.
BPOP did not seem to be provisioning adequately for potential losses from Level III assets and nonperforming assets (NPAs), raising questions about the quality of their earnings (table 8.2). BPOP’s stock price, however, seemed to indicate that NPAs had peaked, in stark contrast with the BPOP CFO’s statement in a Sterne Agee conference in February: “There is no way that the company can make money with this level of provision for loan losses (6 percent), we were caught with very large portfolios of real estate market through HELOC loans, construction loans, mortgage loans that now we’re paying the price for it.”