Concentrated Risk: Pabrai and Pinnacle Airlines
As a frequent reader, and now small-time contributor, to the Berkshire Hathaway group over at MSN, created and wonderfully maintained by Sanjeev Parsad, I was intrigued by a recent post regarding the dumping of Pinnacle Airlines (PNCL) by Mohnish Pabrai. Before I begin, I want readers to understand that Mohnish is one of my idols in the investing world, and I believe that his short term pain will be reversed and success resumed. His framework is too good to fail. My only goal here is to explain the possible workings of an invesment now in distress, and how we might avoid a similar fate. If I’ve stated inaccuracies, let me know and I’ll make the edit.
Now, if you’re a long time CoC reader, long term being not so long, April, one of my very first posts was about a SmartMoney article with Pabrai. In the SM article, Pabari’s #1 idea was Pinnacle. He argued that the company was worth several times its then price, $15/share. By this point, I was already familiar with Pabrai’s thesis on Pinnacle, as he had written up an extraordinarily detailed thesis on Value Investors Club late last year.
I’d also read up on the business myself to try and glean the facts. In the end, I didn’t make a purchase because it came down to some variables that I wasn’t comfortable with. What happens if their business providing regional service to Northwest Airlines is shut down? What are these airplanes worth in liquidation? Why will their cash flows improve over time? I couldn’t get a good grip on the risks. From his writings, it seemed Mohnish did.
. . . . . .
From a total of about 3.3mm shares in the 13F for the period ended 6/30, Form 4’s filed by Pabrai now show the sale of about 430k shares total since the beginning of August, representing nearly 13% of his position. That’s a big chunk, and it doesn’t seem to be abating at this point, instead accelerating from first filing to the more recent filing. The stock has gone from $15-16 down to $6 1/2 per share.
So the question now remains, Why is it that Mohnish is selling down what he recently called his best idea? Is it fund redemptions, reallocation to another position, or some non-invesment related issue? Or, has Mohnish lost faith in the investment thesis itself?
When thinking about this, it’s hard to assert at this point that the selling is due to re-allocation or meeting redemptions. Why sell your best idea, which is now 50-70% cheaper, to find a better one? If your original thesis was that company X is selling at 1 and worth 3, then when it goes to $.40, you should be backing up the truck, not selling. Pabrai knows this. So if the case is that one of his many newer positions, Sears, Wellcare Health, etc. is a better idea, there must have been material deterioration to a business he thought was worth 3-5x his cost.
Even if he was receiving investor redemptions, I would think the first sale is Berkshire Hathaway, a position Pabrai has long dubbed a “placeholder.” Also, in his book The Dhando Investor, Pabrai mentioned a “3 year rule” in which he wouldn’t sell a position for 3 years unless it reached full valuation or the intrinsic value had deteriorated to the point where his margin of safety had eroded away. If my opinion is that Pabrai isn’t selling due to redemptions, then it doesn’t make much sense that he would be selling for any other reason beside business deterioration.
Back to the story, here is the original news piece that gave the shares a drubbing:
“Pinnacle Airlines Corp. said Tuesday that Delta Air Lines Inc. intends to cancel a contract with the operator’s subsidiary on July 31, citing Pinnacle’s failure to meet minimum on-time requirements.”
Now, besides the large contract to fly regional jet service for Northwest Airlines, PNCL maintained small contracts with other carriers, one of them being Delta. In June, Delta came out with its intent to cancel their contract with Pinnacle. Supposedly, these contracts were pretty iron clad, set in stone. Besides that, Mohnish argued, the economics of PNCL’s service made too much sense for a carrier to want out of a contract. Underperformance by PNCL could trigger a breach in the contract, according to Delta.
When Delta came out with this announcement, it seemed that a major underpinning of Pabrai’s thesis was thrown into question. If these guarantees were so strong, if the economics were so right, why in the heck would Delta want out? It wasn’t the absolute dollar loss of business that scared PNCL investors as much as the loss of confidence in a major piece of their thesis, in my opinion.
If this was true, Delta could and would be willing to cancel its contract, what was the fate of the Northwest agreement? The agreement was structured in such a fashion that Northwest would take on the “fuel price risk” from Pinnacle. Thus, Pabrai argued, PNCL’s business model was a much stronger one. I agree. However, one logical question proceeding from this assertion is such: Why would Northwest let PNCL profit during their demise? If PNCL was reaping profits from the avoidance of fuel price risk and customer risk, why couldn’t Northwest change the agreement in a way that would be derimental to Pinnacle and beneficial to Northwest? Delta had already demonstrated that they wanted out from PNCL, why couldn’t Northwest follow?
Another wrinkle was added a few months back: plans for Delta and Northwest to merge. The merger was said to be the first of many in the airline industry, but up until today has remained the sole airline consolidation effort in the United States. How would the merger affect Pinnacle? Would the NWA-Delta alliance still require its service? With Delta having put their agreement with Pinnacle in doubt, there was no question that Pinnacle could be decimated by the merger.
Likewise, as the price of oil spikes, the airline industry continues to suffer. Thus, any regional carrier exposed to a major airline suffers along side. How would PNCL be affected by this spike in oil? The answer is not clear, but the risk remains, and the market has priced it into the stock.
The story today stands as such: Delta is now back on board, resuming their contract, and oil is falling. Great. But PNCL still sells for $6 1/2, down from the $15-16 where Pabrai bought in and recommended the company. This depression stems from overall uncertainty and doubt. Some of it is likely to be unfounded. But it seems that some real risk is inherent now for PNCL, with Delta throwing the certainty of PNCL’s advantages for major airlines into whack.
Are these risks being manifested by Pabrai’s wholesale selling of his shares? I think so, but it seems we might never know, as it is certainly possible that Pabrai stops selling and continues to hold, and the investment works out in a terrific fashion. I don’t know the company well enough to make that judgement. But here we stand, Mohnish selling PNCL at distressed prices.
Addendum 08/16/08:
Justin points out below in the reader discussion that another major risk, one I had not ventured, is the risk that the pilot union may not continue with PNCL. Although he seems optimistic, the risk that PNCL loses its pilots or continues to have trouble with them is one to consider. As I mentioned, I have no special competence in the company, but recognize the customer risk they are taking. This doesn’t change the point of my article, only adds another reason why Mohnish might be selling. Please keep this in mind.
. . . . .
Why do I bring all of this up?
It seems to me that PNCL is victim of a common problem: customer and/or revenue concentration. In these days, it also seems that no matter how “iron clad” a contract or a guarantee may seem, most are breakable, or susceptible to questioning. By making an investment that mostly relies on a legal guarantee with one customer that may or may not be reliable, in a time of distress for the general industry, you open yourself to all kinds of risk, known and unknown.
I made a similar mistake in First Marblehead, the student loan originator. In many ways, dependence on the credit markets is akin to revenue concentration. If you’re a big securitizer, the capital market indeed is a customer. One big, huge, customer. If he goes down, well then you’re SOL. For PNCL, when you find out those contracts aren’t so tight, and the economics of the business you provide isn’t so right, well again you’re SOL. If your entire livelihood depends on one or two companies performing, companies that are in a horrible industry to begin with, the probability that you take a hit rises dramatically. Sears will be okay in the long run because people will always need retail stores, and if not, will always be interested in great brand names and millions of sq footage in real estate. Sherwin Williams will probably be okay for a long time because people will always want to buy quality paint. But major airlines can decide overnight that using a regional carrier is no longer economic, and investors in the regional are finished. Risk.
So I guess the final question is thus: Is it worth taking on those risks? This is a question better answered by each individual, but it is clear that a difficult to judge risk can lead to disastrous results for the investor. Avoiding those risks, I’ve learned, might be a better approach in lots of situations
There is a good opposite argument here, but what I’ve learned from my short experience is that the Yellowstone risk, ironically one that Pabrai has detailed himself, might pop up where you’re not expecting. Yellowstone refers to the small chance that Yellowstone National Park will erupt with volcanic activity again some day. High revenue concentration and customer reliance might just be one of those risks, and the unfinished story of Pinnacle Airlines gives us an preview of how things might go wrong. May we have the skepticism to see these risks before they hit.
Be careful, though, of becoming Mark Twain’s cat who once sat on a hot stove and thereafter wouldn’t sit on any stoves, hot or cold. There will be opportunities to invest in companies with high customer concentration (see: Americredit’s reliance and success in the securitization market), but know that accurately determining the probability of losing those one or two customers is extremely important to the ultimate success of your investment. That risk is all too often ignored or misjudged, but can be the one thing determining whether you win or lose the bet.
Disclosure: Long SHLD.
your post brings up some interesting points: i’ve noticed many a dyed-in-the-wool value manager with long, proven track records blow up recently, or at least significantly under perform due to a few large, ill-advised investments in co’s that appeared statistically cheap on a number of metrics such as price to book, (p/b), p/s, historical p/e, and even net-net situations. some examples are tom brown, bill miller, wally weitz to name just a few. what happened? can it be chalked up to bad luck, a once in a blue moon aberration? or is there something else that has afflicted so many of these guys all at once recently?
tom brown, for instance. much as i enjoy reading his excellent bankstocks.com, i’ve never felt compelled to invest in any of the stuff that he’s championed. for a simple reason: as knowledgable as he is, and as much as he waxes convincingly enthusiastic about some of the execs running the co’s he analyzes & invests in as being great executers of their biz plans & corp strategy, i was always uncomfortable with the apparent lack of a rigorous credit anaysis that asked “what could go wrong” here. and, also, turning it inside out, had some of those co’s recent superior execution & success REALLY been attributable to market trends, or even even burgeoning but as yet dimly visible speculative excesses? just asking… because, yes, many banks & mortgage co’s, homebuilders, brokerages, credit card & financial guarantee co.’s looked cheap & had unlimited access to a hungry, growing securatization market, but what about the basics under-pinning the growth of those sectors? had inflation adjusted average incomes kept pace with the increase of housing prices over the last decade? had incomes & savings kept pace with the growth in revolving credit balances? what kind of financial shape were municipalities really in, & how much did ever rising property values & a long economic expansion mask underlying frailties? the list of questions goes on & on. and i believe this is where buffett distances himself from most of the others. he knows the importance of having a margin of safety at some deeper gut level than that of many other value proponents, who only glimpsed a mirage-image of it. i also believe that many hedge fund & private equity guys have been unwitting beneficiaries of the long, benign credit & capital markets for much of their recent leverage enhanced returns, something that is not likely to last, along with their status as masters of the new investing universe.
btw, i read mohnish’s dhandho investor & think very highly of him on many counts. i wish i could get my hands on mosaic volume at a a decent price. i also think he will rebound from his recent rough patch with flying colors. but other recent vuanted investing legends might not have the same success they enjoyed during the last 10-20 yrs if the environment slowly but inexorably morphs into a ‘70 style malaise where the tide is going out & tries to sink all boats. without wanting to subscribe dogmatically to a pre-ordained sense of impending doom & gloom, the times may be a-changin’.
Interesting post.
SKYW was another company that came into the value range over the past few months. It’s a regional airline similar to PNCL, but its cash flows are stronger (long term contracts with DAL and UAUA).
Still trading at a 50% discount to intrinsic value, but there are probably better plays out there.
Flyboy,
It’s really context depending. You have to know the terms of those regional carriers’ contracts with their majors. But, basically, with Pinnacle, Mesa, RJET, SKYW, you’re not going to get away from the concentration problem.
Link,
Wow, I agree with you on nearly all of your points, including Tom Brown. Though, I have purchased Primus Guaranty but it was subject to my own diligence process and analytics. I got to the same conclusion, though. I agree he hasn’t been nearly skeptical enough. He’ll bounce back, though.
I do disagree with your last statement, that it’d be hell for respected value investors if it turned into the 70’s. I think some of them might be subject to issues, some. But the real legends, the real value investors like Seth Klarman, a Joel Greenblatt, Bruce Berkowitz, I’d even say probably Pabrai, that league of investor, I think those guys will hold up perfectly well if things get really bad. They would probably outperform even more.
Jeff,
From the outside, I’d agree with you. Here are some industry facts. Feel free to check up on them.
- Skywest and Republic are widely regarded as the best RJ operators
- Mesa and ExpressJet are known for being fiscally irresponsible
- Pinnacle is a good operator, but gets pushed around because of its size. Delta tried to screw them, but can’t (contract). However, unless they can charm the new NWADAL, Pinnacle’s hopes for future contracts are dim
- As you know, growth in this industry is a step-function, but earnings are as steady as the contracts: Skywest has had its Delta contract since ‘87 (and added another through their ASA acquisition in ‘05, a month before Delta’s bankruptcy). It added the United contract in ‘97 after Mesa messed up (and maintained the contract through UAUA’s ‘02 bankruptcy).
- Jerry Atkin has been at the helm since ‘75, and he’s known as an excellent manager
Basically, Pinnacle, Skywest and Republic are not in the same league. Pinnacle always up on my cash flow screens, but that’s more about the way they finance their planes and accounting choices that it is true cash flows. Skywest chooses to be ridiculously prudent. Their TBV is $1.5b, after you remove a $400m tax liability.
Value investors should be identified through the success of their actions, not necessarily through what they preach. I’ve met several self-proclaimed “value” people who’re essentially speculators with a story about their company.
Decent article…
However, you actually missed the biggest risk factor of Pinnacle. It has nothing to do with it’s single revenue stream. The Delta situation made that even more clear as the NW contract is much more lenient than the Delta contract. If Delta can’t get out of the contract there’s no way that NW can.
Secondly, the contracts are merger proof. You can actually read them from a couple of online sources.
Last, the major risk to Pinnacle are the pilots! There is still no contract. If the pilots strike that kills not only Pinnacle, but all the airlines they service. If the contract gets resolved that not only makes Pinnacle a lot more attractive to stockholders, but also to major airliners. Therefore, PNCL will start winning more contracts and additional capacity agreements.
Keep an eye out, indications are that the Pilot contract could be a done deal come early September. If you know where to look, you’d figure out that they are negotiating in DC right now - a rather important and meaningful departure from normal negotiations. It’s more of a mediation this time, and word on the street is that the pilots like what they’re hearing.
i too looked at Primus Guaranty, but ultimately passed. my impression is that is that it will at some point make for a terrific multi yr trade, coming out of a recession. i feel the same about a no. of other financials. but in general i’m skeptical of co’s that depend heavily on the kindness of strangers for their sustenance, which is to say co’s that rely on the capital markets for the continual funding of their daily bread. i’m a bit idiosyncratic in my tastes that way. and its not just various financials who benefited from the golden age of buoyant capital markets & the cheap, inexhaustable supply of credit. throw in private equity (didnt they used to be called LBO funds in more sober times?)& certain leveraged hedge funds as well.
i couldnt agree more about Seth Klarman, Joel Greenblatt, Bruce Berkowitz, & Pabrai. they are real value investors who will prob shine in a prolonged bear market. i didnt mean to imply all value investors would be shown to have been swimming naked when the tide goes out. many others who made their legends & reputations starting from the long bull run of the 80’s & 90’s, tho, i am not so sure about. i think they might have been lifted up higher than otherwise simply because on the swelling tides they happened to be surfing in. but that’s just a gut feel.
Flyboy,
Great data, thanks! Helps prove the point re: Pinnacle.
Justin,
I wasn’t trying to argue that Delta necessarily would get out. I made sure to let readers know that Delta was, in fact, in. But a major underpinning of the thesis here is that these majors would never want to get out in the first place. The economics of the business they provide made a lot of sense and the majors like using these regional carriers. The great new aircrafts, the silence, luxury, and speed, etc. Delta saying “lets break” puts doubt into that. Maybe they can do it on their own in this environment?
This isn’t an isolated issue, either. It seems Delta has already broken with XJET and is in a legal battle with Mesa. The contracts always have loopholes and issues. I’m not arguing that they will break, but that investors don’t properly consider the risk that comes with having only a few customers abiding by a legal contract. Even though the contract worked out for now, customer risk remains. What if NWA-Delta goes bankrupt? How does Pinnacle stand in that scenario? What if NWA wishes to alter the contract, and PNCL goes along to avoid litigation?
I did mention that there could be great opportunities in this area. But you’re heaping risk on yourself if you invest in a company such as Pinnacle, often without knowing it. Your margin of safety can be more susceptible than you considered.
The pilot issue, I’m sure, is another big issue at work here. Again, I don’t know the company extremely well, I tried to make that clear.
So I wouldn’t say I “missed the biggest risk.” I pointed out the risk that is often not considered properly.
link,
With Primus, there are a lot of factors at play there. One, you have to take a good look at the paper trail for management. There’s a lot of great stuff to see there.
Two, see how they have performed in this turbulence: extremely well. Primus sells credit protection. It seems very difficult to come up with a plausible scenario that banks don’t want to buy credit protection on their bonds. Yes, they rely on the CDS market being open. But it’s not a market that closes when there is trouble. In fact, the more trouble out there, the more active the CDS market becomes as banks rush to cover their risks.
If there is a major slowdown in activity for Primus, sure the intrinsic value would go down. However, when you find a company with such a huge margin of safety that even in the scenario that value decreases big time, Primus is fine and we don’t lose money.
The major risk for Primus really isn’t the market, per se. It’s a scenario where BBB-AA companies start defaulting at unbelievable rates. In that case, Primus would have to spend a lot of capital covering their contracts and taking on bonds. I’ve looked at some pretty well done analyses of these scenarios, rising defaults and mediocre recoveries, and Primus is priced whereas, again, value would plummet but not much further than $3 1/2 or so.
If some of their counterparties stopped paying, Primus’ book value is still intact. The future earnings stream might be hurt, but they still have book value around $10/share, without considering future payments from counterparties. Even if one or two dropped, Pinnacle could still cover costs and wouldn’t be burning cash, so TBV would still be intact. If almost all their counterparties weren’t paying, we might have a bigger “Armageddon” problem than what Primus is worth ;-).
All of these risks are quite remote, but considerable in their magnitude. However, looking at the price we’re paying to take on the risks, it makes for a good investment. I wouldn’t buy Primus (or any company) without a substantial margin of safety. I also wouldn’t buy a financial company without confidence in conservative management. I get both with Primus and a company with a great track record in good times and bad.
link,
You have some good points but little of it has anything to do with value investing per se. My impression of value investing is that it does not rely heavily on macro trends and economic scenarios. Mostof what you say, which are quite plausible, are speculations on the macro environment.
Maybe we will get a massive credit bust which spreads to all sorts of assets and the world will really be different. Or maybe not.
Maybe we will end up like the 70’s with high inflation and those who did well in the 80’s and 90’s will suffer. Or maybe we won’t.
Maybe we will end up with a huge number of bankruptcies in municipalities, causing all sorts of problems in the, once super-safe, muni bond market. Or maybe we won’t.
The point I’m trying to make is that no one knows. My impression of value investing is that you try to buy at really low valuations and try not to spend too much time betting on what may or may not occur. Yes, you should take the economics into account but that’s only a minor factor.
You say that Buffett isn’t like others and pays attention to macro. I think you are wrong. If he actually thought we were going to have a huge housing bust, he wouldn’t own USG. If he thought consumer credit was going to be problematic, he may have trimmed his American Express position. If he thought the credit situation would worsen, he probably wouldn’t own Bank of America.
Rightly or wrongly, many value investors do not pay much attention to macro. That’s why many are doing poorly this year. The reason many don’t pay much attention is because (i) you can’t predict the future, and (ii) you wouldn’t know what it means anyway. Regarding the latter point, say you knew that consumer debt was high (which it is) and consumers were going to delever in the future. Does this mean American Express is going to dissapear (say, the way Polaroid died?) Or does this mean American Express is going to go bankrupt (due to high excessively high defaults/frauds/etc?) Or will it still do well (perhaps due to foreign expansion?)
Link,
As someone else who owns Primus Guaranty, they aren’t dependent on the capital markets for liquidity. I believe their first debt maturity doesn’t occur until after 2020.
Sivaram,
You make a couple good points about Buffett’s style, but it all really goes back to the Berkshire Owner’s Manual - the policy is not to sell great businesses, regardless of price.
getting rich is not easy
Good point James,
All readers,
Please see 8/16 addendum above just before the second divider. Thanks to Justin for his comments that led to this. I appreciate the reader discussion for this very reason.
Link,
Pabrai’s “Mosaic” may be pricey but you can get almost the entire thing here for free:
http://www.valueinvestingnews.com/poor-mans-mosaic
Jeff, I might have another look at Primus. Some of your comments/insights re-piqued my interest. I do still worry about the potential of corporate defaults spiking beyond what many commentators are currently predicting. More importantly, tho, i worry that the market has not yet PRICED in the very real possibility of corporate default mayhem. But, again, that may not necessarily be true of Primus at these levels. And having a strong, rational, savy mngt team in place is key in a co like this for a value inclined investor to take the leap of faith.
Sivaram, I agree with you a 100% that, generally, one’s macro views- if one holds any at all- should not be the tail that wags the dog when investing. Except, perhaps, in the case of co’s whose very existence or franchise value would be threatened by such a scenario. Shouldn’t stress-testing worth its salt ask “what if” questions of that kind as well? And why shouldn’t that inform an investor’s over all sense of a co’s margin of safety? Does its price already discount plausibly gloomy probabilities?
I think we should be skeptical of absolutism regarding adages & truisms that have earned their place in the collective consciousness because they are BROADLY true: there is always the exception that proves (or is it ‘disproves?’) the rule. Actually, I’d argue that there are more than just a few ‘value investors’ who contemplate macro views which color their thinking. Head over to Pimco’s website, for instance. They’re value guys, even if bonds are their thing more than equities. Reading the articles there by Bill Gross & Mohamed El-Erian suggests that a macro viewpoint overlays much of their thinking & investing. I doubt that they are so married to their big picture views that their whole investment thesis & success hinges on their being right on that score, however. As true value guys tho I’m sure that it is just one of many different imputs that help them evaluate, choose, & intelligently inform the price they willing to pay for investments. Then there’s Prem Watsa & his team at Faifax. He’s probably familiar to anyone who frequents the MSN Berkshire board. Reading Prem’s shareholder letters cant help but leave a person convinced he has very strong macro views & have invested accordingly. But maybe Prem & his team are just value guys who are cognizant of stock market history, the madness of crowds, & speculative hangovers. Call it what you will. As value investors its not that their macro views alone dictate their investment posture, its prices & probabilities. Anyway, I think there is a lot more diversity among value investors than can be neatly summed up in with a few choice adages pithily defining what they do & don’t do. And I find it hard to believe that even Buffett is not in some way influenced by such things like an awareness of the long term widening gap between rising house prices & incomes- to choose just one ‘big picture’, macro-type example in this instance- and that similar concerns on his radar might have been part of why he has said in a few recent interviews that “the recession will likely be longer & deeper than most people expect”.
lincoln minor, wow! thnx a million . i’ve got it bookmarked. and that’s a terrific site too
link,
if you’re reading blogs and are interested in value investing, VIN is one of the best sites around. They aggregate all kinds of popular value investing material, so add it to your RSS feed and enjoy! Also go to George’s other site, fatpitchfinancials.com, another gem.
Linc,
Thanks for pointing out the Mosaic Chapters. I had meant to do it myself, but I slipped!
[i]LINK: ” Reading the articles there by Bill Gross & Mohamed El-Erian suggests that a macro viewpoint overlays much of their thinking & investing. I doubt that they are so married to their big picture views that their whole investment thesis & success hinges on their being right on that score, however. “[/i]
The whole notion of what is value investing and who exactly fits the mold is quite subjective and I suspect that all of us will have differences of opinion. Some people say Bill Miller is not a value investor whereas I think he is. In this case, I really don’t think of Bill Gross and Mohamed El-Erian as value investors. I can see why some would say they are but I personally don’t see them that way. My main reason goes back to what I was saying. They seem to base most of their investment on macro views, and this takes us further away from value investing in my opinion. Bill Gross is very similar to Jim Rogers or Marc Faber, who I also do not consider to be a value investors.
All these guys are macro speculators. There is nothing wrong with that. In fact, I am one too so this isn’t to say there is something wrong with their techinques. All I’m saying is that it has little to do with the core of value investing. Whether it’s Jim Rogers or Bill Gross or any other macro-oriented investor, they are making decisions based on some macro trend that may or may not materialize. For instance, Bill Gross has been so wrong on some key calls (especially US$ bonds) in the last few years.
Maybe Gross has to play in the realm of speculation since bonds are generally priced efficiently. As Martin Whitman often says, credit instruments without credit risk (eg. US Treasuries, Agency bonds (if you assume US govt backs Fannie/Freddie)) are generally efficent markets; so you are down to the riskier junk bonds and EM markets which are just a portion of PIMCO’s investments. In any case, there is very little value investing from what Gross does (I’m not familiar with El-Erian). How can one say there is a margin of safety in buying high-quality bonds? Sure, you can buy/sell them during irrational market behaviour (Buffett does this all the time) but bond investors like Gross are always invested (they don’t always rely on capitalizing on irrational pricing like Buffett or others can).
I can’t say I’m too familiar with Prem Watsa but I view his CDS on credit investment as closer to speculation. Even Watsa has alluded to in some interviews how this is essentially a bet on a low probability event. Risk was underpriced in the last few years but the bet was on a low proability event. It’s closer to a “chaos trade” than anything. It worked out well but I doubt that you could have been certain it would have worked out. In contrast, value investing lies on buying undervalued assets with a high likelihood of making money off it.
Now, I’m not saying that value investors don’t look at macro. They do, and everyone should. Even Benjamin Graham looked at macro when deciding how to shift in and out of bonds versus stocks. However, the question is the degree of emphasis on the future macro trend. I would argue that value investors don’t rely much on it.
[i]LINK: “And I find it hard to believe that even Buffett is not in some way influenced by such things like an awareness of the long term widening gap between rising house prices & incomes- to choose just one ‘big picture’, macro-type example in this instance- and…”[/i]
I’m sure they look at it but the key thing is that they don’t rely heavily on it. If Buffett knew that credit was underpriced or that some assets were severely overvalued, he could have easily sold short or buy put options or something (he has been selling put options on major indexes so this is nothing unusual for him.) I suspect the main reason they don’t rely on macro is because you just don’t know what hte macro trend means for an individual security. Also some of these may be short term dislocations. For example consider the tobacco industry a few decades ago.
If you looked at tobacco a few decades ago and somehow predicted everything to 100% accuracy, you would have seen the following: declining usage in developed markets, almost total ban on advertising (except print I believe,) huge settlements with governments wiping out many years of profits, declining usage amongst teens and young-adults (key future user,) and so on. So tobacco companies would have been poor investments based on macro (assuming you could predict the macro correctly.) Well, Philip Morris is one of the best performing stocks in the last 30 years! Even if your macro call was correct, your investment (say short selling Phillip Morris) would have been a total disaster.
[i]LINK” …that similar concerns on his radar might have been part of why he has said in a few recent interviews that “the recession will likely be longer & deeper than most people expect”.”[/i]
Yes, but did he not also say in the same interview that his buying decisions would not be based on that? He said something like he wouldn’t buy stocks based on those reasons but he also wouldn’t sell based on those decisions either. In other words, he considers the macroeconomic situation but investments are bottoms-up.
To tie all this together, consider what is discussed above: Primus Guaranty (PRS). Jeff might beat me up for this but Primus can easily go bankrupt if corporate defaults skyrocket and a huge chunk of American corporations (or whoever they insured) collapse. I don’t follow PRS but if they are insuring just-above-junk credit, I can see that happening. Can that happen? Yes. Is it likely? No. So would you make an investment decision in PRS based on what may or may not happen? I would say the proper approach is to look at the company itself and consider, but downplay, the macro scenario.
Siv,
You’re right. Primus could go bankrupt if America starts going bankrupt. Considering the price and the probabilities, it is a bet I’m willing to take. Now, I wouldn’t put my entire portfolio in Primus, like James Cullen did (although lots of it in the preferred vs. the common), for just that reason.
However, looking at past levels of defaults, in various periods, the level of defaults would have to rise dramatically. Also, this gives no credit to Primus’ risk management and portfolio management strategies. They aren’t holding an index of credits, but carefully selected ones, instead. They have the ability to close out the contract early at a loss, to avoid a larger one later.
I’ve absolutely taken the “macro” into factor at some level. But basically, the investment is a bet on the market recovering from its irrational state (in regards to PRS), and the company being able to thrive until that happens. I don’t bet based on some macro “overlay” but I don’t close my eyes either.
The credits they sell swaps on are investment grade (97%) from BBB to AA. They are good credits, not near junk status. Lastly the CEO is a legend in the risk management industry, and someone whom I respect highly. Looking at the trail of events that has transpired since Primus went public, I have a good chunk of faith in Tom Jasper’s abilities. He’s managed the company in a shrewd way and only tiptoed into new ground (i.e. selling swaps on ABS instead of corporate bonds, opening CLO’s…)
So, while Ram is right that the downside, theoretically, is zero, I place a low probability on that occurence. It may happen, but I’m betting against it with my words and my wallet. I could be wrong.
sivaram, what can i say? you’re much more of a value investor purist than i am, much as i struggle against certain tendencies in myself that lead me to stray from the straight & narrow sometimes. its not that i’m irrevocably married to any particular macro view , its just that i cant help but to entertain various gloomy “what if” scenario’s that could stress a business from the outside in. never the less, macro concerns didnt stop me from investing in two different broker/dealers even tho i was convinced that the broader brokerage industry was vulnerable on a multitude of fronts, mostly their own speculative excesses & toxic balance sheets. and i’m invested in three different restuarant co’s aside from the fact that i’m a nervous-nelly with regard to things like: the high price of gas, electric, heating oil, groceries, tuitions, health care, rising unemployment, falling home values & the loss of home equity as giant atm machines, low & falling savings rates, increasing credit card debt, higher borrwing costs combined with shrinking credit availability, & even the over-saturation of restuarants generally. and i’m sure that i missed alot of things that worry me in addition to these. these macro worries dont scare me out of the market or out of certain sectors but they do make me more selective.
jeff, on the ABS swap sales that Primus has tip-toed into recently, do you know what the maximum no. of securities are that can be bundled into a single issue? in other words, is it a small enough no. for Primus to analyze security by security? because one of the big problems with the ABS market has been a severe lack of transparency due to the massive tangle of individual securities that make up many of them, rendering them virtual black boxes.
Link,
What you’re really referring to are CDO’s and CDO Squared, which tend to be a bit of a black box.
A mortgage backed security, on the other hand, is just that, a security backed by whole mortgages. So you can go through every mortgage (or, more likely, a database of the loans with detailed statistics of each loan and what they look like in groups).
So they don’t actually have any securities to analyze, just mortgages.
Anyways, it doesn’t matter much. They only sold swaps on $80mm worth of ABS (compare this to over $24B sold on corporate entities), and they no longer are in the business. It’s immaterial to the business at this point.
Like I said, they tiptoed, and now at the sign of trouble ( they were hit with some defaults on the MBS), they are out.
Great post. A business with one customer inherently lacks a moat.
thnx, jeff,
i should have referred to the indivivdual mortgages that make up each ABS security. my bad.
still…
is the case-schiller index a flawed construct that should be ignored or discounted in the eyes of so many involved in mortgage investments? i dont know how ? it seems to be very fundamentally rigorous to me, even tho it smacks suspiciously of a macro data-byte that should have no relevance to bottom-up value investors. i think it gives valuable context on a micro, individual co level also. for instance:
http://bigpicture.typepad.com/comments/2007/08/how-low-will-ho.html
http://bigpicture.typepad.com/comments/2006/11/near_a_bottom_i.html
for those of your readers who are so inclined “the big picture” is a great aggregator of interesting & relevant market data & commentary.
link,
I get to the Big Picture through a daily perusual of Abnormal Returns, but that’s about it. Regarding what I do as an investor and a thinker, analyzing the make up of the Case-Schiller is pretty much noise.
If it was at all time highs or something like that, in bubble territory (2003-2006), I might take a look if I was betting on a bank or a mortgage broker or some similar company. But at this point, I know just by being alive and aware that home prices are in the tank, and they’ll eventually come back in a few years.
The data underneath each assumption there doesn’t change my thinking on a Sears or a Steak N Shake or my other companies. All I know is that they offer a great risk and reward profile with a management team determined not to mess it up. A lot of reading and thinking goes into that analysis but large macro-style indexes generally aren’t one of them.
As an example of an index I might look at, I’m currently interested in a company called KSW. They install HVAC systems in large NYC buildings under construction (high rises, hospitals, etc.), and act as a trade manager for these projects (find the subcontractors, get bids, etc.).
An index I looked at there recently was one detailing the HVAC market over the years. By looking at that simple chart I was able to put 2+2 together and figure out one big reason KSW struggled from 2001-2004: That market was at a 30 year low. There’s a useful data point.
Huge indexes detailing something as broad and complex as housing prices doesn’t offer me up much. One, as you said, you have to decipher the makeup of the index itself. Is it measuring what I want it to be measuring? Two, I need to dechiper what the index is telling me, in a way that is useful. Then I have to take my insight there and say, how does this affect Company X in a material way? Lastly, I’d have to get into prognosticating the future of the index (in this case, home prices). Each step I lose strength in my analysis.
Maybe some day I could do it, but today isn’t the day. I’m sure some people can do it, but I can’t.
jeff, i understand your skepticism re broad, complex indexes like case-schiller. although i’m less concerned that housing prices may still be 15% overpriced according to it than i am about the implications of falling real income growth, which has been anemic at best for the last 25 yrs. the ever widening gap between house prices & income growth during that time has been an eye opener. its a simple series that does a better job measuring affordabilty than more sophisticated housing affordability indexes that include the cost of mortgage payts in the mix. those are prone to skewed results due to increases in average mortgage maturities, lower interest rates, & some new-fangled mortgage engineering. but like you say, these macro data series are prob only of value to bottom up val investors at extremes.
Your last comment sums it up, Link. It’s only useful at extremes. That counts for the major stock indexes too. The movement in the Dow is meaningless unless its up or down a thousand points or something.