The Investor's Consigliere

David Tepper Wall Street Journal Profile

The WSJ profiles hedge fund manager David Tepper of Appaloosa, whose fund was up 120% in 2009.

Tepper's success this year is a testament not only to his gutsy bets, but to successful positioning.  After the annoying experience of having been unduly influenced by his investors not to short the Nasdaq in 2000, he resolved more or less to ignore his LPs.  By the time I got to Wall Street a few years later, Appaloosa was well-known as a fund that made bold bets, which would produce very great years but also some very stressful years.

If even I knew this, then Appaloosa's investor base knew it too, which reduced the fund's asset/liability mismatch in terms of risk tolerance.  A bold portfolio required bold capital providers, and over time that is what the fund has attracted,

Ultimately, this "everyone on the same page" state allowed Tepper to make his 2009 moves relatively unmolested (Alan Shealy of Boise does not count as a molester).

Terra Firma/Citigroup Lawsuit Over EMI

Bloomberg article here.

You can learn a lot about an investor when he sues someone or gets sued.  A lot is revealed through discovery and depositions and testimony.  It will probably become a bigger part of money manager due diligence, at least in the world of private equity.

The other thing to examine, as the article mentions in passing, is the use of the lawsuit as a tactical or strategic instrument, as itself a type of investment.  To pursue a civil lawsuit requires an outlay of money, time, effort, and reputation in the hope of achieving some monetary reward.  A large corporate lawsuit can rival a good-sized PE acquisition in terms of the financial and human resources required.  Each lawsuit has its own prospective risk-adjusted return which can be evaluated (some even do it professionally), and when a professional investor like Terra Firma sues someone, that lawsuit becomes another portfolio asset and a subject of due diligence. 

 

Bryan Burrough's Vanity Fair Profile of Marc Dreier

Anyone who co-wrote Barbarians at the Gate belongs in the Business Writers Hall of Fame.  Anyone who wrote Vendetta about Edmond Safra also belongs in the Hall of Fame.  Anyone who wrote The Big Rich about the great Texas wildcatters belongs there too.  Bryan Burrough did all three, which puts him on Mt. Rushmore. 

Now that I've regained my composure:  The November 2009 Vanity Fair features Burrough's extended profile of Marc Dreier, which Dreier cooperated with.  It's a shame Bernard Madoff came along and ruined everything because Marc Dreier's scheme was even more audacious and difficult to imagine.  It's one thing to go after and defraud the naive and the gullible, rich widows and orphans and status-seekers who don't know much about investing, and to do it via a Ponzi scheme, which has an internal logic to it that makes it easier to prolong.  Dreier just "went full con artist", which everyone knows you should never do (start watching at 0:25 and stop at 1:10), and he went after and defrauded the best, stealing from a who's who of hedge funds.  

The obvious question is how someone like Dreier could have stolen so much from people who are so good.  And he stole the most from the best--you're just going to have to trust me when I say this.  Without knowing the details of the scheme in full, all I can say is that if Dreier had had to deal one-on-one with the managers of these hedge funds, rather than with people who reported to them, he would not have had a prayer of success.  It's one of the buried risks of investing in large funds--the founding genius can't oversee everything.

Michael Moritz on Talent Scouting

Out on bail, fresh out of jail, Consigliere dreamin' . . . 

Just kidding, I haven't been in prison.  I've been locked in my apartment working on a writing project, a real grown-up one that I may even get paid for.  But I miss my blog and speculate that by continuing to write for it it will help me write the other thing.  Practice makes perfect.  So expect more posts.

Here's a little one, more for the personal file of this self-styled "investor talent scout":  Fortune magazine recently devoted nearly an entire issue to Steve Jobs of Apple.  It featured an interview with famous venture capitalist Michael Moritz,  who wrote a book about Apple a long time ago when he was just a reporter for Time.  As I've blogged before, I like to study successful venture capitalists because they are supposed to be experts in spotting human talent, a skill that's relevant to investment manager selection.  Moritz was asked about this and here is what he said:

How has your study of Jobs and Apple helped you in your job as a venture capitalist?

Extraordinary, rare companies -- like Apple in those first two or three years -- have some common traits. The individuals will be different, the businesses will be different, the decade will be different, but the purpose, the drive, the sense of mission, the intelligence of the founders -- those will be common. If you have been around the start of success, it's far easier to recognize it again.

I think the last sentence is key.  If your job is to recognize something--e.g. a young company that's about to be very successful--what makes it far easier is not necessarily the ability to divine the future of a product or be a genius or something complicated like that, but simply the experience of having already observed that something before.  They used to think that chess grandmasters had a special kind of intelligence, a way of seeing many moves ahead that others lacked.  But over time, people who study chess intelligence have de-romanticized that opinion, and now think that skill at chess is a more simple matter of having studied and memorized positions and how they were played out, and having the ability to recognize patterns so that, when a novel position is confronted, the grandmaster can relate it to one he (or she) has seen before and knows the "answer" to.  Moritz is saying that the experience of observing the young Steve Jobs in action has by itself made it far easier to recognize what a successful company founder looks like, even though no founder is exactly the same.  I think the same thing applies to successful investors--the experience of having observed and studied them in action makes it easier to evaluate young investment talent.  I've never seen Warren Buffett in action but through study I've come about as close as possible to it, and when I meet with a new investor I'm simply asking myself "how close is he to Buffett"?  I did have the good fortune to work for a hedge fund manager with one of the best long-term risk adjusted records ever, so I have seen him in action, which helps me know what to look for in a successful young hedge fund manager.

By the way, a similar logic applies to the craft of investing itself.  Warren Buffett is a genius in terms of IQ and computational ability and all that, but a large part of his success comes from that fact that he's studied and memorized more business and investing "chess positions" than anyone else and knows how they've played out.  When he confronts a new position, then, he can relate it to one he's seen before and knows the "answer" to. 

Galleon Due Diligence

From the FT.  An excerpt from one due diligence report:

“Crudely, there are three ways to make money as a hedge fund manager,” said one large multi-billion dollar asset manager.

“You can take advantage of trading technology, but few do.

You can be more intelligent than others, but few are.

“Or you can have some specialised source of sustainable information. Unless that information is from fundamental analysis – and in Galleon’s case it did not all seem to be – then that’s a red flag for us.”

J. Christopher Flowers Profile

Fortune profiles Chris Flowers, one of the best-known private equity investors in financial services companies.

My working hypothesis, as I try to expand my manager selection skills from stockpickers to other platforms like real estate investing and private equity investing, is that these other platforms can and should also be viewed through the lens of value investing.  Simply put, you evaluate a private equity fund manager the same way you evaluate a hedge fund manager: by trying to predict that individual's ability to generate superior risk-adjusted returns over time.

"Risk-adjusted," in the value investor's dictionary, simply means the combination of the probability of permanent (as opposed to quotational) capital loss and the magnitude of that loss when it occurs.  In private equity, adjusting for risk in this way is especially important because private equity relies on leverage.  In private equity investing in banks, it's even more important because banks themselves are highly leveraged businesses.  Small mistakes in predicting the future by managers become big mistakes to limited partners.

A value investor creates superior risk-adjusted returns mainly by investing with a margin of safety.  "Margin of safety" is often defined simply as a bargain price, and it's certainly true that the lower the price of an investment relative to its intrinsic value, the lower its risk according to our definition.  I prefer the slightly more elaborate definition contained in Seth Klarman's aptly titled book Margin of Safety because it gets to the epistemological truth about why value investing works as well as it does:

Margin of Safety--investing at considerable discounts from underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e., a "margin of safety") while avoiding sizable losses (my emphasis).

Value investing is ultimately a theory about the future, in particular the future of any given set of cash flows one chooses to predict.  Value investors like Klarman see the future, almost intuitively, as subject to imprecision, bad luck, and analytical error, and seek to minimize the impact of this on their investment returns.  They do this primarily by looking only for bargains, but also by making sure what they think is a bargain is actually a bargain--by investing only when they can predict the future of a given set of cash flows with relative certainty.

Protecting yourself and your investors from imprecision, bad luck, and analytical error, and making sure you invest only when you can reasonably predict the future--that is, ensuring you have a margin of safety--becomes especially important in private equity because of the leverage involved.  Leverage does not change the probability of a given universe of outcomes so much as it magnifies the effect of those outcomes to equity holders.  The more leverage, the greater the probability of a great outcome if things go well, but also the greater the likelihood of permanent capital loss is if they don't.

So figuring out whether your PE manager invests with a margin of safety is very very important.  This Fortune profile only gives a glimpse of whether Flowers does it.  It cites two examples of permanent capital loss, but also gives ample evidence that Flowers really knows his way around a bank.  So I can't draw any firm conclusions.  And I take no comfort from the fact that Warren Buffett is quoted as saying of Flowers "I think he's a smart guy."  In the language of Wall Street, "I think he's a smart guy" is a way of saying something without revealing anything.  Also, I'm familiar with the Warren Buffett style of personal testimonials, which he takes as seriously as haiku, and can say with confidence that when Warren Buffett wants to praise someone, he doesn't simply say "I think he's a smart guy."  He says something like this:

Jim Kilts transformed Gillette.  Before his arrival, the company was a study in self-deception.  Great brands were being mishandled, operational and financial discipline was nonexistent, and fanciful promises to investors were standard practice.  In record time, Jim excised these business pathogens.  I've learned much from Jim.  So, too, will readers of this book.

or this:

In this book, Adam Smith says I like baseball metaphors.  He's right.  So I will just describe this book as the equivalent of the performance of Don Larsen on October 8, 1956.  For the uninitiated, that was the day he pitched the only perfect game in World Series history.

or this:

I knew Ben [Graham] as my teacher, my employer, and my friend.  In each relationship--just as with all his students, employees and friends--there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit.  If clarity of thinking was required, there was no better place to go.  And if encouragement or counsel was needed, Ben was there.

Walter Lippman spoke of men who plant trees that other men will sit under.  Ben Graham was such a man.

Because I can't draw any conclusions from the Fortune article, I'll instead close with two more general point about margin of safety in PE, especially famous PE investors with great reputations:

1) It's important to keep in mind that a famous PE investor enjoys a personal margin of safety that his L.P.s do not:  If a given fund goes badly, he can always say "bad luck, who could have predicted these macro shocks" and go raise another fund, while if it goes well he'll become extremely rich, or extremely richer.  So a given PE investment may pass the personal margin of safety test while failing to provide an adequate margin of safety to his investors.     

2) The intuitive understanding of and desire for a margin of safety when investing are independent of a PE manager's pedigree, brainpower, contacts, fame, deal flow, skill at chess*, etc.  If you possess all of the latter but lack the former, you may be more dangerous to your investors' long-term wealth than if you possess all of the former but none of the latter.  If you put a gun to my head and forced me to say what Buffett meant by his faint praise of Flowers, I would speculate that he thinks of Flowers the same way he thinks of John Meriwether: "I think he's a smart guy, but . . . he doesn't invest with a margin of safety."

*As an aside, I hate it when skill at chess is presented as a metaphor or proxy for competence in general, especially when applied to investors.  It is factually untrue.  Chess masters and grandmasters have been studied to see if their skill at the game translates into skill at anything else, or IQ, or other measures of intelligence.  Generally it does not: skill at chess implies only that you are skilled at chess.  The most you could say is that skill at chess is a proxy for the ability to practice hard enough to get good at a mental exercise like chess.  That aside, judging investors by their skill at chess, or bridge, or other games of skill, is like judging offensive linemen by their bench presses at the scouting combine.

Disclosure: Long Berkshire Hathaway.

Update:  The Public Buffett Giveth, the Private Buffett Taketh Away.  Check out page 2 of Rice MBA student John Reuwer's notes from his class trip to Omaha.  If the link ever breaks, here is the money quote:

[For Bank of America] to pay anything for Merrill was silly.  Everyone knew Merrill would be basically free one day.  It's not smart to pay a premium when you don't have to.  The Fairness Opinion from Chris Flowers was a joke.  I want to write a Fairness Opinion about the Fairness Opinion. 

Buffett--I mean Gaines--on Valuation

To evaluate investors one must evaluate how they evaluate their investments.  One of the things I look for is what I call "elegance" in valuation.  It' s hard idea to define; you kind of know it when you see it.  Warren Buffett rarely discusses valuation, but when he does he almost always demonstrates this quality.

I guess what I mean by elegance is the ability to restate a problem (in the context of investing, the problem is most often "what is this asset worth?" or "is this asset undervalued?" or "what is the expected return of this asset?") in such a way that the solution presents itself with disarming clarity.  Think of the legendary story of a precocious German schoolchild daydreaming in class in the 18th century.  The dour schoolmaster commanded his students to sum all of the integers from 1 to 100, expecting the tedious calculation to occupy at least a half hour of his students' time.  Instead our precocious schoolchild, the youngest in the class, almost immediately blurted out the correct answer, making the dour schoolmaster even more dour.  The child was Carl Friedrich Gauss, who became one of the greatest mathematicians ever, and he solved the problem not by his ability to calculate 1 + 2 + 3 +. . .+ 100 faster than anyone else, but by recognizing immediately that the problem could be restated in a way that made the solution easy: the list of 100 integers could be grouped into 50 pairs, each of which sums to 101 (1+99, 2+98, 3+97, etc.), so the correct answer was simply 50 x 101 = 5050. 

There are many professional investors who can "sum the integers from 1 to 100" the hard way, by outworking everyone else or by using technology.  But the very best investors are almost invariably elegant in their thinking; they have the Gaussian ability to simplify problems so that the difficult process of evaluating an investment becomes much easier.

A recent example of elegance in valuation caught my eye.  It's maybe not up to the level of Gauss' trick but it is elegant nonetheless.  My friend and editor John Mihaljevic recently interviewed Brian Gaines of Springhouse Capital for his Portfolio Manager's Review publication, and posted an excerpt on his blog.  The excerpt included the following discussion of Netflix, a company whose traditionally high P/E ratio and new business model made it unpopular among value investors:

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

What made this analysis elegant was Gaines' ability to restate the "is Netflix undervalued?" problem in a different way, by substituting business reality for accounting "reality."  According to GAAP, subscriber acquisition costs must be treated as an expense on the income statement (I vaguely remember this rule coming about in the mid 1990s and it caused AOL to trade way down).  For a growing enterprise that does a lot of marketing, this will depress GAAP earnings, the E in the traditional P/E ratio, which will in turn raise the P/E ratio beyond the reach of most value investors.  Gaines' insight was to treat subscriber acquisition costs not as an expense, but as mostly an investment in future growth, similar to a capital expenditure.  Only a portion of this expenditure, analagous to maintenance capex, was to be subtracted from the pro forma income statement, as it represented the cost of maintaining then-current volumes.  

Gaines' insight had the effect of significantly increasing the profitability of the non-growth portion of Netflix's business, which in turn lowered its operating P/E to a very value investor-friendly 5-6x.  Having determined that Netflix's product was performing well, having calculated that he wasn't paying anything for the company's future growth, and having assumed that its heavy investment in future growth would likely earn a good return (or else would dramatically be curtailed), Gaines turned a growth investor's speculation into a value investor's investment, with a significant margin of safety, and was well rewarded.  Elegant.

Some More Real Estate: The Danger of the Personal Guarantee

My real estate self-education project continues.  Again, I'm trying to see if I can apply value-oriented manager selection to real estate investing.  There will likely be a lot to do in real estate in the next few years, both in public and private markets.  Many new funds have been and will be formed to take advantage of all the bargains that are widely assumed will be available.  My suspicion is that many of those hoping to take advantage of the bargains will be the same people who "took advantage" of all the non-bargains in the last days of the boom by buying overpriced properties.  I want to stay away from those people.

Steve Roth of Vornado alluded to this in his 2008 letter to shareholders, under the heading "Price Does Matter":

It sounds trite, but buy low still works.  A good friend of mine and Mike's, who runs a large real estate opportunity fund, years ago made an observation which I still remember.  He said they analyzed every deal in every cycle and concluded that everything bought in the first half of a business cycle was profitable to super-profitable, while everything bought in the second half was a struggle or worse.

If the way it works is this stark, ideally you want to invest with someone who

a) Knows exactly when the first half of the cycle is about to become the second half
b) Does his buying only during the first half, and
c) Does his selling (and his golfing, fishing, traveling, etc.) during the second half.

An unattainable ideal, but that's why the margin of safety was invented.

Margin of safety is especially important in real estate because almost all real estate is bought with leverage, often a lot of it.  In real estate investing, skill at building the right side of your balance sheet is as important as skill at building your buildings.  Because leverage magnifies returns both on the upside and the downside, and because of the idea expressed in the Steve Roth quote above, the stakes are very high when it comes to evaluating a real estate investor's use of financing.  It's often said that the secret to getting rich as a real estate developer is to use Other People's Money.  Don't forget the corollary: the secret to getting rich investing with a real estate developer is to remember that Other People's Money to him is Your Money to you.

Wednesday's Wall Street Journal featured a long article about the Cababie family, one of Mexico's most successful real estate developers (who I'm sure trace their routes to the Jewish quarter of Aleppo, Syria, which isn't so Jewish anymore, if you know what I mean.  It sometimes seems that if you fled from Aleppo to Latin America there was something wrong with you if you did not become extremely rich).  To finance their move into US real estate, the Cababies crossed an investing Rubicon by issuing personal guarantees on two major real estate deals, a huge condominium project in downtown Miami and a portfolio of 56 office buildings in Southern California.

A personal guarantee is just that--an individual or family personally guarantees to repay a loan if it cannot be paid back otherwise.   The WSJ elaborates:

Personal guarantees can cause problems for real-estate developers because they give creditors enormous power to go after all of their assets in the case of a default. During the real-estate collapse of the early 1990s, personal guarantees helped create huge financial problems for Donald Trump and took down scores of others, including William Zeckendorf Jr. Easy money during the last boom enabled most real-estate borrowers to stay clear of such guarantees, but a few, like New York developer Harry Macklowe, used them and have been forced to sell properties to pay them off.

To a value-oriented manager selector like me, an investor who issues personal guarantees, even if it backstops money you yourself are investing, is a red flag.  Not automatically bad, but something to take a close look at.  Manager selection requires you to create a kind of psychological profile of the investing temperament of the person to whom you're giving your money.  A personal guarantee on the right side of an person's own individual balance sheet can be revealing.  If it's guaranteeing the 250th enormous condominium project built in downtown Miami (not even on the beach!) in the last few years, then it's very revealing.  The combination of boom-time psychology, optimism, and testosterone that leads someone to expose their own money to that kind of risk must make you suspicious about what they are exposing your money to. 

The same principle applies to REITs or other real estate corporations, and even corporations as a whole.  The mix of recourse vs. non-recourse debt, as well as cross-guarantees and cross-default provisions, must be evaluated carefully, as it is a key factor in the shareholder's margin of safety equation.  Warren Buffett, who has been a closet genius at using leverage his entire career, pulled back the curtain a little in his 2005 letter to shareholders, in the section called "Debt and Risk."  Read the whole thing, but the guiding principles are that the more debt you take on, the more secure the income stream (not asset value) to service it must be, and significant debt must always be non-recourse to the rest of the enterprise.  John Malone, who has been an out-of-the-closet genius at using leverage his entire career, has used the nautical metaphor of the compartments of a ship's hull, separated by bulkheads--if the hull is breached in one compartment, it may flood with water, but the bulkheads prevent water from penetrating the other compartments, which could take down the entire ship.  Even during TCI's most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one "compartment" (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole).

 

Debt is Not (Always) a Four-Letter Word

A story in Tuesday's FT quoted heavily from a letter sent by PE firm TPG to its investors:

Last month's letter, obtained by the Financial Times, made the case that the leveraged buy-out was "an investment structure which is useful at some times during the cycle but not at other times".

"When debt is mispriced and inexpensive, as was the case before 2008, it makes sense to replace equity with debt, hence the abundance of LBOs," the letter said. "[Now] it makes sense to replace debt with equity, -leading to restructurings and recapitalisations."

Once upon a time I was young and a total Buffett-worshipper, and being a Buffett-worshipper to me meant YOU DON'T BORROW MONEY EVER.  Like a a true Capricorn, however, I've loosened up with age and now look differently at investors who use debt.  I now realize that there is debt and there is debt, and evaluting how an investor uses it, both qualitatively and quantitatively, is an important part of manager selection.

The best investors work both sides of the balance sheet, they're in the spread business.  A dollar earned from the right side spends the same as a dollar earned from the right.  Any stream of cash flows, whether going in or coming out the door, can be cheap, and value investors buy things cheap.  If you can buy cheap AND maintain a margin of safety, you're well on your way.  So you can scold the Masters of the Universe for what they did in the last few years, but many of them were smart: they recognized a cheap liability and "bought" it, and some of them did so with a margin of safety too. 

Once I deprogrammed myself from the no-debt-ever cult, I began to see more clearly that Buffett has never been as strict with himself as his aphorisms imply.  His primal urge to use Other People's Money is as strong as the most venal subprime packager, he's just done it more intelligently and always with a margin of safety.  Not just insurance float, but also borrowing against utility earnings and to finance mobile home purchases, issuing debt for unspecified later use, even its derivatives bets.  Take a look at the right side of Berkshire's balance sheet today--it's loaded with debt.

It's not just Buffett either.  Baupost has drifted away from public market bets towards things like real estate, using non-recourse debt when the numbers make sense.  Charlie Munger's first fortune came from a heavily leverage real estate development--again, non-recourse.  John Malone has waged a decades-long war against the IRS, using levered cash flow growth, backed by what were essentially government-enforced monopolies, to shield earnings.  Much of David Swensen's outperformance in the last decade comes from large allocations to real estate and PE funds, both of which took advantage of cheap debt. 

It begs the question:  Where are the debt arbitrages of today and tomorrow?  If you're a creditworthy individual, and if you're worried about inflation to boot, now may be a great time to purchase a house in much of the country--the government is helping you out.  I've in the past wondered whether Japan is the next great PE opportunity, as super-low borrowing costs on liabilities are starting to coincide with lower PE ratios (higher earnings yields) on assets.  The same may be true for residential real estate too: according to the Economist, the price-to-rent ratio is lower in Japan than in any other OECD country.  That implies higher cap rates, which in combination with lower borrowing costs means a fertile ground for dealmakers in the next few years. 

So I'm keeping my eye on who is best using the liability side of the balance sheet.

Disclosure: Long Berkshire Hathaway.

Castle Hall Alternatives White Paper: The New Standard of Operational Due Diligence

Read it here.  An excerpt:

One of the lessons of the recent crisis is that managers who unduly impatient and unhelpful in 2006 and 2007 were, quite consistently, those firms who appeared to protect themselves ahead of their investors at the end of 2008.