June 26, 2008
When media start advising investor to short it is may be time to do the opposite.
Talk about timing, if I had held onto my puts for two more days I would be up 38% instead of 20% return I realized. However, I still would not be doing any shorting especially with CNBC's headline like that.
Majority of investors talk about risk and return in the same breath, the saying goes " no risk no return". I find that one of the most erroneous terms coined by Wall Street, and there are many of them. Actually the way I see is by limiting my risks, I will earn above normal returns.
Investors should distinguish between risk and volatility. Volatility is backward looking and pertain to price movements day-to-day, it is actually defined as the standard deviation of prices around their historical mean. There is not much insight from that figure, if any, to your investment decision making process.
However, Risk in investing should be future looking in nature and not backward looking as volatility. Price movements and historical financials bear little on an investment's risk profile. One thing is clear in my mind Risk does not equal volatility and more certainly risk does not equal more returns. Wikipedia defines risk as:
.... a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that "Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect". Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss.And it is calculated as:
Risk comes from the assessment of the company operations and economics accompanied with probable future adverse scenarios that the business might endure. Your analysis of these scenarios and their affect on the financial health of the business is how you assess how risky a business is. I try to find businesses that have limited probable risks associated with their operations. In this case more risk does not mean more return, it actually means exposure to more possible losses, which I am certain most investors want to avoid.
The example best used with the saying "more risk more return" applies to choosing between various types of asst classes, for example money market vs bonds vs stocks. Wall Street argues that with stock you will make more returns due to more risk involved with owning equities. To illustrate my point how erroneous that saying is, I ask you which asset will you hold: a GM bond or P&G common stock?
June 25, 2008
- Time value of the option is deteriorating now as the option is getting closer to expiry date, so I am not able to get adequate "pop" in the option for each point decline in the S&P.
- The prevailing expectation is for a decline in stock over the immediate term, and when every one is thinking the same way it is hard to make money. I have taken the put when Wall Street was talking about recovery and the market have gone up unjustifiably. Puts were cheap based on their volatilities, no body wanted them so I bought, now they are a bit more rich.
- Shorting using options is about timing and timing does not fit in my circle of competence; general market analysis is outside my scope of strong abilities.
- Options are very tricky; your prediction can be right on the money but you still would lose money using options, there are may moving parts in your valuation.
- I need the cash to be ready to buy for my long-term positions.
June 19, 2008
I have sold my CHC shares today at $31.95 on the news that the buyout will be delayed. I am leaving on the table $.73 or 2.4% on my original purchase price. The investment generated 5.5% (including a dividend payment).
It is time to move on from this investment as the uncertainty in a special situation like this does not warrant the extra return. I have no doubt that the transaction will close eventually but the delay can ruin your rate of return.
The relative performance of the buyout outperformed the S&P but failed to outperform the TSX. The TSX returned 9.25% while the S&P lost 3% over the same period. I think the better benchmark for CHC is the TSX as it was a Canadian company but to make myself feel better and look good for the reader I will claim that I have outperformed the S&P.
Although on annualized basis buyout investing or risk arbitrage can yield north of the 20% p.a., I do not pursue it aggressively. I am opportunistic with this strategy. I will only invest in situations where I know the players involved and I can buy risk in face of uncertainty. Also, I try to avoid complicated deals that have a lot of moving parts. This buyout was simple and all cash offer, easy to understand and value.
I do believe that risk arbitrage is no place for a retail investor. There are multiple ways where a buyout can fail and results can be disastrous.
In the CHC situation, I had a good knowledge of First Reserve and their track record and investment strategies. However the market was preoccupied about uncertainties of deal financing and I took that bet. Fortunately things worked out. It is time to redeploy capital to work on other opportunities.
June 17, 2008
I have not done any fundamental analysis on the company to determine its value because the way I looked at it is as follows: I do have an opportunity to make a quick profit with relatively little or no risk as I bought in below the the auction price range. However as I looked at the details of the auction and the financials of the company there is a good potential for a nice price appreciation after the buy back is completed. Moreover, insiders are buying heavily into the company, actually a big chunk of this company is owned by insiders. As I go through the owners list I see that Bruce Berkowitz have bought in at $18 a share. Mr Berkowitz is the founder and the Managing Member of the Fairholme Fund who boosts a stellar track record of value investing. That peaked my interest in the business.
URI has an Entp. Value(EV)/ EBITDA multiple of 5.5 on a TTM basis. After the recapitalization, if the market to apply the same multiple to URI's business, its shares should appreciate to high 30s. URI could use its $500 million cash to do the recap or borrow more either way their Enp. Value will not change, but shareholders will get a bigger piece of the company cash flows. If I reverse solve for URI price and market cap after the recap I should get $38 per share as per table below. Now the market may not keep the same multiple due to more debt added to the balance sheet but the potential for a run up in the price of URI have a high probability of occurring.
... an equipment rental company. During the year ended December 31, 2007, excluding its traffic control operations, the Company’s network consisted of 697 rental locations in the United States, Canada and Mexico. It offers for rent over 2,900 classes of rental equipment, including heavy machines and hand tools, to customers that include construction and industrial companies, manufacturers, utilities, municipalities, homeowners and others. In February 2007, the Company completed the sale of its traffic control business to HTS Acquisition, Inc., an entity formed by affiliates of private equity investors, Wynn church Capital Partners and Oak Hill Special Opportunities Fund, L.P. In February 2007, the Company acquired High Reach Equipment Services, LLC (High Reach).The company's customer base is commercial contractors that account for 70% of their business. The commercial construction is not dead and continue to do ok but may suffer in the near future, who knows. I am not a top down guy so I do not put a lot of emphasis on economy and sector outlook when analyzing a company.
The problem with an operation like URI is it will hardly generate any free cash flow, although they will have fantastic profitability margins. The business requires a steady and continuous capital investment to maintain operations. If you look at URI free cash flows for the past 10 years, it is highly variable. The company ends up blowing all of its cash flow from operations back to the business to buy more rental equipment. The company during the past 10 years have generated negative cumulative free cash flow in the tune of $1.4 billion.
|Cash from Operations||216.1||421.4||512.7||696.7||517.9||342.3||737.0||643.0||858.0||868.0||961.0|
|Free Cash Flow||(348.0)||(420.4)||(449.3)||199.4||(191.5)||(35.6)||88.0||(180.0)||(107.0)||(122.0)||116.0|
Some may argue to exclude capex in this situation as the company is still growing and need to add to its equipment fleet. Ok lets assume that the company will grow at the same rate forever, then what? They will never generate any free cash flow as they will need to add more to their assets to match fuel revenue growth.
The company, no doubt, has improved some of its metrics and profitability in recent years and its recent recapitalization may add more value to its shares. However, I am not in a hurry to hold it long term as I am not confident enough in my analysis, or more accurately the lack of, so i will tender my shares at $23.5. A price in the middle of the road and will yield me a nice return for couple weeks of holding, if it was tendered.
June 16, 2008
I grew up in a small town outside Philadelphia and went to the local high school, where I ran track all four years. Our team practiced outdoors, and in the winter, in the bitter cold, the experience was pretty miserable. The school was set on a hill, and as we ran around the parking lot the wind would come whipping around the building and hit us. We had to watch our steps carefully so as not to slip and fall on the ice. While we were doing our laps, the coach—a 50-year-old named Jack Armstrong—would stand against one wall protected from the wind, bundled up in a huge coat and wool hat and gloves, clapping and smiling cheerfully. Every time the pack shuffled past, he’d shout, “Remember—you’ve got to make your deposits before you can make a withdrawal!”
Now, this was a public school with no special facilities, and the team was made up of average athletes with differing levels of intelligence and motivation. But we never lost one single meet. And because of that success, and maybe because of the way in which the advice itself was delivered—I remember it when people yell at me—Coach Armstrong’s words resonated. I’ve thought of them a million times throughout my career in finance, and they’ve guided this firm, too.
Coach Armstrong came to mind in one of my first weeks on Wall Street, 35 years ago. I’d stayed up all night building a massive spreadsheet to be ready for a morning meeting. These were the days before Excel, and it was a huge feat for someone as bad at statistical stuff as I was to do this all by hand; I was pretty proud of myself. The partner on the deal, however, took one look at my work, spotted a tiny error, and went ballistic. As I sat there while he yelled at me, I realized I was getting the MBA version of Coach Armstrong’s words. Making an effort and meeting the deadline simply weren’t enough. To put it in Coach Armstrong’s terms, it wasn’t sufficient to make some deposits; I had to be certain that the deposits would cover any withdrawal 100% before we made a decision or did a deal. If I hadn’t done all the up-front work and made completely sure that my analysis was correct, I shouldn’t have put anything forth. Inaccurate analysis produces faulty insights and bad decisions—which lead to losing a tremendous amount of money.
Today, whenever I’m under pressure to make a decision on a transaction but I don’t know what the right one is, I try desperately to postpone it. I’ll insist on more information—on doing extra laps around the intellectual parking lot—before committing. I take the same approach with people, too. For example, when we were looking for a manager to start up our long-short hedge fund, we interviewed for a year and a half. The timing was ripe for that asset class, and if you weren’t doing something with it, you were losing out. It took a huge amount of time and effort for Blackstone, but we found a young money manager we were comfortable with, and he’s become an enormous asset.
Every year I speak to our new associates and give them this advice, although in my own words. This isn’t like school, I tell them, where you want to get your hand in the air and give an answer quickly. The only grade here is 100. Deadlines are important, but at Blackstone you can always get help in meeting them. As a firm, we can always figure out how to do another lap around the parking lot. Because what’s true when running track is true when doing deals: The person who’s the most ready for game day will be the one who wins.
Although I have not written since beginning of June, I have been busy with my portfolio. I have added to some of my positions and initiated new ones. In this post I will quickly outline some of my moves.
- I have added to Dr. pepper (DPS) and I will continue to add to it. Wall Street and Media have taken extremely negative view on the company, see article here, that makes me more bullish on the company and its prospects. Most of the negatives discussed with regards to DPS is faced by Pepsi and Coke as well, so the discount to those names is not warranted. DPS actually came with strong quarter and improved its guidance for the future.
- I added to my International Index Fund and I will continue to add to it as a way for international diversification.
- I started buying Brookfield Properties. I have reviewed BPO in the past, see my post here, and I liked it but I was waiting for a better entry point, although I wanted buy in the $17-18 range, I decided to buy a little at $19 for few reasons:
- The sale of GM building at a record price should give some new higher valuation to new York class A office properties.
- The credit environment is improving therefore reducing the risk of their funding miss-match. Also Brookfield Asset Management will be a lender of last resort for them as they own a large piece of the the company.
- Replacement costs for buildings have gotten so much higher as higher commodities prices makes BPO's buildings a bargain in comparison.
- I like Real Estate, unique with high barrier to entry real estate, as a class and I think over the long term it should do well.
- I bought United Rentals (URI) @ $21.4 as a special situation investment. URI has announced a Dutch Auction to buy 1/3 of its outstanding shares between $22-25, so when the market traded at $21.4, I reckoned if someone will offer me a higher price in few days later, I will take that bet. Actually United Rentals is interesting for several reasons:
- It was slated to be sold to private Equity last year but the deal fell apart leaving URI with a hefty breakup fee.
- The company is undergoing a huge recapitalization buying back 1/3 of its outstanding shares and redeeming all their preferred shares and increasing their debt levels. The recapitalization can enhances equity returns and offer superior profits for the remaining shareholders. The remaining shareholders will be part of their own private equity deal.
- A lot of insiders and institutional purchasing the shares lately.
- The negative with this kind of business is that it is asset dependent. Most of its free cash flow will end up buying more assets to grow the business with nothing, if any, to show for shareholders' cash flow.
- I will look into this further but my main objective here is to tender at $24-25 making a quick gain for anywhere from 2.8-16%.
My plan going forward is to:
- Accumulate more shares in the following businesses:
- Brookfield Properties
- Dr. Pepper Schewps
- Sears Holdings
- FirstService Corp.
- CB Richard Ellis
- TicketMaster Spinoff from IACI Interactive
- Prologis REIT
- Pacer International