Zeke Ashton, founder and Managing Partner of Centaur Capital, recently concluded his presentation at the Value Investing Congress. The following are our notes from the presentation, entitled Surviving the Worst Case: Risk Management and Value Investing.
LONG Investment Idea: Alleghany (NYSE:Y)
- Holding company that operates primarily in the specialty and property & causualty insurance industry.
- Long term track record of value creation by building, acquiring, and selling businesses. Expertise in the insurance, investment management, and natural resource areas.
- Investment results are in the high teens. Alleghany uses a “total return” approach to investing its float and has a good investment track record. Over the past five years, the company has produced a 10.6% annualized return vs. a -2.2% annualized return for the S&P 500 Index.
- The company has a $4.1 billion investment portfolio and has a portfolio of valuable assets.
- Valuation: Sum of Parts: RSUI (insurance with 80% combined ration in 2008) 1.5x book = $1.65 bil. Capitol Transamerica – 1.2x book = $360 mil. EDC .75x book = $125 mil. Cash and investments at parent = $800 mil.
LONG Investment Idea: Odyssey Re (ORH)
- Globally diversified insurance and reinsurance company, one of the top 20 reinsurance companies in the world.
- 71% owned by FFH, investment portfolio managed by Prem Watsa.
- Grown BV/share by more than 20% annually since going public in 2001.
- Buying back a ton of stock below book value. ORH spent $351 million on share buybacks in 2008, about 13% of shares outstanding in 2008.
- Bottom Line: ORH is classified as a medium risk stock. Current book value is about $43.80/share (as of Mar. 31), thinks BV/share should increase to $47-$48. At 1.3x book, company would be worth upwards of $55+/share.
Risk Management & Value Investing
- Many value manager downfalls may have been due to complacency. Questions for discussion: If the core principle of value investing is "margin of safety" then how did so many well-known value investors lose as much or more than the market average during the bear market that began in 2007? Did they do something wrong or are they unlucky? Why did their value investing principles, years of experience, and long track records of success fail to protect them? Did they become overconfident?
- Value investors previously assessed risk at the individual position level. This was all the "risk management" that seemed required. A lesson he recently learned was that risk must be assessed from the portfolio level—looking at the portfolio from the "top down" can be a useful exercise. He believes managers should try to determine if a bubble is building and where the economy is at in the business cycle.
- Centaur doesn’t want: 1) Excessive concentration—never wants the outcome of any one or two ideas to determine their ability to survive or dominate results in a given period, 2) Excessive portfolio-wide exposure to any one specific factor or theme (i.e. inflation, interest rate/currency fluctuations), 3) Excessive leverage at the portfolio level or the individual idea level, 4) Political risk – does not want investments to be overly vulnerable to change in government regulations, laws, tax codes, etc, 5) Liquidity risk, 6) Shorting stocks—wants to avoid “blow-up” risk. Believes we will see some short funds blow up due to recent market rally.
- Concept of Risk Limits: Zeke thinks that limits prevent investors from taking unacceptable risks, which should be thought about in advance. Home run style investors will have a different risk management style than high probability investors.
- Helpful Limits: 1) Position size limits, 2) Total Exposure Limits (long and short), 3) Leverage Limits, 4) Limits on illiquid stocks.
- Example of Fairfax Financial Holdings (FFH): Many people were short FFH in prior years when it really should have been a long (due to their large CDS portfolio). –Not a typical insurance holding.
- Centaur’s ideal position is about 5%, i.e. 20 stock portfolio. Believes that 20 names in a portfolio is better than 6 or 100, thinks 20 is the sweet spot. The ultra-concentrated model increases the odds of experiencing occasional periods of outstanding performance, but also increases odds of really terrible performance.
- Diversifying by idea doesn’t necessarily help if there is excessive sector or single factor correlation. “If you owned a bunch of different stocks in different industries that all had leveraged balance sheets, you probably didn’t benefit much from diversification in a year like 2008.”
- Two types of leverage: 1) Recourse (high-risk leverage) 2) Non-recourse (smart leverage). Best way to achieve non-recourse leverage is by using in-the-money LEAPs—which offer reasonable implied borrowing costs as well as an implied put below a certain price.
Two Schools of Value Investing
- Home run (i.e. Eddie Lampert) – magnitude of winners is the success factor. If one idea triples, you can afford to have a few ideas that do not do well.
- High-probability (i.e. Seth Klarman) – Less concentrated portfolio, but more concentrated relative to the rest of the world. Centaur has 15-30 positions—1-2 big winners will not drive portfolio performance. Zeke follows the high-probability approach.
- Each style depends on the type of investor. Key is matching investment style to the type/characteristics of the capital base and manager philosophy.
- It is important to match the attributes of the capital base to the investment style of the manager. The "home-run" style investor must have stable, long-term capital in order to compensate for higher volatility of fund performance. These types of investors are at the highest risk of business failure.
- "High probability" investors can operate with a much more fluid capital base—business failure is driven more by showing favorably divergent returns over time.
- Centaur risk limits: Position 7.5% --10% maximum size at market. Sector – no more than 20% in any one sector—25% at market.
- Ingredients of a blow up: 1) Excessively sized bets, 2) Excessive leverage, 3) Unexpected negative event, 4) Inadequate liquidity to unwind the position without negatively affecting price.
Take away from Kelly Formula: 1) The better the idea, the bigger you can go. 2) The more undervalued the idea, the lower the risk, the bigger the position should be. Believes that investors who rely on the Kelly Formula as intellectual support to take excessively sized bets will accelerate gambler’s ruin, not avoid it.
About Zeke Ashton
Ashton is the founder and Managing Partner of Centaur Capital Partners, a Dallas-based value-oriented investment firm. He and co-portfolio manager Matthew Richey are the advisors to the Centaur family of private partnerships using a long / short equity strategy, and are the sub-advisors to the Tilson Dividend Fund, a mutual fund utilizing a unique, income-oriented value investing strategy.
Disclosure: No positions.