Notes From the Value Investing Congress

by: Tom Au, CFA

Last month I attended the Value Investing Congress on behalf of Seeking Alpha. Although I published a bunch of notes in Instablog format in the following days, here is an edited, condensed, version of those notes.

The Congress began with some speakers showing how value investing can be undertaken internationally. Amitabah Singhi of Surefin Investments in Mumbai (Bombay) mentioned that India is joining the world economy, and is poised for explosive income and consumption growth in key sectors, typically 5 times in 10 years. Individual companies can grow 2-3 times as fast, or 10-15 times in ten years. This dynamic won't last, but is good for another decade or two

His portfolio follows Graham and Dodd parameters using mainly local shares, with single digit P/E ratios, but you need a lot of local knowledge to do this, nowadays. Crossover investors can play the country using large blue chip names like Larsen & Toubro, Bajaj Auto, and Housing Development and Finance Corporation, with multiples of 20-30 times earnings. (Some near-term caution is now recommended, following the 2009-2010 global run-up.) But the latter is more of a growth strategy than a value strategy.

Francisco Garcia Parames, of Bestinver Asset Management in Spain, noted that his colleagues are not only value investors but are from the "Austrian" school of thought (featuring pragmatic, businesslike thinking). Thus, they avoided banks and real estate, leaving few investments in Spain. Instead, they operate on a Pan-European basis looking for cash flows.

Examples include:

  1. BMW Preferred. (This is like a common share without voting rights, except in a merger situation, but with a much higher yield.) Market cap of 31 billion euros, minus 5 billion net cash, leaves an enterprise value of 26 billion euros vs. 3.6 billion euros of cash flow (a 7 times multiple). De facto family control means no added value for holding voting common, anyway. Company looks to low price, not daily trading volume, for liquidity.
  2. CIP of Italy. Holding company with 18% average annual asset growth. A market cap of 1.1 billion euros gets an investor a utility valued at 1.9 billion euros, and the company's operations in communications and auto parts are worth 1.3 billion euros. Sum of parts is 3.2 billion euros, almost 3 times market cap.
  3. Ferrovial, infrastructure company, based in Spain. Flagship operation is a toll road in Toronto. The implied value, following an IPO, is 6 billion euros. Other operations, toll roads and airports in Europe, are probably worth another 6 billion euros (total of 12), versus market cap of only 7 billion euros.

Guy Squier of Aquamarine Capital produced a list of Japanese stocks that could be bought for the Graham and Dodd "net- net" working capital basis. Except for Japan Railway, these were smaller caps with Japanese names that I didn't recognize.

Then contrarian investors made pitches for their brands of out of favor stocks.

Lee Ainslee of Maverick Capital told us why we should consider buying tech stocks now. They were cash rich companies as shown by three separate metrics:

  1. There were free cash flow yields of 10%- 12% for the industry, and most companies within the industry.
  2. Cash (and liquid investments) have risen from 5%- 6% to 10%- 12% of assets in the past few years.
  3. P/ E ratios are now in the 9-11 range.

Naturally, stock selection is important (the speaker was an engineering major and understands most technologies), but low valuations mean that the stocks are a lot more forgiving than at most other times.

The macro environment is very different from ten years ago. "Buildouts" are now mostly behind, not ahead, of companies. That's why they're so cash rich. Most companies have pretty much defined themselves, making for a lot less uncertainty going forward.

Alexander Roepers, a "GARP" investor with Atlantic Investment Management, was a bit more selective, holding only 15-20 names in the mid-cap space. He had no holdings in information tech or biotech, two hard to understand businesses. Also, no financial, real estate, or highly leveraged companies. Phone and electric utilities were generally too slow growing.

So the concentration was in industrial names, such as defense companies. These included ITT (NYSE:ITT), with its defense, fluids, and motion control businesses. A sum of parts analysis indicates that the latter two roughly cover the company's market cap, so the defense business is almost "free." Similarly with Germany's Rheinmetal, where the market cap is almost covered by the auto parts business, leaving defense as almost a "gimme." Other favorite U.S. holdings are Raytheon (NYSE:RTN), and Xerox (NYSE:XRX), which is now more of a parts and service, rather than printing, company.

On the other hand, Zeke Ashton of Centaur Partners regarded property-casualty (P-C) companies, and asset managers as out of favor sectors. PC has a bad name after the 2005 hurricanes that reminded people of "tail risk." Pricing is "soft" right now because of excess capacity, but will soon turn "hard" when weaker players fold, leaving only the survivors. Favorites include Fairfax Financial (OTCPK:FRFHF), Canada's Berkshire Hathaway, with double digit growth and good balance sheet management. The company has sued short sellers, but with good reason, for telling lies. The other insurance recommendation is Aspen Insurance (NYSE:AHL), in the Graham and Dodd mold, with its discount to book value, plus ability to recruit specialty insurance teams from others in key segments.

Ashton won't recommend any asset managers other than Calamos Asset Management (NASDAQ:CLMS) except to note that many are selling for less than 3% of assets under management, a key ratio. He recommended choosing by management and sector exposure.

A couple speakers sounded "macro" warnings. David Burbank of Passport Capital noted that U.S. spending will be on a collision course in ten years or less. By 2020, mandated spending (social security, Medicare) plus interest will equal receipts, leaving (theoretically) nothing for discretionary spending. This can't happen of course. Something has to give before then.

He also noted that cash rich developed markets arre now very much a minority. These include Singapore, Canada, Australia, New Zealand, and Switzerland, Hong Kong and Ireland, though technically cash rich, are special (not-so-good) cases because of their ties to China and Europe, respectively. Other developed markets countries, the U.S., U.K., Japan, France, Italy were "debt poor." Germany, with relative fiscal discipline, is the (less bad) "standout" in this group.

Emerged markets consisting of the BRIC markets plus some others, including eastern Europe, most ASEAN countries, plus Saudi Arabia and certain other cash rich Arabian peninsula markets, are more like the cash rich, than debt poor developed markets.

J Kyle Bass of the Hayman Capital Master Fund warned that global monetary authorities haven't gotten their arms around sovereign debt levels. That's because national debt includes not only public debt, but debt issued and held by banking entities (e.g. Fannie Mae and Freddie Mac in the U.S.), and their equivalents abroad. Off balance sheet debt sank Iceland, threatens to sink Ireland, with Greece being the third default candidate. If anything, early default might be a "good" idea for the latter two countries, because they could get more favorable terms than later defaulters.

Japan is the most likely major country default candidate, because total debt is some 550% of GDP, in a zero growth economy. It's basically approaching the "point of no return" where debt can't be financed nationally, and will require an international bailout. Lousy demographics really hurt; in 2008, more people left the work force than entered it for the first time in modern Japanese history, and the country is not amenable to immigration.

Government debts worldwide have had a "crowding out" effect on corporate debt, so don't be encouraged by falling corporate debt numbers, but rather look at national aggregates.

In a similar vein, Michael Lewitt of Harch Capital Management noted that governments have gone from being countercyclical to pro cyclical, worsening crises, because they are too much captive of special interests, Beginning with oil crisis in late 1970s to early 1980s, there's been a global economic crisis every three to five years. the recession of 2008 will be followed by a new crisis in 2011-2013.

Other speakers focused on processes. Mohnish Prabai of Prabai Capital Funds noted the usefulness of checklists in reducing "fatal" errors, in activities as different as airplane manufacture and injections/transfusions in hospitals. His fund has developed its own check list for danger signs in investment grouped under five areas; 1) leverage, 2) quality of management, 3) quality of "moat", 4) quality of investment analysis, and 5) insider selling. Has had no major losses since his checklist system was adopted in the fall of 2008.

Michael Kao of Ankthos Capital noted that different parts of capital structure of the SAME company perform differently, particularly in times of stress. Although his vehicle of choice is convertible bonds, and preferred trade is long converts, short stock, one needs to rebalance the short stock position to maintain a constant hedge ratio, because "deltas" change over time, and over the various price paths.

GM is a case in point. When the company went bankrupt, the bonds went to as little as 5 cents on the dollar, like U.S. railroad bonds before World War II. They have since rebounded to 32 cents, and may be worth 50 (based on comparable yields for bonds of similar quality) even though they have effectively lost the conversion feature. But in the absence of GM stock, the portfolio sold short Ford (NYSE:F) stock as a hedge.

Short sellers had their say. Carlo Canell of his namesake capital management firm liked to short "dinosaur" or "Irish elk" (both extinct) stocks, that were too big to grow much, and were too clumsy to adapt to a challenging new environment.

David Einhorn made a case for selling short St. Joe (NYSE:JOE) stock. While conceding that the stock might go up in value if the company's property development plans proceeded smoothly, he used 119 slides to show that both sales and development had slowed to a crawl based on the current and foreseeable future economic environment. He opined that the company's value was worth closer to its value as a forest products company ($7-$10 a share) than its recent quote in the low $20s, which would reflect a large amount of development. Bill Ackman, who made his name short-selling MBIA, instead may a long case for JC Penney (NYSE:JCP), also based on property values.

Whitney Tilson and his partner Glen Tongue concluded the event. Tilson noted that the recent economic downturn was as severe as 1973-74, but that there was no corresponding snapback this time around. Both very good and very bad economic outcomes were possible, but the base case is for a muddling through for about seven more years, until the end of Vitaliy Katsenelson's 17-year "range bound" market. And the workout of housing problems by the major banks figures to be a drag on the U.S. economy for some years to come.

Their first stock pick is BP. Following its recent problems, it is statistically the cheapest of the major oils, but the most serious problems have been contained (the fund doubled its position after the leak was plugged). Other majors have different problems, and in some cases, an inferior reserve replacement record to BP.

The second idea is Liberty Acquisition (LIA), a "SPAC" (Special Purpose Acquisition Corporation) with cash assets of about $9.72 per share, bought for about $8 a share, a 20% upside, because of its illiquidity.

It is now being used as an acquisition vehicle for Groupo Prisa, a highly-leveraged Spanish media company. There is a bid of $10 a share (a small premium) for Liberty by a buyer who wants to participate in the merger, providing an exit for others who don't. Grupo Prisa owners want to do the deal also before the company gets eaten alive by debt. The deal values Prisa at 6 times EV/EBITDA versus 8.5 for other comparables.

Disclosure: No positions