The Best Day to Bury Bad News
When companies want to bury bad news, they often release it on a Friday, after the markets close -- preferably on a Friday before a holiday weekend. That's exactly what The St. Joe Company (JOE) did on Friday. It tucked the paragraph below into an 8-K it filed Friday afternoon:
The Company previously disclosed in January 2011 that the Securities and Exchange Commission (the “SEC”) is conducting an informal inquiry into the Company’s policies and practices concerning impairment of investment in real estate assets. On June 24, 2011, the Company received notice from the SEC that it has issued a related order of private investigation. The order of private investigation covers a variety of matters for the period beginning January 1, 2007 including (a) the antifraud provisions of the Federal securities laws as applicable to the Company and its past and present officers, directors, employees, partners, subsidiaries, and/or affiliates, and/or other persons or entities, (b) compliance by past and present reporting persons or entities who were or are directly or indirectly the beneficial owner of more than 5% of the Company’s common stock (which includes Fairholme Funds, Inc., Fairholme Capital Management L.L.C. and the Company’s current Chairman Bruce R. Berkowitz) with their reporting obligations under Section 13(d) of the Exchange Act, (c) internal controls, (d) books and records, (e) communications with auditors and (f) financial reports. The order designates officers of the SEC to take the testimony of the Company and third parties with respect to any or all of these matters, and the Company is cooperating with the SEC.
Waiting a Week to File the 8-K
Note that the 8-K states that JOE was notified about this investigation by the SEC on June 24th, and yet the company waited until after the market close on the Friday before the July 4th holiday weekend to share this information with its shareholders.
Revisiting JOE's Margin of Safety
At this point, it's worth revisiting an exchange I had with The Fairholme Fund's Charlie Fernandez last month, which I noted in a Seeking Alpha article at the time ("Bruce Berkowitz: Beat the Pack by Breaking with it"):
Q & A with Charles Fernandez, President, Fairholme Capital Management
[Charles Fernandez happened to be sitting next to me, and was kind enough to answer a couple of my questions after the event]
Q: In his short presentation on St. Joe Co. (JOE), David Einhorn wrote that if valued JOE's remaining real estate at the average sales price of the last ~500k acres it sold, the company is worth $7-$10 per share. You obviously think the company is worth more than that. Why?
A: JOE's remaining land isn't comparable to the last ~500k shares it sold; that was less valuable land.
Q: Fairholme's investment in JOE seems to be a deviation from Bruce Berkowitz's investment method -- "we need more time to understand what we have" suggests that he didn't do as thorough and quantitative an analysis on JOE as on other investments.
A: We invested in JOE because we felt that our margin of safety was large enough to accommodate the current uncertainty. The company has no debt, plenty of cash on hand, and we've been cutting its expenses.
It appears that the Fairholme Fund's margin of safety on St. Joe Co. may have been smaller than Bruce Berkowitz, Charlie Fernandez, and their team anticipated.
The Cost of Hedging JOE as of Friday's Close
The table below shows the costs, as of Friday's close, of hedging JOE against a greater-than-20% decline over the next several months, using optimal puts.
For comparison purposes, I've also added the costs of hedging the SPDR S&P 500 Trust ETF (SPY) and the SPDR Dow Jones Industrial Average ETF (DIA) against the similar declines. First, a reminder about why I've used 20% as a decline threshold, and what optimal puts mean in this context.
The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but is not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold -- you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). Then the app uses an algorithm developed by a finance academic to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
How Costs Are Calculated
To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).
Hedging Costs as of Friday's Close
The data in the table below is as of Tuesday's close.
Cost of Protection (as % of position value)
|(JOE)||The St. Joe Company||15.8%*|
SPDR S&P 500
|(DIA)||SPDR Dow Jones Industrial Avg.||1.26%*|
*Based on optimal puts expiring in January, 2012.
Disclosure: I am long puts on DIA and JOE.