Interview: Greenbackd Sees Big Storm Clouds Everywhere

by: Miguel Barbosa

I’m proud to present the following interview with the founder and editor of The Greenbackd Blog. Greenbackd is dedicated to unearthing undervalued asset situations, where a catalyst exists likely to remove the discount or unlock the value. Greenbackd seeks securities trading at a substantial discount to asset value. In addition, Greenbackd is a “Gold Standard” contributor to Seeking Alpha and a GuruFocus guru.

Disclaimer: We are a bit biased; Greenbackd is our favorite investment ideas blog.

Background Questions:

When did you first become interested in allocating capital?

A. I got interested in the stock market near the end of my undergrad, about 1999, when I read Barbarians at the Gate. After groping around for a way to understand the market, a friend pointed me to Buffett’s Berkshire Hathaway (NYSE:BRK.A) letters and the scales fell from my eyes. He’d bought the 1934 edition of Security Analysis and, with a pretty rudimentary application of the principals in it, was having some stunning success. His method was to get one of the annuals on listed companies – I forget which one now – and find companies whose stock prices had crashed through the year but whose underlying financials had remained steady. Incidentally, he revisited those initial picks five years later and, despite one stock going to zero, he’d returned around 24.5% compound a year across the portfolio. On his advice I read Buffett’s letters and then the Roger Lowenstein book, Buffett: The Making of an American Capitalist and I was hooked.

Q. There are many approaches to investing. Why did you become a “deep” value investor?

A. I used Buffett’s letters to reverse engineer his valuation methodology. I found it to be excellent at identifying companies whose earnings were about to fall off a cliff, thereby justifying the previous, seemingly cheap, stock price. It didn’t often translate into good stock picks and I got plenty of bad surprises using it. The transition to deep value started when I started working as a lawyer in 2002. My first big matter was a defence against two semi-famous investors from the 80s who had a blocking stake in a going private management buy-out. They bought their stake late in the game at close to the buy-out price and managed to get another $1 out of the purchaser, pushing the price from around $5 to around $6 per share. About the same time I noticed there were investors taking positions in busted dot coms and making money. These were all companies with horrendous cash burn problems and no business plans. They weren’t comprehensible in a Buffett context, and it made me realize that there was more to investing than the methodology discernible from Buffett’s letters. As a result I revisited the 1934 edition of Security Analysis, found the chapter on liquidations and I’ve been doing that ever since.

Q. We confess, you run our favorite investment ideas blog, Greenbackd. You’ve managed to create a blog that feels like Ben Graham’s classroom. Why did you start the blog? What’s your favorite part of running the site?

A. One of my professors during my undergrad ran a fund focused on Graham stocks. His method was to write down his rationale for each investment, and that’s the primary reason I do it: to have a record of my thinking for each position. Investing notes help me to avoid the false post hoc explanation for why I opened a position, which is especially important if I want to revisit them much later, say in five to ten years. I was inspired by Jon Heller’s excellent site Cheap Stocks to make it public, to keep me honest in my analyses and to meet like-minded investors. The best part of running a blog is interacting with the readers. There are some very good investors who frequent the site and generously share their views and stock ideas.

Q. Which investors and economists do you admire? Besides these people who else has influenced you?

A. Buffett and Graham are givens. Marty Whitman, Walter Schloss, Carl Icahn and Seth Klarman are also all obvious choices for me. Thomas Mellon Evans is perhaps the only investor that might not be immediately identifiable by all of your readers. He was one of the original activists. His nickname was “Net Quick” because he liked to buy at a discount to “net quick assets,” which is the forgotten name for “net current assets.” He got control of his first company by buying the distressed bonds for cents on the dollar. When the company declared bankruptcy he was the largest creditor, and he traded his bonds for equity to become the largest shareholder. He was 28 years old.

I’m a follower of the Austrian School of Economics. I read the essays of Frederic Bastiat first, and they led me to Henry Hazlitt, Ludwig Von Mises, F.A. Hayek, and Carl Menger.

Investment Questions:

Q. What’s your approach to fundamental analysis? What’s your edge?

A. I don’t think I have any particular edge in valuation. Anyone can read the 1934 edition of Security Analysis and get the same valuations as I do. My background is not in industry or consulting, so I tend to be very conservative in my valuations, which means I often miss out on a great deal of upside. I think my edge, if I have one, is at the catalyst side of the investment equation. Takeovers, M&A, activism and liquidations are somewhat rare and often complex corporate events, and the lawyers have an outsized influence on the end result. I spent seven years doing corporate legal work, preparing filings and negotiating various agreements in relation to the acquisition, sale, issuance, or liquidation of securities. I feel much more confident understanding those events than I do, say, projecting earnings for a company, where an industry specialist will have the edge. That’s why I don’t try to invest like Buffett.

Q. How did your (academic) background prepare you to invest in activist and liquidation oriented investments?

A. I’m an ex lawyer, so I read filings like a lawyer, which means I’m always trying to find the seemingly innocuous note that reverses the headline position. I also think of the company as a creature separate from its business. Buffett-style investors desire a “wonderful business at a fair price.” To me, that’s only half the story. A company with a broken business model or no business model can be a great investment, for example, if an activist can get on the board or persuade management to take the cash burning business to the woodshed and salvage some of the value on the balance sheet. Soapstone Networks (SOAP) and Avigen (AVGN) are good examples of this phenomenon. They were both examples of what I call “activism by defenestration”: management were the ones who threw the business out of a window, but at the pointy end of an activist campaign.

Q. Given your interest in activist oriented ideas and liquidations, how do you search for investment ideas? Where do most of these ideas come from? Do you look out for any specific SEC filings?

A. I screen for sub NCAV, negative enterprise value, deep discount P/B, liquidations, and 13D filings. I get heaps of ideas from the readers of Greenbackd too. Most ideas start on the sub-NCAV screen or the SEC Edgar website’s list of 13D filings.

Q. This March the list of net-nets in the market exploded as the market bottomed. Do you think as a result, the wealth of opportunities will dry up as the market continues to appreciate?

A. The short answer is yes, the opportunities disappear as the market goes up. It’s a good thing. I think that an absence of net nets indicates that the market is overheating and it’s time to consider raising cash. To get some statistical rigor around that theory, I’ve just started a new research project to determine the usefulness of net nets as a “canary-in-the-coal mine.”

Q. Furthermore, how will you adjust should the list of net nets become reduced? Will you adjust your formula or are you more likely to hold cash?

A. I don’t just consider net nets. In fact, pure net nets make up only a small proportion of my portfolio. Very low P/B stocks also fall within my undervalued asset philosophy, and they represent a much larger investing universe than pure net nets. Generally I calculate liquidation value as the downside. It’s only very rarely that it represents the upside. It’s well documented that low P/B stocks perform quite well over the long term, especially relative to high P/B stocks. It may seem odd that that should be the case, because one wouldn’t necessarily equate book value, which is a historical measure, with the concept of “intrinsic value” conceived by John Burr Williams and propagated by Buffett, which is forward looking. Regardless, there are several academic and industry studies in support of the view that low P/B outperforms – Thaler and DeBont, Ibbotson and Lakonishok, Shleifer, and Vishny all spring to mind – and it works to me, whatever that’s worth.

Q. What kinds of adjustments do you make to the typical Graham-style calculation for NCAV?

A. As far as I am aware, Marty Whitman and Seth Klarman have done all of the thinking in this area. They both seem to agree that there’s really no hard-and-fast rule for valuing all assets of a particular category. Whitman’s view is that some assets classified for accounting purposes as fixed – for example, an office building tenanted with credit worthy tenants - are often easier to liquidate than some assets classified as current – for example, retail inventory. Whitman also includes off-balance sheet liabilities in his assessment and some property, plant and equipment. Klarman’s writings offer a similar perspective.

Q. Are you willing to employ your investment strategies to countries with less developed markets, such as India where opportunity appears ripe?

A. I am to some extent, but I’ve got no immediate plans to do so. I’ve never invested in India, but I understand that the laws of India are broadly similar to the US, with the caveat that the devil is always in the details and India is a huge and diverse market. My personal preference is for India over China. I worked on the establishment of a business in mainland China and found it to be an unfamiliar process for a western lawyer. Hong Kong is a different story again. It’s a developed market, so it doesn’t really fall into this category, but it’s interesting for a connoisseur of net nets. It seems to be dominated by net cash companies. There’s no point running a net cash screen, just randomly pick a stock. They tend to be controlled by a single shareholder, though, so obvious catalysts are rare.

Q. You often look at stocks in the pharma sector, are you ever afraid that these companies will burn through assets like cash to fund development of new drugs?

A. That’s just a quirk of the market. Biotechnology companies this year were like the IT companies and dot coms of 2000 to 2002. They all raised cash in a frothy market on essentially no business plan and found their share prices wrecked along with the market. It was certainly a concern that they’d burn through the cash because that’s what they’re established to do. I would never consider an investment in one without the conditions in place for a successful activist campaign, by which I mean an open shareholder register, a 13D filing on the record, a failed drug candidate and some very unhappy shareholders.

Q. If you are willing, can you give us an example of your best and worst investments? What did you learn?

A. ValueVision Media (VVTV) was my worst investment to date. I got into it because it was trading at a discount to liquidation value assuming it didn’t liquidate immediately. VVTV owns the ShopNBC home shopping business. It has a very large, fixed fee broadcast contract with NBC relative to its other assets and income. I struggled with the correct treatment of that contractual obligation. In liquidation, contractual obligations are like contingent off-balance sheet liabilities. If the company cannot fulfill its contractual obligations, and the counterparty is successful in a claim for breach of contract, they’ll line up with the other unsecured creditors, all of whom stand in front of the common shareholder for the residual assets. I’ve got no idea about the long term economics of TV home shopping. At the time, I could think of many very good reasons why the business might disappear. I thought best case scenario it might do some deal and dilute the common to almost nada or worst case scenario it liquidated and the common would be worth nothing. I was wrong in almost every aspect of my analysis. It did a deal and it’s up 1100%+ from my exit point. If I had been a better poker player, I would have realized that it was unlikely to liquidate and a reasonable deal was on the cards. Carlo Cannell got it right. It’s a decision that I flagellate myself about occasionally. I’m very embarrassed about it.

I hope that my best is yet to come. Vanda (NASDAQ:VNDA) had a good pop, but that was more luck than skill. SOAP has turned out quite well in a situation where my understanding of the facts and my analysis were right, so I’m reasonably pleased with it.

Q. What has the financial crisis taught you?

A. Patience. The period from mid 2005 to the end of 2008 was a very long, frustrating time, where there were very few deep value opportunities around. Even though intellectually I knew that the market was expensive, it was still hard to be patient while I couldn’t find much appetizing but good returns could be had by essentially randomly picking stocks. It didn’t feel like it was ever going to come back down. I made some mistakes through that period that a little patience would have prevented. It did finally come back to earth, however briefly. Now it’s back up again for really no good reason. I think the world is in for a very long, painful depression, and this current run up is just part of a much longer bear market. I don’t see a lot of value around at the moment. I’m back to trying to be patient again.

Q. What financial issues concern you the most (domestic and international financial)?

A. My view is the same domestically and internationally. There’s really nowhere to hide. I’ve been banging the drum on my site for the Austrian view that, as of October 2009, globally, all asset markets - bonds, stocks, commodities, property, and cash - are expensive, corporate earnings aren’t real, we all – governments, corporations and individuals – have too much debt, and massive inflation is here now and will stay around for a long time (although it’s not running through the CPI yet, so it doesn’t exist according to the orthodox view). Very cheap to free money makes people do silly things. I know this is not the popular view, which is that we have traversed the great travail and it’s clear skies ahead, but I see big storm clouds everywhere. As far as the eye can see, high inflation, additional regulation and increased taxation are on the horizon, none of which is good for business. It is unavoidable and it will be unpleasant. Batten down the hatches.

Q. Activist investments have been very popular this year. We’ve seen BA Value Investors agree to the Oxigene (OXGN) deal. How would you analyze an activist fund’s reliability? Can we trust that these hostile groups are truly representative of shareholder value? How do you detect greenmail or other unfavorable outcomes in these situations? What is really going on behind the scenes between management and the activist fund?

A. VaxGen (VXGN.OB) was a disappointing outcome. I think BA “agreed” to the deal like the passengers on the Titanic agreed to the iceberg. There’s a Russian proverb to the effect, “He who lives by the graveyard cannot weep at every funeral.” I’m trying to remember that.

Q. Value investing may raise certain skepticism due to its qualitative, logical nature and lack of ’sophisticated’ terminology. Aside from basic arithmetic, do you find advanced quantitative capabilities helpful to the investment process? At what point does qualitative data become sufficient in a decision?

A. I read an article by James Montier in 2006 called Painting By Numbers: An Ode To Quant about how simple statistical models tend to outperform expert judgments. Montier’s article is relentless in demonstrating this phenomenon to be so. Not only that, but experts think they can improve the output of the simple statistical model, when in actuality the statistical model represents the ceiling in performance from which the expert detracts. The fund manager thinks he’s improving the output of his screen by selecting certain stocks and ignoring others, when the screen as a whole actually does better than his selections. When I relate the conclusions of Montier’s article, it tends to conjure thoughts of Long Term Capital Management in the minds of the listener, so I generally keep it to myself.

I’ve also read about various studies – I forget who authored them but it could have been Kahneman, Tversky or Thaler or some other behavioral finance guys – that conclude that additional information doesn’t enhance the accuracy of a decision, just the decision-maker’s confidence in the accuracy of the decision.

Graham was well known for relying on his simple statistical or arithmetical models and professing to know little about the underlying business. Maybe there’s something to that.

Additional Questions

Q. How have you evolved as an investor?

A. The biggest change was from chasing Buffett’s wonderful businesses to Graham’s undervalued assets. More recently, it has been including an Austrian macro view in my analysis. I don’t include it in an individual stock investment decision, but I certainly think about it, for example, when deciding what return I need from equities generally to justify investment there.

Q. Where do most value investors screw up?

A. I’m not sure. I can tell you where I screwed up. I assumed that value was immutable, when it’s dynamic, and varies depending on whose eye is doing the beholding. That’s especially important in a liquidation scenario.

Q. Which books [works?] have made you a better investor & decision maker?

A. Buffett’s letters to shareholders of Berkshire Hathaway started me down the path to value investing and led me to the 1934 edition of Security Analysis. Frédéric Bastiat’s essays, particularly That Which Is Seen and That Which Is Unseen, had the same effect and led me to Henry Hazlitt’s Economics in One Lesson and then into other Austrian school literature. The Austrian literature is largely available free online, bless their anarcho-capitalist hearts. A great source is the site.

Closing Questions:

Q. What advice would you give investors interested in activist investments & liquidations?

A. At a general level, I would say read the 1934 edition of Security Analysis, Seth Klarman’s Margin of safety and an ocean of liquidation proxy filings and 13D notice filings. Read some Dostoyevsky, Chekhov or Solzhenitsyn to get into the mood.

At a more specific level, I divide these types of stocks into two categories, and I factor into both a margin of safety:

The first category is those for which the strategy is liquidation. I would deduct six to twelve months of cash burn, contractual liabilities and professional fees from whatever written down asset value I feel is appropriate. I don’t include any value for IP in my written down asset value, so if there is some residual value in it, it’s a surprise to the upside. Most often my initial estimate for the IP – zero value – is accurate. VNDA was the exception to the upside. This is the broken business model/no business model type stock. SOAP is a recent example.

The second category includes marginal stocks with some ongoing business – however terrible - for which liquidation is not the strategy, but the downside. These are cyclical businesses at a (hopefully) cyclical low. I wouldn’t include contractual liabilities and professional fees in the calculation of value, but it might be appropriate to include six to twelve months of cash burn. These can be stunning successes if they turn around and the market starts valuing them on cash flow or earnings. I’m generally a vendor at that stage. They’re like Warren Buffett’s horse. You buy them when they’re limping and sell them if they start walking again, always bearing in mind that you might be taking them to the glue factory. Digirad (NASDAQ:DRAD) is a recent example of this type of stock.

Miguel: Greenbackd, Thank you very much for taking the time to interview with us. We will continue to track your success and hope to interview you in the future.