Lessons from the Recent Years and Opportunities for the Years to Come
Chris DeMuth Jr
It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a misplaced bet - that they can occasionally find one.
- Charlie Munger
I look and sift the world for such misplaced bets. Occasionally, I find one that can be exploited for profit. Here are the lessons that I have learned over the last seven years that will guide me in the years to come.
The financial crisis drove down prices and shook loose investment opportunities. I lived on the Upper East Side of Manhattan with my wife and new son. Walking to work at Rangeley Capital, a new hedge fund in Midtown, I worked out which opportunities I would seize. Rangeley focuses on event driven investing - where corporate events hide valuable opportunities long enough for investors to take positions before events play out and that value is revealed. My job was to find the best ones. The best ideas may have involved uncertainty as to how they would play out, but that uncertainty sometimes drove their prices down. I liked that because I wanted safety. One could find safety when security prices have been driven down to bargain prices.
But what if the prices were right? I wanted to sort out prices driven to levels that make little sense, prices that can't be justified by likely outcomes, prices that are just wrong. I had three tools in my tool kit. The first was value investing. A majority of the most successful investors are value investors. But this outlook is both the best and the most underrated. Despite the success of value investing over decades, the number of new adherents has been small enough so that the advantage has not been lost. This durable advantage remains a mystery.
My theory is that there are plenty of people smart enough to be value investors, but not enough with both the brains and the fortitude to stick with it over a long enough time.
But whatever the reason, it works. Securities can be valued by comparing the price to their cash flow, earnings, and assets. The cheaper, the better.
I did not want to spread myself to thin. I could not follow everything. I could have started at the beginning of the alphabet. I could use the computer to screen for value, but I never liked to do that because many of my favorite opportunities tend to fail to show up on traditional screens. Instead, I used corporate events as my hunting grounds because these events could hide value and confuse markets. Analyzing such events would be my second tool.
Thirdly, I would study investors as well as investments, searching for situations where investors were particularly constrained. When it comes to investing, I can be a bit of a coward. I do not want to pit my judgment against yours. I far prefer to take a position at a price based on constrained counterparties that must sell (or must buy when I am selling) for one reason or another.
Few investment ideas satisfy all three criteria, but I was willing to watch and wait. Almost all of my work is based upon primary resources. Instead of reading others' analysis, I prefer to go right to the source. In the case of most investments, that involves reading reports filed with the SEC and asking follow up questions of a company's management or board while also seeking answers from the company's competitors, vendors, customers, and other knowledgeable players. However, there are a few secondary sources that I use for convenience. One is Goldman Sach's Hedge Fund Trend Monitor which is a handy aggregator of where major hedge funds are most exposed.
High hedge fund concentration in a given security can be worth understanding. It is not always positive or negative, but worth knowing because hedge funds are a large part of the market's trading volume and are especially large in the kind of event driven opportunities that I tend to invest in. Hedge fund redemptions can force funds to sell such positions, driving down prices in such positions regardless of their underlying merits. It is important to know that can happen and to either avoid such concentrated hedge fund bets or to buy them after forced selling has taken its toll.
One such investment that was a big holding of many hedge funds was Liberty Entertainment (LMDIA), a stock spun-off from Liberty Capital (LCAPA) in March 2008. This proved to be too rough a time for the equity market to sort through how to value a new and complicated structure. By November 2008, it cost just over $10 per share despite owning more than $10 per share of DirecTV (NYSE:DTV) and a number of other assets including Starz (later ticker STRZA). Liberty's stock was cheap relative to its assets and its assets were cheap too. Due to this double discount, it was probably worth between four or five times what it cost. It was a perfect investment for Rangeley - cheap, event driven, and sold without sensitivity to its price by hedge funds that needed liquidity. One of my goals became to find at least one such investment each year.
What happened to Liberty Media?
LMDIA and its components have been perpetually event driven opportunities and they have been values the entire time. As described in The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, Liberty CEO John Malone held monthly meetings with his tax committee. At such meetings, he frequently came up with new and complex structures. Through buybacks and various combinations of his assets, he has been able to capture much of the very discounts that he created.
In May of 2009, a deal was announced in which Liberty Starz (LSTZA) was spun off to LMDIA owners before a fixed-ratio stock merger in which LMDIA would ultimately be exchanged for DirecTV shares. Liberty Starz was made up of Starz Entertainment, 37% of satellite broadband service provider WildBlue, PicksPal, Fanball and about $650 million in cash and cash equivalent securities. In 2010, ViaSat (NASDAQ:VSAT) purchased WildBlue for $568 million.
As for DirecTV, the price has moved from about $20 in November 2008 to over $80 today. In May 2014, DirecTV announced their sale to AT&T (NYSE:T) for cash and stock currently worth over $95 per share. If the deal closes early next year, there is over a 24% annualized net return between the current DTV price and the value of the deal price. After over half a decade, it is still an event driven opportunity.
What are the opportunities to invest in parent companies for net negative costs today?
Opportunities such as buying DirecTV at a discount via Liberty Media known as "parent-subsidiary stubs" are among my favorite opportunities. For example, one can invest in Yahoo (YHOO)'s domestic business at a negative cost. In recent years, Yahoo has a substantial investment in Alibaba (NYSE:BABA). Yahoo has been used by investors as the only convenient way to invest in Alibaba. But that changed with Alibaba's recent IPO. Now, investors seeking exposure to Alibaba can do so directly. The subsequent abandonment of Yahoo's equity left it at a market capitalization less than its Asian assets. The domestic web portal is essentially free. One share of Yahoo last traded for $38.45. To subtract the Asian stakes, one can buy ten shares of Yahoo and then short approximately twenty shares of Yahoo Japan and four shares of Alibaba. The remaining exposure costs a net -$3, which is -$12 net of Yahoo's cash. For that, you get exposure to their domestic web portal. What then? The easiest way to monetize Yahoo Japan would be if it (or all of Yahoo) were taken private by its largest holder, SoftBank. As for the stake in Alibaba, the most tax efficient solution would probably be for Alibaba to buy Yahoo.
Negative stub values such as these are real arbitrage opportunities worth exploring. In theory, one can deserve a big discount if the management is going to destroy value through malinvestment. The major caveat to this idea is that Yahoo CEO Marissa Mayer could go on an acquisition binge in which she potentially squanders her company's cash on dubious, pricey tech targets. In practice, that is unlikely in the case of Yahoo, where investors are actively encouraging a value enhancing resolution of the curious puzzle of an equity stub that costs less than nothing.
The partners at Rangeley Capital spent the final month of 2008 on an idea that I selected as my best investment prospect for 2009. The fourth quarter of 2008 was the worst quarter of my investment career for almost every asset class, leaving many promising bargains in its wake. Among the most deeply discounted was the senior secured loan market. Lehman Brothers had filed for bankruptcy late in the third quarter and had flooded the market with their senior secured loan portfolio. Other leveraged holders with overlapping portfolios or direct exposure to Lehman became forced sellers, too, as loan prices were driven down.
Highly leveraged, forced sellers usually liquidated their assets in a Bid Wanted In Competition/BWIC process that immediately sold assets to whatever bidder could be found. Sometimes billions of dollars of loans traded hands within the course of a week as leveraged structures liquidated. This resulted in prices that would normally be associated with defaulted securities even though few were actually in default. The BWIC sales process is an extreme of price-insensitivity and time-sensitivity, which makes it ideal for buyers who are price-sensitive and time-insensitive.
Senior secured loans are first to get paid in default and have a lien on assets. The two key assumptions are the default rate and the recovery in default. We were working on the assumption of a 15% default rate and a 50% recovery in default. Even with these draconian assumptions, the senior secured loan market was attractive at prices that had plunged to around sixty percent of par value after trading close to par for years.
I wanted a Liberty Media-like double discount for our 2009 investment candidate and found it when we reviewed the Investment Company Act of 1940. According to Section 18, closed-end investment companies had strict limits to their leverage. While many hedge funds were invested in loans through total return swaps/TRSs leveraged over five times and collateralized debt obligations/CDOs were often leveraged around ten times, the closed-end funds could leverage only one and a half times. The problem was that their debt was relatively stable while their equity prices were plunging. This price move had the perverse consequence of increasing closed-end fund/CEF leverage to the point that they were forbidden from making any distribution payments to the CEF shareholders. That is when the bottoms really fell out of their prices.
I called many of the managers of these funds. They were highly diversified and for the most part all owned substantially similar portfolios. I had one request and one question. My request was that they hold onto their securities if they default. My question was simply, "what are your shareholders asking?" In each case, the shareholders were predominantly retail investors who cared only about the monthly distributions. When the distributions stopped, they sold at any price they could get. Discounts that were around 15% in early December crept out to around 25% by the end of the month. At a 25% discount to 60% of par, we could pay around 45% of face for loans and make a positive return at up to 100% default rates. Thus, senior secured loans were picked as our best new asset class allocation and our favorite vehicle was Pimco's Floating Rate which was later renamed Pimco Income Strategy Fund II (NYSE:PFN).
What Happened to the Pimco Floating Rate Fund?
By the beginning of 2009, we had bought a substantial position in PFN along with various other senior secured debt vehicles such as Ares Capital Corp (NASDAQ:ARCC). In hindsight, Ares worked out much better than PFN, but PFN was where we decided to put much of our capital, alongside one other Pimco fund and several similar funds managed by Eaton Vance. January was fine but February and early March were awful. The price declined by over 50% (without any distributions during that period, the total return equaled the market price).
We held onto our investment, knowing that only a few months of retained interest payments on the performing loans would deleverage the CEFs enough to allow them to turn back on their distributions. The distributions were turned back on, the prices stabilized, and the rest of the year was positive for this idea.
The underlying loan portfolio started at 62% of par and ended the year at 86% of par while the discount started at over 15% and ended as a premium of over 7%. Bill Gross, Pimco's founder, assumed direct responsibility for the fund's asset allocation. We held our position until it was eligible for long-term tax treatment at which point we sold it for a premium to net asset value/NAV.
What similar opportunities are there today?
None that I am aware of, but I would appreciate suggestions in the comment section below. Today, I see no such opportunities in either the senior secured debt market or in closed-end funds. Where 2009 started with liquidity constraints and forced selling, by today the market is awash with liquidity. The market is more like that which led to the credit collapse that I tried to exploit. I have no remaining loan exposure, but were I forced to choose, I would rather short it than own it today.
We had one equity candidate for 2010 - Loral Space & Communications (NASDAQ:LORL), a satellite company where my partner Rich Townsend used to be CFO. The market valued Loral at less than the value of its Telesat stake, perhaps because Telesat was not consolidated in Loral's financial reporting. Telesat was worth about 8x EBITDA or $38.75 per share and the Space Systems/Loral (SS/L) subsidiary was worth about 6x EBITDA or $11.25 per share for a sum of the parts of about $50.00. LORL's board and management were likely to take specific steps to maximize shareholder value.
What happened to Loral?
It was not as ugly as loans in 2009, but it was a rough start to the year.
After initial weakness, it recovered substantially over the rest of the year. On the last trading day of 2009 when I initiated this idea, the stock cost just under $11. It closed the year over $26, still at a substantial discount to its value. In 2012, Loral sold their SS/L subsidiary for $968 million to MacDonald, Dettwiler and Associates (MDA) and distributed $899 million of that amount to Loral shareholders. That $29 per share distribution was over two and a half times the idea's original price as well as over two and a half times our estimate of SS/L's value. Is there such an opportunity today? Yes, Loral has performed well since this idea was first initiated, but it is still attractive today.
As with many of my ideas, I was completely off on timing.
I thought that Loral would have been wrapped up by now. The fact that it is for sale for under $70 per share is an opportunity. In the first half of 2014, the fundamental value of Loral's investment in Telesat has grown significantly. The fundamental value increased from a range of $80-$90 per share to $90-$100 without a control premium. During the second quarter
- Telesat reduced net debt by $112 million. This equates to an implied increase of about $2.26 of per share value for Loral holders.
- Telesat increased TTM adjusted EBITDA from $671M to $708M. If we apply a multiple of 10.5 times, this equates to an additional $7.87 per share to Loral holders, with no control premium added.
At today's price, Loral is for sale at a discount to its standalone value and is likely to be sold within the next few years when its Chairman decides to exit his investment.
Our best investment candidate for 2011 was Long LaBranche (NYSE:LAB) common stock. The company was the parent of LaBranche Financial Services which offered securities execution and brokerage services to institutional investors and LaBranche Structured Holdings, a market-maker in options, futures, and ETFs on various exchanges. A year earlier, LaBranche had sold its NYSE designated market maker, redeemed its debt, and authorized a share buyback. 2011 was likely to be a year for the company to continue efforts to unlock its considerable shareholder value.
LaBranche was cheap, costing about 60% of its tangible book value. About 95% of its market capitalization was cash. It was event driven since the company was buying back shares as quickly as they could and were selling operations. There was a benign explanation for the price in that no sell side analysts covered it and few people cared about it as an investment. The major caveat was that it was run by CEO Michael LaBranche, a cautionary tale of nepotism and generational mean reversion.
What happened to LaBranche?
A month and a half after the idea's conception, the company was bought by Cowen Group (NASDAQ:COWN) for $4.71 in stock a premium of slightly over 30% above the idea's $3.60 per share cost. The buyer can use both LaBranche's cash and their net operating losses/NOLs. The deal was horribly negotiated by LAB management, which essentially gave away their tax assets to the saavier COWN team. Despite their management being outclassed in deal talks, LAB shareholders came out ahead that day.
Where can I find such an opportunity to buy a pile of cash and NOLs at a discount today?
One such opportunity is QLT Inc. (QLTI), a small pharmaceutical company with a tumultuous past. In 2008, QLT had three drugs on the market. The company's key drug, Visudyne, was losing market share to competitors. It sold the two other drugs, and focused on its pipeline and technology. The company was spending heavily on the development of a new technology to deliver medication to the eye through punctal plugs. After a few years, activist shareholders were unhappy with the company's spending and disagreed with the potential value of the company's pipeline. A group of activist shareholders replaced several board members, and the board has since restructured the company by:
- Reducing personnel by 83%
- Selling Visudyne to Valeant Pharmaceuticals (VRX)
- Exploring options to spin-off or sell the punctal plug delivery technology
- Paying shareholders a special dividend
- Buying back shares
- Refocusing development efforts on a drug to treat retinal diseases
Today, the market capitalization is $203 million of which $166 million is cash. They also have $96.2 of deferred income tax assets that could be useful to a buyer. All in all, the shares are worth over $5 per share as a standalone and over $6 per share to a buyer at a cost of under $4 per share.
Our best investment idea for 2012 was Ocean Shore Holding (NASDAQ:OSHC). Ocean Shore was a holding company for Ocean City Home Bank, a federally chartered savings bank based in Ocean City, NJ. The bank operates a stable regional banking model with a high quality loan portfolio and low fundamental risk. We originally made a significant investment in OSHC by participating when the bank converted from mutual ownership to public stock ownership. We paid $8.00 per share, about 60% of book value. Comparable financial institutions were selling for roughly 85-90% of book value, giving the investment an adequate margin of safety.
This type of conversion requires three years from going public until Ocean Shore is allowed to be purchased. Our thesis was that the bank would grow its book value and reduce its discount to that value during this three year waiting period. The three year regulatory window on Ocean Shore ended in December 2012.
What happened to Ocean Shore?
While the equity performed well in 2012, management failed to sell to a strategic buyer. Later, I sent their board this letter and filed a 13D with the SEC:
Dear Board of Directors:
I am writing to urge the Board of Directors to undertake a strategic review. This would be a board-level decision. Our hope and expectation is that the board will make the right decision on behalf of Ocean Shore's owners.
Rangeley Capital Partners, LP, the investment partnership that I manage, owns 539,508 shares of the outstanding common stock of Ocean Shore Holding Co., representing approximately 7.7% of the Company's outstanding shares. We have been owners of Ocean Shore since the company fully converted from a mutual in 2009. I want to congratulate the Board on the successful completion of the conversion and the expiration of the three year moratorium on corporate actions. Over the past several years, this process has created significant value for all shareholders in the Company.
The current Board of Directors also has important duties to Ocean Shore owners. Looking ahead, since the moratorium on corporate actions has expired and Ocean Shore is in a strong position regarding its loan portfolio and overcapitalization, we believe it is an ideal time to undertake a strategic review of potential avenues to maximize value for Ocean Shore's owners.
To maximize value, the Board of Directors should consider the possibility of a sale. Ocean Shore continues to trade close to tangible book value, a lower multiple than its peers. Even using conservative price estimates, a strategic buyer would likely pay a substantial premium to acquire the company today.
It is in the interest of all shareholders for the Board of Directors to consider options that may be available to unlock substantial value for shareholders. As such, a strategic review would be in the best interests of the company and its stock holders and would likely receive a positive reaction from the capital markets.
I would be happy to discuss our views on any of the options available to the bank.
Chris DeMuth Jr.
Early in 2015, Beneficial Mutual Bancorp (NASDAQ:BNCL) will have completed its demutualization and could be well positioned to buy Ocean Shore for a substantial premium to its current price.
Where is there such an opportunity available to today's investor?
You could still buy Ocean Shore for under $15 and sell it for at least $18 if a deal materialized next year. We are still holding ours. But what if you are looking for an opportunity similar to buying Ocean Shore when it was at $8 per share? One possibility is Putnam County Savings Bank. This growing financial institution is likely to convert to a publicly-traded bank within the next few years. You can visit any one of its branches and purchase a certificate of deposit /CD. This CD will give you a right to participate in an equity offering if one is launched as anticipated. Typically you would get to buy shares at a substantial discount to their market value.
Gramercy (now ticker GPT) was my favorite long equity idea for 2013. It was a safe, cheap, and ignored real estate investment trust/REIT that halted dividends and replaced their management team following the turmoil of the financial crisis. The key to the investment was that despite the appearance of a substantially negative book value, GPT's substantial CDO liability was non-recourse to the parent company. The true financial health of a healing, growing business was masked by this CDO exposure. We expected them to re-start dividends and thought that the sub-$3 stock was actually worth about $6 per share.
What happened to Gramercy?
The shares substantially closed the discount to their intrinsic value during the course of the year. Early in 2014, the share price reached our $6 valuation, accrued preferred dividends were paid and quarterly dividends were reinstated on both the preferred and common shares. Gramercy had been returned to financial health.
Are there such opportunities today?
Since our investment in Gramercy, we have been on the lookout for healthy companies that suspended their common and preferred dividends and would be likely to turn them back on in the near future. But as of today, we are still looking.
My best idea for 2014 is the Sanofi contingent value right (NASDAQ:GCVRZ). They will ultimately pay out between $0.00 and $13.00, depending on whether or not the FDA clears an MS drug called Lemtrada and whether the drug hits various sales milestones.
A contingent value right (NYSEMKT:CVR) is a contract traded like a public equity. The company pays the owners when pre-specified milestones are achieved. These are often used in mergers when the buyer and seller cannot come to an agreement about the future value of a specific asset. In this particular case, when Genzyme was purchased by Sanofi in 2011, a CVR was used because the two sides could not agree on the future value of Lemtrada. The two companies devised a series of milestones that would eventually be worth between $0 and $13 for Lemtrada depending on FDA approval and global sales. The milestone for Lemtrada are as follows:
The first sales milestone for GCVRZ, worth $2.00, will be paid if sales for Lemtrada reach $400 million in annual sales for the total of four consecutive quarters, which is less than 3% of the global market share and 6% of market share in Europe. Based on our country by country analysis of the MS population in the five core European countries alone (UK, France, Germany, Spain, and Italy), we believe the likelihood of reaching the first sales milestone is high. So we expect to receive a payment of $2 per contract in the in the next two and a half years. Since Lemtrada is administered in two treatments versus ongoing treatment for competitors, the sales of the drug are front-loaded and thus provide an advantage in achieving these sales milestones early.
Using data from the Multiple Sclerosis International Federation, the number of people diagnosed with MS in those five core European countries is as follows:
When initially diagnosed, about 85% of people with MS are in the Relapsing-Remitting stage of the disease, which is the group that medications like Lemtrada are designed to treat. The total population of those diagnosed with MS in the five core European countries is about 400,000. To be conservative, we assume that only 40% of those patients are in the Relapsing-Remitting stage of the disease. Then we further assume that only 60% of that subgroup is actually seeking treatment - as we said previously this percentage is growing as treatment options become more effective and more easily administered. In these 5 countries alone, where Lemtrada is already approved, Lemtrada needs only about 6% of the current drug treated market share to reach $400 million in sales. Based on the increased efficacy of Lemtrada, the migration away from injectable treatment, the unique dosing regimen and comparable market share of other drugs we believe this has a high probability of success.
Reaching $400 million in sales would require about 3% of the global market share. Furthermore, we are not including sales in Canada (approved December 2013), Australia (approved December 2013), and all the other EU countries. If any of these countries add to the global sales, it makes the milestones even more achievable. Overall, it is realistic to expect to receive the $2 payment within the next few years.
What happened to the Sanofi value rights?
Reminiscent of my ideas for 2009 and 2010, it was a rough beginning of the year for these rights, with the price declining from around $0.35 to around $0.30. So far this year, Lemtrada was approved in Mexico, Brazil, and for reimbursement by the UK's National Health Service/NHS. Genzyme resubmitted Lemtrada's application for FDA review and that application was accepted for a six-month review in May. Genzyme presented data showing slowing brain atrophy was sustained after three years and that treatment effect was maintained by over two-thirds of patients after four years. The early returns on the rights have been strong this year, especially after the FDA cleared it earlier this month.
Are other such opportunities available today?
One can still buy Sanofi value rights for a small fraction of the value of even their lowest milestone payment. But this year there have been several other such opportunities. One was the Durata Therapeutics (NASDAQ:DRTX) contingent value right/CVR. As of this writing, it cost $0.64. According to the tender offer for Durata,
- Each CVR holder will be entitled to receive $1.00 per CVR payable by Parent if, prior to December 31, 2018, authorization is received that permits any seller to market and sell dalbavancin with approved labeling as a single dose infusion for the treatment of adult patients with acute bacterial skin and skin structure infections.
- Each CVR holder will be entitled to receive $1.00 per CVR payable by Parent if prior to December 31, 2018, any Selling Entity receives approval from the European Medicines Agency to market and sell dalbavancin in the European Union for the treatment of adult patients with acute bacterial skin and skin structure infections.
- Each CVR holder will be entitled to receive $3.00 per CVR payable by Parent if the cumulative worldwide net revenues during the period beginning on January 1, 2016 and ending on December 31, 2017, are equal to or exceed $600 million.
Based on the safety and efficacy of the drug, it is reasonable to expect that both approval milestones will be secured. Additionally, it is possible to hit the revenue milestone. Such a milestone could be met based on US sales alone if dalbavancin secures an approximately 3% market share. There are reasons to discount the potential of hitting the revenue milestone. Dalbavancin is substantially more expensive than generic vancomycin - the former costs over $1,500 for one 500mg vial while the latter typically costs under $500. Vancomycin is a well-entrenched incumbent. Clinical trials comparing the two drugs show them to produce similar results. With good execution, annual peak sales should hit $400 million. If it ramps up quickly enough, the revenue milestone could be in reach. This comes down to an opportunity to pay $0.64, probably get $2 and maybe get another $3.
Event Driven Investing is a Subspecialty of Value Investing
Everything taught in the major cannon of value investing holds true for event driven. Value investing involves focusing on capital preservation and demanding a margin of safety so that one has selected securities at prices that can withstand inevitable future disappointments. So does event driven investing. Value investors think about securities as fractional ownership in businesses or loans to those businesses. They attempt to buy at prices that represent discounts to values measured based on one's analysis of the underlying businesses. So should event driven investors. Additionally, they rely on prices making fundamental sense over the long-term. With event driven investing, instead of waiting for the long-term, we wait only for the consummation of various corporate events for security prices to move towards fundamental value. Neither value investors in general or event driven investors specifically are engaged in predicting market directions, whether a specific stock will next move up or down, or what charts look like. We know that we don't know (and suspect few of the people who think they know actually do).
As with other types of value investing, there is no advantage to hyperactivity. There are tens of thousands of publicly traded securities and thousands of corporate events, but most can be ignored. Diversification is important, but one can take almost all of the advantage of diversification after the first dozen uncorrelated ideas. So, event driven investors can afford to be highly selective.
Each core tenant of value investing is critical to even driven. Event investing is bottom-up - it is all based on facts specific to specific corporate events. Generalized ideas about markets are of little or no interest. Event investing is properly judged on its absolute return. It is not excused by weak markets and it does not require apologizing for inevitably underperforming frothy markets. Event investing is also best sized and monitored with an eye to the downside. Winning event driven investments take care of themselves, typically offering a profit, liquidity, and portfolio simplification at the same time. The analyst can feel smart and the world appears to be working as it should. It is limiting the downside that requires care. It is this downward focus that unites event driven with all of the varieties of value investing.
What do you do with good ideas? Once you determine that an idea is within your circle of competence, that it is analyzable, and based upon your analysis it has a substantially positive expected value, then what? I consider two quantitative constraints and two additional qualitative constraints to sizing good ideas.
A key first step to sizing is to size anything outside your circle of competence at zero. Zero risks nothing. It is tax-free. It costs no more time. It avoids even the energy necessary to track small positions. However, even at zero, I organize a comprehensive Alert Portfolio comprised of all of the ideas that I like but for their current market prices. These are analyzable opportunities within my circle of competence that are too expensive but could be added at lower prices. In addition to these ideas, I use the alert portfolio for tracking prices of each of our live positions when they move a few percentages within the range of our upsides and downsides. This has the advantage of instantly alerting us to non-trivial moves while freeing us from obsessing over trivial daily fluctuations in the stock market.
The first quantitative constraint is statistical diversification. Such diversification requires only a dozen or so positions to achieve almost all of its potential benefits. The key is to ensure that the positions are not correlated. This tends to lead typical portfolios towards two or three dozen positions with care that they do not overly concentrate in a given industry or investment theme. Failing to reach this level of statistical diversification is dangerous; further diversification is unnecessary. A little bit of diversification goes a long ways. Hyper diversification involving hundreds and hundreds of positions adds only a de minimis amount of safety at the great cost of making serious research impossible. A mean question to ask hyper diversified fund managers is, what is your least favorite of your hundreds of positions, why do you own it, and how did you compare it to your marginal idea on your reject pile?" While someone with twenty five or thirty ideas could answer that, it would probably be impossible for someone with hundreds of positions.
The second quantitative constraint is John Kelly, Jr.'s Kelly Criterion. This formula determines the optimal size of a series of prospects in order to maximize the value of a portfolio.
When f* = fraction of a portfolio to invest
b = net market implied probability based on security prices
p = probability of a favorable outcome defined as the reasonably likely profit
q = probability of the reasonably likely loss, which is 1 − p
The simplest way to think about Kelly is that sizing is determined by your edge over the odds. It requires a statistically significant sample size, so works best in investment strategies with a large number of opportunities or an investment organization with a long time horizon. It does not offer as much in terms of singular decisions over the near term. The key to Kelly is that the crucial input is one's informational advantage in a given investment. What is your edge over the market's implied odds of a given event? The answer can determine how much to invest.
If I rushed over these first two sizing guidelines, it is because they work well to determine maximum positions but there are two additional qualitative constraints that are more relevant to daily activity - transitivity and fortitude.
Transitivity is among the simplest mathematical properties.
In its simplest form, whenever A > B and B > C, then also A > C. If a given position C has a change leading to a higher expected value B (for example at a lower price, all else being equal) then it should be larger. If that expected value increases further to A (for example, by the price declining further, all else being equal) then it should be larger than B and it should be even larger than the original C. Transitivity is one of the most basic forms of rationality in investing. One might imagine that it is universal. It is not. Frequently, when prices decline somewhat, investors may add if their premises are still valid. However, if prices continue to decline, the same investors might begin to reduce positions. These non-transitive relations between prices and expectancy can create investment opportunities.
Dan Loeb, founder of Third Point LLC recently wrote,
In early October, a confluence of events transpired in relatively short order, including weaker economic data, political uncertainty, a potential global plague, and bureaucratic meddling, which caused fear to spike, sentiment to decline, and investors to de-leverage. The month got off to an especially rocky start for hedge funds when a court dismissed a claim in connection with the Fannie Mae (OTCQB:FNMA)/Freddie Mac (OTCQB:FMCC) GSE complex. Many investors were oversized in this trade and their forced selling kicked off the "de-risking" cycle. Next, oil prices declined sharply and many funds who had large positions in E&P companies suffered enormous losses. Then last week, AbbVie (NYSE:ABBV) halted its announced inversion transaction with Shire, inflicting great pain on the arbitrage community. Opaquely blaming mysterious "meetings with the Treasury Department," AbbVie walked away from an entirely lawful deal that had been touted as enormously accretive and strategic as recently as two weeks ago, incurring a substantial $1.6 billion break-up fee. A rational conclusion is that instead of a legislative solution that might require comprehensive tax reform, this Administration has decided to unilaterally curb inversions using whatever means are available. Needless to say, this regulatory uncertainty (along with prior detours from the rule of law) will be a wet blanket on top of investors until transparency and a level playing field are restored to the markets.
The impact of catastrophes for both the GSEs and then AbbVie's deal with Shire led to dramatically irrational price movements in unrelated securities. For example, here is a basket of merger arbitrage targets over the course of October 2014:
There has been no fundamental change in any of these situations this month. What do they have in common? There is substantial cross ownership between these securities and the poorly performing GSE and Shire securities. When the AbbVie-Shire deal broke in the middle of October, prices declined by several percent leading to greater selling instead of buying for several days before prices recovered. The correct position sizes are sizes that allow an investor to exploit such opportunities.
In addition preparing the portfolio for non-transitive dislocations, fund managers need to prepare themselves. The intelligence required to analyze and exploit the best market opportunities is only moderate. One needs to be able to ask the right questions and know where to find the answers. Many people can do that. The requisite fortitude to actually do it is rarer. Because the worst days in terms of profits and losses are often the best days in terms of opportunities, it is easy to feel different when the best opportunities become available than when one was researching them. It is a valuable strength to naturally have great fortitude. However, it is also a virtue that can be nurtured. Entering and exiting positions via writing puts and calls is one way to pre-decide one's positions without having to actually make the investment as the price is moving. Over-researching and over-communicating with partners relative to the marginal requirements of an investment decision make it easier to endure inevitable mistakes and surprises. But above all, size positions so that you can take advantage of volatility instead of being taken advantage. That will be a different size depending upon the manager and fund but it probably should be small enough that one could maintain flexibility in a crisis. That might involve doubling the position size in a given position. If a year's performance - or even an investment firm - were badly threatened by a single position, that sizing would probably come at a great cost to one's fortitude at the moment when that fortitude is most valuable.
My search for a best investment idea for 2015 focused first on the issue of safety. If nothing much happens, where could I invest money so that it would be unlikely to lose value over the course of the year? Only after I had a satisfactory answer did I consider the next question of whether a corporate transaction could unlock shareholder value. Where could I find an investment ripe for such a corporate event? For my answer, please read my upcoming article.
Disclosure: The author is long STRZA, DTV, YHOO, LORL, OSHC, GCVRZ.
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.