Sunday, October 26, 2014

Book review: "Merchants of Debt" by George Anders

Merchants of Debt is a history of Kohlberg, Kravis & Roberts, the leveraged-buyout firm. KKR was founded in 1976 and Merchants was was published in 1992, so it covers the first fifteen years of KKR's existence.

The three partners who founded KKR and gave it its name met at Bear Stearns. Jerome Kohlberg was a Bear partner, while Henry Kravis and George Roberts were new hires. Bear had already completed several several LBOs under Kohlberg's direction when Kravis and Roberts joined, but together they pushed the firm to do more and larger buyouts.

Bear's focus at the time was lower-risk short-term trading, but Kohlberg had enough influence that the firm let him, Kravis, and Roberts commit more of its capital to LBOs. Unfortunately, the trio's deals weren't very successful. One early acquisition, a for-profit technical school in San Francisco, went bankrupt. Another, a shoe company named Cobblers, met the same fate after its president committed suicide. Eagle Motor Lines, a trucking company, was a loser. Boren Clay suffered during the early-'80s recession, and while it was eventually a profitable investment, the returns were much lower than expected.

Kolhberg, Kravis, and Roberts also had several winners, but their overall record was mediocre. That, along with philosophical differences, led to an acrimonious departure from Bear and their decision to found their own company. Their timing was perfect: KKR began life in 1976, just a few years before interest rates peaked and the stock market began an unprecedented surge.

Apart from good timing, KKR was successful because it pioneered a new way of financing LBOs. Traditionally, the sponsor of an LBO financed the transaction by investing a small amount of its own money in the LBO and borrowing the rest from an insurance company at high rates. KKR changed how both the debt and equity were funded.

Instead of borrowing exclusively from insurance companies, KKR convinced banks to lend it money as well, and it began issuing junk bonds once they gained acceptance in the early '80s. KKR also didn't invest any of its own money in its buyouts: instead it created limited partnerships, which it earned large fees for managing, that purchased the buyouts' equity.

The biggest investors in these partnerships were public pension funds. KKR won the funds' investments through a mixture of client hand-holding and legal bribery. The book describes it as follows:

Investing pension money with KKR also provided civil servants with a ticket into a glamorous new world. They didn't need to be mere spectators in Wall Street's biggest, most exciting takeover battles. By allying themselves with KKR, the Walter Mitty types who ran big state pension funds could feel that they were players, too. Roberts, Kravis, and Kohlberg shrewdly cultivated this "fan club," playing tennis with their pension fund backers, sending them confidential briefing books, and inviting them to private two-day conferences at elegant hotels. At those sessions, modestly paid civil servants got the chance to rub shoulders with KKR's founders, and to address them as "Jerry" and "Henry" and "George."

Drawn closest to KKR was Roger Meier, the long-time chairman of the Oregon Investment Council. In conversations about the buyout firm, Meier sometimes would say "we," then pause, correct himself, and say: "I mean, KKR." In 1983, Meier joined the board of a KKR-controlled company, Norris Industries, based in Los Angeles. Several times a year, right before or after board meetings, Roberts and Meier played doubles tennis matches at the plush Beverly Hills Hotel, pairing up with the hotel pro, former Wimbledon champion Alex Olmedo. "It was delightful," Meier later recalled. "Here was a little yokel from Portland, Oregon, operating with really some pretty fantastic high fliers. I was pretty impressed."

Meier had even more reason to be impressed after he retired from OIC in 1986 and KKR let him buy stock in one of its portfolio companies at a below-market price.

So how did KKR's others investors-- the ones who weren't allowed to make below-market purchases-- do? Merchants of Debt has an appendix that lists all the KKR deals that had been completed by time the book was published, along with their internal rates of return. The appendix suggests that KKR's record was very similar to its founders' record at Bear Stearns: many winners, but also a number of investments that went to zero. Two late-'70s deal went bankrupt. KKR's first big deal, the buyout of Fortune 500 constituent Houdalille Industries, returned only 22% per year even though KKR had borrowed 97% of purchase price. The buyout firm had to shut down one of Houdalille's two divisions a few years after the acquisition because Japanese competition had made it structurally unprofitable.

Some later deals earned 50-60% annualized returns, but even that's not as impressive as it may seem:

As a mischievous exercise, Goldman, Sachs partner Leon Cooperman at one point devised on paper a crude variation on the principle of the leveraged buyout, involving taking out big loans to buy stocks. Cooperman's method: Buy a cross-section of the stock market, paying nine-tenths of the purchase price with borrowed money at a 15 percent interest rate. Then wait a few years, see how much the stock price has climbed, and tally up the profits on the one-tenth "equity" portion of the purchase price. For a few years, Cooperman pointed out, his method would have yielded annual profits of 74 percent, an even better showing that the returns that KKR's passive investors were collecting. 

The largest deal that Merchants covers-- and the all-time largest LBO when the book was published-- was KKR's purchase of RJR Nabisco, which nearly went bankrupt a year after KKR bought it. The reason for the near-bankruptcy is that RJR had issued toxic securities called reset bonds-- if the bonds traded down from their issue price, the interest rate would reset higher to compensate for the fall in price. Essentially, the yield to maturity at time of adjustment would become the new coupon yield.

The reset bonds plummeted when the junk-bond market seized up in 1989. KKR averted bankruptcy by injecting new equity into RJR, but it reportedly lost a billion dollars when it sold RJR years later. KKR had gotten into a bidding war for RJR, dramatically overpaid for the company, and financed the purchase recklessly.

KKR's experience during the last economic cycle was similar: it made a string of successful deals during the housing bubble, culminating in its acquisition of TXU, which replaced RJR as the largest LBO ever. TXU, which changed its name to Energy Future Holdings, declared bankruptcy earlier this year as low natural gas prices crippled its profitability. KKR and its partners lost $8 billion on the buyout.

KKR's unlevered returns during the 1980s seem to have been similar to the stock market's, so KKR was collecting large fees for providing beta. And some of those fees were egregious: In addition to earning carried interest and a 1.5% management fee on the partnerships it set up, KKR gave itself a transaction fee equal to 1% of purchase price on every company it bought. This was a source of controversy during its negotiations to purchase Houdaille and later RJR. KKR also took a large fee for selling RJR, even though its investors had lost money on the deal.

Merchants of Debt has an impressive level of detail about KKR's strategy and its investments, and its treatment of the company and its principals seems very balanced. Unfortunately, the book suffers somewhat from a lack of context. For example, while it implies that reset bonds were common among junk issuers, it doesn't quantify this or give any examples other than RJR. (In retrospect, it's amazing that anyone issued them.)

The book also doesn't compare KKR with its rivals. Although KKR became the most prominent buyout firm during the 1980s, Merchants mentions that the single most prominent deal was Wesray's 1982 acquisition of Gibson Greetings. Wesray sold Gibson less than eighteen months later for a $200mm profit on a $1mm equity investment, demonstrating the enormous potential rewards of LBOs. But the book doesn't describe any of Wesray's other deals or compare their record to KKR's.

Kill your investing gurus

Dwight MacDonald was a prominent cultural critic during the 1950s. In Masscult & Midcult, he argued that a common feature of bad art is an emphasis on the artist, his personality, and his supposed genius rather than on the art itself. He mentioned Lord Byron as an example of this:

Byron's reputation was different from that of Chaucer, Spenser, Shakespeare, Milton, Dryden and Pope because it was based on the man--or what the public conceived to be the man-- rather than on his work. His poems were taken not as artistic objects in themselves but as expressions of their creator's personality.

There is a similar phenomenon in investing, in which many investment gurus are famous less for their ideas than for their personalities. They are famous for being themselves.

Warren Buffett is the most prominent example of this. Buffett was originally known for making a string of great investments and publishing shareholder letters that explained his philosophy of investing. Today, he's known for being "Uncle Warren," a down-to-earth Midwesterner who dispenses homespun advice in the manner of Will Rogers.

Buffett's ideas are no longer discussed or debated on their own merits; instead, public discussion of Buffett revolves around his witty sayings, personality quirks, and past successes. To the extent his ideas are mentioned, they're cast as pronouncements from "the Oracle of Omaha"-- i.e., Buffett doesn't deserves respect because his ideas are good, his ideas automatically deserve respect because they're his and he's Buffett.

MacDonald claimed that Byron's private writing was different from-- and much more cynical than-- what he wrote for public consumption: "Of course it wasn't really Byron himself but a contrived persona which fitted into the contemporary public's idea of a poet."

Likewise, there's a wide chasm between Buffett's public persona and his more cynical private beliefs. It wasn't always this way: one need only compare Buffett's letters from the 1970s to his CNBC interviews today to see how much his persona has changed.

A parable

The prologue to The New Market Wizards, Jack Schwager's trader interview book, includes a story from Ed Seykota:

One cold winter morning a young man walks five miles through the snow. He knocks on the Jademaster's door.

The Jademaster answers with a broom in his hand. "Yes?"

"I want to learn about Jade."

"Very well then, come in out of the cold."

They sit by the fire sipping hot green tea. The Jademaster presses a green stone into the young man's hand and begins to talk about tree frogs. After a few minutes, the young man interrupts.

"Excuse me, I came here to leam about Jade, not tree frogs."

The Jademaster takes the stone and tells the young man to go home and return in a week. The following week the young man returns. The Jademaster presses another green stone into the young man's hand and continues the story. Again, the young man interrupts. Again, the Jademaster sends him home. Weeks pass.

The young man interrupts less and less. The young man also learns to brew the hot green tea, clean up the kitchen and sweep the floors. Spring comes. One day, the young man observes, "The stone I hold is not genuine Jade."

Ostensibly, the moral of this story is that patience precedes wisdom. If a trader wants to become successful, he can't depend on other people for tips and easy answers. He must learn how to think for himself.

I have a different interpretation. Like the story itself, my interpretation is hokey and not entirely serious, but like the story I think it makes a valid point.

The story's real message is that many respected gurus are full of crap. The young would-be apprentice thought the jademaster would teach him valuable lessons. Instead, the jademaster exploited the young man's adulation and got him to perform free domestic labor, all while pulling his leg with a ridiculous story about tree frogs.

Warren Buffett is a modern-day jademaster. Buffett has carved a lot of jade over the course of his career, but many of the stones he's pressed into the public's hands are merely quartz.

When Buffett describes how Rose Blumkin was thrifty and dedicated to her business, he may as well be talking about tree frogs. Everyone knows that thrift, industriousness, and dedication are good qualities. The obvious doesn't become profound just because a guru says it.

When Buffett bemoans Corporate America's ethical lapses, he's fingering a particularly cheap lump of quartz. Buffett has treated Berkshire's minority shareholders admirably, but he's also used his image as an honest outsider to cut insider deals. His reputation as a man of strong principles has given him cover to violate some of them.

When Buffett praises quality businesses, he may as well be talking about tree frogs again. Like the jademaster, Buffett can talk interminably about his favorite subject without ever revealing the foundation of his success. Like the would-be apprentice, investors have to endure lots of diversionary stories before they figure it out for themselves.

I don't think anyone has interpreted the jademaster story this way before, but my whimsical interpretation does have one thing in common with the original: it argues that people can't depend on a guru for easy answers. That's true whether the guru is a long-forgotten gem carver or the world's richest investor.

Wednesday, October 22, 2014

Two great posts from Credit Bubble Stocks

Credit Bubble Stocks has two older posts that deserve to be reposted.

The first is a review of Benjamin Graham: Building a Profession, which is a collection of Graham's articles and speeches.

The book's highlight is its discussion of Computing-Tabulating-Recording Co., which was a predecessor of International Business Machines. Graham liked C-T-R because he had extensive experience using its products, which knew were high-quality, and because its stock traded at only 7x earnings. He urged his boss to buy C-T-R's stock, but his boss flatly refused:

So early in 1916 I went to the head of my firm, known as Mr. A.N., and pointed out to him that C.-T.-R. stock was selling in the middle 40s (for 105,000 shares); that it had earned $6.50 in 1915; that its book value-- including, to be sure, some nonsegregated intangibles-- was $130; that it had started a $3 dividend; and that I thought rather highly of the company's products and prospects.

Mr. A.N. looked at me pityingly. "Ben," said he, "do not mention that company to me again. I would not touch it with a ten-foot pole. (His favorite expression.) Its 6% bonds are selling in the low 80s, and they are no good. So how can the stock be any good? Everybody knows there is nothing behind it but water."

By water, Graham's boss meant that its tangible assets had been written up to make its property, plant & equipment look more valuable than they really were.

I find this fascinating because it shows how much valuation standards can change over time. Today, a company is praised for earning a high return on equity (ROE). In Graham's time, companies were praised for having significant assets, even if reporting significant assets depressed their stated ROE. Then, 7x earnings was considered too expensive for a company that had minimal real assets. In 2011, when Graham's most famous disciple invested in IBM, it traded at 13x earnings and its tangible book value was negative. These days, a company with negative tangible equity and low-rated bonds is considered to have an efficient capital structure.

CBS's second post presents a theory of why breadth declines at the end of bull markets:

The problem with low-information momentum investing is that since you don't have a theory of the value of your holdings, you have to put a lot of thought into stop loss rules that get you out of the position when the momentum fades. Mr. UES has a stop loss rule to dump anything that goes down 10 percent from his purchase price or subsequent high price. 

I've noticed that when he blows out of a stock that "isn't working" anymore, he'll push most of the proceeds into ideas that are "still working" - going up.

This is what creates narrowing breadth at the end of a rally!

This reminds me of a story I read in high school, Joseph Addison's The Vision of Mirza. The story describes a bridge that's shrouded in mist at both ends. The length of the bridge that's visible has numerous trap doors: as people walk from one end to the other, they gradually fall through the traps and into the water below. Many people start at the beginning of the bridge, but no one reaches the end.

The Vision of Mirza was meant to be a metaphor for death and the evanescence of human life. Less dramatically, it's also a metaphor for the stock market. The beginning and end of a bull market are often impossible to identify in advance. They're shrouded in mist, if you will. And few of the stocks that have strong momentum at the beginning of the bull market maintain that momentum for the bull's entire duration.

Monday, October 6, 2014

Andy Beal's business model

Andy Beal is an unconventional banker who avoided participating in the housing bubble and made a lot of money buying distressed loans in its aftermath. In 2009, Forbes published an article about him called The Banker Who Said No. The article emphasizes Beal's foresight and maverick personality, but it also describes his business model, and I would argue that this has been equally important to his success.

Beal owns 100% of Beal Bank, which funds itself is by issuing certificates of deposit. Many CD buyers are "hot money" depositors who seek out the CDs with the highest interest rates, and this gives Beal a lot of flexibility in borrowing money: if he sees opportunities to make profitable investments, Beal Bank can quickly raise money by offering high-interest CDs. Conversely, if its existing loans are being repaid and he can't find any new investments, it can reduce its liabilities by letting its outstanding CDs mature.

Few mainstream investors have the same flexibility. It would be very difficult for a hedge fund manager to sit out a boom the way Beal sat out the housing bubble and stay in business. (Michael Burry foresaw the housing bust, but he faced an investor revolt when his housing bets initially lost money.) Even if the manager's clients didn't leave him for underperforming the market, they wouldn't be willing to pay him management fees for holding cash. It would also be very difficult for the typical fund to find new investors during a crisis, whereas FDIC insurance lets Beal raise money with ease.

For a typical bank with a low-yielding portfolio, issuing high-interest CDs is a tough way to raise money, but a high cost of deposits is less of an issue for Beal because he specializes in buying distressed loans that have both higher interest rates and the potential to appreciate. The downside to Beal's business model is that he can't invest widely, e.g., regulators wouldn't let him issue CDs in order to trade stocks or currencies. But Beal's focus is debt– according to the Forbes article, he's bought only one stock in past 15 years– and for that it seems like a fantastic model.

Avoiding value traps

Although I panned Daniel Strachman's book about Julian Robertson in my last post, the book has one great quote that's worth sharing:

Robertson’s mantra was, as long as the story around the investment remained the same, the position should get bigger. As soon as the story changed, it was time to get out...

To understand the concept of story, consider this example. Say you are interested in a solid oak wooden table. [An] analyst could tell you that he had checked out the market for tables, evaluated the information, and come to the conclusion that the table was a good buy at $100 because it was well made, solidly built, and would not fall apart. This is the story. So you go to the shop, prepared to buy the table. And then, just as you are running your hand over the table, a corner falls off. Well, now the seller is desperate to get rid of the broken table and is willing to sell it for $20. To the analyst, this seems like a steal. He sees an incredible opportunity to buy something for $20 that is really worth $100 and needs just a bit of fixing to get it there. But in Robertson’s eyes, the story is now flawed, and now he would say that you should want no part of the deal. How could something so well built, made of the finest oak, break?

This is a simple analogy, but it conveys a profound truth about value traps and how to avoid them.

When a company with a long record of success starts performing badly, investors tend to view the present in light of the past and assume its problems are temporary. If the stock goes down, they'll see it as a buying opportunity-- witness the numerous VIC writeups on Dell, Staples, and Tesco. Instead, investors should ask if the bad performance indicates that the company's competitive position has permanently deteriorated. If it has, then the company's historical performance and the fact that its stock is cheaper than it used to be are meaningless.

The same principle applies to valuation standards. One of my first posts on Young Money was about gold miners. Although they were trading far below their historical valuations, I argued that they were value traps: since the price of gold had been low for years, investors historically had ignore the miners' low earnings and valued them on the profits they would earn if gold surged. But when I wrote that post, gold had already surged and the miners' earnings were still low. The assumptions that investors had historically used to value the miners had been disproven, so it didn't matter where they traded relative to historical levels.

I used to be a hardcore statistical value investor, and it took me years of experience to realize how important this is. If a business is declining or its competitive environment is changing in a way that will permanently impair its profitability, there's almost no price at which it's worth buying.

The problem goes beyond falling earnings. When a company's business model deteriorates, management typically doesn't know how to respond. If they're used to running a growing company, they won't know how to run a shrinking company. If they're used to dominating their industry, they won't know how to compete from a position of weakness. In many cases, they'll do things that exacerbate the company's problems.

Their capital allocation also typically worsens: it's common for structurally-declining businesses to try to grow their way out of their problems by making overpriced acquisitions in growth markets. See HP and Autonomy, Kodak, Post Holdings, etc. Other structurally-challenged businesses try to maintain their earnings per share by buying back stock. This often starves their operations of necessary cash and can actually lower EPS in the long run.

For a company with a durable business model and long-lived assets, bad capital allocation isn't necessarily fatal. If the company wastes the next few years' earnings on overpriced acquisitions, that impairs only a small part of its present value. By contrast, the next few years represent a huge share of present value for companies that are in decline or that face a step down in profitability because of new competitive pressures. It's a sad irony that the companies for which capital allocation is most important tend to have the worst capital allocation.

As an example of this, Best Buy, Gamestop, and Western Union are all buying back lots of stock. These business face existential threats and could go out of business within the next decade. In my opinion, a company like that should never buy back stock-- it should try to dividend as much of its cash to shareholders as possible before it goes to business heaven. I feel the same way about retailers and tech companies-- most of them operate in an environment of constant change and have no residual asset value, so the surest way for them to reward shareholders is to pay dividends or special dividends while business is good.

Wednesday, October 1, 2014

Julian Robertson

I've been reading as much as I can about Julian Robertson. He interests me not only because he's been very successful but because his style of investing is different from mine. I'm always trying to learn new ways to invest, and whom better to learn from than a legend?

One biography of Robertson has been published, Daniel Strachman's Julian Robertson: A Tiger in the Land of Bulls and Bears. The book gets terrible reviews on Amazon, and unfortunately they're justified. The book is riddled with solecisms and awkward metaphors, but its worst flaw is its extreme repetition, which includes gems like "The firm would need to diversify its assets to ensure that it did not put all of its eggs in one basket" and "Winning, you see, is everything to Robertson. Robertson is all about keeping score. To the victor goes the spoils, and he always wants to be the victor."

John Train provides a much better-written profile of Robertson in Money Masters of Our Time. Robertson has also given numerous interviews over the years. The best of these are his two Barron's interviews from the late 1980s, and his 2006 interview with Value Investor Insight. In 1996, Businessweek published a hatchet job on Robertson called "The Fall of the Wizard." Below is what I've been able to piece together about his career.

Tiger's early years

After serving in the Navy, Robertson worked at Kidder Peabody for two decades as a stockbroker. Unlike many brokers, he tried to understand securities instead of merely selling them, and he began trading stocks as a sideline. Early success as a trader attracted the attention of his colleagues at Kidder, and he agreed to manage money informally for several of them.

One of those colleagues was Robert Burch, the son-in-law of hedge-fund pioneer Alfred Jones. Burch and Jones probably gave Robertson idea of starting a hedge fund. In any case, when Robertson left Kidder and set up the Tiger Fund in 1980, they were among its first investors, and Tiger employed the strategy that Jones had pioneered, buying some stocks while shorting others as a hedge.

Robertson founded Tiger with Thorp McKenzie, another broker from Kidder, but McKenzie left the fund in 1982. From then on, Robertson ran Tiger as a glorified one-man shop: while he depended on numerous analysts to research potential investments, he made all the trading decisions personally.

The 1987 crash

Tiger's performance during its first five years was phenomenal: despite being partially hedged in a roaring bull market, it consistently beat the market indices. Returns slackened in 1986, however, and the 1987 crash blindsided Robertson. Two weeks before Black Monday, he wrote to Tiger's investors that "I do not see great danger of a drastic market decline until we all get a great deal more complacent."

He had assumed that the overvalued Japanese stock market would peak first, providing a warning signal for any downturn in the US market. In fact, Japan held up comparatively well during the crash, and since Tiger's largest shorts were Japanese stocks while its longs were mostly American companies, its hedging strategy failed dramatically.

Robertson was bullish after the crash, partly as a reaction to what he saw as near-universal bearishness. He told Barron's in December 1987 that "there are so few bulls that I can’t imagine who’s going to impregnate the cows." He also thought that the crash would have a limited effect on the general economy-- it might even help it by lowering mortgage rates, which he considered more important to most Americans than the stock market-- and that many stocks were cheap. In Barron's he touted Ford Motor trading at 4x earnings, thrifts at 4-6x earnings and a discount to tangible book value, and PVC manufacturers at 6x earnings.

Japan's bubble

Robertson became bearish on Japan in 1986. Japanese companies traded at astronomical valuations even though, contrary to popular perception at the time, they were earning much worse returns than their American counterparts. In the 1987 Barron's interview, he mentioned Nippon Telegraph and Telephone and Japan Airlines as being particularly overvalued. Incidentally, although Japan's Nikkei index rose 70% from the time of Robertson's interview to its peak on the last day of 1989, JAL was flat during that period. NTT also peaked long before the Nikkei.

During the 1990s, Tiger profitably shorted Japanese bank stocks. By then Japan's economy had slowed and the banks' problems with bad debt had become well-known, but they continued to trade at much higher valuations than American and European banks before belatedly crashing.

Not all of Robertson's predictions proved correct. During the late '80s, he assumed that the Japanese stock market would plunge and that this would spur the Japanese to invest more abroad. While the market did plunge, it had the opposite effect, as Japanese businesses curtailed their foreign investments.

A move to macro

As Tiger's assets under management grew from a few hundred million in the late 1980s to $22 billion at its peak in 1998, Robertson's interest in macro trading grew commensurately: "I think, without actually realizing it, we put more and more into those types of trades because we realized that they were more liquid than anything else, so we became—sort of by osmosis—more involved in macro."

Although his macro returns seem to have matched his stock-picking returns, they were much lumpier. Tiger had a phenomenal 1993, followed by two disappointing years and then a roaring comeback in 1996-97. In October 1998, Tiger fell 18% because of a wrong-way bet on the Yen. Around the same time its original long-short strategy began to fail as the Internet mania reached a fever pitch, and Robertson had to shut Tiger down in March 2000 after it fell 43% in the preceding eighteen months.

Since 2000

Robertson supposedly quintupled his money in the eight years after closing Tiger. In 2006, he predicted the housing bubble and drew an important distinction between debt and equity bubbles:

"I actually think the insanity of the late 1990s is repeating itself... There’s a more serious bubble today than there was then... The Internet bubble affected a few of us, but the vast majority of Americans were not fazed by that. Now you’ve got people living on the refinancing of equity in their homes and almost all of us own homes."

In the same interview, he described how his idea of value has evolved:

"When I started in the business and for a long time, my concept of value was absolute value in terms of a price-earnings ratio. But I would say my concept of value has changed to a more relative sense of valuation, based on the expected growth rate applied against the price of the stock. Something at 30x earnings growing at 25% per year – where I have confidence it will grow at that rate for some time – can be much cheaper than something at 7x earnings growing at 3%."

I suspect that, as with Robertson's increasing reliance on macro trading, necessity motivated this change in philosophy. The statistically cheap stocks that Robertson had been buying in the '80s had all but disappeared by the late '90s, and they remain rare today.