Wednesday, October 21, 2009

Notes From The Fifth Annual Value Investing Congress Day 1

David Nierenberg, Founder, D3 Family Funds
D3 War Stories: Practical Lessons About Building and Protecting Shareholder Value by Improving Corporate Governance

David Nierenberg, who has appeared at several other VIC’s including Pasadena this past May, led off the first day of the Congress. Nierenberg’s typically invest in busted microcap growth companies. His average holding period is 7 years, and there is 5 year lockup for investors.

The focus of this presentation was the importance of corporate governance. Nierenberg believes that much of the activism occurring these days is focused on the wrong things. He believes that putting a board in place that is capable and independent, focused on the real issues, and properly incented for the long-term can greatly improve potential company success.

Nierenberg highlighted three companies, including Move Inc (MOVE), Brooks Automation (BRKS), and Heartland Payment Systems (HPY). D3 currently has holdings in these companies, including 18.2% of Move, and 7.2% of Brooks.

Nierenberg believes that Heartland, a credit and bank card processor which currently trades for around $14.00, may ultimately be worth more than $ 40. Nierenberg cited the Company’s strong management, solid compound annual growth rates in revenue, EBITDA and EPS, and an overreaction to a security breach that sent the stock plummeting.

Nierenberg concluded with 3 points:
• Investing is not all about the numbers, it’s also about people and process
• Selling is not the only exit option (change can be brought about by major shareholders)
• In microcaps, large block positions and knowledge about governance can protect and build shareholder wealth.

Steve Dobson, CEO Amherst Securities
Fishing in a Poisoned Pond

Frequent VIC attendees have become accustomed to their bi-annual dose of bad news on the mortgage and housing front, and I am among many that are thankful for the honest portrayal. For the past two years, that somber topic has been delivered by Glen Tongue and Whitney Tilson, authors of “More Mortgage Meltdown”. Today, it was Steve Dobson’s turn.

Dobson’s expertise and analysis was a critical component of the book, and his candid portrayal of the continuing difficulties facing the residential mortgage market was sobering.

Among Dobson’s more frightening observations (and there were many):
• There are 8 million homes currently not paying their mortgage
• Once a borrower has missed 2 mortgage payments, foreclosure is all but inevitable
• The rate of recoveries is still declining
• The resolution process is grinding to a halt
• The amount of bank-owned real estate is falling, but that’s primarily because of a slowdown in the foreclosure process
• 29% to 50% of modified mortgages re-defaulted within six months
• 79% of all defaulted loans have a current loan to value (LTV) ratio above 120%

If there was any good news, Dobson reported that loss severities (recovery rates) have stabilized in all states.

Dobson concluded that:
• Loss severity will not increase substantially
• Losses will take longer to realize
• Loan modifications/Government programs to address the situation will evolve

David Einhorn, Chairman, Greenlight Capital
Liquor Before Beer, In the Clear

Einhorn opened his presentation with his thoughts on the importance of learning from bad decisions. He cited his 2005 IRA Sohn conference presentation on the merits of homebuilder NBC Holdings, which ultimately fell 40% as the homebuilding sector collapsed. Although the rest of the sector fell much further, an average of 70%, Einhorn learned the following:

• It is not reasonable to be agnostic about the big picture, a macro view is vital
• Even given the above statement, you can still be a stock picker

Einhorn went onto give a stirring speech about what he believes to be the current macro risks:

• The government is too focused on the short-term, too focused on getting re-elected.
• Too much focus on special interests (protection of banks, for one)

Einhorn believes that the lesson of the Lehman collapse, a company that he very successfully shorted, is that companies should not be so big that their collapse can jeopardize the entire financial system.

He went onto state that he has changed his view about the validity of owning gold, given its propensity to perform well not just during inflationary times, but when monetary policies are poor in general. In terms of form of ownership, Einhorn owns physical gold, believing that to be even more efficient than the ETF.

Joel Greenblatt, Managing Partner Gotham Capital
Formula Investing with a Value Mindset

Greenblatt, author of “The Little Book That Beats the Market”, presented a re-cap of his concept of the “Magic Formula”, which utilizes earnings yield and return on invested capital as the criteria to select stocks that will outperform. While he admitted that historical return on capital is backward looking, he stated the importance of estimating future ROC.

Greenblatt described two periods of underperformance by the strategy:
• 2/1/2006 through 12/1/2008 (34 months)
• 5/1/2002 through 6/1/2003 (13 months)

Despite his somewhat self deprecating depiction of the Magic Formula, the returns utilizing the strategy have been outstanding. For instance using back tested data, the strategy returned 291 percent or 14.6 percent annualized, for the 10 year period ended 5/30/2009. During the same period, the S&P 500 Index was down 2 percent (-.2 percent annualized). Furthermore, the Magic Formula has outperformed the market for ten of the past eleven years, through 9/30/2009.

Despite the simplicity of utilizing the Magic Formula, Greenblatt’s data suggests that it is not a good candidate to use for identifying short candidates. For instance, going long the top decile of Magic Formula companies and short the bottom decile substantially increases portfolio volatility, and does not enhance return.

Julian Robertson, Founder, Tiger Management
Question and Answer Session

Investing legend Julian Robertson took questions for a half hour; an extremely pleasant surprise for this Congress. Here are some of Robertson’s thoughts:

Concerns about the current state of affairs:
• Big concern is that we are still spending more than we earn, which is not sustainable. Debt must be paid back, and we are not even thinking about that. More focused on borrowing more from the Chinese, and hoping they won’t decide they have better things to do with their money.

On Energy:
• Although bullish on oil stocks, he is impressed by advances in solar energy. Believes that solar will continue to improve, wind power too, and this will ultimately help the environment and hurt oil companies.

On China:
• Might be a bubble
• Consumption not enough to pull the world out of recession

On Gold:
• An anti-gold bug—“none has been used since it was discovered”

On Norway:
• The most prosperous/sound country in the world

Companies he’s bullish on:
• Visa, Mastercard, Ryanair, Intel

What He’s Learned/Best Advice:
• Never be overconfident
• Don’t get overly enthusiastic about your business

Lloyd Khaner, General Partner Gotham, Kahner Capital
The Key to Turnarounds

First time presenter at the Value Investing Congress, Khaner, who has compounded 445.4% since 1991 (versus295.2% for the S&P 500), looks for the following attributes in potential investments:

• Unique management
• Strong decision making ability
• Avoid value traps
• Debt/Equity less than 70%
• Avoid dying industries
• Franchise companies with manageable debt

Khaner is a big believer in the concept of “CEO family trees”, placing value on those that have been trained or worked under other successful CEO’s.

Khaner listed the signs of a successful turnaround, including:
• Cutting unprofitable sales
• Cutting headcount
• New senior managers
• Fix customer relationships
• CEO sets plan within 3 months
• Gross Margin up
• SG&A down
• Focus on Return on Capital
• Restructure Debt-Push out maturities.

One of Khaner’s favorite ideas is Starbucks (SBUX):
• Slowing new store openings
• Improving service
• Expects positive comps fiscal 2010
• ROIC growth 100-200 bps next 3+ years
• FCF $500-$750 million 3+ years

Candace King Weir and Amanda F. Weir, Paradigm Capital Management
Bottom-up Stock Picking Back in Fashion?

Candace King Weir and Amanda Weir presented the case for bottom-up stock picking, especially in the small cap universe, believing that in this space:

• Management is more accessible
• Business models are more easily understood
• Companies tend to be domestically based, and have less currency and commodity exposure
• Companies are more nimble, have ability to scale, and can react more quickly to changing events
Part of the Weir’s strategy involves frequent contact with management. They focus on one name at a time, and are agnostic to both sector weights and macro trends. They believe the current market provides unique opportunities for investors, and such markets occur only once every 1 or 2 decades.

One of their current favorites is retailer Wet Seal (WTSLA):
• Cheap clothes with a fashion edge
• $350 million market cap, $150 million in cash
• 575 stores (495 Wet Seal, 80 Arden B)
• Hired New merchandise managers
• Sees expansion opportunities for Arden B

Paul Isaac, CIO Cadogan Management
Investing as a Pari-Mutual Proposition

Isaac, a first-time VIC presenter, is a 40-year industry veteran. Issac presented the long case for Waste Management (WM):
• Largest waste management company in the US
• 273 landfills, 355 transfer stations
• Trading at 15 times trailing earnings, 14.5 times 2010 consensus estimates
• Trades at 6.8 X EV/EBITDA
• Return on Invested Capital: 8.5%
• Free Cash Flow Yield: 8%
• Dividend Yield : 3.7%
• Bought back 17 percent of outstanding shares over the past ten years; new buyback recently announced
• Barriers to new entry in this business due to regulation
• Permitting new sites is difficult
• Could trade up to 8 X EV/EBITDA
• Potential IRR up to 20%
• Rising operating and net profit margins

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