Variant Perceptions

Category: Klarman

Charting Banking XIII: history of bank failures

Before continuing exploring the possibilities of our new tool, the Texas Ratio, I think it is important to have some historical perspective on the risks of bank failure. Banks are quite fragile leveraged institutions and bursts of financial failures are essential to consider for normal times bank investing. I much rather invest in banks at the end of a crisis, when the risks can be quantified and prices are cheap, but there is a case to invest in them in any case.

The extension of risky loans with overpriced collateral, thin covenants, to lenders with insufficient cash flow, and even in some cases becoming complicit or target of frauds, can lead to over leveraging a particular sector of the economy and reach unsustainable bubble prices.  In the old times, the boring banking times of the 50s and 60s, those four conditions were called the 4Cs of lending with fraud avoidance called character. Even in the old times, there were periods when these standards were breached and problems ensued.

However, as we can see from our most recent history, something different is going on lately. There are different views on the reasons, but I would like to emphasize the rise of credit scoring that was a much less costly and standardized way of lending that checking the character of a borrower. That it turn opened the possibility  for the rise of securitization, that is not as new as people think: the 1980s collateralized junk bond obligations or 1990s car loans securitizations being just two examples.

In theory, securitization helped banks to reduce risky assets in their balance sheets. But as we have learned it is not so simple: there is less control of potential massive scale frauds, an asset bubble deflation will still impact more traditional loans and banks can sometimes end up holding junk like in the S&L 1980s crisis. It all started with the best of intentions but we have to live now with the consequences.

A pile of junk is still junk no matter how you stack it – Margin of Safety, Seth Klarman

Charting Banking Series Intro

“We worry top-down, but we invest bottom-up” – Seth Klarman

Despite its name, this is not a series on Technical Analysis. I think it is time to share some nice graphical data, result from a lot of time spent recently analyzing banks, that tell some underappreciated, misrepresented, or difficult important facts on the strength of the industry. Most of these graphs are from companies that I do not have and even some of them will be from companies that could be good shorts. So just the facts.

The streetcapitalist has a great interview with a bank analyst that raises some very good points on the suitability of this industry for value investing. The black box nature, leverage, and thin margins can look more suitable for speculative plays:

In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?

It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.

So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.

So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.

Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE: CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.

So why did value investors get it wrong?

As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.

The thing is that now banking microeconomics has become the developed world main risk. With banks and shadow banks being the main channel of credit, and with a government every day more limited in its options, it is clear we need a healthy banking system… and I worry.

And since the sector interconnectedness and fragility is the main driver of the credit cycle, this is a critical issue to follow in a top down risk analysis. I would argue that to understand the risks and the probabilities of a revisit of the March 2009 lows, a rapid recovery, or a range bound market it is important to understand the health of this industry and have a view on it. And if these analysis bring some collateral bottom up opportunities even better.

Alpha Magazine Hall of Fame – The Fundamentals

This is the Alpha Magazine Hall of Fame 2008 that includes interviews with some of the usual suspects in the hedge fund industry. I will start with some quotes of my heroes, the fundamentals (Seth Klarman, Julian Robertson, David Swensen and Alfred Winslow Jones) and leave macro traders for a later post.

Institutional Investor’s Alpha Magazine – June 2008

The Industry

  • He had two powerful ideas. One was that you didn’t need the traditional allocation of bonds and cash and all that – you can go 99% stocks, you’ll get a bigger return. Two was that you stay in there, you hang in there because you’re hedged. Those were his two things: always being in the market and having a big percentage of assets in stock – Robert Burch on Jones
  • Not having other sensible home for these non-S&P-like strategies, we decided that we would create an asset class and call it ‘absolute return’”- Swensen
  • Their clients are pressuring them for short-term results, or they think their clients want short-term results. That’s probably the biggest problem for professional managers. It makes it very, very hard for an investor to hold a stock that’s going down, to take a contrarian viewpoint – Klarman
  • The consultant’s numbers are substantially inflated by survivorship bias. When managers exit for bad performance, their records disappear – Swensen

Research

  • Every manager should be able to answer the question, what’s your edge? – Klarman
  • Max Heine was great at not looking at what something was called, what its label was. He looked at what it actually was – Klarman
  • Michael Price was fabulous at pulling threads. he would notice something, and then he would get curious and ask questions” – Klarman
  • When I got so many talented analysts, I realized it was better to go for more expensive growth stocks because the analysts could project earning well into the future – Robertson
  • I think I wised up a bit and realized it wasn’t just price that created value. If you can buy a stock at 25 times earnings that you are sure will grow at 20 percent for a long period of time, it is better value than a stock trading at seven times earnings that is going to grow at 3 to 5 percent – Robertson
  • One, dig, dig and dig deeper… Two, the value of a world-class information network … The third thing was the importance of management. Bad management with good assets can fritter value away – Touradji on Robertson
  • At Yale the most important shift in vetting hedge fund managers over the past 15 to 20 years has been in increasing focus on the character and quality of the investment principals –Swenssen
  • Human nature makes it hard for the markets to be efficient… so the questions is not, Are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, Are there periods when none of that matters because their human natures get the best of them?

Leverage and Shorting

  • We don’t even think of ourselves as a hedge fund. We see ourselves as basically long-only investors. Unlike hedge funds, we don’t leverage the portfolio- never a nickel of portfolio leverage. We have a minimal amount of shorts currently less than 1 percent of the total assets – Klarman
  • The first thing Alfred would say about hedge fund managers today is that they are not hedged. The word is being abominated. Anybody leveraged 30 to one is not hedged – they are just using the word to get the 20 percent performance fee – Robert Burch on Jones
  • I also think leverage is a great risk. If you look at hedge fund failures, virtually all of them were on the back of excess leverage – Klarman
  • Another illusion is that short-selling is somehow more dangerous than buying a stock for a rise in price. A stock can theorically go up to infinity and down only to zero… and in both cases there is no danger that cannot be provided for by adequate diversification – Jones
  • The ability to short was where you separated the wheat from the chaff – Robert Burch on Jones

Alpha Magazine Hall of Fame – The Fundamentals

This is the Alpha Magazine Hall of Fame of 2008 that includes interviews with some of the usual suspects in the hedge fund industry. I will start with some quotes of my heroes, the fundamentals (Seth Klarman, Julian Robertson, David Swensen and Alfred Winslow Jones)

Institutional Investor’s Alpha Magazine – June 2008 – (40).

http://www.nxtbook.com/nxtbooks/ii/alpha0608/index.php?startid=40

The Industry

He had two powerful ideas. One was that you didn’t need the traditional allocation of bonds and cash and all that – you can go 99% stocks, you’ll get a bigger return. Two was that you stay in there, you hang in there because you’re hedged. Those were his two things: always being in the market and having a big percentage of assets in stock – Robert Burch on Jones

Not having other sensible home for these non-S&P-like strategies, we decided that we would create an asset class and call it ‘absolute return’”- Swensen

Their clients are pressuring them for short-term results, or they think their clients want short-term results. That’s probably the biggest problem for professional managers. It makes it very, very hard for an investor to hold a stock that’s going down, to take a contrarian viewpoint – Klarman

The consultant’s numbers are substantially inflated by survivorship bias. When managers exit for bad performance, their records disappear – Swensen

Research

Every manager should be able to answer the question, what’s your edge? – Klarman

Max Heine was great at not looking at what something was called, what its label was. He looked at what it actually was – Klarman

Michael Price was fabulous at pulling threads. he would notice something, and then he would get curious and ask questions” – Klarman

When I got so many talented analysts, I realized it was better to go for more expensive growth stocks because the analysts could project earning well into the future – Robertson

I think I wised up a bit and realized it wasn’t just price that created value. If you can buy a stock at 25 times earnings that you are sure will grow at 20 percent for a long period of time, it is better value than a stock trading at seven times earnings that is going to grow at 3 to 5 percent – Robertson

One, dig, did and dig deeper… Two, the value of a world-class information network … The third thing was the importance of management. Bad management with good assets can fritter value away – Touradji on Robertson

At Yale the most important shift in vetting hedge fund managers over the past 15 to 20 years has been in increasing focus on the character and quality of the investment principals –Swenssen

Human nature makes it hard for the markets to be efficient… so the questions is not, Are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, Are there periods when none of that matters because their human natures get the best of them?

Leverage and Shorting

We don’t even think of ourselves as a hedge fund. We see ourselves as basically long-only investors. Unlike hedge funds, we don’t leverage the portfolio- never a nickel of portfolio leverage. We have a minimal amount of shorts currently less than 1 percent of the total assets – Klarman

The first thing Alfred would say about hedge fund managers today is that they are not hedged. The word is being abominated. Anybody leveraged 30 to one is not hedged – they are just using the word to get the 20 percent performance fee – Robert Burch on Jones

I also think leverage is a great risk. If you look at hedge fund failures, virtually all of them were on the back of excess leverage – Klarman

Another illusion is that short-selling is somehow more dangerous than buying a stock for a rise in price. A stock can theorically go up to infinity and down only to zero… and in both cases there is no danger that cannot be provided for by adequate diversification – Jones

The ability to short was where you separated the wheat from the chaff – Robert Burch on Jones

Valuation of Oil and Gas Reserves Part 2 ($CFW)

Now the fun part, how do we go about valuing the reserves. A good place to start is with an estimate of the Enterprise Value (EV) valuing all securities at market. That way we get to compare on an equal level companies with different capital structures.

In this case, we will consider the debt and preferred at par, given that this is not a distressed company. There is no excess cash but there are hedges that are liquid investment that can be sold at market so we will subtract them from the calculation

  • Debt: $43.7 million
  • Preferred Stock: $25.1 million
  • Common Equity: $50.2 million
  • Hedges: $14.6 million
  • Enterprise Value: $104.4 million

Multiples

A first approximation to valuing CFW is to use multiples of Enterprise Value. The usual rule of thumb is the 1/3 rule: on average a barrel of undeveloped oil reserve is worth around 33% of the current oil spot price. At current prices that would be $22/BOE. There have been some transactions at close to $20/BOE but let’s be conservative and use $10/BOE.

  • Proved Reserves: 49.1 MBOE
  • Value of Proved Reserves: $490 million

That is almost five times the enterprise value. But hey, we are talking about waterflooding, a capricious process where we have uncertainty on its timing and its results. So let’s be conservative again and value only the proved developed

  • Proved Developed Reserves: 10.1 MBOE
  • Value of Proved Developed Reserves: $101 million

Interesting result, it indicates that at current prices we can buy Cano for just the value of their proved developed reserves. So anything, and I mean anything, that the Panhandle undeveloped waterflooding decides to give us is free. At this price Cano is a free option on the success of the proved undeveloped, probable, and possible reserves.

Comparables

Another way of looking at this is to compare its enterprise value per proved reserves versus other companies. As an example I will compare it to Breitburn Energy Partners -BBEP, a company notorious for Seth Klarman’s investment, with a substantial proportion of gas reserves that are worth less than oil reserves, and currently undervalued against its MLP peers

Cano Petroleum

  • EV/Proved: $2.1 /BOE
  • EV/Proved Developed: $10.3 /BOE

Breitburn Energy Partners

  • EV/Proved: $9.8 /BOE

I have run these numbers against other companies and Cano Petroleum still looks cheap. Have also found other undervalued prospects but will leave them for another occasion.

I suppose my discounted cash flow friends are complaining that these methods are meaningless, since they do not take into account prices, costs and value of time. For you we are going to go through a third method in the next post, the most popular, the standardized measure and PV-10,

Disclosure: Long CFW