Wednesday, January 16, 2008 15 comments ++[ CLICK TO COMMENT ]++

I'm Thinking of Averaging Down on Ambac

UPDATE: Thanks to everyone for their useful comments. The situation has completely unraveled. Everything is happening so quickly that investors like Neanderthal thinking of exiting don't even have that option anymore. It's pretty much down to the last choice of waiting and seeing. I'm going to wait and see what they say in the conference call on Tuesday. Raising capital is going to be very difficult now, especially since they have to do it within one to two weeks. If Ambac can't raise capital it is the end of the business as we know it... it's taking down the whole monoline sector, including reasonably well-capitalized Assured Guaranty (AGO)... oh, the irony of buying Ambac just before it completely falls apart.. oh well...



I took the biggest one day loss (dollar terms) in my life today. Percentage-wise it wasn't so bad because nearly all my other holdings were up. My portfolio was down -7.86%. In dollar terms I think I wiped out one third of my (realized) profits over the last 4 years (there are some sizeable unrealized losses on stocks like Takefuji and Montpelier Re so the situation is worse than it seems) . Needless to say, the key driver was Ambac, which was down 38.65% (Ambac was around 25% of my portfolio before). The problem with these big price drops is that you need a higher return to get back to where you were. Since returns are geometric, you need a 100% return from a new price level to get back a 50% loss; and you need a 50% gain to offset a 33% loss (eg. say price is 15 and it drops by 1/3 to 10, then going from 10 to 15 is 50% of 10).


I'm thinking of averaging down but am not sure if that is an irrational, emotional, action. I was saving up some money (I have around 15% cash) to invest in some Japanese small-cap or for risk arbitrage but am thinking of buying Ambac instead. I remember some guy on the Calculated Risk Comments Section saying last week that I was being foolish by investing in Ambac so is this double foolish or what? I'm just not sure. It's all murky.


I guess this is what seperates value investors from newbie "contrarians" like me but I'm just not sure what the intrinsic value of Ambac is. If you were somewhat confident with your intrinsic value calculation you can decide whether buying more is worth the risk but right now I'm uncertain.


The problem is that the future of Ambac is contingent on future losses in real estate assets. I am pretty confident with the business Ambac is engaged in; but not its potential losses. I can see Ambac with long-term earnings around $400 million per year (this was the earnings back in 2000). This would value Ambac at 4x P/E right now. The question is the losses. My investment thinking is based on the view that the current loss estimates account for most of the issues. I'm expecting around $2 billion in (after-tax) losses with a bearish possibility of around $4 billion. I can live with a $4 billion loss but anything above that (say the $7+ billion Ackman mentions for MBIA) will either bankrupt the company or dilute the shareholders to almost nothing.


What still keeps me wanting to invest is the fact that book value is still decent. The latest write-down is massive and takes book value down to the $20's (adjusted book value down to the $50's), but it's nowhere near zero. In contrast, something like GM has negative book value (admittedly the situation is different and GM likely has a lot of tax shelters and other intangible benefits). If you do not think that Ambac will post another big loss then the book value makes the stock attractive (of course, if you think further losses are coming then it's a bad investment).


If I do decide to average down a bit, the question is whether to do it now or to wait for the share issuance. If Ambac offers shares or warrants to the public, I'll participate. But there is a possibility that it may be a private placement (due to timing) so the public stock may not be a bad idea.


Regardless of whatever happens this will be a defining investment in my life. Unlike Neanderthal, and maybe CAK, I'm not as old so it won't be as catastrophic but it will wipe out several years of savings (or maybe 4 years of stock market returns, for someone who has nearly all his money invested in stocks). This is also a good test for me because it is the type of investment that resembles some of Buffett's investments, such as Geico or American Express. In other words, some company that seems to have a decent business but massive short-term problems than can bankrupt the company (some thought AMEX was going bankrupt due to their liability from the Salad Oil Scandal).


One of the questions that's running in my mind is something that I would pose to Neanderthal, who is thinking of exiting the position and taking a massive loss: if you were investing right now, would you invest in Ambac (or MBIA)? Why? Why not? I just don't think anything that is unfolding is a surprise to me (except the management shuffle, which seems to be based on a difference of opinion on how to raise capital (check the 8K that was filed or read this BusinessWeek article)).

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15 Response to I'm Thinking of Averaging Down on Ambac

Neanderthal
January 16, 2008 at 11:00 PM

Siv,

Let me outline my original reason for buying this stock.

Up until that time, I was a mutual fund investor and doing very well. I came back from a trip and saw that there were a big drop in the stock prices, particularly home builders and financials.

I knew that I did not have the ability to do a due diligence, so I relied on my mutual funds to provide some stocks that they already are invested in. ABK came up as one of the stocks from rsvax, a very conservative value investor. In addition, Third avenue was into this one. Upon cursory examination, it seems the company has very good business model and good balance sheet etc. I bought it at an average cost of $33.

After today, I had to re-examine the validity of my investment thesis. Looking back, it seems small investors like us don't really know much. Many things happened in the last couple of months that lead all of us to adjust to the "new" realities. For example, one of the reason for owning this stock is the discount to the enterprise value. In the last couple of months alone, the enterprise value per MStar went from $112 down to the eighties down to the fifties. After today, I am sure it would be in the teens or twenties. Diddo with book value. In the article from AccruedInterest, he estimated $6 bil loss to be taken over three years, In one swoop, the loss is at 5 Bil. This seems to be worse than the worst case scenario predicted by AccruedInterest and more in line with Bill Ackman.

The CEO leaving at this juncture does not pass the smell test. I realize that they are talking about this being the difference of opinion about fund raising, but for the good of the company, which he owns a chunk of, they would probably get him to stay on until the fund raising is done. This tells me that something bad might still in the works. The fact that they are using equities to raise money also confirms this. As you pointed out, equity raising gives them flexibility but is more dilutive to existing share holders at these prices. It must be that they want to leave the option of issuing notes later on.

I would probably not buy more ABK at this juncture. The question is if I exit the position. It seems I either get out now or wait out the storm and risk losing the remainder of my investment. The third option is to wait a couple of months to see if it climb back to the high teens.

I am still pondering.

John

cak
January 16, 2008 at 11:39 PM

SIV-

Excellent post. It is never easy to suffer a monumental breakdown in an investment, especially in such a short period of time. But that is the paradoxical dilemma of 'value' or contrarian investing - taking above average risk at the toughest time in order to achieve extraordinary gains - the proverbial "pioneer catching the falling hatchet".

While I have also been thinking about adding to my position in AMBAC, the situation just seems too cloudy at the moment. Personally, I happen to think Genader's exit was for the best. After all, just two months ago he publicly refuted a Morgan Stanley analyst's assessment of Ambac's financial situation, a report that has turned out to be correct. He also stated Ambac would not need to raise additional capital to maintain AAA, another wrong attitude. In a recent two hour conference call with analysts he painted a very sanguine picture, never indicating any trouble. Overall, his rosie outlook was so far removed from reality that he may have permanently damaged the company. Hopefully, his Pollyanna-ish behavior was not so prolonged as to destroy the company's ability to raise that much needed cash. Granted, there might have been an internal struggle between Genader, upper management and the board on handling a cash infusion but that would not necessitate his "retirement" per se. Sometimes, like at Sallie Mae, leadership becomes lax, removed and maybe a little bit arrogant ("this can't happen to us").

And if they have NOT raised the cash then his departure is a totally classless and cowardly act. Let's hope he is a better man than that.

From what Ambac has stated it looks as though they are working on a Warburg/MBI type deal. What's interesting is today's resignation from the board by the director from Cerberus. This is pure speculation on my part but perhaps the open seat will go to a new investor, someone who demands directorial oversight of the company. Usually hedge funds are desirous of such positions so maybe Ambac has gotten something going with Blackstone, Farrallon, Citadel, Atticus, Fortress or any other Wall St vulture with extra cash on hand. And the guy from Cerberus did not want to deal with a competitor. That is total conjecture on my part but Ambac's major write off today may have been part of the deal, along with dumping Genader and Cerberus, so as to clean the slate. Given the company's other assets and operations such an investment would not be farfetched. Though it may just once again reflect Ambac's pie-in-the-sky outlook the company did point out the junk could make a come back someday. Hedge funds love squeezing something from nothing.


Again, all of the above is total speculation. I guess we'll find out next Tuesday.

cak
January 16, 2008 at 11:58 PM

Like NEAN, I am in ABK right around 28 - 29. I was impressed with the company's transparency when they released CDO exposures on their website, along with that seemingly forthright rebuttal of Morgan Stanley. With decent cash flow from ops, what I thought was a fundamentally sound and profitable co and px'd at .4 to book what was not to like? Ay-yi-yi!

My plan is to hang in for a while and see if they can get their s*** together. I will, however, try to recoup some of the loss by writing, and probably overwriting, calls against the position. It gets difficult to sell options for decent premiums the more the stock drops from my initial cost but hopefully a few dimes and quarters will cut my basis down a couple bucks.

MFang
January 17, 2008 at 12:10 AM

Siv, sounds like you are just embarking on a lifetime of an investing journey. I do hope however ABK turns out, you will stay the course and not give up.

I would like you to consider this on the eve of you averaging down and plowing more savings into ABK: Investing and speculating, unlike other endeavors, often deliver random reinforcement. What I mean is that this is one field where you can do everything correctly and still end up losing money, or you can be completely reckless and end up wining big. It is a perverse and cruel game. What is worse, you may end up taking away the wrong lesson depending on the outcome of ABK.

I am dilberately vague here by not elaborating what I mean in "doing everything correctly," or "taking away the wrong lesson" You're a smart guy, and you'll figure it out.

Lastly, don't forget to tend to your mental capital, not just your physical capital, when you consider the length of time it takes to recoup you investment and then earn a return on it.

Mental capital, unfortunately, is a finite, but vastly more precious resource than physical capital. You expend a bit of it everyday you are underwater and waiting for the stock to come back, all the while accumulating an opportunity cost of other investments NOT made.

You will know what I mean if you do choose to average down.


Lastly, the urge to average down is a common human reaction. Even Andrew Tobias can't withstand the urge (on a different stock, FMD), despite my arguing otherwise.

http://www.andrewtobias.com/newcolumns/071213.html

Good luck.

Neanderthal
January 17, 2008 at 12:33 AM

Cak,

Good post. What you say about the equity deal made a lot of sense. I remember when MBI did a similar deal, they also had to disclose more bad loans which drove down their stock prices before the deal happened. It will probably go through at slightly above the going price like $14 or %15 with some options for a higher price. I think I would hold on to it for a while. It does not sound as ominous as it first appeared.

John

Anonymous
January 17, 2008 at 1:45 AM

Siv:

I am going to give you some advice.

Don't do it. Period.

Thoughts to consider:
1. Warren Buffett wouldn't touch the current companies equity. He may end up buying the salvage, but the equity holders will be under water so it won't matter to you.
2. Warren Buffett isn't your friend on this one. He is your competition. Think about that.

This is not a typical company and I don't think you understand it well enough. Once they lose the AAA of the subs, they are in runoff. That eliminates any chance of doing better then getting a few dollars/share. It is no longer a going concern.

They are charging using the unit 'basis point' and the losses are in the 10's of percents.

This is two orders of magnitude difference.

Don't bet it all on something you have a vague understand of.

I have bought blue chips in the past because they 'seemed cheap' and you can do pretty well, even if you don't fully understand the business. Not the same thing.

If you absolutely have to own this, then do what Marty Whitman is doing -- look at his investment - $% of his portfolio????? Do not bet more then Marty unless you understand the situation better then Marty.

You do not have to average down on this. Stocks are getting killed and there are current opportunities and will be a lot more opportunities in the future.

Anonymous
January 17, 2008 at 2:04 AM

"et returns, for someone who has nearly all his money invested in stocks). This is also a good test for me because it is the type of investment that resembles some of Buffett's investments, such as Geico or American Express. In other words, some company that seems to have a decent business but massive short-term problems than can bankrupt the company (some thought AMEX was going bankrupt due to their liability from the Salad Oil Scandal)."

ABK is not American Express. The salad oil scandal had nothing to do with axp's core business. It was fraud in a non core business area. The only decision was whether it would bankrupt the company. As long as Buffett was sure of that, then it made sense. ABK's problems are in its core business. Even if survived, it isn't a great company. There is no real franchise value.

Averaging down in this case is an emotional decision.

Not only did Warren Buffett not buy this stock, Warren Buffett would not buy this stock. He said that 'structured finance' is too hard. In this case, it is true.

To use a Tiger Woods vs Amateur analogy....you see amateur golfers all the time in the rough in the most god awful places. They will inevitably try go for the green or advance the ball, even though it requires a near miracle shot. And, they have just proven that they couldn't hit a simple shot straight down the fairway. Sometimes Woods will take a difficult shot. A lot of other times he will pitch out and take his chances on hitting an iron dead to the pin and holing out.

I think you are way out of your league on this one.

January 17, 2008 at 10:20 AM

The whole situation is unravelling completely... Moody's warned of a downgrade and Ambac, and MBIA, are both down substantially... raising capital is going to be extremely difficult now...

I'm just going to wait until Tuesday and see what happens...

January 17, 2008 at 10:38 AM

Thanks for the thoughts everyone... It looks like Ambac may lose its rating, and possibly end up bankrupt...

Neanderthal
January 17, 2008 at 10:57 AM

Sold out at $6.00. Good luck everyone. This was a substantial part of my portfolio. Never should have strayed from my original competence, which was selecting mutual funds.

John

January 17, 2008 at 11:16 AM

What is really making me scared is not the business of Ambac or its future losses (I am pretty confident with the business and the ability to take losses over time), but the fact that Ambac may not raise enough capital to maintain its rating. I was pretty certain that they will do whatever is necessary to keep their rating. Right now, that is being called into question. If I didn't think they would retain their rating, and if I was still interested in a monoline, I would have gone with something like Radian (since they are not dependent on a high rating).

As CAK speculated, there is something weird going on behind the scenes. We don't know if it's good or bad. They moved up the conf call to Jan 22 so they were going to announce something: something horribly bad, or something good. It may be possible that they had a capital infusion deal worked out.

The scary thing now is that any capital deal they were working on may fall apart with today's Moody's (and to a lesser extent S&P) rating re-reviews.

January 17, 2008 at 11:16 AM

Sorry to hear than Neanderthal. Wish it worked out differently but oh well... good luck in your future...

Neanderthal
January 17, 2008 at 4:23 PM

Siv,

I looked back at my own track record and it has not been good whenever I try to buy individual stocks. I was able to pick very good mutual funds, however.

The way I see it, there are so many factors which even the fund managers, who spend their entire life looking at these things, are unable to learn until they happen. Investment is a bit of a probability game in which one must work very hard, have large number of positions(the concentrated ones are talking about 20-40 stocks) and hope that they work out in the longer term. In the mean time, things do implode on them on a regular basis. I used to think that if the manager buys them, then they are "safe". Nothing can be further from the truth. Bill Miller was wrong about CFC(even after he staked his reputation on it). Now it seems Marty is wrong about MBI and ABK.

I think that you should examine your overall approach and see what is wrong. Otherwise you will continue to go down this path time and again, like moth to fire.

Good luck to you.

John

January 17, 2008 at 4:51 PM

Thanks for the suggestion Neanderthal. I'm glad to hear that you have developed a strategy with mutual funds and hope that leads to what you seek.

I appreciate your advice. I will re-evaluate some of my decisions and thinking in a few months. Since I'm still a shareholder and too close to the situation, it's hard to do an analysis of yourself right now.

The difficult thing for newbies like me is that it's hard to say when one is speculating and when one has a solid investment...

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February 10, 2008 at 3:06 PM

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