Articles for the week ending October 23rd of 2009
Some articles I found interesting...
When A Potential Liquidation Blows Up
Although I read the Greenbackd blog quite a bit, I didn't look into the potential liquidation of VaxGen (I'll mention why below.) But reading what happened in the last week, this looks like a good lesson for special situation investors. I think microcap investors should also study this case. I am always concerned about microcaps because insiders can transfer wealth to themselves (this can happen in any company but much harder when the media and regulators are watching you, as is generally the case with large companies) and this is a good example of that.
To recap quickly, VaxGen (VXGN) was very close to liquidation—basically no operations and only 5 employees—and there were even some activist investors attempting to liquidate the firm. But all of a sudden, management, with the backing of the board of directors, entered into a deal to merge with another firm at a value that appears way below the liquidation value. The deal requires shareholder vote but VaxGen automatically pays a sizeable amount to its proposed merger partner if the deal is cancelled. So, not only are the shareholders of VaxGen being ripped off, the other merger partner gets paid some money even if the shareholders reject the deal.
This is a classic case of insiders (management and board of directors) transferring shareholder wealth to themselves: the company is essentially dormant and the insiders are simply happy to collect their salaries for not doing anything, and the longer this goes, the better it is for them. Shareholders have launched several lawsuits but the downside to the insiders appear low (insurance, as well as VaxGen, will probably foot all the costs even if the court rules against the insiders.) In some cases, insiders carry out some illegal actions and they can be held liable and event sent to jail for that. However, everything seems legal here. It's just that it is all unethical rather than being illegal (I'm not a legal expert and this is just my distant opinion.)
The lawsuits may have also damaged VaxGen's net worth. Value Investor, a reader at Greenbackd, speculates that VaxGen may be worth far less than the current share price (or any prior liquidation estimate) given the lawsuits. It may even be worth zero, although that's hard to say. On top of the legal fees, it's possible the company may have to pay out huge sums if a court rules against the insiders.
Vetern investors know how companies can be seriously hurt by shareholder lawsuits, even when the fault lies with illegal activities of insiders. I remember when Nortel, a leading Canadian telecom equipment manufacturer, and one of the largest in the world, had to pay out several billion due to criminal actions by management. Nortel had to raise billions on the stock market (by issuing shares; it may also have taken on debt, not sure) to pay out to its own shareholders and this clearly didn't help its already-weak balance sheet. In the case of VaxGen, a tiny company, there is no way outside shareholders are going to inject money into it so all the money will have to come from what little cash it has. You can easily see how there may be serious damage to the net worth of the company if a court rules against management and the board. Of course, the lawsuits may be withdrawn but that's uncertain.
Anyone investing in small companies should think about what just happened here. This doesn't mean you should avoid them but do factor in the risk somehow. I am always scared of small companies for reasons like this, where the insiders loot wealth without breaking any laws.
(On an unrelated note, I mentioned I skipped VXGN and let me explain why. This is just my strategy and it isn't something that is "right" or "wrong." I have a problem doing liquidations with biotech (or similar) companies. VaxGen was basically near a dormant state but many other biotech companies that Greenbackd and other liquidation investors have pursued make no sense to me. These companies tend to sit on cash and have no earnings, or often lose money for a long time, so they look like good liquidation candidates. After all, the role of a capitalist is to turn around money-losing operations, and as a last resort, liquidate the firm and hopefully re-deploy the capital back into the economy into a different venture. But the thing is, these companies are start-ups researching new products and hence have no profitable products or services. In fact, the perpetually-money-losing nature of these businesses is essentially the nature of their business. I'm sure that many investors of these companies are ok with what is happening (i.e. constantly losing money with little visibility into future products) because that is what they were investing into. They are investing on the hope of a major drug development or some medical advance. I don't really know if liquidation investors should be getting involved in them. I don't really see the merit in liquidating these firms. There are some exceptions with firms that are near "death" and shareholder wealth should be preserved by liquidating as quickly as possible. But how many such companies are there? Probably not many. Anyway, that's my thinking and why I automatically ignore these as liquidation investments. Anyone else have a dissenting view? Am I wrong in my thinking?)
Value Investors & Technology
I'm not a pure value investor so I am not hostile to the technology sector. In contrast, many value investors automatically rule out the sector.
Depending on whether you look at sales, profits, market value, number of employees, or growth, the technology industry probably represents around 25% of the American economy. If you include certain businesses that may or may not belong under the technology umbrella&mdas;an R&D-focused retailer like Amazon for instance—technology is probably as influential on the American economy as autos and radio were in the 1930's. So one is missing out on a big chunk of the economy.
As Ravi Nagarajan points out, there are several valid reasons value investors are uncomfortable with technology. One reason I believe is that, as Warren Buffett has remarked, 'he didn't grow up with it and doesn't understand it.' This is definitely the case with some elderly investors who have no idea how technology ties into general life. Note that you might use some technology but not understand it, either from a product point of view or its business usage in society.
But the main reason tech is ignored, again as Buffett has mentioned, and Ravi summarizes, is because long-term earnings and industry structure is unpredictable. I think there are only two ways around this latter problem.
One solution is to invest in established companies with clearly visible competitive advantages (e.g. Microsoft, Oracle or Intel.) Microprocessor and semiconductor technology may change but it is really hard to see how Intel will fall apart within 10 years at a minimum.
Another strategy which I like but is probably unproven and not widely followed is to adopt Bill Miller's thinking about technology. I have been influenced by Bill Miller's thinking that one should not look at the products/services of technology companies. Instead, one hsould look at their market share! In other words, products and services change so rapidly that it seems everything is unpredictable. However, Miller has suggested that the market share of companies do not change very much. There is actually a moat but you won't see it if you look at the product line.
Sticking with the Intel example, who knows how chip technology will change? Maybe there will be greater emphasis on memory on the microprossor instead of processing power. Maybe the CPU will become less prominent. Or maybe the microprocessors, which are mostly used in computers, will be used more in mobile devices, tablet devices, and other products not even invented yet. The point I'm making is that the individual products that Intel sells can change radically. The life span of their products may be a few years—or even a few days, in a futuristic society with extremely low costs.
But if you look at Intel's market share, I'll bet it will still be pretty strong in 10 or 15 years. The products look volatile but the market share is not. Sure, Intel can gain a bit or lose a bit, but it largely looks similar to what it was 10 or 15 years ago. Some companies will go bankrupt and this is where you, as a stockpicker, need to do good analysis. But in the grand scheme of things, the company's revenue is not as volatile as one may imagine.
What I presented above is what I have learned from Bill Miller and how I look at the technology industry. The earnings of many companies are more predictable than it seems.
Having said all that, as Ravi Nagarajan points out, start-ups and early-stage companies are a completely different game. None of what I said applies to them. On top of lack of decent financial history, these companies have no market share to speak of. Many haven't even generated enough sales to survive.
- (Highly Recommended) When insiders act against shareholders - The VaxGen case (Greenbackd): Special situation investors, as well as microcap investors, should study this situation when they have some time. VaxGen was a potential liquidation that was very close to liquidation but the board of directors decided to enter into a questionable merger with another company at a low price. Depending on the purchase price, a special situation investor investing on the basis of a liquidation is looking at huge wealth destruction regardless of whether the merger goes through! (Further comment below)
- Going for the trifecta of stocks, bonds & gold (Buttonwood at The Economist): The buttonwood tree is always interesting and so is the Buttonwood column at The Economist: "Gamblers dream of achieving a trifecta: picking the first three horses, in the right order, in a given race. The payout is huge but so are the odds against success. The same could be said, in financial markets, of a strategy that backed equities, gold and government bonds. The three asset classes do not tend to perform well at the same time...The bet has paid off this year, however. According to Dhaval Joshi of RAB Capital, a fund-management firm, the three asset classes have all produced double-digit returns over the past three months. That has occurred only twice before in the past 50 years." Something is amiss and someone is going to get killed, probably next year. Most people think it will be (government) bond investors but I have a feeling it will be gold investors or stock holders.
- Another conspiracy theory about Bear Stearns (Rolling Stone; h/t fk at GuruFocus): When it's all said and done, Matt Taibbi will probably end up being Wall Street's public enemy #1. Just like how Michael Lewis was spilling the dirty secrets in the 80's and 90's, it looks like Taibbi has taken on that role now. The only problem I have is that his views are based on wild speculations, rumours, and possibly disinformation from enemies of fingered firms. The truth in the last few years is murkier than usual.
- (Recommended) GuruFocus interview with Donald Yacktman and Brian Yacktman (GuruFocus): I am so bored to death of these interviews with prominent investors...but this one was actually insightful. I liked it a lot.
- Gary Shilling maintaining his bearish views (Forbes; h/t GuruFocus): Gary Shilling, the uber bear, thinks stocks are in a bubble. I'm surprised to hear that he is maintaing his $40 earnings call for the S&P 500. Shilling had one of the lowest estimates early in the year and even with the earnings beats by many businesses (I forget the number but I think companies are beating earnings by around 70% vs past average of around 60%) he is sticking with his views.
- Slideshow - China's top 10 companies (Fortune): Many of them are banks or SOEs.
- Value investors & the technology sector (Rational Walk via GuruFocus): Ravi Nagarajan has a good article recapping the dilemma faced by value investors who look at the technology industry. Many value investors skip the technology sector for several reasons and, in doing so, miss out on roughly 25% of the American economy. (Further comment below)
- (Not related to investing; Canadian Econopolitics) It's time the public sector started sharing the pain of government deficits (The Globe & Mail): Eric De Cloet of The Globe & Mail has a nice opinion piece calling for the public sector to start curbing their compensation schemes in light of the debt problems in Ontario and Canada at large. I left several comments to the article supporting his view. The fact of the matter is that the public sector has seen continuous wage increases while the private has seen essentially flat compensation for more than a decade now. In addition, the government workers get great pensions while most private sector workers don't even have a pension. I am a somewhat-typical liberal and am generally ok with a large government—in contrast, many on the right are outright hostile to government workers—but they cannot keep paying more and more while running up their debt. My view is that the pensions and wages are an illusion similar to how GM compensated its workers over the decades. The promises and salaries look real but they are paid with debt (borrowed money) and hence isn't sustinable.
- A brief look at the fall of Communism (The Star): Karl Marx is one of the greatest economists of the last 500 years but good riddance to the end of so-called Communism. The monster that was unleashed was so bad that it even makes fascism, another horrible totalitarian system, look mild in comparison.
- India's last remaining Maoists (The Globe & Mail): Great journalistic work by Stephanie Nolen of The Globe & Mail in covering the Maoists in Eastern India. The prior link might imply Communism is dead but not quite. The reason it is hard to overcome these problems is because the so-called capitalists on the other side are just as corrupt as the Maoists who are popular. Add in the mix of a poor region—many parts of India are poorer than many African countries—with little hope and it's a not a pretty sight.
When A Potential Liquidation Blows Up
Although I read the Greenbackd blog quite a bit, I didn't look into the potential liquidation of VaxGen (I'll mention why below.) But reading what happened in the last week, this looks like a good lesson for special situation investors. I think microcap investors should also study this case. I am always concerned about microcaps because insiders can transfer wealth to themselves (this can happen in any company but much harder when the media and regulators are watching you, as is generally the case with large companies) and this is a good example of that.
To recap quickly, VaxGen (VXGN) was very close to liquidation—basically no operations and only 5 employees—and there were even some activist investors attempting to liquidate the firm. But all of a sudden, management, with the backing of the board of directors, entered into a deal to merge with another firm at a value that appears way below the liquidation value. The deal requires shareholder vote but VaxGen automatically pays a sizeable amount to its proposed merger partner if the deal is cancelled. So, not only are the shareholders of VaxGen being ripped off, the other merger partner gets paid some money even if the shareholders reject the deal.
This is a classic case of insiders (management and board of directors) transferring shareholder wealth to themselves: the company is essentially dormant and the insiders are simply happy to collect their salaries for not doing anything, and the longer this goes, the better it is for them. Shareholders have launched several lawsuits but the downside to the insiders appear low (insurance, as well as VaxGen, will probably foot all the costs even if the court rules against the insiders.) In some cases, insiders carry out some illegal actions and they can be held liable and event sent to jail for that. However, everything seems legal here. It's just that it is all unethical rather than being illegal (I'm not a legal expert and this is just my distant opinion.)
The lawsuits may have also damaged VaxGen's net worth. Value Investor, a reader at Greenbackd, speculates that VaxGen may be worth far less than the current share price (or any prior liquidation estimate) given the lawsuits. It may even be worth zero, although that's hard to say. On top of the legal fees, it's possible the company may have to pay out huge sums if a court rules against the insiders.
Vetern investors know how companies can be seriously hurt by shareholder lawsuits, even when the fault lies with illegal activities of insiders. I remember when Nortel, a leading Canadian telecom equipment manufacturer, and one of the largest in the world, had to pay out several billion due to criminal actions by management. Nortel had to raise billions on the stock market (by issuing shares; it may also have taken on debt, not sure) to pay out to its own shareholders and this clearly didn't help its already-weak balance sheet. In the case of VaxGen, a tiny company, there is no way outside shareholders are going to inject money into it so all the money will have to come from what little cash it has. You can easily see how there may be serious damage to the net worth of the company if a court rules against management and the board. Of course, the lawsuits may be withdrawn but that's uncertain.
Anyone investing in small companies should think about what just happened here. This doesn't mean you should avoid them but do factor in the risk somehow. I am always scared of small companies for reasons like this, where the insiders loot wealth without breaking any laws.
(On an unrelated note, I mentioned I skipped VXGN and let me explain why. This is just my strategy and it isn't something that is "right" or "wrong." I have a problem doing liquidations with biotech (or similar) companies. VaxGen was basically near a dormant state but many other biotech companies that Greenbackd and other liquidation investors have pursued make no sense to me. These companies tend to sit on cash and have no earnings, or often lose money for a long time, so they look like good liquidation candidates. After all, the role of a capitalist is to turn around money-losing operations, and as a last resort, liquidate the firm and hopefully re-deploy the capital back into the economy into a different venture. But the thing is, these companies are start-ups researching new products and hence have no profitable products or services. In fact, the perpetually-money-losing nature of these businesses is essentially the nature of their business. I'm sure that many investors of these companies are ok with what is happening (i.e. constantly losing money with little visibility into future products) because that is what they were investing into. They are investing on the hope of a major drug development or some medical advance. I don't really know if liquidation investors should be getting involved in them. I don't really see the merit in liquidating these firms. There are some exceptions with firms that are near "death" and shareholder wealth should be preserved by liquidating as quickly as possible. But how many such companies are there? Probably not many. Anyway, that's my thinking and why I automatically ignore these as liquidation investments. Anyone else have a dissenting view? Am I wrong in my thinking?)
Value Investors & Technology
I'm not a pure value investor so I am not hostile to the technology sector. In contrast, many value investors automatically rule out the sector.
Depending on whether you look at sales, profits, market value, number of employees, or growth, the technology industry probably represents around 25% of the American economy. If you include certain businesses that may or may not belong under the technology umbrella&mdas;an R&D-focused retailer like Amazon for instance—technology is probably as influential on the American economy as autos and radio were in the 1930's. So one is missing out on a big chunk of the economy.
As Ravi Nagarajan points out, there are several valid reasons value investors are uncomfortable with technology. One reason I believe is that, as Warren Buffett has remarked, 'he didn't grow up with it and doesn't understand it.' This is definitely the case with some elderly investors who have no idea how technology ties into general life. Note that you might use some technology but not understand it, either from a product point of view or its business usage in society.
But the main reason tech is ignored, again as Buffett has mentioned, and Ravi summarizes, is because long-term earnings and industry structure is unpredictable. I think there are only two ways around this latter problem.
One solution is to invest in established companies with clearly visible competitive advantages (e.g. Microsoft, Oracle or Intel.) Microprocessor and semiconductor technology may change but it is really hard to see how Intel will fall apart within 10 years at a minimum.
Another strategy which I like but is probably unproven and not widely followed is to adopt Bill Miller's thinking about technology. I have been influenced by Bill Miller's thinking that one should not look at the products/services of technology companies. Instead, one hsould look at their market share! In other words, products and services change so rapidly that it seems everything is unpredictable. However, Miller has suggested that the market share of companies do not change very much. There is actually a moat but you won't see it if you look at the product line.
Sticking with the Intel example, who knows how chip technology will change? Maybe there will be greater emphasis on memory on the microprossor instead of processing power. Maybe the CPU will become less prominent. Or maybe the microprocessors, which are mostly used in computers, will be used more in mobile devices, tablet devices, and other products not even invented yet. The point I'm making is that the individual products that Intel sells can change radically. The life span of their products may be a few years—or even a few days, in a futuristic society with extremely low costs.
But if you look at Intel's market share, I'll bet it will still be pretty strong in 10 or 15 years. The products look volatile but the market share is not. Sure, Intel can gain a bit or lose a bit, but it largely looks similar to what it was 10 or 15 years ago. Some companies will go bankrupt and this is where you, as a stockpicker, need to do good analysis. But in the grand scheme of things, the company's revenue is not as volatile as one may imagine.
What I presented above is what I have learned from Bill Miller and how I look at the technology industry. The earnings of many companies are more predictable than it seems.
Having said all that, as Ravi Nagarajan points out, start-ups and early-stage companies are a completely different game. None of what I said applies to them. On top of lack of decent financial history, these companies have no market share to speak of. Many haven't even generated enough sales to survive.
This is Value Investor from the Greenbackd forum that you mention in your article. The one thing that carries significant importance in a liquidation situation, and especially in the small cap market, is the that the company must have a catalyst. If you purchased a company because it was trading for less than its readily ascertainable asset value and that business was burning through cash on a quarterly basis without having a catalyst, then you've found a company that meets your description and would be correct in taking a pass on the business. But, if you found a company, such as what I've described, in which it had a catalyst and presented at least a 50% margin of safety to its readiy ascertainable asset value; then you have a real opportunity with little downside risk.
ReplyDeleteI was lucky in the VaxGen deal in that I bought at such a large discount to value that when all hell broke loose, I was able to exit with a profit. VNDA was a similar situation. It was selling at a large discount to its cash, had an activist investor threatening to engage in a proxy fight for liquidation, had a pending FDA approval. These were all remarkable catalysts. Two months after my purchase, I produced over a 900% return. Is this common? Absolutely not. The one thing that Greenbackd and I share in common is the 'catalyst'. Neither one of us will invest without one and the more catalysts that are present, the more upside potential is available. During a recession, I have found no greater wealth creator than investing in Net-Net companies who have a catalyst. Greenback has produced well over a 150% return doing this and I have been fortunate in producing in excess of 800% for the year.
Thanks for dropping by :)
ReplyDeleteI'm not questioning your strategy of going for situations with catalysts--I also would not participate in anything if I didn't see a catalyst--but does it make sense for biotech and similar companies? These companies will necessarily burn through cash and I don't see the thinking behind trying to liquidate them.
I think the VXGN case is not a good example because I think that is the type of the company that should be liquidated. If I didn't avoid biotech or medical companies then I would have seirously considered that as well.
However, let's look at VNDA. I wasn't following it much so correct me if I'm wrong, but did it make sense to attempt to liquidate that? Numbers may yes but that is the type of company that is researching for years while losing money. I would imagine that the majority of the investors in a company like VNDA know what they are getting into (i.e. a company seemingly bleeding forever, until it runs out of money or fails to get drug approval or some such thing.)
If I remember correctly VNDA's management decided to liquidate the firm if it didn't get approval but what if management decided not to (i.e. decided to keep going)? I don't recall how much of the company the activist owned but would the liquidationists have won a shareholder vote on liquidation? I am not so sure.
In contrast, industrial companies, service companies, and others, are a different scenario--at least in my eyes. I'll bet every single sharheolder, if educated on the matter, would be in favour of liquidation (assuming a better buyout/merger/etc does not materialize).
(Of course, VNDA received approval and it skyrocketed but that's beside the point. That's a total fluke and is not representative of a typical liquidation.)
Value Investor: "During a recession, I have found no greater wealth creator than investing in Net-Net companies who have a catalyst. Greenback has produced well over a 150% return doing this and I have been fortunate in producing in excess of 800% for the year."
ReplyDeleteCongratulations on your strong performance! At least someone out there is making money ;) I have profitted from some of Greenbackd's research and ideas so he/she is doing an excellent.
In general, I agree with what you are saying about net-net investments in the current environment. I share similar views and think that such investments will outperform. In fact, I would generalize that a bit more and say that special situation investing outperforms during bear markets. Risk arbitrage (such as trying to profit from M&A deals), which Greenbackd doesn't cover and is more tricky, will also perform quite well.
I suspect net-nets, liquidations, and the like, will produce lower returns going forward (because valuations have risen) but it remains to be seen how it stacks up against so-called 'buy & hold'.
I agree with many of your points.
ReplyDeleteYou wrote: "<span>If I remember correctly VNDA's management decided to liquidate the firm if it didn't get approval but what if management decided not to (i.e. decided to keep going)? I don't recall how much of the company the activist owned but would the liquidationists have won a shareholder vote on liquidation? I am not so sure."</span>
That is true regarding VNDA's management agreeing to liquidate the company. They publicly made note of that and had the FDA not approved their drug, and if VNDA decided at the last minute not to liquidate their business, a case could made that a fiduciary responsibility would have been called into question. You can't tell your shareholders one thing and then do the exact opposite. It's illegal.
Although I agree that VNDA was a special situation, I disagree with the notion of it being a fluke. A value investor with a keen understanding of business and understanding the risks versus rewards of the opportunity could clearly see that the upside potential far outweighed the downside risk. After all, that is what value investing is. VNDA was a special and unique situation, but it certainly was no fluke.
As the market rises, net-net's will become extinct. The only time we find net-net's is during a recession. A few here and their may pop up every so many years, but none of the quality we've seen during the recession.
ReplyDeleteI too invest in M&A's and agree that during a bear market, they are great opportunites to earn rewards. I'm not sure if Greenbackd (Toby) only invests in net-net's or if he only dedicates his website to net-net discussion. I get the impression when I talk to him that he's been investing for many years and his website has only been around for a short period of time.
I kind of maintain my view that VNDA was a fluke. Think about it this way...
ReplyDeleteWhen you were evaluating the upside what did you think it was? And how probable was that scenario? I'll bet the drug approval scenario would have been considered insignificant (since the probability was likely very low).
As for management changing their views, I'm just a newbie and have no idea what they can and cannot do. I think it depends on how vague their original opinion is. For instance, I have seen cases (nothing to do with M&A or liquidations) where they renege on what they said (such as spinning off assets, expanding their stores, and the like.) They certainly get away with that because it is couched in some vague language. So I'm not sure about this case.
If management was ethical, they would stick with what they said--especially in liquidations, M&A, and the like. But as we have seen, it's hard to trust them. For me, all this is an interesting exercise in learning agency theory first hand. One part of investing is to figure out how various interests (management, workers, government, etc) treat shareholders.
Greenbackd is a brand new site and I'm not sure if he was writing for other sites before. My impression is that he doesn't cover risk arbitrage (M&A) but I wonder if he'll expand to that area if liquidations and activist situations dry up.
ReplyDeleteAnyway, the quality of Greenbackd is amazing. Professional thinking and writing, all free :)