Jaclyn: Arbitrage for the Little Guys

Arbitrage is as time-old as any market "technique" out there. When we talk about arbitrage spreads, we are speaking of two companies merging, a large tender offer, or other “workout” situations with a defined shareholder payout and a (relatively) defined time period. There are also defined reasons why our investment won’t work out. Buffett called it “upsetting the applecart.”

Introduction

When these events are announced, there is always a “spread” between the market price and the price shareholders will receive at the end of time period X, which represents doubt that the transaction will be completed. In these arbitrage situations, what can kill our investment is not market movement or changing valuation ratios, but rather corporate and legal events such as failed regulatory approval, shareholder approval, and financing commitment.

If you are new to arbitrage, I’d suggest reading Joe Ponzio’s post here. (As an aside, I participated successfully in the Tribune Co. going-private transaction late last year as well.)

In general, I can’t say arbitrage gets me psyched up in this day and age. There is a great deal of brainpower and computer power out there that can efficiently price arbitrage spreads, so it’s generally a waste of time. When you are talking about a little old individual investor such as myself, the odds of outsmarting the market plummet. For those reasons, merger arbitrage isn’t something I spend much time on.

Of course, for every rule there is an exception. When the arbitrage situations arise in small companies, we’re talking companies with sub $500mm market caps, they tend to be much less heavily analyzed by institutional “arbitrageurs.” That creates opportunity for those of us running smaller portfolios.

Jaclyn, Inc.

On that note, Jaclyn Inc. (JLN) announced last year that they’d decided to reduce their shareholder count below 300, and delist from the AMEX stock exchange to reduce costs. They decided the best way to complete this would be to pay every shareholder with 250 shares or less $10.21 a share, a sizeable premium to the then-stock price of about $7/share. The SEC filing with all of the information is here.

When I found this transaction, the shares were still around $7.50, early this year. With an offer of $10.21, the arbitrage spread was about 35%, which is a huge spread. However, if you do the math, the maximum amount of capital you could possibly put to work here is 250*$7.50 or $1,875. For anyone with a portfolio north of about $35,000, this arbitrage won’t help you much, sorry!

Luckily for me, I’m not running any sizeable portion of money, so I could participate here and it would be well worth my time. The next step was to go ahead and look at what might upset my applecart. What I found was delightful: there was really nothing!

What might upset the applecart?

One general worry in arbitrage is regulatory approval- take for example the potential merger of XM and Sirius Satellite. Regulators might say, geez guys if the only satellite radio providers out there merge, won’t there be a monopoly? Of course, Jaclyn merely wants to cease having to file with the SEC, so there is no regulatory approval needed.

The second thing that might upset our applecart is shareholder approval. While the premium was sizable enough that I didn’t think that’d be much of a problem, I looked in the proxy filed for the event anyways. I found this terrific nugget:

“ At the close of business on the Record Date, 1,257,643 of our outstanding shares of common stock (approximately 50.9%) were held by signatories to the Stockholders Agreement. As we noted above, the Stockholders Agreement entitles a four-person stockholders committee (presently consisting of Abe Ginsburg, Robert Chestnov, Allan Ginsburg, and Howard Ginsburg) to direct the voting of the shares of our common stock now or in the future owned by certain parties to that agreement, or as to which they have or may have voting power. The stockholders committee has indicated that it intends to direct the voting of these shares of our common stock “FOR” the Transaction. Accordingly, if all of the shares subject to the Stockholders Agreement are voted in favor of the Transaction, the Transaction will be approved.”

Insiders own 51% of the outstanding shares, and they will obviously be voting “yes” for the transaction, which means shareholder approval isn't going to upset our applecart.

The last worry would be financing issues, and the relevant section of the proxy statement is thus:

“We expect that the consideration to be paid to the Cashed Out Stockholders and the costs of the Transaction will be paid from cash on hand and from funds under our existing revolving loan agreement with TD Banknorth, N.A. The revolving loan agreement provides for short-term loans and the issuance of letters of credit in an aggregate amount not to exceed $50,000,000. Based on a borrowing formula, we may borrow up to $30,000,000 in short-term loans and up to $50,000,000 including letters of credit. Substantially all of our personal property assets are pledged to the bank as collateral. The revolving loan agreement requires that we maintain a minimum tangible net worth, as defined, and imposes certain debt to equity ratio requirements. We were in compliance with all applicable financial covenants as of December 31, 2007. As long as no default or event of default under the revolving loan agreement exists, we may repurchase, and we may use the proceeds of loans we borrow under that agreement to repurchase , our shares of common stock in the Transaction in an aggregate amount not to exceed $3,000,000. In the event that the total cost of repurchases of our shares of common stock in the Transaction exceeds $3,000,000, we have been advised by TD Banknorth that it will work with us to enter into a mutually agreeable amendment to our revolving loan agreement so that we may complete the Transaction.”

So there are two sources Jaclyn plans to use to fund the transaction: cash on hand and $3,000,000 from their existing line of credit. According to the proxy, the bank has already effectively said “Yes, you can use $3m of your line of credit to purchase shares, and if it ends up being more, we'll help.” The company has already updated the proxy several times, and they were well within their financial covenants on the line of credit as of the end of last year.

Will that $3m from the bank be enough? Well, the proxy says that the total cost of the transaction will be approximately $3.7mm:

“We estimate that the total funds required to pay the consideration to record holders who are entitled to receive cash for their shares, holders of shares in street name, and other costs of the Transaction will be approximately $3,728,000”

Thus, as long as the company has more than $728,000 in the bank, complete financing should be in place. Luckily for us, at the end of last year, the company reported $1.5mm in cash on their balance sheet, an increase from the previous quarter.

Conclusion

So what does this all mean? There is financing in place, stockholder approval in place, and the risk of regulatory approval is nil. The next step right now is for the matter to be voted on by shareholders at the annual meeting on May 7. At that point, the transaction will be approved, and they should set an effective date to pay out the $10.21 and receive the shares. Another piece of information that looks great is the 8-k filing JLN reported last week notifying AMEX that they plan to delist. That means the train is still moving forward.

The price has crept up to around $8.50 at today’s market price, which has brought the spread down to 20%. But for what shouldn’t take longer than another 2-3 months to complete, and probably less, that’s an annualized return of 80-120%, which sounds pretty darn good to me. There is no such thing as a riskless investment, and something could always come up, but I like our odds in this transaction.

Always do your own homework, and make sure to keep on top of any new developments in any investment. Sometimes being the “little guy” in the market can have its advantages.


Disclosure: I hold a position in JLN.

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5 Lessons from a Parting Columnist

Sorry for the flurry of posts today. I guess some days I'll hit you guys with a ton of stuff, and most days there will be nothing. However, I just read a tremendous going-away column from Herb Greenberg of Marketwatch. It contains some terrific advice, and I think my readers should take advantage.

Herb has written articles on Marketwatch about hundreds of different companies. The articles he penned were well-researched, original, and often humorous. His recent battles with the CEO of Overstock, Patrick Byrne (who is certifiably nuts) come to mind.

Herb has decided to leave MarketWatch to open a stock research firm, and thus his last column appeared today, which you can read it in its entirety here.

Here are the 5 "Lessons" he imparts at the close of the column, the summation of his decades-gained wisdom.

Lesson No. 1: The numbers don't lie. They can be stir-fried, oven-fried or convection-baked, but in the end they always hold the keys to the kingdom. That is why some short sellers and forensic analysts don't like to talk to companies. They want to avoid the spin or the face-to-face meeting that can create a psychological connection that may skew what otherwise would be black-and-white analysis. Don't ever underestimate the power and influence of the human factor.

Lesson No. 2: Quality, not quantity. Ignore the "beat the Street" headlines on earnings. It is what goes into the earnings that counts. As I quoted investment legend Thornton Oglove as saying here the past week, the real story is often on the balance sheet. And let's not forget the cash-flow statement. And this tip: The more complex and convoluted the financial statements get, especially for businesses that aren't overly complicated, the more reason to worry.

Lesson No. 3: GAAP isn't the same as a Good Housekeeping seal. Generally Accepted Accounting Principles, according to which all financial statements are supposed to be prepared, include plenty of gray areas that give management enough rope to hang itself. GAAP, after all, is subject to interpretation, and some managers are more conservative than others. Remember, just because the accounting is legal doesn't mean the end results won't be lousy.

Lesson No. 4: Don't confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie. Sometimes they are pushed artificially higher by a rotation by investors from one industry group to another, because that one sector happens to be in favor. Sometimes they lie because of short squeezes, which occur when short sellers -- who bet stock prices will fall -- are for some reason forced to rapidly purchase the shares they sold short. And sometimes they lie because of momentum. Momentum can take stocks to infinity and beyond, but true believers can wind up learning that momentum has a dark side: It is called reverse momentum, and it tends to kick in when you least expect.

Lesson No. 5: Risk isn't a four-letter word. A good rule of thumb is that before you buy, instead of asking how much you can make, first ask how much you can lose. That is what the smart guys do.

These are things you'd expect to hear from the smartest investors out there, and I have no doubt in my mind that Herb will be immensely successful with his new firm. His message is thus: look hard at the company underlying the gloss.

For every press release, stock update, and talking head commentary, there are thousands of living, breathing companies out there with a unique story. Looking at income statements and P/E ratios don't tell the whole story, so take your time and learn the businesses you choose to invest in. To be truly successful, one must look past the GAAP numbers, the analyst comments, and the ever-optimistic comments from management, because in those SEC filings there is much more to be found.

Here is the best quote for me, because it could have come right from Ben Graham:

"Don't confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie."

Good Luck, Herb.

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New Stuff from Buffett Re: Wrigley and Other

I don’t watch CNBC, at all, but I do have their Buffett Watch in my RSS aggregator, so I know when they do interviews with him, which has been fairly often in the past year. CNBC is 99% noise, but when they do pieces on Buffett, you can usually pull up some valuable nuggets.

As such, today was one of those days: The big announcement today that Buffett would be providing $6.5b in financing for the Mars-Wrigley deal got us lucky Buffett fans some new quotes on circle of competence, buying companies, and knowledge in the markets. I thought my readers might want a couple of the good ones:

One the folly of prediction:

“I never have any idea what the foreign exchange or the stock market or the bond market is going to do in any given week or month or year."

On the attraction of a Mars or Wrigley:

“But there is really nothing that can go wrong with something like the Wrigley or the Mars brands. It's literally true that they have, ah, faced the test of time over decades and decades and people use more and more of their products every day.”

On those who are buying big banks now:

“Well, I understand a Wrigley or a Mars a whole lot better than I understand the balance sheet of some of the big banks. I know what I'm getting in this, and some of the larger financial institutions, I really don't know what's there.”

On when to buy a great company:

“Well, I think a good time to buy a really great business is when you can do it. Many, many years ago, as I remember, Herman Lay offered the Frito-Lay company to Coca-Cola. And he offered them the company first, as I understand it, and they decided for one reason or another they didn't want to do it then. And of course Pepsico bought it and it's the best thing they ever did. So if you get a chance to buy a wonderful business, then my advice is, grab it. As Yogi Berra would say, 'When you come to a fork in the road, take it."”

And Lastly, on our favorite topic here, the Circle of Competence:

“Well, what holds an interest for me is a business I can understand and one that's got durable long-term competitive advantage and the good management and the price makes sense. If I can find that any place, I’ll do it. And a lot of times, things are just beyond my competence. Somebody can have a wonderful idea that I don't understand and God bless them. I'll stick with stuff I understand.”

Read the entire transcript or watch the video here.

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Anticipating Einhorn’s Book

If you want to be a successful investor, Warren Buffett and Charlie Munger have laid out the basic mechanism you need: read, and read all of the time. Now, under this mandate from Warren and Charlie there is a tremendous breadth of material that investors need to consume; magazines, newspapers, articles, annual reports, and importantly, books.

There are a few books that every investor needs to read, and I’ve added those that I put in said category in the box to the right entitled “Books All Investors Need to Read.” In my unqualified opinion, those are the essentials, the classics that every investor has to read and re-read. There are dozens more that also hold tremendous weight, but if I had to pick the most important investment books as it pertains to my own philosophy, those six do the job nicely. You start with Graham, move to Buffett & Munger, and end with Pabrai’s modern treatise. Of course, that all needs to be supplemented with other investment readings, financial history, general history, biographies, and other works to fill out your base of mental models, but those are the “Investing 101” books, in my opinion. I’d add to that Phil Fisher’s Common Stocks and Uncommon Profits.

I also find one type of book tremendously interesting: books written by former or current investment managers, detailing their experiences in the markets. Beating the Street, John Neff on Investing, Market Wizards, Reminisces of a Stock Operator, these are just some of the awesome examples of books that come straight from the source. Another class of books that I tend to read is those detailing financial events or periods in history that have some special importance. Two terrific examples of this class of financial literature come to mind: When Genius Failed, detailing the LTCM crisis; and Irrational Exuberance, detailing the tech stock bubble.

Thus, when I received a regular e-mail that I get from Whitney Tilson (of T2 Partners and Tilson Mutual Funds) that mentioned David Einhorn was releasing a book soon on his battles with Allied Capital, I was much intrigued. The book is entitled Fooling Some of the People, All of the Time. If you aren’t familiar with Einhorn or the situation, he manages a $5 billion hedge fund called Greenlight Capital, a tremendously successful long/short fund with value investing roots.

In 2002 Einhorn began shorting a company called Allied Capital with the belief that their shoddy accounting practices would soon come to light, causing the stock to plummet. He made a presentation at a local charity event on his favorite investment idea, Allied Capital. Since then, not only has the stock not plummeted, but Einhorn has been investigated by the SEC, threatened by the company, and generally put through the ringer. If this story sounds familiar, Bill Ackman’s more recently publicized battles with MBIA and Ambac roughly parallel the story; although his has turned out successful where Einhorn’s has not.

Here is Whitney’s review on Amazon:

"David Einhorn's new book about his long-running battle with Allied Capital is an amazing book. More than just an investing book, it's an investing novel, with good guys and bad guys and clueless, gullible and conflicted investors, regulators, Wall St. "analysts" and media. I stayed up all night to read it.

The review by George Anders in the Wall St. Journal recently missed the point. Anders focused on Einhorn, highlighting his tremendous track record and saying he's gutty, tenacious, patient and disciplined, but that's not the story! The real story is what Allied Capital has done and the utter failure of regulators, investors and the media to do anything about it. I don't see how it's possible to read this book and not come to the conclusion that this company has done -- and continues to do -- all sorts of terrible things, but rather than expressing an opinion on this, Anders makes it seem like a he-said-she-said tempest in a teapot and, reading between the lines, seems to be saying that because the stock hasn't plunged, that Einhorn's investment thesis has been proven wrong. It hasn't -- but it can sometimes take many years.

(Full disclosure: Funds I manage are short the stock of Allied Capital and I'm mentioned briefly in the book.)”

I don’t have to tell you that I have the book ordered and on the way when Amazon releases it. It seems to promise a story full of fear, greed, manipulation, and battling intellect. Not only does it give a look at Greenlight’s research process, interesting in and of itself, but it looks to give readers an inside look at the workings of Wall Street, and the dangers that can come with activist-style investing. Public crusades can hurt badly because companies do not like to made look like fools by some rich hedge fund manager.

To get a taste of David Einhorn's thinking, I'd highly recommend that you read his recent speech called Private Profits and Socialized Risks in which he condemns Wall Street investment banks for reaping profits during good times and asking for help during bad times. A fun fact there: Wall Street banks typically pay out over half of their revenues as compensation. That is a staggering figure.

Once I get through the book, I’ll be sure to post my impressions and a review; needless to say I don’t think I’ll come away disappointed. If anyone is interested, I’m currently reading a book called The Origination and Evolution of New Businesses by Amar Bhide. Mohnish Pabrai recommended the book some time back, and as I read it I see why; many of his investment theories come straight from Bhide's work on entrepreneurship. For instance, the concept of "heads I win, tails I don't lose," that constitutes such an important part of the Dhando Investor framework, comes straight from Bhide. I would recommend the book to those looking to learn more about how successful entrepreneurship defies the conventional nonsense of "risk-taking." In fact, most successful entrepreneurs take little personal financial risk, for a number of reasons. I always like a good slap to the face of conventional wisdom.


Quick Update 4/28/08: Check out WSJ's Article on Einhorn and the Allied Capital saga.

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Newest Post on the "Freakonomics" Blog

If you haven’t read Freakonomics, the extremely popular book by Dubner and Levitt, run, don’t walk to Amazon.com and pick it up. It’s an interesting read on how “common knowledge” is more “common,” than “knowledge.”

The two write a blog for NY Times, and a column in the NYT Magazine. I read their most recent article over the weekend, in the NYT Magazine’s “Green Issue.”

It is about reducing emissions through correct incentives for drivers, emissions being a negative externality to excessive driving (i.e. Your driving causes me problems through pollution and environmental degradation, and I have no control over it). Their main thesis is that drivers have not been correctly incentivized to reduce their driving mileage. The real social costs of our driving are not being compensated for:

“According to current estimates, carbon emissions from driving impose a societal cost of about $20 billion a year. That sounds like an awful lot until you consider congestion: a Texas Transportation Institute study found that wasted fuel and lost productivity due to congestion cost us $78 billion a year. The damage to people and property from auto accidents, meanwhile, is by far the worst. In a 2006 paper, the economists Aaron Edlin and Pinar Karaca-Mandic argued that accidents impose a true unpaid cost of about $220 billion a year.”

Dubner and Levitt’s solution; pay as you go car insurance. With the developments of modern technology, auto insurers would have the ability to monitor your driven miles, and charge you accordingly. If I know anything about Americans, it’s that we like to save money. Once the costs of your driving start hitting you in the wallet properly, you’ll surely be conscious of it (something we’re beginning to see with $3.50 gas). This struck me as a tremendously powerful concept, one that I think, as time goes by, will be adopted in some shape or form.

The reason this article resonated with me on an investing front is that it exemplifies what Charlie Munger has said time and again: to get the behavior you desire, you must have the correct incentive system. If you allow loopholes that you know can be exploited, well by golly they’ll be exploited. As investors, one of our jobs is to look at incentives in a few ways:

1. How is management incentivized? As long term investors, we are looking for management incentivized to create long-term shareholder value. How often do you really see this? I can name only a few, notably American Express, Amazon, and Berkshire Hathaway. Most of the time earnings per share growth, stock price growth, and sales growth take precedent over free cash flow generation and return on capital; the more important factors in creating shareholder wealth.

2. How is your company’s target market incentivized? Hopefully, the incentives point them towards using your product over and over, but maybe not. For example, American Express customers are incentivized to own and use an American Express card because it is very widely accepted and it makes them feel part of the American Express “club.” If you are well-off, chances are you have one because god damn is it sexy. A black American Express card screams “Rich” like very few things do. It’s part of American culture. That is a powerful concept.

The point is that incentives determine behavior. Look at the incentive structure, and you’ll most likely establish what behaviors are likely to occur. Managers who love their businesses are incentivized to sell to Berkshire Hathaway because they know they will be able to run their company autonomously. Poor incentives caused the massive housing and credit bubble, and it will take a revised incentive structure to prevent it from happening again. The incentive-behavior loop is a powerful model to carry in your mental toolbox.

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The First Marblehead Problem

Today I’ll talk a bit about another big investing mistake (remember I mentioned that I invested in AHM before its bankruptcy) I’ve made, recently, that I still hold today. I figure I’ll get my mistakes out of the way early, that way you all know what an idiot I am and that you should probably never listen to me. In fact, the blog should probably be called “Blow-Ups” since that has been a good theme to my investing life so far.

A primer is that I’ve been learning investing on my own for a few years now, and finally opened up my portfolio about a year ago. Since then, I’ve learned the value of Warren Buffett’s advice to run one’s own portfolio, in real life, rather than on paper. In about a year I’ve learned more about investing than I could have learned in a lifetime of paper investing or just reading about it. Having one’s skin in the game is vital to success in running a business or merely learning about investing. Since my start, I’ve totally lost two investments:

1. American Home Mortgage, a now bankrupt mortgage lender. This was a “trying to catch the falling knife situation,” and I didn’t do a tenth of the necessary research…this was one of my first investments and I chalk it up to inexperience in research and analysis.

2. Short term (7 months) Discover (DFS) calls I bought after the spinoff, something I’d never even consider doing it again; I blame it on too many readings of You Can be a Stock Market Genius! I learned, in fact, that I am categorically NOT a Stock Market Genius…
I’d consider LEAPS (options with a life of 2 years or more) now, but at the time I was not so smart. A bad decision, but a great learning opportunity.

Another disastrous investment, so far, has been First Marblehead (FMD). (Are you starting to notice what type of company is not in my circle of competence?) First Marblehead is a company that packages student loans into billion dollar+ securitizations and sells them off to Wall Street. They hold a residual from the securitization, often the lowest rated portion, and thus are last in line for payment. They also originate student loans through a bank that they wholly own, a part of their business that is now becoming increasingly important. FMD recognized revenue in two ways. The first was a structural advisory fee earned in cash up front, the other was the present value of the future expected residual cash flows. The earnings quality of the latter had come into question numerous times by the analysts covering FMD.

I initially read up on FMD on Tom Brown’s bankstocks.com. I did own my research through the company filings, and I felt confident the stock would be worth much more in the coming years. Their bonds had performed admirably, management seemed honest, and the stock was selling at a terrific price, considering their unbelievable profitability. Demand for student loans has been, and remains, on the rise so business had been booming until mid last year. I figured that, even if their securitization margins got killed, the amount of loans they were securitizing was growing so fast that their earnings would continue to rise, albeit at a slower rate.

However, FMD being squarely outside my circle of competence, I did not correctly weight their reliance on the securitization markets, and what could happen if that market closed (which it did). I did not have the ability to analyze their outstanding securitizations and make an edcuated decision on how strong they were and the cash flows they'd most likely throw off. I can read the annual report of a retailer, a manufacturer, a restaurant, etc. and know what I need to know, be able analyze the strength of the company and its evaluate its future cash flows. On the other hand, the cash producing assets and cash consuming liabilities of a financial entity like FMD or AHM have many unknowns that I'm not yet equipped to deal with. I understand that now, but didn't when I invested in them. Heed Charlie Munger's advice and learn as much as you can from others' failures rather than your own; don't leave your circle of competence.

What Went Wrong

Soooo… FMD is down from the 30’s to about 4 right now. While I highly respect Tom Brown, and I think he’ll rebound strongly from his awful year last year (his hedge fund was down about 50%), his bet on FMD has gone to hell since late 2007. He has been a vocal bull on the company for years now, and his thesis had been completely right until the securitization markets shut down last year. With the option of securitizing and selling the loans shut off, FMD is bleeding a bit right now and suffering write-downs on their residuals as student loan defaults have increased.
TERI, The Education Resources Institute, is the financial guarantor that backs FMD's securitized loans. About 6 years ago FMD bought, from TERI, their 20 year database of data regarding student loan payments, defaults, prepayments, etc, and feels that this data is a major competitive advantage in originating and securitizing student loans. As well, loans to be guaranteed by TERI are required to meet their underwriting criteria (FICO above 720 and so on).

When FMD securitizes, TERI opens a pledge fund and deposits a certain amount enough to cover expected defaults on the securitized pool. Problem is, TERI miscalculated and may run short of cash to cover the actual defaults. That doesn’t bode well for FMD, for obvious reasons. TERI has filed for bankruptcy to protect themselves from other creditors, in hopes that they will continue being able to guarantee the bonds. In their PR following the Chapter 11 notice, the CEO of TERI stated:

``It's essentially kind of your classic liquidity situation,'' Hulings said. ``This was the best action for us to take in order for us to preserve both our company as well the rights of all the creditors against one's contractual right to cash.”

At the end of last year, First Marblehead went ahead and received a large capital infusion from Goldman Sachs’ private equity arm. The deal was a $260mm equity investment, and a $1b line of credit. The equity would help them survive the crisis, and give them added cushion until securitization was available. The LOC would allow them continue funding the strong demand for student loans under their own brand, Astrive. Unfortunately, Goldman’s equity investment is limited to 25% of FMD’s book value. Well, with FMD facing looming write downs due to the TERI bankruptcy, the Goldman investment will now shrink. At Dec 31 07, FMD had $770mm of these residuals (listed under “Service Receivables in the 10-Q). So let’s say FMD writes them down by a hypothetical 30%; they are now left with only $539mm in residuals, and book value goes from $921mm to $690mm. That limits Goldman’s possible investment to $172.5mm. That guess is probably optimistic right now. To add to it, FMD stated that they will not tap the LOC offered, for reasons I cannot figure out (if anyone knows, please pass it on).

The Future

As for FMD as a viable company, if they want to securitize future pools of loans in the near future, they will need a new guarantor. In the meantime, they will hold billions of dollars in loans on their balance sheet and collect payments, just as any thrift would do. In effect, their very low capital needs changed to very high capital needs, as they used to be able to clear their balance sheet in one fell swoop, and now it will balloon as they must hold the loans they are originating. They are funded for at least another 2 quarters (According to management in the last conf. call), and will probably need capital beyond that unless the securitization market opens up before then. They may also need a new source of funding to continue originating loans. Otherwise, they’ll have to put that on hold. They are collecting on their originated loans, which have a very nice coupon, so I don’t believe the company is imminent for bankruptcy, but they will need to change and adapt. Their business model was all securitization, and for the time being that is not possible.

I think that Tom Brown had a good thesis of an undervalued company, but he did not foresee either that the securitization market would basically stop functioning or that FMD was so susceptible to a shut down (I would guess the former over the latter). If FMD does survive this nightmare intact, the stock will be worth several multiples of its current price. If they get new capital and/or funding, or they manage to securitize, FMD will be worth much, much, more than the current price. At $4 a share the downside is indeed zero here, but as a new FMD investor you'd have to work out the probabilities of that 0 actually occurring. I'm not so sure about it myself. I’m holding on because I believe that the company will make it through this; their balance sheet remains relatively strong, and the demand for student loans is through the roof. It's a very tough decision, and I may be proven wrong even further. Intrinsic value is very muddy, but within a 2 or 3 quarters it will become much clearer, in which case I can make a more informed decision. In any case, a company that earned $3.92 a year ago and currently sells for $4 makes for an interesting case study. Soon enough, I'll talk about some investments which I am a bit more optimistic about.

This makes for a good study of why circle of competence is so important. I strayed, and I paid.


Disclosure: Author owns a position in FMD.

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Pabrai in SmartMoney: "It was a good bet"

I'm not sure if anyone has read this month's issue of SmartMoney. I like the magazine, I find it is well written, and while it is aimed at the general public (i.e. lots of retirement advice and such in there) occasionally there is very interesting article or stock pick to investigate.

This month's issue, as I mentioned, has a 3 page article about Mohnish Pabrai entitled: "Looking Up to Buffett." No shock here; Mohnish has said many times in the past he is merely a "shameless cloner" of Buffett. The article is a typical piece on a money manager; fawning over his success, reveling in the simplicity of his approach, asking him for a stock pick. I'm a huge fan of Pabrai myself, so in this case it doesn't bother me; I think he deserves a ton of respect, and he has the record and approach to back it up.

Now, if you follow Mohnish at all, you know he bet big (to the tune of 10% of his fund at the time, $40-$50mm) on a now-bankrupt mortgage lender in 2006, Delta Financial Corp (DFCLG). Not only did he bet big, he added to his stake late in 2007, arranging $10mm in convertible financing for the company along with Angelo, Gordon's $60mm in financing. The company went under shortly after, caught in the tidal wave of a securitization market slammed shut. Headline story: One of the most highly respected value investors out there bet big and lost over $50mm.

The most important part of the SM article, in my opinion, is where SM asks Mohnish about DFC:

SM: "How do you deal with a Delta Financial, professionally and personally?"

MP: "Investing is a game of probability. Sometimes when you make favorable bets, you still lose them. Even a blue chip could go to zero tomorrow. With Delta Financial, the company didn't have enough financial strength- that was probably a mistake on my part. I think of it as a favorable starting blackjack hand where unfavorable cards showed up afterward."

SM: "If you could do it over, would you have done the same thing?"

MP: "It was a good bet."

There are a number of lessons here that we as investors can take away. The first one, the most obvious one, is to take your losses and move on. It doesn't sound to me, from the tone of the article and his words, that he thinks about DFC much. Clearly he studied the reasons he lost the bet and learned from them, but he's not hung up on a bad choice.

The second big lesson here is the importance of thinking probabilistically about investments. Buffett+Munger have said in the past that investing is a simple game of probabilities, and if you get 'em right, you'll be successful over the long term. It's just intelligent, informed, rational, betting. Finding mis priced bets, squarely in your circle of competence, is the key to beating the market.

Myself, I almost made the same bet Mohnish did. There were lots of good reasons it could have worked out, the stock was undeniably cheap, and you had a vote of confidence from a very successful investor (Pabrai). In the end, I couldn't get comfortable. I had the tremendous benefit of having lost my whole investment in American Home Mortgage earlier in the year, a nice slap in the face that showed me one area that was squarely outside my circle of competence.

As Pabrai points out, investing intelligently doesn't mean every bet will go well. The pari-mutuel nature of the market is such that even when you get a fat pitch, you still might swing and miss. Get used to it.



Disclosure: None

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Welcome to the Circle of Competence Blog

Welcome to the Circle of Competence Blog! I'm an ever-learning investor hope to impart my own insights into securities, value investing, the world of Wall Street, or anything financial that comes to mind. Leave comments or drop me an e-mail and tell me what you think, what you'd like to hear, or tell me I stink!

I'll stay within my circle of competence, and I'll even tell you when I'm outside of it. I believe the most important traits a long term investor can have is a well defined circle of competence and a solid framework in the mold of Ben Graham, Warren Buffett, and Charles Munger, whom I'll adoringly refer as the Holy Trinity of Value Investing.

I won't necessarily disclose my holdings up front, but If I post about one, I'll make sure to let you know if I own it.

I hope to learn more about my own framework, and get some criticism from my readers. I'm inexperienced by most measures, and not all that smart anyways.

I'll leave you with a quote:

"You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

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