Quick news: EMAK, WestLB and Tonnelerie

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EMAK

I just saw that after the capital increase, EMAK has a new “number 2” shareholder, a company called “Girefin SpA”. Girefin SpA is a holding company which holds 55% of Landi Renzo SpA, a quoted Italian company. Girefin is controlled by Stefano Landi who was CEO of Landi Renzo before.

From a minority investor point of view this might be interesting, to have a “local” guy on board.

WestLB

There is an interesting article in the FT Germany (in German) about the current situation at Westimmo, the real estate lending sub of WestLB. If they succeed in moving the whole subsidiary into the government owned “bad bank” and maybe at book values, than the 2011 result might only show minimal losses if all. This would be very good for the 2011 “Genußscheine”.

Tonnellerie Francois Frere

There are news that Tonnelerie and listed competitor Oeneo are negotiating about Oeneo’s oak barrel business, Tonnelerie Radoux. Although the news was already out on Friday, it looks like some people who think that this is a reason to buy Tonnellerie.

However in my opinion one has to wait to see what Tonnellerie is actually paying for this and how they finance it.

What’s you competitive advantage (in investing) ?

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There is a very interesting post at the (higly recommended) Psy-Fi blog about the general chances of small investors against institutional investors.

They compare it for short term trading to the “Sanzibar war”:

In terms of competitive advantage private investors engaging in short-term trading against financial institutions is the greatest mismatch since the Anglo-Zanzibar War of 1896 which lasted only 45 minutes – and which ended with the British being paid for the shells they’d fired into their opponent’s country.

They also correctly mention privileged information from companies available for institutional investors:

We find significant increases in trade sizes during the hours when firms provide off-line access to investors, consistent with off-line access providing selective access advantages. We also find significant increases in trade sizes after the presentation when the CEO is present, consistent with CEO meetings providing selective access advantages. … Finally, we find significant future absolute abnormal returns after the conference for firms providing off-line access, suggesting such access is potentially profitable for investors. While we cannot conclusively state that managers are selectively disclosing new information outside of the presentation, our evidence does suggest that investor conferences confer a selective access advantage on the buy-side investors that have been invited to attend.

Additionally they think that private investors ar much less likely to exploit statistical anomalies:

The ability of the securities industry to automate trading to capture the abnormal returns from any anomaly in the market (Pricing Anomalies, Now You See Me, Now You Don’t) means that anyone attempting to out-compete them is facing the hopelessly overwhelming odds of the Zanzibar Effect and, like the hapless Zanzibarians, paying them for the privilege.

So should we just stop messing around with managing our own money and hand over our hard earned money to the institutions ?

Psi Fi offers some hope: They stress that small cap investing with a longer time horizon could be one way to beat the institutions:

Our competitive advantages are elsewhere; the Law of Big Numbers dictates that smaller companies simply aren’t big enough to justify lots of institutional analysis, so the asymmetric informational advantages often lie with private investors prepared to put in the effort. One reader noted that he invests in smaller French companies because the reporting language rules out a lot of competition. Nor are private investors constrained to make quarterly or annual returns – we can buy companies with good business models but which are temporarily distressed and wait. Or we can make sure we’re ready to supply liquidity to the markets when institutions are forced to give it up in one of their once a decade panics.

I fully support their arguments, but I think in addition to long term contrarian small cap investing , private investors have much more advantages than they are aware of.

1. Asset class restrictions

Most asset managers are restricted to certain asset classes. Many large institutions (pension funds, insurance companies) employ either consultants or own employees who are supposed to be great allocators acrosss asset classes, leaving actual money managers with very narrowly defined mandates for only small sub sets of the investment world.

Anyone with some institutional knowledge can tell some stories how the supposedly superior asset allocation process works: Money almost always goes into the historically best performingasset classes which is the dominant “cover your ass” strategy in this area.

As a private investor, you have a big advantage here : you are not restricted at all. You can look at stocks if they are cheap, or bonds if they seem to be a better choice. In 2008 for example, it was relatively clear that the risk/return of subordinated financial bonds were much better than owning stocks. However as a typical stock portfolio manager you were not allowed to buy bonds.

In my opinion, this is also one of the underappreciated competitive advantages of Warrent Buffet’s Berkshire set up. Despite the whole “moat” thing, his structure allows him for instance to go to “pref shares + options” type of trades as well a selling options, buying distressed debt etc.

2. Instrument restrictions

Many money managers are further restricted with regard to instruments they can buy. So either they can buy only stocks or only bonds or only convertible bonds, but few can freely decide what instrument tob uy.

The best current example for this are currently in my opinion the now closed former open ended German real estate funds. I do not know any institiutional mandate which would allow this kind of investment.

The German Insurance regulation for example explixitely does not allow insurance companies to invest in open ended funds which have stopped taking back shares, meaning that if you owned them before they have closed, Insurance companies were forced to sellt hem.

So being abletoinvest in any instrument as aprivate investor,in my opinion opens up a lotof very attractive risk / return scenarios.

3. Reputational risks

As I mentioned in point 1., a lot of the activities in institutional asset management is based on “cover your ass” strategies. For every portfolio manager it is much easier to talk to his bosses, clients or to attractive persons on cocktail parties about “great” companies one owns and manages. If thegreat company turns out to be a not so great investment, this gets attributed very rarely to the money manager.

It is much harder to explain why one owns subordinated bonds of banks under Government control, shares in now closed investment funds or “obscure” Italian companies, where everyone knows from “Bild” that Italy goes down the drain. Many people think that those “special situations” are much riskier than the “great and easy to explain” investments andthis is exactly why they are often much more interesting from a risk return point of view.

4. Size & Control of funds and liquidity premium

As an institutional money manager, one has the following two problems if one wants to exploit illiquidity premiums:

a) you do not control in and outflows of money. So if you think a relatively illiquid market segment is an interesting opportunity and you invest, suddenly the clients wants out and you have to liquidate your positions at great losses. So even if you have a long time horizon as an institutional money manager personally, your time horizon in reality might be much shorter. This is by the way the second “institutional” feature which is in my oninion very important to understand Warren Buffet’s success.

b) many times, size is an issue. Even with my “modest” 10mn EUR virtual portfolio, I find it hard to enter and exit into smaller but interesting situations. For a 1 billion portfolio, it just doesn’t make a lot of sense to research a potential 1mn EUR investment which leaves a lot of ideas unexplored.

So summarizing this whole post, I would conclude the following:

For individual investors, the freedom to invest in any asset class, in any type of instrument, regardless of name, country of domicile and size creates a significant competitive adavantage to institutional money managers.

Combined with the control of the funds and a long time horizon, in my opinion this is almost unbeatable by any traditional money manager. Only money managers who manage to overcome those limitations (Berkshire, Private Equity funds, Hedge funds, family offices) can come close.

IMPORTANT: It is not a guarantee to outperform. There are many bad investments, value traps, frauds and semi-frauds out there, but mostly they can be avoided through thorough due dilligence and common sense.

Nintendo Co. – from “Moat Superstar” to Net-Net ?

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There was an interesting article in Business Week about Nintendo, which is expected to book its first lost since a long long time.

One of the quotes were:

It’s hard to say whether Nintendo can regain its footing, says Melissa Otto, director of active equity at TIAA-CREF, the manager of retirement accounts for employees of nonprofit institutions. The company’s stock has fallen so far—shares reached a 52-week low on Jan. 27—that it’s approaching the company’s cash value, she says. “They have a fantastic track record,” Otto says. “They have a wonderful brand. But the question is: Does the consumer care now?”

A quick look into the balance sheet shows:

The company currently trades close to book value (P/B 1.2). Net current assets are only slightly lower, no goodwill, no financial debt.

Cash and marketable securities were around 6000 Yen per share per end of year 2011. There seems to have been a certain cash burn in the first 9 months of FY 2011, this is somthing to watch. However this could also be an FX conversion effect if the cash was held for instance in EUR.

Interestingly for the 9 Month 2011, tha largest part of the announced losses were currency losses.

The stock chart in YEN looks quite bad, we are back at 1989 levels:

Shareholders:

The shares shares are widely held, no dominating shareholder. 10% are treasury shares. I wonder wether this would be a nice target for some shareholder activism….

Analyst sentiment is bad (which is good).

For the time being, I have no idea how to value Nintendo, but it is definitely something to watch. The “Intangible” value of the game franchises (Mario, Pokemon etc.) could be huge, however there are many well known headwinds like Mobile phone games etc.

If Nintendo again manages to reinvent itself like they did with the WII, then the upside could be huge. If they fail, at least they will not go bankrupt any time soon.

In any case, Nintendo is an interesting example how a “Moat” or “Gillette Razorblade” business model can dissappear through technological change pretty quickly, at least in the consumer electronics area. So watch out Apple.

Hyundai Motors capital structure arbitrage continued

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Yesterday, I posted some first thoughts about a potential Hyundai Capital Structure arbitrage.

I know (through Thomtrader) that it is possible to buy the pref shares, but the short side for the commons is more difficult.

As mentioned, there are traded single stock equity futures on the Korean Stock exchange, but I think it might be difficult for private investors to find a broker who offers this access. I didn’t find any Hyundai Motors CFDs, so shorting through CFDs doesn’t seem to be feasable either.
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German Preference share spreads & Hyundai Motor capital structure arbitrage

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Last year, I had a couple of posts about preference shares in general (part 1 and part 2) and spreads between German common shares and pref shares in particular (here).

II looked at a post of Valuation Guru Damodaran, who tries to come up with a theory of explaining the spreads between votung an non-voting shares.

Among other factors, his assumption is that shares with voting rights should generally trade at a premium and c.p. the premium should be higher for badly managed companies where a change of control event is likely.

When we looked at German pref shares, we could see that in certain cases this held up but not in general.

How do spreads look right now ? Let’s look at current spreads from quoted German companies with both, common and pref shares compared to last July:

Company VZ ST Current spread old Delta
MINERALBRU UEBERKING-TEINACH 6.81 12.04 76.8% 100.0% -23.2%
METRO AG 27.43 29.64 8.1% 52.4% -44.4%
MAN SE 60.1 83.52 39.0% 47.3% -8.4%
BAYERISCHE MOTOREN WERKE AG 44.85 69.04 53.9% 46.9% 7.0%
SIXT AG 13.24 15.63 18.1% 27.3% -9.3%
FRESENIUS MEDICAL CARE AG & 44.9 54.71 21.8% 17.4% 4.5%
EUROKAI KGAA 20.35 25.542 25.5% 15.5% 10.0%
WMF*WUERTTEMEB METALLW-AKT 29.2 32.5 11.3% 7.1% 4.2%
SARTORIUS AG 39.84 36.083 -9.4% -1.9% -7.5%
RWE AG 30.565 32.605 6.7% 7.3% -0.6%
DYCKERHOFF AG 31.77 30.01 -5.5% 4.1% -9.6%
BIOTEST AG 38 39.51 4.0% 3.3% 0.7%
AHLERS AG 10.401 9.86 -5.2% -0.5% -4.7%
EFFECTEN-SPIEGEL AG 12.29 12.749 3.7% 1.4% 2.3%
KSB AG 442.05 483.1 9.3% -1.4% 10.7%
HUGO BOSS AG -ORD 76.01 68.02 -10.5% -9.2% -1.3%
VOLKSWAGEN AG 142.6 127.6 -10.5% -9.2% -1.3%
FUCHS PETROLUB AG 38.075 34.29 -9.9% -13.1% 3.2%
HENKEL AG & CO KGAA 47.31 40.1 -15.2% -17.4% 2.2%
DRAEGERWERK AG 70.66 53.58 -24.2% -21.2% -2.9%

Most interesting is the developement at Metro, where spreads between prefs and common shares almost disappeared. The most prominent example against Damodaran’s theory, BMW (well managed, no chance of change in control) even increased it’s spread.

If we look at BMW again, we can see that after a some tightening, the spread is almost back to it’s peak:

Personally, I don’t really understand this. Of course liquidity is better for the common shares and they are in the DAX, but a 50% higher valuation for the common shares with a controlling shareholder family who does not want to sell doesn’t make sense.

Another intersting idea from Thomtrader are Hyundai Motors pref shares.

Hyundai pref shares (3 different series) trade at around 48-60 k Won against 220 k for the regular shares. That is a ratio of ~4-5:1, a massive discount. Again, this can not be explained through “conventional wisdom”.

If we look at the historical spread between the pref shares and the common Hyundai Motor shares, we can see that historically they were correlated quite well but are now diverging since the last couple of months:

Although I do not want to own them outright, a long Hyundai Pref short common shares trade looks interesting. One could buy 4 Pref shares and short (I don’t know if this is possible in reality) 1 common share.

Historical correlation is around 0.85, not perfect but Ok. The nice thing is that we have a good carry of ~ 3 pref dividends, which translates into a “carry” of around 7% for the nominal position (in hedgefund lingo) before borrowing costs, non-frefundable taxes etc..

Again the “Volkswagen” risk of shorting common shares should be relatively small as it is yet to be proved that anyone can take over a Korean Company.

This is a trade I am actually considering is another “capital structure” trade similar to the Draegerwerke long/short.

UPDATE: I just saw that there are single stock futures traded in Korea. I am not sure if a private investor can trade this but as an institutional invetsor, this should be possible.

“Risk free” rates and discount rates for DCF models

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In the discussion to the Piquadro valuation, I quickly mentioned that the concept of “risk free” rates is a difficult concept at the moment.

Let’s have a quick look at the “academical” world:

CAPM

If we look at the CAPM (no matter if one beliefs this or not) we can see that the risk free rate of return plays an important role there. First, it is the basis return on needs to achieve with any investment, secondly it also influences the equity risk premium.

Risk free rate of return

The definition of the risk free rate itself is quite “fishy”. Investopedia for example states:

Investopedia explains ‘Risk-Free Rate Of Return’
In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.

In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.

This is of course not really applicable for any serious long term investor. Damodaran has a nice paper about “risk free rates” here.

His major points are as follows:

The first is that there can be no default risk. Essentially, this rules out any security issued by a private firm, since even the largest and safest firms have some measure of default risk. The only securities that have a chance of being risk free are government securities, not because governments are better run than corporations, but because they control the printing of currency. At least in nominal terms, they should be able to fulfill their promises. Even this assumption, straightforward though it might seem, does not always hold up, especially when governments refuse to honor claims made by previous regimes and when they borrow in currencies other than their own.

So this is important: No default risk !!! So it is wrong for instance to use current yields of Italian Govies for valueing Italian stocks, as considerable default risk is embedded in current spreads. The “country” risk could/should be embedded into the equity risk premium, not into the risk free rate. A hypothetical Italian company with 100% of its business in Germany for example, should only get a very small country risk charge if any.

A second point is the following:

There is a second condition that riskless securities need to fulfill that is often forgotten. For an investment to have an actual return equal to its expected return, there can be no reinvestment risk.

In theory, one should discount annual cash flows with the respective annual risk free rates. With a flat yield curve, this is not so important but for steep yield curves the differences can be significant. However in practice Damodaran recommends using the duration of the cash flows of the analysed investment as proxy for the risk free rate. As the best proxy if we don’t want to do this, he recommends the 10 year rate.

For the EUR, he recommends specifically the following:

Since none of these governments technically control the Euro money supply, there is some default risk in all of them. However, the market clearly sees more default risk in the Greek and Portuguese government bonds than it does in the German and French issues. To get a riskfree rate in Euros, we use the lowest of the 10-year government Euro bond rates as the riskfree rate; in October 2008, the German 10-year Euro bond rate of 3.81% would then have been the riskfree rate.

With regards to currencies he says this:

Summarizing, the risk free rate used to come up with expected returns should be measured consistently with the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk free rate will be the US Treasury bond rate. This will remain the case, whether the company being analyzed is a Brazilian, Indian or Russian company. While this may seem illogical, given the higher risk in these countries, the riskfree rate is not the vehicle for conveying concerns about this risk. This also implies that it is not where a project or firm is domiciled that determines the choice of a risk free rate, but the currency in which the cash flows on the project or firm are estimated.

The most common mistake with currencies is usually to use current exchange rates for future cashflows which then results in a preference for projects in countires wiht high nomnal rates.

About Inflation, he is not really clear in my opinion. He argues basically, inflation does not matter because we get the same result if we use yields of inlfation linked bonds combined with inflation adjusted growth rates.

Especially the current situation, where we see negative real yields in many markets, one could argue about his appoach. A negative real yield means for an investor, that the “risk free” nominal asset would have a guaranteed loss in real purchasing power over the investement horizon.

Consider for instance the UK: 10 year gilts run at 2.158% yield, this would be the proxy for the risk free rate. Current inflation runs at 5%, UK 10 year implied inflation from inflation linked bonds is around 3%.

So if I would use the 10 year gilt as proxy as the risk free rate, I woul dalready accept a loss of -1% p.a. in real terms p.a. or almost -3% p.a. based on current inflation rates.

I think this topic might justify even a doctorate thesis, but in my opinion, one could go the following pragamatic way:

Proxy for risk free rate: Higher of 10 year risk free Govie Yield in currency or inflation ).

So in the case of the risk free rate for an Italian company I would compare:

a) 10 year risk free EUR rate = 10 year bunds = 1.89%
b) Inflation: Currently =3.4%

I would the use the higher of the two rates, 3.4 %. This would be a pragmatic way to avoid unnecessary country risk premium and still make sure, the risk free rate does not imply a guaranteed loss in real terms.

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