Margin of safety in junk bonds

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

The book I'm currently reading is Margin Of Safety by Seth Klarman. This book is widely described as a value investing classic and now I know why. It's a coincidence that the current book I started reading would have a section dedicated to junk bonds. As you may have read my previous post discussed Michael Milken and the height of the high yield / junk bond era.

About halfway through the book now, so wanted to share a few thoughts and quotes by Seth Klarman on high yield / junk bonds:

"Prior to the 1980s the entire junk-bond market consisted of only a few billion dollars of "fallen angels." Although newly issued junk bonds were a 1980s invention and were thus untested over a full economic cycle, they became widely accepted as a financial innovation of great importance, with total issuance exceeding $200 billion. Buyers greedily departed from historical standards of business valuation and creditworthiness. Even after the bubble burst, many proponents stubbornly clung to the validity of the concept." Page 27 

"As we shall see,the legitimate opportunity in a virtual handful of distressed securities that were overlooked by others was carried to excess when Milken extrapolated from  a historical relationship to an entirely new type of security." Page 70

"All the parties who stood to benefit from junk bonds-individual and institutional investors, underwriters, and brokers-"got religion," praying that junk bonds would turn out to be as miraculous as Milken preached. At the same time the sermon shifted from the low historical rate of default to a new theme: junk bonds as the economic salvation of America. Our country's nagging problems of slow growth, declining productivity, and diminished international competitiveness would quickly be solved through increased junk-bond issuance." Page 74

In the next blog post I'll add a few more quotes from the book that I found interesting such as institutional fund managers having 'skin in the game' when investing on behalf of their clients.

"Economist Paul Rosenstein-Rodan has pointed to the "tremble factor" in understanding human motivation. "In the building practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."?

From Barbarians to philanthropists

"A fool who recognises his own ignorance is thereby in fact a wise man, but a fool who considers himself wise -- that is what one really calls a fool" - Buddha

Recently watched the classic finance movie Barbarians At The Gate and got me doing some research on the 1980s financial environment. Of course this eventually led to Michael Milken and Drexel Burnham Lambert. Like most people born in the '80s the main things I had heard and read about Milken was his use of high-yield bonds / 'junk bonds', and subsequent US Federal indictment. The assumption in articles that briefly mentioned him assumed he was guilty.

However after viewing these two video clips I realised the truth - my assumptions were misinformed:
- Steve Wynn on Milken (6 minutes long): http://www.youtube.com/watch?v=gk1G_O3UQRo
- Michael Milken on at the United States Conference of Majors (one hour long): http://www.youtube.com/watch?v=NTeQ03VQwA4&list=FLBQOYAj87D3-HgrbtSZhBWw&index=4

If you don't have time to watch these clips then this quote by author Alvin Toffler in his 1990 book Powershift will summarise it:

By forcing open the sluice gates of capital, Milken had rattled the entire structure of smokestack power in America...Before Milken, the greatest financier had been J.P. Morgan, who saw markets as a zero-sum game in which he tried to be the winner at someone else's expense. For example, when financing AT&T, Morgan used his enormous Wall Street and banking influence to ensure that potential AT&T rivals lacked access to capital. Milken did the opposite, opening access to capital for thousands of smaller companies. Milken showed it was possible to align the interests of all corporate stakeholders - investors, entrepreneurs, debtors, creditors, consumers, management, employees and society - to create jobs, wealth and economic growth. The key was his profound understanding of capital structure and how it must change as exogenous conditions change. [See Milken's articles "Why Capital Structure Matters" and "The Corporate Financing Cube".] By the late 1970s, he had already shown it was possible to unlock great potential value hidden in accumulated assets. As others began to exploit this insight, Milken turned increasingly to such issues as education, wage disparity, expanding human capital, and medical research.

A few quick points:
- Milken believed that a company that applied the appropriate capital structure between debt and equity would naturally boost the value and lower the risk of it's bonds. This was quite novel back in the 1970s but is now supposedly common material taught in MBA classes.
- He also demonstrated that a portfolio of high-yield bonds provided an attractive risk-adjusted return when compared to rating agencies investment-grade bonds.
- His money-raising ability also facilitated the growth of leveraged buyout (LBO) firms such as Kohlberg Kravis Roberts (KKR). 
- In 2008 the Milken Institute continued to support better credit rating agency regulation and continued to educate investors on bond investing.

Further interesting info:
- Milken Institute 2011 Review - 'Where Is Sputnik' 
- Or for those that really like diggin in the crates, here is another great article: http://www.edwardjayepstein.com/archived/milken.htm
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I have also been researching some current US finance entrepreneurs recently such as Carl Icahn and Henry Kravis. Was impressed with some interviews from KKR (Kohlberg Kravis Roberts & Co) co-founder Henry Kravis where he acknowledges that a large part of KKR's success vs some other firms was their culture of inclusion where each employee is encouraged to share information, resources and expertise for the good of the team.

By chance I was later reading a report on Moody's due to Buffett's holding in the firm and found mention of KKR (NYSE stock code: KFN) in the specialised finance peer group. On comparison to other companies in the group I noticed it was trading on a PE of under 10 (mental note to look further into why it's on such a low PE...)

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To those who haven't heard, Jeff Bezos is personally buying the Washington Post. He will assume the company's pension plan liabilities. In a time when most pension funds are underfunded the Post pension fund is currently reported to have $1 billion more than it needs.

The employees of the Washington Post have Warren Buffett to thank. In 1975 Buffett advised then-chairman Katharine Graham via this letter on how to prepare for the impending pension liabilities given future inflation assumptions and likely fund manager investing performance.

Well worth the read for any Buffett fans: http://www.scribd.com/doc/160301289/Warren-Buffett-Katharine-Graham-Letter



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Icahn beating Buffett / Berkshire Hathaway over 10 years

With all the media coverage on the Herbalife, Ackman, Soros and Icahn recently I decided to investigate Icahn Enterprises (IEP) in more detail.

In particular this article got me interested to start digging further:
http://www.kiplinger.com/article/investing/T052-C000-S002-carl-icahn-better-investor-than-buffett.html

So how does Icahn Enterprises fare vs some other benchmarks?

See the table below from their June 2013 investor presentation:

Source: http://www.ielp.com/index.cfm

So is IEP worth a further look?

The next question on my mind was to see how much the CEO got paid. For investment funds and diversified holding companies the executive remuneration and/or fund manager fees play a key criteria in deciding the overall long term returns to the shareholders.

A bit of searching led me to this article:
http://money.cnn.com/gallery/news/companies/2013/08/06/one-dollar-salaries/6.html

According to the article Carl Icahn's most recent remuneration was rather modest:

Salary: $1

Stock, options, other pay: $147,559

Total pay: $147,560

I'm sure most investors would be accepting of a CEO / fund manager taking a pay of $147,560 while share performance has outperformed the market by such a large margin over time.

A few questions:

Does anyone out there have ideas on the stock? 

Would you invest in IEP over Berkshire currently? 

Comments or questions?

Berkshire Hathaway's holdings in listed companies and their return on equity

Berkshire Hathaway's holdings in listed companies and their return on equity:

I've been spending a bit of time recently reading over large cap US stocks. I tend to look over the following information to get a quick overview of a company: Return On Equity (ROE), Debt to Equity, Price to Earnings Ratio (PE Ratio).

S&P have some good information so I decided to look over Warren Buffett's Berkshire Hathaway's largest listed holdings from their latest 2012 annual shareholder letter and analyse their Return On Equity (click to enlarge image).

Here are several of Berkshire's holdings in which I found their Return On Equity from Standard & Poors data:

Sample Berkshire Hathaway holdings ROE
Year	2012	2011	2010	2009	2008	2007	2006	2005	2004	2003
American Express	23.8	27.8	26.7	16.5	24.3	37.6	35.4	24.2	22.4	20.6
Coca Cola	28	27.4	42.5	30.2	27.5	30.9	30.5	30.2	32.3	33.6
IBM	85.2	73.4	64.9	74.4	58.8	36.6	30.6	24.7	29.3	30.1
Procter & Gamble	13.9	18.5	17.8	17.2	17.9	16.3	22.1	45.7	41.8	37.9
Wal-Mart	23	23.5	22.1	21.2	20.4	20.4	21.2	21.9	22.1	21.3
Wells Fargo	13.1	13.1	11.1	14.3	4.9	17.2	19.8	19.7	19.5	19.3

Note this is only a sample but quick look at these selected companies shows they all have 'high' Return On Equity. By 'high' I mean above 20% with the only exception being Wells Fargo.

Taleb, Spitznagel, Prabai and...Buckminster Fuller?

Still on the Antifragile ideas again! 

Although I've seen nearly all of Taleb's talks on Youtube I've just found one that's on Bloomberg only. His latest interview which I found is here: 
http://www.gurufocus.com/news/209020/nassim-taleb--my-fear-of-bonds-is-forcing-me-to-buy-stocks

On another note, an ex-colleague once recommended I also check out Mark Spitznagel of the hedge fund Universa Investment LP. Spitznagel and Taleb has often worked together and share many similar views. Spitznagel also writes articles semi-regularly, some of which can be found here:

http://dailycapitalist.com/2011/12/24/christmas-trees-and-the-logic-of-growth/

http://universa.net/UniversaSpitznagel_research_201205.pdf

Ok, besides the recent 'long volatility' option trader / investors I've been focusing on recently I decided to revisit a Mohnish Prabai value investing interview. I have to say the Prabai interview is very worthwhile and highly recommended. In it he speaks about 'cloning' success! The interview can found here: http://www.youtube.com/watch?v=GBXRNH9VfhA

On a final note, Nassim often speaks about certain environments requiring 'constant stressors' to remain healthy (antifragile). He often uses example of the economy and the human body. For example, if you were to put a human into outer space or a sterile environment without any stress - no stress from gravity or bacteria - then if they were to return back to a normal city life their body would suffer. Imagine someone stepping back into a New York subway immediately after years living in a sterile environment!

This idea of requiring constant stress reminds me of Buckminster Fuller's concepts of tensegrity: constant tension, discontinuous compression. This concept can be seen in building resilient structures and includes the structure of the human body. See an short example here: http://www.biotensegrity.com/continuous_tension_discontinuous_compression.php

For those with an interest in investing, health, architecture I hope you enjoyed this post. Take care

Trading: From Taleb to Jeff Yass and poker

While currently reading Dynamic Hedging by Nassim Nicholas Taleb I came across a mention of Jeff Yass. Taleb says the greater fool theory is well explained by market maker Jeff Yass on his approach to  trading options:

"Somehow "value" is conditional on the most recent information rather than the overall picture. If a market operator is given a position by someone else, he receives more than a position: He gets information, and the information would necessarily eradicate the edge." (Taleb, 1997)

This of course led to do a quick google search on Jeff Yass. Unfortunately I couldn't find any youtube  videos of his interviews/speeches. I found out he was a rather private individual but luckily came in rather comprehensive article published by the Philidelphia Magazine. The article details how Yass has used the disciplines and skills from playing poker to since his college days to consistently win on the markets over the last 30 years.

I enjoyed the article and hope you do too. Although I don't consider myself a trader (or poker) player, like Rakim said, you have to respect the technique!

Link to article is here: http://www.phillymag.com/articles/beating-the-odds/

Beyond margin of safety

I'm sure most of you have heard of The Motley Fool so I wanted to recommend a blog by ex-Motley Fool writer Dean Morel called 'Fusion Investing'.

Having recently finished Nassim Taleb's 'Antifragiilty' I the article quite nicely combines the ethos of Benjamin Graham's margin of safety with Taleb's belief's on risk vs return.

The link is here:

http://www.fusioninvesting.com/2013/02/step-beyond-margin-of-safety/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+FusionInvesting+%28Fusion+Investing+and+Analysis%29

Hope you enjoy it!

Cheers