Hi, I was over at a value investing blog - Barel Kasan and saw that he posted this pair trade. I dug more into it. I thought it'd be an interesting opportunity for us to analyze an arbitrage play.
Investment Thesis
As of May 2, 2009, Retail Ventures (RVI) owns Class B Common Shares of DSW representing approximately 62.9% of DSW’s outstanding common shares and approximately 93.1% of the combined voting power of such shares. DSW currently trades at $12.91 with a market cap of 565.64M (as of market close Aug 10). Therefore RVI's stake should be worth 355.79M.
RVI is currently trading at $3.38 (as of market close Aug 10). RVI's market cap is $165.39M. RVI's book value as of May 2nd, 2009 was $363.1M. The thesis is that there is an arbitrage opportunity since RVI should not trade below its DSW stake. The difference is quite significant and the thinking is that we could take advantage of it.
RVI is basically a holding company. It doesn't have any operating segments. Its main asset is the 62.9% of DSW common shares that it owns, the $103.3M in cash, $10.3M in restricted cash and $81.4M in short-term investments.
RVI does have $128.1M in long-term obligations and $100.4M in Other non-current liabilities. The $128.1M consists entirely of Premium Income Exchangeable Securities (PIES). PIES are a structured product. The total principal amount of PIES is $143.75M. The PIES bear a coupon at an annual rate of 6.625% of the principal amount and mature on Sept 15th, 2011. Except to the extent RVI exercises its cash settlement option, the PIES are mandatorily exchangeable on the maturity date, into Class A common shares of DSW, no par value per share, which are issuable upon exchange of DSW Class B common shares, no par value per share, beneficially owned by RVI. On the maturity date, each holder of the PIES will receive a number of DSW Class A common Shares per $50.00 principal amount of PIES equal to the "exchange ratio" or if RVI elects, the cash equivalent thereof or a combination of cash and DSW Class A Common Shares.
The exchange ratio is equal to the number of DSW Class A Common Shares determined as follows:
(i) if the applicable market value of DSW Class A Common Shares equals or exceeds $34.95, the exchange ratio will be 1.4306 shares;
(ii) if the applicable market value of DSW Class A Common Shares is less than $34.95 but greater than $27.41, the exchange ratio will be between 1.4306 and 1.8242 shares; and
(iii) if the applicable market value of DSW Class A Common Shares is less than or equal to $27.41, the exchange ratio will be 1.8242 shares, subject to adjustment as provided in the PIES.
The maximum aggregate number of DSW Class A Common Shares deliverable upon exchange of the PIES is 5,244,575 DSW Class A Common Shares, subject to adjustment as provided in the PIES.
DSW is a leading U.S. specialty branded footwear retailer. It was wholly owned by RVI. DSW had its initial public offering on July 5, 2005. DSW operates 303 shoe stores in 38 US states as of May 2, 2009. DSW offers a wide selection of better-brand dress, casual and athletic footwear for women and men, as well as accessories. DSW also operates 365 leased shoe departments for four other retailers and sell shoes and accessories through dsw.com.
At first glance, this looks like a straight forward arbitrage play. 2 companies, 1 owns a large chunk of the other but is selling at a large discount to its stake. This time round the PIES structured product messes around with the play.
The reason is simple. The debt can be paid back in DSW shares (ie there is a convertible feature). This lessens the value of RIV's stake in DSW and changes the valuation of RIV's stake in DSW. So the effect of the PIES is to put in doubt the actual value of RVI's 62.9% stake in DSW. We know it's less 'coz RVI might elect to pay the principal amount of debt ($143.75M in DSW shares). In fact, if RVI paid back in DSW shares right now, it'll probably only have to pay out the maximum amount of shares (5.244M shares) which is only worth $67.7M right now. The more shares RVI pays out to the PIES holders, the less the difference in the value of the arbitrage. This means you take off $67.7M from the value of RVI's stake, this leaves RVI's holdings in DSW at $288.09M. It also means that the difference in RVI's value and its DSW stake decreases by $67.7M as well ($122.7M left in the arbitrage amount).
Then you need to account for the conversion feature of the PIES, 'coz that's worth something. Right now, it approximately stands at $76.05M (I treat it as a deep in the money option, so it's just the difference between the principal amount of debt and the value of the shares paid out). That leaves $46.65M in the arbitrage amount.
Having said all the above, $46.65M is only 28% of RVI's market cap. I don't think there's a sufficient margin of safety to do this trade.
Thursday, August 13, 2009
Wednesday, August 12, 2009
Paul Tudor Jones on Bear Market Rally
I was over at the Pragmatic Capitalist (http://pragcap.com/) and read this really interesting piece. Thought I'd share it with you too.
As put forward in our last correspondence of late April, global growth performance is turning out to be better than markets and the consensus expected just a few short months ago. The large negative overshooting in economic activity over the turn of the year is now poised to be reversed in a V-shape type of recovery—although with such V stabilizing below pre-crisis levels of trend growth—led by an inventory rebound and the impact of the massive stimulus implemented by global policy makers.
Policy initiatives targeted at eliminating tail risks have successfully reduced risk aversion and risky assets have rallied almost across the board, reversing some of the large wealth losses suffered by global consumers. To be sure, many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth, and the damage inflicted by the crisis to potential growth in many countries will likely deliver a recovery that will look subdued by the standards of the past decade.
High and persistent levels of unemployment in an environment of very large fiscal deficits will greatly complicate policy making. In fact, as tail risk has diminished significantly, policy makers have started to focus on exit strategies, with sometimes premature and excessive impetus. The lack of understanding by both markets and policy makers of the impact of the mix of large fiscal deficits and quantitative easing policies has increased volatility and generated fears of uncontrolled inflation. In addition, fears of debt monetization have sharply increased central banks’ caution with quantitative easing actions. As a result, despite having some further room to ease, the main central banks have moved into a wait-and-see stance. The Fed is very unlikely to increase its purchases of Treasuries, though it will likely keep rates on hold at 0.25 percent until at least the summer of 2010. The ECB will very likely keep policy rates at 1 percent for a long time while allowing money market rates to remain lower with the effect of engineering looser financial conditions for as long as needed. The BoJ has successfully implemented many credit market initiatives, but is unlikely to increase its Rinban purchases despite surging JGB supply. The complex combination of decelerating inflation, very low short-term rates, rising fiscal deficits, and marginally hawkish central banks will pose a challenge for fixed income markets, as we discuss below.
Overall, the period of fiscal and monetary polices pushing in the same direction is over, and policy makers are starting to weigh the costs and benefits of erring on the side of caution. Even the Chinese authorities are starting to show some policy restraint, after two quarters of very rapid credit growth. Some critical initiatives, mostly related to financial sector restructuring, have been cut short as polls show negative voter sentiment toward active government intervention. As a result, toxic assets remain on balance sheets and credit growth will likely be subdued for a long period of time. Policy stimulus will peak around Q1 2010, and many liquidity facilities and credit guarantees will likely be discontinued around that time; at that point, markets will have to assess the sustainability of growth. Despite the current inflation fear, a deflation scare—driven by the medley of low core inflation, high output gaps, high unemployment rates and very weak wage growth—can’t be ruled out in 2010. But, until then, the return of positive rates of economic growth will likely sustain stock prices and generate a constructive environment for risky assets.
Bond Markets.
The unprecedented financial crisis we have witnessed in the last 12 months has lead to equally unusual fiscal and policy measures. The authorities’ response to the crisis was broad in scope and large in magnitude, such outsized measures aimed at slaying the debt deflation monster perceived to be lurking in the background. We are now pretty much in uncharted territory, since the precedents for these policy responses are very few and far between (especially for industrialized countries). As a result, the implications of these policy measures for inflation, real interest rates and the shape of the yield curve are particularly challenging.
Looking hard for guideposts to help us navigate the fixed income markets, we are focusing on three key themes, namely: the potential inflationary consequences of the explosive growth of the monetary base; the lingering deficit implications of expansionary fiscal policies; and the dampening effect of credit contraction on growth prospects. The inflationary risk would materialize if the seemingly bottomless demand for money became satiated and began to decline. If the monetary authorities were perceived not to be sufficiently quick to drain the excess liquidity in the system, the spillover effect on prices could be substantial. Fixed income markets would come under pressure, in this scenario, as investors would demand an inflation premium to hold nominal assets.
In a similar vein, the fiscal expansions engineered in most regions of the world to counter the drop in private sector demand has left a trail of funding requirements that will stay with us for several years. The resulting supply of government bonds is on the rise globally, and investors may demand a price concession (i.e. higher yields) in order to absorb it.
These bearish fixed income risks, however, could well be swamped by weak consumer spending, a relapse in investment activity (post-inventory re-build) and weak external demand facing the major industrialized countries. This scenario could be underpinned by the reluctance on the part of financial institutions to extend credit, the desire on the part of consumer and businesses to repair their balance sheets, and the protectionist tendencies that emerge internationally during periods of financial strain. The resulting increase in savings, and potential widening output gap, could well offset the negative forces mentioned earlier and lead investors to seek refuge in fixed income assets.
We would expect these opposing forces to ebb and flow over the next few months, as market participants, as well as policy makers, read the tea leaves of economic data as they emerge in the aftermath of this very unusual period. Bond markets will react accordingly, but probably remain range-bound between now and the rest of the year. Excessive rate moves in either direction will raise increasingly greater doubts about their sustainability, given the mixed signals we expect going forward. The trend, for now, need not be a friend. A resolution of this impasse may not come for several months, and until then, our positions in fixed income markets will be more tactical than strategic.
Currencies.
Last quarter saw market participants embrace risk assets, thus lifting commodity linked currencies and broadly weighing on the US dollar. The path ahead for the US dollar will hinge on reserve accumulation and diversification by surplus countries. As global trade and risk allocations recover, reserve accumulation will prompt diversification into euros, pounds and, to a lesser extent, yen and the Australian and Canadian dollars. Reserve accumulation and diversification trends will be persistent and mutually reinforcing with the direction of the US dollar. The weaker the US dollar the more likely reserve managers are to diversify into the above currencies. The US dollar will have bouts of strength that will surprise markets—for example, the US dollar typically is supported at the close of economic recessions—but it should nonetheless end the year lower than now and the correlation between risk assets and currencies will remain high.
A key question for the Australian dollar, as well as for other commodity currencies, is, “How long will China add raw materials and can usage keep pace with inventory?” China went on a commodity spending spree during the first half of the year as it built inventories and bought controlling interests in mining and other resource corporations. We expect there to be little let-up in Chinese stimulus through year-end which will keep the currency bid. The RBA has been very effective easing financial conditions and likely will be the first G10 bank to shift to a hiking bias, which is also supportive of the Australian currency, in addition to a current strong M&A pipeline.
Yen strength versus the US dollar has surprised many market participants. The cross will continue to present two-way risk. Further yen gains will depend on Japan’s return to trade surplus, corporate earnings repatriation under the Japan HIA tax provision and foreign buying of Japanese equities. Yen depreciation pressures will depend on Japanese domestic demand for high yielding FX denominated investment vehicles. The Japanese domestic sector has been slow to embrace a risk seeking environment but we believe that Q4 may see an increase in these outflows.
Emerging market commodity currencies with solid public sector balance sheets will continue to appreciate over the medium-term.
Equities.
At a gain of over 45% in less than 100 trading days we ask, “Is this a new bull market, or only a bear market rally?” The question is largely irrelevant from a trader’s perspective but we will offer a view: bear market rally. Back at the lows there had been such a large risk premium built into equities, along with a concomitantly large short/underweight position, that when the extreme tail risks were avoided, a rally for the ages resulted. As we previously have written, however, impressive counter-trend rallies are a feature, not an oddity, of secular bear markets. It is tempting to get overly influenced by the percentage change metric, but all moves must be taken in the context of the broader volatility regime within which they occur. Stating the obvious, the last year has been a period of record volatility. While 45% is nothing to ignore, one should take into account that the S&P through July 31 is still down more than 20% on a price basis year-over-year. The bottom line is that we are not inclined to aggressively chase the market here. Rather, we eye a better opportunity to be long equities into year-end on a potential autumnal pullback.
As outlined above, the macro risks are becoming increasingly two-sided. After a period where fiscal and monetary policies neatly aligned globally, they will start to become discordant. While there is no expectation that any central bank of note will actually raise rates this year or perhaps even early next, the fact that “exit strategy” has entered the lexicon is probably worth an incremental notch higher in the risk premium. We are certainly not alone in remembering the catastrophic misstep by the Bank of Japan when its officials attempted to raise rates in August 2000. The ECB last summer serves as more recent reminder of how equity markets treat policy mistakes—none too kindly. Sentiment toward the asset class is improving by the day but it would be a mistake to confuse momentum for resolve. Investor psyche is still fragile. The inevitable slowing of China (the second derivative argument cuts both ways), and the return of swine flu headlines as a front-page topic are further catalysts for global equity markets to pause in September.
Regionally, we are intrigued by Japan. It appears to be the developed equity market in which investors remain the most underweight, and we believe the upcoming Lower House election, which should lead to the LDP losing control for one of the few times in the last 54 years, likely will lead to a considerable closing of this underweight positioning between now and year-end. We are also willing to retain some long beta exposure via emerging markets. Europe and the UK offer more at the moment to distinguish themselves positively from the S&P but come with greater risk from new equity capital raisings, particularly in Europe.
In summary, as impressive as recent price action has been, we do not see the current reward/risk profile for new longs here as compelling. Macro risks are an underpriced consideration and seasonal influences should combine to weigh on the market near-term. Once these play out by mid-fall, the stage should be set for another run of meaningful size into year-end. We will seek our entry point to participate in such rally as autumn unfolds. Ultimately, however, we likely will find even such year-end upswing to have been yet another bear market rally, with markets retracing next year.
As put forward in our last correspondence of late April, global growth performance is turning out to be better than markets and the consensus expected just a few short months ago. The large negative overshooting in economic activity over the turn of the year is now poised to be reversed in a V-shape type of recovery—although with such V stabilizing below pre-crisis levels of trend growth—led by an inventory rebound and the impact of the massive stimulus implemented by global policy makers.
Policy initiatives targeted at eliminating tail risks have successfully reduced risk aversion and risky assets have rallied almost across the board, reversing some of the large wealth losses suffered by global consumers. To be sure, many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth, and the damage inflicted by the crisis to potential growth in many countries will likely deliver a recovery that will look subdued by the standards of the past decade.
High and persistent levels of unemployment in an environment of very large fiscal deficits will greatly complicate policy making. In fact, as tail risk has diminished significantly, policy makers have started to focus on exit strategies, with sometimes premature and excessive impetus. The lack of understanding by both markets and policy makers of the impact of the mix of large fiscal deficits and quantitative easing policies has increased volatility and generated fears of uncontrolled inflation. In addition, fears of debt monetization have sharply increased central banks’ caution with quantitative easing actions. As a result, despite having some further room to ease, the main central banks have moved into a wait-and-see stance. The Fed is very unlikely to increase its purchases of Treasuries, though it will likely keep rates on hold at 0.25 percent until at least the summer of 2010. The ECB will very likely keep policy rates at 1 percent for a long time while allowing money market rates to remain lower with the effect of engineering looser financial conditions for as long as needed. The BoJ has successfully implemented many credit market initiatives, but is unlikely to increase its Rinban purchases despite surging JGB supply. The complex combination of decelerating inflation, very low short-term rates, rising fiscal deficits, and marginally hawkish central banks will pose a challenge for fixed income markets, as we discuss below.
Overall, the period of fiscal and monetary polices pushing in the same direction is over, and policy makers are starting to weigh the costs and benefits of erring on the side of caution. Even the Chinese authorities are starting to show some policy restraint, after two quarters of very rapid credit growth. Some critical initiatives, mostly related to financial sector restructuring, have been cut short as polls show negative voter sentiment toward active government intervention. As a result, toxic assets remain on balance sheets and credit growth will likely be subdued for a long period of time. Policy stimulus will peak around Q1 2010, and many liquidity facilities and credit guarantees will likely be discontinued around that time; at that point, markets will have to assess the sustainability of growth. Despite the current inflation fear, a deflation scare—driven by the medley of low core inflation, high output gaps, high unemployment rates and very weak wage growth—can’t be ruled out in 2010. But, until then, the return of positive rates of economic growth will likely sustain stock prices and generate a constructive environment for risky assets.
Bond Markets.
The unprecedented financial crisis we have witnessed in the last 12 months has lead to equally unusual fiscal and policy measures. The authorities’ response to the crisis was broad in scope and large in magnitude, such outsized measures aimed at slaying the debt deflation monster perceived to be lurking in the background. We are now pretty much in uncharted territory, since the precedents for these policy responses are very few and far between (especially for industrialized countries). As a result, the implications of these policy measures for inflation, real interest rates and the shape of the yield curve are particularly challenging.
Looking hard for guideposts to help us navigate the fixed income markets, we are focusing on three key themes, namely: the potential inflationary consequences of the explosive growth of the monetary base; the lingering deficit implications of expansionary fiscal policies; and the dampening effect of credit contraction on growth prospects. The inflationary risk would materialize if the seemingly bottomless demand for money became satiated and began to decline. If the monetary authorities were perceived not to be sufficiently quick to drain the excess liquidity in the system, the spillover effect on prices could be substantial. Fixed income markets would come under pressure, in this scenario, as investors would demand an inflation premium to hold nominal assets.
In a similar vein, the fiscal expansions engineered in most regions of the world to counter the drop in private sector demand has left a trail of funding requirements that will stay with us for several years. The resulting supply of government bonds is on the rise globally, and investors may demand a price concession (i.e. higher yields) in order to absorb it.
These bearish fixed income risks, however, could well be swamped by weak consumer spending, a relapse in investment activity (post-inventory re-build) and weak external demand facing the major industrialized countries. This scenario could be underpinned by the reluctance on the part of financial institutions to extend credit, the desire on the part of consumer and businesses to repair their balance sheets, and the protectionist tendencies that emerge internationally during periods of financial strain. The resulting increase in savings, and potential widening output gap, could well offset the negative forces mentioned earlier and lead investors to seek refuge in fixed income assets.
We would expect these opposing forces to ebb and flow over the next few months, as market participants, as well as policy makers, read the tea leaves of economic data as they emerge in the aftermath of this very unusual period. Bond markets will react accordingly, but probably remain range-bound between now and the rest of the year. Excessive rate moves in either direction will raise increasingly greater doubts about their sustainability, given the mixed signals we expect going forward. The trend, for now, need not be a friend. A resolution of this impasse may not come for several months, and until then, our positions in fixed income markets will be more tactical than strategic.
Currencies.
Last quarter saw market participants embrace risk assets, thus lifting commodity linked currencies and broadly weighing on the US dollar. The path ahead for the US dollar will hinge on reserve accumulation and diversification by surplus countries. As global trade and risk allocations recover, reserve accumulation will prompt diversification into euros, pounds and, to a lesser extent, yen and the Australian and Canadian dollars. Reserve accumulation and diversification trends will be persistent and mutually reinforcing with the direction of the US dollar. The weaker the US dollar the more likely reserve managers are to diversify into the above currencies. The US dollar will have bouts of strength that will surprise markets—for example, the US dollar typically is supported at the close of economic recessions—but it should nonetheless end the year lower than now and the correlation between risk assets and currencies will remain high.
A key question for the Australian dollar, as well as for other commodity currencies, is, “How long will China add raw materials and can usage keep pace with inventory?” China went on a commodity spending spree during the first half of the year as it built inventories and bought controlling interests in mining and other resource corporations. We expect there to be little let-up in Chinese stimulus through year-end which will keep the currency bid. The RBA has been very effective easing financial conditions and likely will be the first G10 bank to shift to a hiking bias, which is also supportive of the Australian currency, in addition to a current strong M&A pipeline.
Yen strength versus the US dollar has surprised many market participants. The cross will continue to present two-way risk. Further yen gains will depend on Japan’s return to trade surplus, corporate earnings repatriation under the Japan HIA tax provision and foreign buying of Japanese equities. Yen depreciation pressures will depend on Japanese domestic demand for high yielding FX denominated investment vehicles. The Japanese domestic sector has been slow to embrace a risk seeking environment but we believe that Q4 may see an increase in these outflows.
Emerging market commodity currencies with solid public sector balance sheets will continue to appreciate over the medium-term.
Equities.
At a gain of over 45% in less than 100 trading days we ask, “Is this a new bull market, or only a bear market rally?” The question is largely irrelevant from a trader’s perspective but we will offer a view: bear market rally. Back at the lows there had been such a large risk premium built into equities, along with a concomitantly large short/underweight position, that when the extreme tail risks were avoided, a rally for the ages resulted. As we previously have written, however, impressive counter-trend rallies are a feature, not an oddity, of secular bear markets. It is tempting to get overly influenced by the percentage change metric, but all moves must be taken in the context of the broader volatility regime within which they occur. Stating the obvious, the last year has been a period of record volatility. While 45% is nothing to ignore, one should take into account that the S&P through July 31 is still down more than 20% on a price basis year-over-year. The bottom line is that we are not inclined to aggressively chase the market here. Rather, we eye a better opportunity to be long equities into year-end on a potential autumnal pullback.
As outlined above, the macro risks are becoming increasingly two-sided. After a period where fiscal and monetary policies neatly aligned globally, they will start to become discordant. While there is no expectation that any central bank of note will actually raise rates this year or perhaps even early next, the fact that “exit strategy” has entered the lexicon is probably worth an incremental notch higher in the risk premium. We are certainly not alone in remembering the catastrophic misstep by the Bank of Japan when its officials attempted to raise rates in August 2000. The ECB last summer serves as more recent reminder of how equity markets treat policy mistakes—none too kindly. Sentiment toward the asset class is improving by the day but it would be a mistake to confuse momentum for resolve. Investor psyche is still fragile. The inevitable slowing of China (the second derivative argument cuts both ways), and the return of swine flu headlines as a front-page topic are further catalysts for global equity markets to pause in September.
Regionally, we are intrigued by Japan. It appears to be the developed equity market in which investors remain the most underweight, and we believe the upcoming Lower House election, which should lead to the LDP losing control for one of the few times in the last 54 years, likely will lead to a considerable closing of this underweight positioning between now and year-end. We are also willing to retain some long beta exposure via emerging markets. Europe and the UK offer more at the moment to distinguish themselves positively from the S&P but come with greater risk from new equity capital raisings, particularly in Europe.
In summary, as impressive as recent price action has been, we do not see the current reward/risk profile for new longs here as compelling. Macro risks are an underpriced consideration and seasonal influences should combine to weigh on the market near-term. Once these play out by mid-fall, the stage should be set for another run of meaningful size into year-end. We will seek our entry point to participate in such rally as autumn unfolds. Ultimately, however, we likely will find even such year-end upswing to have been yet another bear market rally, with markets retracing next year.
Tuesday, August 11, 2009
The Art of Short Selling by Kathryn Staley
Hi,
I've been reading a book called The Art of Short Selling by Kathryn Staley. I think she does a wonderful job of explaining how to go about finding and researching short selling. So I thought that over the next few weeks, I'd summarize the various chapters and share it with my readers.
Chapter 1
Just so we are all clear - Short selling is selling a security that the seller does not own but promises to deliver by borrowing it from someone else, in order to profit from the subsequent price drop.
What sorts of companies are short sellers looking for?
1. Companies whose management lie to investors and obscures events that will affect earnings.
2. Companies with over-inflated stock prices
3. External events that have a negative impact on companies
The only way to find these companies is to read extensively (WSJ, Barrons, various trade publications, SEC filings etc), talk to people in the industry.
The process of researching a short sale has 6 steps:
1. Analysis of the company's financials - cash flow statements, breakdown of its balance sheets and the quality of the earnings.
2. Track insider trading activities and management's salaries through their Form 4s, Sch 13D and DEF 14A filings. Importantly, try to understand how the management views its shareholders. Are they shareholder value driven or are they in it for themselves?
3. Check the company's business strategy execution. Does it run its business well? How does the company stack up against its competitors?
4. Follow the stock's trading patterns, short interest, 13D filings by institutional shareholders.
5. Read anything to determine the consensus.
6. Watch the company over time to see what happens, how earnings and price progresses and what changes.
Risks of short selling:
1. The price moves up after the stock is sold, requiring more cash infusions into the account.
2. Or the lender demands the return of the stock. If the broker cannot find another position to loan to the short seller, the customer will be forced to buy it at the current market price. This is called a buy-in. To avoid the risk of buy-ins, some short sellers only short large cap stocks and never discuss positions or talk to reporters.
All in all, short selling is not for the faint of heart or for the inexperienced investor.
Thanks for reading.
Shaun
I've been reading a book called The Art of Short Selling by Kathryn Staley. I think she does a wonderful job of explaining how to go about finding and researching short selling. So I thought that over the next few weeks, I'd summarize the various chapters and share it with my readers.
Chapter 1
Just so we are all clear - Short selling is selling a security that the seller does not own but promises to deliver by borrowing it from someone else, in order to profit from the subsequent price drop.
What sorts of companies are short sellers looking for?
1. Companies whose management lie to investors and obscures events that will affect earnings.
2. Companies with over-inflated stock prices
3. External events that have a negative impact on companies
The only way to find these companies is to read extensively (WSJ, Barrons, various trade publications, SEC filings etc), talk to people in the industry.
The process of researching a short sale has 6 steps:
1. Analysis of the company's financials - cash flow statements, breakdown of its balance sheets and the quality of the earnings.
2. Track insider trading activities and management's salaries through their Form 4s, Sch 13D and DEF 14A filings. Importantly, try to understand how the management views its shareholders. Are they shareholder value driven or are they in it for themselves?
3. Check the company's business strategy execution. Does it run its business well? How does the company stack up against its competitors?
4. Follow the stock's trading patterns, short interest, 13D filings by institutional shareholders.
5. Read anything to determine the consensus.
6. Watch the company over time to see what happens, how earnings and price progresses and what changes.
Risks of short selling:
1. The price moves up after the stock is sold, requiring more cash infusions into the account.
2. Or the lender demands the return of the stock. If the broker cannot find another position to loan to the short seller, the customer will be forced to buy it at the current market price. This is called a buy-in. To avoid the risk of buy-ins, some short sellers only short large cap stocks and never discuss positions or talk to reporters.
All in all, short selling is not for the faint of heart or for the inexperienced investor.
Thanks for reading.
Shaun
Wednesday, August 5, 2009
Quest Capital Corp (NYSE & TSX: QCC)
I found this Canadian mortgage bank, Quest Capital Corp (NYSE: QCC). It's quite an interesting company. Basically, QCC specializes in construction loans. Meaning that it lends to developers the initial loan to get the building built. These loans are inherently risky due to the numerous issues that could crop up during the construction process and as such the interest rate is also rather high. Normally, developers re-finance these loans at a lower rate once the project is complete. So these loans have a short maturity date.
QCC has
- Market cap of 139M.
- Debt of C$ 46.3M
- Preferred Shares of C$ 38.9M.
- Trading at 0.5 of book value
- Total Assets of C$ 382.824M
- Debt to Asset Ratio of 0.12
- Debt plus Preferred Share to Asset Ratio of 0.22
We are faced with a simple problem here. Banks are essentially blind investing pools, no one knows how good or how bad their underwriting standards are until it's too late. So we need to figure out how much losses they can take. QCC is unique 'coz its equity cushion is so high (78% of their asset base is funded by equity) and you are only paying 50 cents on a dollar for that equity.
The company's total asset base is C$ 382.824M. 97% of that comprises of loans (C$ 370.382M). 1% comprises of cash (C$ 3.875M). 1% - future income tax assets (C$ 4.232M). 1% - other (C$4.335M). These figures are from their Q1 report, which is the latest report available.
As at March 31, 2009, QCC’s loan portfolio consisted of 54 loans of which 51 were mortgages secured by real estate and 3 were bridge loans secured by various mining and energy related assets.
As at March 31, 2009, the mortgage portfolio was comprised of 99% first mortgages and 1% second mortgages. The above table shows the evolution of the portfolio. As at March 31, 2009, the mortgage portfolio was concentrated in western Canada, with loans in British Columbia representing 40% of the portfolio, the Prairies 46% and Ontario 14%.
Credit Quality and Non-Performing Loans
As at March 31, 2009, the Company had fifteen non-performing loans in the amount of $113.8 million (31% of their loan portfolio) (2008 - 4 non-performing in the amount of $12.6 million) on which remedial action has been undertaken. On eleven of these loans totaling $66.8 million, the Company has provided aggregate specific reserves for credit losses of $16.3 million. For the remaining four impaired loans, totaling $47.0 million, management has not provided for any specific loan losses as the estimated net realizable value of the collateral securing the loans is in excess of the carrying value of the impaired loans.
From year end 2008, QCC continued to have 14 loans which are classified as impaired and added another loan for a total of 15 loans, of which 11 have a specific loan loss provision. As at March 31, 2009, the Company’s allowance for loan losses increased to $16.3 million, mainly as a result of an increase in the specific loan loss provision related to 4 loans, 3 of which continued to be impaired from December 31, 2008.
Loan Loss provisions are as follows:
1. QCC has 3 impaired loans in the Okanagan region of British Columbia, which are primarily land loans awaiting re-development amounting to $31.9 million. As a result of further development costs to maintain the property value, QCC increased the specific provisions on one of these loans by $0.3 million.
2. QCC has a $4.7 million loan located in northern Alberta whose specific loan loss reserve has increased by $1.0 million to $1.4 million. Marketing efforts on this property to date have made it necessary to increase the reserve.
3. QCC has a resource loan for $2.7 million on which the loan loss allowance has been increased by $0.6 million to $1.9 million mainly as a result of further deterioration in the value of the collateral.
4. QCC has a residential construction loan in northern Alberta with a current net loan exposure of $6.3 million. In order to maximize value and ultimately collect on the security, Quest will continue to fund the construction until completion. Quest has taken a specific loan loss of $0.9 million on this loan.
In addition, QCC has a net loan exposure of $25.8 million on a property in downtown Vancouver, British Columbia which is currently subject to receivership proceedings. The loan continues to be classified as impaired however no provision for any loan loss has been determined as required as at March 31, 2009. An independent appraisal from a qualified third party obtained in early 2009 has a value in excess of Quest’s carrying value. However, the appraisal is based on a number of significant conditions including the condominium project being built on a timely basis, which is subject to the receivership proceedings being successfully concluded in the short term.
After all the information download onto you, there still remains the analysis that has yet to be answered. How should we analyze this company? Obviously with 31% of its loan portfolio classified as Non-Performing, this company is definitely risky. We have to wonder about its underwriting standards. On the other hand, I must also highlight that the company has a 78% equity cushion and that one is buying that equity cushion at 50 cents on a dollar. Is that worth the risk?
I've been attempting to answer that question by trying to find mortgage loan default rates in British Columbia, Ontario and the Canadian Prairies. I've not been successful. If anyone out there knows of relevant data, please please email me at shaunhhh@gmail.com. Thanks.
QCC has
- Market cap of 139M.
- Debt of C$ 46.3M
- Preferred Shares of C$ 38.9M.
- Trading at 0.5 of book value
- Total Assets of C$ 382.824M
- Debt to Asset Ratio of 0.12
- Debt plus Preferred Share to Asset Ratio of 0.22
We are faced with a simple problem here. Banks are essentially blind investing pools, no one knows how good or how bad their underwriting standards are until it's too late. So we need to figure out how much losses they can take. QCC is unique 'coz its equity cushion is so high (78% of their asset base is funded by equity) and you are only paying 50 cents on a dollar for that equity.
The company's total asset base is C$ 382.824M. 97% of that comprises of loans (C$ 370.382M). 1% comprises of cash (C$ 3.875M). 1% - future income tax assets (C$ 4.232M). 1% - other (C$4.335M). These figures are from their Q1 report, which is the latest report available.
As at March 31, 2009, QCC’s loan portfolio consisted of 54 loans of which 51 were mortgages secured by real estate and 3 were bridge loans secured by various mining and energy related assets.
As at March 31, 2009, the mortgage portfolio was comprised of 99% first mortgages and 1% second mortgages. The above table shows the evolution of the portfolio. As at March 31, 2009, the mortgage portfolio was concentrated in western Canada, with loans in British Columbia representing 40% of the portfolio, the Prairies 46% and Ontario 14%.
Credit Quality and Non-Performing Loans
As at March 31, 2009, the Company had fifteen non-performing loans in the amount of $113.8 million (31% of their loan portfolio) (2008 - 4 non-performing in the amount of $12.6 million) on which remedial action has been undertaken. On eleven of these loans totaling $66.8 million, the Company has provided aggregate specific reserves for credit losses of $16.3 million. For the remaining four impaired loans, totaling $47.0 million, management has not provided for any specific loan losses as the estimated net realizable value of the collateral securing the loans is in excess of the carrying value of the impaired loans.
From year end 2008, QCC continued to have 14 loans which are classified as impaired and added another loan for a total of 15 loans, of which 11 have a specific loan loss provision. As at March 31, 2009, the Company’s allowance for loan losses increased to $16.3 million, mainly as a result of an increase in the specific loan loss provision related to 4 loans, 3 of which continued to be impaired from December 31, 2008.
Loan Loss provisions are as follows:
1. QCC has 3 impaired loans in the Okanagan region of British Columbia, which are primarily land loans awaiting re-development amounting to $31.9 million. As a result of further development costs to maintain the property value, QCC increased the specific provisions on one of these loans by $0.3 million.
2. QCC has a $4.7 million loan located in northern Alberta whose specific loan loss reserve has increased by $1.0 million to $1.4 million. Marketing efforts on this property to date have made it necessary to increase the reserve.
3. QCC has a resource loan for $2.7 million on which the loan loss allowance has been increased by $0.6 million to $1.9 million mainly as a result of further deterioration in the value of the collateral.
4. QCC has a residential construction loan in northern Alberta with a current net loan exposure of $6.3 million. In order to maximize value and ultimately collect on the security, Quest will continue to fund the construction until completion. Quest has taken a specific loan loss of $0.9 million on this loan.
In addition, QCC has a net loan exposure of $25.8 million on a property in downtown Vancouver, British Columbia which is currently subject to receivership proceedings. The loan continues to be classified as impaired however no provision for any loan loss has been determined as required as at March 31, 2009. An independent appraisal from a qualified third party obtained in early 2009 has a value in excess of Quest’s carrying value. However, the appraisal is based on a number of significant conditions including the condominium project being built on a timely basis, which is subject to the receivership proceedings being successfully concluded in the short term.
After all the information download onto you, there still remains the analysis that has yet to be answered. How should we analyze this company? Obviously with 31% of its loan portfolio classified as Non-Performing, this company is definitely risky. We have to wonder about its underwriting standards. On the other hand, I must also highlight that the company has a 78% equity cushion and that one is buying that equity cushion at 50 cents on a dollar. Is that worth the risk?
I've been attempting to answer that question by trying to find mortgage loan default rates in British Columbia, Ontario and the Canadian Prairies. I've not been successful. If anyone out there knows of relevant data, please please email me at shaunhhh@gmail.com. Thanks.
Monday, July 27, 2009
NCTY Part 2
I wrote about The9 Limited (NASDAQ: NCTY) last week. I'd just thought I'd give you a update on what I've found after more in-depth research.
1. Investment Thesis
The investment thesis for shorting NCTY is this: NCTY's main business is World of Warcraft (WoW) in China. It recently lost its license to run the game in China. It is spending its remaining cash position to develop new games to generate new revenue. I believe that that is unlikely to occur for the following reasons:
A. These games are very very complex and difficult to program. They take years to build. You can't do it on the fly, burning cash and under pressure from the market to deliver revenue. As it is, most computer games are only delivered years past originally promised completion dates and are notoriously buggy. And for them to have the game gain wide acceptance would take years because consumers need to get accustomed to the game, slowly explore it and recommend it to their friends.
B. They simply don't have the technical capability. NCTY's original function was as a server platform for WoW. They didn't add new functions to the game ie they are not game developers. They wouldn't exist if not for the Chinese gov insistence on having a local entity run these computer games. Blizzard sells WoW to the rest of the world directly without a 3rd party intermediary.
2. Financials
WoW's financial position is actually quite good right now. They are sitting on a US$ 315.5M cash pile right now. Plus US$42M in investments in 4 companies, 9Webzen HK, Object Software, Sunmi Rise and Ideas. The Company invested US$ 3.5M in preferred and common shares in Ideas (a Korean online game developer). NCTY wrote down the US$ 2.1M that they invested in the preferred shares to 0. The Company also invested in a college called Shanghai Institute of Visual Arts (SIVA) a sum of US$1.5M. Their total assets stand at US$ 478.3M as of 31 Dec 2008.
3. Pricing & Valuation
Having said all this, I'm waiting for a rally to around $12 to short the stock. At $8, there is not enough of a margin of safety. The stock did rally to $12 around June for some odd reason. (The announcement for the loss of license was in April.) At $8, their market cap is at USD$240M, which is a 24% discount to their cash value. At $12, their market cap is USD$360M. There is no discount to their cash value and gives us the necessary margin of safety to short the stock.
Extra Data
1. WoW China consists of about 5 million subscribers. The total WoW subscriber base is more than 11.5 million. That means China accounts for about 43% of WoW's subscriber base.
2. NCTY's founder Jun Zhu owns 39.6% of the outstanding stock of NCTY either directly or indirectly as of 31 Dec 2008 from his 13G filings. It is uncertain as to whether he has been selling his stock because the SEC does not require foreign issuers to fill in Form 4s.
3. The reason for the move from NCTY to NetEase is because NetEase agreed to better royalty terms with Blizzard. Wedbush Morgan analyst Michael Pachter thinks that the switch from The9 to NetEase was done for primarily financial reasons: While Blizzard has an estimated 22% royalty rate for WoW income in their partnership with The9 (about 50-55 million USD annually), analysts are predicting that the NetEase agreement would come with royalties of at least 55% - resulting in annual revenue of more than $140 million every year. So switching to NetEase puts approximately $90 million more in Blizzard's pockets every year.
4. The WoW swap from NCTY to NetEase has not been smooth. As of June 7, 2009, WoW has been down in China. It continues to be unavailable in China as of today. There has been rumors that a Beta version of it will be available to existing users July 30, 2009. It is estimated that this will cost Blizzard between US$10 to US$15M.
In my opinion, Blizzard swapping to NetEase is a greed call. They should know that moving from one server to another is always a messy process. For an increase in profits, they cut off more than 43% of their subscriber base for more than 2 months! What are they thinking?! Lost profits aside, they could potentially lose subscribers. Unlike the rest of the world, WoW users in China can play WoW through a prepaid card system. So they are not stuck with a useless monthly subscription. They could easily walk away from the whole thing.
Furthermore, since Blizzard constitutes 91% of NCTY's revenue, I'm sure they could ask for an increase in royalties. I don't quite know what occurred in the negotiations between NCTY and Blizzard. All in all, this is a real big mess.
Hopefully, at least some people can benefit out of it!
1. Investment Thesis
The investment thesis for shorting NCTY is this: NCTY's main business is World of Warcraft (WoW) in China. It recently lost its license to run the game in China. It is spending its remaining cash position to develop new games to generate new revenue. I believe that that is unlikely to occur for the following reasons:
A. These games are very very complex and difficult to program. They take years to build. You can't do it on the fly, burning cash and under pressure from the market to deliver revenue. As it is, most computer games are only delivered years past originally promised completion dates and are notoriously buggy. And for them to have the game gain wide acceptance would take years because consumers need to get accustomed to the game, slowly explore it and recommend it to their friends.
B. They simply don't have the technical capability. NCTY's original function was as a server platform for WoW. They didn't add new functions to the game ie they are not game developers. They wouldn't exist if not for the Chinese gov insistence on having a local entity run these computer games. Blizzard sells WoW to the rest of the world directly without a 3rd party intermediary.
2. Financials
WoW's financial position is actually quite good right now. They are sitting on a US$ 315.5M cash pile right now. Plus US$42M in investments in 4 companies, 9Webzen HK, Object Software, Sunmi Rise and Ideas. The Company invested US$ 3.5M in preferred and common shares in Ideas (a Korean online game developer). NCTY wrote down the US$ 2.1M that they invested in the preferred shares to 0. The Company also invested in a college called Shanghai Institute of Visual Arts (SIVA) a sum of US$1.5M. Their total assets stand at US$ 478.3M as of 31 Dec 2008.
3. Pricing & Valuation
Having said all this, I'm waiting for a rally to around $12 to short the stock. At $8, there is not enough of a margin of safety. The stock did rally to $12 around June for some odd reason. (The announcement for the loss of license was in April.) At $8, their market cap is at USD$240M, which is a 24% discount to their cash value. At $12, their market cap is USD$360M. There is no discount to their cash value and gives us the necessary margin of safety to short the stock.
Extra Data
1. WoW China consists of about 5 million subscribers. The total WoW subscriber base is more than 11.5 million. That means China accounts for about 43% of WoW's subscriber base.
2. NCTY's founder Jun Zhu owns 39.6% of the outstanding stock of NCTY either directly or indirectly as of 31 Dec 2008 from his 13G filings. It is uncertain as to whether he has been selling his stock because the SEC does not require foreign issuers to fill in Form 4s.
3. The reason for the move from NCTY to NetEase is because NetEase agreed to better royalty terms with Blizzard. Wedbush Morgan analyst Michael Pachter thinks that the switch from The9 to NetEase was done for primarily financial reasons: While Blizzard has an estimated 22% royalty rate for WoW income in their partnership with The9 (about 50-55 million USD annually), analysts are predicting that the NetEase agreement would come with royalties of at least 55% - resulting in annual revenue of more than $140 million every year. So switching to NetEase puts approximately $90 million more in Blizzard's pockets every year.
4. The WoW swap from NCTY to NetEase has not been smooth. As of June 7, 2009, WoW has been down in China. It continues to be unavailable in China as of today. There has been rumors that a Beta version of it will be available to existing users July 30, 2009. It is estimated that this will cost Blizzard between US$10 to US$15M.
In my opinion, Blizzard swapping to NetEase is a greed call. They should know that moving from one server to another is always a messy process. For an increase in profits, they cut off more than 43% of their subscriber base for more than 2 months! What are they thinking?! Lost profits aside, they could potentially lose subscribers. Unlike the rest of the world, WoW users in China can play WoW through a prepaid card system. So they are not stuck with a useless monthly subscription. They could easily walk away from the whole thing.
Furthermore, since Blizzard constitutes 91% of NCTY's revenue, I'm sure they could ask for an increase in royalties. I don't quite know what occurred in the negotiations between NCTY and Blizzard. All in all, this is a real big mess.
Hopefully, at least some people can benefit out of it!
Sunday, July 26, 2009
Psychology
Hi,
I've just been reading a lot about psychology, especially in the context of the markets.
http://www.newyorker.com/reporting/2009/07/27/090727fa_fact_gladwell?currentPage=all
The above article by Malcolm Gladwell, talks about how the older and more experienced we get, we overate the accuracy of our judgments. Specifically, he focused on Jimmy Cayne and how he was overly confident and led to the downfall of Bear Stearns.
I've also been reading Contrarian Investment Strategies by David Dreman. There he talks about how analysts tend to psychologically be unable to handle configural/ interactive processing of information. Configural processing of information is processing information with multiple variables which are interdependent and have unknown and unstable relationships with each other. Thus they have a really difficult time coming up with accurate earnings forecasts. Also, how analysts are overly confident with regards to their forecasts, even though statistics show how inaccurate they are. They keep insisting that this time will be different. Or how they didn't have enough information or made some mistake along the way. Dreman suggests that it's not that we don't have enough information. It's the opposite, we have too much. Humans just aren't able to process all that data and come up with an accurate prediction.
Next comes The Psychology of Human Misjudgement by Charlie Munger. It's a paper that Mr Munger writes about human cognitive biases and how they affect our ability to assess different situations.
Finally, Margin of Safety by Seth Klarman, where he talks about humans continually insisting on assessing risks of securities by their past rates of returns/ default rates. We just somehow don't understand the concept that "Past performance is no guarantee of future returns". This line is constantly written in every single prospectus out there but we just don't get it that the past is no guarantee for the future. The future is dynamic and constantly changing.
The most curious thing I found in Margin of Safety was when Mr Klarman talks about CBOs (Collateralized Bond Obligations) and how they were able to convince the rating agencies to give Triple A ratings to 75% of the structure. Basically, CBOs are securitized junk bonds. Doesn't this seem familiar? Doesn't it remind you of the Collateralized Mortgage Obligations (CMOs) and the Collateralized Debt Obligations (CDOs) from our recent past? They spun the same trick of getting the ratings agency to rate most of the structure as triple A as well. The question is how did we manage to fall for the same trick over again? Come on, they barely changed the name! We really don't learn, do we?!
My main worry is this how can I overcome the problems with my cognition?! It's part of me. I can't change it. Worst of all, I don't know where my limits lie. Or when my brain is failing me or it's just simply I didn't do enough homework on the investment. I guess there is no answer as to where our limits lie and how much we should trust our judgment in any given situation. The flip side of the coin is analysis paralysis. We just have to admit that there are some situations where we simply don't/ can't know about - the Unknown Unknowns - as Mr Rumsfeld so eloquently puts it. Guess this makes the game all the more interesting eh?
I've just been reading a lot about psychology, especially in the context of the markets.
http://www.newyorker.com/reporting/2009/07/27/090727fa_fact_gladwell?currentPage=all
The above article by Malcolm Gladwell, talks about how the older and more experienced we get, we overate the accuracy of our judgments. Specifically, he focused on Jimmy Cayne and how he was overly confident and led to the downfall of Bear Stearns.
I've also been reading Contrarian Investment Strategies by David Dreman. There he talks about how analysts tend to psychologically be unable to handle configural/ interactive processing of information. Configural processing of information is processing information with multiple variables which are interdependent and have unknown and unstable relationships with each other. Thus they have a really difficult time coming up with accurate earnings forecasts. Also, how analysts are overly confident with regards to their forecasts, even though statistics show how inaccurate they are. They keep insisting that this time will be different. Or how they didn't have enough information or made some mistake along the way. Dreman suggests that it's not that we don't have enough information. It's the opposite, we have too much. Humans just aren't able to process all that data and come up with an accurate prediction.
Next comes The Psychology of Human Misjudgement by Charlie Munger. It's a paper that Mr Munger writes about human cognitive biases and how they affect our ability to assess different situations.
Finally, Margin of Safety by Seth Klarman, where he talks about humans continually insisting on assessing risks of securities by their past rates of returns/ default rates. We just somehow don't understand the concept that "Past performance is no guarantee of future returns". This line is constantly written in every single prospectus out there but we just don't get it that the past is no guarantee for the future. The future is dynamic and constantly changing.
The most curious thing I found in Margin of Safety was when Mr Klarman talks about CBOs (Collateralized Bond Obligations) and how they were able to convince the rating agencies to give Triple A ratings to 75% of the structure. Basically, CBOs are securitized junk bonds. Doesn't this seem familiar? Doesn't it remind you of the Collateralized Mortgage Obligations (CMOs) and the Collateralized Debt Obligations (CDOs) from our recent past? They spun the same trick of getting the ratings agency to rate most of the structure as triple A as well. The question is how did we manage to fall for the same trick over again? Come on, they barely changed the name! We really don't learn, do we?!
My main worry is this how can I overcome the problems with my cognition?! It's part of me. I can't change it. Worst of all, I don't know where my limits lie. Or when my brain is failing me or it's just simply I didn't do enough homework on the investment. I guess there is no answer as to where our limits lie and how much we should trust our judgment in any given situation. The flip side of the coin is analysis paralysis. We just have to admit that there are some situations where we simply don't/ can't know about - the Unknown Unknowns - as Mr Rumsfeld so eloquently puts it. Guess this makes the game all the more interesting eh?
Thursday, July 23, 2009
GGP Valuation
Hi, I just ran a valuation table. My estimate of 2008's NOI is around $2,100M. Ackman has the NOI figure around $2,500. At around $2,100M NOI, the valuation of the firm ranges from $35,000M to $26,250 depending on the cap rate. GGP being a REIT won't want to emerge from this too highly leverage 'coz of the mandatory 90% payout of all earnings, making it really hard to build new equity. Assuming that it comes out with 35% equity and 65% debt as its new capital structure, that would mean that it has to have a cap rate of 5.0% and a Enterprise Value of $42,000M. I think these figures show that Ackman has a rather optimistic point of view of GGP.
Another thing, occupancy rates in terms of commercial property have been continually falling. That should not come as a surprise given the level of unemployment and falling consumption by the general population. All my NOI calculations assume that NOI is stable and does not fall in the interim. Even that might be an overly optimistic assumption.
Although the long term debt stands at $24.3B, the total liabilities stand at around $27.3B. I believe that total indebtedness is a better yard stick than just pure long term debt. 'coz any debt/ liabilities come ahead of equity.
Given my conservative estimates, I don't believe that there is an adequate margin of safety with GGP common stock. I guess I'm going to pass on this one.
Subscribe to:
Posts (Atom)
