Aswath Damodaran: What Is Private Equity All About? (#investing, #PrivateEquity)

NYU Stern corporate finance professor Aswath Damodaran has a good summary of the types of private equity investors that exist in the financial markets, how they add value through their corporate activism and what motivates them on his blog in “Private Equity: Hero or Villain?“:

Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially.

Overall, a useful post for anyone looking to understand the basics of private equity, just don’t pay too much attention to his naive suggestion that the political problem facing this country is potentially just “mismanaged” government.

What’s The Yield On Saudi Prince Alwaleed’s “Strategic” Twitter Investment?

Saudi Prince Alwaleed bin Talal has made a $300M “strategic” investment in Twitter, according to Bloomberg.com:

Alwaleed, who leads the 2011 Arab Rich List, and his investment company agreed to buy a “strategic stake” in Twitter, Kingdom Holding said today. A strategic holding means more than 3 percent, Ahmed Halawani, a Kingdom Holding director, said in an interview. That would give the San Francisco-based company a valuation exceeding $10 billion.

Alwaleed is described by Bloomberg as a businessman and an investor. But Alwaleed is a politician, not a businessman– he is a member of the Saudi royal family, and his capital and wealth are continually generated by the Saudi royal family’s political control over Saudi oil fields. Similarly, Alwaleed is an “investor” in businesses like Citi and Twitter in the same sense that the CIA “invested” in Google and Facebook– for information and for control, not for economic or financial profit.

If this is a challenging view to accept, let’s consider just this recent purchase of his Twitter stake from insiders. According to the article, an industry research group recently cut their forecast for Twitter’s 2011 ad revenue from $150M to $139.5M. What kind of value multiplier did Alwaleed “invest” in if he paid $300M for more than 3% of the company which is now valued at over $10B?

Let’s give Alwaleed the benefit of the doubt and say that Twitter’s 2011 ad revenue comes in at $150M. Let’s further assume that Twitter is a highly profitable company and 30% of their revenues drop down to the bottom line and become net profit. That’s $45M of net profit in 2011.

At a $10B market cap, Alwaleed’s investment was made at 66.6x Price-to-Revenues and 222.2x Price-to-Earnings. I should hope I don’t need to do the math for you to show what kind of growth expectations you have to factor into those ratios for them to make sense.

Now, ask yourself, have you ever heard of the “Best Investor In the Universe”, Warren Buffett, investing in companies at these kinds of multiples? Ask yourself, what kind of margin of safety does Alwaleed have here when paying so much for so little. Ask yourself, is it a credible idea that Alwaleed is truly a successful businessman and investor who has managed to grow his personal fortune to $19.6B (according to Wikipedia) since 1979 by investing at such high multiples?

Alwaleed “is a savvy investor and the hot thing in the IT world is social networking,” said Nabil Farhat, a partner at Abu Dhabi-based Al Fajer Securities.

Historically, how do even “savvy investors” fare investing in the latest “hot thing”?

As hinted at earlier, there is a more reasonable explanation for why Alwaleed invested in Twitter, why he has invested in Citi and News Corp., and why he invests in almost anything– Alwaleed is part of a political front and he makes investments as part of a political agenda. Politics is not an economically efficient system, it cares not for scarcity and cost in the economic sense of productive effort and opportunity cost. Political systems get their revenues from coercion, and they use economic resources as but another means to their arbitrary political ends.

Why did Alwaleed invest in Twitter? Because Twitter played an embarrassing role in the recent “Arab Spring” of revolutionary fervor across the Middle East this year and Alwaleed and his sponsors want to be in a position which allows them the knowledge and influence of the insider, of control. This is what is meant by the savvy Mr. Alwaleed’s “strategic” investment in a not-so-profitable social media favorite.

Why did Alwaleed invest in Citi? Because Citi is a centerpiece to the financial chicanery involving the global drug trade controlled by the CIA, the power-politics of world political intrigue and espionage and the dangerous, corrupt game of arms dealing and the financing of imperial military adventurism.

Why did Alwaleed invest in News Corp.? To control the news!

Let us not confuse legitimate businessmen and investors with political operatives and speculators any longer!

Flight Of The Permabulls?

Legg Mason’s Bill Miller, famous for being permabullish during the entirety of the world’s largest bubble of all time (essentially his whole career, when he kept catching his one card straight draw on the river with bailout after Fed-engineered bailout over and over again), is finally calling it quits (Bloomberg):

Bill Miller, the Legg Mason Inc. (LM) manager famous for beating the Standard & Poor’s 500 Index for a record 15 years through 2005, will step down from his main fund after trailing the index for four of the past five years.

Miller, 61, will be succeeded by Sam Peters as manager of Legg Mason Capital Management Value Trust (LMVTX) on April 30, which is the 30-year anniversary of the fund, the Baltimore-based firm said today in an e-mailed statement. Miller will remain chairman of the Legg Mason Capital Management unit while Peters will be chief investment officer.

Miller, a value investor known for his bullish views of the economy and stock markets, became mired in the worst slump of his career as he wagered heavily on financial stocks during the 2008 credit crisis. Value Trust lost 55 percent that year as the S&P 500 dropped 37 percent, including dividends, prompting a wave of withdrawals. The fund’s assets have plunged from a peak of $21 billion in 2007 to $2.8 billion.

Bill Miller is a living example of selection bias at work. Notice what happens when his coin-flipping strategy of “heads” stops working.

We’ll likely see more announcements like this from other “top stock pickers” of the past few decades in the coming months and years. Good riddance!

Whitney Tilson’s Terrible, Horrible, No Good, Very Bad Investment ($NFLX)

Whitney Tilson, famed value investor and manager of T2 Partners, has had a tumultuous and sordid affair with NFLX, a company he first failed to romance as a spectacular ever-rising short and which he now may very well fail to romance as a spectacular ever-cheapening long (Bloomberg):

Tilson had bet against Netflix from at least December, when he first wrote about shorting the stock, until February, when he disclosed to investors in a letter that he covered the short and was no longer confident that his investment thesis was correct. Tilson said he decided to buy shares today because he deemed them “cheap.”

“It’s been frustrating to see our original investment thesis validated, yet not profit from it,” Tilson, 44, said in a statement e-mailed from his New York hedge fund. “The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Netflix plunged 35 percent to close at $77.37 in New York trading, its biggest drop since Oct. 15, 2004. The shares have declined 56 percent this year.

This is every investor’s worst nightmare and I am not calling attention to this to slander or heap ridicule on Tilson. Far from it– I don’t know if I’d have the cajones to go long a stock (at nearly 18x earnings) that I was previously trying earnestly to short.

That being said, let’s review this performance. If he started shorting in December he probably did it around $165-170/share. If he covered in February it was probably anywhere from $205-220/share. Let’s say $165/share short and $210/share cover. That’s a 27% loss.

The good news is the stock went as high as approximately $298/share, so he dodged that bullet. But then it plunged dramatically since then and is now trading at about $77/share. Assuming Tilson had just held his short (and kept making margins calls, or better yet, kept adding to it), he would’ve ultimately made a 53% gain!

What’s interesting about this? One, it would’ve taken Tilson nearly a year to be vindicated in his thesis. Value investors typically think of themselves as “long-haul” capital allocators. But in the world of shorting, time scales are compressed and a period like a year is more like a decade. A lot more seems to change. The moral of the story, perhaps, is to focus on shorts where you have identified an immediate, short-term catalyst that will cause the market to abandon its effort to push the stock higher. Simply recognizing a stock is overvalued doesn’t appear to be robust enough.

Two, investor psychology appears to be completely different between shorts and longs and with good reason. With a long, many value investors (like Tilson) invite the position to go against them, at least temporarily, rationalizing that this just makes it cheaper and easier for them to make money when their investment plays out. But with a short, where your potential loss is infinite, no investor ever has nor I assume ever will invite the position to go against them. Nobody ever says, “I hope the stock rises substantially from here because it just means another opportunity to short it more and make more money when it finally crashes.” Instead, many end up throwing in the towel, often at the worst possible moment.

Three, this episode demonstrates the need for humility. It’s possible Tilson will eventually make a good bet with his decision to go long NFLX. But if he doesn’t, he’s going to look doubly foolish, rather than singly. And, because he’s had a poor experience with this company once before, he risks making rash, emotional decisions about it in the future out of a subconscious effort to conquer his fear or slay the wild beast that marred him in battle once before.

If I was a big T2 investor, I’d be wanting to know what kind of safeguards Tilson and his team have put into place to prevent emotional bias from getting in the way of their analysis of NFLX going forward. And frankly, I’d have a hard time fighting my urge to tell Tilson to just leave the damn thing alone and reminding myself that I invest with him because I trust his judgment and if I were the expert I wouldn’t be paying him to manage part of my wealth.

The good news is Tilson is an experienced, grizzled value investor with an outstanding track record so even if he ends up totally boffing this one again it’ll likely be far from his undoing. For every potentially poor decision like this Tilson has demonstrated he can make many more superior ones and he doesn’t make the kind of levered, concentrated bets that could lead to a one-position wipeout that some of the less savvy figures like John Paulson have suffered in recent months.

Say what you will about value investors but one thing is for sure, they’re generally more prudent than the average bear, and I mean that metaphorically, not descriptively. Then again, this whole episode makes me wonder how Tilson defined his risk, then and now.

One Consequence Of Law Divorced From Economic Scarcity: $308MM Death Sentences

This latest travesty of criminal and economic justice courtesy of The Atlantic:

Their report showed that since the current death-penalty statute was enacted in 1978, [California] taxpayers have spent more than $4 billion on only 13 executions, or roughly $308 million per execution. As of 2009, prosecuting death-penalty cases cost upwards of $184 million more each year than life-without-parole cases. Housing, health care, and legal representation for California’s current death-row population of 714—the largest in the country—account for $144 million in annual extra costs. If juries continue to send an average of 20 convicts to San Quentin’s death row each year, and executions continue at the present rate, by 2030 the ranks of the condemned will have swelled to more than 1,000, and California’s taxpayers will have spent $9 billion to execute a total of 23 inmates.

Law and the legal system is part of the economy, that is, it falls under it, not outside of it. The law is a means to a particular end (justice). It is irrational to turn the means (law) into an end itself by placing it outside the economic calculation nexus. When you do, the result is arbitration and punishment costs which far exceed any reasonable estimate of the actual damage the convicted has caused along with the potential settlement cost of future torts following a potential “vigilante” solution to the problem.

Value Idea: Japanese Net-Nets

Japan seems awfully cheap these days:

A study made under the authors’ direction (covering some 3,700 stocks traded on the Japanese exchanges), found 512 stocks selling for less than net current asset value (includes long-term investments) and 212 selling below ⅔ of net current asset value (Graham’s famous “66% net-net” threshold). Equally interesting, 763 of the businesses were selling for less than cash plus short and long term marketable securities. Suffice it to say, there are large parts of the Japanese market selling for extremely cheap.

Based on the studies previously referenced, we would anticipate this basket of cheap Japanese stocks to similarly outperform the market indices. If the 30 businesses were afforded a modest multiple (8-times earnings before interest and taxes) + net cash, similar to what businesses typically sell for in private-party transactions, the average valuation for the 30 businesses would be $191 million vs. a market-cap-inferred-price of $86 million. You’re theoretically getting $191 million worth of private-party businesses for the public market price of $86 million. This represents a tremendous upside potential when the market’s sentiments toward Japan become normal again– offering a handsome potential reward for those brave enough to test their resolve in the face of threatening headlines.

Individual securities can be attained through most brokerage houses without too much fuss. Although the trading costs can be steep (we’ve paid $100 per trade through one of the bigger name houses), we feel the potential upside justifies the transaction costs, depending on the size of your portfolio. For smaller amounts of money and certainly increased liquidity, WisdomTree’s Japan SmallCap Div Fd ETF (NYSE:DFJ) may be a good way to participate in Mr. Market’s mispricing of Japan. Although the DFJ is not as cheap as a readily-attainable basket of individual stocks (Price-to-Book of ~.77 vs. much less), the liquidity and diversification is quite attractive.

I like the idea of investing in Japan. It’s strongly within the econo-legal orbit of Western countries and Western attitudes toward law and commerce. There is definitely fraud and corruption, as there is anywhere in the world, but it’s probably less worrisome in Japan than it is in a place like neighboring China.

The challenges to investing in Japan are:

  1. Cost of trading
  2. Language barriers in studying company publications
  3. Convenient access to reliable market data
I am not sure how affected Japan will be by a China slowdown. I am not sure how much a person should worry about the fact that many of these Net-Nets appear to be in the engineering and construction consultancy business– this was an area that was a focus of corruption and overspending during the boom years in Japan and it’s questionable how many of these businesses are kept alive now or in the future by political connections.

Finally, at some point Japan is going to have a day of reckoning related to their massive government debts. For the average Japanese business with earning power and some growth prospects the implied inflationary solution to that problem seems like a tailwind. But for a Net-Net with no real exciting business prospects and a lot of cash on the balance sheet, that seems like it could destroy a lot of value, if anything.

Austrian economist Gary North insists that won’t happen, but I’m not sure what will take place instead.

The best strategy, were someone to attempt to take advantage of this scenario and these low prices relative to net current assets, would probably be to build some kind of a basket of the best of the best, as the author suggests.

I read a good article by Geoff Gannon on How to Pick Net-Nets, and he argues the main idea is to protect yourself from the downside, not to worry about the upside, when it comes to Net-Nets. He says the main risks to look out for are:

  1. Fraud
  2. Solvency
  3. Ownership dilution
I’m going to keep my eye on the Japanese NCAV situation, but for now it might be cheapest and easiest for me to find a few issues in the US, first. Meanwhile, I wonder what’s going on in Europe as far as Net-Nets go?

Exercises In Imagination

A friend sends along the following video:

Ignoring the pitch for Ron Paul’s political campaign at the end of it, that’s about as good as a libertarian video comes. The key is the identification of one moral standard for all people. It is hypocritical to expect any other person or persons to appreciate a “foreign policy” that you yourself would not appreciate if applied to you.

Here’s another good video about libertarian philosophy from Stefan Molyneux:

The reality of government financing is exploitation of its citizens. The people are not fully and fairly compensated for their labor as the exchange being made (via taxation) is not voluntary and deemed to be mutually beneficial.

I’d like to help produce more videos like these. I think YouTube is a powerful medium for spreading the message of individual liberty through the use of economies of scale.

Want To Lose Money In An Uninspired Way? Become A GM Investor

The UAW, which represents tens of thousands of GM hourly workers, has negotiated a base pay increase as well as an increased profit-sharing bonus, with the help of executive management (Bloomberg):

“When GM was struggling, our members shared in the sacrifice,” UAW Vice President Joe Ashton, who directs the union’s General Motors Department, said in a statement released last night. “Now that the company is posting profits again, our members want to share in the success.”

One Berkley “labor professor” (what the hell is that?) compared the compensation negotiations to economic stimulus:

“It’s an impressive agreement in a very tough economy,” said Shaiken, the Berkeley professor. “This agreement amounts to a stimulus package because it generates jobs and puts purchasing power into the economy.”

Question: why would anyone in their right mind want to be a GM shareholder?

Management has conspired with Marxist labor unions to increase hourly wages during a time period of general economic weakness, great challenges for the auto industry in particular and a near-death environment for GM specifically. Additionally, unionized factory employees are now being treated like they have capital-at-risk, when they do not. Factory employees don’t own or control GM capital and have nothing to do with intelligently or otherwise allocating that capital– it makes absolutely no sense that any entrepreneurial gains from the successful allocation of that capital should accrue to factory workers as some bargaining chip for securing their employment, especially when there are tens of millions of unemployed people looking for work in this country.

This is an odd inversion of the socialist principle of a divorce between costs and benefits.

To add insult to injury, the company has evidently become an auxiliary extension of the US government and its stimulus policy.

GM shareholders aren’t playing with fire, they’re standing outside the charred remains of a multistory apartment structure expecting to enjoy a high standard of living by moving in.

Abodeely: Discounting The Value Of Experience

JJ Abodeely, author of the Value Restoration Project blog, writes about a theme that deserves more attention– that experience isn’t always an advantage and may even be a disadvantage, particularly at times like today where there appears to be a paradigm shift underway:

Consider how many firms espouse the experience of their managers as a key selling trait. The idea that experience might actually be detrimental to returns is not one that the investment management industry is willing to promote. However, an intellectually honest assessment of the role of experience in driving investment decision-making and results is in the best interest of advisors, managers and clients alike.

Perhaps even more importantly, relying on experience often means relying on a cloudy, biased recollection where our “memory is not as much a factual recording of events as it is a perception of the physical and emotional experience,” as behavioral finance professor John Nofsinger teaches us. Focusing on exposure, on the other hand, frees us to think beyond what our experience allows for. Perhaps ironically, forsaking experience for exposure may allow for a greater respect for the rhythm of history with a more objective and long-term analysis.

In practical terms, most investors today are impaired by their experiences in the 1980s and 1990s. They lack a historical understanding of secular market cycles and valuation, the closest thing we have to a law of gravity in finance. Similarly, most economists, with their data-heavy analysis, lean almost exclusively on the post-war period when modeling how the economy should behave. Most economists, strategists, analysts and investors have not experienced debt-induced financial crises, de-leveraging global economies or the demographic headwinds we face today. Nor does anybody’s experience include the ways in which today’s world is unique from any other point in history and the ways in which tomorrow’s history is completely unwritten.