13 May 2008 – The Aleph Blog

Losing Money is Part of the Game (Part II)

Posted on 13 May 2008 by David Merkel

Continuing on, here are losses six through ten:

Dana Corp

In some ways, this one was pure slop on my part.? In September 2005, I thought the setback in Dana’s auto parts business was temporary, and bought a little more.? After the second dose of bad news, I looked at the statements afresh and kicked myself.? How could I have missed the growing negative divergence between earnings and cash flow?? I waited a few days for a rally, and sold.? As it was, Dana filed for Chapter 11 in March 2006.? This could have been a lot worse for me.

		David Merkel
		Dana Files Chapter 11
		3/3/2006 2:19 PM EST

How much can you lose on a $7 stock? Seven dollars. Dana (DCN:NYSE) just filed for bankruptcy, and trading is temporarily suspended. I think the common will get wiped out, so any long trades here are purely speculative. Unsecured debt is trading in the high $60s, so they look like they are the new owners of the company (but that’s just a guess).

Just another reason to not be afraid to take losses when you make a mistake. Same for PXRE Group (PXT:NYSE), which has continued to fall since my sales.

Don’t be afraid to take losses, if you know the situation is worse than the current price would indicate.

The common was wiped out when Dana recently emerged from bankruptcy in February of this year.? PXRE made out better, merging with Argonaut.

National Atlantic Holdings

I’ve written more than my share on NAHC, and for the good of my readers, probably too much.? Perhaps this one might be a good example of taking time to accumulate a position.? My average cost is $6.67, which means that if the deal goes through at $6.25, this isn’t one of my ten largest losses.? Tentatively, though, I plan on filing for appraisal rights if the deal goes through.

Consider the 1Q08 earnings conference call on Monday:

Operator:
And we have a follow up from David Merkel with Finacorp Securities.

<Q – David Merkel>: Hi.? Sorry to trouble you, one follow up. It’s basically the questions I asked on the last call.? Your loss reserves, there’s nothing there in terms of future development that should have been reflected in the first quarter that isn’t there in the statements, and your bonds are stated at their fair market value to the best of your knowledge.? You’ve got a high-quality portfolio there.

<A – Frank Prudente>: Yes we do, David.? This is Frank Prudente. I’ll take the second part of your question first if you don’t mind.? Our portfolio remains to be very conservative and very high quality.? With the implementation of the new accounting standard we’re at Level 2 two for all of our available for sale securities.? So we continue to feel very comfortable about our investment portfolio.? And as Bruce alluded to earlier, we do a comprehensive actuarial analysis every quarter which is further validated by the review performed by our external auditors each and every quarter.? And what I can tell you is we base our estimates of loss and loss adjustment expense reserves based on all of the most relevant data we have available to us for each and every financial statement close process.

<Q – David Merkel>: Thanks, Frank. I appreciate that. Take care.

What that may mean to the court is that twice after the announcement of the merger, they publicly stated that their most variable assets and liabilities were correctly and conservatively stated on their balance sheet.? That means anyone receiving much less than book is not getting fair compensation.? This one is not over yet; I may get out of this one with a gain.? :(? (Dreamer…)

My failure here was not carefully evaluating the management team, and rely on my usual benchmark that a short-tail P&C company earning money, and trading below book is a good deal.

Vishay Intertechnology

I am still invested in Vishay.? It earns money, generates free cash flow, debt is being reduced, and the balance sheet looks decent.? The sorts of electronic components that they make will be difficult to make obsolete.? I still like the name; I don’t think this one will be a loss for me in the end.

Tellabs

Tellabs looked cheap and got cheaper.? Almost every small tech company was getting thrown out; valuations reached record low levels by the end of third quarter 2002.? Tellabs had disappointment after disappointment, and I concluded that if it couldn’t earn money, the book value was overstated.? I sold, and bought stocks that I thought have more promise.

That said, my rebalancing discipline allowed me to reduce the overall losses from this volatile stock.? I didn’t lose nearly as much as a buy-and-hold investor would have.

Deutsche Bank

This was a failure to integrate my overall markets view, and allowing short-term valuation issues to dominate my decision.? I thought the investment banks wouldn’t do well, but I thought Deutsche Bank might escape the troubles.? Well, I was wrong.? European institutions mimicked Wall Street to a higher degree than most would have expected.

My last buy was a rebalancing buy, but as results came in from other European banks, I ended up selling Deutsche Bank, and RBS as well.? Time will tell how smart that was… the investment banks of our world are tied together through counterparty exposure — to a degree, they succeed and fail as a group… that’s why the Fed bailed out Bear Stearns.

Summary of Part II

I’ll repeat what I said in part one, and add a little.

Don?t play with companies that have moderate credit quality during times of economic stress.
Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
Spend more time trying to see whether management teams are competent or not.
Cut losses when your estimate of future profitability drops to levels that no longer justify holding the asset.

The next two articles in this series will be about investments that went right.? They should come soon.

Full disclosure: long NAHC VSH

Losing Money is Part of the Game (Part I)

Posted on 13 May 2008 by David Merkel

I’ve been debating in my mind how I would write this piece. In the end, I just decided that I would tell it plain. Part of investing is losing money. There is a connection between willingness to lose money in the short run, and ability to make money in the long run. My experience has been that if you don’t take the risk of losing significant money, you don’t make significant money. Another way of saying it is that if you don’t blow one up every now and then, you’re not taking enough risk.

With that introduction, let me present my 10 worst losses since starting this strategy 7.7 years ago, beginning with the worst, and moving to progressively lesser losses. These ten losses comprise 55% of the total dollar value of losses since I started this strategy.

Deerfield Capital

What can I say?? My original thesis was that Deerfield was a mortgage REIT that did it right.? In spite of my negative real estate views, I did not think that the risk would extend all of the way to prime mortgage and Alt-A (no stated income) collateral.? Alas, my training as an actuary should have told me to avoid companies dependent on market confidence to maintain financing.? As the repo haircuts rose, free assets diminished, aand they had to collapse their balance sheet.? My main mistake was thinking that repo haircuts couldn’t get that high.? I was wrong. I finally sold when I thought the likelihood of insolvency was significant.

YRC Worldwide

I got in this one too early.? My industry models sometimes flash “cheap” when things will get cheaper.? Sometimes I have the sense to remember that.? This time I didn’t.? YRC has more debt than I would like, but it has a huge amount of upside when the economy turns.? Waiting for that turn could be fatal, but I continue to do so.? One other note: for the remainder of this piece — where my graphs say exit, it does not mean sale. For companies that I still owned at 4/30/2008, I market them down as “exited” because that is where my calculations end.

The jury is out on this one.? As with all of my investments, I try to analyze a company versus its likely future prospects.? I don’t care a lot about the past, I just try to analyze current price versus future prospects.? My estimate of future value warrants continued inclusion in the portfolio.

Dynegy

Catch a falling knife?? When there is fraud, I give other investors a pass.? As for me, I should have known better.? Cash flow was light relative to earnings — not a good sign.? Another warning sign ignored: avoid managements that are self-absorbed.? Dynegy and their investment banks had to kick in to fund a settlement.? (Note: it is only worth going through the settlement process when a deep third pocket gets tagged.? Most fraud cases are broke, and only the lawyers do well.)

I’m afraid that friends influenced me here; a number of people in my investment department owned Dynegy, and when I bought, e comment was “Welcome to the Dark Side.”? Dark? — better to say red ink. I can’t prevent being taken in by fraud, but I can minimize it if I focus on companies with strong cash generation.? It’s hard to fake free cash flow.

Jones Apparel Group

Again, my industry models flashed “Cheap” too soon.? Everything depends on whether Jones can turn their operating businesses around.? I think they have a chance, and given the recent sale of one of their subsidiaries, there is enough cash.? That said, I tend to worry when debt levels verge on high, and the debt maturities are near.? There is a new CEO, who was the old CFO.? At present, I still think there is value here, but I will take my loss before the end of 2008 if earnings results don’t turn.

Cable & Wireless plc

One of my ways of trying to make money is to buy strongly capitalized companies in an industry that is having troubles.? Well, the strength of C&W’s balance sheet was overstated; there was a bit of a fraud issue there.? And, I should have listened to Cody Willard, who e-mailed me before we really knew me, and said something to the effect of, “Yeah, they have a balance sheet, but no good businesses.? Can’t make money with that.”

Part I Summary

Every loss is stupid in hindsight.? We all get tempted to say “woulda, coulda, shoulda.”? But the same principles that led to my losses also led to my greatest gains.? Two articles from now in this series, I’ll go over those.? But it is best to lead with failure… we learn far more from our failures than our successes.? What are my lessons here?

Don’t play with companies that have moderate credit quality during times of economic stress.
Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
Spend more time trying to see whether management teams are competent or not.

I’ll see if I can’t do better on these concepts in the future.

Full disclosure: long YRCW and JNY