Tuesday, July 6, 2010

Interview with Seth Hamot of Roark, Rearden, & Hamot Capital Management

Seth Hamot, 48, is the founder and managing partner of Roark, Rearden, & Hamot Capital Management. His fund has over $150 Million under management, has performed well through 2-3 recessions, and returned an annualized 17% to investors net of fees.

The following is an interview to try and learn a little bit about his experience. As you read this, do remember that he has spent 15+ years building this investment fund and this interview cannot capture that, but hopes to bring a small portion to the public surface.

Dr. Sergio Magistri, who led a company through the dot-com bubble and exited with a large acquisition by GE also shares this thoughts on what happened. He led InVision Technologies, which turned out to be an amazing investment for Seth’s fund, and today, InVision’s products can be found in airports helping to prevent terrorism. With his input, we can analyze this amazing investment from the side of Seth and Sergio, both.

Seth Hamot – “…really great companies make errors, but they can move on. “

When did you launch your investment fund and what were you doing leading up to that?

RRH launched in the mid to late 90’s and prior to that, I was working with partners buying distressed and defaulted debt backed by real estate. I started doing that in 1989 and 1990. Prior to that, I was the President of College Pro Painters, a painting contracting company with a student labor force. I graduated college and since CPP was owned by a foreigner, and needed a local president and leadership, I was brought on board. It was going through financial distress, had no local leadership, and so I was brought in to turn it around. We went from $3 Million/year in revenue to $11 Million when I left. Shortly after, a real estate recession kicked and, and so I began looking for turnaround situations with distressed debt that could be bought. My partners from those ventures eventually retired and so I continued what I was doing into the public markets. We found poorly performing assets that were either too encumbered with too much debt or too little leadership, focusing on hard assets like real estate and mining assets.

What is your fund’s underlying approach? What wrong do you right in the markets?

I want to find companies going through a transition. Eventually, that transition will translate into others seeing that the company will be worth more than they originally thought. It might be divesting a cash burning division, or new credit facility, or maybe the company just did a merger or acquisition allowing the business model to be leveraged, etc. The objective is to NOT be an activist in these situations. There are a lot of great opportunities because really great companies make errors, but they can move on. We enjoy dealing with smart businessmen on a daily basis. Often times though, managers slowly become content to have a larger span of control and more remuneration. They change by rationalizing their business to make themselves better focused and more efficient and effective.

Where did you get your first 5 investors for your fund and how many are still with you today?

College roommates, families of college roommates, friends, my own money, etc.

What were the first 5 years of your fund like? How many employees did you have and what were some of the larger challenges?

It was a small fund and so picking investments was the main challenge. It was just myself initially. We took a very large position in a liquidating insurance company that lasted 2-3 years, but was very profitable because the markets misunderstood it entirely. It took a little bit of activism and at the end of it, I met someone, who introduced me to his own limited partners, and that’s where I brought in some fresh capital.  One of the joys there was that I met some great people who were also doing small cap value investing. Eventually I was introduced to a well-run fund of funds on the west coast. I was told that we made some great investments, but our documentation was on napkins and we used grid pads for calculations. We got a real lawyer, real documentation, put together information for investors, and then began to grow. From the original $2 Million that we started with, we had grown to somewhere around $15-20 Million, and then these guys came in. We’ve been successful in our performance with investors: Over the last decade, ended December 2009, we’ve returned 17% annualized, net of all fees.

The name of your fund has a very unique name – it has names of characters from the books of Ayn Rand. Can you tell us why you did this?

In general, we take a contrarian view. Doing it all the time is not contrarian and so this allows us to take investments from a unique vantage point.

What do you look for in an investment?

A perfect investment would be in a business that was once well covered by investors, analysts, raised a lot of money, etc. and then the company and industry went through a transformation and the stock trades very cheaply. Even after that, the underlying business itself makes sense and with some tough decisions, it can regain its value and it will right itself.

A simplistic example is a REIT that for some reason no longer pays its dividend, driving the stock price very low. It’s a hard asset business that won’t just disappear. If you can foresee the dividend coming back, it will get bought again for its yield eventually.

So if someone calls in and says, “I’ve got this REIT I want you to look at,” I’ll respond by asking, “Is it paying a dividend?” If the answer is yes, then I don’t care, but if the answer is no, then let’s talk!

How do you find your investments? Are they brought to you or do you screen for them?

We don’t use as many screens as our competitors – we look for situations of transition. We monitor a lot of announcements for spinoffs, acquisitions, divestitures, distributions and one-time dividends, etc. A good 1/3rd of our investments come from people who call about how they’ve lost a lot of money and they don’t understand why the equity is performing so poorly. They want information, but in another sense, they’re questioning whether an activist could help out. More often than not, present management and the board of directors will deal with the issues.

We don’t want to be activists, generally, but to the extent that we’re wrong that the CEO isn’t good, we have to do it. If it’s activism, it’s because the board or CEO is not reasonable.

When we are activists, we always say to CEO’s and board members that we see this (something specific) as a problem and that any reasonable businessman would see this as a problem. Reasonable owners, your shareholders, see this as a problem. “Why don’t you get in front of this and solve it?”

It’s only when they refuse to address the issue and completely ignore rational shareholders that we become activists. It’s not a case of them not being granted an opportunity to fix it.

Furthermore, when they stick to their actions – often to feather their own actions, they refuse to accept that we are the shareholders and owners of the business. Instead, they try to publicize that we are a “lesser class” of shareholder, a hedge fund.

One extreme example is a board that said they had a program in place to find new, more docile, shareholders. Instead of realizing value by spending time to follow suggestions, they were spending time on finding money and new bosses.

How long do you typically hold an investment for?

Our average investment period is well over a year, probably closer to a couple of years. I’m the chairman at TEAM, chairman at ORNG, both of which we have owned for over 4 years. Some of our other big positions are in the 3rd year of our ownership. We’re not traders and our investors see it by the tax bill – we’re not paying short-term taxes nearly as much as others.

Some of your investments are in pharmaceuticals or biotechs along with energy, mortgage processors, etc., how are you doing this?

We’re generalists and start digging into anything. If the problem is product based, we don’t dig into that. We’re focused on the business. If the company has successful products, but is spending too much on R&D, it’s a question of capital allocation.

We avoid biotech companies without significant revenues because we don’t have a take on science. At the same time, we don’t have any problem in investing in a pharmaceutical spending a lot on biotech, but already has successful drugs in the marketplace.

If there is a mismatch between capitalization and value of drugs that are already in the market, there will be a major discount to the market value of the company. A big discount points out that investors don’t value the R&D pipeline even though the drugs are kicking off a lot of cash.

How much do you care about where the overall markets are and where they are headed?

We used to not care at all, and through 2008, a lot of my competitors and I started to care very greatly. I don’t really pay all that much attention to it though, because I’m investing longer term than most, 2-4 years, and if they can turn a business around in 2 years, any 1 days headlines today won’t be the headlines 2 years from now.

Do you take long positions only or short positions as well? Is any of this as a hedge or do you look for companies with something that is fundamentally wrong when taking a short position?

We do take short positions, but we’re not nearly as good at them as our longs. We look for bad business models, too much leverage, and companies generally run for the benefit of senior management and board members. Shorts tend to go against us because whenever any activity continues, the investment community rates it highly. We’re not too good at anything other than when the debt comes due causing the company to reorganize or hand over ownership to the debt holders.

Your firm seems to be okay with small cap positions. Do you ever worry about a complete lack of liquidity that small caps will see whenever there’s a downturn?

Yes, we worry about liquidity. We think about it more today than 2 or 3 years ago because it is an issue and with many stocks that we used to get involved in, we will no long get involved in.

How do you manage and define risk?

We define risk as leverage – certainly not beta. Our only use of leverage will be used to trade around positions. That said, liquidity is the first coward and when liquidity dries up, you just have to put up with the bumpy road. There’s a desire to avoid volatility at all costs. The flip side is that you’re paying for it in liquidity. Our 17% annualized return partly comes due to an illiquidity premium. Neither the auditor nor the IRS makes us give back our excess return due to that though!

Your fund has lived through 2 or 3 economic downturns – which one were you most prepared for?

2000 Internet crackup. In 2002, when the S&P500 fell 22%, we were up almost 10%. These crises are very good for us, eventually. They’re not so good short term because we go through hell too. Just after it though, we tend to double and show over 100% returns. Leading up to the recent troubles, we were short on homebuilders and held CDS’s at one point, however gave those up on suspicions that the markets were rigged.

Do you ever notice that it’s easier to be right than it is to know when you’ll be proven right?

Yes, very much so. It happens in real estate quite a bit. You can buy a property one minute and then in the next minute, you can come up with a number for what it’s worth. Sometimes, it takes longer, and sometimes it’s shorter. This applies to stocks too – you know what it’s worth when you buy it, you have to wait though. We were investing 3-4 years ago and are still waiting for the investments to complete. We see how they will, but the markets have not recognized it yet.

Historically, do you have any investments that you remember as amazing? Maybe an investment where you were just so darn right that it was memorable?

Yes, two in specific:

1. Nursing Homes

In the early parts of the last decade, nursing homes were providing elderly housing and elderly care. They were expanding the elderly care to provide ancillary types of procedures, like occupational therapy, breath therapy, etc. and all these things made tons of money. The underlying business was great, and then they issued a ton of debt, raised capital, etc. Shortly after, congress cut back funding. With that, the top lines and margins went through the floor, leveraged ones went bankrupt, and the industry in itself went through a transition.

The markets priced that as if nursing homes would go away. In reality, there would only be more elderly people given enough time. We were buying healthcare REITS, preferred shares with 20% yields, dividend-paying instruments for 50% of pay, etc. Lo and behold, the Internet stocks went to hell and these nursing homes were going through a change too. Even while they went through a change, they had to keep paying rent, and so the REIT dividends kept coming in. It was priced like a junk bond, but the yields were better and actual ratings were better too!

2. InVision Technologies (Seth Hamot’s point of view)

INVN, InVision Technologies. During the internet bust, you would hear tons of ideas that all began, “This company has so much cash on hand and is only burning this much per quarter.” We found INVN, which was a collection of venture ideas that were being commercialized. The CEO of this company, though, was committed to being profitable. Same sort of upside, but without the cash burn, as the Internet investments. The CEO basically said this: “They (our investments) turn positive NOW, not later on.” Meanwhile, I’m getting a ton of calls from people to buy 1 of 6 online pet food supplier stocks, they have a ton of cash and little burn – they don’t need money for two years! I heard that all day long and then went to buy Invision. I paid less than the cash they had and saw some upside on a logger product that was going to make logging much more efficient. They weren’t burning cash either, and that’s what made it attractive.
I went over just 1% of the company by September 10th, 2001. On the next morning, terrorists attack the country and so the markets don’t open for a while. Invision actually had technology that sniffs for bomb threats in airports. At this time, it was in beta testing at a few regional airports. I hadn’t paid attention to this part of INVN at all, but now it was a lot more important than all the other activity at the company. I had been buying the stock for $3 per share, less than net cash. It was a “net net.” As you know, the markets remained closed until September 17th, when it opened around $7.50. By that afternoon, it traded around $9. This is when all the value investors got out right away. Around this time, I said, “You know, if it’s a real business, and it’s up to $9 today, because it was installed as a beta test, the government will want hundreds and thousands of these in the recent future, these will be hot.” Eventually, I got out between $17-20. If you travel now and look behind the check in counter, those machines that they put your luggage through are Invision machines. I have no idea what happened to the log cutting advancements or anything else, I was following a CEO who wanted profitability even when everyone else had different ideas.

2a. InVision Technologies (Sergio's point of view - CEO/President)

Dr. Sergio Magistri was the President the CEO of InVision Technologies, which developed technologies for Explosive Detection Systems (EDS) and other civil aviation security. He joined in 1992, raised $21M in 1997, and entered into a merger agreement for $900M, or $50 per share, on December 6th, 2004.

1.    Does the description that Seth gave of the situation sound adequate?

Yes, from a contrarian investor point of view looking at the overall high-tech space near the end of the dot-com bubble.

At InVision (INVN) though, we never felt that we were part of the dot-com mania. We had a long-term strategy that was quite simple:
(1) Security is an event driven market
(2) The best marketing is the quality of our products
(3) Keep developing the best technology in the industry without running out of money and maintaining at least a cash flow break even or better
(4) At some point in time, the market demand will come.

In retrospect, I wish we would have been wrong or at least the demand (as a consequence of a terrorist event) would have been lesser.

2.    Why did you care about cash flow break even or positive at a time when most others did not?

At the valuation we had before September 11th and during the dot-com period, the company was not re-financeable almost at any valuation, because we were not “fashionable.” We had real products, revenues, and even some profit.

3.    Did you get a hard time from anyone for pursuing cash flow breakeven and profitability before others?

Quite a lot of our investors (and our own people) were pushing for some kind of splash change in strategy to appease the dot-com believers, but at the level of management and board of directors, we decided to keep executing our security strategy. We had a clear understanding that we didn’t belong to the dot-com world.

4.    Seth mentioned a logging enhancement that your firm was working on, but that might have been hidden by the success of the Explosive Detection Systems. Could you tell us what eventually happened?

After September 11th, we were management and resource limited. For a while, we tried to spin it off as an independent and financed entity to avoid defocusing our security effort. Once this failed, we decided to abort the development. Even today, while recognizing the need for the decision at the time, I believe that this was and will be a very interesting opportunity.

When dealing with small caps, do you ever think about why some of them are publicly traded to begin with?

All the time. If you actually understand the classical theory of public markets, they exist for raising initial capital. No one would actually give capital unless there’s an exit strategy, and the public markets allow that exit strategy to be a reality for small holders of stock.

Looking at your current positions, can you offer any insight as to some of the more interesting ones?

Aeropostale (ARO)Aeropostale is the premier teen retailer in my estimation.  When you compare the company’s fundamentals to the other large players, AEO and ANF, you see the superiority clearly.  Yet, ARO is relatively cheaper than its competitors.

Let’s first look at the ability to drive same store sales.  In 2009, arguably the worst year for retail in the last generation, ARO had year over year gains every month.   Furthermore, if you consider the gains in total sales compared to the recent trimming of inventory – that’s right, the decline in inventory – you realize the increasing efficiencies that are driving huge cash flows at ARO.  [Specifically, let’s take the summation of the last four quarters of “percentage yearly revenue gains” and subtract from that number the summation of the last four quarters of “percentage of yearly inventory gains,” the latest quarter being actually a reduction in inventory.  ARO’s resulting number is 50.83 and accelerating.   AEO’s is 21.88, and going in the wrong direction and ANF’s is 34.68 and also headed in the wrong direction.]

Analysts miss all this though.  They are so wed to their bullish calls on ANF and AEO that they have conjured up a story that once the recession ends, all those customers who are moving to a lower price point by shopping at ARO are going to return to the competitors’ stores.  Hence, ARO trades at 5.43x its LTM EBITDA, while ANF trades at 7.26x and AEO traded at 7.14x until it lost 35% of its value in the last quarter.  Caught up in their past view of the world, they are missing one of the great retail stories around today, which continues to improve its business quarter over quarter.

Nabi (NABI) – this is a wonderful story. Nabi has a vaccine that helps with smoking sensations. Glaxo Smith Cline (GSK) actually put up $45 Million to partner with them on this drug. No one spends $45M on a drug that isn’t credible. That will probably move forward by the end of 2011. When I entered my position, I wasn’t paying more than cash and the NPV of royalties, probably lower and upper 3’s. GSK validated the vaccine and the ramifications of its approval are mind-boggling. You take 4-5 shots over 6-8 months and you can get over smoking. Our nation spends a lot of money on smoking and so there will be a lot of push behind this drug, you could make budgets balance if less people smoked. Even if you doubt it, the GSK guys have been looking at it for months and when they’re done with the next phase of development, GSK will pay NABI another $30 Million for the work they’re doing, and then the numbers get really crazy for royalty payments. When I was buying, I got in at prices where most of the story was for “free” because of where the stock price was trading.

BreitBurn Energy Partners (BBEP) – This company found they were overleveraged at one point last year and so they cut the dividend distribution, causing the stock to go down to $6. Dividend money went to cut down debt and now it’s at $15. We went from $6 to $15. Baupost is there and the interesting thing is that they got involved with a proxy contest with the largest shareholder. Quicksilver, the largest shareholder, went on the board and removed 2 guys – the chairman and CEO, the two folks whose name is in the company name itself. They became management employees.

Quicksilver (KWK) is overleveraged and owned 21 million shares of this company at one point, or about 40% of the company. They had a proxy contest and those 2 were removed. You have to take a step back and wonder what’s going on. If there is nothing going on, why would they bother to remove people from the board who will object and not be happy about the situation? There’s a possibility that managers were taken off the board of directors so that potential M&A activity could be kept segregated from the operations, which offers a potential exit strategy for Quicksilver. In the meantime, I got a 10% dividend and 37.5 cents per quarter per share, not too bad at all, and mostly tax-free.

How do you try and structure your portfolio? Your top holding is 15% of your invested portfolio and the top 5 make up 44% of your portfolio, even though you had 29 positions at the last 13F filing.

We tend to buy as much as 6-7% of the portfolio and will be pruning as it crosses the 10-15% threshold. We’re usually always pruning.

How do you deal with prices at which you are okay holding a stock, but not buying? Opportunity cost would say that if you aren’t willing to buy it at the current price, you shouldn’t be holding it, because by not selling, you’re effectively buying at the current price.

One of the pains is you buy stocks out of favor. Often times, they become in favor! Just because they’ve risen past fair value, and you saw that in InVision, where the fundamentals had markedly changed, you have to be patient and see it runs its course. By the same token, if I was buying for the log cutting machine software, and if it was done with the beta tests without much business activity, I would have found another investment to move onto. From my point of view, I can be patient.

Can you recommend a few books for investors that you found to be helpful?

Sure - Ben Graham's Security Analysis, The Intelligent Investor, and Seth Klarman's Margin of Safety. Additional reading includes Warren Buffett's annual letters and an understanding of topics of leveraged buyouts and stability of cash flows.

Sunday, May 23, 2010

Jim Taggart Discovered! (‘Fooling Some of the People All of the Time’ Book Review)

As I began working on my first well-researched short sale, I quickly realized that I would need to learn under the guidance of someone experienced. Who better to look to than David Einhorn of Greenlight Capital? Reaching out to him wouldn't be easy, so I found another way to learn.

David battled unmotivated regulators, journalists who just didn’t care, a company that was pulling his phone records without his permission, and he had to pay for legal expenses out of Greenlight’s own pocket. Instead of getting support for uncovering a great problem in the markets, he was seeing a strong lack of support from the very people who should care – analysts, investors, board members, and everyone else associated with Allied Capital. Did I mention that during all of this, Greenlight Capital decided to donate 50% of all profits made on this particular investment?

Fooling Some of the People All of the Time is a book that thoroughly explains David Einhorn’s “long” short position in Allied Capital. After conducting research into Allied’s situation, David made a presentation at the 2002 Ira Sohn Conference, and on the following day, the shares of Allied opened down 20 percent. At the time, Einhorn did not realize just how much of his effort this investment would take, even though it was only 3-8% of Greenlight’s portfolio at any given time. It wasn’t until 2008 that they would see Allied fall by 50%.

In the process of being handed over 6 years of his wisdom gained from the Allied situation in a book that is only 350 pages long, I made a discovery – I found James Taggart. James Taggart is a character from Atlas Shrugged, by Ayn Rand. In the book, James makes many references to maintaining social order, operating his business because the country needs it, and in general, working for a social purpose.

As I read Fooling Some of the People All of the Time, I realized I found James in real life. Look at these 2 quotes from Allied Capital’s CEO, Bill Walton, that Einhorn included:

"We've got 85,000 retail shareholders that depend on the dividend. We really operate the business for dividends. I think that's a pretty good SOCIAL PURPOSE..."

"I think most informed investors would appreciate some time spent with us so they can talk these things through unless you're simply trying to develop the short thesis to scare people and make a quick buck and move on. I don't find that a very high SOCIAL PURPOSE."

Businesses exist in order to create wealth for shareholders. This happens because mankind starts with nothing, and creates things. We dig things out of the ground and modify them to improve our lives. You’ll even hear arguments about a limit on natural resources, however those are false as well. Thanks to technology, we are learning to do more with less – we can extract oil from algae, information can be transmitted in milliseconds across the globe, and we are curing medical problems much better than ever before. When a CEO creates a business out of a social purpose, you need to question if he understands that wealth is created and not distributed. If businesses exist to create wealth, consumers and employees of these businesses will all benefit, therefore it is in the best interest for everyone to support businesses, not the other way around. Based on this, you should wonder why the CEO of a company says they exist for a social purpose – if they create great things, the social benefit will be very easy to see and measure.

For Atlas Shrugged fans, this alone should be enough of a pitch to read the book.

If you haven’t read Atlas Shrugged, do yourself a favor and stop everything you’re doing and go read it. It is a very valuable book to read and once you read it, you’ll see 2 types of people in this world: Those who have read it and those who haven’t.

Going back to Fooling Some of the People All of the Time, I will present information about the 5 parts the book is divided into.

Part One: A Charity Case and Greenlight Capital

The first 5 chapters cover David’s life before Greenlight’s formation, the formation of Greenlight capital’s business plan on a napkin, early wins thanks to insurance company demutualizations, spin-offs, etc. We also get an early glimpse into short sales of Boston Chicken and Samsonite. This led him to value investing through the internet stock bubble, including value investment in AOL despite questionable accounting practices. In all, you are walked thorugh many early successes and relatively smaller, short term, wins that would help David and his team through the longer struggle of dealing with Allied Capital. The end of this section of the book brings us to Allied Capital and a basic overview of how Allied Capital rated its investments and you get to dip your toes in early issues that were discovered.

Part Two: Spinning So Fast Leaves Most People Dizzy

The following 10 chapters (6-15) start off with a description of the reaction just after his presentation. The morning after his presentation, he had a mutual fund analyst waiting outside to find out just what happened the night before. Allied Capital opened 20 percent lower this morning. We are also introduced to the concept of Allied selling the winners and keeping the losers, because it helps maintain their high book value and keeps the income statement in line with expectations. More events followed, with the uncovering of bad loans by Off Wall Street, further investigation into Business Loan Express, WorldCom’s bankruptcy filing, numerous quarterly conference calls, accounting changes, improper valuations for Business Loan Express, and the list goes on. In essence, the title of Part 2 is very appropriate and Greenlight Capital’s perseverance is demonstrated as they kept up with all of this information and stayed on top of every occurrence.

Part Three: Would Somebody, Anybody, Wake Up?

The next 6 chapters talk about hiring an independent organization to dig into specific Allied investments that were concerning them. On May 8th, 2003, Einhorn spent the morning with the SEC and was grilled with questions such as, “When did you start manipulating Allied stock?” These lawyers might as well have been saying, “Why were you sleeping with the president’s wife?” Any answer you return with puts you as someone committing an evil and to be clear.

A lot of research from the independent organization began coming in and customers of a company Allied held a stake in described the management as incompetent, dishonest, and crooked. This research was enough to prove that Allied was clearly lying about the value of the investment in this company. Allied Capital was writing loans backed by the Small Business Administration (SBA) and even with such clear evidence, they couldn’t get the SEC or SBA to take action against anyone other than short sellers.

In one of many interesting developments, we also learn about Allied accepting defaulted loans from BLX (Business Loan Express) for full value. There was a bankruptcy for a convenience store that revealed Allied had taken $9 Million of such loans.

Part Four: How the Systems Works (and Doesn’t)

The following 6 chapters bring us even more ridiculous events. It starts out in the middle of 2004 when Einhorn gets calls warning him of phone records being stolen. Initially, his accounts seem okay, however soon after he finds that someone had gotten access to his entire phone history. The only analyst with a sell rating on Allied had his records stolen as well.

Greenlight began working under the False Claims Act, which allows them to share in the money gained by reporting fraud against the federal government. Jim Brickman was working on this case and with his efforts, both quickly learned that there was little caring on the government’s part. We also saw more attacks against Einhorn’s short sales, this time coming from Overstock.com’s CEO.

Should the lack of governmental inquiry into the loans made by the SBA backed lenders be a surprise?

The federal government issues this standard for governmental employee ethics:
The District government ethics rules are designed to guide and regulate employees to achieve these ethical standards and to add to the overall appearance of integrity, promote government efficiency, and maintain the public’s trust and confidence.

If you’re worried about the appearance of integrity, what does that say about an organization’s ethical behavior and intentions?

Part Five: Greenlight Was Right … Carry On

The following 7 chapters wrap up the whole story and we learn that good guys really do win, and this entire book is proof of just that.

It began with a tiny disclosure on page 82 of a filing that BLX made making it clear that the SBA and Department of Justice have been investigating the lending practices of BLX. After a lot of problems had been uncovered, Allied’s management still told analysts that what was found in the Detroit office under Harrington’s control was a single event and bad behavior that was discovered did not exist anywhere else at BLX. Soon after, the SBA was considering suspending their preferred lending status, a crucial piece to BLX’s and Allied’s profitability on paper.

Fitch even came out and said, “… the large majority of its nearly $2.7 billion in serviced loans are viable assets.” Off Wall Street’s Mark Roberts reached out to the author of the Allied rating piece on Bloomberg and was told that there was no interest in research showing this Fitch rating might have not been correct.  Einhorn wrote a letter to the board of Allied, which was made public, and the stock fell $2 down to $28 on January 22nd, 2007.

Less than a few weeks later, Allied issued a press release that admitted they had stolen Einhorn’s home phone records. A half hour after this, a press release was made talking about a 1-cent increase to the quarterly distribution, you can draw your own conclusion about why they might have done this.

Months later, in June, the SEC released results of the investigation. It outlined 3 examples of problem investments and in essence, basically said that Greenlight was right all along.

Message to David Einhorn and Greenlight Capital: Keep up the good work – you guys have done some amazing research and set an example for investors everywhere. David, you put up with a lot because you believed in what you were doing – I bet if your goal was to make a quick buck, you would have left this short much earlier on. I hope your team made a lot of money on this and I have no doubt that your amazing team will continue this level of excellence.

Fooling Some of the People All of the Time is an excellent book to read and if you're at all interested in avoiding fraud or learning about the steps taken to uncover a fraud, you will be well served by taking out the time to read this book.

Friday, April 16, 2010

A Guide to Detecting Accounting Gimmicks (‘Financial Shenanigans’ Book Review)

While the stock prices of a company move up thanks to aggressive accounting policies, you will never hear a board member make a statement regarding the stock price being too high. Further more, these aggressive accounting policies may be hard to detect and recognize to begin with. After all, it may be only 1 of 20 positions for an investor. For the company and its managers though, it’s the only thing that they focus on and so we should have the tools necessary to detect these problems as early as possible.

These problems are not only found in hard-to-understand businesses, but also in the easier-to-understand businesses. This includes Waste Management, a trash hauler. Financial Shenanigans starts with examples of accounting problems and their subsequent impact on the stock price. Waste Management peaked at $57 in 1999; however fell to $14 in 2000 less than 1 year later.

Takeaway for investors: If a trash hauler can fool the public, get by the SEC, and keep auditors quiet, you simply have to watch out for yourself with your own analysis.

Financial Shenanigans is a 17-chapter book that was written by Howard Schilit. Each chapter is about 15 pages long and so it’s a book that you can easily read even when you don’t have a lot of time.

The book discusses 7 important topics, which are the meat of the book:
1.     Recording Revenue Too Soon or of Questionable Quality
2.     Recording Bogus Revenue
3.     Boosting Income with One-Time Gains
4.     Shifting Current Expenses to a Later or Earlier Period
5.     Failing to Record or Improperly Reducing Liabilities
6.     Shifting Current Revenue to a Later Period
7.     Shifting Future Expenses to the Current Period As A Special Charge

The next 2 chapters discuss methods of finding these companies. There are quantitative methods (largest drop in cash flow versus net income, sequential sales decline, receivables growth, etc.) as well as qualitative methods (changes in estimates, customer financing, bill and hold, nonmonetary transactions, etc.) to help detect this. The book also walks readers through a common-size analysis, where balance sheet items are represented next to the income statement as a percentage of net sales or revenues. This can give you clues as to where the problems may exist.

If you aren’t familiar with accounting tricks, here’s a great example from the book:
            “Sale of Assets Acquired in a Pooling Transaction
As an example of a business combination accounted for under the pooling method, assume that a company acquires another company by exchanging stock with a market value of $1 million (but a book value of $200,000). The company holds the new business for one year, then sells it for $1.1 million. Clearly, the company’s economic gain is $100,000. Because of a quirk in GAAP, however, the company would report a gain of $900,000…”

The pooling method’s loophole was closed up in 2002 and so it isn’t an issue now, but don’t be fooled and think that there won’t be accounting tricks in the future.

The book goes on to discuss acquisition accounting tricks in lots of detail, revenue recognition problems, and wraps it all up with more history of accounting problems, including Enron.

Financial Shenanigans is a book that will arm you with the tools necessary to help detect these problems early. Howard Schilit has simply done an amazing job at presenting this information in a compelling book that is enjoyable to read. Investors concerned with the possibility of fraud should be reading this book and learning just how the professionals detect fraud.

Disclosure: I receive books from publishers for free because I am an editor. The links made to the Amazon page for this book have my referral code in them. This does not cost you anything and rewards me for providing an informative review.