Learn From The Master - Investing lessons from a "professional opportunist"

By Larissa Fernand
Morningstar India
August 7, 2015
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Known as the Grave Dancer, Sam Zell gravitated towards assets others shunned.

What term would you use to describe this young boy?

At the age of 12, on his way to attend Hebrew school in Chicago, he would buy Playboy magazine for 50 cents near the railway station and resell it to his friends in the neighbourhood for $1.50-$3. He did not refer to this as his first stint with pornography but his “first lesson in supply and demand”. (It's all about perspective!)

That boy was Sam Zell, now one of the richest men in the world and also one of the smartest investors of all time. And he likes to describe himself as a “professional opportunist”.

Of course, most don’t call him that; they call him the Grave Dancer.

Zell earned the epithet of Grave Dancer based on his tactic of buying cheap real estate from distressed owners and selling when the price was high. He believed the term grew out of the headline of an article he wrote in New York University Review in the 1970s describing his strategy of profiting off distressed real estate following the inevitable bubbles of investment enthusiasm. The article mentioned how he was “dancing on the skeletons of other people’s mistakes.”

A couple of years ago, the Lehman estate agreed to sell Archstone, a sprawling apartment complex company of over 45,000 top-tier apartments. Archstone, one of the largest owners of U.S. apartments, has a large portfolio of properties in metropolitan areas, where apartment buildings have been pricey and difficult to come by. Zell partnered with one of his competitors AvalonBay Communities for the buyout. The deal was for $6.5 billion and the buyers also took on Archstone's debt, for a total transaction value of $16 billion.

According to International Business Times, the deal was classic Zell: Use a minimal amount of equity in an attempt to wrest control of a troubled company. Zell's strategy is to take meaningful positions in debt securities with the flexibility to hold the investment, or to actively participate in a restructuring that results in a significant ownership stake.

Incidentally, Lehman picked up Archstone in 2007 for $23.7 billion in leveraged buyout.

The very same year that Lehman Brothers picked up the property, Zell was gearing up for a massive sale. In 2007 he sold his supersize real estate portfolio of 573 properties assembled over three decades to the Blackstone Group for $39 billion. The sale of Equity Office Properties Trust was pegged (at that time) as the largest private equity deal in history and instantly turned Blackstone into America’s largest office landlord.

The press speculated whether Zell was cashing out too early. By exiting at the top of the red-hot market, Zell was far from myopic. The speed at which the deal occurred made it obvious that he did not believe that valuations would last. He could have got more by putting up the firm for auction but he opted for a “take-the- cash-and-run” strategy. The New York Times said it well when it stated that few deals better exemplified the excesses of the real estate boom than the dismemberment of the Equity Office empire.

Zell’s investment thesis has always been simple. He is drawn to where he believes there is significant inherent value beyond the price he is paying. It is this very philosophy – focusing on distressed assets that others had written off, that funneled him into a self-made billionaire.

When Zell was an undergraduate at the University of Michigan, his friend lived in a small town house. One day the owner decided to buy the adjoining house, rip it down, and build 15 unit apartments. Zell and his friend convinced the owner to let them rent the apartments on the premise that they know exactly what students need and desire. It turned out to be a roaring success. Other owners began approaching them. By the time they graduated law school, they had managed about 4,000 apartments and owned about 100-200 apartments.

Following a market crash in 1973, Zell began to acquire millions in real estate assets, much of it for “a dollar down and a hope certificate”. He approached lenders and offered to take future operating losses off their hands in return for equity. Zell was able to carry the properties long enough for them to return to — and exceed –prior valuations. He made hundreds of millions of dollars.

In the 80’s, he and his partner diversified by acquiring controlling interests in troubled companies, often ones that had recently emerged from bankruptcy and had in their balance sheets tax credits for past losses. Such credits could be used to shield profits from taxation for many years.

Zell’s philosophy can be broken down into three levels: Hunt for bargains, typically assets that are out of favour or in bankruptcy; ensure that those assets are of a high intrinsic quality; structure the deal so that you pay as little in taxes as legally possible. It is by following this strategy that he converted his company into an industry goliath.

Zell’s daring to go against the common grain and shut out conventional noise is what has benefited him. During the tech boom more than a decade ago, he refused to run with the crowd but did not question technology. His angst was with the valuations. “New technology will change our lives, but it will not change the basic laws of economics.”

That does not mean he has always got it right.

In 1992, he acquired the Carter Hawley Hale stores in California. His firm’s analysis concluded that the 79-store chain would be worth at least 80% of the purchase price if it had to be sold in a fire sale. Following a sharp recession and a major earthquake, he bailed out and sold the chain to its competitor, Federated Department Stores, at 80% of what Zell paid. Granted, it was a failure, but the learning is that he accurately identified the risk he was prepared to take and took it.

He may be a contrarian, but not a stupid one. He constantly balances risk and return, and works hard at understanding the ramifications of his assumptions. He confesses that his focus on understanding the downside has given him a better-than-average track record as an investor.

In an interaction with the Cheung Kong Graduate School of Business, China’s leading business school, he claimed to be a Benjamin Graham kind of investor, always keenly aware of what his exposure is and very focused on what liquidation value is. “At every point in our process, we address the question of “what is the downside” so that we know the risk we are taking”, he says.

When once asked if he has moments when he second guesses himself, he answered: "I made my fortune by turning right when everyone else was going left. In the late ’80s and early ’90s, I was buying office buildings at 50 cents on the dollar. I kept looking over my shoulder to see who my competition was, but there was no one. I could not help but question whether I was wrong. Fear and courage are very closely related."

Indeed, they are!

This article was also published in Morningstar on 7th August 2015.