Learn From The Master - When bad news is good

By Larissa Fernand
Morningstar India
November 16, 2015
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Legendary investor and billionaire looks amongst the dirt for diamonds.

Almost two decades ago, Fortune wrote a fascinating article on Michael Price that began with a captivating incident.

John Teets, the CEO of a conglomerate called Dial, was going through a bad phase. The company’s profits were down, morale was low, and its brands were tired. Accusations were doing the rounds of Teets utilizing the company’s assets for his own personal use, including a New York penthouse and a Gulfstream jet, as well committing sexual improprieties. But here’s the clincher - the writer did not feel the above were Teets' biggest problem. Teets’ biggest worry was Michael Price, who had taken a 9.9% position in Dial's stock, worth more than $250 million.

Why would this cause so much of trepidation?

Because Michael Price, the legendary mutual fund manager and value investor, was known as a corporate raider and very dramatically described as the stalker of underperforming CEOs.

Eight years prior to this incident, Price grabbed control of Sunbeam and put his own chief executive officers in place (he replaced one CEO with another when unhappy with the results). Not surprisingly, Teets was shown the door. Price was also responsible for the merger of Chase Manhattan Bank and Chemical Bank after he purchased 11 million shares of Chase Manhattan.

In both the above instances, massive layoffs took place, around 6,000 in the case of Sunbeam and 12,000 due to the bank merger. And in both cases, Price benefitted, as a result of which investors in his fund did too.

Unlike other corporate predators, Price was a fund manager, which translated into retail investors being allowed to hop on for the ride.

Price was hired by Max Heine of Mutual Series mutual funds. After Heine’s death, he took over control and ownership of the fund. In 1996, when the value of the funds crossed $17 billion, he sold it off to Franklin Securities for $670 million. He now manages his own personal wealth through his private firm, MFP Investors LLC, a value focused hedge fund that he founded in 1998.

Price likes to describe himself as a value investor who, by making such moves, unlocks value in a stock. He told the reporter at Fortune, "I'm just trying to find cheap stocks and realize the value." And unlocking that value could often mean ousting a CEO.

Looking for dirt

At a talk to the students in Columbia Business School, he shot a question: “When most people look at the day's stock tables, what do they turn to first?" He himself provided the answer: "The day's most active stocks” before going on to state that he looks “at the day's biggest decliners” because “I love to read about losses."

In a conference in London, he told a bunch of investors to go where others are not. “When you play tennis, you hit the ball where the opponent is not.” This explains the principle he follows when constructing a portfolio: buy cheap.

He once explained that two-thirds of his portfolio trades below its intrinsic value and the balance are those involved in special situations such as a proxy fight, lawsuit, litigation, government action, fight for control, a takeover, bankruptcy, liquidation, or even a tragedy like the BP oil spill.

Such a portfolio, he believes, weathers the storms.

Here is an example he cited.

Hospira was a pharmaceutical company that manufactured drugs. Its earnings per share were at $3 that kept growing steadily and were connected to the basic growth of healthcare in the U.S. Being a popular growth stock, its stock price was $45 (15 times $3).

Then came the bad news: The FDA investigated and shut down its largest plant. The stock market overreacted and the stock price dropped to $28 overnight.

Price explained that if there were 200 million shares of Hospira in the market, a drop from $45 to $28 (17 points x 200 million shares) would result in a $3.5 billion discount from the night before.

Will it cost $3.5 billion to fix the plant? No.

Yet the stock market put that much of a discount on the bad news.

Will the company shut down? No.

There were 17 other plants and it would only be a matter of time before the shut down plant was up and running once again.

Price concluded: This is what value investors wait for, the time when growth investors sell to them because they want out due to bad news on the table.

The value investor knows that the stock is going to get back to $3 in earnings after a few years. And it will cost the company around $500 million to fix the plant. But the intrinsic value of the business is intact and once the company is past its problem, the stock price will go up to $45 once again. That is when the value investors sell back to the growth investors.

He also looks at management making mistakes resulting in underperformance. However, the key is that the companies that stumble should have built up intrinsic value.

How does he define intrinsic value?

He is emphatic that intrinsic value is not 12PE in a market which is 15PE. It is not what sell-side analysts say it is worth.

It is what a businessman would pay to own 100% of the company after having conducted a complete and thorough due diligence.

After arriving at its intrinsic value, he will wait for the market to hand it to him at a huge discount to that value. Note, the key word here is wait. He is extremely comfortable with sitting on cash if he does not find anything cheap.

He believes that a potential investment is best evaluated through its capital structure - equity (where you own part of the company) and debt (where you lend to it). Everything else, in his view, has been invented by Wall Street to rip off investors and generate fees.

To put it in his own words, he “focuses on the steak and not the sizzle”. Steak in this analogy is the balance sheet and the notes to the financials; it is what you are buying – earnings stream, asset values, cash, real estate, and so on and so forth. He figures out the intrinsic worth of the steak and then attempts to buy it at a big discount, say 25-30%. In other words, you figure what is cheap and buy it. If you can’t find cheap stocks, you wait.

He has often explained his construction of the portfolio as one that has a natural propensity to add to stocks as they get cheaper.

The top 5 holdings will each corner 3-5% of the assets.

The next 10 will each be 2-3% of the assets.

The balance (which should be around 20 to 30 stocks) would be held at 1% each.

The latter will be constantly monitored to see if the position should be upped. As for the top stocks, they will be monitored to see whether they should be sold and their position reduced in the portfolio.

So basically he trades around positions on which he has conducted extensive research and is convinced that the stock will do well over time. He also believes in constantly re-evaluating if he wants to continue to hold his position in a given stock.

He cautions investors about getting lost in spreadsheets and relying solely on projections put in them. Depending too much on the excel spreadsheet and forecast of discounted cash flows is a big mistake.

Price does not approach valuation by discounting a stream of future earnings, nor does he use price-to-book or price-to-EBITDA. He believes in starting where the transactions exist and seeing what companies are doing with their cash flows. The merger proxies and bankruptcy disclosure documents are a treasure trove of industry data – an area not frequented by analysts.

But Price has also had his share of losses.

In 1989 he was betting that the court would block the Time-Warner merger and allow Paramount Communications to carry out a hostile bid for Time. The court ruled against Paramount, Time merged with Warner, and Price lost around $100 million.

His funds underperformed the market in 1989, 1990, and 1991. He was heavy in cash post the Gulf war in 1990. When the market picked up, he missed much of the gain.

When asked once what investors should look for, he cited three steps:

  • Buy cheap. Find a company selling at a discount to asset value.
  • Look for a management that owns shares; the more they own, the better.
  • A clean balance sheet— little debt— so there is less financial risk. He does not believe in buying companies that are highly leveraged.

But most importantly, he believes that the key in the business is weathering the bear markets, not outperforming the bull ones.

Advice all of us would do well to pay heed to.

This article was also published in Morningstar on 16th November 2015.