A bit more about the Safeway merger arb

One of the great things about running a blog is that you almost always receive useful feedback on your idea’s. My write-up on Safeway was for example lacking a bit in the valuation of the Casa Ley stake, but the spreadsheet shared by “rowerburn” corrects this omission. Since the SEC filings of Safeway only provide information on the earnings and the book value of their Casa Ley stake an in-depth valuation is impossible, but it is enough for a rough ballpark figure:

Casa Ley valuation

I think that the company will be liable for taxes when their stake is sold for more than book value ($0.89/share) so that would slightly reduce the value of the CVRs if it is sold at an earnings multiple above 17.5x. Since that seems to be pretty high I think that is going to be unlikely and that taxes aren’t a major concern. If Casa Ley is sold for $0.75/share the annualized IRR will be 28.7% if it takes the full three years to sell their stake:

IRR sensitivity analysis

Of course, when it takes longer to sell Casa Ley the business has more time to grow and generate earnings. So perhaps we should expect a higher value the longer a sale takes. On the other hand, that would probably mean that there is little interest in their Casa Ley stake. But since CVR holders will receive fair value as determined by an international investment bank if Casa Ley isn’t sold before the deadline that might not be a problem?

Disclosure

Long Safeway

Safeway merger arb: get the Casa Ley CVR on the cheap

Albertsons acquisition of Safeway is a done deal after receiving clearance from the FTC today and the company expects that the merger will be completed within the next five business days. When a deal is this close to being completed the spread between the share price and the offer price is usually non-existent, but Safeway’s case isn’t that straightforward since shareholders will receive two contingent value rights (CVRs). The merger consideration will consist of:

  • $32.50/share cash consideration for the merger
  • $2.38/share consideration for the sale of Safeway’s PDC subsidiary
  • $0.07/share CVR related to this sale consisting of money in escrow
  • An unknown amount for Safeway’s 49% stake in Casa Ley since it hasn’t been sold yet

The biggest unknown factor is the CVR for Casa Ley, a Mexico-based food and general merchandise retailer. Safeway estimated that the value of PDC and Casa Ley would be between $3.45/share and $3.85/share. If we subtract the $2.45 that was received for PDC it means their interest in Casa Ley should be worth something between $1.00 and $1.40/share.

Safeway merger presentation on CVRs

With Safeway currently trading at $35.15 we can buy the two CVR’s for just $0.27. I think the $0.07/share payment for the PDC CVR has a relative low risk, so we would effectively be buying their Casa Ley stake for just $0.20/share. That sounds like a pretty sweet deal to me!

The timing of the Casa Ley payment is uncertain. The deadline in the CVR is set at three years after the close of the merger and if it isn’t (fully) sold by then CVR holders will receive fair market value (see page 154 in the merger agreement for more details). Both CVRs are non-transferable so if the sale of the Casa Ley stake takes a lot of time you will have zero liquidity for years (the $0.07/share for the PDC CVR is payable within a year though). This could exactly be why the market is offering the current deal.

I don’t think that owning assets with a limited liquidity is a problem, since owning stocks should be done with a long-term time horizon anyway. And if the market is willing to pay a significant risk premium for owning illiquid assets I’m happy to pocket it. It could of course also be the case that I’m simply missing another risk that the market isn’t…

Disclosure

Long Safeway

Diversification is underrated

At the end of the year, when people inevitably start comparing their performance with others one common theme usually emerges: every great stock picker runs a concentrated portfolio. When you “only” generate a 15% positive return while others are making 30%, 50% or even 100%+ it’s easy to envy those mind-boggling returns and start wondering what you should do to emulate those results. When you learn that those results were without exception generated by investors who had the balls to concentrate on just a few good ideas the implication seems obvious: time to bet big!

And as a matter of fact the undeniable truth is that the only way, to achieve those mind-boggling returns, is by having a concentrated portfolio. Intuitively concentration makes sense, but unfortunately everybody’s intuition sucks at statistics. What is ignored here is the base rate of people trying a concentrated strategy. How many shoot for the moon only to end up with an evaporated portfolio at the end of the year? Because that is the flipside of the story; the investors with the mind-boggling losses are also the concentrated investors! But that is, of course, a story that most people prefer not to tell (kudos to the few that do!).

Let’s believe for one second in an efficient market and imagine that 50% of investors are concentrated and 50% are diversified. Since the market is efficient no-one can generate any alpha, yet at the same time a large number of investors is expected to outperform the average. The diversified investors should generate a return that is close to the average, but approximately 50% of the concentrated investors – 25% of the total population – is expected to outperform the average while the other half is expected to underperform. Depending on how concentrated they are some could outperform spectacularly. A naive interpretation of the phenomenon would be that concentration would be the way to go while the opposite is true since it only increases risk in an efficient market.

If you are reading this you probably don’t believe in an efficient market. I know I don’t. But the reality is that most outcomes in investing are the result of random noise. You can’t know what will happen. No-one expected oil to drop from $80/barrel to less than $50/barrel in two months time. No-one expected that the Swiss franc would gain 30% in minutes yesterday. You can only expect the unexpected. And the only realistic way, to protect yourself against the unexpected, is to be diversified across industries, countries, and asset classes.

Another problem with the large amount of luck that is involved in investment results is that it is easy to look like a genius and think that you are while you aren’t. Even when you are a pretty good investor it is incredibly hard to be right consistently, and you are probably delusional when you think that you can outperform the benchmark by a large margin. But the bigger problem is – even when you are realistic about your skill – that there is a large amount of uncertainty about your skill level. There is always the possibility that you don’t add alpha.

If you concentrate and you are wrong about your skills it is almost inevitable that you will blow up at some point in time. Betting too big relative to the expected value of the bet will result in a suboptimal geometric growth rate: that’s what Kelly teaches us. Investing isn’t about hitting a great return in a single year. It’s not even about generating on average a great return: any series of returns, that includes a zero, has a zero as the final portfolio value! The geometric growth rate is the only thing that matters and if you keep everything else equal you maximize it by reducing variance.

To be fair: at the same time Kelly also provides a strong argument for concentration. If you find a great idea with limited downside and/or a small probability of a large loss and a large upside the formula is probably going to suggest that you put the majority of your portfolio in a single stock. But you have to account for the uncertainty in your estimates, including the unknowable, making a strict application of the formula unwise.

It is also only true when it’s the only good bet available. There are more than 100,000 listed companies worldwide. If you aren’t able to find a decent amount of reasonably comparable good bets your are probably lazy or the markets are incredibly efficient. But if they are so efficient is it reasonable to assume that there is somehow one overlooked huge opportunity? That’s not something I would want to bet on, and being lazy is certainly no excuse.

Disclosure

I consider myself to be concentrated and diversified at the same time. The fact that I’m writing this post with 50% of my portfolio in my top six positions is kinda ironic…

2014 performance review

With 2014 behind us, it is of course time for the obligatory year-end portfolio performance review. While one year is a too short time frame (for most strategies) to determine with any amount of certainty if you are able to beat the market it is still better than nothing. Trying to track if you are able to add alpha is hugely important since it determines what the appropriate investment strategy is. Given the low base rate of people being able to add alpha you should be skeptical that someone, who is outperforming, is skilled instead lucky, and that includes yourself. I’m slowly but surely building a decent track record, but with the benchmark up in the double digits for the third year in a row it is relatively easy to look like a genius:

YearReturn*Benchmark**Difference
201218.53%14.34%4.19%
201353.04%17.49%35.55%
201427.71%18.61%9.10%
Cumulative131.66%59.34%72.33%
CAGR32.32%16.80%15.52%

* Return in euro’s after transaction costs, dividend withholding taxes and other expenses
** Benchmark is the MSCI ACWI (All Country World Index) net total return index in euro’s

While my results for 2014 are absolutely more that satisfactory, I did in fact, underperform global equities in the second half of the year. I returned just 3.8% in the second half of 2014 while the benchmark returned a whopping 11.0%. The fact that I managed to generate a positive return in the second half of the year is a small miracle in itself, and mostly the result of favorable currency movements. The strong benchmark performance has the same underlying reason since the MSCI ACWI is up just 4.16% for the year when measured in US dollars.

Conduril was (and is) my biggest position with an almost 30% portfolio allocation at the start of July. Unfortunately, it gave away a large part of the gain that it made earlier this year when it dropped 28% from €85/share to €61/share. That’s a pretty strong tailwind to overcome! At the same time, Awilco dropped from more than $25/share to less than $11/share. Other losers in the second half included Conrad, Argo, Deswell Industries, Clear Leisure and Burelle. As a result, my performance attribution graph looks totally different compared to six months ago:

Performance attribution 2014

When looking at this graph you have to realize that it isn’t adjusted for position size. While I made the largest amount of money on Conduril the stock actually underperformed my portfolio slightly. What I find encouraging is that I made money on a lot of different ideas. This contrasts with the first half of 2014 when almost all my gains could be attributed to Conduril.

The more independent bets you make the easier it becomes to discriminate between luck and skill. Unfortunately, stocks are never totally uncorrelated, and I think you can make a decent case that my portfolio is mostly long low liquidity and short high liquidity. So perhaps I’m at risk of large losses in certain market conditions and are the above average returns, thus far, just a fair compensation for this risk. I don’t think that that is true, but given the randomness and uncertainty inherent in investing it is not an easy statement to disprove (if possible at all).

I think that my portfolio is currently well positioned for adverse market scenario’s given the reasonable diversification across countries, industries, and companies. My portfolio is at the moment pretty conservative (too conservative) with a long exposure of just 85.7% and a short exposure of 2.7% for a net long exposure of 83.0%. This is however mostly the result of my recent Conduril sale, and I intend to move closer to being fully invested when possible. Unlike many other value investors, I don’t like holding cash given the associated opportunity cost.

Portfolio composition start 2015

While I probably should add some reflection in this post on what my biggest mistakes were in 2014 I’m not going to do that – it’s getting long enough as it is – but I’m going to discuss why I think my investment in Awilco wasn’t a mistake nor not selling it when it was trading above $25/share. I have seen various people mention this as one of their biggest mistakes of 2014, but I think that is mostly results oriented thinking. Oil suddenly dropping from $100/barrel to almost $50/barrel was a low probability event that I don’t think anyone could have forecast.

Every single stock can be hit by an unfavorable event, and some are more at risk than others. Dropping oil prices were always a possibility, just like rising oil prices. Who knows what could have happened in an alternative world that would have resulted in oil shortages? What would have been a mistake if I would have sized my position in Awilco such that nothing could go wrong. I also don’t think that not selling at $25/share was a mistake. I thought it was roughly fairly valued at that level, and I actually sold some shares but holding a fairly valued stock is in my opinion not a mistake. You will incur transaction costs when you sell, you might be liable for taxes and you get cash in return that earns nothing if you don’t have a good idea on standby. Not selling a clearly overvalued stock: that’s what I call a mistake.

Disclosure

Long everything in the portfolio overview

Betting against Biglari

I think most of my readers will be familiar with Biglari Holdings, the company run by Sardar Biglari. He likes to present himself as a young Warren Buffett and to complete the picture he has even gone as far as copying the general design of berkshirehathaway.com. But while he talks to talk, he doesn’t walk the walk. The company is quickly becoming an interesting case study in creative ways to screw shareholders. The license agreement that would entitle him to receive royalties for the use of his name if a change of control occurs is especially ridiculous.

As a result Biglari Holdings is trading at a depressed valuation and, despite Sardar’s tight control, it has attracted the attention of the activist investors at Groveland Capital. They announced a small stake in the company in November together with the intention to acquire a board seat. Biglari Holdings is a target that is bigger than usual for them since they are mostly active in the micro cap space. They did for example briefly own Solitron.

Pretty ironic to see an activist investor taking aim at the firm of a fellow activist investor, but what we have so far is just an interesting story (that’s mainly why I follow Biglari, it’s fascinating). But this all changed when Biglari decided to respond. He was apparently “op z’n pik getrapt” and decided to retaliate against Groveland by taking a large stake in a couple of of small companies that they own: Air T and Insignia Systems. I have no idea what his thought process exactly was behind this move, but Biglari’s buying has fueled both stocks to new highs.

Based on the poison pill that Air T quickly adapted I think Groveland is worried that Biglari will try to gain control over the company without paying all shareholders an appropriate premium. That makes sense because he obviously doesn’t want this to be beneficial to Groveland, but it has been pretty great so far for shareholders that have flexibility in selling shares.

Since 21 November, the date Groveland made their intentions known, Air T has advanced from $16.50/share to a high of $27.20/share: a gain of almost 65% while Insignia Systems gained almost 50% when it went from $3.00/share to a high of $4.45/share. Both stocks have dropped from the recent highs because it seems that Biglari has stopped buying:

Price development AIRT and ISIG

This massive increase in share price is unrelated to the fundamental development at both companies. Biglari has been very aggressive in acquiring a position. He now owns 338,500 shares (representing a 15% stake) of Air T and he probably bought the majority of this stake in just a couple of days based on the trading volume. That’s in my opinion pretty retarded since that would normally be a complete month of volume. His buying spree in Insignia Systems has been equally ridiculous. He now owns 2.3 million shares (close to a 20% stake) while the daily trading volume in the month before December was usually around 20,000 shares. When someone is buying so fast a big price impact shouldn’t be a surprise.

Because of this I thought that shorting some Air T was a good idea. I didn’t go for Insignia Systems because it had a more expensive borrow, and Air T was at that moment still trading near its highs. That proved to be excellent timing since the stock dropped almost 15% in a few minutes after I tweeted this:

I’m guessing that both stocks will soon go back to the original price level, although Biglari remains an unpredictable factor. So far he already overpaid a couple of million dollars just to make a point, and it is of course easy to waste some more money if it isn’t your money. One thing is certain: entertainment value is almost guaranteed!

Disclosure

Short AIRT, no position in ISIG or BH