In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Asif Suria discuss:
- Mastering Event-Driven Investing
- Corporate Spinoffs: Should You Invest in RemainCo or BadCo?
- Lessons from Shinsei: Duration Over Short-Term Returns
- The Power of Insider Buys: Spotting Strong Signals from Key Executives
- The Effect of Presidential Elections on Market Volatility
- Is the Wisdom of Crowds Becoming Less Effective in Modern Markets
- Uncorrelated Investing
- Inside Arbitrage: A Comprehensive Tool for Tracking Special Situations
- The Recent Market Wobble Explained
- Merger Arbitrage Strategies: How to Minimize Risk and Maximize Returns
- What Starbucks’ New CEO Can Learn from Chipotle’s Success
- Corporate Buybacks in Cyclical Industries
- Profiting from Volatility
- The Art of Position Sizing
- The Downfall of WeWork
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: And we’re live. This is Value: After Hours. I’m Tobias Carlisle, joined as always by my co-host, Jake Taylor. Our special guest today is Asif Suria, who’s written a new book, The Event-Driven Edge in Investing: Six Special Situation Strategies to Outperform the Market. Welcome, Asif, how are you?
Asif: I’m doing great. Thanks for having me on, Tobias and Jake.
Jake: Yeah, welcome.
Tobias: Let’s start what is event driven investing? What are special situations?
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Mastering Event-Driven Investing
Asif: Yes. Event driven investing or special situations investing is about acting on maybe a corporate action. It could be one company acquiring another one, like Microsoft acquired Activision Blizzard. And that created a situation where the stock that’s being acquired doesn’t often end up trading at the acquisition price. There’s usually a discount to that acquisition price for various reasons. And so, that strategy of buying the stock of the company being acquired, waiting for the deal to close, is called merger arbitrage. So, that’s one of six situations that I’m discussing in the book.
Spin offs are the other common one that most people know about. So, companies go through this process of acquiring companies, then they figure out that it’s not a good fit, or maybe they have a division that’s doing very well and they want to get rid of it. And in some cases, it’s getting rid of it, because there are bad assets within the division. Sometimes they just want to motivate the management team of that division to go build on their own, like McDonald’s did with Chipotle way back when, or Fiat Chrysler did with Ferrari. And so, that’s the spin off strategy. So, those are two of the primary strategies most people focus on.
I also included insider transactions, where company insiders are buying and selling their own stock. It’s not traditionally considered an event-driven strategy, but it’s something that I’ve followed for a really long time, because in some sense, it’s related to a corporate action. I included that as an event-driven strategy. SPACs, management changes and stock buybacks by the company, those are the other three strategies that I’ve discussed in a book.
Tobias: The SPAC, it’s de-SPACing or the SPAC acquisition, or what’s the best way to play SPACs?
Asif: So, you used to get a couple of different ways of approaching it. So, you could buy the SPAC IPO after it’s announced, and you wait for them to announce a transaction with an operating company. So, you have the de-SPAC process. People used to buy the IPO, wait for the units to split into the stock and warrants. When it came time to make a decision about whether they wanted to stick with the combined company, they would usually sell the stock for the $10 a share that they paid for it and keep the warrants for free. So, if you had a runaway hit or a runaway success, you essentially are betting for free on that with the warrants.
There’s a little bit of downside there where the companies are very smart as well. If they think that things are going very well, they might buy back the warrants. So, you don’t necessarily have all that runway. But the other side of SPACs is actually quite interesting. So, as you guys know, two or three years ago, we had this big SPAC boom. Everybody is trying to go public through a SPAC. You had all these science projects that shouldn’t have been a public company that decided to go public. Sure enough, after the de-SPAC, those stocks felt like a rock. And so, they provided ample opportunities on the short side if you were so inclined to short companies.
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The Downfall of WeWork
Tobias: What are some good examples of your favorite kinds of event-driven strategies in terms of the names of the companies that went through the tickers?
Asif: Yeah. So, WeWork was one of those companies that tried to go public, the traditional route, and they just got clobbered after everybody read their S-1 filing, and noticed that they were talking about community adjusted EBITDA. So, you already have EBITDA, and then you have adjusted EBITDA and you’re already in fairytale land by that point. And now you have this community adjusted EBITDA. After a little while, they realized they couldn’t go public, the traditional route. They went public through a SPAC. It started dropping.
So, I was at the WeWork office in the San Francisco Salesforce Tower. It was a beautiful office. A friend of mine asked me to take a look at it. He said, “It’s a wonderful service. They have beautiful offices. You should check it out as a long investment.” And so, I pulled up the balance sheet, and I looked at the debt that they had and I tried to model the company. It didn’t matter if you assumed 100% occupancy or thought about them doubling what they charged their members. There was no way this company was going to make money with all that debt.
And so, the logical conclusion, considering they also had a CEO that was an expert in restructuring, is they’re eventually going to go bankrupt. So, that was one of the companies I ended up shorting. Shorting is to short people. So, that’s just one example of a SPAC where the opportunity was on the short side and not necessarily on the long side.
Tobias: I didn’t realize WeWork went public with a restructuring CEO, and nowhere to cover their debt.
Asif: They did. They had the CEO who worked through the restructuring of General Growth Properties. And so, he had the real estate background, and he had the restructuring background and it made sense that was probably the intent all along.
Tobias: General Growth worked out pretty well though.
Jake: It would be like, marrying a woman whose already got a divorce attorney, like retain.
[laughter]Asif: Exactly. Strangely enough, he didn’t last through the WeWork bankruptcy. He ended up quitting probably a few months or a year or two before the bankruptcy.
Jake: Too hard for him, even.
Asif: Yeah, possibly.
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Merger Arbitrage Strategies: How to Minimize Risk and Maximize Returns
Tobias: What else? What are the more sort of bread and butter type where you’re just looking for a shorter-term smaller size game. Like, Joel Greenblatt’s book, You Can Be a Stock Market Genius, he had some similar strategies in that. What’s the difference between what you’re proposing in The Event-Driven book and his, You Can Be a Stock Market Genius?
Asif: Yeah. So, Tobias, when you introduced me to Herman House– It had been nearly two decades since Greenblatt wrote his book. A lot has changed. So, I wanted to have fresh new case studies, one where the strategy actually works out great and one where the strategy actually doesn’t work out. So, I present both sides of each strategy. I have a dark side section to each chapter, where it informs you about the risks and the problems you might run into. So, that was the impetus of the book. There are certain things like SPACs and insider transactions that are covered more comprehensively in The Event-Driven Edge.
Greenblatt’s book, You Can Be a Stock Market Genius, is a classic. It’s something I loved reading and I recommend to people all the time. So, in some sense, I think The Event-Driven Edge is complementary to Greenblatt’s book, because it’s a little bit more current compared to what Greenblatt had out there.
Jake: I don’t want to say complaints, but let’s say negative things I’ve heard lodged against, especially merger arb, is that people will make a little bit of spread on 9 out of 10. And then on the 10th one, something will break in the deal and it’ll gap down huge and they’ll give back all of that they made before and then some. How do you keep that from happening?
Asif: You can’t and you can. So, two different ways to approach it. So, if you think of merger arbitrage as investing in bonds, you have the option to invest in treasuries, you have the option to invest in investment grade corporate bonds, but you can also go invest in junk bonds and try to use a better yield on the bond, but you know there’s going to be potential default risk.
Merger arbitrage is exactly the same way. Most people hear about the headline deals, Microsoft buying Activision Blizzard or Elon Musk trying to buy Twitter and then deciding he doesn’t want Twitter and then being forced to buy Twitter. And then you have JetBlue buying Spirit Airlines, or Alaska right now trying to buy Hawaiian. So, you hear about these big deals with large spreads. These are trading at massive discounts to where they should be acquired. That’s why a lot of people focus their attention. But most of the other deals with the smaller spreads do end up going through.
So, I have this table in the book that looks by year how many deals were announced, how many actually completed and how many failed. I decided to refresh that data before this call to take a look at what’s happened since I wrote that book about a year ago. And 95% of all deals end up closing. If you were to exclude those headline deals with those large spreads, I would assume that that is closer to 98%. So, to your point Jake, let’s say you do 9 out of 10 deals, one fails. You could still come out ahead with the strategy as long as you try not to focus on just the deals with the largest spreads out there.
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Tobias: I think Buffett said, “You could average about 20% on invested capital doing just merger arbitrage.” That seems high, but does that feel right-
Jake: Got to add some leverage.
Tobias: -to you and gets some push?
Tobias: Is that long or short?
Asif: If you add leverage or use options, it might be possible. Back when Buffett was doing it, I think spreads were juicier. The regulatory environment wasn’t quite as difficult as it is right now with Lina Khan heading the FTC. So, things have changed since Buffett was doing it. But you see him pop into deals every now and then. He was doing Red Hat and IBM. He was doing– Monsanto being acquired by Bayer. He was actually in Activision Blizzards, acquisition by Microsoft as well. He just didn’t stay through the entire process.
So, when he got into Activision, it was trading at about $80 a share. The acquisition price was close to $95. But I waited a little bit longer, and I got in at $75, because my downside risk for that deal failing was about $10, so I figured it could end up at $65 if the deal failed. But the upside was $95. So, I really like that risk reward odds. So, he came in at $80, and I think he left shortly after that without too much of a profit or loss on that deal.
So, I’ve seen him come in, swoop into very large deals, because those are the ones that he can participate in. But we were investing for ourselves or our clients. That is an opportunity to invest in some of the smaller deals that might not have the same regulatory risks that the big headline deals might have.
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Tobias: Let me give a shoutout to– I’ve got listeners, fellas. Toronto, first in the house. Savonlinna, Finland. Good to see you again. Santo Domingo. Tallahassee. Mac in Valparaiso. What’s up? Bendigo, Victoria. Strong, early start for you. Tampa. Toronto again. Jupiter, long way. Is that in Florida? Good for you. Cromwell, New Zealand. [crosstalk]
Jake: Milky Way.
Tobias: [laughs] I think it’s the solar system.
Jake: Okay.
Tobias: Bangalore, India. Stirling, UK. Nashville, Tennessee. Boise. Pittsburgh. Teetsout, Fordalads, Norway.
Jake: Oh, boy.
Tobias: I think I’m going to get demonetized. [chuckles]
Jake: San Diego.
[laughter]===
Tobias: Asif, when 2008, 2009 happened, there were a whole lot of busted SPACs. The SPAC just traded down below their cash and then everybody was trying to get into those to vote down the, whatever, last-minute merger that they stuck in. Has that passed us by? Is that the 2021 SPAC boom now already ended in tears, or are they still around those kinds of opportunities?
Asif: I think it’s pretty much over at this point, you have a bunch of SPACs that did IPO that are still looking for companies to merge with. But quite frequently you find that even after a merger is announced with an operating company, they do end up terminating the agreement. So, just watching what happens where a company is trying to go public through a SPAC, because it wants the capital, and the folks who end up providing the capital end up doing it just for the warrants and leave right after the deal is announced. So, they end up in this really difficult situation where they don’t end up with the capital that they really need to grow the company, assuming it is not a science project and a legitimate business.
So, all around it necessarily is not the best structure at this point. Both the SPAC investors, as well as the companies that want to go public through a SPAC are beginning to understand that. So, there isn’t that veneer of respectability, if you will, of trying to go public this way.
Jake: Very thin veneer.
Tobias: I like merger arb and various other little special situations, but I tend to wait until there’s some big blowout. I think we talked about this a little bit recently. But when the health insurers were all– United was number one by a long shot, and then the other four were merging together into two. The Obama administration stopped the mergers of those smaller ones and they all– Those spreads blew out, but then spreads blew out everywhere on merger arb, because I guess there were just a whole lot of people who will leave it into those, and then they knock on to other merger arbs, and so the spreads became very wide there unusually for a short period of time, like six months or something like that.
Is that the way to do it? Do you wait until the– You’ve got six possibilities of things that you can do. You just wait until one looks unusually juicy and then you do that one? Is that the best way to do it?
Asif: The folks who do it consistently, Tobias. I do it very consistently, and I do it as an alternative and fixed income. And so, if I’m doing it like that, I’m going to do it more frequently. I’m not going to wait for specific events to happen around the market. Sure, if something like last Monday happens and you have this massive spike in volatility and everybody’s selling indiscriminately, that does widen the spreads. Then it’s Christmas or Diwali or whatever you celebrate, and you have to act on it right away. So, that works out well every once in a while.
But for the most part, most of us are looking at every deal. We follow it every day to see what’s happening to the spreads. There are ways to handle the risk. There were deals where, for example, UnitedHealthcare was buying Change Healthcare. So, I was in that deal, but I also had put options to protect my downside. I did the same thing when Oracle was buying NetSuite. I had some put options. Or, when Microsoft was buying LinkedIn. So, having those put options to protect some of the downside does help.
There are times when, for example, Apollo, the private equity firm, was buying Apollo Education, the company that runs University of Phoenix. I ended up expressing that deal through call options rather than buying the stock and buying protection. So, people take different approaches to this. Some people might look at the preferred shares instead. Some people might look at the bonds of the company that’s being acquired. So, there’s so many different ways to approach this. And the people who’ve been doing this a long time have figured out a little bit of the secret sauce of using different instruments and combining them to manage the risk.
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The Power of Insider Buys: Spotting Strong Signals from Key Executives
Tobias: Talk to us a little bit about insider buys, insider sells. What’s the signal there is a buy from one person? Is that enough or are you looking for a cluster of buyers, or how does that work?
Asif: I don’t mind looking at something where its only one person buying, as long as it’s a very interesting person doing that. By interesting, I mean somebody who might be on the board of directors for 10 years or 15 years, hasn’t bought stock in the last decade, and then suddenly comes in and buys a large amount and has an investing background. So, that’s the kind of person I’m really looking for. So, if it’s just that one person who comes in, management is selling, it doesn’t matter. I think that’s a very strong signal for me.
Peter Lynch used to say that, “Insiders sell for all kinds of reasons. They want to buy a new vacation home. They want to send a kid to college. But they only buy for one reason, which is they think the stock is going up.” That might have been true when Peter Lynch was running Magellan, a really long time ago. But as you see with theory of reflexivity, the markets observing what’s happening with these insider transactions, and the management team understands that they are.
So, sometimes they just buy the stock to signal the market. You might see a cluster purchase where a bunch of insiders together might buy it to even try to send a stronger signal to the market. So, the insider buy or even a cluster insider buy is not the do all be all. It really is a mechanism for idea generation.
So, for example, this morning, we reported on 22 insider transactions, insider purchases. As were going through that last night, I found five out of that I found really interesting, and I added it to a watchlist to do more research on. So, I see it as an idea generation strategy. And then there are specific things like an independent director that I was talking about that buys that hasn’t been buying before. That would be a strong signal that I would look for. Some of that is happening right now.
Jay Hoag, who is on the Board of Directors of Zillow, bought a few months ago. As you probably noticed, a few days ago, they announced that the founder, Rich Barton, is stepping down and they have a new CEO. When Jay Hoag bought a few months ago, I couldn’t quite figure out why he was buying it, considering the lawsuit that the National Association of Realtors just settled. That didn’t seem like an appropriate time to be buying a stock like Zillow. But now I understand what might have been its motivation.
So, I see this every now and then where they buy, and it doesn’t make sense and eventually, you figure out why they were buying. So, the kind of insider is what I focus on, as well as the idea generation aspect of following it.
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Corporate Buybacks in Cyclical Industries
Jake: How about the corporate buybacks? It’s not clear to me whether that’s a good signal or not necessarily. It seems like they’ve been cyclically– Sorry, Asif, did you hear question?
Asif: I did not. Sorry, I have a connection issue.
Jake: Yeah, no worries. I was just asking, on the corporate buyback side of things, I’ve seen—Obviously, you think of these outsiders’ types of CEO’s who are executing these amazing buybacks, the Teledyne stories of the world. But then I think the broader base rate of buybacks, if you look at the entire S&P 500, is a pretty bad history of buybacks. They tend to be procyclical. So, how do you untangle idiosyncratic like “Yeah, these guys are good at it versus generally, it’s a pretty bad base rate”?
Asif: Yeah, you’re spot on about that, Jake, because what happens is you find that in cyclical industries, the CEOs find themselves with a lot of cash at the top of the cycle. They don’t know where to invest it, because other companies in the industry are also doing well and they’re expensive and everybody is very confident. And so, they end up buying a stock on the open market and they end up buying back their own stock at elevated prices exactly at the top of the cycle when they shouldn’t be buying. At the bottom of the cycle when there are bargains all over when you could potentially either invest in new exploration of mining projects if you’re in the oil and gas industry, or buying up competitors, they have no money left because they used all the money for buybacks.
So, you’re absolutely right. Some companies and CEOs are very good at understanding what’s happening at the industry level, at the macro level. But for the most part, they don’t. They are focused myopically just on their companies, and might not have the same sense of where things are going as analysts might. So, once again, I look at buybacks as an idea-generation strategy. And then I look at a combination of things. So, I’m looking at companies where the company is buying back its own stock, but also the insiders of the company are buying stock on the open market with their own money. And so, we track that in a custom screen, we call the double dipper. And so, when I see something like that going on, that really gets the juices flowing and something that I would look at a little bit closely.
Jake: And then do you penalize them for excessive stock-based compensation going the other direction?
Asif: Oh, absolutely. So, what’s interesting is they announce these massive buybacks. But we not only track the announcements on inside arbitrage, we also track the actual buyback that has occurred by tracking the 10-Ks and the 10-Qs. We have a graph of that buyback. And so, we look at that to see, are they announcing these buybacks simply to offset the dilution from stock-based compensation, or are the shares actually reducing over a period of time?
So, absolutely, I am looking at that to understand, are they trying to signal the market, are they trying to offset dilution, or is this a real buyback that they believe in? And then, is the company in a cyclical industry, is the valuation elevated? All of that plays into whether I would invest in that company or not.
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Corporate Spinoffs: Should You Invest in RemainCo or BadCo?
Tobias: Tyler Pharris is our unofficial producers. He’s got a good question for you. “When a company is spinning out a BadCo does that tend to unlock value for the RemainCo or is the situation to short the BadCo after the spin? Any lessons on sizing around spinoffs?” I think you raised two good examples before where there was Ferrari coming out of Fiat. And Ferrari has been a great investment. Fiat, not so much. And then you mentioned another one too, where similar, the spinouts done really well. Chipotle-
Jake: Chipotle.
Tobias: -and McDonald’s. What are the lessons there? Is the spin the way to go?
Asif: Oh, It–
Tobias: I lost him. Go again. Go again Asif.
Asif: The question is spot on, because not a lot of people realize that sometimes the spinoff is being done to leave the parent company in a better shape. They tend to load the spinoff with a lot of debt and with bad assets. I’m not saying this is the case with the recent one where Howard Hughes is spinning off their Seaport division, if you will. They have this several block section in lower Manhattan where they’ve been investing a lot of money on the retail side, where they’ve been losing money. And so, they spun off that division. Bill Ackman who owns 37% of Howard Hughes through Pershing Square has indicated that now he wants to buy the company after they spun off their Seaport assets.
So, you got to look at what the spinoff is going to have. If the spinoff is of bad assets, then sometimes I end up buying the parent company, just like in the case of Howard Hughes, that may become more attractive for an acquirer. In the case of the spin off ending up with attractive assets, whether it’s Chipotle or Ferrari, or even Biohaven, which was spun out of a company that was also called Biohaven, because it was acquired by Pfizer, the spinoff was actually interesting, because it had a bunch of cash that the parent company gave to the spinoff, as well as a pipeline of drugs. It was trading at an extremely low valuation.
So, it’s a case-by-case basis. If I find that it’s a BadCo situation, then I end up buying the parent company. I do not short the BadCo shorting unless it’s a very specific situation, is very difficult to pull off.
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Profiting from Volatility
Tobias: When the volatility kicked off last week, does that turn up in your screens? Does that create interesting opportunities for you?
Asif: Absolutely, it does. So, one of the things I end up doing is I create a watchlist as I look at these situations, I look at my custom screens. I’m monitoring the watchlist, both for how the companies are performing in terms of their quarterly results, as well as a price point at which I might be interested in buying. And so, situations like last Monday give us an opportunity to then act on those watchlists. So, that’s one of the advantages.
If there’s a significant outflow in the market, people are panicking– Even merger up situations deals that are quite likely to go through the odds are very good. Might end up with a larger spread. So, you get another opportunity on that front as well.
Tobias: Yeah, I wondered about that, because they should be pretty market neutral for the most part. But I guess everybody suffers when the volatility comes in. Do you have any threshold return that you require before you will put a position on?
Asif: I do. For merger arbitrage, right now, it’s annualized return of 15%. So, for example, let’s just say it’s 16%. And so, I’m looking for deals that might generate about 4% or 5% in spread and returns. If I can do three or four of those a year, then I can get to that 15%, 16% return, not taking compounding into effect. Most deals tend to close in about 120 days because of the regulatory environment that we are in right now. They now take about 131 days.
You’re going to have the outliers like Genworth that took four years and went through significant regulatory approvals. When they got to the finish line, the buyer decided to walk away. So, you have these situations that go on forever. Kroger buying Albertsons. That was announced in 2022. That’s the only 2022 deal that is still active that hasn’t closed. So, most deals tend to close quickly. If I can get a 3% or 4% return on them and get me to that annualized threshold of 15%, I’m happy with that.
Again, the threshold is determined by what’s happening with treasuries and what’s happening to interest rates? When interest rates are zero, I’m happy with the 10% to 12% return. When the interest rates move up to 5%, then I want 15% return to compensate for the risk. A merger arbitrage is also called risk arbitrage. And so, people shouldn’t forget that there’s risk in the strategy, and you need to be compensated for that risk.
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The Art of Position Sizing
Tobias: And how do you size? How do you think about sizing?
Asif: That’s such a difficult question, Tobias, because as you evolve as an investor, sizing keeps changing. The way I think about sizing is if you’re a young investor who’s just starting out, you want to be very diversified.
Tobias: A 100%.
[laughter]Asif: And then as you gain experience and expertise, either it’s with a strategy or with a sector, you can start going more concentrated. The way I used to size merger arbitrage was about twice my standard position size. So, I tried to do 20 to 25 positions. And so, if I was putting 5% into each position, a merger arbitrage situation I used to supersize, I would do 10%. But then if I take a merger arb situation with a very large spread, I understand that I’m taking on risk, I might not do a 10% position. I might do a 3% position there because of the risk inherent in the deal. So, safer deals, I would go 2x the size. Riskier deals, if I decide to participate in it, I might go half the size.
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Lessons from Shinsei: Duration Over Short-Term Returns
Tobias: Good one. JT, top of the hour. Give the people what they want. Vegetable time.
Jake: Well, I’m not sure about–
Tobias: Give the people what they came for.
Jake: Yeah. [laughs] All right. So, today, we’re going to explore this concept called Shinsei. I’m just going to take you on a little journey here. You’re in the heart of Kyoto. And beneath the shadows of this ancient [unintelligible 00:29:05] and the fluttering cherry blossoms, there’s a serene little teahouse. It’s a sanctuary for those seeking solace and connection. Here, in this teahouse, there’s a gentleman named Sen Genshitsu. Don’t hold me on if I’m saying that even remotely right. He’s not merely a custodian of tea. He’s also a living embodiment of this Shinsei spirit.
Sen was born into an illustrious lineage of tea masters. He’s 15th generation, a direct descendant going back to the 16th century master who’s considered the founder of this Japanese tea ceremony.
And around the same time of this tea ceremony was adopted by the samurai class, who saw it as a way to develop their spiritual and aesthetic sensibilities. So, Sen has dedicated his life to this meticulous practice of tea ceremony, which is called chanoyu, I believe. I’m probably saying that wrong also. Everyone’s groaning, our Japanese audience. But this guy’s a living embodiment of the concept of Shinsei. So, what is this word that I keep using? Shinsei is a Japanese term that refers to a company that’s thrived over a really long period of time, particularly one that is known and trusted for the quality of its products and the unique management practices.
Shinsei are long lived Japanese companies, some over 1,000 years. The oldest one is this 1,400-year-old construction firm called Kongō Gumi. There are approximately 28,000 Shinsei companies in Japan. They concentrate in sectors like sake brewing, hotels and inns, and kimono and fabric retail. But most of them are small family businesses, and more than half of them have 10 or fewer employees.
So, let’s stop for a minute right now and just think about the investment return equation. It’s 1+R(n). Everyone tends to be focused on that R number, the annual return. Every lap around the sun, we need to get that number up right. Those are rookie numbers. In the equation though, the R is linear. It’s preceded by a plus sign. It’s additive. Maybe even ephemeral in a shorter cosmic sense. But the n in the equation is the duration of compounding. How many years are we going to multiply out our returns? And in the equation, it’s nonlinear. It’s a compounding series, a power function. So, just purely from first principles, shouldn’t we be focusing on the n much more than the R? And yet, where does most of the investment world’s preoccupation lie? It’s on the R.
So, these Shinsei businesses to me are really fascinating, because they’re real-life examples of duration in the wild. It’s hundreds and hundreds of years of n that have been captured here. You really can’t fool nature for that long. So, it makes sense, I think, to study this species and look for what does duration actually look like.
And so, here are some things about these companies. Unlike Western firms, that are often driven by growth and beating competitors, Shinsei prioritize continuance of their values. The goal is not necessarily to grow at all costs or hyper scaling or all these other things, but it’s the continuance and transfer of principles, customs and values that have been handed down for generations. The employees are trained more through mentorship programs than formal training. There’s a saying in Japanese leadership like,” Show them your back.” Meaning, do the actual work and the mentee can observe like looking and seeing what you’re doing.
The Shinsei businesses leaders really, example. Like, they show their backs. They also prioritize integrity, and responsibility and societal harmony over short-term profits. So, fairness and honesty matter. Profits that were made by deception or even during an economic bubble are not considered honest profits. And yet, they really have to live and work within the society.
There tends to be a focus on quality over quantity, obviously. There’s also even a little bit more reliance on intuition and experience over quantitative metrics. They still look at those numbers, but there’s something deeper happening there. This goes back to our recent segment we had a couple weeks ago about chicken sexing and pattern matching. When you have these deep values, you know what matches your values or not, and then it’s more obvious what’s the strategic choice.
So, right now, you might be rightfully wondering, how do the Shinsei then stay relevant in an ever-changing world? How do you stay important for your customers when the world changes as much as it does? Really, who has time for tea ceremonies when we’re going to Mars or inventing flying cars or whatever? The thing is, they don’t shun new ways of doing things, but it has to be in service of their longstanding values. So, there’s a give and take to that. They innovate very cautiously and preserve their core competencies. They tend to be in slow changing industries that are built on tradition. I think that the business environment selects for these type of businesses.
So, they also maintain really strong community ties and stakeholder relationships. In fact, there’s a concept in Japan called Sanpo-Yoshi, which translates to three-way satisfaction. Toby, I’m going to let you get your mind out of the gutter there with what that—
[laughter]Tobias: I was eager to hear what it was.
Jake: Yeah. So, three-way satisfaction. But it’s a business philosophy that emphasizes the importance of ensuring that it’s a win-win for the sellers, the buyers and society at large. Those are the three-way transactions. So, it’s a much more holistic approach. It aligns the ethical practices and long-term sustainability, which is, obviously, you have to have win-win across all these parties in order to survive for thousands of years.
So, anyway, next time that you’re having a cup of tea, think about Sen Genshitsu, the 15th generation master of tea ceremony, and his dedication to his craft and the continuity of purpose. And then think about the businesses that might embody some of the principles of Shinsei, and what that might mean for maximizing n of duration over the R of returns.
Tobias: Someone should study that construction company that’s lasted 1,400 years. How did that happen? Because a construction company that’s lasted one cycle is [crosstalk] impressive.
Jake: Yeah.
[laughter]Tobias: What are they doing?
Jake: Yeah, it’s a good question. I wish I had more– [crosstalk]
Tobias: Money up front?
Jake: Yeah. Well, one of the big takeaways I think often in these, is that if anytime you have super high volatility, there’s a drag to that then you end up with path dependency issues. Like, you could end up with the biggest wins with high volatility, but you could also end up with the biggest losses.
So, you have to really tamp down your bet size on everything. Like, that’s how you constrain. If you max Kelly bet, that gives you the highest geometric return, but it also gives you huge variance around that. So, you can end up blowing up, if you’re even a little bit off, if you’re a little bit over. So, I think you just have to stay pretty far away from the edge as far as bet sizing goes. That’d be my guess.
===
The Recent Market Wobble Explained
Tobias: We got to figure out what happened last week with the volatility in the markets. You’re a markets guy, Asif, so you must have been following that closely. What do you think happened? What was the cause of the wobble last week?
Asif: Oh, as you see with these things, it’s hardly ever one reason. There’s a multitude of factors that come together. We talked about the–
Tobias: The yen carry trade.
Asif: Yeah, the yen carry trade was a big thing. They decided to move up their interest rates just a little bit. We talked about cutting our interest rates. So, you had unraveling of the yen carry trade. But if that really was what was causing it, you would expect this to continue for at least a short period of time and not a one and done.
Jake: More than half an hour?
Asif: Exactly. So, I think the yen carry trade might have been what lit the fire, but there wasn’t much fire to be had. The wood was wet, if you will, and it didn’t continue.
Jake: I was wondering how leveraged are all of these people if a 25-basis point movement blows you up?
Asif: Yeah.
Jake: What–
Tobias: You’ve got to juice it up, otherwise, you’re earning 25-basis points or you’re not any much of a return. So, I guess you’ve got to be juiced up to be in there. You can’t wear much of a movement. You can’t wear much volatility.
Asif: Yeah. Currency trading inherently has a lot of leverage. You do juice it up quite a bit.
Jake: Boggles the mind.
Tobias: Is it all just a carry trade? All of this stuff that we’re doing, we’re all doing our own little thing, thinking we’re doing something original and-
Jake: Clever. [laughs]
Tobias: -unique, and really it turtles all the way down. It’s carry trade all the way down.
Asif: [chuckles] I don’t know about that. You could invest in good, high-quality companies. And over a long period of time, it works out well. But I think over the last 10 years, everybody has just learned that one lesson. It doesn’t seem to matter what these companies trade at. Everybody’s willing to buy them. The price you pay doesn’t matter anymore, which is a very strange investing environment, if you’ve been doing this for longer than a decade. So, I always keep thinking about that. Sure, I want the Costcos of the world and I want the high-quality companies, but shouldn’t it matter what you pay for these companies?
Jake: Yeah. Do you want them at 50 times earnings?
Tobias: Well, anytime there’s volatility, that’s where the market runs to. That’s where the market goes. You want to be in those high-quality companies. You don’t want to be in those little shitcos that-
Asif: [laughs]
Jake: May or may not be a–
Tobias: -found their way to my portfolio.
[laughter]Asif: Maybe you find a balance of a little bit of both. You find decent companies that are not the extreme high-quality ones that everybody’s willing to pay 80 times earnings for, and you pay up a little for them.
Tobias: The market sneezes in my portfolio, doesn’t catch cold, like falls down, dead. [Asif laughs] It still hasn’t recovered at all. I don’t know if we talked about this much, but the smalls– You probably see a little bit of this, Asif, but the smalls had this monster rally over the last month, minus a week. And then it seems to me that it’s just given it all back in a week, back to where we were. I’m not complaining, it’s still like it’s– [crosstalk]
Jake: Oh, we can’t have nice things.
Asif: [laughs]
Tobias: Actually, we don’t even have time to do that. We don’t even have time to rush out the markets in turmoil podcast to capitalize on it.
Jake: Shortest victory lap ever.
Asif: I wonder some of that is also, because the Japanese authorities, the government tend to intervene directly in the markets. Unlike our regulators and others who participate in our markets, they do actually buy ETFs and stuff like that. So, they probably stepped in and started buying on the equity market and propped it up. So, that could have been one of the reasons things started turning around so quickly.
Jake: I’ve thought about this like, who’s the patsy at the table in this entire big game? I can’t help but wonder if it’s me, actually.
Tobias: Smaller value.
Jake: Well, yeah. No, that’s the obvious answer. No, is it me? Because I don’t want to structure things for myself in a way where I need the government to come bail things out for me. But maybe that’s the much more logical way, like, go risk on. They’ll get your downside. It’s the fed put argument, right? Maybe they are much more logical and smarter than I am. And I’m like the idiot who wants to have self-
Tobias: Where’s your PhD from?
Jake: -preservation. Yeah, that’s the problem. I don’t have one.
===
Uncorrelated Investing
Tobias: Because that’s what you need to get into [unintelligible [00:41:07], that building. Asif, you’re not necessarily market neutral, but uncorrelated, idiosyncratic with special situations. Does it enter into your thinking at all?
Asif: It does. Yeah, I do find that I’m quite uncorrelated. 2022 was down for a lot of people, or was it 2023, I forget now.
Tobias and Jake: 2022.
Asif: I think it was 2022, right? I fed quite well during that year because of that uncorrelated nature of things. But that also means when the market is on a crazy bull run, I’m not participating on that upside either. So, that’s the issue with being uncorrelated. You pick up some of the upside, at least you dampen the downside at the same time. So, that helps. The downside dampening helps, but you lose some of the upside.
We have seen in specific instances like March 2020 where the insiders after that big drop stepped up so significantly that you saw that the net insider buying exceeded net insider selling for the first time in a decade. I’d never seen that happen before. We always report insider selling is 20 to 25 times, insider buying very consistently on a weekly basis. We’[as Leon] see some– [crosstalk]
Jake: Is that bad, huh? I didn’t realize it was– [crosstalk]]
Asif: It’s not bad. Sometimes it’s 50 times, sometimes it’s 100 times. If you’re going through an earnings-related quiet period, those are the doldrums where not much is happening. You might even see– 2020 period, there was massive amount of insider buying. And so, that was a strong signal for me, that was helpful.
Then you see sector specific signals. So, the regional banking crisis that we had and Silicon Valley Bank failing and being acquired for a song by First Citizens, at that point in time, every single night, you were seeing dozens and dozens of regional bank insiders stepping up and buying. That has dried out quite a bit in recent weeks. But at that point, they had stepped up quite a bit.
In May 2020, when those WTI crude futures went negative, the insiders of oil and gas companies were buying hand over fist. So, I find some fascinating sector signals as well as macro signals that has helped on the long side for me.
===
Tobias: How are you tracking?
Jake: False signals there? Any management teams catching falling knives that you’ve noticed?
Asif: Yeah, they catch falling knives quite frequently and they get cut, because of those falling knives. In some sense, they are tuned in with value investors, because they see the stock. I was joking with somebody recently when I met them for lunch at San Francisco. He was talking about how the stock looked really attractive, and it couldn’t go any lower. I said, “Those words are magic to me when you say couldn’t go any lower, because I know it’s going down 30% from here-
[laughter]Jake: Yeah.
Asif: -that’s why I’m going to buy.” But the insiders do the same thing. They are early getting into situations, because they see the value. But the market momentum continues and mean reversion takes a while. It overshoots the trend line. And so, you often will find that the stock might drop for a few days or weeks after the insider purchases, which is why a lot of people end up dismissing insider buying, because they see them buying and they see it dropping. They’re not looking out long enough. They’re not looking at a six-month horizon to a two-year horizon, where some of the things that the insiders thinking about when buying actually starts to play out.
===
Tobias: I got another good question here from Tyler Pharris. “Do you find the special situations easy to find in bull markets or bear markets?”
Asif: In bear markets, I find a lot of fascinating situations, because you see insiders step up their purchases. In bull markets, insiders really scale back their positions. You’ll also find that in bull markets, merger arb spreads might contract quite a bit, so your opportunity is lower, because everybody is so confident they’re making money everywhere. In bear markets, you might find that some of these merger arb spreads might increase. So, specifically on days when there’s a lot of turmoil, you might get opportunities. So, I find more opportunities in bear markets.
Spinoffs are market agnostic. They happen all the time. And so, there might be specific situations like SPACs and spin offs or management transitions. I like management transitions that are going to happen all the time through bull markets and bear markets. So, out of the six strategies, a couple of them favor bear markets, a few of them are market diagnostic.
Jake: What’s this bear market term you keep throwing around? What’s that mean?
[laughter]Tobias: There was one last week.
Jake: Oh, okay.
Tobias: What are you talking about?
Asif: We might see one in the next decade. [chuckles]
Tobias: It ran from, whatever, Sunday night to Wednesday morning or something. [Asif chuckles] I don’t know, if you– I don’t know. There’s no way to track this. There’s no way to preempt this.
===
What Starbucks’ New CEO Can Learn from Chipotle’s Success
Tobias: But the Starbucks has picked up a new CEO from Chipotle. Starbucks is up 20% on the day, something like that. That’s a big bounce. What’s he going to do that’s so different? What does Chipotle do that Starbucks doesn’t?
Jake: Put guac in the coffee– [crosstalk]
Tobias: [laughs] Guac is extra.
Asif: And a company like Starbucks, if he’s going to turn it around, it’s probably going to take him three to four years to pull it off. The larger the company, the deeper the problem, the longer it’s going to take a CEO to turn things around.
Larry Culp, who came over to GE from Danaher, did an excellent job. So, that’s a case study in the book about how he came in. I noticed GE, the new one, not your grandfather… that was insider purchases. He did all the spinoffs, loaded the spin off with debt, ended up with GE with a clean balance sheet and a division that was higher margin, faster growing and all of that. You see Pat Gelsinger at Intel trying the same thing for the last three to four years and hasn’t quite happened.
So, I guess the larger the company, the deeper the problem, the longer it’s going to take. Some are able to pull it off and others aren’t. But you start seeing some of those signs, usually in year two for the very large companies. For the smaller ones, hopefully after about six months or so.
===
Tobias: What can they do to bail out Intel? I owned Intel a few years ago, but I had to sell out of it. I haven’t regretted selling out of it. It’s not been pretty. What’s their best move? Sell to Nvidia or something like that?
Asif: [laughs] There’s no way the regulators are going to allow Intel to either make a very large acquisition or to be sold to anyone. Really, I guess the government backing them with their fabs is going to eventually payoff. They really have to come up with chips that people want to buy, whether it’s on the CPU or the GPU side. It seems like that’s far away from that at this point.
===
Is Tegna a Value Trap or Deep Value Opportunity?
Tobias: You feel like the markets have calmed down after that volatility. Do you see the spreads closing and start feeling a bit better about that, or are we setting up for more volatility into the election or do you have any view there?
Asif: I have absolutely no view on that. From the spreads that I’m seeing, they’re pretty normalized at this point in time. I used the volatility last week to buy shares in a company that might benefit from the elections. So, the company is potentially a deep value situation or a value trap. They often have similar–
Tobias: Yeah, there’re few of us.
Asif: Yeah. And so, Tegna is the company. It’s a TV broadcasting company. Almost nobody watches TV anymore…
So, that’s the reason it trades at four times earnings. It usually benefits from the presidential election cycle as well as the other two years when Senate elections are going on. So, this is the time for the next six months they’re likely to do well.
Standard General tried to buy this company and the regulators did not let that go through, and that was at a much higher price than where it’s trading right now. The entire segment looks quite interesting. Nexstar, Gray Television and Tegna. Tegna seems to have the best margins in this peer group. So, I used that volatility last week to buy some Tegna.
Tobias: Are they regional television stations? Is that–
Asif: Yeah, the regional television stations, they own also the true crime network. They are a key NBC affiliate and they reach about 39% of US households. So, you have the Olympics that benefits the NBC network. You have the election coming up. So, if you look at the financials, you are going to find one really good year and then one down year and one really good year. So, you’ve got to average it out over four years and see how they’re doing. They’re actually doing quite well. They’re buying back stock, there was some insider buying, there was a merger arb situation. So, I love it when you have multiple special situations all happening with the same company. I pay close attention when that happens.
Jake: What’s been your experience on the buyout side of things? How much of it’s been private equity taking companies that you are interested in private?
Asif: You see quite a bit of private equity participation. Usually, that is good, because often regulators will not step in and block the private equity firm, unless it’s like Thoma Bravo, which is going out and buying every software company they can lay their hands on. Hopefully, nobody from Thoma Bravo is listening to this. But if somebody comes in and they start rolling up a specific industry, then the regulators are starting to take a look at that. But if it’s a one-off private equity deal, they don’t.
In the case of Tegna, while Standard General was buying Tegna, there was also Apollo participating in the transaction. They had another company that was already going out to Dish Networks and saying, “Once we roll up Tegna, we were going to bump up our broadcasting fees,” and so on and so forth. Somebody sent that to the FCC, and “You had this issue where the private equity firm owned a complementary company,” and that ended up creating a problem for this deal. So, we do see a good mix of both strategic buying as well as PE firms buying companies.
Jake: I’d be curious with some of the indigestion in the private land, if maybe some of that deal flow slows down somewhat.
Asif: It hasn’t. I thought when interest rates went up quite a bit, you would see the deal flow go down. That hasn’t happened either. There’s just too much money in the system right now to dampen spirits.
===
The Effect of Presidential Elections on Market Volatility
Tobias: Yeah. I would’ve thought rates would have impacted things a lot more than they have. Rates have done nothing. It’s time to cut.
Asif: I know.
Jake: The cut already, yeah, survived a 25. They’ll lower them back down.
Asif: Yeah. Home builders–
Tobias: Sorry, Asif.
Asif: I was going to say the home builders ended up doing even better with high rates. The REITs managed to survive, except for maybe office REITs, and to some extent, some retail REITs. But you’re right. The interest rates going up as rapidly as they did. Almost had no impact.
Jake: Well, in fairness, the S&P 500 as an entity– If you looked at as a single entity, they borrowed long and fixed. So, they haven’t had any real resets. Smaller caps, much more reset, shorter term and more variable. So, they’ve probably felt it a little bit more.
Asif: Yeah. You had that big drop in tech stocks in 2022 after every analyst adjusted their DCF models with higher interest rates and realized, “Oh, my God, these companies making money 15 years from now spells trouble at higher interest rates.” And so, you had that big drop in 2022 because of that. So, yeah, I guess I was wrong in saying that there was no impact. There was an impact, but we got through that so quickly, and it surpassed where it was during those 2021 highs. So, net-net, I think we’ve survived the interest rate increases quite well.
Tobias: There’s some volatility often going into the business end of the presidential cycle. Market doesn’t like uncertainty. And then whoever we get as president, the market probably rallies from there for a little while. Not that it’s not really investing, it’s just my observation of what’s happened the last few times, lots of volatility going in. Any way to play that? Any good ideas there, besides the TV station? There’s a few people who like Gray TV, by the way, in the chat.
Asif: Yeah. So, the merger arb world would probably be thankful for a change in administration, because the regulatory environment for the last two or three years has been very difficult. And so, depending on who wins, I think we’re going to see some impact on merger arbitrage specifically. You know what happened when Trump won the last time? Everybody thought the market was going to drop. It did the exact opposite, because they saw him as being very business friendly. I think some of that might still play out this time as well. They’re going to see Trump win as being more business friendly, less regulation, if you will.
If Kamala Harris wins, I think people might see that as potentially a negative for maybe the insurance industry or other industries where regulators might step up even more than they have the last three or four years.
Tobias: I think when Trump won, there was a big sell off that night, wasn’t there? Because Icahn said that he got a billion dollars of SPY futures from somewhere in the thin market that trades overnight on a Sunday night or whatever it is, Tuesday night.
Jake: [laughs]
Asif: That was fascinating. You see this sometimes even with individual companies reporting results, the way the after-hours market interprets the events is actually very different from what happens the following morning.
Jake: It’s down 20% in after hours. And then morning comes and it’s like, “Oh, flat, yawn.” [laughs]
Tobias: That’s happened a few times. I feel like we’ve been– The overnight futures were looking ugly and then it sorted itself out very quickly in the normal trading. I don’t know. So, I guess it’s so thin it doesn’t mean anything.
Asif: Or, the wisdom of crowds, if you’d like to call it that during the regular trading session.
===
Is the Wisdom of Crowds Becoming Less Effective in Modern Markets?
Tobias: Do you think you get the wisdom of crowds in the stock market? They’re independent. Actually, there’s a good interview with Cliff Asness on Bloomberg Invest where he talks about some of this stuff.
Jake: Does he say it’s breaking down because indexing?
Tobias: No. He thought that the markets have become less efficient over the last 32 years since he’s been doing, which I thought was interesting. There’s still a pretty big value premium there. It doesn’t seem to be converting into returns with the premiums there. [laughs]
Jake: Oh, it’s there. That’s as good as money, sir.
Tobias: You have to look at it. [crosstalk]
Asif: The wisdom of crowds is interesting. We are in such an information rich environment right now where we have so much information about so many things. You have so many smart participants looking at all this information and acting on it. So, there’s something to be said for that wisdom of crowds. The reason that people follow things after it’s above the 200-day moving average or whatever it might be. But I guess it just ends up being taken too far. That’s probably where the opportunity is, both on the upside and the downside.
===
Inside Arbitrage: A Comprehensive Tool for Tracking Special Situations
Tobias: Asif, you’ve got a service that tracks these special situations. What’s your service called?
Asif: So, it’s called Inside Arbitrage. It’s a website I launched about eight years ago. And so, what we do is we have the six strategies I’ve discussed in the book, The Event-Driven Edge in Investing, on the website as well. We ended up building a series of tools to track these strategies. So, if you were to go there, there’s a merger arbitrage tool that tracks all active US deals that have been announced and haven’t closed yet.
We also track pre-deal situations. Bill Ackman potentially making a bid for Howard Hughes. Howard Hughes has hired Jefferies as their investment banker to work through this. And so, that’s a pre-deal situation that we also end up tracking.
The PE firm, Standard General that was not able to buy Tegna, ended up buying Bally’s, the casino operator. And so, that was a pre-deal situation where they had made a public bid for it. But Bally’s had not accepted it. So, that was another thing we were tracking.
So, we track pre-deal situations. We track deals from announcement to closing. We have a completed spinoffs section where we track how both the parent and the spinoff company are doing. We have an upcoming spinoff section. So, we ended up building tools for each strategy. And then we write about these strategies in an article called Insider Weekends every Sunday, or Merge Arbitrage Mondays, every Monday, or a monthly newsletter where we feature two spotlight ideas that we found by following special situations.
Tobias: Do you track that insider buys? Can you see that at a sector level? Can you see what the industry or sector insiders think about something?
Asif: Yeah, we ended up creating something called an Insider Heat Map, that is sector level for management changes. If you want to add directors to it, you can do that. But we exclude 10 person owners and directors, and we look at what management are buying by sectors. It lights up red or green, depending on how much they’re buying. So, we look at that.
Actually, that can be quite interesting, because if you find multiple insiders of different companies within the same sector buying, maybe that’s an opportunity like you saw with the regional banks last year, like you saw with oil and gas in May 2020. So, that’s the reason we ended up building that tool.
Tobias: Where are they buying now?
Asif: They are not buying quite as much at this point. We are seeing some amount of insider buying in the TV broadcasting. We saw a little bit of that. But nothing that really jumps out to me at this point.
===
Tobias: That’s interesting. Well, Asif, thanks very much for joining us today. The book is The Event-Driven Edge in Investing: Six Special Situation Strategies to Outperform the Market with Harriman House. That’s a good publishing house. Thanks very much for joining us today, JT. As always, folks, we’ll be back next week. Same bat time, same bat channel.
Asif: Thank you, Tobias. Thanks, Jake. Thanks for having me on. It was a wonderful conversation.
Tobias: My pleasure. Thanks for joining us.
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