Monthly Archives: November 2014

Porsche: The Hedge Fund that Also Made Cars

I usually only write book reviews because I feel books have enough content in them that a book review is a handy way to organize one’s thoughts from the book. However, I’ve recently read a 6000-word article on a website that I felt had so many learning points that I just had to write a review on it. The article is Porsche: The Hedge Fund that Also Made Cars by Priceonomics Blog. The article is basically a case study on how Porsche tried to takeover Volkswagen but ended up being taken over by Volkswagen instead.

Firstly, Wendelin Wiedeking was clearly a capable businessman. He managed to turn Porsche, which had been on the verge of bankruptcy when he became CEO in 1993, into a company that made $166 million in profit in 1998. He did so by improving quality, reducing inventory, increasing efficiency, and reducing headcount. He hired a team of experts from Toyota to revamp the production line.

Secondly, while Wiedeking’s work at Porsche showed he was a more than capable CEO, he would really be remembered for also having a keen eye for investment. Over time, Porsche had become increasingly reliant on Volkswagen. For example, the Porsche Cayenne and Porsche Panamera were both built using VW chasis. There was a threat that another company could buy over Volkswagen and sever this partnership because Volkswagen had a very depressed stock price. VW had annual profits of only $2.2 billion from $123 billion in annual sales or a net profit margin of  1.7% and so was very poorly rated by the financial community. Interestingly, Porsche decided to buy a stake in VW. In 2005, it acquired a 20% stake in VW which acted as a deterent against a hostile takeover of its partner. Wiedeking had not only made a strategic investment by buying a stake in a partner company that allowed his own company to keep a high profit margin, he had done so at a very undervalued price. I like that Wiedeking was not only a good CEO, he was also a savvy value investor.

Thirdly, Wiedeking made a mistake by becoming the market for VW shares. While things started well for Wiedeking, it seems like he got overly ambitious. He started to buy more shares in VW and tried to turn VW around. By 2008, Porsche owned 50% of VW and VW shares had tripled in prices from Porsche’s first buy price. The market noticed Porsche’s interest in VW and VW’s share price continued to trend upwards even though the company performed poorly because investors believed Porsche would continue to buy up shares. This attracted many short sellers who believed that VW shares would plummet once Porsche stopped buying VW shares. Porsche had essentially become the market in the sense that it’s holdings of VW shares were only valuable on paper. If Porsche tried to sell any of its VW shares, the value would likely drop since the market would no longer expect Porsche to continue buying VW shares. This was a very dangerous moment for Porsche.

Fourhly, Wiedeking was bold enough to pull of an amazing stunt. As the Great Financial Crisis hit, short sellers piled on VW and 12.8% of the shares were sold short. Porsche pulled off a clever move where it announced that it raised its stake in VW to 42.6%, and also purchased cash-settled options to purchase another 31.5% of VW shares, taking it’s stake in VW to 74.1%. The company also announced it’s intention to acquire VW, which would allow it to use the cash on VW’s balance sheet to finance the acquisition. This created a short squeeze and VW’s share price went from $200/share to $500/share to $1000/share. Porsche didn’t have to disclose its growing position because it used cash settled options which technically wasn’t considered buying shares in the comapny. Moreover, it did so by buying the options through six different banks so no individual person knew the extent of Porsche’s move. Porsche was on the verge of completing an audacious takeover move and I am very impressed by how it has done so.

While Wiedeking had so far played his cards very well, he had made a few mistakes. Firstly, he was too optimistic that the German government would repeal the “Volkswagen Rule”. The local German government of Lower Saxony owned 20% of Volkswagen and could prevent anyone from acquiring the company without their permission or anyone from having more votes than them over shareholder matters. It was argued that this law was incompatible with EU laws and so would be soon repealed. Once the law was repealed, Porsche would be the frontrunner to acquire Volswagen since it had a large stake. I feel that Wiedeking should have waited for the law to be revoked before increasing Porsche’s stake in VW above 20%. The 20% stake already made Porsche the most likely to acquire VW. By increasing the stake, he was making it more expensive to acquire more shares, even though the VW rule was in place and preventing him from taking over the company.

Secondly, Porsche financed these share purchases by accumulating debt and it needed more capital to buy off the rest of VW. Precisely when Porsche needed banks the most, banks stoppped lending money. Banks were no longer interested in lending more money due to the GFC. As Porsche CFO Holger Harter said, “We learnt the hard way that banks are there for you when you don’t need them, and when you do need them, they’re no where to be seen.” Porsche neede money to repay some loans that couldn’t be renewed. I feel that using debt to finance these share purchases was foolhardy since Porsche was not in the position to complete the takeover anytime soon since the VW rule had to be repealed. In my opinion, using debt means that your end goal has to be reached before the debt comes due.

The Great Financial Crisis was transforming Porsche’s move from brilliant to stupid. By March 2009, Porsche owed $13 billion to 15 different banks, each of which could bankrupt Porsche if so it wished. Porsche needed a bailout. If you read the article, you’ll learn that Ferdinand Piesch, the Chariman of VW, was also on the board of Porsche. In fact, Piesch was the grandson of Porsche’s founder and was the second largest shareholder in Porsche due to his lineage.He used to work at Porsche but family squabbles made the family decide that no family member could work in the company. Piesch went to work for Audi, rising to CEO in 1988 and became CEO and Chairman of Volkswagen by 1993.

While the story of Wiedeking and how he made Porsche make millions from its stake in VW was fascinating, I reserve most admiration for Piesch. While Porsche was building its stake in VW, Piesch remained silent on the issue. He sat on the board of both companies so he was very aware of what Porsche was doing. Observers speculated that he may be selling Volkswagen to Porsche so he could profit from the move, since he was one of the largest shareholders in Porsche. In 2006, Piesch even announced that he would step down from the VW board  in two years time. While Piesch sat around and let events unfold, he was in fact biding his time for Porsche to make a hiccup.

This hiccup came during the Great Financial Crisis when Porsche was in need of a bailout to repay its bank debt. Piech used VW to provide an emergency loan of $1 billion to Porsche. By doing so, Porsche went from predator to prey. As the $1billion loan approached maturity, Piesch started commenting about his waning confidence in the Porsche management team. Since Porsche was unable to repay the loan, VW mandated that Porsche would have to sell itself to VW. By biding his time and striking when the iron was hot, Piesch transformed his stake in Porsche to a stake in both VW and Porsche.

I feel that this case study was very illustrative and would serve as good reading to all.


Book Review: Confidence Game

After writing 2 reviews of books not directly related to investing, it’s time for me return to reading investing books. I found Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street’s Bluff by Christine Richard to be a most riveting story about Bill Ackman’s short trade on a bond insurer called MBIA. The narrative was engaging and fast paced yet the book went into close detail as to how Ackman structured the trade, his investment thesis and also how the bond insurance industry worked. As such, my takeaways from the book can be categorized as firstly what I can apply to trading and secondly to what I learnt about the insurance industry.

One of the first things that stood out to me was how long the trade took to work out. Bill Ackman first publicly released a report detailing his analysis on MBIA and short thesis on December 9, 2002. He had spent the past several months researching about the company, meeting with management and discussing the company with investment research analysts at banks. The stock opened on Dec 9 at $43.65 and closed down nearly 4%. The stock reached a high of about $74 in Jan 2007. This means that at one point of time, the stock had gone up almost 70% from Bill Ackman’s short trade. The market only started realizing the issues with the housing market and bond insurers shortly after that in early 2007 and the stock started plummeting and capitulating in October 2007. He finally closed out his trade in Jan 2008 after MBIA’s credit rating was downgraded. This means that it took about 6 years of work for his thesis to work out. This was in spite of the fact that Ackman not only publicly released his bearish thesis, but also actively tried to persuade regulators and the credit rating agencies to intervene with the company’s business model. This reminds me of the saying by John Maynard Keynes that “Markets can remain irrational longer than you can remain solvent” and emphasizes the importance of the timing when placing short trades. I feel that only someone with Ackman’s immense self-confidence and stubbornness (perhaps even pride or arrogance), to maintain his conviction and position. In the epilogue, the author writes that “the small fund set up exclusively to short MBIA in the credit-default-swap market back in 2002 was wound down at the end of 2008. Those who didn’t add to their investment over time lost more of their money as MBIA CDS contracts expired with no worth. Those who continued to bet with Ackman and kept putting more money into the fund made multiples of their investment.” I’m sure most investors didn’t make the kind of return that Ackman did simply because they didn’t have the conviction to maintain and add to their position.

I believe Ackman was able to maintain his short position because the way he structured the short allowed him to put a cap on the cost of holding the position. While he did sell MBIA stock short, his position was mostly structured by buying credit default swaps on MBIA debt. CDS contracts are essentially life insurance on companies. The buyer of the contract makes regular payments over the life of the contract to the protection seller, who promises to make a lump sum payment to the insurance buyer if a security defaults. This means that Ackman’s downside was fixed. He couldn’t lose more than the amount of premiums he had to pay, which was a fixed amount. Since the par value of the CDS contracts was significantly larger than the total amount of premium payments made over the life of the CDS contract, CDS contracts provide leverage. Thus, Ackman’s position not only had a fixed cost, it also had a potential upside that was many times larger and had a long tenure of 5 years. To illustrate this point, the book writes that at the beginning of 2002, it cost $35,000 per annum for a 5-year CDS contract on $10 million of MBIA debt. This means that the contracts provided a leverage multiplier of almost 57 times for a tenure of 5 years. Unfortunately, I doubt retail investors like I will ever get to trade a CDS contract, even through private banking products. However, we can trade put option contracts which work in a similar way. Thus, always remember to try to cap the cost of your position and maximize the potential return.

Ackman’s trade also reminded me of the importance of “going for the jugular”. Similar to Ackman, George Soros is famous for breaking the Bank of England by shorting the British Pound in 1992 and John Paulson for making “The Greatest Trade Ever” when he made billions betting against subprime in 2007. What’s remarkable of these trades is the sheer size of the bet. Even as MBIA’s stock price increased over the years while defending itself against Ackman’s campaigns, Ackman not only maintained his position but also added substantially to it as he found more and more evidence that made him more certain that he was right. The book’s author writes that at one point, members of his investment team “physically restrained him, as if he were ‘an alcoholic reaching for a bottle’” while Ackman proceeded to increase the size of his bet. Moreover, Ackman also knew to “ride his winners”. As their investment thesis was working out and MBIA’s stock price was capitulating in Jan 2008, Ackman’s investment team thought it was insane not to take some profits. The position had grown to become by far the largest position in the fund. Their nerves were frayed and they couldn’t sleep at night. When they advised Ackman repeatedly to reduce the position, Ackman simply replied “We’re going to ride this into bankruptcy”.

I believe Ackman was able to keep his calm and maintain his conviction in this way because of the voracious amount of research he had done. The book even writes that none of the fund’s analysts wanted to take on the job of making their own independent analysis and conclusion because it wasn’t possible for any MBIA analyst to ever know as much about the company as Ackman. The fund was charged a $109,000 photocopying bill for copying 725,000 pages of financial statements and other documents, to comply with a subpoena. From the book’s narrative, it really seems that Bill Ackman lived and breathed MBIA for the six years of his trade, taking his readings with him when he went on vacation, and discussing his thesis with everyone he met, even his tour guides while on vacation. Since he understood the company so well, he could clearly and quickly understand the impact the changing market conditions had on MBIA’s business model, liquidity, and solvency, and hence its valuation.

Bill Ackman was very public in his bear thesis and it could be described that he was running an activist short campaign. Typically, this activism pressures management to improve their business model. In this case, management did all it could to defend itself and attack Bill Ackman. Ackman paid a huge personal price. His name was frequently smeared in the press, including the Wall Street Journal and New York Times. The book suggests that MBIA hired an influential lawyer to sway a judge’s decision against Ackman’s first fund, Gotham Partners, in an unrelated case which caused the fund to be wound down. Ackman was investigated by the New York Attorney General’s Office, the Securities Exchange Commission, the New York State insurance regulator and a whole bunch of other regulators multiple times for multiple reasons. For some of those charges, he could have been sent to prison for a few years. This lasted throughout the whole 6 or so years from when Ackman first went public on his bearish thesis to after he was proven right. I do not believe that I would be willing or be able to go through all this. Instead, I look to Warren Buffett’s example. The book writes that Ackman asked Buffett at the 2003 Berkshire Hathaway shareholders meeting to comment on the bond insurance business model. From Buffett’s response, it is clear that he understood that the bond insurers were mispricing risk, didn’t deserve a triple-A credit rating, and the accounting rules didn’t consider derivative contracts accurately. I believe that Buffett’s long-only approach allows him to have a very favorable reputation from people and is a net benefit for him.

Having good relationships and a large network allows an investor to gain important insights, views and  advice. If anything, the book reinforced my view that many industries resemble an old boys club. Bill Ackman and Whitney Tilson, another hedge fund manager, were friends since their undergraduate days at Harvard. Tilson had suggested Ackman buy shares in a company called Farmer Mac. Ackman’s research on Farmer Mac made him realize that some companies didn’t deserve the high credit ratings that they had while their business model depended on them. He then asked a salesman at Lehman Brothers’ if he could think of another triple-A-rated company that might not merit its lofty rating. This salesman told Ackman that he was skeptical of the bond insurers. Later Bill Ackman shared his analysis of MBIA with David Einhorn, another hedge fund manager, whom he had met at an “idea dinner” where investors shared information about and got feedback on investments. While dealing with the PR campaign against him, Ackman received advice from Tilson, Einhorn, and other managers. The SEC and Barney Frank did not respond to Ackman’s requests for meetings to discuss MBIA until they received calls from Marty Peretz who had been Ackman’s undergraduate thesis advisor. I feel that these connections are invaluable in bouncing off ideas, testing theories, aiding learning and understanding the markets. It’s important to have an ear into the market chatter. That’s what I’m trying to do by reading many financial blogs and following other investors on Twitter and StockTwits.

As seen, there are many things that Bill Ackman did well, yet there are some things he did that I feel he could have done better. Although Bill Ackman’s return from MBIA was so large, Pershing’s main fund still closed in the red. It could be argued that his loss of 11% meant his performance surpassed the stock market which was down 40% that year but I’d argue that investors still lost money when in fact they could have made many times their money that year. Unfortunately for them, the gains on short positions in MBIA and the other bond insurers were offset by losses on retailers such as Target Corporation and Borders Group Inc., even though the short position was so large. Perhaps Ackman was so focused on proving that MBIA’s credit rating would be downgraded that he didn’t realize that literally all stocks would decline drastically due to the resultant credit crunch. He had in fact foretold the disastrous effects that a bond insurer credit rating downgrade would have on the credit markets and financial system earlier. It could be argued that he had missed the forest for the trees.

Ackman could have underestimated the inertia of regulation. From the narrative, it would appear that many people, whether regulators or analysts, doubted Ackman’s thesis because he was essentially arguing that something that was extremely profitable and working very well was a sham. There was no incentive for anyone to rock the boat because everyone was benefiting. Even when the subprime mortgage market was starting to unravel in 2006, the credit rating companies only downgraded the bond insurers in late 2007. They really left their ratings there until it was clear for all to see that the ratings didn’t make sense.

Interestingly, MBIA and bond insurance is actually a business that I would love to own. The book explains that MBIA was started by a bond investor and an investment banker who realized that there were many bonds on which the risk of default was practically zero and so selling insurance on bonds that would never default would be an excellent business. Municipal bonds were less risky than they appeared because credit ratings did not take into account the understanding between investors and public officials that bonds used to fund public projects wouldn’t default. Thus, a great businessman would set up a business guaranteeing bonds that were safer than they appeared. “In exchange for receiving an upfront insurance premium, the bond insurer agreed to cover all interest and principal payments over the life of the bond if the issuer defaulted. As long as the bond insurer maintained its triple-A rating, the bonds remained triple-A. The beauty of bond insurance was that the bond insurer didn’t need capital to buy the bonds. The bond investor put up the capital. The insurer would collect the insurance premium up front in exchange for guaranteeing the bonds and would invest the premiums over the long term.” Thus, selling insurance is exactly the same as selling put contracts, something that I do in my investment portfolio all the time since 2011.

The key to a bond insurance company’s success is that it writes to a no-loss standard. The company must be very astute to only guarantee bonds that would in fact never default. The company must make much more from the premiums it collects from each bond it insures, to cover the bigger loss it would incur if just one bond defaulted. One way to reduce this risk is to diversify by selling a large volume of insurance on different bonds. However, people often think they are diversified and so are safely positioned just because they have many different stocks across a range of sectors. However, this does not mean that they are diversified at all. What’s important is to be diversified across a range of risk factors. For example, you could own a bank stock, a homebuilder and a furniture retailer stock and think that you were diversified over three different stocks when in fact you owned three different stocks with the same risk factor: housing. Thus you really were not diversified at all. The problem with the bond insurance companies was that they started selling insurance on structured finance products such as housing loan CDOs. Their models showed that these CDOs were diversified over the whole range of housing markets in the USA and so were very safe. They forgot that while each CDO was diversified over many housing loans in many different housing markets, the CDO as a whole was still not diversified from risk to the housing market in general. As Warren Buffett said in his response to Ackman’s question on the bond insurers at a Berkshire Hathaway shareholding meeting: “There’s nothing more deadly than unrecognized concentrations of risk”. I have made it a point to regularly review my portfolio, organize it amongst risk factors, and ensure I am adequately diversified.

Overall, I’d say I’ve learnt a ton from reading this book and have been greatly edified by it.

Thanks to David Merkel at The Aleph Blog, John Hempton at Bronte Capital, GuruFocus and Future of Capitalism for writing comments/reviews on this book from which I also gained insight.