Sunday, June 26, 2011
The Paulson Sino Forest loss
I am more sympathetic than the non-practitioners though I think Paulson's excuses sound lame.
Here is my sympathetic view:
There are two approaches to running a funds management firm. One approach is to have analyst teams covering every sector and to have depth of coverage. The other approach is a small and more flexible team. Each of these approaches has its problems.
I got a good idea of the problems of the broad coverage approach when PMI (the mortgage insurance company) double-booked an investor relations meeting. I sat in on a meeting between PMI and the Fidelity analyst who covered the sector and watched the incredibly nuanced discussion the Fidelity guy had about mortgage insurance. The Fidelity guy could make detailed distinctions between mortgage insurers and could tell you which ones he would prefer owning.
This was 2005.
Of course the right investment decision for mortgage insurers in 2005 was to own none of them. A year later the right answer was to short all of them.
But because Fidelity had a guy who knew lots about mortgage insurers they owned mortgage insurers (probably at near market weighting) and they duly lost money.
A small team would either decide hey - they want to be part of this high growth mortgage market and own them - or decide the did not want to be part and not own them. If they were aggressive they might short them. There was a reasonable chance that the small team was going to do better than the big team because it was not the nuances between mortgage insurers that determined the outcome.
Generally I think the small-team works better. I came from a shop with a great record and eighteen investment staff. Most the good ideas came from nine of those staff. They were better than large teams - and every time we increased the size of the team we diluted those staff. The main reason for increasing the size of the team was that the new staff - whilst they did not contribute much - were being trained. And after a four or five years one in say five of them might join the anointed ones. And as we had a good name the others might find worthwhile jobs elsewhere...
But there are problems with the small teams. First small teams have blind spots. The world is a big place (too big to paint anyway) and there is no way that the senior fund manager can cover everything. There are large specialized stock areas about which I know nothing (eg most German industrial companies, US Health Care, South American resource companies). Things just pass me by. A really good nine person team has less blind spots than Bronte (three people) but blind spots are a part of life.
Secondly we use shortcuts. In the pre-internet days I used to "know" for instance that monopoly town newspapers earned 35 percent EBIT margins and trade at 3.5-4 times sales. The dominant competitive newspaper in a duopoly town earned 20 percent EBIT margins and traded at 2-2.5 times sales. When someone came to me with a newspaper stock (a sector about which I knew plenty) I used to ask about the competitive position of the papers (which towns were monopolies, which duopolies etc) and the margins, do the sums quickly in my head and decide whether it was good value. Beyond aggregate numbers I probably did not open the accounts. A portfolio manager with a diversified portfolio makes a lot of decisions and they take shortcuts. The shortcuts are a necessary part of life - and they are how you apportion and guard your time.
I am an expert on fraud - but it is entirely possible that I would miss a well executed fraud at a newspaper company because my starting assumption was that I could take the numbers as gospel.
The shortcuts we use as portfolio managers (and these are often sophisticated shortcuts born from some deep understanding of the industry) can make even the best portfolio manager susceptible to fraud.
Moreover a portfolio manager needs to work out how to ration their time. They can't do in-depth analysis of every stock in a 20 stock portfolio. (Well they can - but most the in-depth analysis you do are of stocks not in the portfolio as you need to decide what to invest in rather than becoming more expert on the things you own.) So you tend to spend your time on things that you perceive pose the most risk or the best returns.
Timberland is famously low risk. There is a German charitable trust that has been around since the 16th Century living off a 500 year old bequest. It owns timberland. Timberland - along with unlevered land below large buildings in major cities - is one of the few assets that seems to hold its value and earn returns for centuries. (Gold may hold value but earns no returns.)
I can understand how a deeply bearish investor (and Paulson was a deeply bearish investor) got suckered into Sino Forest. They saw it as timberland. They did not do the due diligence that was required to spot the fraud. It had a respectable board and reputable auditors and a long history. It did not feel like a fraud.
Chinese stocks present massive fraud risk but trees are low risk.
Paulson didn't see China for the trees.
And guess what - it happens to all of us. Fraud is pervasive in financial markets - its just that nobody talks about it. When they are had they are more-than-likely going to blame it on bad investment decisions than fraud. Moreover it is embarrasing - even business threatening - for professional investors to admit they were victims of fraud - so they don't talk about it even when they know they were had.
Fraudsters themselves are rarely prosecuted because it is hard to distinguish business misadventure from fraud. Sure the business failed. Sure the CEO sold $20 million worth of stock before it failed - but the business failed for honest reasons - or so he tells the jury. It doesn't matter that the business involved mass fraud - unless the fraud is huge the CEO is going to get away with it. And even if it is huge he will probably get away with it. (In the crisis it is hard to tell the deluded promoter of bad paper from the fraudulent promoter of bad paper. In my view most were deluded, not fraudulent, but fraud was still common enough.)
Paulson's mistake on Sino Forest then wasn't "amateur hour". Rather it was a mistake a competent fund manager might make because he is blindsided. Because he uses his shortcuts (trees are safe for instance) rather than does detailed analysis of every stock.
Every fund manager makes mistakes. Its part of the game. I try to minimize them - but I have made some real beauties. I purchased Washington Mutual preference shares for instance - and I blogged about it.
Whilst I am sympathetic to Paulson's mistake I am more concerned about his excuses.
The first Pauslon excuse is the one I have most sympathy for - which is that he estimates the loss based on the cost base of the position rather than its valuation before Muddy Waters comes along. We have a few positions like that.
Take our well-publicized position long the preference shares of Freddie Mac. I blogged about them in a ten part series (see here for Part 1). The preference shares are highly speculative - the money owed to the government needs to be repaid before the preference shares will realize anything. But they were trading at below two cents in the dollar and I thought there was a reasonable chance they would pay and hence were worth a bet.
I think there is an improved chance they will repay now (note falling delinquency for example). They are trading about 10c in the dollar. They are still however a wildly speculative bet which I think is worth making.
If they were to go to zero how much have we lost? Is it the original amount or the high water mark? Should I trim the position just because it it has appreciated? Does it matter that the position is being diluted by new clients anyway? Do the losses feel worse for a new client (who is implicitly buying in at 10c in the dollar rather than 2c in the dollar)?
I do not have a consistent answer to these questions. I am somewhat sympathetic to Paulson's answer because I do not think there is a consistently good answer anyway.
Where I am less sympathetic is to Paulson's statements that staff went to see the operations (and hence they judged they were real) and also to the line that they did a thorough review of the financial statements.
If you go see Sino Forest's operations you will see what Sino Forest wants to show you. They will show you trees. You can't tell whether that is 5 thousand hectares or 500 thousand hectares. Seeing trees does not answer the question. There is no point looking at things that are not going to tell you anything anyway - and so Paulson's staff member wasted his time looking. That is an amateur-hour mistake.
If you are going to look at the operations (and it is often worthwhile) then do the work properly and look through the eyes of a competitor or a customer or a supplier. And find them yourself rather than talk to sympathetic ones supplied by the management.
When management say good things about themselves that provides no actionable investment information. When management say good things about a competitor that is golden. When suppliers you have found yourself say good things about a company that is useful. When management say bad things about their business that is useful.
Speaking to management and hearing good things about them said by them does not help in investment and hence does not constitute actionable analysis. Using that sort of analysis as an excuse is pathetic and Paulson (a man who made his fortune betting against the conventional wisdom) knows that perfectly well.
As for analysis of the accounts - the Sino Forest accounts contain enough red-flags to make any eagle-eyed observer cautious. I am sympathetic to making an investment without looking at the accounts at all because limited time and shortcuts often make that an efficient way of behaving. What for instance would I learn about Microsoft by looking at the accounts that I do not already know? Microsoft will be a fabulous investment if it maintains its strong position for the next decade. It won't be otherwise. The answer is not in the accounts (but it might be in understanding the technology and the way people interact with the technology).
I would be sympathetic to a statement that Paulson did not even look at the accounts for Sino Forest beyond a cursory look because he may have had detailed short-cuts in his head for a forestry company. But if some analyst really did a detailed look at the accounts and did not spot the red-flags then they are incompetent. For that I have no sympathy at all.
PS. I will add one thing though. Sino-Forest accounts have become more plausible over time so the job of detecting problems is harder with (say) the 2009 accounts than the 1997 accounts.
In 1997 accounts the company was outright strange. It claims to have shipped 1.165 million bone dry metric tonnes of wood chips including exporting to Japan. (It did not claim to sell standing forest until many years later.)
However timber sales were only $23 million. This is not very much per tonne. You can find real prices at this link.
Sino Forest claims 603 thousand hectares of forest which it was phasing in (of which quite large numbers were in operation and quite a lot more was being planted).
But the balance sheet was thin. There was $9.3 million in machinery and equipment that was not being depreciated because it was "under construction". The only equipment being depreciated was $211 thousand in vehicles.
You can't move a million tonnes of woodchips with $211 thousand in vehicles.
Indeed Sino Forest had no equipment of any kind being depreciated except vehicles. This was a logging company with no chainsaws!
Those accounts were silly. The later ones are full of red-flags - but they are not so obviously silly.
I am more sympathetic to Paulson buying the stock in 2009 than I am to anyone who purchased the stock in 1999.
The person that purchased in 1999 probably sold some and made money. Indeed if they sold today they are probably still up fairly well.
Which reminds me of the saying among professional investors: "I would rather be lucky than smart". Someone who purchased Sino Forest in 1999 was not smart. But they sure were lucky.
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