Tuesday, 17 May 2016

Guy Spier, Mohnish Pabrai & Horsehead Holdings

I finally had the chance to read Guy Spier's annual letter to shareholders of the Aquamarine Fund yesterday. Mr Spier is well known in value investing circles and is known as a real Buffet-Munger disciple. I was surprised then to read of his disastrous investment in Horsehead Holdings. Horsehead entered a voluntary Chapter 11 restructuring process after a technical default on a line of credit from Macquarie Bank - to quote Mr Spier, "Macquarie froze Horsehead's bank accounts, which triggered the bankruptcy". Spier wasn't the only investor that I admire caught up in the trouble at Horsehead. Mohnish Pabrai, a close friend of Spier's, was also heavily invested. This is two men famous for having forked out $650,100 to charity for a lunch with Warren Buffet. A couple of things struck me when reading Spier's letter.

Firstly, he describes the trouble that Horsehead ran into as a black swan event. To my mind there are relatively few, if any, black swan attributes to the events that occurred. Instead I see an investment in a commodity business based on hope and the 'false predictability' of macro factors ("global zinc supplies were tight and... demand was steady").

Given this, lets examine a couple of quotes from the letter. First:

  • "Horsehead raised capital through debt and equity financing"

Now for some, debt and the benefits that it can provide a business is something they can get comfortable with. Personally, I have a strong aversion to any debt and companies that are increasing debt loads to strengthen balance sheets, fund capital expenditure, R&D etc. When looking at investments, I like companies that tick as many of the following boxes as possible:

1.     Deleveraged: debt/equity < 20%
a.     Total debt < tangible book value
b.     Total debt ≤ 2/3 tangible book value (Munger)
c.      Total debt < 2x NCAV (Graham)

2.     Can net earning pay off long-term debt in two years? (Buffet)

3.     Current Ratio > 2.0

a.     Quick Ratio > 1.75

If I can tick most of these boxes,  I may be interested in further investigating a potential investment. I try to remain conscious of letting quantitative analysis dampen my focus on critical thinking, particularly around low probability risk. This checklist really just acts as a complex filter for potential investments.

In running a checklist like this that helps me focus on potential issues that could arise with an investment, the last questions I ask myself are the following:

1.     What is the downside – always invert?

2.     Does the investment thesis depend on heroics tomorrow?

a)     Do not invite over-optimism.

3.     We want to see returns today – not optimistic future projections.

4.     We don't want investments based on projections that are disconnected from historical records.

a)     Hoping for rapid growth far into the future, favourable macro environment, R&D breakthroughs, patent approval, dramatic margin improvement, large payoff from capital expenditure etc?

Ironically, the inspiration for an investment checklist came from Spier and Pabrai who have both been vocal about the benefits of implementing such a process. I appropriated the above questions from Allan Mecham and Charlie Munger and again, was inspired by Munger and his latticework of mental models. I found that cloning their ways of thinking and using these questions was a great way to incorporate critical thinking about the possible downside in any potential investments.

Curious to me then, were the hefty investments made in Horsehead by Pabrai and Spier. Considering I initially rejected the company after employing a process largely informed by reading and listening to these two investors, I thought it worthwhile to study what has played out since. I know that both will learn many lessons from this investment, considering Pabrai has taught me to "examine every trade that doesn't work out and what went wrong. Mistakes are inevitable, the point is to learn from them". What I can't quite understand is how two great investing minds, so acutely aware of the need to stay alert to risk, could become besotted with an investment heavily reliant on optimistic future projections. This is the biggest lesson being reinforced in my mind: counter any over reliance on the future. Regardless of the fact that the risk must have been deemed low-probability, Spier's projections were quite obviously reliant on a favourable macro environment and a large payoff from capital expenditure.

Two more quotes from Spier's annual letter:

  • "I would never have predicted that zinc prices would plunge below the marginal cost of production and remain there for so long"
  • "I never would have predicted that Horsehead would have such trouble getting its plant up and running"

I don't know why Spier thought he could accurately predict the zinc price and more importantly, why he thought it was within his circle of competence to do so. Critically, he even then allowed an investment in a company that couldn't withstand a severely depressed commodity price. I understand this train of thinking isn't everyone's cup of tea, however for mine, this reeks of what Nassim Taleb refers to as "epistemic arrogance". Spier should know that we "think we are better at making predictions than we really are". The "misplaced sense of confidence in our forecasts" that Marathon Asset Management discuss should be a risk that all investors are attuned to. In this particular case I have wondered if perhaps both Pabrai and Spier had a sense of comfort with the investment, knowing that the other was heavily invested too. Given what happened, perhaps they let this comfort diminish their appetite for critical thinking. I will also posit that Daniel Kahneman and Amos Tversky's 'Illusion of Validity' may be at play here. As discussed in their paper, Probabilistic Reasoning, "people often predict by selecting the outcome that is most representative of the input. The confidence they have in their prediction depends primarily on the degree of representativeness (that is on the quality of the match between the selected outcome and the input) with little or no regard for the factors that limit predictive accuracy".

Spier explains that:

  • "Many more things can go wrong with an investment than we can possibly imagine and that the markets.... produce bizarre situations that defy logic"
  • "I saw its debt rising.... and failed to recognise how vulnerable this could make the company in extreme circumstances. Knowing the vicious nature of leverage, I should have been more sensitive to this increased risk"
  • "Horsehead was also highly sensitive to two key variables - a sharp move in zinc prices and its make-or-break project to build the new plant"

It is true that it is much easier to break down the investment in Horsehead Holdings retrospectively and I am not here to detract from Spier and Pabrai who both have wonderful long term records. I have only explored the above as a way to reinforce in my mind the need to factor in the lowest-probability risk and to be alert for developments that suggest it could be around the next bend. Additionally, I understand that the above has been my take on a series of events and that others may view the initial investments as acceptable, even knowing what has transpired since. 

However, more than anything, my investing mindset revolves around risk aversion. Fundamental to this, I have found that dealing in predictions of the future (and by virtue of this, commodity companies) is fertile ground for disaster. As Charlie Munger would say "invert, always invert". This notion would be familiar to Pabrai and Spier, however their investments in Horsehead Holdings demonstrate the need to continually return to the low-probability risk and downside in one's investments.

Additionally, not remaining infatuated with an investment's potential when there are warning signs is something that I haven't focused on enough to date. Largely my process has revolved around what stocks to invest in, rather than a 'mid flight' health check. Spier mentions this as something he too learnt from his investment in Horsehead. He discusses how he will implement a 'mid flight' health check for future investments, mentioning new debt and significantly changed leverage ratios as two items he will focus on intently. 

Unfortunately, Mr Spier states that "there was - and is - plenty of upside with Horsehead: if zinc prices were strong and the plant operated properly, the company would generate hundreds of millions of dollars a year in EBITDA". Personally, when the upside in an investment relies on too many 'ifs', I find the company unattractive. There are always 'ifs' in investing, it is inherent in the game, but macro hopes and heroics in the future relating to payoffs from capex is not something I want 7% of my portfolio to be relying on. This was the case for the Aquamarine Fund. It has been an expensive lesson thus far for Mr Spier, but one I have hopefully learnt watching from the sidelines. 

1 comment:

  1. great post - i follow Pabrai funds & couldn't believe it when i saw Horsehead - a commodity price reliant company there -
    Fiat is another one that hasn't/didn't do too well - (that i stayed away from) and i find it strange that as Fiat would benefit from lower Commodity price's for cheaper materials etc...Guy Spier & Pabrai were betting on higher Commodity price's for Horsehead??
    Fiat is also now the 8th largest car maker - where is the Moat??
    Aer Cap's is the Industry Leader & it's earnings have been helped by falling oil price's and has been decent for Pabrai so far..i just wish i had got in closer to his buy price just above Tangible book :-)