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European Distress and Colorado Brownies

Cushman & Wakefield recently released a thorough review of the European Real Estate Loan Sales Market in which the company estimates that nearly €600 billion of non-core real estate exposure needs to be worked out or sold across Europe in coming years. We think this presents a compelling opportunity for well-positioned investors to capitalize on distress as activity accelerates compliments of Europe’s bad banks.  A few notes from the report before wrapping up with a recent presentation we gave on the subject:

  • A record €40.9 billion of CRE loan and REO sales have transacted in H1-14, over 30% more than in the entirety of 2013 and 611% more than in H1-13. Despite the record volume witnessed so far, the deleveraging process throughout Europe is far from over. The upcoming stress tests being enforced by the ECB should ensure that the current high levels of activity in the market will be sustained over the next few years.

 EU Closed Transactions

  • Nine European “bad banks” hold over 46% of total gross exposure to non-core real estate. NAMA holds non-core CRE assets with a face value of €61 billion split between Ireland and the UK, while SAREB holds non-core Spanish real estate assets with a face value of €102 billion. Recall that KW purchased the real estate asset management division of Banco Popular last year after initially entering Dublin through a similar deal with the Bank of Ireland.
  • With €192 billion in gross non-core real estate exposure, investor sentiment in Spain should continue to grow. SAREB, the Spanish asset management agency holds over 53% of this exposure. Despite being two of the most dominant markets in terms of deleveraging over the last three years, the UK and Ireland still have significant non-core real estate exposure, highlighting the extent of the original problem and the large amount of assets yet to be sold or worked out. KW Europe is squarely focused on opportunities in these three markets.

 EU Non Core Real Estate

  • Despite the overall rise in average transaction size, there is an increasing number of smaller deals under the radar of the larger firms and too large for the private investor. Can you say sweet spot?

Bottom Line: Europe still represents the biggest NPL opportunity worldwide.  Perhaps the biggest distress opportunity ever seen.  We were recently invited to share our work in the region along with our investment thesis in KW/KWE with a new group of friends at ValueX Vail.  The full deck is embedded below. You can access our initial report here.

Already looking forward to heading back next year.  If nothing else, I’d like to spend some time better understanding why brownies in Colorado are ten times the size of those in the rest of the country. Anyone care to guess?


Posted in Portfolio Strategy, Security Analysis.

Sex, Bribes and Tax Aversion

Last week, U.S. drugmaker AbbVie bought Dublin-based Shire in a $54.7 billion deal that will allow it to slash its tax bill by relocating outside of the U.S.  One week prior, Salix Pharmaceuticals announced plans to merge with Cosmo Technologies, an Ireland-based subsidiary of Italy’s Cosmo Pharmaceuticals. The deal would allow Salix to re-domicile in Ireland, reducing its tax rate to the low 20% range from the high 30% range.

The strategic rationale for these deals becomes painfully clear (at least for US-domiciled firms) with one glance at the chart below. In response, Congress has predictably responded with threats to stop these deals from occurring (rather than addressing the underlying reason for their occurrence), but in the interim, we think it’s safe to assume that pending restrictions are likely to drive increased activity ahead of any potential rule change. Not a bad thing for certain owners of European commercial real estate.

Source: Wikipedia

Source: Wikipedia

Lately, however, drug companies have been showing us that they know how to mix things up as many are in hot water over a slew of issues in China  (none of which should surprise anyone with experience operating on the mainland): bribing doctors, government officials, falsifying data, etc.  The latest from our favorite pharma news source, which has lately been reading like a spicy gossip rag, is a bizarre story of a British PI who, in the process of investigating a GSK executive suspected of bribery, managed to obtain a videotape of said executive and his local girlfriend in flagrante delicto.

Chinese officials were originally planning to hold the related trial as a closed proceeding, but have bowed to international pressure and agreed to a public trial.

So for those of you who enjoyed the Clinton-Lewinsky transcript, keep your eyes out for a video adaption from the world of Big Pharma.

Posted in Letters & Links, Policy, Security Analysis.

Don Draper Buys Protection

Best headline of the week goes to Bloomberg’s Michael Regan - Everyone’s Don Draper Now as Volatility Nostalgia Sweeps Markets.

According to Regan, “Many on Wall Street are sounding a lot like Madison Avenue’s Don Draper these days, nostalgic for the not-so-long-ago wounds to markets that created profitable opportunities.”

Per The Don, “In Greek, nostalgia literally means pain from an old wound.”  While our own wounds have long since healed, we are still left with potent memories which continue to guide our decision making today.  My impression, though, is that these memories have been long forgotten by the consensus, evidenced by new all times in margin debt, increasing corporate leverage and near-record lows in volatility. As J.K. Galbraith lamented:

“In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by an always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Low volatility is once again incentivizing a rapid accumulation of leverage. We’ve read several reports in just the past few weeks highlighting the continuation of the so-called “Great Moderation” – as if this was a good thing!  According to one analyst, investors have nothing to worry about as “monetary policy remains as competent, if not more so, than it was in the pre-crisis period.”  If that doesn’t make you sleep better at night, try an Old Fashioned perhaps.

It would seem that the consensus has once again been lulled into complacency by the sweet sirens of Wall Street strategists who suggest that, “So long as a gradual economic recovery continues as we expect, so should the current low-vol environment.”

We’ve heard others actually claim that, “The aggressive re-regulation of markets has made us less vulnerable to Minsky Dynamics today than in the past.”  And consequently, “these factors will likely extend the stability and sustainability of this cycle relative to past cycles.”  For our part, we are left wondering exactly what “aggressive regulation” has eliminated risk from the system so effectively.

Today’s low volatility is not just a US phenomenon.  It’s not just an equity phenomenon either.  It is a global phenomenon across virtually all asset classes.  While the street may take comfort in the claim that low market volatility is the norm at this point in the business cycle given current economic conditions, we wonder if anyone has considered what happens if when current conditions change.

Plugging consensus forecasts into models might suggest that there is a good chance that the current low-vol regime will persist for some time.  We just hope that they are not the same models used by the same banks to forecast housing prices and/or their own balance sheet risk last time around.

Rather than rely on forecasts that extrapolate the present into the future, prudent allocators of capital would be better served to consider the alternative. Technically speaking, shit just happens every once in a while.

The fact that volatility is near all time lows today suggests that there is less room for it to move lower and a very long runway to move higher.  History would suggest that “random” shocks occur more or less regularly over time.  In our own experience, I have yet to see one “forecasted” by an economic model in advance.

So while low volatility may be consistent with current economic conditions, it would be wise to consider that conditions have, can, and will change.  That doesn’t mean there are not opportunities to make money in this market (there are and we’ll share a recent idea in our next post).  It just means that sticking your head in the sand and pretending that goldilocks will stick around forever – after crawling back into bed with financial markets – is setting folks up for disappointment.  Or worse.

The current low-vol environment is not unprecedented.  But today’s combination of low vol and low rates has pushed option prices to the lowest levels in decades.  Consequently, we think a fully invested Don Draper would be well served to buy some protection.  We are.


Posted in Macro, Portfolio Strategy, Uncategorized.

We’re Not in Kansas Anymore

Truly incredible deck embedded below.  Reminded me of a few notes from a meeting on the west coast last year:

  • The Chinese equivalent of Amazon does not need to compete against a Wal-Mart because they don’t exist.
  • Mobile penetration today is only 30% in China and should be higher than internet penetration in 12-24 months.
  • This is significantly different than what has played out in developed markets where mobile ultimately trends toward internet penetration levels.
  • China eCommerce sales are surpassing the US, as brick and mortar retail is underdeveloped and prices are too high given inefficient logistics.
  • VIP Shop is the online version of TJX in China. The stock has moved from a low of $5 to $180 in the past two years, putting the market capitalization at $10 billion.
  • To put this in perspective, consider that the market capitalization of TJX is about $40 billion in the US. Imagine what Amazon would look like today if the Internet was around in 1964.

Posted in China, Emerging Markets, Tech.

Money for Nothing

Couldn’t resist.  Is there a better way to start the weekend than MTV with Dire Straits?

The European Central Bank cut its deposit rate below zero yesterday making it the first major central bank to use a negative rate.

ECB Money for Nothing

Government bond yields are at record lows, yet unconventional monetary policy is not feeding into bank lending (this should sound familiar). Irish bond yields are trading below US treasury yields for the first time since 2007.

Irish Yields

While small business continues to struggle across the Eurozone, the macro backdrop is ripe for certain well-positioned and opportunistic investors. We recently detailed our investment thesis on shares of Kennedy Wilson, which is available here. Yesterday, while Mario Draghi was pointing his monetary bazooka at the banks, KW announced the acquisition of two additional properties in Dublin for EUR 44.6 million, while the FTSE approved the inclusion of KWE in the FTSE 250 Index. Not a bad day’s work.

Posted in Macro, Security Analysis.

Lessons from Omaha

Glad to be back in Lenoir this morning, applying a few lessons learned from the Oracle after a whirlwind tour through Omaha with 30,000 of Buffet’s closest friends. Thanks again to the Blumkin Family for being such gracious hosts Friday evening.  Hope to be back next year!

Here’s my top ten list from Warren and Charlie, as well as a few other value guys we bumped into along the way:

  1. People don’t change when they get older. They become more of what they were. While this was my first visit to Omaha, it’s pretty clear that Warren and Charlie have become a lot more of “what they were” over the years. Would have loved to have been a fly on the wall when this partnership started at 29 and 35 years young.
  2. You can learn a lot by asking questions. You can learn even more by asking “the right” questions. People generally like to talk, so give them a reason to do so. Larry Bird was able to sign the highest-valued contract in the NBA at the time by asking the right questions. He talked to every agent in the league and asked them, “Other than you, who is the best agent in the NBA?” He then went on to sign with the “second” best agent in the league.
  3. If you aren’t confused, then you probably don’t understand. Common diseases cause uncommon symptoms more often than uncommon diseases cause common symptoms. Don’t try to over-simplify complex matters, especially when dealing with systems with complicated interactions. In this case, Munger was referring to The Federal Reserve’s policy of Quantitative Easing rather than medicine.
  4. A bird in the hand is worth two in the bush. At the most basic level, this is the essence of value investing. Of course, there are a few questions that naturally arise. One: Are you really sure there are two in the bush? And, two: How far away is the bush?
  5. The nature of boards is that they are part business organizations and part social organizations. Large shareholders have multiple levers to pull to effect change. Some are more public than others.
  6. People would accomplish more if they picked their spots. If we all yelled every time we saw something we disapproved of, we wouldn’t be able to hear each other. We can achieve better results by always putting ourselves in the other fellow’s place and thinking about what we would do ourselves. It takes some imagination, but it pays.
  7. “Ignorance removal” is the simple secret to success.Or as Oliver Wendell Holmes stated in Medical Essays, “The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins. Nothing more clearly separates a vulgar from a superior mind, than the confusion in the first between the little that it truly knows, on the one hand, and what it half knows and what it thinks it knows on the other.”
  8. Your true cost of capital is what can be produced by your second best idea. Holmes once said that, “When a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.” Buffett seems to imply that he may have been referring to MBA’s coming out of today’s business schools as they “calculate” their cost of capital.
  9. Size Matters. Okay. This one didn’t come from Buffett or Munger, but it did come from two good friends at an event we attended on Friday. So in case you were wondering how much capital you should have in your “second best” idea (or any idea for that matter), the formula is quite simple, compliments of the Kelly Criterion. Position size should effectively equal “Expected Value” divided by “Range of Outcomes.”
  10. There is nothing new under the sun. It has all been done before. If you’ve studied Buffett and Munger as much as we have, you can just about anticipate the answer of each question before it’s given. What we couldn’t anticipate was another remix of “YMCA” by the Village People.


Posted in Guru Focus.

Forever Blowing Bubbles

It’s been quiet on The Blue Ridge lately, which usually means we’re busy working on new ideas.  In this case, we’ve also been busy working on a number of organizational enhancements which I look forward to sharing in the near future.  But not before I take off for the holiday weekend and a much needed escape with my beautiful bride next week.  Looking forward to recharging the batteries and enjoying some beach reading – on deck next week is Battle Cry of Freedom, Economics in One Lesson, Flash Boys, and The Complete Sherlock Holmes.  Not necessarily in that order!

Until then, keep an eye out for our next report which should be published shortly.  Here’s a sneak peak at the intro, compliments of Dean Martin – click the image below for the classic soundtrack.

Dean Martin

I’m forever blowing bubbles
Pretty bubbles in the air
They fly so high, nearly reach the sky
Then like my dreams they fade and die

Fortune’s always hiding
I’ve looked everywhere
I’m forever blowing bubbles
Pretty bubbles in the air

“I’m Forever Blowing Bubbles” was a popular American song written by John Kellette which debuted in 1918. More than a half century later, in 1973, Dean Martin released Sittin’ on Top of the World featuring Dino’s own version of Forever Blowing Bubbles.  Our extensive research on the subject has yet to uncover the link between Dean Martin, The King of Cool, and Alan Greenspan, The Maestro, but the Rat Pack’s influence on the Federal Reserve is irrefutable. Ain’t that a kick in the head?

Posted in Letters & Links, Policy.

Heads I Win, Tails You Lose

It would seem that there are risks to the macro outlook.  For the time being, equities appear content to ignore disappointing macro.

Disappointing Macro

It also appears that if the consensus turns out to be correct, bonds will begin to discount the expected tightening, at which point equities should react accordingly.

More Dovish

Posted in Macro, Portfolio Strategy.

Getting Lucky

Emerging market equities, now trading at a discount to slower growing western markets, are beginning to look attractive by some measures (blue line below).  Ceteris paribus, disciplined value investors may be inclined to increase positions as this discount widens further.  But all else is not equal.  Given the structural shift underway in emerging economies and the increasing likelihood of credit crisis in China, we believe the recent de-rating of emerging markets is more likely to represent a longer term inflection point. The EM discount is not yet extreme by historical standards.

EM Discount

The valuation of US equities, on the other hand, is quite extreme based on the same metric (green line above).  We are still finding select opportunities at home, but if you believe profit margins are susceptible to the laws of gravity (we do) than current stock prices are even more expensive.

Fortunately, there is a silver lining for value investors.  Or in the case of these charts – an orange lining.  Developed Markets Ex-US are still trading at relatively depressed multiples of relatively depressed earnings.  Note the spread between the orange and green lines in the chart above.  Valuations look fair and are supported by fundamental and technical tailwinds.  There is a strong structural case for owning high quality, multinational brands against this backdrop. Specifically, we expect a massive “trading up” in consumption in the developing world, compounded by an even greater “trading up” of capital flows into developed markets.

To be clear, Europe is far from fixed.  But disciplined capital allocators are beginning to put money to work.  European equities remain cheap.  And while US profits are back above the prior cycle peak, the rest of the developed world has far more upside (orange line in chart below).

Upside Outside US

We have spent much of the past two weeks analyzing a potential investment well positioned to capitalize on the accelerating efforts of EU banks and governments to shed distressed assets in order to strengthen their balance sheets. More to come on this in coming weeks.  In the meantime, maybe EM investors will Get Lucky.  Personally, I never realized how much I missed Soul Train until I saw this!

Posted in Emerging Markets, Portfolio Strategy, Valuation.

Buffett’s Alpha & Suspicious Minds

In a few weeks, I’ll be officially crossing Berkshire’s Annual Meeting off my bucket list.  Many thanks to our friends in the furniture business for allowing me to crash your Blumkin Family Party! And to any of our friends in the investment business that find themselves in Omaha for Buffett-a-palooza, please drop me a line.

Berkshire’s Annual Letter is closely scrutinized by the media these days, but in case you missed it, Buffett’s “certain fundamentals of investing” are worth highlighting:

  • You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
  • Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
  • My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Over the years, many self-proclaimed value investors have rehashed Buffettisms.  But while the masses talk the talk, few walk the walk.  Buffett’s track record is in a league of its own. According to a recent NBER Working Paper, Berkshire has the highest Sharpe ratio of all US stocks from 1926 to 2011 and a higher Sharpe ratio than all US mutual funds around for more than three decades.

Buffett Alpha

These results were produced without luck or magic.  Rather, Buffett’s genius is largely a function of his conviction, wherewithal and skill to manage leverage and risk over multiple decades.  He recognized early on that applying leverage to safe, cheap, high-quality stocks would magnify returns without the risk of fire-sale, allowing him to stick to the principles outlined above over the course of multiple economic and market cycles.  The author’s estimate that Buffett’s leverage has averaged about 1.6 to 1 over time boosting both his risk and return, proportionately.  They conclude that, “If one had applied leverage to a portfolio of safe, high-quality, value stocks consistently over this time period, then one would have achieved a remarkable return, as did Buffett.”

Of course, no one has actually managed to do so. See you in Omaha.

Posted in Guru Focus, Letters & Links.

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