Dead as a Severed Horse’s Head

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Dead as a Severed Horse’s Head
Photo by miss.libertine

Dead as a Severed HorseHead

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Six years ago, I reviewed a book The Club No One Wanted To Join. It was a poorly done book written by a bunch of people who were swindled by Bernie Madoff. Now, I didn’t want to be unsympathetic — after all, they were cheated. But they missed many signals that tipped off others, and could have tipped off them to the fraud. Worse, they tried to argue that since many top-performing mutual funds had total returns similar to that of Madoff, there was no way anyone could have figured out that it was a scam. They neglected to note that Madoff’s returns were ultra-smooth, while the returns of the mutual funds were not. Big difference.

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For much of the past decade, Crispin Odey has been waiting for inflation to rear its ugly head. The fund manager has been positioned to take advantage of rising prices in his flagship hedge fund, the Odey European Fund, and has been trying to warn his investors about the risks of inflation through his annual Read More

There’s one more thing: many of them gave in to the idea that they had found a hole in the system. Far from it being “The Club No One Wanted To Join,” rather, it was their own secret private club that they were smart enough to join when fate smiled on them, and they got their opportunity.

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Tonight, I am talking about a different sort of scam that sucked in a different class of people. This scam was a corporation where the management took a firm into bankruptcy that could easily pay its debts, at least in the short-run. The management likely conspired with the bondholders against its shareholders, seemingly in an effort to gain a greater reward from the bondholders who would own the firm post-bankruptcy than they could from operating the firm outside of bankruptcy. The name of this firm is Horsehead Holdings [ZINCQ].

For background, you can read this article in the New York Times. For the ultimate result of the bankruptcy, you can read this article in the Wall Street Journal: Zinc Producer Horsehead Cleared to Exit Bankruptcy.

I’m not writing about this to give a blow-by-blow description of how the bondholders and management cheated shareholders out of their ownership interests, though I will touch on that at points. I am writing about this to respond to those who wrote to me in the midst of the bankruptcy trial to try to gain some coverage of what was going on.

Over 20 people wrote to me and almost 100 journalists/media in an attempt to create “viral” coverage of the trial, and if nothing else, bring public attention to the travesty that was the bankruptcy process. As it is, I wrote one paragraph on the matter, but I didn’t see anything from any major publication until after the trial completed. I did mention to a number of the writers that efforts to get coverage would not affect the outcome of the bankruptcy court; it is relatively insulated from public opinion, as it should be.

(As an aside: if you write such a letter to journalists, or me, try to stay on topic. It is not relevant to call the bondholders “greedy,” that they are a hedge fund, or talk about their prior dealings with Collateralized Debt Obligations that failed during the recent financial crisis.)

Aleph Blog is mostly about risk control. As I read the letters from the shareholders who were watching their ownership rights be destroyed, I noted a few things that might have enabled some of them to avoid much of the unfavorable outcome:

  • Buying a levered highly cyclical company.
  • Relying on the insights of bright investors who buy concentrated stakes in a few companies.
  • Not diversifying enough.

Let me take these in order:

HorseHead Holdings – Buying a levered highly cyclical company

If you look at the risk of owning a single company, there are two ways where a company can affect the degree to which a change in sales can raise the profits of the company. The first way is to choose a production method that has high fixed costs and low variable costs, which is typically true of cyclical companies. The second way is to borrow money. Both methods magnify returns, right or wrong.

Typically, you only do one at a time. Supermarkets are stable, so they often borrow more to lever up returns. Mining companies, among other industries that require heavy capital investment, are anything but stable booms and busts are common and follow product prices.

Horsehead Holdings had a high degree of leverage from both debt and being in a cyclical industry. It ran into a scenario where the price of its main product, zinc, fell hard. At the time before they filed for bankruptcy, management could legitimately say to themselves, “If the price of zinc remains this low we will shortly be insolvent, particularly if our new processing plant doesn’t work out.”

Now, the bankruptcy code is a rather flexible beastie. It allows for a management team to file before things are at their worst so that they can try to preserve a better outcome for the company. My suspicion is that management’s motives were mixed when they filed — they wanted the best deal they could get for themselves, but may have assumed that there wasn’t much life left to the equity anyway. Who could have predicted that the price of zinc would rally back so much, such that the company could have survived in its pre-bankruptcy state?

Now, has this ever happened to me? Not exactly, but there are other ways that managements can dispose of a company to the detriment of the stockholders. I lost money on C. Brewer Homes when management did a leveraged buyout when the stock price was unduly depressed. Enough stock was in the hands of arbs that the deal went through. Oh, and if you want another one, there was the loss on National Atlantic Holdings which I described in ugly detail in this article.

The main point is this: don’t assume that management will act in the interests of stockholders, particularly in a stressed situation. The leverage and cyclicality of Horsehead Holdings set up the possibility of that occurrence, and the fall in the price of zinc triggered it.

HorseHead Holdings – Relying on the insights of bright investors who buy concentrated stakes in a few companies

I respect both Mohnish Pabrai and Guy Spier. They are bright guys, and from what I can tell at a distance, ethical too. They were big holders of Horsehead Holdings, and I’m sure they had good reasoning behind their decisions. But, even excellent investment managers aren’t infallible. If you are just picking one of their ideas, that could be a rocket to the sky — or the ground, while their portfolio as a whole might do well.

Also, they will make their decisions with some lead time over you if the data shifts. Any investment advisor you mimic is not required to tell you when they change their mind, aside from required filings with the SEC… which are delayed, and sometimes don’t cover everything.

Has this happened to me? Yes it has. I have sometimes invested partly on who is invested in a company, though never to the point of not doing my “due diligence.” But aside from some early failures 20+ years ago, it never hurt me much because I was never guilty of:

Not Diversifying Enough

A number of the people emailing me said they put more than half their savings into Horsehead Holdings. If you are going to engage in such risky behavior, you need to know more than everyone else investing in the stock. No exceptions. I agree with investing in a concentrated way, but my view of that for average people is no positions larger than 5% of your capital. That is plenty concentrated enough.

I have one holding that is 13% of my assets — a private company that I know exceptionally well. My house is another 13%. After that, my next largest holding is 3% of my assets. I believe in the assets that I buy, but I concentrate enough by only owning individual stocks, and very little in the way of pooled investment vehicles.

With 75% of my assets in risk assets, I take enough risk. I don’t have to amplify that by taking disproportionate security-specific risk. (The stock portfolios that I provide for clients have 35 or so stocks in them… given that I tend to concentrate in a few industries, that takes reasonable rsk.)

Summary

Again, my sympathies to those who lost on Horsehead. I can’t do anything about those losses. At least you have the opportunity to sue the management of the company. It certainly seems like the management team cheated the stockholders, though I can’t say for sure.

What I can help are future investors, and my counsel is this: Diversify! You are your own best defender, so don’t merely mimic bright investors; do your own due diligence. Be wary of investing in cyclical companies with high debt levels. Don’t implicitly trust that management teams will act in your interest. And finally, diversify, as it protects against failures in other areas.

PS — I looked through my notes of the past. I did look at Horsehead Holdings, and I passed on it. That said, I don’t know why… hopefully it was for a good reason, though I expect that I didn’t have room for another cyclical company, and not another one in base metals.

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Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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