Deep value investment and bankruptcy case studies

**lzhang** Fri Oct 06, 2006 3:28 am

Deep value investment and bankruptcy case studies
Article "Seth Klarman on the Art of Complex Deep Value Investing http://www.gurufocus.com/news.php?id=2867" outlined Klarman's philosophy behind deep value investing with deep distressed stocks, presumably, bankruptcy cases. As described in the article and a note (http://www.fool.com/community/pod/2006/060504.htm) by Ronald R. Redfield, CPA, PFS, the beauty of investing into bankrupt companies is the complexity of the analysis. This complexity, as described often in his book, leads to potential opportunity, as many investors shy away from the complex analysis. Pending a bankruptcy, costs get leaner and more focused, cash builds up and compounds with interest. This cash buildup can simplify the process of reorganization, because all agree on the value of cash.

Indeed, nobody wants to see the companies he/she owns into bankruptcy protection. The question, it seems to me, is how to identify the company, obviously in deep trouble, and its true value deeply overlooked because of the trouble, which can be recovered with the company even after bankruptcy reorganization.

So the principles we are following to search for those distressed stocks must give us enough protection against possible (huge) equity dilution, and to the worst case, against stock cancellation.

We are trying to find some clues with studies of the recent distressed (most into bankruptcy protection, emerged or not) companies: AMERCO (UHAL), OCA Inc. (OCA, OCAI), Netease.com Inc. (NTES), Fresh Choice, Inc. (SALD, cancelled, now Fresh Choice Restaurants, LLC.), SEARS HLDGS CORP (SHLD, KMRT), and USG Corp. (USG).

Let's first go through each company and find what seemed to be the problem.

1. AMERCO (UHAL) is a truck rental and self-storage rental company. It also has a property and casualty insurance subsidiary. It has 14,000 independent truck rental dealers and over 1,300 company owned moving centers. It operates over 340,000 storage rooms, approximately 29 million square feet of storage space with locations in 49 states and 10 Canadian provinces. U-Haul’s self-storage facility locations range in size up to 156,000 square feet of storage space, with individual storage units in sizes ranging from 15 square feet to over 400 square feet. It owns the storage facilities.

UHAL ran into problem around 2000 when it entered into riskier insurance business. Its insurance used to make fat profit when it was confined to its own truck rental and its business-related insurance. But it lost big (100+M) each year after it entered the riskier insurance ventures. Another big problem it had was its over-growth in its self-storage business. It borrowed huge debt to buy self-storage facilities. To hide the debt in order to get better terms for new debt, it created a shell company SAC (Storage Acquisitioin Co.) Holding to make UHAL's balance sheet healthier. When it restated its balance sheet, the debt/equity ratio was not that good (but its book was very undervalued because of real estate). It defaulted its debt October 2002 because it can not refinance the debt, or pay the principal. It went into bankruptcy protection in June 2003 and emerged from bankruptcy early 2004 with decent financing (lower rate then before).

2. OCA Inc. (OCA, OCAI) is a business service company for orthodontic and pediatric dental practices. OCA provides full business services to orthodontists or dentists: administrative, marketing, accounting, software, renting and leasing, etc. OCA does not own clinics. Dentists are still owners of dental clinics, but dentists outsource pretty much all the daily business operation to OCA. OCA charges dentists by a percentage of clinics' profit for the service provided. Usually the service contract lasts for 20 to 25 years and there is penalty for breach of contract.

The problem with OCA happened after it accquired OrthAlliance, where many doctors were suing to leave. It also had accounting problems, mainly in the account receivables and revenue part. Accounting problems caused delay of quarterly and yearly SEC filings. The filings were further delayed due to Hurricane Katrina, which hit New Orleans where OCA's headquarters was located. It went into bankruptcy protection in March 2006 to stop its affiliated practices from leaving. It was supposed to emerge from bankruptcy protection in summer 2006, becoming a private hold company. It now has about 70 fully-affiliated offices.

3. Netease.com Inc. (NTES), through its subsidiaries and contracts with its affiliates, operates a leading interactive online and wireless community in China and is a major provider of Chinese language content and services through its online games, wireless value-added services and Internet portal businesses.

In the second quarter of 2001, it reported an accounting problem from its internal audit, namely, it should not recognize some advertising revenue in fiscal year 2000. Its shares were suspended from trading at NASDAQ from September to December 2001. It was traded below $1 while it had about $2.5 cash.

4. Fresh Choice, Inc. (SALD, SALDQ, cancelled, now Fresh Choice Restaurants, LLC.) was a chain of self-service restaurants launched in 1986. At its peak time, it had more than 58 restaurants in California, the state of Washington and Texas.

Due to severe competition and mis-manangement, the company went into bankruptcy protection in July 2004. The company emerged from bankruptcy protection in December 2005 as a private held company and management-owned in conjunction with financial partners Crescent Real Estate Equities and Cedarlane Natural Foods. It now has about 30 restaurants, in California (28 ), the state of Washington (1) and Texas (1).

5. KMart (KM) opened its first Kmart store in 1962. Sam Walton opened his first Wal-mart store the same year. For many years, KM lead WMT in many respects. In early 2000, WMT long ago had roared past Kmart. KM went into bankruptcy protection in January 2002. It came out of bankruptcy in May 2003, with the old stock cancelled and ticker changed to KMRT. In late 2004, KMart merged with SEARS HLDGS (S) and formed a new company, SEARS HLDGS CORP (SHLD).

6. USG Corp. (USG) is a company that manufacture building materials. USG filed bankruptcy protection in 2001. The main reason of filling was due to huge cost of asbestos lawsuit. USG products during 70's and 60's contained asbestos, which caused cancer and numerous other diseases. USG had paid asbestos claims before 2001 every year in hundreds of millions. USG had more than 2 billion of dollar of asbestos liability on balance sheet based on its own estimate. The real cost could be much bigger than USG's own estimate. The uncertainty of asbestos lawsuit made this stock very cheap. USG had PE of 3.5 as of 2004. USG came out of bankruptcy in June 2006 with $3B deal on its asbestos settlement.

So what can we learn from these cases? In order to screen out those bad bets, I think we must emphasize:

1. The troubled company must have enough asset to pay off its debt and in the worst case when got liquidated, share holders can get some equity. To have enough protection, the price must be under net asset value.

By this "cut", we will remove OCA, SALD. USG is a little bit different because it does not have solvent problem. Its earning is more than enough to pay its debts.

UHAL had enough commercial real estate to sell, if it would, to pay down its debts.

NTES, when it was traded below $1, had about $2.5 cash and debt-free.

KM has thousands of commercial real estate, big lot, all over the US.

2. The trouble must be gone in the foreseeable future to further unlock the value. If the trouble is more likely to hang around, any remaining value will be destroyed.

UHAL had quit its money-losing insurance ventures in 2002, and its core business in truck rental and storage rental is very profitable and stable. Once it stopped hyper-growth, it could use the cash to pay down its debt. So it had the potential to raise significantly as its earning grew.

NTES' accounting problem was detected by itself and its business was about to break even. With revenue from advertising, and short message service, it was about to generate lots of profit. So it had the potential to raise significantly as its earning grew.

On Sept 15, 2004, Senate majority and minority leader both agreed in principle of 140 billion dollar asbestos fund method for compensating the asbestos patients. USG's liability would be limited.

On the other hand, how to restore the profitability of SALD and KM remained a big question to its old managements.

3. The management must have signficant interests in the company. Its interest must be aligned with shareholders'. Talking is cheap, so it means executives and management team must hold signficant shares, say, >20%. Bad management can destroy shareholder's value.

The Shoen family members, UHAL employees (through retirement plan), held about 70% of UHAL shares, and they did not sell a share during the troubled period.

Ding Lei, NTES' founder, held more than 50% of the company.

W. Buffett held 15% of the USG and its board prevented him from taking the company cheap with poison pill plan.

While OCA's founder held only 10%, and none other executives had signficant holdings. KM's management gave the equity of old KM to Mr. Lampert for free and did not recognize any real estate value for old shareholders. It is hard to imagine when one files bankruptcy, he will give his house to creditors without asking questions like how much the house is worth.

4. No matter how hard we study, there are still some of those distressed companies doomed to fall apart. We never know what will happen for sure. To protect against those risks, we must diversify. As previous studies showed, 10 stocks are required to have sufficient diversification. 5 stocks are not enough, but in cases where the price is far below NCAV (NTES) or NAV (UHAL), and we have confidence that the stock will not be cancelled (as insiders have huge holdings), and we have confidence that the business will perform well, we may put 20% of the portfolio for the stock. Anything more than that is considered very dangerous and is not worth to try. As Mr. Buffett has warned, "a long string of impressive numbers multiplied by a single zero always equals zero."

No matter how great he is, one can always make mistakes. Mr. Duan picked up NTES, UHAL, he also picked OCA, SALD. Mr. Lu (blast) had USG, he also got OCA. It is perfectly fine, only dead people make no mistake. We just need to diversify so we can be safe.

We must say, the troubled companies provide a large playground for value investors to find hidden gems. By careful study of their businesses, we can be rewarded enormously because emotional people tend to ignore the true value by focusing too much on irrelevant uncertainties (like wide price fluctuation). We must also say, it is also a dangerous playground, full of traps. Our memory should not focus on the successful stories, rather, we should remember and study the cases when we fail. The survivorship problem will limit our ability to make unbiased judgements based on both successes and failures if we do not summarize what we can learn from failure in a timely manner.

Ref links:

http://www.gurufocus.com/news.php?id=2867

http://www.fool.com/community/pod/2006/060504.htm (Notes To The Book "Margin Of Safety" by Ronald R. Redfield, CPA, PFS) (PDF file http://www.rbcpa.com/Notes%20To%20Margin%20of%20Safety.pdf)

http://www.berkshirehathaway.com/letters/2005ltr.pdf

http://hepinvestor.blogspot.com/2006/10/portfolio-concentration-or.html

http://hepinvestor.blogspot.com/2006/09/risk-volatility-investment-return.html

Original post @ http://hepinvestor.blogspot.com/2006/10/deep-depressed-value-investment-and.html

**lzhang** Fri Oct 06, 2006 3:42 am

I felt compelled to write something on what I have learned during last a few months and I think I am done for now with a series of contest articles at this forum.

I hope my articles can help myself to clarify a few things for value-investment and I certainly hope they will be helpful to others.

As a group, we need to learn, to grow, and I certainly like other people to share their ideas and experiences.

Thanks for reading and feedbacks.

**grapes** Fri Oct 06, 2006 1:42 pm

Original, very good.

By the way, can you talk a little bit more about the management ownership in pre bankruptcy KMART and SALD?

lzhang wrote: I felt compelled to write something on what I have learned during last a few months and I think I am done for now with a series of contest articles at this forum.

I hope my articles can help myself to clarify a few things for value-investment and I certainly hope they will be helpful to others.

As a group, we need to learn, to grow, and I certainly like other people to share their ideas and experiences.

Thanks for reading and feedbacks.

**grapes** Fri Oct 06, 2006 1:45 pm

Also, I think the original picker of NTES, Uhual and OCA etc is chriend03, right? You have any more information about him?

lzhang wrote: I felt compelled to write something on what I have learned during last a few months and I think I am done for now with a series of contest articles at this forum.

I hope my articles can help myself to clarify a few things for value-investment and I certainly hope they will be helpful to others.

As a group, we need to learn, to grow, and I certainly like other people to share their ideas and experiences.

Thanks for reading and feedbacks.

**lzhang** Fri Oct 06, 2006 2:11 pm

If my memory serves me right, I think that is true for NTES and UHAL. chfriend bot tons of NTES already before NTES was suspended in 2001 and kept buying after NTES resumed its trading. So ton of NTES under $1. I did not know if Mr. Duan got this pick from chfriend. Obviously Mr. Duan was a friend of Ding Lei at the time. Even he bot later than chfriend, I do not think he needed any hint from him to pick up ntes.

chfriend bot lots of UHAL in late 2002 and early 2003, with funds partly from NTES and partly from liquidation from sales of his own commerical real estates. From Duan's statement, uhal was introduced to him by chfriend. But Mr. Duan did lot of studies by himself. He went to uhal stores, he hired accountants and lawyers to study its book.

As far as I know, Mr. Duan bot oca long before chfriend touched it, and he admitted he could not understand OCA and quitted it and never touch it again.

I do not know chfriend. According to Mr. Duan, he was a math professor in southern CA (San Diego), made a fortune in real estate, quit his professor job to become a full time investor. Once he posted something here.

I think the bottom line is, not matter how great one is, he can make mistakes and we must learn from our past mistakes, which is the most important thing, because opportunities are always there, but if one can not prevent serious mistakes from repeatedly happening, one fatal mistake will blow him away.

grapes wrote: Also, I think the original picker of NTES, Uhual and OCA etc is chriend03, right? You have any more information about him?

lzhang wrote: I felt compelled to write something on what I have learned during last a few months and I think I am done for now with a series of contest articles at this forum.

I hope my articles can help myself to clarify a few things for value-investment and I certainly hope they will be helpful to others.

As a group, we need to learn, to grow, and I certainly like other people to share their ideas and experiences.

Thanks for reading and feedbacks.

**lzhang** Fri Oct 06, 2006 2:17 pm

Thanks, but I did not know much details. You know, that is exactly the problem with survivorship. We can not find info easily on those disappeared companies, but those info is crucial to make less biased judgements on our strategies.

grapes wrote: Original, very good.

By the way, can you talk a little bit more about the management ownership in pre bankruptcy KMART and SALD?

lzhang wrote: I felt compelled to write something on what I have learned during last a few months and I think I am done for now with a series of contest articles at this forum.

I hope my articles can help myself to clarify a few things for value-investment and I certainly hope they will be helpful to others.

As a group, we need to learn, to grow, and I certainly like other people to share their ideas and experiences.

Thanks for reading and feedbacks.

**lzhang** Fri Oct 06, 2006 10:50 pm

Just searched sec filings for KM and SALDQ. According to their latest filings before bk,

KM's directors and executive officers as a group had 3.2% holdings
http://www.sec.gov/Archives/edgar/data/56824/000104596901000386/0001045969-01-000386-0001.txt

SALD's directors and executive officers as a group had 30.8% holdings (but if we subtract Mr. Duan's 17.3%, we have 13.5%)

http://www.sec.gov/Archives/edgar/data/893741/000114544304000340/d14210.htm

The problem with SALD might not be its insider holdings, but because of its economic value. As in retailer industry, it is hard for those small fishes to survive. Unless it has hard value as real estate and shareholders can lliquidate those value, it is hard to find any remainings.

grapes wrote:
By the way, can you talk a little bit more about the management ownership in pre bankruptcy KMART and SALD?

**blast_investor** Sun Oct 08, 2006 8:28 pm

Excellent summary on several bankruptcy cases.

Over past many years, I have encountered success and failures. The biggest lesson is the "management" part. Insider ownership % and insider buying are absolutely required to be confident on any bankruptcy related picks.

Kmart and OCA are recent cases of management destroying value of shareholders. This is management "value trap".

Edward Lampert success on real estate story behind Kmart are well known in stock market. The initial investors of Kmart stock after bankruptcy made triple and quadruple and more money in couple of years with Lampert because of real estate value behind Kmart stores.

However, the same real estate hidden values were there behind the old pre-bankruptcy Kmart companies. The real estate value behind pre-bankruptcy Kmart stocks were destroyed by the old management and old Kmart stocks were cancelled.

Investing into a stock is investing into a "management team". Assessing management' quality is toughest part in value investing.

**blast_investor** Sun Oct 08, 2006 8:52 pm

Yes, survivorship will limit the data for research. The good part is, the previous cases on this topic has already been large. There is a lot to learn already.

Kmart pre-bankruptcy story and other stories were very similar. Insider had very little ownership. Lawyers were milking the Kmart by millions day by day under bankruptcy fees. CEOs and management never dared to do any good things to reward shareholders.

It is premature to assume that old Kmart management knew nothing about those large hidden real estate values. However, in bankruptcy mode, all the management folks were in their own interest, they would not have any motivation and interest to do real large reorganization and liquidation. Once it is in bankruptcy mode, the company is under gun of bond holders too. Bond investors would try their best to kill the company and maximize the value for bond. The less value the old shareholders in pre-bankruptcy receive, the more value bond investors would get after bankruptcy emergence.

In such trouble shape, the strategic investors such as Buffett, or large insider ownership (minimum 15%) is absolutely required for boosting the odds of success in pre-bankruptcy common stock investment.

Most pre-bankruptcy stocks are too risky for consideration of investment.

lzhang wrote: Thanks, but I did not know much details. You know, that is exactly the problem with survivorship. We can not find info easily on those disappeared companies, but those info is crucial to make less biased judgements on our strategies.

**lzhang** Sun Oct 08, 2006 10:19 pm

I agree we should not guess if the km mgm team know the value of KM or not. But I think it is pretty clear they were not in the owner's mindset. If I were a small grocery store owner in a small town and a super wmt center just opened one block away from me, and if I found it was very hard for me to compete with wmt, it would be of my best interest to rent the store out or just sell the store. The new tenant or owner might find it make more sense to open a restaurant at that location. I certainly get what I should get no matter what happen afterwards.

What was in the km mgmt's mind was how to lower the price, how to get more customers, how to open more stores, how to compete with wmt. They might be good businessmen in retailer (but not as good as wmt, tgt), but they failed to understand what is the most important thing to stockholder (the real boss) is to retain and improve the value of the stock. If they downsize the business, shareholders will be rewarded with greater value, but they (the mgmt team) will have a feeling that they have less power (as the number of stores are less). So if they were really working for shareholders, they should have done what Mr. Lampert did for the new KMRT.

blast_investor wrote: Yes, survivorship will limit the data for research. The good part is, the previous cases on this topic has already been large. There is a lot to learn already.

Kmart pre-bankruptcy story and other stories were very similar. Insider had very little ownership. Lawyers were milking the Kmart by millions day by day under bankruptcy fees. CEOs and management never dared to do any good things to reward shareholders.

It is premature to assume that old Kmart management knew nothing about those large hidden real estate values. However, in bankruptcy mode, all the management folks were in their own interest, they would not have any motivation and interest to do real large reorganization and liquidation. Once it is in bankruptcy mode, the company is under gun of bond holders too. Bond investors would try their best to kill the company and maximize the value for bond. The less value the old shareholders in pre-bankruptcy receive, the more value bond investors would get after bankruptcy emergence.

lzhang wrote: Thanks, but I did not know much details. You know, that is exactly the problem with survivorship. We can not find info easily on those disappeared companies, but those info is crucial to make less biased judgements on our strategies.