1 April 25, 2016 Fundamental Value Fund 2016 Q1 Letter to Partners
Total Page：16
File Type：pdf, Size：1020Kb
417 Fifth Avenue, 6th Floor New York, NY 10016 trlm.com Matt McNamara [email protected] April 25, 2016 212-401-2722 Fundamental Value Fund 2016 Q1 Letter to Partners Dear Partners, In the first quarter of 2016 the fund returned -1.7%. Large stocks, represented by the S&P 500 returned 1.3%. Small stocks, represented by the Russell 2000 returned -1.5%. Unfortunately, the sailing wasn’t nearly so smooth when observed with daily resolution. First, markets plummeted in January to the tune of 11% before sharply rebounding to make up the damage by quarter-end. It would seem that, as it is for measuring the coastline of Britain1, the length of one’s measuring stick can have a tremendous influence on one’s observations. Markets sometimes seem almost designed to disappoint us. A friend of mine once generalized Kahneman and Tversky’s famous paper on financial loss aversion2 to the stock market: “Think of it this way: if losing money hurts twice as bad as making money feels good, and the market is up 75% of years, if you check your stocks once a year you’re barely breaking even!” The logic seems pretty solid. Regardless of the behavioral/emotional aspect, I spent every day watching as some excellent businesses were quoted at completely unreasonable prices (feels pretty good), many of which we already owned (feels pretty bad). Financials took it the worst, with our losses compounded by the added volatility of holding TARP warrants as opposed to common shares in some cases. Were it not for our roughly 37% concentration in financial stocks as of year-end 2015, the fund would have been up about 5% for the quarter. Interactive Brokers (IBKR) Some good did come of the weakness in financial stocks. I finally had the chance to add a position in a business I’ve been following for years: Interactive Brokers (IBKR). If you’re a viewer of financial “news” channels on TV, you’ll be familiar with their unintentionally campy commercials. Interactive Brokers has, over decades, built up a tremendous technological and cultural advantage over other discount brokers. In a highly competitive commodity business such as discount brokerage, it is almost unheard of for a business to offer the lowest prices while at the same time maintaining the highest margins, but Interactive Brokers, under founder Thomas Peterffy makes it seem easy. The shares have almost always been too expensive for me to justify buying, but when shares dropped 30% in a month for no discernable reason, I had to act. I couldn’t buy nearly as many shares as I would have liked due to liquidity issues (management owns more than 80% of shares outstanding), but I’m thrilled to own part of this excellent business at a great price ($32/share). 1 Mandelbrot, B. 1967. “How Long Is the Coast of Britain? Statistical Self-Similarity and Fractional Dimension.” Science 156 (3775): 636–38. 2 Tversky, A., and D. Kahneman. 1991. “Loss Aversion in Riskless Choice: A Reference-Dependent Model.” The Quarterly Journal of Economics 106 (4): 1039–61. 1 Fortress Investment Group (FIG) Another holding I added late last year that I haven’t commented on yet is Fortress Investment Group (FIG), an asset management company. My familiarity with FIG dates back to 2009 when, deep in crisis, a collateralized debt obligation holding vehicle (okay, technically a real estate holding trust that could also invest in CDOs), Newcastle Investment Corp (NCT), managed by FIG reported massive write-offs and losses amounting to many times its book equity. As with many assets during the crisis, the mark-down in price seemed to have little to do with the real damage done to the earning power of their collection of CDOs, NCT has made quite a recovery since those dark days. Despite NCT’s share price going from a split-adjusted $190/share pre-crisis to about $1.75 in 2009, FIG remains the manager of NCT. That’s some job security. Today FIG manages a diverse array of hedge funds, private equity funds, and credit funds along with permanent capital vehicles like NCT mentioned above. All told, FIG has about $70 billion under management not including the permanent capital vehicles. In general, asset management can be a pretty good business: it’s scalable, requires little in the way of fixed assets, and costs are highly variable in many cases. Offsetting that is the fact that asset management is deeply unfashionable right now with asset flows heavily favoring ETFs and other passive vehicles. FIG, despite these headwinds managed to grow assets under management last year despite lackluster results in many of its funds. In fact, it’s FIG’s reaction to a failing fund that first caught my attention last year. In October, FIG announced that Mike Novogratz, its public face, founding partner and manager of its flagship “macro” fund would be “retiring” and the fund subsequently wound down. It was a below-the-fold detail, however, that made me think this could be fun to work on: FIG would be buying in Mr. Novogratz’ founders’ stake in the company (13%) at a steep discount to the then quoted trading price. Shuttering a $1.6 billion dollar fund earning yearly management fees is hard enough for an asset manager to do, but buying back shares struck me as downright owner friendly. The earnings of an asset manager can be hugely volatile given that in a good year incentive fees (usually paid as a percentage of gains) can create a bonanza while in leaner times management fees (usually paid as a percentage of assets under management) can scarcely cover expenses. Valuing FIG would have to start from the balance sheet. At the end of last year, FIG reported net cash and investments per share of $2.95. Cash I understand, but “investments” can mean a lot of things. In FIG’s case, a substantial amount is invested in private equity that, as far as I could tell, got hit pretty hard in the first quarter. The exact figures aren’t public, so to be on the conservative side, I’ll call that $2.95 $2.00 even, giving FIG full credit for cash and half credit for investments. Next down the line, FIG has about $0.80/share in unrealized incentive fees net of expenses. That’s probably worth the full $0.80. So that’s $2.80/share on the balance sheet under some pretty harsh assumptions. Moving on to earnings, FIG makes about $0.32/share in management fees per year. FIG plans to return essentially all its earnings to shareholders, so let’s capitalize those earnings near the top of the dividend-paying spectrum, say, 8%. That equates to another $4.00/share. Putting it all together with cash + investments + embedded incentive fees + capitalized management fees gets us to about $6.80/share. The stock, at quarter-end was trading around $4.80. 2 That’s a pretty dire picture I’m painting. I’m assuming FIG’s investments never recover, AUM never grows and none of their funds ever earns an incentive fee again. If the future instead looks more like the recent past, the shares are easily worth $10 or more with management's focus on share buybacks. Ambac Financial Group (AMBC) It wouldn’t be a day at the office without something crazy going on at everyone’s favorite insurer-in- rehabilitation. Some very large credit funds (CarVal, Canyon) stepped up their campaign to take advantage of Ambac’s perceived weakness in the wake of Puerto Rican default by pressuring the board to accelerate the payment on bonds in a sort of modern-day credit market greenmail. Frankly, at that point I was tempted to exit Ambac as the then-7% position in the portfolio had absorbed a disproportionate amount of time and effort that could be productively redirected to sniff out other values in the spasming market. I can find value on a balance sheet, but I can’t fight powerful enemies with vastly greater resources. Just in time, we made some powerful friends as well. Nearing the end of March, Ambac announced the appointment of two new members to its board of directors: David Herzog and Ian Haft. Mr. Herzog served as CFO of AIG from October 2008 (just after the government’s investment of $182 billion) to January 2016. He knows a thing or two about rehabilitating insurers. Ian Haft, a partner at reluctantly-famous investment firm Cornwall Capital, knows a thing or two about finding value for shareholders. Along with the appointment came letters of support from holders of more than 20% of shares outstanding. I doubt CarVal and Canyon are going to give up the fight that easily–their attacks on management have become desperate as annual meeting season nears. Regardless, creditors getting control of the company seems increasingly like a longshot. My hope is that soon we can go back to just worrying about Puerto Rico. JP Morgan (JPM) I get asked quite a bit about my affinity for owning shares of financial companies, banks especially. Banks are often called “black boxes” or “unanalyzable” by the press or other analysts. True, analyzing banks can be a tough, boring, tedious task, and there’s much that seems like it must be taken on faith, like loan quality and sufficiency of reserving practices, but investing is always going to be a game of odds. We do the best we can with limited information. I suggest that those who refer to banks as “black boxes” probably don’t realize the assumptions they might be making about what goes on in their companies’ factories or stores (or specialty pharmacies for that matter).