Return
|
S&P1
|
Difference
|
HFRX2
|
Difference
|
|
2009
|
50.92%
|
26.46%
|
24.46%
|
13.40%
|
37.52%
|
2010
|
18.83%
|
15.06%
|
3.77%
|
5.19%
|
13.64%
|
2011
|
2.28%
|
2.05%
|
0.23%
|
-8.88%
|
11.16%
|
2012
|
16.41%
|
16.00%
|
0.41%
|
3.51%
|
12.90%
|
CAGR3
|
17.06%
|
14.56%
|
2.50%
|
2.99%
|
14.07%
|
And here is how $100,000 would have compounded versus those two benchmarks if it was invested at the end of 2008:
Compared to the hedge fund universe at large (HFRX), we have done well. But compared with the S&P, we have done just okay.
As erstwhile Buffett lieutenant David Sokol once said, I am pleased but not satisfied. With the exception of 2009, our investments have tracked the S&P 500 very closely. In fact, one might draw the conclusion that I am “index hugging”. To value investors, including myself, that is a pejorative. So while I am pleased we have not had a down year (yet) and I am pleased we have outperformed the S&P (if only by a slim margin these past few years), I am not satisfied. My goal is to outperform by a bigger margin.
***
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1This is the total return of the S&P 500, including if dividends were reinvested.
2The specific index here is the HFRX Global Hedge Fund Index, widely used index to praise or pan hedge funds in the press.
3CAGR = Compound Annual Growth Rate. Note that our 17.06% return is actually an IRR (explained in footnote 4) from 2009-2012 rather than a simple CAGR, which would have been a more inflated 20.88%.
Being able to pick the right stocks is only part of the equation of successful investing. Heretofore, I had spent nearly all of my energies in finding the most attractive securities to invest in, reading newspapers and trade publications and annual reports and financials and trying to distill all of that with the wisdom of the giants upon whose shoulders I stand on. And it’s been mostly a rewarding endeavor.
I compiled the IRR4 and the Cash-on-Cash5 returns on all stocks, twenty one in total, I either bought or sold last year. Meaning, I looked at how much each of my picks gained or lost individually. Then, I took the median and the average:
IRR
|
C-o-C
|
|
Median
|
19.2%
|
35.1%
|
Mean
|
24.1%
|
30.2%
|
It is an admittedly crude method. I did not do dollar-weighted averaging or sector-weighing or any other arithmetic gymnastics. There are fancy services called Performance Attribution that will drown you with data with which you can figure out exactly when and what caused your out- or under-performance for the year. But anyway, it’s a bit of an overkill for us, at least for now. Because the overall takeaway would be the same: I’ve done a decent enough job at picking the right stocks.
So why did we not return 20-30% last year then? One word: cash.
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4IRR = Internal Rate of Return. IRR is a tricky concept to define precisely with words, but think of it as the annual compounding rate taking into consideration multiple cash flows and timing (e.g. trading around a position).
5Cash-on-Cash, as I am defining it (because it is a non-scientific and quite fungible term), is the total gain or loss divided by total amount initially invested. This is different from IRR in that it does not take into consideration time. So for example, if you made $50,000 on a $100,000 investment, your C-o-C would be 50%. But if it took 5 years to realize that $50,000 gain, then your IRR is only 8%. I find C-o-C useful because sometimes you will buy a stock and it will pop for some reason so you sell within a month or two. Your IRR in that case would be huge. Triple digits. Because IRR assumes you can reinvest that gain at the same rate for the entire year. C-o-C in this case would be a more accurate assessment of the performance, common-sense wise.
For three months, from February to April, our uninvested cash balance was between 30-40% of our total portfolio. That is too much. Cash is in and of itself a form of investment. It is an investment in U.S. dollars. And for those three months, our biggest position by far was a 0% profit on holding U.S. dollars. We don’t need fancy performance analytics to tell us that is inefficient. This is called cash drag.
Besides being able to pick the right stocks, you have to know how to allocate the right amount of capital to them. Allocate too little, and you suffer from cash drag. Allocate too much, and you run the risk of excessive loss if you’re wrong about a stock. For the longest time, I’ve erred towards allocating too little. Earning 0% is better than losing 20%, obviously. Buffett’s maxim, Rule #1: Don’t lose money; Rule #2: Don’t forget rule #1, echoes in my head every time I place a bid.
That philosophy won’t change. I will always err towards prudence rather than peril. But I need to do a better job at moving closer to the optimal risk/reward balance rather than cowering in the corner of conservative cash hoarding. It’s like a batter waiting patiently, forever, for the right pitch, and when it finally comes, he decides to bunt instead.
***
Now let’s talk stocks.
Finally Sold Those Legacy Financials
2012 saw us taking profits on a few long-term holdings that were initially acquired during the Great Recession. American Express (AXP), Goldman Sachs (GS), and Wells Fargo (WFC) were all aggressively accumulated in 2009 when the sky was supposedly falling. Three of the greatest financial franchises in American history – what other time can one buy them at basically fire-sale prices? Each returned over 20% annually for us when I finally sold the last shares in 2012.
Allegiant Travel Company (ALGT)
For a while in 2011, an airline was one of our biggest holdings. Most of us coast-abiding metropolitan citizens have never heard of Allegiant, much less flown them, because we are not their target customer. Instead, they service cities like Middle-of-Nowhere Wyoming and fly their travelers to and from “vacation destinations”.
Allegiant has been remarkably profitable because there are a surprising amount of people who live in the middle-of-nowhere and, like normal human beings, want to go to Las Vegas or Fort Lauderdale on holidays. Allegiant saves them hours of driving into a major city airport hub AND provides them with low fares.
This is their biggest competitive advantage over the Uniteds and the Deltas of the industry. Those big boys don’t want to fly in or out of small towns because there just isn’t enough travel volume there to be worth it. Allegiant thus operates a de facto monopoly in their little corner of the global transportation system.
I started buying shares in 2010 and added to them in early 2011 with a cost basis in the low $40s. By mid 2012, other investors started waking up to the Allegiant story and I was able to sell our shares in the mid $60s, netting us a 28.6% IRR.
The Agony and the Ecstasy of Getting Bought Out
Two names in our portfolio got bought out in 2012. Getting bought out is both a good and a bad thing. The good is obvious: you wake up one morning to a huge gain in the stock. Your thesis is validated, your risk greatly reduced. You feel good for pretty much the whole day. But then the bad: after the buyout closes, you are left with a pile of cash. Now what?
This is called re-investment risk. Some people would call this a high quality problem, and that is a fair assertion. But as discussed earlier, cash earns 0%, and as the stock market continues to march ever higher, good ideas are becoming scarce. Hence, the dichotomy of agony and ecstasy.
In August, a small regional bank holding company in Las Vegas called Western Liberty Bancorp (WLBC) got bought out by a bigger bank, Western Alliance Bancorp. I invested in WLBC because it was being sold for 0.5x book value with a big chunk of its book being cash. Its Tier-1 ratio6 was like 30% or something obscene. They were clearly overcapitalized, and thus, provided a big margin of safety.
Furthermore, Western Liberty was born from a SPAC7 led by Jason Ader. Mr. Ader, a fellow NYU Stern MBA alumnus (’93), has a reputation of being sharp and opportunistic and has the track record to back it up. The importance of having someone you trust, someone on the inside of the company, cannot be understated when investing in public equities. My confidence in Mr. Ader as a steward of WLBC shareholders, in conjunction with the dirt-cheapness of the stock, led me to build a sizeable position in the name at a cost basis of ~$2.70 per share. Western Alliance then bought it out for $4.02, netting us a 48.8% gain in just half a year.
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6This is the number that banking regulators look at to assess the safety cushion of a bank, the ratio of core equity to total risk-weighted assets. The higher the number, the safer the bank. The average Tier-1 ratio of big banks in America is somewhere around 10-12%. Anything lower than 8.5% gets the bank in trouble.
7Special Purpose Acquisition Company. Basically, a shell corporation with a pile of cash looking to buy a company. If you’re interested in nitty gritty details of WLBC’s birth, click here: http://apps.shareholder.com/sec/viewerContent.aspx?companyid=ABEA-5LXF9L&docid=6716695
Our other name that got bought out was unfortunately a much smaller position, a Canadian furniture company called The Brick (BRK on the Toronto Stock Exchange). This idea came from Guy Gottfried of Rational Investment Group, who presented it at the October 2011 Value Investing Congress. BRK at the time was selling for 7x free cash flows after undergoing a recapitalization led by Fairfax Financial. Fairfax is run by Prem Watsa, a highly regarded value investor frequently tabbed as the “Warren Buffett of Canada”. Furthermore, both The Brick itself and its insiders were aggressively buying and retiring shares.
The confluence of 1.) a cheap stock, 2.) Prem Watsa being the majority shareholder, and 3.) heavy buying by insiders, was irresistible. I bought a small position at $2.71 per share almost immediately after reading Mr. Gottfried’s presentation8. I told myself I will return to do more in-depth research and add to the name after that.
A full year passed. In November 2012, Leon’s, another big Canadian furniture chain, bid $5.40 per share for The Brick. But unfortunately, for over twelve months, I had barely paid any attention to that position. I can’t explain it besides constantly assuming there will always be time later to look at a boring furniture company. What a colossal mistake of omission on my part. The eye popping 95% gain in one year was barely 1% of our overall portfolio.
Virgin Media (VMED)
Virgin Media was another idea originated from another investor. Philippe Laffont of Coatue Management presented the idea at the Ira Sohn Conference in May 2012. Virgin Media provides cable TV and internet services in the UK. At the time of Mr. Laffont’s pitch, VMED was trading around $22 per share, which was around 6 to 7x free cash flows.
Here’s what’s nice about big well-run telecom companies: their operating cash flows are very predictable. Consumers in the 21st century would rather part with running water than with their TV or internet. And there’s a huge barrier to entry in the form of all those cables or fiber that need to be put into the ground.
Here’s another thing about big well-run telecom companies: their GAAP9 net earnings almost certainly understates their true earnings power because depreciation eats up so much of their GAAP expenses. Big telecom spends heavily early on to lay all those cables that all flow through depreciation in later years, but once that initial investment in infrastructure has been spent, the true costs of maintaining it is much less than the non-cash depreciation expense. This has the effect of making net earnings appear much smaller than their free cash flows and are thus ignored by investors who do basic price-to-earnings ratio screens.
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8Which you can access here: http://www.marketfolly.com/2011/10/guy-gottfrieds-long-brick-presentation.html
9GAAP = Generally Accepted Accounting Principles. In my opinion, GAAP is a valiant attempt by a bunch of CPAs to create a one-sized-fits-all solution that often falls short when used to determine the intrinsic value of a company. Knowing exactly where and how much it falls short can lead to big profits. I call this GAAP arbitrage.
So anyway, Virgin Media had just built out this super fast 50-100 Mbps cable infrastructure and cash was coming in hot and heavy. So their board basically looked at each other and said, well, since we don’t have to spend it building things anymore, we can spend it on our own stock! And so they did. Since 2010, Virgin Media has repurchased 25% of their total shares outstanding, and they aren’t done. Mr. Laffont believes they have the capacity to buy back all of their shares in five years with their free cash flows alone, and he is determined to be the last guy holding shares. Well, make some room for me too. I plowed aggressively into VMED at $22.
Here’s what the VMED chart looks like since we’ve owned it:
It is the single biggest contributor to our fund’s return in 2012. I started taking profits when VMED passed $30 and had sold about half of our position by year end. Total cash-on-cash return in just 6 months was 56%. Let me briefly warn you this is not typical and I never expect this quick or this steady of a march upwards. Sometimes it’s better to be lucky than good.
PennyMac Mortgage Investment Trust (PMT)
PennyMac is a name we have owned for exactly two years now and have yet to sell a single share of. I typically try not to talk about current holdings in these letters, but PMT has been a major contributor to our profits so I feel it would be remiss to not bring it up. PennyMac has two main operations: 1.) Buy distressed mortgages and work them out through short-sales and foreclosures, and 2.) Originate new mortgages and sell them, mostly to the GSEs10.
PennyMac was founded in 2009 in the wake of the mortgage crisis by ex-Countrywide executives. In that one sentence alone you can get a good idea of why it was mispriced. In 2011, the housing market was still deeply wounded and Countrywide was public enemy #1. Who wants anything to do with mortgages or housing or especially Countrywide back then? Nobody.
I started accumulating shares in early 2011 with an average cost basis of $18. Back then it was yielding a 9% dividend and I was convinced it was not only a sustainable dividend but a growing one as well. Say what you will about Countrywide, but those guys know the mortgage market. I was also convinced another big leg down in housing was not going to happen. The Fed by then had the money spigots wide open and mortgage payments were falling lower than rents and institutional investors were stepping in.
PMT did little in 2011 besides trade sideways, which was fine by me, because they kept paying and increasing their dividends as predicted. In 2012, the stock finally started to move as investor sentiment towards mortgages and housing brightened. PMT ended the year above $25. Including all the dividends we’ve been banking, PMT has been a stellar 32.1% IRR winner for us, a 60% cash-on-cash total return. It is getting close to the point where I will consider booking the profits, but I believe the probability of even more upside is high given that the housing recovery is still in the mid-innings.
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10Government Sponsored Enterprises, shorthand for Fannie Mae and Freddie Mac. Together, the GSEs own pretty much all of the outstanding mortgages originated since the crash.
And Now We Interrupt All This Insufferable Bragging With A Big Mistake
Mistakes are inevitable when investing. The only investors who have not made a mistake over the long run are Bernard Madoff and Charles Ponzi. That’s because investing is, at its essence, an attempt to predict the future. Everyone playing in any market is making intelligent stabs at what the future will look like. For stocks, we’re trying to guess at future cash flows, which depends on industry dynamics, management, financial health, etc. etc., and compress all that information into one number: the stock price. This is not a game anyone gets right. This is a game of odds. And sometimes, hopefully not often, the odds will turn against you.
In 2012, I invested in Real Goods Solar (RSOL), a company that puts solar panels on rooftops. They are a so-called downstream servicer in the solar industry. “Upstream” would be guys like First Solar and SunPower who design and manufacture actual photovoltaic panels. Downstream guys like Real Goods Solar and SolarCity agnostically purchase PV panels and make money from the installation. Upstream guys were getting killed by a flood of cheap PV panels coming in from China, driving prices below their marginal cost. But low prices benefit consumers, and for the first time in history, solar became more affordable than buying electricity from utilities for chunks of the nation that live in sunny suburban areas.
RSOL was selling for right around book value, $1.20 per share, when I built our position. I believed servicers with scale like Real Goods Solar had a sustainable moat around their business. They could procure PV panels at ever cheaper prices, had the scale to handle financing for customers, and demand would grow as more and more people became aware of the viability of solar as a way to save money. A big chunk of RSOL was owned by a self-made multi-millionaire entrepreneur named Jirka Rysavy and a respected private equity shop called Riverside Partners. Furthermore, SolarCity, a much bigger downstream servicer, was preparing to IPO and chatter around its valuation was astronomical. I thought investors would come around to RSOL and, as a comparable, raise its valuation as well.
Those facts were and still are all true. But then in late summer, both the CEO and the CFO left the company in rapid succession. Despite the considerable tailwinds, Real Goods Solar was not executing. They struggled to integrate a big acquisition done the year prior. They continued to lose money even during the peak summer season. In the third quarter of 2012, they took a huge write-off that wiped out 80% of their book value. The big shareholders, those sophisticated insiders, were silent. RSOL was just too small for them to really care about. The entire operation as it fell apart was just an annoying write-off for them in the grand scheme of things.
I dumped our shares for around $0.55 per share, a humiliating 54% loss on a sizeable position11. I estimate this loss alone affected our overall performance by 4-5%. In retrospect, I bet too big on RSOL being able to turn a corner it had never turned before. I underestimated the difficulties of operating a successful EPC12 company. And I overestimated the impact of sophisticated insiders who I thought would step in and stem the bleeding but instead turned a blind eye because it was not a significant enough investment for them to bother. Lessons like these will help me avoid similar value traps in the future.
***
Outlook
2013 has gotten off to a fast start, both in the overall broad market and in our portfolio. Thus far, sentiment wise, 2013 seems to be the year that investors at large finally shake off the miasma caused by the 2007-2009 recession. In particular, hedge fund manager David Tepper, who manages $15 billion, made a bizarrely entertaining appearance on Bloomberg Television proclaiming his bullishness13.
While his antics were off-beat, his reasonings were sound. The Federal Reserve has continued to pin interest rates at zero. 30 year mortgage rates are at the astounding lows of 3.5%. The result of this, what some would call manipulation by the Fed, is that most risk-free to low-risk securities earn an investor next to nothing. Pension funds and endowments and plain old 401k’s and IRAs cannot abide by that – future retirees are counting on much more. So what to do? Ben Bernanke has finally, tyrannically, left savers with no choice but to take risks. And risks = stocks. It is of little surprise that the S&P 500 has hit 1,500 for the first time since 2007.
The current price-to-earnings ratio of the S&P 500 is 13x. Flip the P/E ratio, and you get an earnings yield of 7.7%. Meanwhile, a 10-year U.S. Treasury bond is yielding 2%. The premium on the risk in investing in a diversified group of the largest American corporations versus an obligation of the U.S. government, 5.7%, remains wide. And furthermore, corporations can grow earnings. Coupons on a government bond won’t.
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11SolarCity finally IPO’d in December of 2012, and in its wake, RSOL rebounded nearly 80%, adding considerable salt to this wound of mine.
12Engineering, Procurement, and Construction
13http://www.bloomberg.com/news/2013-01-22/appaloosa-s-tepper-bullish-on-stocks-as-u-s-growing-3-.html
This doesn’t mean I’m predicting the overall market will rise. Allow me to repeat the trope of all Buffett-schooled value investors: I haven’t the faintest idea where the market indices will be at the end of the year. I’m just saying I wouldn’t be surprised if it went up significantly as big money succumbs to the reality of a low interest rate environment and shifts capital over to the equity side of the ledger. In fact, the higher the market climbs, the more wary and cautious I become. Whereas a few years ago I could find interesting bargains in billion dollar companies, those opportunities are mostly gone. Any bets on mid-to-large cap companies is a highly correlated bet on where the broader market is heading.
My current strategy is to focus more on stocks that fly under the radar. With a relatively small sum of money comes the luxury of investing in small companies that big hedge funds won’t bother with. Here is where the risk/reward continue to favor the enterprising and patient investor, offering potentially outsized gains with limited losses should the broader market decline. I hope to discuss a few of these with you in next year’s letter.
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iThe information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.
