Sold Enzon (ENZN) and other portfolio notes

One of the most difficult things for me about investing is selling a position at a loss, and the longer I’ve held the position the more difficult it becomes. I’ve written in prior blogs about the need for patience in investing. Well, this is the opposite problem; how do you NOT fall so in love with a position and NOT hang on to it far too long, even after your original investment thesis has clearly not panned out.

I’ve finally bitten the bullet with Enzon. Last week I sold the entire position at $1.70/share as I finally had to admit that the original investment thesis simply hadn’t worked out. True, there still may be more value in the shares than is currently reflected in the market price. And it may be that I have sold just before the intrinsic value is about to be realized, but I calculated that the shares were more valuable to me ‘dead than alive’, i.e. the tax loss savings is probably greater than any short term upside in the current share price. Why sell now? I want to give myself an opportunity as a non-shareholder to re-evaluate the shares before inevitable year-end tax loss selling by other investors. In other words I want to clear the air and see whether I would buy at current or lower prices were I not an owner, and at the same time provide myself the best opportunity to re-enter the position, in December when others will likely be selling. Now for a summary of the grizzly details. 80% of my holding was purchased in the 4th quarter of 2010 with the remaining shares purchased a year later. Average cost across all shares, about $10.10. Since then there has been a dividend of $0.186 per share (12/21/12) and two distributions categorized as a return of capital, one of $1.814/share on 12/21/12 and one of $1.60/share on 6/4/13. So, prior to the sale, I had a cash basis of $6.50/share. The sale thus resulted in a loss of $4.80/share or about 48%.

What went wrong?

First off, remember this was a coat-tail position. Both Icahn and Klarman held stakes when I first bought my position. Klarman was fresh off a successful investment in Furiex, a spin off from PPD, which I thought had a lot of analogies with the Enzon situation. A royalty stream and patents but no real operating business. There were differences, though; Enzon was not a spin-off but was the result of a restructuring whereby most of the operating portion of the company had been sold and what was left was cash, patents and a royalty stream (that had the potential to grow considerably). Yet it wasn’t this difference that caused the path of these two shares to diverge. What I failed to appreciate, in retrospect, was that these kind of special situations in the pharmaceutical industry tend to have binary outcomes and therefore work only 1) if an investor has superior knowledge, 2) in the context of a portfolio of similar investments or 3) you’re just blind lucky. In this case my investment thesis was that the PegIntron patented delivery method that Enzon had developed and successfully licensed to a couple of major pharmaceutical manufacturers would be adopted for other drugs and that that the existing royalty streams would grow with the success of the current drugs and the addition of new ones. Neither of these happened; The drugs for which PegIntron was licensed were not particularly successful and the delivery technology was not more widely adopted. How could I have known that when I invested? Perhaps I should have focused more on the downside potential rather than the ‘success’ scenario. What assets would the company be able to sell off if the patented processes turned out not to be successful? Had I looked closely I think I should have seen that there wasn’t much to be sold off. In fact I think I was lucky that the shares ‘only’ declined 48% and that’s due the fact that the two large investors have taken an activist role to make sure that most of the remaining cash is returned to shareholder; without them the cash would have probably been ‘re-invested’ by management to keep the company alive (and thus feeding management their salaries) as long as possible. I hope I have learned my lesson on this (though I’m not sure). Yes, coat-tailing is OK, but NO, not where there is no margin of safety. As an asset-based investor this should mean I require hard net assets (not intangibles) that are worth at least the market cost of the equity.

Other investments with a similar faulty investment logic

So are any other of my positions based on a similar faulty investment logic? Perhaps its time for me to contemplate this, and , if necessary, take advantage of year-end tax loss selling. Let’s review the three positions where I am deeply underwater.

1) Fortress Paper: The problem here is commodity prices, in particular disolving pulp prices. The company has 2 main operating segments, security paper segment (the Lanqart, Switzerland mill that produces banknote stock) and the disolving pulp (DP) segment, which include the currently operating Thurso mill, acquired in 2011, and the LSQ mill which still requires significant investment to become operational. The DP segment is where the company focus is while the security paper segment was part of the original asset acquisition, operates at a slight loss and about which there has been talk of divestiture. There was a  third operating business, the only one that was profitable; the non-woven wallpaper segment (the Dresden mill) was sold in the second quarter of this year to fund the expansion into the DP business. The key problem here is that DP prices have plunged since the original business plan was developed. Furthermore most DP (used in Rayon and other synthetic materials) is consumed in China which has their own high-cost mills and is looking into ‘dumping’ by non Chinese manufacturers (perhaps as a way to support employment at home rather than enjoy lower commodity prices). So this means there is a political aspect, not just a market aspect to DP pricing. Despite Fortress being one of the lower cost producers it appears to me that Thurso will continue to be unprofitable unless DP prices increase at least 20% from where they are today. If they do,  and revert to where they were 3 or 4 years ago, though, Fortress has huge operational leverage to the upside. Overall, the company is in a favorable liquidity position despite the operating losses in both segments as the Dresden Mill for over $200 million, and thus can withstand weak DP pricing for the next couple of years. Shares in Fortress have swooned from the mid $20 range when I first began the position to around $6 currently. Is there a margin of safety? In looking at the assets I don’t really think so. The Landqart mill probably would not bring it’s book value in a sale; while the economics of the operations have improved since Fortress purchased the company from Mercer about 7 years ago, it continues to run at a loss. The Thurso mill was purchased for very little and Fortress’ investment has been in PP&E to upgrade the mill to DP production. If Fortress can’t run the mill at a profit why would anyone else want it? The only mitigating factor here is ownership. While management at Enzon held almost no equity in the company, the CEO of Forthress, Chad Wassilenkoff owns about 17% of the equity. So, again, why do I continue to hold Fortress? In the short term it doesn’t appear that there are any factors that might increase the market price of the equity as DP pricing continues to be depressed. In the long-term, however, the operational leverage of the company makes the investment enticing. Could the company earn $3 or $4 per share at the top of the cycle? Easily, perhaps even more. Short term, however, I will be looking at some tax loss selling once 3rd quarter earnings are released in early November (and they won’t be a pretty sight!).

Ebix: This is one of the most-shorted NASDAQ stocks, if not THE most heavily shorted stock. The company has been under a short attack for the past year. I am still on the fence about management, but the price of the shares against current operating earnings is too attractive to forego. I began accumulating about 18 months ago at $17 a share. Since then the shares moved to the mid $20s before coming under the first short attack by ‘Gotham City Research’, an anonymous research outfit, which knocked them down to the high teens. Then there was a proposed going private/management buyout offer by Goldman Sachs last May that was withdrawn in June on the announcement of an SEC investigation. Strangely, the alleged accounting improprieties and ‘leaks’ about impending SEC actions have not led to any official SEC announcements except that the SEC was looking into Gotham’s claims. I’m always biased to the underdog, and maybe my investment analysis is being unduely influenced by this tendency (OK for a sports fan but out-of-place in investing where I need to be looking for the straightest line between a and b), but it looks to me that the accounting irregularities, if any, aren’t company threatening. However, I remain a bit gun shy because of the continuing short onslaught. During the last short attack (this summer) management announced a $100 million share repurchase program. I think this will be a litmus test for me on whether to hold or fold. If, when 3rd quarter results are announced, no shares have been bought back despite what might be considered VERY attractive prices, I think it may be time to take the loss an move on. Why would management of a company which is generating considerable cash flow (or so they say) not use the cash to buy their own shares if the open market price is so attractive, that is, unless it isn’t! If no shares were repurchased I’ll infer that either they are contemplating an investment (and they better tell me about it!) with a better ROI than a share repurchase or the cash was simply not there. Let’s see, shall we?

NovaGold: With gold prices falling from over $1,700/oz. at the beginning of the 2013 to the current $1,300/oz. it is hardly surprising that gold mining stocks have followed suit. The more speculative, the more they have fallen. NovaGold is the most speculative kind; it isn’t actually mining gold at all, nor does it have an operational mine. It owns a half interest in a supposedly large, high-quality goldfield in Alaska that is currently in the permitting stage. In other words, it will be another couple of years before construction of the mine might begin and another year or so before the first ore is extracted. The issue here is that the mine is rather high cost; unless the price gold is over $1,500/oz., the mine may not be an attractive investment. Then there is the issue of raising the financing to open the mine. Furthermore the other half owner, Barrick, has already announced that it doesn’t intend to pursue development of this particular mine. Shares of NovaGold, which 2 1/2 years ago peaked at $13, have now fallen to close to $2. Interestingly, Klarman is also a large holder of the common equity and he purchased before shares fell to current levels. What is the investment thesis? Here, too, like the Enzon situation, we have a binary outcome. If gold prices soar because of international events (galloping inflation, world conflagration, etc.) the price of NG will soar with it. If prices remain where they are or fall, shares will likely trend toward $0. So in some sense the shares should be considered more like an option than regular common equity. If you have a negative view of the current world economic/financial situation, as I do, shares of NG may provide some upside in a market crash (only, of course, one accompanied by an increase in the price of gold). Likewise, they provide some hedge were there to be a dollar crisis. At current levels, NG shares seem to provide a good risk/return profile with multiple upside potential against limited downside. I will continue to hold, or perhaps take some capital losses prior to year-end with the thought of repurchasing after 30 days.