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What’s wrong with my portfolio? (part 2)

April 26, 2011

In my last post I reviewed half of the positions in my portfolio to see if they would pass the ‘smell’ test I had come up with after seeing a webcast of Pabrai’s recent Columbia Business School lecture.

Remember that my ‘smell’ test is just a quick over-the-top, common sense look at a holding to confirm that, indeed, the position can achieve the sell target price (and thus IRR) that I initially set. For the purposes of this review I picked a 25% IRR as my target return. I try to do this kind of thing at least semiannually so that I don’t leave positions in place out of pure laziness or, worse, some unfounded hope that a losing position will miraculously turn around and graciously allow me to bail out at breakeven. In other words I don’t really trust myself to fess up to my mistakes.

So here we go with the last 7 positions:

Level 3 Communications (LVLT): I bought a small position in LVLT as kind of a flyer. I didn’t do a lot of due diligence, like reading the last 5 years of ARs. I did, though, go through the long thread on LVLT at The Corner of Berkshire and Fairfax forum. It’s really kind of exhaustive and perhaps too detailed even for me. But my takeaway was that, while LVLT continues to lose money and has basically done so since inception, it has a fabulous portfolio of assets that might, under certain operating and political conditions that I could imagine as possible, generate major cash flows. With the shares trading below $1 in December 2010 because of what I perceived as an inflated fear that those controlling the last mile of the internet might control transport pricing, I took a (small) plunge. My reasoning was 3x up potential to 1x down, that is, if the pricing power for internet transport were to shift slightly away from the ‘last milers’, in fact or even just in expectation, then LVLT might make a decent return on its assets and the leverage in this operating scenario would produce generous cash flows that could generate considerable investor enthusiasm which would, in turn, drive the share price to at least 3x its current level. If that didn’t happen, the worst that might happen is I could lose my entire investment as the company is quite highly leveraged. The continued growth in movie streaming (read continued success of Netflix) and a more balanced view of the power of the ‘last milers’ has moved sentiment away from last December’s dire predictions. This has resulted in a more sunny investor outlook with regards to LVLT. However, I think any lift in share price from here will need to see more than just sentiment shift. But with the shares up over 70% from my original purchase price even if they tread water for another 8 months (until the LTCG holding period kicks in) I’ll have met my IRR target.

Contango Oil and Gas (MCF): This was a position I particularly liked at entry. Here was a company that was the lowest cost producer of natural gas, no debt, shares were not being constantly diluted by options, excessive stock grants or secondary offerings and the CEO owned 15+% of the company. Furthermore, when last fiscal year’s lackluster results came in (primarily because of continued low gas prices) management skipped their bonuses (imagine that!). But in June last year they announced that they would be writing down their estimated reserves by a considerable amount, and the share price promptly tanked. I had been following MCF for a while and was hoping for an opportunity to buy at a reasonable price… and lo! here it was! Since I purchased in August, the shares have recovered to their pre-announcement levels (up about 40% since my purchase) but the market is also up 30%. Is the 10% outperformance what I was looking for? Well not exactly. Though the shares have returned more than my 25% hurdle rate I think I will have to reassess the investment hypothesis at my one year holding anniversary. My reversion to the mean play is no longer a valid investment thesis; it has played out. I really don’t have any particular insight into natural gas pricing (though everybody seems to think it will remain depressed for the next several years – which is a positive in my opinion since expectations on the upside should be relatively easy to beat). So unless I can come up with a new investment hypothesis for MCF the position will probably be closed out later in the year.

Myrexis (MYRX): Ah! Here is a position that should be able to teach me something. MYRX was spun off from Myriad Genetics in July 2009 with substantial cash, somewhere around $7.50 a share. I bought a position in the period following the spinoff when I anticipated that institutional selling pressure would be the greatest. The company was being valued in the market for around 55% of cash on the balance sheet. My investment thesis was simple; MYRX would be an attractive acquisition target for a larger pharma firm as it could, in large part, be financed with MYRX’s own cash balances. How naïve on my part! (I’ll go into that later) The shares traded up to $6 and change three months after the spin. Everything was going according to script. Then, out of the blue, MYRX made a bid to acquire Javelin Pharmaceutical. How could they? This wasn’t supposed to happen! MYRX was supposed to be taken over at a premium, not waste its dwindling cash hoard by buying up some other R & D company. But of course I had missed a key point in the spinoff documents. Management at MYRX had only a very small ownership interest, thus their incentive was to remain as management of MYRX. If MYRX was taken over, they wouldn’t get paid but a farewell bonus! Of course, they wanted to keep their salaries, their work, their ‘baby’. Who cares about the shareholders! Ahhhh incentives. Sorry Joel, I wasn’t paying enough attention on this one. Even when the Javelin deal was shipwrecked by a third-party making a higher bid, MYRX shares didn’t recover. The cat was out of the bag; Management’s interests weren’t aligned with shareholders’. The shares trended down to the mid $3 range where they have been for the last 6 months, only recently jumping up to the low $4s with the most recent drug development announcement.  So I haven’t made my threshold IRR with MYRX and don’t really believe I will. I think I would be kidding myself if I thought that the shares will trade at much of a premium to dwindling cash on the balance sheet with no monetization in sight for any of the research.Of course, there is the slight chance that MYRX announces some phenomenal discovery of which we currently are unaware, but what are the odds? I am, perhaps, being overly lax here, but I have given myself until the 2 year anniversary of the spinoff to liquidate this position and chalk it up to experience.

PDL Biopharma (PDLI): I’ll admit that I was influenced by Baupost on this one. I have been holding PDLI in another account for several years. Early last year when shares sunk under $5 I almost upped my position, but for several logistical reasons didn’t. I kicked myself later when the share price recovered. So I was ready last February when the share price dipped again below $5; I pounced, purchasing a position in my value portfolio. This decision was in no little part influenced by the fact that Baupost had just repurchased a stake in PDLI during the last quarter of 2010 after selling their initial investment in the company back in the summer of 2009. I recall that in some interview Klarman said something to the effect that the 30% return he anticipated in PDLI (at then current levels) made the investment a ‘no brainer’. So I imagined that to reenter the same position he would be looking for a similar return. And since it didn’t appear that he could have purchased his latest stake in the open market for a price less than what Mr. Market was offering it to me for at the end of February, Klarman logic would have this a 30%+ return investment for me. No, I didn’t just use this rationale, I actually looked at what the cash flows from the company might be (see my earlier post on this). Unless something went terribly wrong with the patent rights it looked like this would provide a 15%+ minimum return under $5 a share. Since February the share price is up 25% (plus one dividend payment), and I still think I will be rewarded further. However, if everyone gets too ecstatic about the company’s prospects and bid the shares up over $8 I would certainly be a seller unless there were some material change.

Premier Exhibitions (PRXI): Premier is strictly a story stock. (If you want the story please review my previous posts on Premier.) The story’s next known event will take place in August when the court will decide whether to turn over the latest group of Titanic artifacts or auction off the artifacts (estimated value $110 million) and provide PRXI with the proceeds. In either case the timing is great as April 2012 is the 100th anniversary of the sinking of the Titanic. I started buying last August with the shares at $1.90 and have continued to buy on dips through February at a low of $1.55. The shares are now trading just above my average cost. I still believe the intrinsic value of the company is north of $3.00 a share and am willing to wait for Mr. Market to recognize this. Even if it takes 3 or 4 years this investment should provide my minimum 25% IRR. Of course, we’ll have to reassess after the August court decision and any subsequent operational developments.

Seahawk Drilling (HAWK): Another of my investment mistakes. The stock now has little chance of reaching my original target price. Well, I should really say it has no chance of reaching the target price; it would be something if I got out of this breakeven! (but I really don’t think that will happen). So why am I still holding this position? Yep, you got it, INERTIA! I’m still a little unclear as to what is going to happen during and post bankruptcy. It appears to me that the main issue is the Mexican government liability. The value of the drilling assets is now capped at the value of the Hercules Offshore shares that will be received in exchange for rig assets. So the great unknown is what liabilities with HAWK be burdened with. I assume this question will take several years to work out and will be decided in a court proceeding. And if there is one thing I know it’s that I don’t know enough about the legal system to handicap the outcome of a legal proceeding. So, again, what am I doing holding on to this position? Well, I’m just holding to see if Mr. Market on some crazy day will offer me over $6.70 a share for my HAWK holdings. My long-term capital gain clock is ticking so if he’ll do it before July, I’m out. If he doesn’t, I’m out too. Let’s see if I can exit gracefully from this one.

Terra Nova Royalty (TTT): Last but not least is TTT. I started accumulating shares in the company’s predecessor,  KHD Humboldt Wedag (KHD), more than 2 years ago at significantly higher prices. The company has been transformed during these last 2 years; the main industrial operations were spun off to form KHD Humboldt Wedag Int’l.; there was a dilutive rights issue, then the surviving entity was merged with Mass Financial (which had been spun off several years ago from old KHD). My ownership interest in KHD has appreciated nicely since the beginning of the four-step spinoff, especially because I purchased additional shares last June when very few investors were seemingly interested in this complex corporate transaction.  In terms of the TTT shares I own, I really can’t say the same thing. However, I almost prefer the outlook for TTT over KHD, and I especially prefer the former’s level of management share ownership which would seem to align management interest with those of us little shareholders (unlike the situation at KHD). TTT is selling at some 90% of book value (which is mostly composed of cash) and is being piloted by Michael Smith, a rather good capital allocator. There is not much hidden asset value in Terra Nova, in fact, the only hidden asset is management talent which has yet to be fully put under the microscope in its current corporate guise. In the past, Michael Smith has done quite well in building book value at Mass Financial; if we buy TTT shares now and he can do the same thing at Terra Nova, we are essentially getting the skill of Michael Smith practically for free.  This seems like a reasonable punt.  Will it get us a 25% IRR? To date it sure hasn’t. I think from here on there is a good probability of realizing our 25% target, but I don’t know about making up the past 2 fallow years so that our overall IRR is above 25%. I am inclined not to think so.

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