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Investment review

March 21, 2012

You’ve heard of a spending review? You know, where you look at every single line item from a zero basis rather than incremental growth. Well, every once in a while I like to go through a similar investment review. The idea usually starts buzzing around my head because of something I’ve read and the result is often that I end up questioning my whole investment philosophy. This time the catalyst was a read through of Jim Chuong’s latest annual letter. I got there from the Corner of Berkshire and Fairfax, which is often my entryway to interesting articles that are somewhat off-the-beaten-track. Chuong has an investment portfolio of only 6 stocks, and a great investment record. By his own admission he is a lazy investor (me too!), he has a very long-term investment horizon (me too, again) and his investment philosophy is to find a family controlled company with what he considers good management and ‘glom on’ by buying an interest in the stock market (I’m not there yet). He doesn’t believe in diversification and he is willing to wait 3 to 5 years after identifying a potential investment to purchase a position, waiting until the price is just right. Wow, wait 3 to 5 years to make an investment? He’s got a really long attention span! I’m not sure I could operate under a system where I have to identify a number of potential companies then wait years until Mr. Market gets really crazy and offers one or more of these at an unbelievable price. It sounds interesting, but is it workable? The more I reflect on it, the more I question how to implement such a strategy. For example, if you start with cash, how long does it take to get fully invested? up to 20 years? (1 new position every 4 years on average) What happens to your performance during that time? OK so maybe it’s more fluid than that. Let’s skip this question for a moment and focus on portfolio concentration.

The relevant question for me, and it’s not a new one, is whether my portfolio should be more concentrated like Chuong’s. I don’t really know and I’m not sure how to address the question, but I think it might help if I could see what my portfolio might look like if it was more concentrated.  To do this I’ve gone through a hypothetical rejuggling of assets, cutting down my 18 active positions to my ’10 best ideas’. Kind of like the Pabrai model. I think this is a good exercise for all portfolio managers. After you’ve come up with your ’10 best’ list, you need to go back and ask yourself what, if anything, the other stocks in your actual portfolio add. Were they included to reduce the volatility of the portfolio? Were they included because there is safety in numbers, i.e. your conviction in each position wasn’t that high so you used a shotgun approach?  Were they included because, like me, you’re a ‘collector’ at heart and just couldn’t resist the latest opportunity? The exercise is a good one and might even force you to sweep out a few cobwebs. In any case it should force you to reflect on optimal portfolio size in light of your investing goal; If you’re a personal investor that goal should be return and not low volatility.

OK, so what does that mean for my portfolio. I came up with the following ’10 best list’ from my current  holdings.

  1. AIG
  2. MIL
  3. BAC.WS.A
  4. HHC
  5. LVLT
  6. XLS
  7. EBIX
  8. ABH
  9. NG
  10. GKK

They are listed in the order of my current weighting, not my ideal weighting, which, according to Pabrai, should be close to equal.

What about the rest? Let’s take a look.

  1. MCF: I’m looking to exit this position because my original thesis was based on a temporary price break in the wake of reserve write downs in June 2010. Although the shares have performed slightly better than the overall market since I purchased, the outperformance I anticipated has not occurred because of depressed natural gas prices. I have reduced my exit price target to the high 60’s and anticipate exit before the summer. Shares are currently up 47% from my purchase price.
  2. KHDHF: Ever since the corporate antics of Jan/Feb 2011 (where a chinese partner was allowed to buy a 20% minority interest at effectively a 20%+ discount to market) this position has been on my sell list. Unfortunately the ADR price has continued to remain significantly below my calculated intrinsic value. The ADRs have been tending up nicely since the beginning of the year. If the company reports improved 4th quarter results in the near future this may provide a strategic exit point. I have also continued to hold as I anticipated MFC Industrial would spin-off their remaining shareholdings in KHD as announced last Fall; unfortunately that has been delayed.
  3. BBEP: Secondary offerings, first by major shareholder Quicksilver Resources last Summer and Fall, then by the company itself in January, have capped prices of units in this limited partnership. I am hoping that with the Quicksilver overhand gone and the recent secondary completed, unit prices will rise to my target range of over $21 a unit.
  4. PRXI: This is now an ‘event’ stock; the April auction will, in large part, determine a valuation framework for the company. I have no idea what will happen at the auction so my current thinking is to exit prior to the auction results announcement if the price of the shares rallies from current levels in anticipation of a ‘best case’ result (which in my view is unlikely). With the focus now on the auction results and not on when or how the capital might (or might not) be returned to shareholders there is the distinct possibility of some euphoria from Mr. Market.
  5. ENZN: Enzon, like many biotechs, is difficult to evaluate. They have cash that funds a research team which develops one or more compounds that may be used by some other pharmaceutical company to produce a drug. No one knows until the compounds have been ‘developed’ and tested whether that alchemy of turning cash into a pharma asset is successful. So, watching what happens at Enzon is exactly like watching grass grow, except that I can’t even see what is happening at Enzon. Are they creating value or not? The shares are down over 30% since I first purchased about 1 1/2 years ago. There has been some restructuring of the company to reduce costs after the cancellation of some drug trials last spring. The hedge funds (Icahn, Baupost, et al.) continue to hold (maybe they don’t have a choice) so I do too, though I would like to redeploy my capital elsewhere.
  6. GRVY: Gravity is a situation where I continue to like the stock but it’s simply not one of my top 10 ideas at current prices. The original investment thesis was based on the ADRs trading significantly below cash per ADR. Last Fall Mr. Market became distracted; the ADRs tanked and became a Ben Graham net-net (that’s when I backed up the truck). Since then Mr. Market has woken up, and the improved outlook for Ragnarok 2, the sequel to their primary money-making game, has led to a doubling to the ADR price. I reduced my position by 50% when the ADRs briefly strayed above $3.00, my target sell price, last month. If they were to fall back below cash per ADR, say $1.90, I might be a buyer again as I still see considerable upside. Otherwise I expect to exit the position at target.
  7. MYRX: Get me out of this! Myrex was a classic spinoff with over $7 of cash per share when it separated from Myriad Genetics some 2 1/2 years ago. Unfortunately management was unable to transform cash into intangible pharma assets. They have squandered over $3 a share with nothing to show for it. Old management has now been ousted and new management brought in to salvage what is left. There is still over $3.50 a share in cash and hopefully something else from all the research that has been done. The Board has announced it will review all possible opportunities to increase shareholder value, and management has cut back on all expenses. This situation should work itself out over the balance of the year, I hope!
  8. AAVBF: Last but not least Aberdeen is my smallest investment, s really just a toe in the water. Subsequently have I decided that NovaGold with its upcoming spinoff and likely transactional denouement is probably a better gold hedge. Abedeen also has a significant ‘overhang’; being a closed end fund with a stated goal of doubling or tripling in size, presumably through secondary offerings.  I’ll be happy to relinquish this small position on the altar of ‘house cleaning’.

So that’s the hypothetical. Next post I’ll take a look at what’s left and see if the 10 best ideas make a viable portfolio. In the meantime I’m ready to dispose of my ‘laggards’ should the opportunity present itself.

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