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The First Half, 2012

July 4, 2012

Every one else in the value investing blogshere seems to have given in to peer pressure, or at least to reader pressure, but, no, I’m not going to; I’m not going to post the results of my portfolio for the first half of the year on a stock by stock basis. Suffice it to say that my actual portfolio was up more than the S&P 500. The reason for not posting results is the same one that I cite when readers ask for a scorecard; this is not a site that tells you how to build a portfolio. The site simply contains a list of companies in which I have invested and my investment rationale behind each purchase. It’s too easy for a blog reader to view an online portfolio and mimic it because of good results on a scorecard. Think of it this way, I’m trying to help you be less lazy! You need to do your own homework and decide whether any of the stocks I mention might be appropriate for you.

So instead of reviewing a scorecard for my half-year review I’m going to make a few comments about each of my holdings, and I’m going to try to do this without anchoring on purchase prices. Why am I still holding each security and should I be sitting tight or changing the composition of my portfolio are the questions I’ll be asking. These are the same questions you should be asking yourself when you review your own holdings. Is the reason you made the investment in the first place still valid? Or have enough factors changed that you need to adjust your portfolio, either increasing, reducing, or eliminating a holding. So for each of my holdings I’m going to see if the investment thesis is still intact.

AIG – This is my largest position by a factor of two. It’s also my highest conviction position (well, I should hope so unless I’m totally inconsistent). The shares are currently trading around 55% of book value. The share price remains constrained by the overhang of Treasury ownership. This is a good thing at the moment as the company has plenty of cash and is in the process of generating more (Maiden Lane III sales and potential AIA stake sale) which it hopefully will use to repurchase shares when the Treasury next sells off some of their holdings. The lower the share price, the more AIG can repurchase (they repurchased about ½ of the offer in the last two Treasury sales) and thus the more accretive to book value. Treasury is under increasing political pressure to wind down the TARP program as the elections near, and this means that they are not as price sensitive as they might be, which is all to the benefit of AIG owners. I’d think about increasing my position under $30/share but I do need SOME diversification.

MFC Industrial – This investment has been a bit of a disappointment. Michael Smith, after all the shenanigans over the past couple of years, spinning off KHD, splitting KHD into two then remerging Mass Financial with the KHD’s mineral rights, has done little to enhance the value of the new company over the past year. Or at least he has done little that is VISIBLE to shareholders. The company is, to say the least, opaque, so there may have been some value enhancing moves that are not, at least as yet, apparent. I sold off a few shares at higher prices about a month back to redeploy into other investments that looked to have more potential. Currently the shares trade at around 75% of book value and yield 3.6% on a forward basis which should provide some downside protection. Michael, my patience is wearing thin. What have you got up your sleeve?

Fortress Paper – What can I say? I still owe readers my investment writeup on this. The share price has swooned over the past 3 months. I started buying too soon, as usual. But with the price now around $18 a share you are getting a company that could earn $3-$5 in 3 years. The CEO, Wasilenkoff, appears to be a great wheeler-dealer, buying assets for cents on the dollar, and hopefully a great capital allocator as well. I may pick up more shares if the price falls below $15.

Bank of American A warrants – Little to say here, the warrants have about 7 years left to run. The price goes up, the price goes down (mostly up this year after a big down year last year). I added to my position a bit in the first half but not at the $3 level when I should have. I continue to think this is a no-brainer, but, of course, I’m also still underwater.

Breitburn Energy Partners – Can’t get no respect! Units in Breitburn peaked about 14 months ago and have trended down ever since despite increasing the payout in each of the last 4 quarters at a 9% annual rate. There have been three secondary offerings, two by the company and one by Quicksilver Resources, during this period and that hasn’t helped matters, but I’m really not sure what has spooked the market on BBEP so much. The macro outlook isn’t that great, especially for natural gas, but the company does a good bit of oil and liquids as well as gas, and the prices for these have held up quite well. Book value has come down with dilution from the secondaries so my target sell price, once at $23-24, is now down to around $21. With any luck we might see that price in the next year. In the meantime I’m getting an 11% dividend (over 20% on my cost).

KHD Wedag – The Michael Smith cast-off. KHD ADSs have traded down 6% during the first half and now are priced at just over book value and 80% of cash. Shares trade on the Frankfurt Stock Exchange (as well as ADSs in the US), so that hasn’t helped as markets in Germany have been weak this year, but the company operates mostly in emerging markets (including Russia and China), is solidly profitable and had a nice increase in its backlog during the first quarter. I didn’t like the rights offering 18 months ago which excluded US ADS holders; my view on management is negative as far as shareholder interests. Nevertheless, at these prices I’ll be holding my position as the ADSs still have a good 50% upside before they begin to approach my estimate of intrinsic value.

Howard Hughes Corp. – Whatever possessed me to add only 50% to my position last Fall when HHC shares traded down into the $40 range? I should have backed up the truck! Shares have bounced back nicely this year, and, if they were to appreciate another 25-30%, I’d have to consider selling or trading out for a stock with a greater discount to IV. HHC trades primarily on perceived future value more than current CF making the stock quite volatile, so if one is inclined, shares might be traded quite profitably over the next 3-5 years. (Ouch, that was hard to say for a value investor)

Enzon Pharmaceutical –  A Klarman pick that has gone nowhere but down since I purchased a position a couple of years ago. Icahn also has a big position and board influence; In May the CEO/CFO was dismissed (She had been promoted to the CEO position less than a year ago when the former CEO was forced out) and replaced by an Icahn Board member. Does this signify major investors were becoming impatient and we are now closer to a value realization catalyst? In April some type of collaboration with a Chinese drug manufacturer was announced which does not point in the same direction; however, the partnership was made prior to management realignment. The company continues to spend down its cash hoard, albeit at a diminishing rate, on drug development and testing. Time to increase exposure or reduce? I’m sitting on the fence but favor a wait-and-see posture based on the latest corporate developments.

Steel Partners Holdings – I’ve just picked up a few more units in this Lichtenstein managed conglomerate at prices reflecting close to a 40% discount from NAV. Furthermore I believe that NAV is understated as it is based on prices of publicly traded shares that I feel do not fully reflect the underlying assets of these companies. So potentially a discount on top of a discount! That’s the way I like to shop, so I may continue to increase my position if unit prices fall further. The units are thinly traded (and thus illiquid for a large position) but provide, in my opinion, good downside protection for those with patience. My edge here is just that, the patience to wait for value realization, be it in a year or five.

Ebix – Despite the CEO’s recent sale of 500,000 shares (ostensibly to pay income tax on options exercised) the share price continues to rebound from a May low. When I look at what the company has done and continues to do with its serial roll-up strategy I just don’t understand how the company’s share price has remained so low so long. Oh yes, there IS a ‘short’ thesis about how the company is only a house of cards built on serial acquisitions and supported by fraudulent accounting, but I think that Ebix’s cash generation over the past couple of years disproves this theory entirely. It’s a classic clash of the shorts and the longs, but, this time, I think the shorts have it wrong. Any time the stock falls below $17 it is a buy in my mind and I increased my position by 1/3 in June when the share price dropped back down to that level. However, once the share price begins to reflect a market (15-17x) multiple that will be my cue to exit.

Exelis – Classic unloved spinoff. Who wants to invest in a contracting industry (defense) especially when the company has unproved management and capital allocation ability? I guess just me if the P/E is right and everybody else wants to dump the stock. We’ve had a bit of a roller coaster this year but, then, spinoffs don’t usually outperform until the second year after the spin. We’ve got another year and a half for this one to work out. Unless something better comes along, and I mean a real screaming bargain, I’ll continue to play the odds on this one. My expected exit prices is still between $16 and $18 per share.

Gramercy Capital – There was a lot of uncertainty about the fate of GKK at the beginning of this year. Would the company put itself up fo sale or would management try to grow it? That’s all been resolved now with the recent announcement of a new CEO; the strategy is to grow the company. In retrospect, this outcome should have been expected due to the low level of management ownership and the high salaries of board members. I’m not sure this is the best solution and I’m a bit worried that management may decide they need a larger sandbox to play in, i.e. larger capital base, which could mean dilution for existing shareholders. Shares have been quite steady over the past 6 months, neither falling into my buy range (under $2.30) nor gaining substantially to a point I might be tempted to sell ($3.50). This is one I’ll be watching closely with an eye to liquidation should management decide shareholders should provide the bigger sandbox.

Resolute Forest Products – Ouch and double ouch! I was really patient and waited until I thought Resolute traded down as low as it could go, only to see the share price shrivel considerably further as soon as I purchased a position. This is a 3-5 year bet on improving North American economies. I’m neither a buyer or seller at these levels. I think there is considerable value (and certainly operational leverage) in the company for an investor with patience and perseverance.

Novagold/NovaCopper: Did I get suckered into a gold play just as the price of gold took a vacation? In some ways yes, in some ways no. It’s funny how everybody thinks of Gold as the safe haven; when everything else is going down, gold is supposed to go up, right? Well, that didn’t happen in May did it? In any case, my investment hypothesis for NovaGold was not that the shares were a surrogate for the physical metal. I view the investment this way: 1) gold miners have not experienced the same run up as physical gold so they have more upside than the physical metal, and 2) NG is a lopsided bet on gold prices increases as it is operationally highly levered to the price of the metal – the price of gold goes up big, NG goes up way bigger, but if gold goes down, there’s not so much downside in NG shares. Asymmetric or am I kidding myself? In any case I think of the shares as a kind of market hedge and they are less of a value-wasting asset than a put option on the market.

Myrexis:  Shares in Myrexis have performed miserably this year; first they sunk in January on news of the suspension of clinical trials on one of the four drugs in the company’s pipeline and then again in May on the news of a management change. But I don’t think the latter was bad news. The company hired a veteran manager from the biotech field with a track record of creating shareholder value. Not sure why there was a selloff unless expectations were that the company was closer to some value creating event, but that should have been clear from the January suspension announcement. The company is still an interesting play. Shares are selling for less than cash/share and the company has enough liquidity to continue on its current path for another 3 years before it needs additional financing. Were shares to fall back under $2, my interest might be piqued again.

Hartford Financial – Yes, I’m a sucker for assets, a balance sheet junkie. I couldn’t help but take a small position in the company’s TARP warrants when the shares were trading at a 50% discount to stated book value. The problem is, now they are trading at a 62% discount. The TARP warrants are interesting because 1) they have a long expiration date, 2019, 2) the strike price (and shares received) is adjusted for dividends over $.05 per quarter and the company is currently paying out more than that, and 3) the premium on the warrants is quite small as they are in the money (but this also reduces the leverage). I’d be willing to add to my position below $9 per warrant, but the price has only come titillatingly close to that over the past month; I’m still waiting.

RadioShack: OK here we go. I did several write ups on RadioShack a month or so back. I even took a small exploratory position at $6 a share, fully expecting the share price to drop further. Well, drop it has, all the way down to $3.90 a share. So why haven’t I added to my position now that my forecast has proved, at least directionally, correct? That’s just the problem. Things should never go according to plan in the investing world. Perhaps we need to ask whether “Something is rotten in the state of Denmark” as the Bard once wrote. Does the fish truly stink from the head or are there other factors at work here, factors that are only temporary. Is this a ‘glitch’ investment or is RadioShack a victim of a secular decline in bricks and mortar electronic retailing. Are we perhaps projecting the Best Buy problem onto RadioShack when the problem is something else? Many have speculated, half will be proved right. I know not which half. Thus my reluctance to commit more funds at this level. Unfortunately in a liquidation scenario it doesn’t appear that RadioShack would realize book value because 1) much of the book value is comprised of inventory which, in my humble opinion, would be worth far less than 50 cents on the dollar in a liquidation scenario and 2) the costs of winding down the myriad leases are not fully reflected in the financials and they would substantially eat into liquidation value.  If the share price were to drop to $3.00 or under I might be tempted to review the situation again, but in the meantime I think there are better investment opportunities elsewhere. From a purely gut perspective I don’t yet have that nauseous feeling when contemplating an investment in RSH, and that’s not a good sign.

Gravity – After a very successful position in Gravity that was liquidated in Feb/March of this year for $3.00-3.47 a share (125% gain) I repurchased a small holding in May at $1.77, or half my best sales price. I can see nothing in the operations to have caused either the run up in the share price or the subsequent fall; it was all pure emotion regarding the launch in February of Ragnarok 2 in Korea. At the end of last quarter cash per share had declined slightly as the company ramped up marketing of Ragnarok 2 but remained around my entry price. I would consider taking a full position again in the $1.50 to $1.60 per share range with the same investment thesis as last time, but how many times to you get to make the same wager more than once? One can just hope.

Aberdeen International – Wow, did I learn my lesson. Never again will I invest in junior gold miners. I thought perhaps the 30%+ holding company discount would act as downside protection. That and the subsequent sale for cash of a gold royalty stream. But, of course, I now know better. Are the shares a better investment now that the price has dropped almost 40% since my purchase? In most similar circumstances I would have little hesitation in responding with a resounding ‘Yes’, but perhaps not here. I’m not sure what’s happening with the deployment of the newly received cash but I would have to see some sign of good capital allocation in order to come to a positive investment conclusion. I’m on tenter hooks, Bharti, prove me wrong or right. As to Hielko’s initial reluctance to invest in this ‘gem’, gotta hand it to you, I think you were spot on.

OK, now that I’ve gone through the individual stocks that make up my portfolio I have some comments about the portfolio as a whole.

  1. The top 4 positions (out of 20) account for about 50% of the total portfolio value; without some concentration there is no outperformance as diversification leads generally to average results.
  2. Within the top 4 positions there are 2 companies that are well-known and widely followed, AIG and BAC (warrants). This is inconsistent with my general thesis that individual investors have a greater edge in smaller-capitalization stocks that large funds cannot buy. Is my selection of these two mega-cap companies an anomaly or simply wrong? Food for thought.
  3. I mostly look for undervalued assets, but I do have a couple of cash flow plays. Am I straying from the straight and narrow path? I hold shares in Ebix and Exelis, both of which sell at prices significantly above book value but at low P/E multiples. They are both story stocks; Ebix is a roll-up story with a large short position (thesis: the shorts are wrong, management is a good cash allocator and the operational strategy will be proved out over time), Exelis is in an unloved industry (defense) and the stock was dumped after the breakup of ITT (thesis: the company’s cash generating ability will become clear over the next year or two).
  4. I hold shares that have depreciated considerably in value since I purchased them. My general rule is double down or liquidate in these situations, but I’m still doing nothing. Do I need to apply my rule more stringently? Am I      making the archetypical neophyte mistake of hanging on to losing positions      too long? More food for thought.
  5. Theoretically I subscribe to the Pabrai theory to diversify minimally (10-20 positions) but equal weight all positions. When I look at my portfolio I see anything but equal weighting! Why am I having difficulty implementing this? Is there something about the mechanics that is stopping me?

Sorry that was a little too long. But its July 4 and over here there are no fireworks so I had a bit of extra time. Happy July 4th to all who made it through this post.

  1. Arden permalink

    Great post

  2. Aberdeen International: I suppose nowadays I am on the fence about whether you should put a single penny into junior miners. A lot of the smaller companies are undercapitalized and they have to spend lots of money (or dilute shareholders… same idea) to raise capital. Filing fees, promotional costs, underwriting fees, etc. are very significant. And at many of them insiders are paid too much and eat up a significant amount of shareholder money (whereas with large cap stocks this usually isn’t a big deal). At some of these juniors, very little of the money they raise is actually spent on exploration.

    That being said… if there is a time to invest in juniors, you should probably do it at times when people are really scared and share prices are depressingly low. Like now.

    If their share prices are low then people don’t want to invest in them and this can cause serious problems for the entire sector because almost all of them are undercapitalized. When share prices are high… people want to invest in them and this can be somewhat self-reinforcing. The volatility is extreme and when they go up… boy do they go up.

    Almost all of them have corporate governance issues. Almost all of them do not allocate capital well (they have to waste a lot of money raising capital and on associated activities like promoting the stock). That’s just the way things are.

    I never looked too hard at Aberdeen because Northfield Capital seems like a much better idea (far superior management, though it might “only” trade at a 20% discount to NAV). At Aberdeen the discount isn’t as high as you would think because some of the private companies they own may be propped up by loans from Aberdeen. The debenture they received from the royalty sale has an ‘option’ embedded in them from Premier… Premier can potentially repay the debenture in overpriced shares of Premier, overpriced shares in the royalty company that they hope to IPO, or cash. (Though honestly the option in the debenture doesn’t make that huge of a difference compared to the valuation of the private companies, which is too hard for me to figure out.)

  3. Billy Basu permalink

    You have a great blog and are clearly very bright and above many of your peers in the finance industry.As you know,when the market goes down,it pretty much takes everything down with it and small caps have been hit even harder.Everyone feels dumb when the prices of their stocks decline and feels smart and vindicated when prices turnaround and shoot up.We are living in challenging times and the macro is likely to affect future stockmarket performance affecting 80% of all stocks for a long time to come.Stocks as part ownership of businesses are affected by the global economy.In the meantime,most stock prices have been gyrating based more on Mr Market’s emotions of how various economies will emerge than anything else.

  4. burt permalink

    Great blog! I have a question about Steel Partners. What do you think about the reputation of Mr. L, the head of Steel.

  5. Thanks Burt. About Lichtenstein, well, he’s a hedge fund manager. You know what you get. They’re in it for the money. They’ll generally stay just this side (hopefully) of legality. I have no illusions here. The comfort factor is that Mr. L has a 34% interest in SPLP as of April. Hopefully that 34% will align his interests with those of us little unitholders. You will note that he took units instead of cash for the accrued management fee in April, but he allowed himself a 15% discount on the unit price due to ‘illiquidity’ (he can’t sell right away… but seemingly neither can we as the daily volume is quite low). I think this is a situation an investor needs to watch closely. Remember that the partnership was created when he forced conversion of a hedge fund in the face of heavy redemption requests in 2008. His investors were none to happy about it, even if a court said it was ‘legal’ to do what he did. So I’ll be watching this one on 3 fronts: 1) how are the operations doing, 2) are trasactions creating value and 3) are the fees or other shenanigans draining value out of the holding company. To answer your question, I don’t know yet but I’m cautiously optimistic.

  6. Re XLS, I have owned this after the spinoff from ITT until they disclosed the huge pension defict (~1.94B$ as of 3/31/2012). This is disproportional larger relative to the market cap, than for other defense companies, and if you include this liability in XLS EV value, the shares are not cheap any more.

    • Feuerball you’re absolutely right about the unfunded pension liability; It certainly makes the company look far less undervalued when factored in. But I think the pension liability is a major reason most investors are avoiding the stock. I like the great amount of activity (both actual contracts and PR) that has taken place since the spin and so I’m willing to give management a little room to run at 4-5x earnings despite the pension liability. Their first year results as an independent company should be telling..

  7. Jon permalink

    Given your interest in Exelis, have you looked at L-3’s upcoming spinoff of Engility? People seem pretty negative on this one as well.

  8. Alex H permalink

    Your blog is very informative for someone like me who is learning. How are you buying the Bank of American A warrants? Is it a ticker symbol?

    • yes the Bank of America A warrants trade as BAC.WS.A on eTrade though they might have a slightly different symbol depending on the trading platform you use. However, be sure to read all about them before you invest (see posts on my and other blogs); the warrants are more leveraged than the stock and will go to ZERO if the stock price remains where it is for the next seven years.

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