Snyder Brown Capital Management’s fourth quarter letter to partners.
Snyder Brown Capital, LP (the “partnership”) returned -4.4%, net of fees and expenses, in the fourth quarter of 2014.
Snyder Brown Capital Management: Investment Process
Our goal is to build a portfolio of investments that will outperform both the broad equity and bond indices over the long term. To accomplish this, we search for securities that are dramatically mispriced by irrational or uninformed investors. The greater the magnitude of this mispricing, the greater our potential gains on an investment and the lower our potential risk if we are wrong and/or unlucky. While we currently have low net exposure to the stock market, we are not market timers. Our primary method of risk management is and always will be to carefully select individual investments which we believe will perform well even if the overall stock market does not.
Snyder Brown Capital Management: Fourth Quarter Performance
As we have stated before, the trading prices of our investments are much more volatile on a monthly basis than the underlying value of these investments. Our focus is on making absolute returns through a repeatable investment process, which cannot be reasonably evaluated over a period as short as nine months. With that being said, we appreciate that the poor performance of the partnership over these first nine months is likely to be frustrating for some of our partners. Per the terms of our partnership agreement, no management or performance fees were paid to the general partner in 2014.
Despite having only nine months of data, we can certainly evaluate the performance of the individual investments we have exited as well as the positive and negative developments at the businesses which drive the long-term investments we have made. We believe an important part of any investment process is a rigorous and intellectually honest evaluation of how investments develop versus the expectations underlying our investment thesis. A summary of this evaluation follows.
On the long side, the majority of our losses were caused by Enhanced Oil Resources and Fortress Paper, a company in which we own debentures we have previously written to you about. These are two investments of which we have never sold a share (or debenture in the case of Fortress) and there remain specific fundamental reasons to believe that these positions will be our best performers in 2015.
Snyder Brown Capital Management: Fortress Paper 6.5% Debentures due 2016
Much has been written lately about the strength of the US dollar and the falling price of oil and gas. These trends are excellent news for Fortress Paper in 2015 – and for our position in the debt securities of this company. Fortress’ major operating subsidiary manufactures cellulose pulp in Canada and has seen its input costs fall roughly 10%, in line with the decline of the Canadian dollar over the last three months. We have invested roughly 1/3 of our portfolio in this CAD$40 million debt issue that comes due in December of 2016. This position is more than triple the size of our largest equity positions, not because of the high likelihood of making large returns on Fortress in 2015, but because of the safety of this investment. We believe that even in a disastrous scenario, we will still make a positive return on this investment.
Because Fortress sells its product in US dollars, but costs are in Canadian dollars, we now expect this company to produce positive cash flow in 2015, on top of the $50 million in unrestricted cash the company already holds. In addition, the company’s largest debt issue is at a subsidiary that does not have recourse to the parent company (where our debt resides) and that lender has just granted the company a moratorium on paying both principal and interest on the subsidiary debt until after our debentures come due. We stand to make more than double our money from here on this very large investment by simply holding these debentures until they mature in 22 months.
We have been actively engaged with management and other stakeholders in this company on a regular basis to both ensure that our concentrated investment in this distressed debt is safe and to work towards a debt reduction strategy that will create value for all stakeholders. We think it is likely that the company completes a voluntary restructuring of some of the outstanding debt in the first half of this year, which should result in these bonds trading up to at least 80 from the current level of the low 50s. This would result in an increase in the mark-to-market value of our entire portfolio of nearly 20%, more than erasing the mark-to-market losses we experienced in 2014. Even at a price of 80, we believe this security would represent an attractive investment.
Snyder Brown Capital Management: Enhanced Oil Resources
Unlike our investment in the Fortress Paper debentures, in which the fundamental value improvements are not yet reflected in market prices, a lot went wrong at Enhanced Oil Resources in 2014. We invested in this company at a valuation of $7.5 million dollars because it owned producing oil properties worth $35 million that produced $3.5 million in annual cash flow. We recognized that we were able to purchase this company at only two times cash flow because of a bloated cost structure in which the managers of the company were paying themselves the entire cash flow each year, but we believed that situation could be improved upon by engaging with the board of directors. We had a number of communications with both management of the company and the board of directors during the course of 2014, not all of which were collegial.
Unfortunately, during the course of our sometimes contentious engagement with management, two major wells had down-hole failures and stopped producing. After embarking on a disastrously expensive effort to re-drill these wells at a cost of millions, management decided to sell the majority of the producing assets for cash, rather than address the bloated cost structure. In no small part due to our efforts to prevent this sale and, even more troublingly in our view, management’s intention to reinvest the proceeds, the board of directors resigned one by one and a new team has come in that has cut corporate costs from $3.5 million per year to less than a fifth of that amount.
As a result of the value destroyed by legacy management, bad luck, and declining oil prices in 2014, the market cap of this company fell by 2/3 since our initial investment to just $2.5 million currently, which is less than the net cash it holds in the bank. The company still owns two large oil fields with significant potential and has a net operating loss carryforward (a credit against future taxes for losses that have been incurred) of more than $100 million. This is still a very small company that is in crisis, but after a disastrous 2014 in which a great deal of value