Alluvial Capital Management’s letter to clients for the first quarter ended March 31, 2016.
Dear Alluvial Clients,
The first quarter saw mixed results for Alluvial’s strategies. The Global Focused Value strategy lost ground, lagging small-cap stocks while marginally outpacing micro-caps. The Global Value strategy produced a better but still negative return in its final quarter as an offered strategy. In its two years of existence, the strategy performed admirably, exceeding the Russell Microcap Index® by 33.1% net of fees and expenses. Finally, the more conservative Global Quality & Income strategy rose, outpacing its benchmark by a hair.
The returns produced by each strategy belie the actual volatility that the market brought in the quarter. At one point in mid-February, small-cap and micro-cap stock indexes had fallen 15-18% and seemed to be pricing in an imminent and severe global economic downturn. Then as suddenly as they arrived, these fears dissipated and stock indexes roared back to breakeven or even positive territory. Well, large-cap indexes did. Micro-cap stocks remain in the red for the year, and have in fact fallen nearly 20% from their highs in June, 2015. In retrospect, I launched Alluvial Capital Management at a fairly poor time for investing in micro-cap companies. In the two years since, micro-cap stocks have provided a total return of a pitiful negative 9.8%. Regardless of the direction of the market as a whole, I believe there will always be opportunities to invest in under-valued companies poised to appreciate. I will continue to dedicate all my efforts to identifying these on clients’ behalf. When searching for these opportunities, it helps to identify factors that increase the likelihood of inefficient pricing and to concentrate efforts on companies exhibiting these characteristics.
- Obscurity. The company may operate in a very unpopular, unfamiliar, or niche industry, may be listed outside of its core business market, or may have reclusive management/ownership that does communicate with Wall Street or the Press. The reduced number of market actors that are even aware of the company’s existence, much less familiar with its operations, increases the chances of a mispricing.
- Small size and/or limited trading activity. A company with a market capitalization of $25 million or one that trades fewer than $25,000 worth of shares per day is simply uninvestable for market actors of significant size. For that matter, so is a company with a market capitalization of $250 million and daily trading dollar volume of $250,000. Not to say there aren’t many sophisticated investors tracking these tiny and illiquid companies, but the number of potential investors is reduced, which decreases market efficiency.
- Financial statement complexity. This is my favorite, because a startling number of market actors perform only very shallow analysis of a company’s filings and news releases. The more complex these documents are, the fewer investors will put forth the effort to make sense of them. This creates opportunities for investors willing to put in the time and effort required to understand the many moving parts. All the same, it is critical not to confuse business complexity with financial statement complexity. I have a strong preference for companies with simple business models over businesses whose profits are derived from arcane processes.
Barriers to discovery, barriers to investment, barriers to understanding. These are Alluvial’s primary engines of idea generation. A prime example of all three is MMA Capital Management.
Alluvial Capital Management – MMA Capital Management
Alluvial’s highest conviction holding and largest position in client portfolios is MMA Capital Management. Though I have mentioned the company more than once in previous letters, I have never laid out my investment thesis in any depth. Clients certainly deserve such an explanation as MMACM’s performance will have a large impact on client portfolios going forward. The intrinsic value of MMACM’s shares is not readily apparent due to accounting conventions and the firm’s history. GAAP rules require the firm to consolidate many assets and liabilities to which it has only de minimus exposure, largely consisting of investment funds managed by past and present subsidiaries. Adjusting for these “phantom” statement entries and giving credit for significant hidden economic value, it becomes apparent that MMACM trades for half or less of its worth.
MMACM is a small specialty finance company with a market capitalization of $104 million. The company, once nicknamed “MuniMae,” was a major player in the low income housing tax credit (“LIHTC”) market but faired extremely poorly in the financial crisis when all liquidity left its markets. MMACM spent years in survival mode, selling off assets and deleveraging. The company ultimately survived as a scaled down version of its former self, a hodgepodge collection of legacy assets with no central business model and significant remaining debt. MMACM has spent the last few years selling off legacy assets, developing new cash flow streams, and restructuring its debt to ensure long-term viability. Oh, and repurchasing lots and lots of stock. Recognizing the persistent discount between its stock price and the economic value of the company’s assets, MMACM’s management has repurchased 24% of the company’s shares since the end of 2012. At present, MMACM’s assets and business lines include the following:
- Bonds – The company continues to hold a legacy portfolio of 39 tax-exempt bonds backed mainly by multifamily affordable housing complexes. These bonds are held at fair value of $309 million against principal value of $310 million. About 16% of these bonds by principal value are non-performing. These non-performing bonds are valued at a weighted average of 72% of principal. Historically, MMACM has had success in resolving non-performing bonds profitably by foreclosing on the underlying properties and selling them.
- Real Estate – MMACM continues to hold interests in real estate partnerships and joint ventures. The value of many of these interests was written down substantially during the financial crisis, and the market value of these assets substantially exceeds their balance sheet carrying value. On a GAAP basis, this real estate is carried at $38.3 million. The fair value is $46.8 million, or $1.30 per share above their balance sheet value. In February, a real estate holding in which the company held a 50% interest was sold for a gain of $2.7 million.
- Solar Financing – In 2015, the company invested $50 million in a solar construction financing joint venture. The venture has been profitable to date.
- Loan Receivable, Repurchase Option – In 2014, MMACM sold off its interest in a South African LIHTC manager for $15.9 million and an option to repurchase the business in five years. The company provided seller financing for the entire amount. GAAP rules prevent the company from recognizing the gain at the present time, which will provide another source of future income. The current loan balance of $13 million does not appear on MMACM’s balance sheet.
- LIHTC Management – MMACM has reentered the LIHTC management market, inking a deal to manage a portfolio of low income housing for Bank of America. MMACM received an upfront payment of 2% of the portfolio’s $211 million equity value, and will receive 2% ongoing annual management fees for its services, plus certain residuals as the portfolio is liquidated. The company also invested in several LIHTC properties outside the Bank of America JV.