With the S&P 500 up near 3.8% as of the July 14 investor letter, Raging Capital Fund (QP) Series B was up 14% year to date. But its more than beating the S&P 500 or even the HFR Hedge Fund Index – down -3.9% over the same period. Raging Capital’s Rocky Hill, New Jersey-based Chairman and Chief Investment Officer William Martin of the famous activist fund thinks differently. It can be seen in his letter to investors – deriding “classic Wall Street” short-term thinking – but more specifically in the performance numbers. It’s not the long exposure in the long / short portfolio that is interesting, but rather Raging Capital’s short book that reads like a who’s who of battleground stocks – and is enjoying a nice run of beating stock market beta.
Raging Capital really likes Cavium but not short-termism
Martin really likes his new position in NASDAQ traded semiconductor company Cavium. CAVM is a proven growth company with product innovations pointing to the stock “trading at a bargain valuation.”
The extent to which Martin thinks he found a value in the stock is based in part on the company’s commitment to product development and research investment. Yes, you read that correctly. A hedge fund likes a stock despite unpredictable revenue cycles due to not knowing when its R&D investment will pay off.
Martin knows this attitude stands apart from the crowd of sheep who slave over quarterly earnings hits or misses. He takes the long view and appears to despise the short-term approach that Wall Street is now known for.
“In classic Wall Street fashion, investors have punished CAVM due to short-term worries about the exact timing of the ramp of its latest network processor and the slow initial uptake of the ARM-server market,” key developments for the firm.
When Martin writes he gives off the impression he is a value investor of Warren Buffett’s pedigree and patience. “We are comfortable being patient in the short term,” he says of CAVM, as if to sound very unlike a typical hedge fund in today’s financially engineering driven, steal earnings growth from tomorrow to satisfy today’s investor environment. He says the network processor business provides “a solid foundation of value” while products in the pipeline give hope for “home-run upside potential.”
Raging Capital loves to hate Valeant, says bankruptcy next step as short book shines
Perhaps most fascinating about Raging Capital’s recent portfolio action isn’t the long book, but the short exposure.
During a quarter when the stock market was up, Raping Capital’s short exposure went had a relatively raging party, gaining 2% — or adding 450 basis points of positive alpha over the S&P 500 and 580 bps over the Russell 2000, where some of the stocks Raging Capital invests in can be found. Year to date the short book is up a stunning 14.3%, contributing nearly 1080 bps of returns – making it the primary performance driver over the period.
This short book is sprinkled with names of against the grain stocks that were initially thought of as “can’t miss” in the hedge fund world, including that most famous stock with “pricing power,” Valeant Pharmaceuticals and insider laden LendingClub.
Valeant has added 220 bps of returns attribution on the year and reflects Raging Capital’s thesis that its business – and debt – “continues to deteriorate in a meaningful way.” The most significant fall in Valeant stock occurred nearly one year ago as the stock price tumbled from a $257 top to end the year near $101.
Raging Capital established a short in May at an undisclosed price. The stock was trading at a meager $32.65 then and today is trying to stay above $20 per share.
Martin doesn’t mince words when discussing his disdain for the stock and its regulatory antics.
“VRX’s bad balance sheet is compounded by the risks associated with past price-gouging misdeeds as well as the fact that (nearly) $1 billion of high-margin revenues are at risk from generic competition in the coming year.” Martin doesn’t think Valeant will be able to reduce its leverage through asset sales “meaning that bankruptcy could ultimately become a more likely outcome.”
LendingClub is facing ethical issues and competitive market with increasingly fickle customers
Another interesting story is LendingClub, the home of former US Treasury Secretary Larry Summers, who sits on the board of directors. Summers was initially thought of as the man to keep LendingClub out of regulatory trouble. But, oddly, the government didn’t seem to listen.
In May CEO Renaud Laplache exited the company on concerns over a lack of transparency regarding related party transactions. The most recent ethical lapse and share price slide, which benefited the Raging Capital short book, involves “disclosures that the company tampered with the selection of certain loans that went into its loan pools, thus putting the integrity of LC in question.”
Martin hits this the topic hard.
“It appears LC was playing games to hit its numbers and possibly to make up for a shortfall in high-FICO score loan obligations,” Martin wrote, describing a similar situation to what was reported to be the derivatives that were packaged during the 2008 financial crisis. The only difference is that this time the actions were discovered before the investment products imploded.
For Martin, this individual ethical issue “was not part of our original short thesis,” but rather “is a symptom of the broader issues LC faces.” Other issues to consider is a lack of differentiation in a competitive market with increasingly picky investors.
Finally, the fund has another short they like PTMS
Raging Capital states:
CPI Card Group (NASDAQ: PMTS) was our largest short contributor in the quarter, gaining 95 bps, as the company materially lowered its full-year guidance. PMTS has contributed 175 bps to returns so far this year. As we detailed at our 2016 Annual Meeting presentation, “CPI Card Group: A House of Canif,”PMTS benefited in 2014 and 2015 from a one-time surge in •MV-enabled credit and debit card manufacturing in order to meet compliance deadlines. Amid this boom, PMTS’ private equity backer did what can be expected: After first failing to sell the company, they chose to lever up the balance sheet to pay themselves a large dividend before pushing out an IPO (at any price) in October 2015.
Now that the rush to meet deadlines is past, PMTS’ business has normalized and many card issuers have even found themselves with excess inventories. As a result, volumes for PMTS are drying up and margins are collapsing. PMTS missed Q I, and we believe its new guidance, particularly in the second half of 2016, is as disingenuous as its prior guidance. Further, the company’s misleading and self-interested dividend policy (designed, in our opinion, to prop up the stock) only enhances the possibility that PMTS ultimately goes to zero. Thus, even though its equity has been more than cut in half, we have added to our short position.