From Whitney Tilson:
September 1, 2011
Continued from part one... Q1 hedge fund letters, conference, scoops etc Abrams and his team want to understand the fundamental economics of every opportunity because, "It is easy to tell what has been, and it is easy to tell what is today, but the biggest deal for the investor is to . . . SORRY! Read More
Our fund declined 13.7% in August vs. -5.4% for the S&P 500, -4.0% for the Dow and -6.4% for the Nasdaq. Year to date, it’s down 22.1% vs. -1.8% for the S&P 500, +2.1% for the Dow and -2.2% for the Nasdaq.
On the long side, our portfolio got clobbered across the board despite generally good company-specific news regarding our major holdings (discussed below). Amidst a tumultuous month in the markets, investors dumped stocks that were even slightly illiquid, or that are valued primarily on future, rather than current, profits – both traits that characterize many positions in our fund. One of our biggest advantages is being willing and able to look out 2-3 years when most investors are looking out 2-3 months (or, in many cases, 2-3 microseconds), but this hurt us last month. Thus, big-cap stalwarts with strong cash flows and balance sheets like Berkshire Hathaway (-1.6%), Microsoft (-2.9%), AB InBev (-4.0%), and Kraft (+1.9%) held up relatively well, but the rest of our portfolio didn’t as more than a dozen of our major holdings suffered double-digit declines: Grupo Prisa B (-28.0%), Resource America (-23.3%), Citigroup (-19.0%), General Growth Properties (-18.9%), Iridium warrants (-17.6%), Seagate (-16.6%), Winn Dixie (-14.1%), J.C. Penney (-13.4%), BP (-13.3%), CIT Group (-13.0%), dELiA*s (-11.5%), Sears Canada (-11.1%), and Howard Hughes (-10.5%).
Our short book performed well, led by declines in Corinthian Colleges (-47.1%), Boyd Gaming (-28.5%), ReachLocal (-20.0%), Lennar (-16.9%), ITT Educational Services (-15.8%), MBIA
(-15.7%), First Solar (-15.4%), OpenTable (-13.9%), SuccessFactors (-13.5%), Salesforce.com
(-11.0%), and Lululemon Athletica (-9.6%).
Our View of Market Opportunities
In our view, the turmoil of the past month has created the best bargains we’ve seen in the market since the chaos and panic of late 2008 and early 2009. Of course stocks aren’t anywhere as cheap now as they were then, but the risks aren’t nearly as great either (we think many people didn’t realize or have forgotten how close we were then to a worldwide Great Depression), so on a risk-adjusted basis we think our portfolio is as attractive now as it was then.
While we have great confidence in the eventual outcome, we can’t make any short-term forecasts. We thought the stocks we owned were very cheap a month ago, but that didn’t stop them from falling quite a bit further – and this could continue. Catching falling knives sometimes results in cuts.
So, then, you might ask, why don’t we stop holding onto falling knives, sell much of what we own, and wait for more clarity, strength, confidence, etc. to return to the market? Oaktree’s
Howard Marks answers this question in his latest book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor (which we highly recommend). He writes:
Common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable. Whenever the debt market collapses, for example, most people say, ?We’re not going to try to catch a falling knife; it’s too dangerous.? They usually add, ?We’re going to wait until the dust settles and uncertainty is resolved.?
The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. Thus a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.
Changes to the Portfolio
We took advantage of the market volatility last month to make a number of changes in our portfolio. Specifically, we:
- Reduced risk by taking down both our gross long and short exposures such that we are now 117% long and 40% short (77% net long).
- Eliminated any position in which we didn’t have enormous conviction. In particular, with only a few exceptions, for long positions smaller than 3% we either bought more or, in most cases, sold entirely. With regret (because we think they’re cheap and will do well), we sold CIT Group, General Growth Properties, Winn Dixie, Kraft, BP and Fairfax Financial, among others.
- We only made a few changes to our short book, most notably covering MBIA (what an wild and profitable ride that has been over nearly a decade!) and Simon Properties (which was a hedge against our long position in GGP).
- For investments with similar risk-reward profiles, we chose our favorite and sold the other. Specifically, we added to Citigroup and exited CIT Group, sold Seagate to buy Western Digital, and trimmed Microsoft to buy Dell (discussed below).
- We took advantage of the carnage among financial stocks and initiated new positions in Goldman Sachs and a tiny position in Bank of America (after Buffett invested), plus added to our positions in Berkshire Hathaway, Citigroup and Wells Fargo. We think investors are lumping imperiled European financials in with U.S. financials, which are in much better shape (though still facing real headwinds to be sure).
The net result of these changes, we believe, is lower risk, less clutter (both in our portfolio and in our minds), some great new positions, and tremendous upside thanks to a portfolio much more focused on our best ideas.
It has now been exactly a year since our performance has taken a nosedive – we’re down 23.3%. We feel terrible about it and obviously wish we’d done some things differently, but we are not at all discouraged or worried, as we’ve been through this before: if you look at our performance table at the end of this letter, you will see that we’ve lost more money, much faster, on two other occasions: we were down 27.4% in eight months from June 2002 – January 2003, and down 32.8% in five months from October 2008 – February 2009. In both of these cases, by playing a strong hand and buying more of our favorite stocks as they plunged, we made back all of the losses (and then some) remarkably quickly: in only nine months in 2002-03 and a mere seven months in 2008-09. We could not be more confident that we will rebound strongly from these latest losses as well.
An obvious difference, of course, is that in the previous two declines, the market was tumbling as well, whereas over the past year, the market is up 18.5%. Thus, while our absolute decline isn’t as large, our relative performance is far worse. This is due to three factors, which we’ve discussed in previous letters: first, we made a few mistakes, such as being short Netflix; second, in a far greater number of stocks, we invested too early (though we are confident that we’ll be proven right); and finally, our macro calls have been completely wrong.
Regarding the latter, it’s been very frustrating to accurately predict the primary causes of the current market turmoil –the weak U.S. economy characterized by persistently high unemployment and a feeble housing market, plus the sovereign debt crisis in Europe – but to have done so a year too early (lest you think we are engaging in revisionist history, we’ve attached excerpts from our July 2010 and 2010 annual letter in an endnote at the end of this letteri). As a result, we were positioned too defensively in late 2010 and our short book hurt our returns so much and grew so large that we were forced to trim it back and forswore making major market calls in the absence of high conviction of a major bubble. Thus, we were positioned normally – substantially net long – when the recent market storm hit.
So what are the lessons we’ve taken from our experience over the past year? That we’re much better bottoms-up stock and industry analysts than we are macro prognosticators. Making (and acting on) a bearish macro call a year ago was a mistake that we learned from and corrected earlier this year. In contrast, we do not think we made a mistake by failing to predict the latest market turmoil. Other than in rare circumstances, it’s just not what we do because we don’t think we’re good at it.
Perhaps a good analogy is that we think we can identify major hurricanes before they hit – like the housing bubble bursting – but are unlikely to see sudden tornadoes such as what occurred in the past month (some believe that, rather than being a sudden tornado, the turmoil of the past month is the front edge of another major hurricane, but we don’t think that’s likely; rather, a ?muddle-through? scenario – discussed in the endnote – is most probable).
Stocks are volatile and since we invest in a concentrated fashion, often in unpopular sectors, are willing to ?catch falling knives? if they’re cheap enough, and never engage in closet indexing, we’ve always known from the day we started this business nearly 13 years ago that our portfolio would occasionally suffer losses and/or trail the market, perhaps to a significant degree. In other words, we guarantee underperformance at times. This isn’t a topic often discussed publicly by money managers, but it’s extremely important for both investors (you) and investment managers (us) to understand that virtually all money managers will underperform at times, occasionally badly and for extended periods, yet the long-term results can still be excellent.
Indeed, the well-respected Davis Funds did a study (http://davisfunds.com/document/read/the_wisdom_of_great_investors#page_7) of the 192 large-cap funds with top-quartile performance during the decade ending 12/31/10 and found some stunning results:
- 93% of these top managers’ rankings fell to the bottom half of their peers for at least one three-year period
- A full 62% ranked among the bottom quartile of their peers for at least one three-year period, and
- 31% ranked in the bottom decile for at least one three-year period.
Davis Funds concluded:
When faced with short-term underperformance from an investment manager, investors may lose conviction and switch to another manager. Unfortunately, when evaluating managers, short-term performance is not a strong indicator of long-term success.
Though each of the managers in the study delivered excellent long-term returns, almost all suffered through a difficult period. Investors who recognize and prepare for the fact that short-term underperformance is inevitable—even from the best managers—may be less likely to make unnecessary and often destructive changes to their investment plans.
How We’ve Built Our Business
Armed with the knowledge that we are certain to underperform at times, we’ve built our business to withstand such periods. As Warren Buffett said at the 2009 Berkshire Hathaway annual meeting, ?You don’t want to be in a position where someone can pull the rug out from under you or, emotionally, where you pull it out from under yourself.? Here are the key ways in which we’ve done this:
1. We read constantly, with an emphasis on company and industry reports, market history, and lessons from the greatest value investors. We do everything we can to tune out the short-term noise so, for example, we almost never watch financial television.
2. We have never pursued hot money and, while that’s cost us in terms of assets under management, today we’re happy to say that we have no fund of funds or any institutional money whatsoever. All of our investors are investing their own money, with no intermediaries.
3. Our redemption terms – either full redemption once a year or ¼ redemptions quarterly, with 45 days notice – have also no doubt cost us substantial assets, but ensure that investors who choose to redeem, which tends to happen when our performance is worst, can’t pull the rug out from under us. We currently have virtually no redemption requests.
4. We’ve done everything we can think of to build a level of trust with our investors. We know of no other fund that communicates with as much openness, depth and frequency as we do. We want our investors to understand what we’re doing so that when tough times come, they stay (or even add to their investments).
Thanks to these steps – and thanks to you – we are not troubled by the recent market turmoil. As we’ve done in the past, we are playing a strong hand and are confident that we will all ultimately be rewarded.
Comments on Some Stocks
In conclusion, we’d like to share some brief comments about a few of our positions:
At one point the stock was down more than 22% in August, so we took advantage and added meaningfully to the position such that this is now our largest on an economic basis (we own it via long-dated, in-the-money call options so it’s our 3rd largest on a cash basis). The company reported decent Q2 earnings during the month and today reported weak August sales thanks to Hurricane Irene, but this isn’t what we’re focused on. Rather, we see a good business (contrary to popular perception, this is nothing like Sears/K-Mart) with plenty of room for improvement, run by a new team of world-class people with complementary skills: a capital allocator (Bill Ackman of Pershing Square), real estate expert (Steve Roth of Vornado), and retail CEO (Ron Johnson, the architect of Apple’s retail strategy, who may well be the best retail CEO in the world).
Johnson doesn’t officially start until November 1st, but we understand that he’s already getting deeply involved – hardly surprising, given that he’s invested $50 million of his own money to buy seven-year JCP call options that are now underwater. All three of these men have huge amounts of money invested in this company and thus are highly incented to unlock value – and, best of all, the stock is undervalued based on the company’s current earnings, so we’re getting them for free!
Iridium’s stock got clobbered last month despite reporting very strong Q2 earnings and reaffirming guidance for the year. Revenues grew 14%, net income jumped 265%, operational EBITDA rose 34%, and total billable subscribers increased 25%. In addition, the FAA approved aircraft to use Iridium’s satellite data service for critical air traffic control communications.
Every element of our investment thesis is intact and the story is playing out so far as we expected, but this is a multi-year story, so the stock is subject to short-term volatility.
Grupo Prisa (B shares)
Like Iridium, Grupo Prisa’s stock dropped sharply despite reporting good news: significant progress in the company’s restructuring program as well as solid earnings, with adjusted revenues declining 1.2% and adjusted EBITDA rising 3.6%. This performance is especially noteworthy in light of the very poor economic environment in Spain and Portugal, which account for 77% of Grupo Prisa’s revenues (with the balance being in Latin America).
We continue to believe that this is a collection of high-quality media properties trading at a large discount to intrinsic value, but in the short term the stock will probably trade more in line with investor sentiment toward Spain in particular and the European sovereign debt crisis in general.
We think the market is completely misreading Goldman’s Q2 earnings, which were below expectations and thus perceived negatively. We have the opposite view: we’re delighted that earnings were weak because it likely means that Goldman was reducing risk, which we now know was precisely the right thing to do in light of the recent market turmoil.
Goldman has plenty of short-term issues that create dramatic headlines – for example, CEO Lloyd Blankfein recently hired a lawyer – but we think when all is said and done, the company will remain the premier investment bank in the world and will trade at a meaningful premium to book value, which we think is likely to grow nicely, so we were delighted to invest at a 10%discount to book value.
We made a lot of money on Wells Fargo during the financial crisis, shorting it around $30 after the Wachovia acquisition, covering around $10, and then buying the stock and riding it back to well above $20 (we dedicated an entire chapter of our book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, to Wells Fargo; please contact us if you’d like us to send you a free copy of the book in the mail, or the Wells Fargo chapter via email).
We were nervous about the housing market so we sold Wells Fargo along with most other financial stocks in 2010, but we are great admirers of the company and think it’s the best banking franchise by far among the large U.S. banks, so we were hoping for a pullback in the stock to reestablish a position. That opportunity came last month when the stock tumbled nearly 20% at one point (it ended the month down only 7%).
The stocks of many big-cap tech companies appear to be very cheap, but we think caution is in order as there are plenty of value traps. We own the stocks of two great companies in the sector, where we think the pessimism is unwarranted: Microsoft, which we’ve discussed at length in previous letters, and Dell, which we aggressively purchased last month such that it is now our fifth largest position.
Dell reported Q2 earnings on Aug. 16th that we thought were excellent, but the market disagreed and the stock dropped 10% the next day. Revenues were up only 1%, but operating income jumped 54%, net income 63% and EPS 71%, thanks to sharply higher margins. This is the result of a deliberate strategy by the company to give up low-margin business and focus on earnings growth rather than revenue growth. This is exactly the right strategy, we believe, so we’re not concerned that Dell revised ?its full-year revenue-growth outlook to 1-5 percent from the previous range of 5-9 percent,? which is why the stock sold off. We’re delighted that Dell is disciplined enough to walk away from low-margin business.
During the quarter Dell repurchased 3% of its outstanding shares (5% year-over-year) and guided to 17-23% growth in operating income for the year, which we think may prove to be conservative given that Dell should be able to steal business from HP, given the chaos at that company.
Dell ended the quarter with $8.5 billion of net cash, equal to $4.54/share or more than 30% of the current stock price of $14.86, meaning the enterprise value of the business is only $10.32/share. With expected earnings this year of $2.00/share, the stock, net of cash, is trading at a P/E of only 5.2x, which is ridiculously cheap. We think a reasonable P/E multiple for Dell is 10-15x, not 5x, so the stock has huge upside in our opinion.