Mitch Julis and Josh Friedman’s Canyon Value Realization Fund Ltd (Class A shares) had 3.59% returns for the fourth quarter and 15.55% in returns for 2013 (both net fees) with a gross internal rate of return (IRR) of 27% and volatility of just 4.1%, compared to 8.5% for the S&P 500 (INDEXSP:.INX), according to a shareholder letter reviewed by ValueWalk. While its total returns didn’t keep up with the S&P 500’s incredible year, its stock portfolio outperformed the market and the fund generated alpha in multiple asset categories.
CVRF sees few obvious options for next year
“Investors searching for ‘the next great thing’ may be in for a frustrating, quixotic journey,” says the fund’s recent letter to investors. “We continue to source what we believe are undervalued individual securities with high return potential, but we are forced to work harder than ever to do so, and we have to cast a wide net.”
QE and other lax monetary policies along with new regulations that effectively limit competition, “contributes to recurrent (though idiosyncratic) mispricing of risk” which does give the fund room to maneuver, but it also requires CVRF to dig deep for investment opportunities, and in many instances it has to push events along.
Activism important in slow growth, low interest rate context
“Our experience in event-driven, activist, and distressed strategies across asset classes continues to furnish us with a meaningful competitive advantage in a slow growth, low rate environment where security selection can be expected to be a more important driver of return than asset allocation,” the fund writes.
Without naming specific securities, CVRF highlights a few sectors with the highest potential for activist strategies (whether confrontational or collaborative) to reap major benefits.
US media continues to come to terms with disruptive innovation and changing consumption patterns, but mergers and acquisitions are “perceived as accretive to both acquirers and targets, fostering additional deal demand and creating the potential for significant price appreciation in specific securities.”
The US energy market continues to undergo a transformation with shale oil turning the US into an energy exporter, renewables becoming ever more competitively priced, and changing environmental regulations favoring some parts of the market over others. Also, CVRF reports that investors are pushing for the separation of high value assets into separate entities.
“Taken together, these developments are creating opportunities to profit from capital structure arbitrage, disrupted (and disruptive) business models, the separation of midstream and upstream assets, transitions between power sources,” says the investor letter.
Finally, CVRF points out that the shipping industry is prone to big swings in value, while the underlying assets, the ships themselves, hold their value across business cycles quite well. Since the sector is currently over-leveraged. CVRF is on the lookout for auctions on shipping company bank loans.
CVRF to capitalize on ‘fractures in mortgage space’
Even though CVRF expects to be a net seller of residential mortgage backed securities (RMBS) over the next year, they continue to play an important role in the fund’s overall game plan.
“We expect to sell material portions of these assets over the next 6-18 months as they improve in credit quality and trade to lower yields. However, this phase of the RMBS story is by no means necessarily the ‘final chapter’,” the fund writes. “Uncertainty about central bank policy will likely continue to result in bouts of interest rate volatility that trigger disruptions in various parts of the RMBS market.”
CVRF also says that the future of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) is still up for grabs, and twists along the way could create dislocations that the funds’ RMBS experts can exploit. Also, the letter describes tapering as “unlikely to unfold seamlessly,” which seems like a generous description even if bullish analysts are almost ignoring the results of tapering in their forecasts.
“Given Canyon’s breadth and long track record of success across the RMBS landscape (from both the long and short sides, across Agencies and Non-Agencies, pass-throughs and derivatives, and high quality and low quality pools), we are well-positioned to capitalize on any additional fractures across the mortgage space,” the fund writes. CVRF’s RMBS portfolio has a trailing 5 year gross IRR of 29.8%, trailing 3 year gross IRR of 18.9%, and trailing 1 year gross IRR of 25.1%.