Snyder Brown Capital, LP (the “partnership”) declined 9.32%, net of fees and expenses, in the third quarter of 2014.
Pros And Cons Of Tail Risk Funds
Snyder Brown Capital: Our 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 significant 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: Third Quarter Performance
As value investors, we almost always purchase securities when they are falling rather than rising in price. We want to buy an investment we have studied carefully from a seller who is panicked, disgusted, or has simply given up on a company. The downside to purchasing bargains in this manner is that almost every security we buy continues to fall in price after we begin accumulating a position. Our goal is to make attractive long-term investments at cheap prices, not to pick the exact week or month that a stock price bottoms.
As you can see from the chart of our six largest investments on the next page, many of the securities we were purchasing in the most recent quarter declined more than the overall market over the last three months. The majority of our mark-to-market losses (changes in value due to the fluctuation in price of an investment as opposed to taking an actual permanent loss by selling a security) in the quarter were caused by our investment in Fortress Paper Ltd. (TSE:FTP) Debentures.
We wrote to you about this investment – which is our largest position by some margin – in our second quarter letter to investors. We continue to believe this fixed-income investment will pay off in full at maturity, returning nearly double our current investment over the next two years regardless of what direction the stock market takes. This company has cash and inventories of $88 million, which is more than enough to ensure that the entire debenture issue we are invested in, with a face value of just $37 million, can be paid in full in 2016. In addition to these resources, Fortress Paper generated an additional $13 million in proceeds during the third quarter by selling an unprofitable, non-core division. All of this makes us more excited to own this fixed income security as our largest and safest investment, however the market for “orphan” securities of this type is often inefficient and the price of these debentures actually fell over the course of the third quarter. This was responsible for the majority of our negative performance, however, we are in no way concerned about the ultimate successful outcome of this investment. As opposed to an equity investment, where we would eventually need to market to agree with our assessment of the value of a security to make money, this position will be self-liquidating by the end of 2016.
As shown in the table above, the average performance of our six largest investments was -16.3% in the most recent quarter, which is reflective of the overall performance of smaller capitalization securities, which underperformed the market over the last three months.
In order to give our limited partners greater insight into our investment process, in each of our quarterly letters we will discuss one or more of our current investments. The investment we added to the most over the third quarter is Nicholas Financial, which is now our second-largest position. This is a company and management team that we have admired for some time and as an investment it offers many of the criteria we look for: it is easy to understand, it has an excellent long-term track record, it is very cheap, we have a great deal of confidence in management, we understand why the stock is cheap today, and – most importantly – we understand what will correct this discount in the future.
This company essentially walked away from a deal to sell itself for $16.00 per share in June because of concerns about the acquiring company’s accounting practices. This led to a great deal of “forced selling” bymerger-arbitrage funds (just one of which owned more than 10% of the shares outstanding) which never
intended to own this company but rather hoped to make a quick buck by buying the stock at a small discount to $16.00 per share and then participating in the sale. We always prefer to be buying an investment from an uninformed, forced-seller rather than a knowledgeable investor who no longer believes in a company’s long-term business prospects.
While this stock has continued to decline since we began accumulating shares, we have been able to build a position at a very attractive valuation of roughly 7 times earnings (which are equivalent to free cash flow) and only a small premium to the liquidation value of the business. For a company that has been profitable every single year for the last quarter-century and grown tangible book value per share at 19% per year, this is a great bargain.
So what is this great business and why is it so cheap? Nicholas Financial is a subprime auto lender, a segment of the market that does not have a great reputation. Because of this company’s unique business model, and despite the sector it operates in, we believe this is a great business. Nicholas operates its business unlike any of its peers, to the advantage of both its borrowers and the dealers it buys loans from, all while ensuring that the company rarely takes losses.
Almost all subprime auto lenders use a statistical model to predict default rates and losses based on FICO scores and the age and value of the car being purchased. The companies run low-costoperations and purchase many loans to spread around the risk that any individual borrower will not pay. These companies can generate a “spread” of a few percentage points between what they receive in payments and what they lose in losses and pay in employee costs. Because a few percentage points is not a great return, these company lever up their returns by at least 4-1 and as much as 10-1. In this way, a 5% return on assets generates an 11-20% return on equity. This is not how Nicholas Financial runs its business at all.
Nicholas is the only subprime auto company we are aware of that actually interviews the people it is going to make loans to, as it scores them on a number of factors beyond their FICO score. Through this intensive process, Nicholas Financial’s loan officers reject as many as 9 out of 10 candidates in their search for “good people with bad credit.” Essentially Nicholas Financial is looking for prime borrowers who have temporarily fallen behind on their bills due to a life event like a divorce or illness. While this process requires a great deal more work and employee costs for Nicholas, the result is the company experiences very low loss rates. Through hard work and careful selection of who to lend to – not unlike our process of value investing – Nicholas is able to generate an unlevered “spread” that is double its peers, or about 10%. This careful way of doing business has not only made this company very profitable, but it has allowed the company to use less leverage and thrive during industry busts, when competitors are driven out of business by losses.
What makes us really excited about this investment, however, is that the company is currently under- levered, even by its own conservative standards. Because the business has produced cash flow faster than it could expand over the last decade, this cash has stacked up on the balance sheet and lowered the profitability of the business by taking leverage down to less than 1-1 (vs. 2-1historically and 4-1 for the closest peer). In order to readjust its balance sheet to use an appropriate amount of leverage, we believe this company can borrow as much as an additional $80 million on its current debt facility and pay a one- time dividend or repurchase shares with the proceeds. This means shareholders could see an additional, immediate return of more than $6.00 per share on top of already owning a great business at less than 8 times free cash flow at $11.00 per share.
This is a great business with a great management team that was sold to us by merger-arbitrageursrunning for the exits. The company is highly-profitable, under-levered, and has many years of growth ahead. We know this management team and we like this business – this is just the type of opportunity we sit around waiting for, and we look forward to a very good return on this investment over the next 12-24 months.
Editor’s note: Incidently, right before we planned to post the article Nicholas Financial announced tonight that they are considering a large self-tender and some of the other suggestions we made to them. The press release can be found here, and an excerpt from it below.
October 21, 2014
Nicholas Financial is Considering Various Financial Initiatives
Clearwater, Florida, – October 21, 2014 – Clearwater, Florida – Nicholas Financial, Inc. (the “Company”) (NASDAQ: NICK) today announced that the Board of Directors of the Company is considering various strategic financial initiatives to increase return on shareholder investment, including (but not limited to) undertaking a share repurchase program or self-tender offer, initiating a cash dividend program, increase its existing credit facility and/or exploring potential expansion opportunities. No assurances can be given, however, as to whether the Board of Directors will determine to implement any such initiatives.