Snyder Brown Capital Management’s letter to partners for the first quarter ended March 31, 2015.
Snyder Brown Capital, LP (the “partnership”) returned 11.1%, net of fees and expenses, in the first quarter of 2015.
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Snyder Brown Capital Management: 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 low net exposure to the broader 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 Management: First Quarter Performance
In the first quarter of 2015, our long and short portfolio contributed almost equally to our positive net performance. On the long side, this performance was driven by the Fortress Paper 6.5% Debentures of 2016, which is our largest investment. On the short side, a basket of nineteen positions in the energy space augmented what would have otherwise been another flat performance. Because we have chosen to hedge out our broad market exposure with index hedges, we would have been pleased to simply break-even on the short side in this rising market.
We continue to evaluate the positive and negative performance of individual investments, but this evaluation is primarily with regard to the value and trajectory of the underlying businesses. The prices of the individual securities we own continue to be volatile in the short-term, and we continue to find opportunity in this volatility. Overall, the net performance of our largest and highest-conviction positions has been about flat since the inception of the partnership, although with plenty of month-to-month volatility along the way. We continue to believe these investments will lead to significant gains in some future period (that period being more specific for the Fortress Paper Debentures, which mature next December). We have made one major investment error in Enhanced Oil Resources, and this loss has effectively cancelled out the positive contribution from a number of smaller investments thus far.
Snyder Brown Capital Management: Q1 Performance Attribution
On the long side, Enhanced Oil Resources once again contributed the majority of negative performance. This position is now less than 2% of our portfolio as a result of share price declines rather than prescient sales by your managers. The group that replaced the Board of Directors is planning to inject fresh capital into the company in the near future, but at such a low price that we will be substantially diluted. This melting ice cube has consistently traded at a small fraction of liquidation value, but that liquidation value has proven to be a mirage thus far.
On the positive side of things, our Fortress Paper Debentures rebounded to near our cost basis in the first quarter, making the largest positive contribution to performance. Despite the fact that this fixed income investment still trades at just 65 cents on the dollar, we continue to believe these debentures are “money good” and that we will receive our principal in full in December 2016. When we first purchased this investment, it seemed that some sort of restructuring was all but inevitable (an outcome we were comfortable with due to the asset value, cash position, and our position as the first maturity to come due). However, the falling Canadian Dollar and continued operational improvements have moved the company into a positive operating cash flow position.
On the year-end conference call last month, the Chairman and CEO stated: “the debt burden is quite manageable … we are currently forecasting internally that we will make it through all our debt commitments.” This is a tremendous improvement from last year, and we believe that absent some dereliction of duty by the board of directors our debentures will be repaid in full. This represents a gain of 65% from the current price, which would contribute roughly 24 percentage points to the gross performance of the partnership, due to our large position size.
In our year-end 2014 letter, we wrote that both Chesapeake Energy and Sears Holdings were poised to once-again be significant positive contributors to performance in 2015 after having cut our position size in both securities prior to declines in price late in 2014. We were able to rebuild our position in both securities at lower prices, but we are only half right thus far as declining oil and gas prices caused Chesapeake to be our second worst performer in the quarter (Sears was our second best performer).
The negative performance of our long energy investments was more than mitigated by significant gains on the short side. However, we caution that these positions have been quite volatile and these gains have more than reversed themselves so far in April as the crowded short trades in oil and overvalued energy equities (and in some cases debt) has unwound with a vengeance. We do not believe we have seen the bottom in energy stocks or in the prices of the underlying commodities due to significant oversupply situations in both oil and gas markets. We will look to profit from this dislocation once again as reality catches up to equity prices.
On the short side, Wausau paper was once again our largest positive contributor. As with our Fortress Paper Debentures, we think the upside (or downside in this case) for Wausau remains in the future despite the gains we have been able to generate to date. During the quarter, seventeen short positions that did not make the above chart contributed positive performance, collectively adding 4.5% of positive gross performance.
Once again our portfolio hedges were the largest detractor from performance on the short side, followed by a short position in Hain Celestial that we have stubbornly held on to. We believe our short position in the United States Oil Fund (an ETF with the symbol USO) will be one of the largest positive contributors going forward; however, this position has moved against us thus far in April.
Snyder Brown Capital Management: United States Oil Fund (USO) Short
We are bearish on the price of West Texas Intermediate (WTI) crude oil for a number of reasons. Most notably is the current and continuing oversupply of oil in the US and the growing glut of crude in storage especially in Cushing, OK, which is the delivery point for the WTI futures contract.
We would usually shy away from a macro call of this type given the inherent informational asymmetries in complex commodity markets, but we feel that we have two key points on which to hang our hats. The first is that the current glut is being caused by Saudi Arabia essentially “stepping on the gas” and producing as much oil as possible to exacerbate this weak price environment. In fact, Saudi Arabia recently increased the discount at which they will sell oil to US refiners, increasing exports into a US logistical system already awash in crude. Secondly, a number of E&P management teams we speak with have suggested that $60 is a level they view as attractive to add hedges. This means that the oil producers will essentially start selling crude into the futures market and push prices down if they reach that level, and as of this writing, WTI is trading near the 2015-high at $57.36 per barrel.
Despite our confidence that there is substantial downside to the price of WTI crude oil, particularly this October when storage in Cushing could actually fill, we would usually express this opinion by shorting the equity of a poorly-run and overvalued oil producer (and we have a number of times over). However, the United States Oil Fund is a special situation; a flawed investment vehicle that we believe is certain to lose material amounts of value between now and October regardless of what happens to the price of oil.
The USO ETF is a vehicle for financial speculation. It owns monthly crude oil futures contracts as its only asset, but it can never actually take delivery of the crude oil underlying these contracts. This means that prior to expiration each month, this ETF must sell all of the contracts it owns and reinvest the proceeds into the “next month” contracts. This process is repeated every month. What makes this interesting to us is that in the current crude glut the market is in “contango.” This means crude is always more expensive in the future because there is more oil than customers in the present; as a result, someone must pay to put millions of barrels into storage for future use each month (and this marginal buyer requires a discount in order to profitably store the oil).
In practical terms, oil for delivery this month will trade for $1-3 per barrel less than oil for delivery next month, and this will continue as long as an oversupply exists. What this means for this ETF is that each month when it sells all of its futures contracts, it reinvests in contracts that are $1-3 per barrel more expensive. Each month as the ETF sells expiring contracts and buys later-dated ones, the owners of the ETF have a claim on fewer barrels of oil per share. In this way, we expect this ETF will “burn” 2-4% of its value each month. In a scenario where storage at the Cushing trading hub actually gets close to full, this monthly “burn” could increase substantially as the ETF finds itself owning expiring futures contracts that no one wants to take delivery on.
We believe the structural flaws in this vehicle for price speculation create the opportunity for an asymmetric risk/reward on a macro view (short oil) that we already hold. There is no free lunch in the markets, but being on the other side of a flawed vehicle for short-term speculation certainly shifts the odds strongly in our favor.
Snyder Brown Capital Management: New Investors
We have continued to selectively welcome new limited partners who understand and agree with our investment philosophy in each of the last three months. Our primary concern is with finding the right investors who have a long-term focus. As such, we will continue to focus our efforts on investing rather than marketing in the belief that if we do our job correctly these investors will continue to find us.
Nicholas C. Snyder, CFA
Tice P. Brown, J.D.
The information contained herein reflects the opinions and projections of Snyder Brown Capital Management, LLC and its affiliates (collectively “Snyder Brown Capital”) as of the date of publication, what are subject to change without notice at any time subsequent to the date of issue. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security.
Unless otherwise noted, performance returns reflect the total returns net of fees for an April 1st investment in Snyder Brown Capital, LP net of a 25% performance allocation. Returns are estimated pending the year-end audit. Past performance is not indicative of future results. Actual returns may differ from the returns presented and each partner will receive individual returns from the Partnership’s administrator.
THIS SHALL NOT CONSTITUE AN OFFER TO SELL OR THE SOLICIATION OF AN OFFER TO BUY ANY INTEREST IN ANY FUND MANAGED BY SNYDER BROWN CAPITAL MANAGEMENT OR ANY OF ITS AFILLIATES. SUCH AN OFFER TO SELL OR SOLICIATION OF AN OFFER TO BUY INTERESTS MAY ONLY BE MADE PURSUANT TO DEFINITIVE SUBSCRIPTION DOCUMENTS BETWEEN A FUND AND AN INVESTOR.