From: Whitney Tilson <@kasecapital.com>
Date: Fri, Oct 16, 2015 at 11:11 AM
Subject: Kase Qualified Fund Q3 letter to investors
Attached is my Q3 letter to investors, in which I discuss my two largest short positions (an undisclosed stock and Herbalife), portfolio construction, and share my thoughts on Berkshire Hathaway, Platform Specialty Products, Micron Technology, Spark Networks and Lumber Liquidators.
The fund is up ~8% this month, so the numbers look better than those in my letter.
From: Whitney Tilson
Sent: Sunday, October 04, 2015 6:09 PM
Subject: Kase Qualified Fund Q3 letter to investors
Whitney Tilson’s Q3 letter to investors, in which he discusshis two largest short positions (an undisclosed stock and Herbalife), portfolio construction, and share his thoughts on Berkshire Hathaway, Platform Specialty Products, Micron Technology, Spark Networks and Lumber Liquidators.
Our fund declined 3.6% in September vs. -2.5% for the S&P 500. Year to date, our fund is down 10.6% vs. -5.3% for the S&P 500 (though after the first two days of October, it’s down 8.5% vs. -3.7% for the S&P 500).
On the long side, nearly half of our fund’s losses during the month were due to Platform Specialty Products (discussed below), which declined 33.9%. Other losers included Pershing Square Holdings (-16.3%), Spark Networks (-10.3%; discussed below), SodaStream (-9.7%), Micron Technology (-8.8%; discussed below) and Howard Hughes (-8.7%). The only winner of consequence was JetBlue, which rose 15.5%.
It was a fabulous month on the short side mostly thanks to a biotech ETF I shorted in mid-August (-33.7%), World Acceptance (-28.6%), Exact Sciences (-18.6%) and Lumber Liquidators (-13.2%). With our short book much smaller (19%) than our long book (94%), however, it wasn’t enough to offset the losses on the long side.
Historical Perspective and Current Portfolio Overview
Our fund has declined each of the past five months, totaling 13.3%. While it is never fun to experience a drop like this, I am not overly concerned about it, in part because I’ve gone through this before – much worse, in fact – and things have always turned out well in the end. Specifically, in our fund’s nearly 17-year history, this is only the third time it’s had a five-month losing streak: it declined 32.8% from October 2008 through February 2009 and 28.7% from May through September 2011. Each of these drops ended after five months and was followed over the subsequent seven months by a sharp rebound: 52.6% and 33.6%, respectively.
I think there’s a good chance that history will repeat itself because I’m more bullish on our portfolio than I’ve been in years. The stocks we own on the long side, which I liked at the beginning of the year, have fallen by an average of nearly 20% this year yet, as a group, I don’t think their intrinsic value has declined at all. Consequently, I believe our long book has gone from moderately undervalued to downright cheap. We now own numerous stocks that I think are a good bet to rise 50-100% over the next year, as I discuss below.
Whitney Tilson – Largest Two Short Positions
I feel similarly about our short book, even though it’s already been an epic year, led by Lumber Liquidators collapsing 80.2% (see pp. 7-8 for an update on this position). In addition, Unilife has plunged 70.7%, World Acceptance is down 66.2%, and Exact Sciences has fallen 34.4%.
We remain short all of these stocks because I anticipate further declines, but the main reason I think our short book will outperform going forward is that our two largest short positions are likely to collapse in the near future. The first is a company that, I’ve discovered, is poisoning its customers with formaldehyde-drenched laminate flooring, just as Lumber Liquidators was. The story parallels the Lumber Liquidators one in other ways as well: an industry insider gave me a tip, I hired a lab to test the products, which confirmed my source’s information, and now I’m working on bringing this story to light. Stay tuned.
Our second largest short position is Herbalife, the only short that’s hurt us this year, rising 44.5%. I remain confident that this will work out well, however, for two main reasons: a) The business is in decline in pretty much every market except China; and b) I think one or more U.S. regulators are (finally!) about to drop the hammer on the company, as evidenced by the following:
- In Q1, HLF spent $2.9 million on “Expenses incurred responding to attacks on the company’s business model” and $2.1 million “Expenses related to the FTC inquiry.”
- In Q2, these amounts soared to $4.8 million and $3.7 million, respectively, a combined increase of 70%.
- Also in Q2 the company changed the language from “Expenses related to the FTC inquiry” to “Expenses related to Regulatory inquiries,” implying that the company is incurring meaningful costs not only responding to inquiries from the FTC, but also from other regulators as well.
At today’s price, I view Herbalife as an absolute gift and if it weren’t already a substantial short position, I’d be adding to it.
Whitney Tilson – Portfolio Construction
On the long side, I seek to construct a portfolio that is both highly concentrated, yet also diverse in terms of industries, types of value, catalysts, and risk. I break it down into the following categories:
- Blue-chip companies whose stocks are the foundation of the portfolio like Berkshire Hathaway, Air Products, Canadian Pacific, GE, Goldman Sachs, Mondelez and Union Pacific. These stocks are moderately undervalued, not crazy cheap, but the businesses are of exceptional quality so there’s less risk;
- “Platform” companies: Howard Hughes and Platform Specialty Products;
- Companies in consolidating industries (discussed in my Q2 letter; user name : semiconductors (Micron), airlines (Delta and JetBlue) and auto rentals (Avis);
- A long-term bet on Korea and, in particular, Korean preferred stocks (Samsung Electronics and Hyundai Motor); and finally
- A handful of special situations, turnarounds or small-cap companies such as Reading International, Tetragon Financial Group, magicJack, Pershing Sq. Holdings, SodaStream, Spark Networks, Fannie Mae and Grupo Prisa.
Allow me to discuss four of these stocks, all of which I’ve been adding to over the past month.
Whitney Tilson – Berkshire Hathaway
I’ve written many times about Berkshire in the past, so I will only provide an update here (for background, see my slide presentation).
Using the valuation methodology I’ve used for two decades (see pages 13-18 of my presentation), which has proven to be quite accurate, I estimated at the beginning of this year that Berkshire’s intrinsic value was $254,593. With the year now ¾ over, I estimate that this has risen by ~6% to ~$270,000, based on the company’s 2.4% increase in book value and 14% increase in operating income of the non-insurance businesses in the first half of the year. Thus, with the stock closing September at $195,260, it’s trading at nearly a 30% discount to intrinsic value.
I think that’s compelling for an extraordinary company that is growing at a decent clip, whose stock offers the wonderful combination of substantial upside and limited downside. But it’s even more compelling than it appears because Berkshire has made a nearly $14 billion profit, equal to $8,428/share, on its investments in Heinz and Kraft, which is not yet reflected in the company’s financial statements. To my knowledge, this extra value hasn’t been noticed by any analysts, media or investors.
Here’s the story: on June 7, 2013, Berkshire invested $8 billion in preferred stock and $4.25 billion in equity in the 3G-led buyout of Heinz. This $12.25 billion investment is carried on Berkshire’s balance sheet in the line item “Investments in The Kraft Heinz Company” and is accounted for using equity accounting. Reflecting some amortization, it is carried on Berkshire’s balance sheet at $11.45 billion in its latest reported financials (Q2, ending June 30th).
A few days after the end of the quarter, on July 6, 2015, Heinz (a private company) merged with Kraft (a public company). In connection with this transaction, Berkshire invested an additional $5.26 billion in the new company. As a result, Berkshire now owns $8 billion of preferred stock and 325 million shares of the new, merged Kraft Heinz Company (whose stock is currently at $71.41), worth a total of $31.2 billion. Berkshire’s cost, however, was only $17.5 billion ($8 billion of preferred stock plus two equity investments of $4.25 billion and $5.26 billion), resulting in a profit of $13.7 billion, or $8,438/A share.
None of this enormous gain is reflected in Berkshire’s Q2 financial statements, so it should be added to the estimate of intrinsic value ($270,000 + $8,438 = $278,438), meaning Berkshire’s stock today is even more compelling than it appears. In addition, there’s a near-term catalyst, as the profit Berkshire has made via its Heinz and Kraft investments will become apparent when it releases its Q3 earnings next month.
See full PDF below.