T11 Capital Management commentary for the month ended September 30, 2015.
- Winning positions in September: LEHct +45.75%, WMIH +13.04%, SCMR +10.79%
- Losing positions in September: IWSY -13.79%, KFS -10.47%,
- New additions to portfolio: None
- New liquidations in portfolio: None
- Portfolio exposure as of September 30th: 100% long/0% cash
- Long Positions as of September 30th: WMIH, KFS, LEHct, IWSY, SCMR
T11 Capital Management – Portfolio Highlights
- WMIH announced that it is uplisting to the Nasdaq, a move which took place on September 28th. The uplisting is a condition detailed by the $600 million preferred B memorandum. As described in the accompanying 8k for the uplisting:
“The Listing fulfills the Company’s obligation pursuant to Section 23(a) of the Company’s Designation of Rights and Preferences of 3.00% Series B Convertible Preferred Stock, which requires the Company to use its reasonable efforts to list its Common Stock on a national securities exchange after becoming eligible to do so and upon approval of the Board of Directors. “
It is uncommon that an OTC shell company will act to uplist its stock before an acquisition that provides a tangible corporate structure and more importantly, revenues. As an example, SGGH (now RELY) uplisted following the announcement of a revenue producing acquisition. Other OTC shells, such as TPHS, SWKH, BKFG and SDOI remain on the OTC, most likely due to the fact that they do not meet the requirements to uplist. ALJJ, a former NOL shell company, remains on the OTC after multiple revenue producing acquisitions over the years. Point being that WMIH has always been a unique special situation stock because it is being driven by what I can best describe as atypical scalability. Every detail that has been disseminated to investors over the past three and a half years is suggesting a rapidly scalable corporate structure.
This move to the Nasdaq is not just a move to provide legitimacy to the company, it is a move that provides scale in share price due to what will become mostly institutional driven purchases. With the early move to the Nasdaq, before an acquisition is even announced, WMIH has provided a venue for institutions to participate immediately. It also provides a venue for institutions to participate upon the unveiling of the acquisition candidate, suggesting that the acquisition will be large enough to warrant institutional attention.
Scalability has been the modus operandi taking place here from day one. We have seen it in the degree of financing offered. We have seen it in the amount of shares that have been authorized. We have seen it in the top tier level institutions involved. And now we have seen it in this unusual move to uplist prior to an acquisition being announced.
It is all being done so that the company can scale appropriately, ultimately suggesting that this will be a large cap company that remains in its infancy today. A unique opportunity, for sure. And more than likely one of the best risk/reward situations in the entire U.S. stock market presently.
- SCMR shares had a respectable gain during the month as further clarity into the intentions of the activists involved in halting the liquidation of the company in favor of a restructuring to capitalize on the tax benefits came to light.
In a 13D filing on September 18th by General Holdings LLC, what I suspected was occurring when we took the position in August was actually detailed for the first time:
The Reporting Persons have engaged, and intend to continue to engage, in discussions with the Issuer’s management and members of the Issuer’s Board of Directors (the “ Board ”) on multiple topics, including the Reporting Persons’ suggestion that the Issuer should revoke its Certificate of Dissolution filed with the Secretary of State of Delaware on March 7, 2013. Such discussions have also touched on corporate governance and corporate finance matters, including but not limited to the potential adoption of a shareholder rights plan, additional equity issuances, the use of net operating losses and other suggestions for maximizing shareholder value. The Issuer has not taken any action with respect to the Reporting Persons’ suggestions described above.
As detailed in the August client letter, the beauty of this investment is that our downside is clearly defined as a result of the liquidation that is seemingly ongoing at this point. Our upside, however, is substantial as the current market cap reflects very little in terms of value for the attached net operating losses.
After witnessing the long road that WMIH has traveled down to detail a plan for exploiting their NOLs, it is only fair to wonder if we have such an inordinately long wait ahead of us for SCMR, as well.
Although all hinges on the decision of management to revoke its Certificate of Dissolution, the process here should move along relatively quickly assuming this takes place. What is important to note, in the case of SCMR, is that any news of the revocation of Certificate of Dissolution instantly turns this from a liquidation play that is based on solely on existing assets in liquidation to a platform/forward revenue play that must be valued according to an entirely new set of metrics. In any case, that shift in focus for the valuation of the name should be dramatic in nature, if and when it occurs, sending the shares markedly higher.
T11 Capital Management – Portfolio Lowlights
- IWSY had a difficult month as shares slipped after initially moving higher towards mid-month. There is a significant amount of short interest in IWSY, which increased during the month due to a negative article that was released regarding the prospects for the company to achieve profitability in the coming months.
I consider IWSY to be a technology platform investment. In this type of investment, we are essentially investing in the future, unrecognized potential for a company to implement an emerging technology successfully. What creates the upside in these types of investments is that the markets have absolutely no idea how to value emerging technologies. There are no earnings models from which to determine what the potential is here since there are so few relevant comparisons. It is brand new territory and markets can’t value brand new territory correctly. Automatically due to the nature of the investment, we have an inefficiency taking place in the share price. The question I have to ask myself is are we are on the right side of the inefficiency? While CEO Jim Miller certainly has a track record of over-promising and under-delivering, I expect that some of the promises of this technology producing substantial results are close at hand. Further, upon validation of the technology by paying customers, this immediately becomes a buyout candidate by a large technology/defense based company.
The Lockheed partnership, which was a substantial driver behind my decision to reinitiate our position in IWSY, is a game changing event for the company. It is essentially validation of the company’s technology, setting them up for revenues from any number of the partnerships in the near future.
Lockheed tested out IWSY’s biometric engine for years before committing to integration of IWSY’s biometric engine into Lockheed’s own biometric offering. The IWSY product is not an option within Lockheed’s IDHaystack platform, it is basically the engine powering the platform. Further, Lockheed is one of a few companies that has access to U.S. Government contracts, setting up IWSY to potentially be a provider to the federal government.
Ultimately, the validity of Imageware’s biometric offerings will be proven in the marketplace through paying customers. That eventuality is close enough now that the stock warrants an investment given the exponential upside once this high margin technology begins producing revenues.
- KFS experienced a difficult month due purely to the disinterest which is a seemingly chronic condition of the 2015 small-cap marketplace. The selling was basically a light volume affair, with the resulting down movement due more to lack of buying interest than any substantial sellers in the market.
The company only recently put itself in pristine condition to expand their operations through a model of acquisitions that I expect to be announced in relative short order. Management is a group of financial engineers who have been successfully seeding and growing investments in the insurance industry over the past few years. I expect that their skill will prove especially beneficial with the coming acquisition to be announced that should result in unencumbered cash flow for KFS moving forward. Cash flow, which, by the way, will more than likely yield above average rates of return as I expect it to be reinvested with equal proficiency.
The classic virtuous profit cycle, in other words. Following the recent decline in share price the risk/reward here has been skewed to the point that KFS has minimal downside potential remaining, with upside in excess of 200% over the next 12 months. I expect the stock to power our 2016 results to a significant degree.
T11 Capital Management – Thoughts & Analysis
The Old Is The New
As we exit a 3rd quarter that was marked by uncertainty and turbulence in the financial markets, I thought it appropriate to first look back at where we were in the portfolios exactly one year ago.
At the end of Q3 2014, the portfolios were long WMIH, KFS and LEHct. There was a 30% cash position in the accounts that would later be used to purchase a significant stake in IMH. From the end of Q3 2014 to the end of Q3 2015 the portfolios have gained approximately 25% versus a loss of near 3% for the S&P 500.
In exactly one year of trading our core holdings have remained generally the same. I have traded around certain positions, choosing to exit IMH, as an example, after a significant profit in a relatively short amount of time. And I have added back IWSY, a company I am intimately familiar with, having first published research on the name in 2013.
Our only real “new” holding over the past 12 months is SCMR. Even then, this is a company I traded in the late 90s and early 2000s, being familiar with how the company went from a once hopeful optics company with plenty of cash and zero debt to now being a shell corporation in liquidation.
The relative simplicity of what has occurred in order to get from point A to point B and on in the portfolios should not be overlooked. I opportunistically seek out companies that are underfollowed and generally lack the earnings structure necessary to clearly define forward EPS projections. As a result we have a portfolio of stocks that is unfettered from the turmoil of excessive volatility brought about by lofty analyst projections and their subsequent revision lower. Instead the focus is squarely on assets, whether traditional or non-traditional, that can be systematically exploited for inordinate profits by a skilled set of executives. Thus giving the portfolios a classic asymmetric or highly advantageous risk/reward opportunity.
In the meantime, I have no reason to look outside of our small circle of investments both present and past for new opportunities. The more I become familiar with the small circle of investments that we are currently participating in or have participated in during past months, the more comfortable I become with the various nuances in trading that allow for us to initiate large positions at favorable prices or exit a position when excessive risk become apparent. Changing this model simply because there is so much variety in the markets invariably leads to the same result as changing my eating habits simply because I’m at a Las Vegas buffet. I end up miserable a few hours later, wondering why I didn’t stick to what has worked for me for so many years.
We are at a point in the bull market cycle where macro fears are at a level that has not been experienced since the entirety of the developed world thought that the global economy was headed towards a Fred Flintstone period of stone wheels and wooly mammoth vacuum cleaners. Fortunately, we managed to avoid such a dreadful fate, returning to prosperity post-2009 much more persistently than most would have expected.
The persistence of this new cycle of prosperity has managed to catch the stewards of capital across our global economy somewhat flatfooted. As a result, we are now witnessing a reallocation of capital away from asset classes such as commodities and emerging markets. The instability created from this reallocation of assets is effecting emerging market economies, such as China and Brazil, with the vibrations from those shocks creating the illusion of instability in the U.S. economy.
While we are certainly experiencing a contraction in revenue/earnings growth, Wall Street analysts have a tendency to overreact on the downside. That overreaction sets the markets up for generally positive surprises from companies that are less weighted towards global industrial exposure. Those surprises to the upside should come from financials and technology, which I expect to lead the markets out of this correction beginning in October.
It is important to remain defensively optimistic in the face of such unjustified pessimism during what has been one of the strongest secular bull markets on record. Defensively optimistic means that there is a controlled tendency towards long positions, as opposed to a leveraged, let it ride mentality that leads so many investors astray. Skilled stock picking alongside generally rudimentary risk control practices goes a long ways towards stabilizing a portfolio within such an environment.
The tendency towards excessive hedges and an overabundance of cash in a portfolio at this juncture of the bull market is a conventional stance that will invariably lead to conventional results. Those who participate in this type of fear based investing that is curve fitted around seemingly relevant fundamental data points will very simply be left in a cloud of dust, as they have been during the entirety of this bull market. Being defensively optimistic as opposed to chronically defensive continues to separate the outperforming portfolios from the rest of the bunch.
A Game Of Risk Obfuscation
For all the resources and time spent on obtaining the pedigree necessary to thrive on Wall Street, the true professional after years of perfecting their craft does not become a master of interpreting company fundamentals, reforming an inept management team or timing the market perfectly. Rather, the true professional on Wall Street becomes a master of obfuscating risk. This matter of risk obfuscation bears its fair share of responsibility for a great many of the ills suffered by investors who think they are buying one thing when they are being sold something else entirely.
Different institutions have different ways of obfuscating risk. In the 90s, there were the Janus Mutual Fund commercials that were essentially bragfests for how Janus fund managers show up at the slaughterhouse of a meat processing plant and weigh each side of beef in ratio to the weight of excrement being delivered by the cows to insure that earnings are calculated to the exact precise degree so they could absolutely nail an investment in meat processors every single time.
The message was that Janus was so involved with management that risk was nearly nullified through what amounted to being an insider at the company. The funds promptly lost more than 50% of their value following the internet bubble bursting in 2000.
Of course, the most infamous case of obfuscating risk came with Long-Term Capital Management. A group of Nobel Laureates so dignified in their pursuit of extraordinary capital gains that the markets would be at their beck and call. They had developed a system of extracting gains from the markets that was both dynamic and full proof, trading in nearly every market around the globe.
The message here was that this group of investors was so smart that losses of any substance would simply be avoided due to sheer brilliance. In 1998 Long-Term Capital Management required a bailout from the Federal Reserve due to the extent of their losses, which briefly jeopardized the entire financial system.
These previous examples are extraordinary cases of obfuscating risk by large financial institutions. The majority of Wall Street obfuscates risk by simply attempting to fly under the radar. They do so through closet indexing and copycat trading. The hope here is that they can just keep up with their benchmark on the upside and when the downside hits, they simply revert to a peer to peer comparison in an effort to convince investors that the risk is systemic in nature, with a reversion to the mean being imminent.
The driving force of the great investors of our time has been to pursue a passion for investing in the best situations possible. They did so through a nearly maniacal obsession with mining the markets, analyzing situations and developing strategies that afforded them the skill and confidence necessary to make a tangible difference in the wealth of their clients.
When billionaire David Geffen exited Eddie Lampert’s ESL Investments in 2007 he stated that he had made more money with Eddie Lampert since initiating his investment in 1992 than he had “from all the businesses I’ve created and sold.”
There is no need to obfuscate risk when you are a competent investor. Your risk is in your analysis. Your system of investing can be explained in a few sentences. Your system of controlling risk is the recognition that mistakes in analysis occur and taking steps to correct those mistakes quickly.
This is the old Wall Street method of investing. It has become a lost art that has been replaced by an attention to every single detail while ignoring the few relevant facts that make an investment attractive.
The competent investor should be able to articulate his methodology on the back of a napkin. Anything beyond that moves into the realm of risk obfuscation, which should create an intense curiosity as to what it is exactly that investor is attempting to cloud.
See full PDF below.