Senvest Capital condensed interim consolidated financial statements for the month ended September 30, 2015.
Senvest Capital – Overall Performance
In the third quarter the major US stock indices suffered one of their worst quarters in many years, with most of the losses occurring in the month of September. Senvest Capital Inc. (“Senvest” or the “Company”) had the same experience reporting its worst quarter since the financial crisis. It was a quarter filled with turmoil from many parts of the world economy.
US equity indices started the quarter with a mixed July as market turmoil bounced from Europe to China. On the positive side, fears of a “Grexit” abated after Greece secured a third bailout from Europe while capitulating to more austerity and demands for asset sales and market reforms. On the negative side, China’s equity market continued to plunge but stabilized somewhat after the government intervened by halting trading in many securities and providing support through a coordinated stock buying effort that Goldman Sachs estimated at about $144 billion. Concerns of a slowing Chinese economy were probably connected to the ongoing decline in commodity and oil prices. In contrast, on the US domestic economic front, the Fed said in its July meeting that the “…labor market continued to improve, with solid job gains and declining unemployment.”
In August, China devalued its currency and reported weak macroeconomic growth data which probably perpetuated large declines in the Chinese stock market. Commodity prices continued to swoon with the Commodity Research Bureau’s spot market price index hitting new five year lows. These data points likely undermined global growth expectations and when mixed in with the prospect of a potential Fed rate hike, equity markets were primed for a sell off. After more than four years without a drop of more than 10%, known as a “correction”, US equity markets tumbled. This correction though was unusually rapid in its descent and occurred over a four day period, including Monday August 24th when the S&P 500 fell 4%. Much of the selling appeared to be forced, with selling begetting more selling. On the worst day of declines (August 24th) we observed ridiculous prices. For example, Ford and JP Morgan at one point fell about 20%. Some exchange traded funds (“ETFs”) traded at large discounts to the underlying value of their shares and many were halted for trading (80% of the roughly 1,300 securities halted that day, according to an analysis by the Wall Street Journal). Some had attributed the violent sell off to systematic selling from “risk parity” and “volatility targeting” strategies (for example, prominent investor Lee Cooperman in a letter to investors, as reported by CNBC). JP Morgan Research (“JPM”) estimated that volatility strategies quickly rebalanced to the tune of $50-75bb in one to five days and that risk parity strategies could represent $50-100bb. JPM further noted that August mutual fund outflows estimated at $40bb fell in the top five highest outflow months since 2007. No matter which strategy was to blame, the rush to the exit appeared to have come mostly from relatively newly developed, passive/systematic financial products and strategies, and less so from fundamental investment strategies.
Equity markets initially started the month of September with a bounce off the August lows of the year while investors awaited Fed chair Janet Yellen’s mid-month decision on the “lift-off” of the fed funds rate. Yellen held off raising rates and cited increased global risks and their potential impact on the U.S. economy in explaining the Fed’s decision. Equity markets didn’t take kindly to the message, even after Yellen attempted to clarify her remarks along with other Fed board members who indicated a likely “lift-off” later in the year. Moreover, the Fed unwittingly revealed a bit of a pickle it has created for itself. On the one hand, Fed members have reiterated the intention to raise rates at some point this year. On the other hand, raising rates may potentially exacerbate the newly cited global risk concerns. Higher rates have in the past led to a stronger U.S. dollar, weaker emerging market currencies and a reversal of capital flows away from emerging markets, straining their economies. (Witness the steep slide in the Brazilian real, at one point down almost one third this year. Chinese foreign reserves have plunged almost $500 billion from their peak last year, including a record outflow of $190 billion in the three months ended September 30, 2015.) Not to mention, a single tweet from Democratic Presidential candidate Hillary Clinton calling for regulation of pharmaceutical prices likely set off the firestorm of selling of drug company stocks, especially those focused on high-cost medicines (biotech) and growth-by-acquisition strategies (specialty pharma), which often include post-acquisition drug price increases. This likely impacted many long-short equity funds with outsized pharma exposure, including our portfolio due to one of our larger long positions in specialty pharma company Depomed (“DEPO”). Some of our largest holdings as at September 30 2015 were, Tower Semiconductors, NorthStar Realty Finance, Ceva, Mellanox Technologies, Radware, Depomed and NorthStar Asset Management.
[drizzle]DEPO plunged 30% in September and 12% in the third quarter. As we have discussed in our prior letter, the company rejected a hostile takeover bid from competitor Horizon Pharma (“HZNP”), which has subsequently countered with a proxy fight to replace the current board members of DEPO. Because HZNP’s offer consists entirely of stock, DEPO has been trading at the hip with HZNP, which also slumped 30% in September. Whether DEPO would have suffered a loss in lock-step with HZNP in the absence of the takeover bid remains unknown, although it surely would not have remained unscathed given the hit the specialty pharma sector has taken.
DEPO stock traded as low as $15/share in September, or roughly 15x its analyst estimated run rate for Q4 earnings, far too cheap (we believe) considering that its proven management team has only just started the “re-launch” of Nucynta (acquired from Johnson & Johnson in 2015). Moreover, weekly prescription numbers provided by the company for its other core product, show strong growth and so far have proven management’s ability to execute on its acquisition growth strategy.
Flavor technology company Senomyx (“SNMX”) fell more than 30% during September, and perhaps slumped in sympathy with bio-pharma companies due to its biotech like business model. SNMX, of course, has nothing to do with drug prices. At the end of August, the company announced the commercialization of Sweetmyx with Pepsi, which has launched a roll out of reformulated Manzanita Sol in the U.S. and the launch of two test markets for reformulated Mug root beer. This is a major milestone for SNMX and we believe that if consumers accept the reformulations of these two sodas, Pepsi will incorporate SNMX further into its artificially flavored beverage portfolio.
Real estate asset manager NorthStar Asset Management (“NSAM”) and its associated REIT NorthStar Realty Finance (“NRF”) lost 14.5% and 12.1% in September, respectively. We can’t point to any specific news to cause the decline in these investments but we suspect that the stocks suffered from a selling-begat-selling condition that can plague companies with high hedge fund ownership. This is speculation on our part. A review of fund holdings on Bloomberg shows that some funds that have a high ownership in both stocks have seen other of their