Senvest Capital commentary for the first quarter ended March 31, 2016. The top value hedge fund is having a tough year after killing it almost every single year. As they note in their 2015 letter: “The Senvest Partners fund is focused primarily on small and midcap companies. The fund recorded a loss of 17.3% net of fees for 2015. It is up over 2200% since inception in 1997.” 2016 is also tough see below for that.
See the commentary below.
Senvest Capital Q3 2015 Letter To Investors
Senvest Capital – Overall Performance
The pace of the late 2015 market decline gathered speed in the first half of the quarter as U.S. equity markets had one of their worst starts to a year ever. The Russell 2000 initially entered bear market territory (down more than -20% from its 2015 peak). In mid-February, on the heels of supportive central bank commentary, macro-economic reports that pointed to an improving economy and diminished risk of recession, equity markets started trending upwards for the second half of the quarter. ECB chair Mario Draghi was back to doing “whatever it takes” as he introduced new policies to support the European economy. These expanded quantitative easing measures included purchases of non-financial, investment grade corporate debt; new refinancing programs; and incentives to reduce the impact of negative interest rates on banks designed to boost lending. A few days after Mr. Draghi’s actions, Fed chair Janet Yellen lowered expectations of Fed rate increases to two hikes this year, down from four, and spoke of taking a cautious approach in raising rates due to global risk. Even though the markets have recovered somewhat, we believe the scars of the 2008 financial crisis remain raw and investor anxiety remains elevated. Uncertainty and concerns about the strength of the U.S. economy stemming from either the Fed raising interest rates, plummeting oil prices or slowing China growth could be any of the “bogeymen” weighing on investor’s minds.
As we have said before (and which bears repeating), investors often overreact and are prone to alarm and drastic pessimism at times, focusing entirely on negative news flow and creating a negative feedback loop in the market. A common reaction for investors is to continue the negative trend by selling, while ignoring key variables and fundamentals that may indicate a company (or industry) will endure and be stronger in the long run. Our research strives to determine whether a company’s prospects are actually better than what investors in the market are currently predicting, and whether conditions will improve significantly within our investment time horizon.
The American Association of Individual Investors (“AAII”) bull index (the percentage of surveyed members who are bullish on the stock market for the next six months) breached the lows last seen during the financial crisis in 2009. Bespoke Investment Group (“BI Group”) reported “for all of 2015, there were only eight weeks where bullish sentiment was above 40%, which is the lowest since 1990. Meanwhile neutral sentiment finished the 2015 year at 51.3%, which is a 12-year high.” The monthly AAII bulls index minus the bears index has hit its lowest point since 2009/10. We believe excessive pessimism can swing the pendulum of market prices too far in one direction and can often more than “bake in” dire scenarios.
Every recession has coincided with a bear market but large selloffs don’t necessarily presage recessions. As economist Paul Samuelson wrote, “Wall Street indexes predicted nine out of the last five recessions” (Wall Street Journal). We don’t profess to be macro-economic experts but we believe worries of an imminent recession are overblown. We monitor trends in what we believe are a few of the most important recession indicators which presently don’t portend a downturn. First, the shape of the yield curve remains upward sloping. Since the 1950’s an inverted curve has signaled every recession (Federal Reserve Bank of Dallas). Second, a graph of the ratio of the Conference Board’s leading economic indicators to coincident indicators also remains upward sloping. BI Group observes “for every recession since the late 1950’s, the ratio of the two indices peaked before the actual onset of recession…well over a year earlier [than the recession]. We have yet to see a rollover during the current cycle.” Third, since 1960, a slowdown in employment growth has preceded every recession. “Employment growth drops below the average change in employment during the expansion about 15 months before the onset of the next recession. Employment growth for the last year remains above the recovery average” (Barclays). Finally, credit conditions support the case for growth. Fed bank data continues to reflect robust growth in lending, with period end loans hitting another record high and rising at its fastest pace since the first quarter of 2009 (Barclays).
The decline in oil prices may concern some investors who interpret the drop due to weakening economic activity. However, we believe excess supply and a stronger dollar are behind a significant part of the drop in prices. The “crash” in oil prices has presumably resulted in a depression in the U.S. domestic energy exploration and production market. Shale oil producers have dramatically curtailed capital investment spending. This drop in spending, coupled with a strong U.S. dollar which makes U.S. manufactured products less competitive globally and decreases exports, have together resulted in an industrial recession in the U.S. This bears out in weak manufacturing data reported over the past few months. However the U.S. economy has evolved into a relatively closed, service-based economy and manufacturing comprises only 12% of U.S. GDP and 9% of total employment (Goldman Sachs). The non-manufacturing or ISM services index still has been signalling expansion. So while low oil prices have had an immediate negative effect on both the industrial economy and the industrial labor market, over time the positive effects of lower oil prices on the broader economy should emerge, principally through higher disposable income for consumers.
Finally, despite the worries of a slowing China and even the impact of a domestic industrial recession, consumer sentiment seems to remain resilient. According to the University of Michigan consumer survey report, the consumer confidence numbers have held up relatively well throughout most of the recent turbulence in the markets.
As previously reported Senvest Capital Inc. (“Senvest” or the “Company”) had a difficult year in 2015.These difficulties persisted into 2016. Most of the major benchmarks were flat to down for the quarter but our decline was significantly greater. The bulk of our losses in 2016 were unrealized, mark-to-market losses. Some of our largest holdings as at March 31 2016 were, Deckers Outdoor, NorthStar Realty Finance, Tower Semiconductors, Depomed, Radware, and Ceva. Of these, Northstar Realty, Depomed and Radware all declined over 20% in the quarter, while Tower Semiconductors declined 14%. Deckers Outdoor was our best performing stock in the quarter with an appreciation of over 25%.
Senvest recorded a net loss attributable to the common shareholders of ($54.8) million or ($19.47) per diluted common share for the period ended March 31, 2016. This compares to net earnings attributable to common shareholders of $68 million or $24.21 per diluted common share for the first quarter of 2015 year. After a 2015 year where there was significant appreciation in the US dollar versus the Canadian dollar, the first quarter of 2016 resulted in a reversal of some of that appreciation. In the quarter a currency translation loss of about $45 million increased the loss attributable to common shareholders. This amount is not reported in the Company’s income statement rather it is reflected in the Comprehensive income. The Company remains committed to being profitable over the long-term.
However the volatility and choppiness of the markets will result in wide profit swings from year to year and from quarter to quarter.
The Company’s loss from equity investments in 2016 was the biggest contributor to the net loss recorded. The net loss on equity investments and other holdings totalled ($127.4) million in the current quarter versus a gain of $133.8 million the first quarter of 2015. Due to the continued depreciation of the US dollar versus other major currencies, our foreign exchange loss for the quarter was approximately $3.3 million.
The Senvest Partners fund is focused primarily on small and mid-cap companies. The fund recorded a loss of 9.9% net of fees for the first quarter of 2016. It is up over 2000% since inception in 1997. With most of the long portfolio invested in small and mid-cap stocks, the fund underperformed its most relevant benchmark the Russell 2000, which was down about 1.5% for the quarter. The fund also underperformed the S&P 500 index for the period although it does not consider that index as a benchmark. The Senvest Israel Partners fund was initiated in 2003 to focus on investing in Israel related companies. This fund recorded a loss of about 9.4% for the quarter but it is up over 850% since inception. The two funds had a total of about $950 million of net assets under management at March 31, 2016. Both of these funds are consolidated into the accounts of the Company.
The Company has a portfolio of real estate investments, investing as a minority partner in selected properties. Real estate investments totalled $46.7 million as at March 31, 2016. About 60% of this amount represents investments in different US REITs. These REITs are not publicly traded and there is no established market for them. The most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties of the REITs and the distribution to its holders. The remaining amounts are minority interests in private entities whose main assets are real estate properties. As described above for the REITs, the most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties.
From time to time the Company enters into derivative financial instruments consisting primarily of options and warrants to purchase or sell equities, equity indices and currencies. All contracts are denominated in US dollars. There is deemed to be no credit risk for the options that are traded on exchanges. The warrant contracts are not exchange traded and allow the company to purchase underlying equities at a fixed price. The maximum exposure to credit risk associated with these warrants or with non-exchange traded options is their recorded amount.
The Company has made significant investments in its US operations, primarily in people, systems, technology and new office space. This investment represents a significant effort in a short amount of time to raise the quality of its infrastructure and personnel. As a result the Company’s operating costs have been increasing in the recent past from historical levels.
The Company consolidates the Senvest Management LLC, entity that serves as the investment manager of the Senvest funds. The portion of the expected residual returns of the entity that does not belong to the Company is reflected as non-controlling interest on the statement of financial position. This non- controlling interest is owned by an executive of the Company and totalled $67.9 million as at March 31, 2016 from $80 million as at December 31, 2015.
At the end of March 31, 2016, Senvest had total consolidated assets of $1,870 million versus $2,146.4 million at the end of 2015. The main reason for this was the change in equity investments and other holdings. Equity investments and other holdings decreased to $1,782.2 million from $2,036.3 million last December. The Company purchased $380.4million of investment holdings in the quarter and sold $335.7 million of such holdings. Both amounts were more than the prior year’s quarter. The Company’s liabilities decreased to $1,125.6 million versus $1,290.1 million at the end of 2015 primarily because of the decreases to equities sold short and liability for redeemable units. The proceeds of equities sold short were $422.2 million and the amount of shorts covered was $427.9 million in the quarter. The decrease in shorted securities versus the increase in shorts covered resulted in the decrease to equities sold short.
Items included in the financial statements of each of the Company’s entities are measured using the currency of the primary economic environment in which the entity operates (the functional currency). The functional currency of the parent company is the US dollar.
The Company has adopted the Canadian dollar as its presentation currency, which in the opinion of management is the most appropriate presentation currency. Historically, the Company’s consolidated financial statements have been presented in Canadian dollars, and since the company’s shares are listed on a Canadian stock exchange, management believes it would better serve the use of shareholders to continue issuing consolidated financial statements in Canadian dollars. The US dollar consolidated financial statements are translated into the presentation currency as follows: assets and liabilities – at the closing rate at the date of the consolidated statement of financial position; and income and expenses – at the average rate for the period. All resulting changes are recognized in other comprehensive income (loss) as currency translation differences. Equity items are translated using the historical rate.
Senvest Capital – Risks
Financial risk factors
The Company’s activities expose it to a variety of financial risks: market risk (including fair value interest rate risk, cash flow interest rate risk, currency risk and equity price risk), credit risk and liquidity risk.
The Company’s overall risk management program seeks to maximize the returns derived for the level of risk to which the Company is exposed and seeks to minimize potential adverse effects on the Company’s financial performance. Managing these risks is carried out by management under policies approved by the Board.
The Company uses different methods to measure and manage the various types of risk to which it is exposed; these methods are explained below.
Fair value and cash flow interest rate risks
Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate as a result of changes in market interest rates.
The majority of the Company’s debt is based on floating rates which expose the Company to cash flow interest rate risk. The Company does not have a long-term stream of cash flows that it can match against this type of fixed debt, so it prefers to use short-term floating rate debt. The Company does not mitigate its exposure to interest rate fluctuation on floating rate debt. If interest rates spike, then the Company could enter into interest rate swaps or more probably just reduce its debt level. As at March 31, 2016, the Company has listed sufficient equity securities that it can sell to reduce its floating rate debt to zero.
Currency risk refers to the risk that values of financial assets and liabilities denominated in foreign currencies will vary as a result of changes in underlying foreign exchange rates. The Company’s functional currency is the US dollar. The following are the main financial assets and financial liabilities that have items denominated in currencies other than the US dollar: cash and cash equivalents, due from/to brokers, bank advances, equity and other holdings, real estate investments, other assets, equities sold short and derivative liabilities and accounts payable.
Equity price risk
Equity price risk is the risk that the fair value of equity investments and other holdings and equities sold short and derivative liabilities will vary as a result of changes in the market prices of the holdings. The majority of the Company’s equity investments and other holdings and all of the equities sold short are based on quoted market prices as at the consolidated statement of financial position date. Changes in the market price of quoted securities may be related to a change in the financial outlook of the investee entities or due to the market in general. Where non-monetary financial instruments ? for example, equity securities ? are denominated in currencies other than the US dollar, the price, initially expressed in a foreign currency and then converted into US dollars, will also fluctuate because of changes in foreign exchange rates.
Equities sold short represent obligations of the Company to make future delivery of specific securities and create an obligation to purchase the security at market prices prevailing at the later delivery date. This creates the risk that the company’s ultimate obligation to satisfy the delivery requirements will exceed the amount of the proceeds initially received or the liability recorded in the consolidated financial statements.
The Company’s equity investments and other holdings have a downside risk limited to their carrying value, while the risk of equities sold short and derivative liabilities is open-ended. The Company is subject to commercial margin requirements which act as a barrier to the open-ended risks of the equities sold short and derivative liabilities. The Company closely monitors both its equity investments and other holdings and its equities sold short and derivative liabilities.
The impact of a 30% change in the market prices of the Company’s equity holdings with quoted value, equities sold short and derivative liabilities as at March 31, 2016 would be as follows (in thousands):
Liquidity risk is the risk the Company will encounter difficulties in meeting its financial obligations. The Company’s largest assets are equity investments and other holdings. Most of these assets are made up of equities in public holdings which can be liquidated in a relatively short time. Due to its large holding of liquid assets, the Company believes that it has sufficient resources to meet its obligations.
All financial liabilities other than equities sold short and derivative liabilities as at the consolidated statement of financial position date mature or are expected to be repaid within one year. The liquidity risk related to these liabilities is managed by maintaining a portfolio of liquid investment assets.
Credit risk is the risk that a counterparty will fail to fulfill its obligations under a contract and will cause the Company to suffer a loss.
All transactions in listed securities are settled or paid for upon delivery using approved brokers. The risk of default is considered minimal, as delivery of securities sold is executed only once the broker has received payment. Payment is made on a purchase once the securities have been received by the broker. The trade will fail if either party fails to meet its obligations.
The Company is also exposed to counterparty credit risk on its cash and cash equivalents, restricted short-term investment and due from brokers
From time to time, the Company enters into derivative financial instruments consisting primarily of warrants and options to purchase or sell equity indices and currencies. These derivative instruments are marked to market. There is deemed to be no credit risk for the options because they are traded on exchanges. The warrant contracts are not traded on an exchange and allow the company to purchase underlying equities at a fixed price.
Capital risk management
The Company’s objective when managing its capital is to maintain a solid capital structure appropriate for the nature of its business. The Company considers its capital to be its shareholders equity. The Company manages its capital structure in light of changes in economic conditions. To maintain or adjust its capital structure, the Company initiates normal course issuer bids or adjusts the amount of dividends paid. The Company monitors capital on the basis of its debt-to-capital ratio, which is as follows (in millions):
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