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Volsung Management On Short Case For AmTrust, Cadiz And CNBM

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Volsung Management letter to investors for fourth quarter 2013.

Dear Partner:

2013 was the third best year for US equities in the past three decades. Despite lagging the broader US stock market, we are satisfied with our strong absolute performance as many of our portfolio companies’ shares gained due to specific, fundamental business improvements rather than investors simply paying more for each dollar of profit. We believe these gains will likely prove more durable over time than those driven solely by ‘multiple expansion’ independent of earnings growth, which was responsible for the majority of the broader market’s performance in 2013.

Volsung Management’s performance & exposure summary

Our performance was achieved while retaining a substantial cash balance in the long-only strategy, averaging more than 21% of month-end assets. We find it increasingly difficult to find attractive long opportunities at current valuations and hold 27% of long-only strategy assets in cash at 01/15/14. Despite the challenges presented by the current environment of exuberance and our relatively conservative positioning, the long-only strategy’s annualized performance since inception continues to exceed that of the S&P 500 Total Return Index by more than 5% per annum, net of all fees.

As expressed in last quarter’s investor letter, such a high-powered market environment is also a challenging one for short sellers to navigate. Thankfully, the most recent quarter offered us some noteworthy successes in the short portfolio, as the fundamental challenges facing several of our shorts became impossible for even the most optimistic of analysts to ignore. The long/short strategy continues to outperform the S&P 500 Total Return Index by almost 1% since inception, which we believe to be a significant achievement given that we have historically retained a net equity market exposure of just 31% in the trailing 3 years.

volsung management portfolio allocation

Volsung Management: Commentary

As the year turns, we wish to comment on some of the key issues we contend with as capital allocators in our primary investment market of the United States. Despite our misgivings, our concerns are by no means sufficient to overwhelm the value of our core business activity: the identification and purchase of relatively predictable value-creating businesses. Furthermore, we retain our conviction that, despite some steps in the wrong direction, the political-economic environment in America remains the best of any large nation, and that our companies and universities remain the best in the world. We do, however, see some causes for concern.

The arcane subject of monetary economics is today the primary topic of discussion for many investment managers, talk show hosts, journalists, bloggers, and other commentators. This seemingly bizarre fixation is the result of an unprecedented regime of monetary easing that has boosted equity markets by making most credit assets uncomfortably expensive. Policymakers continue to view aggressive monetary easing as not only favorable but continually necessary to prevent the world from further economic hardship. Opinions and interpretations of such policies vary wildly, and an in depth discussion would be beyond the scope of this letter. We will, however, state our belief that such policies rest on a dubious assumption: that manipulating certain price signals can reliably change the behavior of market participants so as to produce specific, socially-desirable outcomes.

Volsung managment portfolio allocation -- 2

We believe we inhabit a complex, dynamic, and inter-connected world, where capital flows from one market to another at a pace and trajectory which make explanatory clarity and precise market intervention impossible. If the Federal Reserve is, as Warren Buffet recently termed it, the “greatest hedge fund in history” , it is a highly leveraged and opaque one, which has potentially cornered several large, globally important bond markets. We believe that distorting prices to this degree, in an attempt to stimulate US employment and economic growth, is a risky and potentially dangerous exercise that creates an unpredictable potential chain of effect across asset classes and markets. We worry about the limits and unforeseen consequences of manipulating such critical price inputs.

Unfortunately, monetary policy is but one example of good intentions gone awry. While our last letter focused on state corruption and thievery among the political elite in China, we continue to be concerned by the level of political dysfunction, incompetence, and outright graft here in the United States. Continued regulatory incompetence on the part of unelected administrators and authorities saddles an increasingly large swathe of our society with incoherent and ineffectual rules which sap productivity. Rather than function as a public safeguard or a guarantor of a free and open society, such regulatory malpractice increasingly seems only to benefit departing public administrators, who are able to gain lucrative employment helping others navigate the needless complexity they have crafted. We worry that ineffectual governance is becoming an increasingly large drag on American competitiveness, and that this partisan approach to administering the law threatens our democratic institutions.

Corruption and incompetence is by no means limited to our unelected officials, sadly. As investors, we reserve a special distaste for continued Congressional attempts to protect their own ability to engage in insider trading. As citizens, we are disgusted by the routine dishonesty of high level White House officials and the apparent corruption and lawlessness within the Justice Department. Above all, however, the executive and legislative branch alike seem ill-prepared to address the myriad challenges they face. The dire financial and employment situation of our nation’s youth, the crushing arithmetic reality of pension and entitlement obligations, and floundering healthcare reform speak to the failures of American government. We worry about the prospect of political overreach as politicians seek opportunity from the justifiable outrage which many Americans feel over the state of our society.

As students of history, we are highly concerned by the critical vulnerability of the Japanese and Chinese economies, given the deep-seated historical animosity these powers have for each other and the rapidly militarizing, increasingly tense stand-off that is developing in the narrow stretch of ocean between them. We are similarly concerned by the apparent credence given to the intentions of certain elements within the Iranian regime, and worry that violent ideologues with no respect for human life cannot be trusted to play by the rules. We worry about nuclear proliferation in an increasingly destabilized Middle East, and the rising influence there of fundamentalist extremists, who view freedom and tolerance as threats which must be crushed by force.

Despite our misgivings, we believe markets move in cycles, and retain hope that the political environment does as well.

Volsung Management: The long portfolio

Our largest long positions remain Apple, Inc. (NASDAQ:AAPL) and Porsche Automobil Holding SE (ETR:PAH3) (FRA:PAH3), accounting for approximately 16% and 15% of long/short assets each, respectively and approximately 12% and 10% of long-only assets, respectively, at 01/15/14. During the quarter, we initiated a new long position in Chico’s FAS, Inc. (NYSE:CHS) and closed our long position in Cisco Systems, Inc. (NASDAQ:CSCO). Selected highlights from the fourth quarter in the long portfolio follow:

In conjunction with the announcement of third quarter earnings, Ocean Rig UDW Inc. (NASDAQ:ORIG) announced a long-anticipated plan to begin paying a dividend, and advanced plans to convert to a master limited partnership, which would offer investors a tax-advantaged holding structure. The move is a welcome development for shareholders and a key leg of our investment thesis, as it should create a conduit to return capital to shareholders and broaden the company’s potential shareholder base.

ORIG continues to execute operationally and demand for modern deep-water drilling ships continues to exceed shipyards’ abilities to deliver new vessels. While the market remains fixated on the significant debts incurred to finance the delivery of Ocean Rig UDW Inc. (NASDAQ:ORIG)’s current fleet, we find this use of leverage prudent, as the company is immediately deploying these vessels on multi-year contracts at or near record day-rates. Our leverage concerns are further mitigated by the creditworthiness of the company’s oil major counterparties, their pressing need to replace existing reserves, and the low cost of financing presently available. More importantly, the completion of the current generation of in-place contracts will allow the company to almost fully retire these debts in just a few years, creating a tremendous amount of value for equity holders in the form of largely unencumbered, long-lived drill ship assets. ORIG gained 6% in the quarter and had returned 20% from the time of our initial investment in March 2013 by year-end.

JetBlue Airways Corporation (NASDAQ:JBLU) shares gained significantly as the market began to price in the potential for future fare hikes, with shares gaining 28% in Q4 and 49% for the year. The immediate catalyst in the fourth quarter was the failure of the Justice Department’s attempt to halt a proposed merger between the bankrupt AMR Corporation (NYSE:AAR) (the parent of American Airlines) and US Airways Group Inc (NYSE:LCC). In addition to benefitting from an increasingly rational competitive landscape, JBLU gained the opportunity to win valuable gates at capacity-restricted airports already within JBLU’s operating network. We believe that JBLU offers the lowest-risk vehicle to participate in the vastly restructured domestic airline industry and that the shares continue to offer a compelling risk/reward trade-off.

Shares of Porsche Automobil Holding SE (ETR:PAH3) (FRA:PAH3) continue to trade at a substantial discount to net asset value, composed of a majority ownership stake in Volkswagen AG (FWB:VOW) and a large amount of cash and securities. We believe this discount is excessive, reflecting likely over-stated litigation contingencies and concerns about the family’s stewardship of the company, which has been exemplary to date. We are happy to align our interests with the Porsche family and believe they will take action to narrow the discount over time, potentially even merging the two entities together. Shares of VOW returned 18% in the quarter, while PAH3 gained 17%.

Despite our previously expressed misgivings about the European and Chinese economies, and the importance of these regions to Volkswagen AG (ETR:VOW) (FRA:VOW) (OTCMKTS:VLKAY)’s business, the company is one of only a few global automakers with sufficient scale to comfortably navigate the numerous regulatory, economic, and operational challenges inherent to this sector. To the extent European & Chinese auto markets remain overcapacity, we believe VOW’s balance sheet and operational excellence will allow it to weather downturns its weaker competitors cannot. Furthermore, in contrast to the market, we view the company’s investments in product development and process engineering positively, and believe VOW’s unrivaled R&D and investment spending provide an increasingly large competitive advantage.

Volsung Management’s new long position in Chico’s FAS

During the fourth quarter, we established a position in specialty retailer Chico’s FAS, Inc. (CHS). We were attracted to the company’s stable of established retail concepts and its proven track record of developing and expanding those brands, which were available for purchase at a low absolute multiple of free cash flow. The company’s core customers are women 35 and over with household incomes of $50k to $100k+, which we believe is a modestly underserved but attractive target demographic, even as it fails to generate the same attention as retailers focused on younger, poorer customers.

Chico’s FAS, Inc. (CHS) enjoys strong customer loyalty by delivering product which resonates with and responds to the needs of its core customer, including comfortable, flexible cuts and fits. The company also offers a rewarding loyalty program which helps drive a significant amount of repeat customer traffic. In addition to the Chico’s banner, CHS targets slightly younger customers through its White House | Black Market (WHBM) brand. WHBM offers work-wear as well as formal and evening apparel and has accounted for the majority of sales growth in recent quarters. The company’s third and more recent offering is Soma Intimates, which offers compelling economics thanks to its small format stores and the attractive nature of the intimate apparel market. Soma targets a distinct customer underserved by its core competitor, Victoria’s Secret, and is perhaps the most immediately exciting opportunity for CHS, as it appears to be reaching a scale which could allow for significant potential margin expansion with continued growth.

Chico’s FAS, Inc. (CHS) has made critical investments in logistics and inventory management that we believe enable the company to efficiently serve its multiple brands from a single, integrated distribution network. While other retailers have delayed developing their online shopping experience for fear of cannibalizing their existing retail stores, CHS has plunged headfirst into becoming a fully-fledged ‘omni-channel’ retailer by investing significant resources into its online storefront. While many of these trends can often be reduced to little more than buzzwords used by management teams to bedazzle brokerage analysts, we are, as ever, focused on what management actually achieves. We believe these investments have led to an observable improvement in the company’s operational performance and will enable CHS to compete effectively in an evolving retail environment.

We remain somewhat unconvinced by the company’s recently acquired fourth brand, Boston Proper. Boston Proper was previously a catalog retailer which the company intends to convert into a physical retail chain, having already opened a handful of stores in recent months. Management draws conviction from the decades of catalog sales and customer data, which they believe will allow for a relatively low-risk transition to physical retail. While we would perhaps prefer that the company stick to its established brands, we believe the risk to current shareholders is minimal and that management’s capital allocation discipline suggests the company is unlikely to continue to invest in the brand should early results fail to meet expectations.

Despite its successful track record of growth, established customer base, and strong “high-teens” free cash flow margins to the firm, we were able to purchase Chico’s at a multiple reflecting a significant discount to peers and to the company’s historical valuation. 2013 same store sales have been flat to modestly down, reflecting both a difficult retailing market and the company’s significant same store sales growth in the previous 2 years. We view the company as being more of a victim of its own success than operationally challenged, and so we welcome the opportunity to acquire an established, highly profitable, and growing business at a cheap price. While we are happy to own such a value creating business indefinitely, we believe that the company’s characteristics, and the CEO’s history of selling companies he has managed to financial buyers, suggest a strong possibility of a private equity buyout.

Volsung Management exited Cisco Systems

During the fourth quarter, we closed our position in CSCO. When we initiated our position, Cisco shares were trading at just 6x our estimate of normalized free cash flow to equity, net of cash and securities, which we believed was an overly conservative discount given the company’s defensible market position, strong cash flow generation, and shareholder-friendly management. We believe the market continues to overestimate the threat posed to CSCO by software-defined networking and that the company retains a substantial competitive advantage in the form of its dominant installed hardware base and its service and support organization. We exited our position during the quarter in light of our new investment in CHS, however, which we view as offering greater upside with less risk. While there has been a modest deterioration in the broader enterprise IT market which has affected CSCO’s near-term prospects, we were able to recognize an annualized internal rate of return (IRR) of 18% on our investment due to the low valuation at which we purchased the shares.

Volsung Management’s Short Portfolio

We are pleased with the performance of our short portfolio relative to peers, with the long/short strategy returning 12.4% in 2013, net of all fees, besting the 10.9% performance of the Hedge Fund Research Equity Hedge Index, even as our net market exposure was meaningfully below the average exposure of the index1. We continue to find a rich set of short-selling opportunities as other investors increasingly abandon their investment discipline, and we added one especially meaningful new short position in the quarter.

We continue to maintain an outsized short position in Chinese shares & related securities levered to capital-intensive investment growth in China. As of 01/15/14, the long/short strategy’s exposure to Chinese & related assets was -43%. Our position continues to be comprised of short positions in several indices we believe are highly exposed to a Chinese rebalancing and individual positions in the shares of Chinese property developers, banks, and corporates, as well as miners which are highly leveraged to the Chinese market.

Our largest single-name short positions as of 01/15/14 are Cadiz, Inc. (NASDAQ:CDZI) (-13%), and AmTrust Financial Services, Inc. (NASDAQ:AFSI) (-8%). During the quarter, we initiated our position in AFSI and closed our position in SunPower Corp. (NASDAQ:SPWR), while adding to several other existing positions. Subsequent to quarter end, we initiated new short positions in hhgregg, Inc. (NYSE:HGG) and Medbox, Inc. (OTC:MDBX), which will be discussed in our next quarterly letter. Selected commentary on the short portfolio follows:

Cadiz, Inc. (NASDAQ:CDZI) was the biggest detractor in the short portfolio, gaining 36% in the fourth quarter. CDZI refinanced its primary loans after they were sold by the original lender to a hedge fund at a significant discount to face value. We believe the deal and subsequent refinancing make sense from the perspective of the creditor given the relative value of the company’s land assets to the price paid for the loan, the 8% interest rate, and the substantial portion of common stock offered at no cost as an incentive for concluding the transaction. We believe this to be the case even should the new lenders believe there is little probability of the proposed water extraction project advancing, and the refinancing contains specific language relating to future asset sales.

We continue to believe that CDZI equity, however, is likely to be worthless, and that the proposed water extraction project on which the company’s future depends will fail. While the refinancing will allow CDZI breathing room through the middle of next year by alleviating its immediate liquidity crunch, we believe it ultimately increases risks to equity holders by shortening the company’s maturity profile and increasing the total amount of leverage. We believe these changes increase the probability of a future bankruptcy and likely further challenge the company’s ability to secure the financing necessary to complete the proposed project. Accordingly, we have maintained our position in anticipation of CDZI’s ultimate failure, even as it has resulted in short-term mark-to-market losses for the strategy.

China National Building Material (SEHK:3323 – CNBM) rallied following the conclusion of the highly anticipated Third Plenum in November, which culminated with the publication of a brief document highlighting the Party’s policy priorities for the coming years. Although some analysts hailed the document’s focus on several critical areas widely recognized as requiring overhaul, the document largely reiterated previously expressed reform priorities while providing little detail on how implementation is to be achieved.

While these analysts seem to believe that reform will ignite immediate growth, we believe successful efforts will require short-term pain for long-term gain, and would likely serve to catalyze our Chinese short positions. The Plenum and subsequent events have offered several signs that the incoming executive, Xi Xinping, is successfully consolidating his power, which bodes well for the center’s ability to impose reforms on the periphery. However, we continue to believe that there are significant structural obstacles to implementation that will have to be surmounted in China, as reform will create winners and losers among the political elite.

The prevailing optimistic view of reform seems to be evident in the performance of CNBM shares, which gained 12% in the fourth quarter. We believe that the achievement of the reform priorities highlighted in the Plenum would force CNBM to radically restructure and would likely favor its more efficient competitor Anhui Conch Cement Co. (SEHK:914). Without preferential access to state financing and other subsidies, CNBM would likely require a highly dilutive equity issuance to reduce its significant debt burden and avoid bankruptcy. Furthermore, the company’s failure to operate profitably in what is likely the world’s largest-ever construction boom raises doubts about CNBM’s opportunities in any genuine reform scenario, which would limit future investment growth.

Volsung Management’s new short position in AmTrust Financial Services

During the quarter we initiated a significant short position in AFSI in the long/short strategy, accounting for -8% of strategy assets at 01/15/14. AFSI is a specialty property & casualty and workers’ compensation insurer primarily focused on niche insurance lines for small and medium sized businesses, as well as extended warranty and product protection insurance sold through retailers. AFSI has grown astoundingly quickly, almost quadrupling gross premiums written in the past 5 years through a combination of aggressive organic growth and a series of sizeable acquisitions. AFSI has consistently reported returns on equity which are more than double its peers’ and traded at more than 4x tangible book value at the time of our entry, reflecting a significant and, in our view, unjustifiable premium to peers.

Management claims that it is able to profitably cater to underserved niches due to its proprietary technological platform, which allows it to sustainably earn outsized returns in what is otherwise a mature and predictable market. Our analysis suggests that the company’s competitive advantage is significantly overstated and stems not from superior underwriting but from accounting manipulation. We believe AFSI consistently underestimates its future policy benefit claims and uses highly aggressive accounting assumptions related to intangible assets and capitalized expenses, presenting a distorted view of the company’s profitability.

Accordingly, while accounting earnings have grown consistently, this growth has not translated into a commensurate increase in tangible book value. We believe recent loss development suggests the company is attempting to offset its increasingly aggressive underwriting with rapid growth in in-force policies. Furthermore, the company appears to be entering into increasingly higher-risk lines and underwriting arrangements as it attempts to outgrow potential problems. We believe this is a potentially disastrous combination and that the company’s current level of underwriting leverage is dangerously high.

While our underwriting concerns alone would likely make for a compelling short thesis, our view is strengthened by the company’s corporate governance. AFSI is controlled by its founding family and lacks independent oversight, possessing an organizational structure which we believe to be consistent with previous ‘control frauds’. While we do not believe that there is conclusive, definitive evidence that AFSI has engaged in fraud, we believe that there is a concerning pattern in the factual evidence reinforced by both the ability and the necessary incentives for such malfeasance.

We are particularly concerned by the controlling family’s complex web of related-party transactions, apparent self-dealing, and hiring of executives we believe to be unqualified. AFSI’s CEO, among the highest paid insurance executives in the world in 2012, is the chairman and founder’s son-in-law and lacks any significant management or insurance experience outside of his current appointment. We are even more concerned by the track record of the company’s CFO, who was hired despite having failed to question the inappropriate diversion of funds to senior executives while serving as the controller at a previously failed insurance company. The record suggests that AFSI’s current CFO sought to defend these executives before the court, attacked the methodology of an investigative inquiry which exposed the company’s fraudulent accounting, and pleaded ignorance of any wrongdoing despite his apparent consent to these transactions. In light of this evidence, we question AFSI’s subsequent hiring and promotion of this individual to a senior oversight role, along with the hiring of several other key executives from this company.

Despite these “red flags,” and our significant accounting concerns relating to a series of acquired captive reinsurance entities, our investment thesis remains uncommitted to the exposure of any potential fraud. We do believe, however, that these allegations are highly specific and demand an accordingly concise explanation from management. Given the limited information available to us as outside investors, and the Company’s complex and opaque structure, we believe these concerns are secondary to our thesis and present an additional ‘option’ for further downside should they prove to be justified.

AFSI has been a controversial short position, owing to the coincidental release of several unrelated research reports critical of the company shortly after we established our short position. These reports focused on the company’s accounting for its life settlement assets and its captive reinsurance transactions, and led to a significant decline in AFSI’s shares and increased trading volatility. Management responded by offering a brief, and in our view, unsatisfactory response, while family members offered a show of confidence in the form of a significant open-market purchase of shares. We welcome any attempt by management to create dialog with shareholders, and hope the company will address some of the apparent inconsistencies and deficiencies that we and others have identified in the company’s accounts.

Volsung Management exited short position in SunPower Corp

During the quarter we closed our position in SPWR at a significant loss. While we believe SPWR is egregiously overvalued and that the company’s competitive position is deteriorating, we closed the position in order to move on to less complicated opportunities which we view as offering superior risk/reward.
SPWR is a vertically-integrated developer, producer, and marketer of solar panels. The company’s business is approximately equally divided on a revenue basis between its utility segment, which offers consulting, engineering, and installation services for large solar power generation projects, and its residential and commercial business, which sells and finances solar panels for small-scale home and business installations.

We believe analysts are naively extrapolating aggressive and unrealistic management guidance and that the company’s future growth opportunities are overstated. SPWR’s business is low-margin and highly competitive and the company has struggled to remain profitable. SPWR’s solar panels cost significantly more than competitor’s offerings, even when adjusted for the higher efficiency of SPWR’s panels, and we believe the company’s efficiency advantage is narrowing as models under development near the physical efficiency limits of silicon-based panels. We believe SPWR will struggle to reduce manufacturing costs to a competitive level and that the company’s panels will be increasingly commoditized as its efficiency advantage continues to narrow.

Despite a growing residential leasing segment, we believe the utility-scale business is the only market opportunity of sufficient size to potentially justify the company’s valuation. We believe that current demand for new projects is inflated due to the pressing need to comply with state renewable energy standards and that the potential backlog of new projects has already peaked in the company’s key US market. Our state-by-state analysis of the company’s key markets also suggests that SPWR has lost significant share in bidding for new projects in the US, although this has been obscured by a rapidly growing market. We believe the market is inappropriately capitalizing these project-based cash flows as recurring and that the cash flow SPWR will realize from current projects is immaterial in light of the valuation and the company’s significant debt load.

Despite these challenges, SPWR shares benefitted from an extraordinary run-up in solar stocks in 2013, and SPWR gained 430% for the full year and 235% during the time which we were short the shares. We view the performance of SPWR and other solar stocks to be wholly irrational, but will likely exercise greater caution in the sizing of short positions of companies engaging in such speculative businesses, which are prone to naïve extrapolation of future growth and unrealistic hype.


We retain the utmost conviction in our current portfolio positions and remain optimistic of our prospects in the coming calendar year, even as we conduct our affairs on a longer timeline. As always, we encourage you to contact us with any comments, questions, or feedback you may have.


Nick Poling and Andrew Dzwonchyk

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