Junk Bonds, Subprime and Oliver Stone’s miss

Seth Klarman is a widely respected value fund manager, reportedly generating long term returns of ~18% p.a. for his clients. He is a man worth listening to. Mr Klarman wrote the book Margin of Safety in 1991 and in one particular chapter describes the junk bond fad of the 1980’s. Towards the end of the fad, the collaterised bond obligation (CBO) was created. Ratings agencies gave the senior tranches of these CBO's investment grade ratings by making optimistic assumptions on overall default rates.

Wall St produced a spectacular sequel to the junk bond mania with the more recent subprime fiasco:

Lending to non-creditworthy borrowers. Check.

Packaging tranches of dodgy debt to make it look better (Collaterised Debt Obligation (CDO)). Check.

Ratings agencies giving the dodgy debt tranches investment grade ratings. Check.

Everything blowing up when optimistic underlying macroeconomic assumptions prove incorrect.  Check.

Of course there are some differences. Borrowers of junk bonds were companies. Borrowers of subprime debt were individuals. But the overall parallels are extraordinary.

 

Coincidentally, I was reading Margin of Safety on a flight recently while watching Oliver Stone’s 1987 Wall St. It got me thinking that Gordon Gekko from  might well have used junk bonds to help finance his takeovers.

It’s such a pity Oliver Stone’s own sequel, Wall St II: Money Never Sleeps, was such a flop. Wall St produced an outstanding sequel. Oliver Stone should have done the same.

And beware of crap financial products.

Kristian 

  

MacarthurCook Property Securities Fund (MPS)

There has been further developments. Some agitating shareholders holding ~5% of MPS have requested the Responsible Entity (RE - MacarthurCook Fund Management) to organise a meeting of unit holders to vote on the the following proposed changes: 

MacarthurCook Fund Management is also the current manager. Given the number of shareholders requesting the meeting, I understand either the RE or shareholders themselves can organise the meeting. The RE has yet to respond, however one would expect an announcement to be made shortly and a meeting date to be set. 

The website (www.mpsresolution.com.au) allows people to download the proposed management agreement with One Managed Investments Funds Ltd, and register their contact details for further information. I have been in contact with  some disaffected unit-holders, and have met with Michiel Geerdink who is spearheading the campaign for change. Mr Geerdink informs me that he (or related entities) does not have a financial interest in One'. 

Based on the conversations I have had with various people, I believe there is a lot more than 5% of shareholders who are unhappy with current management. 

AIMS (the owner of MacarthurCook) holds 26.3% of the shares. 

So shareholders will have a choice of sticking with current management or appointing a new manager. What to do? There is only question I am focussed on: who will deliver the greatest Internal Rate of Return (IRR). 

Here are some thoughts. 

I recently met with management. They have previously articulated the strategy to decrease the gap between the share price and NTA (announcement 3 June):

I would be happy to keep the current management and hold for the long term if I start receiving a healthy level of distributions, and the book value and income payments grow over time. The problem is, I don't know how confident I can be that will happen. I therefore see management as having to rapidly prove itself in this regard. 

There is an upcoming meeting to recapitalise the St Kilda Road property. Note this property is also managed by another AIMS fund. Investors hate conflicts of interest - real or perceived - and quite rightly. The conflicts must be addressed, either by removing them, or at least providing a very high level of transparency through regular progress reports. It is not unreasonable to expect regular progress reports on the fund strategy, particularly after full year results have been finalised. 

A further capital raising would be disastrous. I would like to see management clarify publicly this will not happen.  

An outline of future internal cash-flows and indicative distribution guidance should also be provided. This should include the intentions with ongoing court case legal bills. 

As proposed, the other alternative is to simply wind up the fund. One' would have a deadline of 2016, however a chunk of the assets should be paid in the near term. On my ultra crude IRR calculations, realising the investments at NTA would yield well over 20% p.a. on the current price of 7.2c and realising investments at NTA. The primary objection to this strategy is the illiquidity of some of the assets and realising actual NTA may not be possible. Still, even allowing for a haircut of 20% on the assets (ex cash) I get an IRR of 15% p.a. I can't stress enough these are strictly my guesstimates and should in no way be relied upon. The actual sale value and timing of payments will have a substantial impact on IRR. I have no idea of the actual realisable sale value of the assets other using current book value as a guide. Please also note my disclaimer on this blog. 

I would like to see the agitating shareholders provide a detailed analysis of the wind-up strategy and projected IRR range at the upcoming shareholders meeting. I think this will greatly assist shareholders in their decision making. 

Kristian

Disclosure: own MPS

Mega cap or microcap?

I really must put more effort into coming up with catchy titles. Anyway, finance students are taught about the Efficient Market Theory. The perceived efficiency increases based on the market capitalisation of the stock as more analysts, fund managers, journalists etc follow the situation. The reason for investing in small caps is therefore to swim in an inefficient market, finding those companies the market has missed out on. The message by many in the industry is to put the large caps in the too hard basket and go hunt in easier fields.  This all makes sense, and the performance of good small cap fund managers in benign markets can be terrific. 

Case closed? 

After reviewing my notes and trades over the last year or so, I concluded that at least solely focussing on the perceived inefficient parts of the market might be just a little myopic. I should caution though that many stocks, both large and small, have trended exceptionally well this year, so perhaps this isn't the best point in time do an anecdotal survey and there is also the potential for recency bias. However, consider these basic examples: 

• Berkshire Hathaway (BRK) was hiding in plain sight and is up around 37% for the year, thanks in part to a buy-back.  

• Bank of America (BAC), which was trading at a fraction of book value even though the business was being cleaned up. BAC is up ~100% over the last year. 

• Here in Australia has been Telstra (TLS) - the monster dividend payer that nobody loved. Up over 50% over the last few years

Obviously these examples can be seen as cherry picking, however these examples illustrate that deep value can sometimes be found in household names and the share price performance can be eye-popping. There are plenty more examples out there. And there other big benefits to larger cap names such as liquidity and derivative instruments. Ignoring the large end of town can be disastrous. 

Perhaps part of the reason we (I) sometimes walk straight past situations 'hiding in plain sight' in preference for harder ones is the ego's need to uncover something nobody else has. I'm guilty of that. 

I will keep trying to learn the lesson myself. 

Kristian 

Disclosure: own BAC, TLS

Hastings High Yield Fund (HHY)

This is a follow-up to the introductory post on HHY. Re-produced below is the estimated remaining assets and applicable interest rates paid by the investments: 

As pointed out by a commenter following the article, Maher Terminals is probably the biggest risk. Certainly, the face value of Maher is ~50% of HHY's current market capitalisation, so let's start with that. 

Maher Terminals

Below is an excerpt from HHY's presentation 20/2/13 regarding information on Maher Terminals: 

HHY's investment in Maher Terminals is via a US$20m junior debt facility, maturing July 2015. It would be great if this investment could be sold earlier as this will greatly speed up the return of capital to HHY investors. There has been some talk Maher Terminals may be sold, but I have no idea if this will occur and whether it would include the debt; so I personally will treat this  as unplanned but pleasant surprise if that happens - similar to what has just happened with RHG Ltd (RHG). Being debt, the main thing to be concerned about is not the valuation of the debt, but whether interest will continue to be repaid and whether Maher Terminals will be able to pay the loan back in 2015.  

As a pretty broad (and non-original) observation, terminal operations tend to be fairly stable infrastructure assets. This of course says nothing specifically about Maher. It looks like Maher got into trouble during the GFC. Or perhaps more accurately, the new owner Deutsche Bank got itself in trouble by paying too much for the asset. There have been some (seemingly) minor issues at the  New York port of late. Financial details are scant - I can't see an annual report anywhere. Have I missed it? Can't say that I really understand much about this asset at this stage other than what HHY has provided. 

Cory Environmental

The next single largest investment, also in junior debt. Again, here is an excerpt from HHY's investor presentation: 

In case you can't read the last sentence of the Outlook: 

"Hastings continues to closely monitor the investment in the best interests of unitholders however the outlook remains negative." 

Again, financials are scant. Again, can't really say I have a lot of insight to offer. 

Hmmm. 

What to do. 

On the surface, there appears to be value (fact: book value less than market capitalisation). However the underlying assets are opaque. Can we trust the balance sheet to roughly equate to sale price? Is there a big enough return on (my) time to warrant further investigation?   

We are now moving into reporting season. I have not investigated further the other assets, and still digging more into the above two assets. 

Kristian

Disclosure: small position in HHY