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 

My encounter with Ray Martin

My business partner and I landed in Heathrow, nice and jet lagged from Sydney. After passing through customs and getting our bags, my business partner started walking, fiddling on his phone while I followed him like a sheep in a daze. One of Australia's most famous and respected journalists, Ray Martin, sat behind on us on the flight and as happens on these 23 hour journeys you get to recognise the people around you. As we were walking, Mr Martin came up to us and asked us for the baggage carousel number. We mumbled 'number 2'.  He said thank you. We then continued walking only to realise we had somehow managed to miss the big green Exit sign and were literally walking straight towards a dead end. We felt like a couple of half-wits.  

The encounter with Ray Martin prompted some thinking. I watched A Current Affair when I was younger when Ray Martin hosted the show. However, for me the most memorable episode was before Mr Martin's time when Jana Wendt hosted the programme. It was an interview about winning control of Fairfax with three people (two journalists and a then Fairfax supporter) against Kerry Packer in his famously fierce form. I remember feeling sorry for the triplet...

Kristian 

Hastings High Yield Fund (HHY)

HHY is in wind-down mode: underlying assets are gradually being sold-down and cash is being returned to shareholders. It's a true cigar-butt.* 

A chunk of cash has already been paid to shareholders. HHY has now gone ex a further 18.1c capital return. HHY's estimated NTA as at 31 May is 69c; therefore the NTA is ~50.9c. HHY closed is 37.5c. 

This is the estimated run-off of the investment portfolio (provided by the fund):

Investors will now need to wait until September 2015 to get the bulk of their money back. In addition, income payments should still continue to be made assuming the underlying investments continue to provide a return. The table below shows the estimated remaining assets and applicable interest rates:

Corey Environmental is due to mature in 2014 while Maher Terminals is due to mature 2015.

I've assumed it costs $1.4m p.a. to run the fund (based on the current annualised rate - which is a bit rough and ready), no currency impact and the investments will be realised at the current book value at the targeted dates. Based on this, I come up with an annualised return of 18% p.a. if shares are bought at the current price of 37.5c.

These numbers are back-of-the-envelope and should not be relied upon without further examination. The main problem with this type of trade is that usually the upside is capped: it is rare that assets of this type will sell substantially above book value. Therefore, the primary source of surprise would probably be to the downside.

That leads us to risks. All sorts of things can go pear shaped here. The valuations may change substantially - they already have in some other cases such as the Hyne & Son investment. Cory Environmental is on a 'negative' credit watch. Maher Terminals is a large part of the portfolio; a small hiccup may have a big impact on the HHY valuation. And then of course is the potential for left field events.

All very interesting. I am doing some more digging on this one.

Kristian 

Disclosure: small position in HHY 

*(check out page 94 of The Essays of Warren Buffett: Lessons for Corporate America)

FSA Group Ltd (FSA)

Nigel Littlewood is a professional investor and close friend and colleague. Nigel mostly specialises in Australian small cap stocks and has been a big believer and backer of FSA. Nigel recently wrote this article on FSA, which I thought was worth sharing. 

Please note this article was prepared before the recent stock market sell-off. Figures have not been adjusted. I hope you enjoy the read. Also note that Nigel Littlewood is not licensed to provide financial advice. 

Kristian 

Disclosure: own FSA (and so too does Nigel Littlewood) 

FSA GROUP A quality micro cap and specialist finance services company

FSA was born back in 2000 when four eager debt industry individuals got together to start their own business in the debt agreement industry.  Two of the original founders, Deborah Southon and Tim Maher, remain with the company today.

WHAT ARE DEBT AGREEMENTS?

Since the end of the Second World War and the introduction of consumer finance, the level of money borrowed by consumers in the western world has steadily increased. Credit card debt in Australia now totals $36bn generating interest costs of $6.2bn p/a. There are several drivers to this but whatever the reasons, most people are now used to living with debt. However in the last 20 or so years, consumer debt started to reach epidemic proportions and individual bankruptcies started to soar which clogged courts and led to social and financial problems for individuals and government.

As a proposed solution, a debt agreement, was introduced into the Bankruptcy Act (1966) in 1996. A debt agreement is a simple way for an indebted borrower to come to a payment arrangement with their creditors. A debt agreement provides creditors with a superior return compared to bankruptcy and provides the borrower or debtor with a payment arrangement they can afford and ultimately avoid the stigma of bankruptcy.

The industry is overseen by the Insolvency and Trustee Service Australia. More information is available at www.itsa.gov.au.

HOW DO THEY WORK?

Basically when a borrower gets to a point where they cannot repay their debt i.e. they are insolvent, they can approach their lender(s) and try to negotiate a debt agreement. However, most people don’t possess the skills or confidence to do this so they call FSA (or a competitor) who assesses their financial position, negotiates on their behalf with the creditor(s) and then administer the agreement over its life to (ideally) a successful completion. FSA gets paid a percentage (15-20%) of money collected over the life of the agreement.

That is where FSA started and within a couple of years, they had backed the company into a public shell and FSA was born. The future of FSA was in the hands of the executive directors Tim Maher and Deborah Southon. They would both prove to be very competent asset allocators and sensible managers and with the vast majority of their own wealth in FSA shares, appropriate shareholder-friendly incentivisation is in place.

As the company grew it became the largest broker of non-conforming home loans in Australia. Some people who call FSA end up refinancing their home mortgage to repay their unsecured debt rather than entering a debt agreement. The pre-GFC debt boom and associated securitisation market resulted in FSA exploiting the opportunity and providing its own non-conforming home loans rather than just broking other companies’ products. This created another arm to FSA along with debt agreements and the smaller factoring business.

The GFC has slowed the growth of this division but the home loan book has performed exceptionally well with nominal capital losses and an average LVR of about 67%. During the GFC the capital provider (Westpac) stood by FSA and the business continued to perform.

The macro environment has finally started to turn in FSA’s favour as banks start to clamber for market share. While this is a real positive and in coming months could lead to an increase in both the size of the home loan warehouse facility and an improvement in its terms, it is incredibly important to appreciate that through the worst debt crisis since 1929, FSA didn’t lose capital for its lender or shareholders and maintained a strong relationship with its bank when many other businesses simply failed.

WHO ARE THE EXECUTIVE DIRECTORS

When investing in the small cap space there is perhaps no more important single element than the quality and integrity of the senior management team.

Over the last 8 years I have got to know Tim Maher well and seen him manage his business through various challenges including the GFC. During this time, I believe Tim has performed brilliantly, nobody is perfect but Tim is smart, motivated, energetic, and appropriately conservative with an entrepreneurial flair and what I affectionately term, a bit of mongrel. Tim is not afraid to get in the ring if he needs to. 

I have used Tim as a benchmark for small cap managers in my investing and find few his equal. In recent years he has become a passionate student of Warren Buffett and capital allocation and investment theory. This ultimately contributed (along with some friendly shareholder prodding) to his decision in mid 2011 that the best allocation for excess capital in the business was to buy back stock at what we all agreed was ridiculously cheap. When Tim announced the buyback (and first dividend) the stock was 27c, trading on a P/E of about 4 times and below its NTA. The company has since bought back around 13m shares (10%) and paid 4.95c in divs.

Tim owns about 36% of FSA and his first priority is to conserve that wealth, consolidate and grow when low risk opportunities present themselves.

Joint founder Deborah Southon who owns 10% of FSA complements Tim. Deborah runs the debt agreement side of the business and sits on the board. She probably knows this industry better than any other executive in Australia and has done an outstanding job consolidating FSA’s position as the dominating market leader in the industry with market share over 50%.

BUSINESS SUMMARY

FSA has three distinct divisions:

1    Services

This division consists of debt agreements, personal insolvency agreements and bankruptcy. It contributed circa 78% of last year’s pre tax profit of $14.9m.This industry was explained above but FSA is the industry leader both by market share circa 51% and by technology and marketing spend. It is the dominant player in the industry.

2    Home Loans

This division contributed $4.1m (NPBT) last year representing 27%. These loans are classified as non-conforming. Therefore, the margin is high along with the risks however, FSA’s experience and track record show that if it’s managed carefully and growth is not chased exuberantly, an attractive return on capital is generated in this business. Ongoing negotiations may lead to a change in the size and terms of funding but I have not factored in significant growth at this stage although the division has big potential.

3    Small Business
This division consists of factoring finance which, is still small. It reported a loss last year due to restructuring costs. Its loan pool grew last year from $12m to $25m at the end of the 2012 fiscal year. While this business is still small, it has the potential for plenty of future growth albeit at a measured pace.  I expect it will contribute around $1m NPBT in 2014.

FINANCIALS

The current share price of 75c with shares on issue of 125m provides a market cap of $94m, there is however around $10m of excess cash on the balance sheet that can be backed out for valuation purposes although the conservative nature of management is such that I don’t expect that capital to be returned to shareholders outside of the (potential) ongoing buyback and regular dividends.

The company has provided NPAT guidance this year and I’m expecting a result around $10.5m providing a P/E of 9x or 8x if we back out the excess cash. Free cash flow is close to NPAT due to the nature of the business so another dividend at the end of the financial year is likely. I’m expecting 2.25c ff making 4c for the full year, equating to a payout of circa 48%. The board has no stated payout ratio but I know Tim and Deborah would ideally like to pay a higher dividend each year, business permitting.

The company has no corporate debt on its balance sheet. The debt from Westpac that sits within the non-conforming home loan warehouse and the factoring finance warehouse is secured by the underlying assets and is non-recourse and limited recourse respectively to FSA.

For 2014 I expect some growth in the home loan division, a flat result in debt agreements and growth in factoring providing npat around $12m (9.6c p/s).

This provides a forward P/E of around 6.5 times based on further accumulation of excess cash (circa $6m after total div payout of $6.25m) on the balance sheet (EV of circa $80m). If FSA pays out 5c (52%) it will yield 6.7% fully franked based on the current price of 75c.

Given FSA is hardly using any additional capital to grow, its profit is effectively free cash flow. If we invert the multiple of 6.5x (as Warren Buffett might) we get a free cash flow yield of about 15% (after tax). That means if you could buy the whole business and consolidate it, that is the yield you would be looking at….Not bad in this environment I’m sure you will agree.

RISKS

As with all investing there are risks. Businesses have problems that’s a fact of life and things happen but when you have a market dominating position, strong IP, debt free balance sheet and good management, risk is somewhat mitigated.

Australians since the GFC have gone from being net savers of zero to savings around 10% of their earnings. If this trend accelerates it is possible the debt agreement business in time starts to reduce in size. Currently, FSA administers around 5000 new agreements per year. If this falls, earnings will fall in that division.

The funding of both warehouses may not be renewed and this shuts down both divisions (assuming no replacement funding can be found). Given Westpac stuck with FSA thru the GFC, I see this as a remote risk.

Key man, Tim is 41 years old (Deborah is around the same age but I’m too afraid to ask), fit, just married and about to have his first child. He is highly motivated to be with us for a long time although I think every shareholder should send him a letter warning him off his occasional cigarette. No doubt in any small business key man risk must be considered but both Deborah and Tim can fill in for each other.

The board has been with Deborah and Tim for a long time and accumulated a great deal of IP however I expect much of the board to undergo a generational change in the next few years.

The home loan business is leveraged to employment and property prices. A significant deterioration in either or both of these variables pose potential risks for this division.

Factoring is a fairly high risk business subject to fraud and small business failure. As this business grows its risk reduces via customer diversification.

The market as always posses its own risk or at least volatility. During the  the GFC in a fit of fury and fear, FSA shares dropped from highs of $1 to lows under 20c for no great (company specific) reason. Volatility is part of investing and its important (as long term value style investors) to keep your eyes on the company rather than the market.  We should be endeavouring to exploit market volatility not be victims of it.

UPSIDE

As I like to say: consider the downside first and only then consider the upside. For taking the risks above we obviously want a much better return than the risk free rate.

Upside will come from dividends and that I’m confident about. Upside should come from modest earnings per share growth over time and the incremental increase in share price. Even if the P/E stays the same, the share price should increase by the eps growth. Next if the company continues to buyback shares, this should lead to increase in eps. Given where the share price is, cash in the bank is earning around 2.5% (before tax) and buying shares back (as illustrated above) is yielding 15% after tax so buying shares makes sense. 

Its worth pointing out that this stock is not leveraged to GDP, global interest rates or central bank activities while so many businesses are leveraged to the economy doing well. FSA is largely insulated and in some ways is counter cyclical.

Finally, there is a fair chance that after many years of institutional neglect, FSA will receive some institutional shareholders and thereby see a P/E re-rating. This is a maybe and not something that I would bank on but it is a possibility. With a rerating from 9x to 12x, the share price would move up 30%.

VALUATION

This of course, is always difficult because ultimately it’s a function of future earnings being discounted back to today at an appropriate discount rate to reflect the risks taken in the business.

Given the nature of the business, the free cash flow yield, strong balance sheet, sound management, I am a happy holder of this quality micro cap and expect it to move into the small cap range over time. I would be most surprised if this company did not provide satisfying investment returns for long-term patient investors who like a regular dividend.

I am a shareholder of FSA.