Interview with Greenstone Value Opportunity Fund Part 2

Here is the second part of the interview from yesterday. For more information on Greenstone, contact Chris White (chris [at] greenstonefund [dot] com).

In managing a book, how do you hedge? What are your thoughts on shorting?

We don’t hold ourselves out as short guys, and Greenstone is long-biased from a standpoint of individual holdings in the portfolio. However we view it as necessary to hedge out the portfolio. Our view is that if we’re going to do it, we’re looking to generate Alpha. We look at individual shorts, as well as broad-based hedging through market or sector ETFs. We really only started shorting in April 2009. Our shorts lost us only 4% in face of a 60%+ broad-market rally, so maybe we should hold ourselves out as short guys. It felt a lot more painful at the time, and to us it’s somewhat of a miserable effort. For example, there are 2-3 shorts we know far better than any name we should from a fundamental perspective, but the market loves the story, so ultimately it does not matter how well we know the story and the stocks continue to move higher. Ultimately we’d like to try and put forth the same amount of patience we show our longs. It can be hard to not to get emotional about stocks that are over-hyped and fooling the market when you’re a deep value investor. We try not to short individual companies on valuation multiples alone, hoping to find something with a relatively near-term catalyst, like a patent roll-off, one off sales, a new entrant to the market, questionable accounting; essentially something in addition to just valuation alone. A lot of times we find what we think are good short candidates when evaluating the competition during our due diligence process on the long side. This often leads to something akin to a pair’s trade, where we are long the cheapest issuer in a group, and short the priciest issuer. In addition to individual shorts, we use sector and broad market ETFs to hedge the broad-market exposure of the portfolio, particularly when the technicals tell us it is prudent to do so. We use sector ETFs if we are over-exposed to certain sectors, such as energy, and broad-market ETFs like SPY or TNA to simply reduce the gross long exposure of the portfolio as a whole. We have also found the leveraged ETFs to be particularly interesting, as their structure inevitably dictates that they destroy their NAVs over time. Because of leverage, it seems to us they are constantly forced to buy high and sell low in order to maintain the proper leverage ratios. Therefore, we constantly monitor the market for the new issuance of these securities to try and take advantage of them and add the right exposure for the portfolio. As an example, if we wanted to short small caps, we might short TNA (3X small caps). That way, we have two ways we can win on the trade: 1) if small caps decline, and 2) if the NAV of the fund is eroded over time due the required rebalancing of its portfolio.

In your opinion, why do assets get mispriced?

In our opinion, emotions are the most defining reason why assets become mispriced, and the most common emotions that impact markets are fear and greed. Fear is an amazingly powerful thing, and it can work both ways. Losing is one of the most painful feelings we can describe, and the fear of losing one's hard earned money can make people do uncharacteristically stupid things. Like sell at the bottom of the market, just when the talking heads on TV are panicking the most and valuations have become the most interesting for long-term investors. Greed, or the “fear of missing out” can work the other way, though, and cause investors to move too much with the crowd, have an unhealthy herd mentality, and help fuel asset bubbles to dangerously high levels. It is amazing to us how quickly investor sentiment can shift from euphoria one moment, to a depressed outlook with nothing but trouble ahead. These emotions cause people to lose the ability to accurately define changes in news, earnings, or whatever in either favorable or unfavorable directions.

We try and filter out the nonsense from people like TV commentators, and essentially just invest in valuations of tangible assets and cash flows, knowing that at some point the market will want to court us at the dance again. If we couple good business judgment with an ability to insulate our thoughts and behavior from the super contagious emotions that swirl about the market place, we think we can be successful. We tend to use sentiment readings as contrary indicators, becoming more bullish when others are scared and vice versa. We actually think one of our key strengths is not getting carried away in any direction because we’re naturally very skeptical individuals. There have been economic bubbles or asset class bubbles since the beginning of time; markets overshoot and then over-correct, but ultimately that is what provides the mispricing opportunities.

If you could have lunch with anyone - alive or dead, who would it be and why?

Buffett, because he is legend. But unfortunately it’s gotten too overpriced to have lunch with him. We’d just take a DQ cheeseburger…shoot we’d even drive to Omaha, and pay!

If you were to peg one valuation technique you really rely on - what would it be? And why?

We track 400 companies across different market capitalizations and industries in a proprietary universe of companies that we feel have at least a chance to be a “deep value.” Underlying each company is a unique spreadsheet where the company’s financials are massaged by us to adjust for one-time events, seasonality, cyclicality, and so on. All of the underlying company-specific spreadsheets flow into a master valuation sheet, using real-time pricing data, that sorts the universe based on what we call a reward-risk ratio. This is a calculation of the multiple of the potential upside from current market if it reaches fair value relative to the potential downside from current market in a worst case scenario. All this model really does is stop us from spinning our wheels looking at companies when we should be focusing elsewhere. Because the universe we follow is very diverse, it also alerts us to flows in and out of certain industries and capitalizations. The other thing about the model is that sometimes companies get cheap for days, months, or just a few minutes. If it’s just a few minutes, it can be harder for us to react if we haven’t done the work…you win some you lose some…but if we stick to our process and discipline we’ll make it work more often than not. From there the valuation technique goes down another tier to EV/EBITDA and Market Cap/Free Cash Flow. We use an adjusted annualized number of the most recent quarter’s EBITDA or FCF, and we rarely if ever rely on forward estimates. What we are looking for are companies that are trading at 5X or less of these two multiples, and the process helps us focus us on the stocks that are the cheapest. Once we're alerted, then the fundamental hard work begins.

How do you generate ideas?

As I mentioned previously, we track a proprietary universe of around 400 individual companies in a real-time valuation model. The goal is to have the right 400 companies in this universe. If there are too many companies, it becomes too much work to accurately track, and the quality of the process is eroded. If there are not enough names in the model, then the breadth and scope of the process is not sufficient to produce enough ideas and give us a feel for where money is flowing. So a big part of what we do every day is make decisions on what companies need to be added to the model, and which ones need to be removed. For every new idea we get, we try and remove a company that we have concluded is a broken story, a value trap, will never get cheap enough, has an unfixable balance sheet, etc.

We use a variety of methods to try and identify new opportunities. We are members of and track high-value websites, such as the value investors club and the distressed investors club. We obviously have a number of like-minded friends and buy-side associates that we exchange information and ideas with. We do a lot of screening with services such as Capital IQ, and we try to read everything we can get our hands on in order to stay informed. Because we are trying to identify companies that are flying under the radar and trading at deep value multiples, we rarely find new ideas at sell-side conferences, where sponsorship already exists. At the end of the day, we think it is about having an open mind towards new opportunities, and more importantly constantly expanding our network of people, places and websites that share our investment approach.

We noticed some distressed debt ideas in your top holdings and commentary. Is that a matter of style or are you seeing interesting opportunities in the distressed space?

It is both a function of style and the opportunities we saw last year. Obviously, from a deep value investor’s perspective, the opportunity to invest in something based on an analysis of liquidation value relative to tangible assets can be very compelling. The economic slowdown and financial crisis also produced a lot of names to look at. However, we aren’t actually seeing as many attractive opportunities in the distressed space right now as we would like. We are probably seeing more post emerging opportunities right now. But that’s today. There was a tremendous amount of high yield debt issued in the 2005-2008 period, with a lot of that coming due in the near future. A lot of this debt was taken on in the thought of continued growth and with too rosey of an outlook going forward With choppy markets ahead, the slowdown in business fundamentals from 2005-’08, and a slow growth environment for the foreseeable future, distressed investing should more than hold it’s own going forward.

We saw where Pimco recently published a piece about dollar percentage default rates increasing for mid cap companies. While corporate America has done a tremendous job in curtailing capex spending throughout the recent crisis, we doubt this can continue for too long without impacting their underlying businesses, and the point from the PIMCo piece is that mid and small cap companies are more constrained to take further capex out of their businesses. Banks are now also recovering to the extent that they will actually call on companies that violate loan covenants. For instance, last year we had a crude tanker investment, and the company was asked the questions “are you breaking any loan covenants, are you hearing from your lenders?” Their response was that “the banks don’t call us, we have not heard from them in over a year.” With NAVs off 50% in a year, the banks didn’t want to create another run on assets, and end up owning boats.

We like the distressed space because quite often more information is available to us when a company is in chapter 11. The monthly operating results requirement, as well as the ability to monitor the items filed on the court docket, make it seem that the information flow is better than what would otherwise show up in the K’s and Q's. Obviously, there are other nuances that create risk: who the judge is, can the creditors wear down the equity holders, does the debtor have access to capital markets, who are the financial advisors, how much will be eaten up in fees, etc. But we think for people willing to spend the time and do the work, the variables can be broken down and this creates opportunity.
Talk about one or two ideas your find particularly compelling. Why are they mispriced? Where is the market wrong?

Tronox Inc. (TRXAQ and TRXBQ)
I should probably first say that we own both the debt and the equity in Tronox. However, given the industry bottoming after a 2 ½ year trough market in TiO2, the restocking of inventories, and recent price increases, we think Tronox’s MORs will improve going into the seasonally strong Q2 and Q3. Therefore, there probably is greater upside/downside for the equity right now than at any time in this process.

The reason we think the market is wrong about this company is the bankruptcy process risk and disclosure. We recently sent a letter to the Judge in the case regarding Tronox’s unfulfilled obligation to file periodic results of the operations of its Non-Debtor subsidiaries, as required under §2015.3(a) of the Federal Rules of Bankruptcy Procedure. There are 18 wholly owned non-debtor subs, and an undivided 50% interest in the assets of four non-debtor entities comprising a joint venture in Australia. It really seems to us that the debtors have dragged their feet exceptionally well on this issue, as we’ve seen no operational disclosure for these entities since the case started 19 months ago. It would be very interesting to see where cash is accruing on the balance sheets of some of these non-debtor subsidiaries.

Even in spite of this game of “hide the ball” on behalf of the debtor, if we annualize the most recent April MOR, we get $175mm in EBITDA, $58mm in free cash flow, and working capital north of $550mm. In Huntsman’s stalking horse bid from last year, they only requested $300mm in working capital; one would assume that number was aggressive given that they were not bidding against anyone else. Just applying a 5X multiple on EBITDA, which we don’t think is aggressive, and adding the $250mm in excess working capital, we get a $1.125bn enterprise value. After subtracting liabilities of $436mm, post petition debt of $423mm, and environmental obligations of $122mm, you get roughly $3.42 in potential equity value. This analysis doesn’t give any value to the non-debtor subsidiaries or their Australian joint venture, and it still yields upside potential of 5-7X current market price.

There is an informative blog on Tronox http://tronoxequity.blogspot.com/

Hawaiian Holdings (HA)

Hawaiian Holdings is the parent of Hawaiian Airlines, which I mentioned earlier. The company is the a beneficiary of the bankruptcy process; not only has it emerged unencumbered, in fact it has net cash of close to $100mm, which is unheard of the in the airline industry. The company has very sound management, and a sound strategy going forward in accessing emerging international markets. With airlines, the big three things to consider are labor costs, fuel costs, and leverage. Their labor negations are complete, not hanging over them anymore, and Mark Dunkerley just resigned his contract. Their fuel is hedged roughly 41% for the remainder of 2010, and they’re unlevered. From a multiple perspective, annualizing last year’s quarterly EBITDA yields approximately $130 million. Based on this earnings power, the company is trading today at roughly 2.1X EV/EBITDA.

The other wild card that investors don’t probably fully understand, or don’t care about because of the market cap, is the recent Haenda approval and the opening up of discretionary recreational visas from China and other Asian countries to the United States. The company recently won approval for a direct route between Haenda, which is a preferred airport out of Tokyo, and Honolulu. South Korea also just relaxed their visa stance, and it will be interesting to see how this models for Hawaiian. Basically, they’re an unlevered player in a consolidating industry that has access to key Asian markets. I would note that the company’s term A and B loans are due late this year, and early next, but we are not concerned about their ability to find attractively priced replacement facilities.

Thank you to the Greenstone team for such an informative interview! We wish you the best of luck in your capital allocating endeavors...


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Anonymous,  6/18/2010  

It should read Haneda not Haenda airport

William Hamilton 6/23/2010  

The HA analysis is misleading since the company leases most of their aircraft under operating leases, which keeps the liabilities off the balance sheet. Most airlines either use capital leases or own their planes, which creates obligations that are categorized as debt on the balance sheet. Adding $976m in operating leases (from '09 10-k) to the EV, I get an EV/EBITDA over 9. Not saying its a bad investment, just saying its definitely not the screaming deal this guy thinks it is.

Anonymous,  6/24/2010  

You bring up a fair point, but if you propose to add the operating leases to “debt” for purposes of calculating EV, should you not also back out the operating lease expenses from Ebitda, and treat them like interest? By our calculations, we arrive at an EV/Ebitda under this scenario of around 4.7x. Any way you slice it, HA is about 50% cheaper and has much less leverage than the comps. With a local market near-monopoly and international growth opportunities, we like their chances.

Anonymous,  6/24/2010  

You bring up a fair point, but if you propose to add the operating leases to “debt” for purposes of calculating EV, should you not also back out the operating lease expenses from Ebitda, and treat them like interest? By our calculations, we arrive at an EV/Ebitda under this scenario of around 4.7x. Any way you slice it, HA is about 50% cheaper and has much less leverage than the comps. With a local market near-monopoly and international growth opportunities, we like their chances.

Anonymous,  7/08/2010  

looks like his Tronox investment isn't working out so well.

a well done pump and dump on the various boards (sumzero, VIC etc).


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.