Mining the Portfolio

On July 1st, a consortium consisting of Ericsson, Apple, Microsoft, Research in Motion, Sony, and EMC bid $4.5 billion dollars to win Nortel's patent portfolio. This offer was well in excess of Google's stalking horse bid of $900M that was put before the bankruptcy court in August. I'd argue that 90% of the players in the distressed debt market felt the number would be larger than Google's offer (the bonds were implying a larger purchase price), but very few people thought the number would be as large as it turned out to be.

I bring this up to introduce a concept I feel is of paramount importance to bottoms-up investors. Mining the portfolio, in essence, is taking information and news from current portfolio holdings, and using it, and the second order effects stemming from that information, to allocate capital in other investments.

The traditional example investors see on a (increasingly more) frequent basis, is when one company gets acquired in an industry, similar companies see their stock prices increase as the market revalues the entire industry to the transaction multiple. To me, this is a difficult game to play because the speed at which the market digests the information and revalues the entire sector. But sometimes, the market may still be pricing similar securities incorrectly even when the news is on the front page of the WSJ.

Take IDCC for instance. Here is a 30 day chart of IDCC. I've marked July 1st with an arrow:

A diligent investor (I know a few that did just this), took the Nortel comp, did the digging on how IDCC's 4G/LTE patent portfolio was in fact better than Nortel's, and started to put the pieces together. And made a ton of money when management did the right thing putting the company up for sale.

In the same vein, Carl Icahn amended his 13D with Motorola Mobility (MMI). He writes in the filing:
"On July 20th and 21st, 2011, the Reporting Persons discussed with the Issuer their view that the Issuer should explore alternatives regarding its patent portfolio to enhance shareholder value. The Reporting Persons believe that the Issuer's patent portfolio, which is substantially larger than Nortel Networks' and includes numerous patents concerning 4G technologies, has significant value. In addition, there may be multiple ways to realize such value given the current heightened market demand for intellectual property in the mobile telecommunications industry. The Reporting Persons intend to have further discussions with the Issuer. "
As Michael Price frequently says, he spends most of his time reading proxy filings and disclosure statements to figure out what ACTUAL dollars are being spent on companies and securities versus a theoretical exercise of applying a multiple to run rate cash flows and calling it a day.

Other "first order" sorts of events would be earnings surprises by comps in the industry, a competitor announcing a price increase of a certain product, a consolidation in an industry changing the balance of power between customers / suppliers (see Medco / Express Scripts), etc. Because, in theory, an analyst should know his companies and industries inside and out, he or she should should understand these first order effects, and be able to communicate how they change the potential revenues, cash flow, or valuations of companies impacted.

Second order effects is a little more tricky, but I believe the opportunities are more interesting. It is always difficult to draw a line saying, "Because this happened, there is a 100% chance this will happen." In my opinion though, the uncertainty makes for increased inefficiencies which leads to larger mispricings. Furthermore, an analyst or portfolio manager than can connect the dots, will find that by deeply understanding the names in the portfolio, these second order effects begin to pop up frequently.

For example, let's say you covered the lodging industry in 2008. Everything is bad. World coming to an end so to speak. You have a few short positions on and are loving life. You talk to some management teams who are utterly pessimistic about the industry and they tell you all building projects have been canceled. First order effect = Results are going to be terrible in the near term. Second order effect = Less supply on market leads to higher prices when the economy recovers and given lodging has massive operating leverage, this will lead to enormous growths in cash flow and transaction prices for properties. The art in all of this is when to cover your short and play for the second order effect, especially since many of these sorts of things are contradictory to the 'next piece of news' information that will drive the security price in the near term.

In fact, mining the portfolio is probably the only reason I will allow myself to talk to management teams. Like Walter Schloss, I understand that the CEO is the best salesman of his company. He does it EVERY SINGLE DAY; probably multiple times (investor meeting, putting a client over the finish line, etc). But asking a CEO how XYZ company is affecting the pricing dynamic or which management team really doesn't understand the current business climate, can pay huge dividends in terms of places for further research.

The question you need to ask yourself is "What are the implications of this piece of news / this data point?" Back those implications with facts and raw data and you could be on to something. Instead of reading sell side reports, I think you should be looking through your portfolio holdings, and seeing how you can leverage all the research and knowledge you have in a particular company or industry (you must have a good amount of knowledge if it's already in the portfolio I hope), into another money-making investment.


John 7/26/2011  

Great, informative article. I'd love to see a more detailed writeup (either as a reply to my comment or as another post) of what types of questions you ask CEOs and other management that extract real, useful information.

Anonymous,  7/26/2011  

excellent article.

Anonymous,  8/23/2011  

I am reading a book: Stalking the Black Swan that addresses your question and decision making. Check it out--it's excellent.


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.