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.

Read more...

Interview with Hedge Fund Manager Peter Lupoff - Part 2

Last week, we posted an exclusive interview with hedge fund manager Peter Lupoff. We continue the interview with Peter in the second part of the interview. As a reminder, you can find more here about Peter's hedge fund Tiburon Holdings

Talk about a current investment idea that is particularly compelling

I’d rather not talk about a specific idea at the moment but would rather talk about themes. We get ideas three ways:

• A top down “thematic” approach. From this, we delve deeply for those trade ideas that can survive the five prong methodology (see part 1 of interview)
• The gritty work the phones, contacts, read the news, watch the markets for leads way – old school
• “Mining the Portfolio” for ideas – that is, the deep work on any one name necessitates looking at comps and events, and in doing this, we uncover other trade ideas.

Let’s talk about themes for a moment. They can be grand in scope, given industry or economic circumstances or extremely narrow, given very rational and predicable behaviors (Rational Actor’s Assessment).

One major theme we played from ’07-’08 was shorting regional and community banks in the top 5 foreclosure markets, trading at (then) 3.5X tangible book and with 80% of their loans in home mortgages, HELOC’s, commercial mortgages and raw land. We then threw out those banks that had assets that could create events that could hurt the trade, i.e., SunTrust’s interest in the Coke trademark, etc.

Going into Summer, 2008, with a complete drought in the capital markets, we ran a screen for companies with ’08-’09 maturities and significant revolving credit availability, hypothesizing the wholesale draw down of the revolver and satisfaction of the near term maturities. Oh yeah, and the freak out of the equity over this action as well. I don’t recall what order it came in, but Apollo did coercive exchanges in Harrah’s and Realogy. Was it not predictable that doing one, they’d come with the other?

The inflow of significant retail money to Loan and High Yield bond funds is not only impacting secondary market prices, but stoking new issue markets opportunities for companies facing near term covenant issues or maturities. As some paper cycles out of portfolios due to refinancing, these technically driven investors are, in some instances, structurally compelled to replace with secondary market purchases or new issues. Assuming we properly do the Rational Actor’s Assessment (again, as part of the Five Pronged Methodology), we should be able to determine what company’s bank facilities have a majority of CDO holders. In those instances you can pretty well count on amendments passing that extend maturities. In those circumstances where near term maturities are extended beyond and once longer dated bond, there is upside in that bond.

I’d like to tell you that there’s a thematic trade that makes sense simply shorting “overvalued” securities in this, now overheated market. I don’t disagree with my friends and colleagues that say “the fundamentals don’t support these valuations” etc, but we live in the here and now, operating in real markets with money to be made or lost daily. How different is the refrain of investors that are short today on fundamentals from the deep value types that were long last year.

Fundamentals will matter and that work is necessary and valuable, however it isn’t what is driving these markets at the moment. Without an outward looking component to your methodology (“Process, Legal and Technical”), you can miss this. I’d hate to be the manager explaining to investors how we’re right and the markets are wrong.

I mentioned what I learned from Marty Whitman, but here’s what I learned from Izzy Englander: as mentioned, I was short regional and community banks in the top five foreclosure markets with 80% of loans in resi and commercial mortgages and raw land, when, in 2Q08, every bank CEO, as if handed a script from Hank Paulson, recited on Quarterly calls, “We will not cut the dividend today, we will not raise new money today”. I gave up half my gains on that theme in a matter of days. I spoke to Izzy about it, explaining why I was right and he reminded me that “you may be, but we are not in the being right business, we are in the money management business, and those are two different things.” You are a fiduciary and have a covenantal bond with the investor and their capital. DO NOT LOSE MONEY. The fund is not a weapon to prove right or wrong. Why not try to be right every day, rather than “eventually”?

Any advice for those looking to get into the distressed debt investing field?

Be a student of the business. What I mean by that is read everything. Not research per se, read books on the relevant topics. Read the sell-side strategist’s materials. Talk to people that have been around. I have worked with some of the best known, best regarded, often perceived to be difficult people in this business. Actively covet dialog with such people.

Don’t be in a rush to do things before you have any real experience. Do what it takes to get real experience. No one has time to train in the traditional sense, so when you get yourself in the right place, be sure you have the base minimum requisite skills to do your job.

Check your ego at the door and don’t get defensive about disagreement. In the right organizations, that dynamism is how the best decisions are arrived at. You are doing your part.

Don’t believe you have a monopoly on brain power or perspective. Be open to the unique and odd places you might learn things that make you better at what you do and that can help you make money or avoid losses.

On trade ideas, know what you know, know what you don’t know and consider that there are things that you don’t know that you don’t know.

At this juncture in life, what motivates you?

My wife, Kelly and little boy Max are everything.

But as to work: I am at heart, a competitive person. I like team sports, played a lot of football and basketball as a kid. This business gives us an opportunity to constantly take on competition whether its beating an index, convincing an investor to make an allocation, or having conviction about our trade theses to make returns uncorrelated to our peers. Internally focused, I am constantly evaluating how to make more civil, professional and productive work environment.

Now that I have my own thing in Tiburon, I can tinker and build on this as long as I am able. That’s exciting to me. I stepped away from the business in 1998 for a short hiatus and when I came back, very few people were there to help, with the expansion of the business, no one knew who I was. I started from scratch more or less. Faced with that, I conceived the strategy for how I could make it work and executed.

Thank you Peter for the great content! Stay tuned in the coming weeks as we have lined up a few more interviews with players in the distressed debt world.

Read more...

Managing a Distressed Debt Portfolio

I am amazed of some of the resources you can find out there if you know how to massage the Google Search. I was running a search on distressed debt portfolio management (for all you followers out there, the exact search was: "Distressed Debt Portfolio" filetype: pdf). What I found was a fascinating PDF entitled: "Risk Management for a Distressed Securities Portfolio" by Marti Murray. This is a great read for any distressed investor.

You can find the document here: Risk Management for a Distressed Securities Portfolio

This is a must read document for those interesting in distressed debt securities. One of the case studies is on the Worldcom/MCI Bankruptcy, which is a spectacular example of a complex bankruptcy where risk adjusted returns were there for those who did LOTS of digging.

Murray points out one of the keys of distressed debt analysis and bankruptcy investing is to determine the key drivers that will make or break an investment. Sometimes it is two or three variables, and sometimes it is significantly more. As a topical example, the bank debt of General Motors has been on a tear as of late (the revolver is 92, the term loan is 95 - both up 40-50 points from the lows). The two main drivers of that analysis were:

1. Is the security granted for either the revolver or the term loan (they are different) greater than the amount of debt outstanding. Most market participants agreed that that was indeed the case.
2. How much will the government crush you? That is where the discrepancy and the mismatch of price vs intrinsic value really came down to.
   

We are beginning to see that the government (unlike in the Chrysler bankruptcy) is going to play ball with the secured lenders at GM. (As an aside: if any lawyers can explain why the differentiation, leave a comment). So the bank debt rallies in response.

Stay tuned in the coming weeks for some interesting feature (more case studies, interviews, more profiles of distressed debt fund managers) we have been cooking up at Distressed Debt Investing.

Read more...