Year End 2013 Portfolio Review

One of my main goals of this blog is to keep myself accountable for my investing decisions because I am a loose believer in the Efficient Market Theory and think most people should invest in low-cost index funds.  All of my retirement accounts and a good chunk of my taxable account are invested in low-cost Vanguard funds (I'm sort of a Boglehead in that sense), but I do believe there are some opportunities for the smallish investor to exploit the market if you have the right temperament and the time/energy to devote to the process.

Strategy Overview
Below is a quick visual of the broad investment themes where I concentrate my time and believe where investors can generate above market returns, the more themes an particular investment hits the better.

I work in the banking/financial services industry, so my background knowledge and circle of competence skews towards investments in asset based businesses.  My goal over the long term (10+ years, multiple market cycles) is to generate an IRR of 20%, which will be difficult, but if I'm going to spend the time and effort, I want to make sure its worth my while over an index fund, otherwise I could be using this time on other income generating activities.

Year End Results and Current Portfolio

I started my active taxable account at the beginning of 2011 (but have been investing since 2004), below are my result from my first three years, a time period where I've admittedly had the wind at my back with only a few short and shallow corrections.  A couple clarifying points, my returns are an annual IRR for each particular year which produces slightly different results based on when I added cash to the portfolio (I haven't made any withdrawals), the 2013 returns are "pure" as I didn't make any additions to the account during the year.  The S&P 500 returns are not based on IRR, so its not quite an apples to apples comparison, and additionally one could argue the S&P 500 is not a proper benchmark given my lean towards small cap value stocks.

At this point, I'm pleased with my overall results, but also realize that I could be just lucky given the short time frame.

I also thought it might be beneficial to post my portfolio on a quarterly basis, so readers can relate and Monday Morning Quarterback my decisions, plus it will force me to only invest in high conviction ideas.  The below is my taxable brokerage account which follows the ideas that I post on this blog, as a full disclosure it's only a smallish portion of my net worth so the appearance of concentration or margin debt is not particularly significant for me, at this point its more of a hobby account.

As of 12/31/13

As I learn and gain experience, I will probably gradually transition some of my retirement accounts and other taxable accounts to a similar strategy, and at that point I'd probably also diversify further to 20-30 positions.  So take the above performance figures and holdings with a little grain of salt.

Year End Quick Thoughts on a few Portfolio Positions

Asta Funding

Asta is quickly turning into my lowest conviction holding and could be on the chopping block if I find a significantly better opportunity, I've started to lose faith in management.  On the latest conference call,  Robby Tennenbaum of Alta Fundamental summed it up perfectly with the following question (via Seeking Alpha)

This question is for Gary. So it looks like the personal injury business is growing nicely, and I'm sure there's good potential in the disability benefits business. But with your stock around $8.50 and a book value in excess of $13, and that's excluding the value of the zero basis portfolio, it's kind of hard to imagine how anything could have a better return on invested capital than buying back your stock. I mean, said differently, the market appears to be valuing all of your noncash assets at about $17 million. So I was hoping you could shed some light on how you think about the trade-off between maintaining the high cash balance for potential investments, especially in this challenging pricing environment, versus buying back your stock.

CEO Gary Stern then punts the question (which he has in the previous couple of conference calls as well) by talking about the private market transaction they did with an activist shareholder (PMCM) in June 2012 - they've also allowed their share repurchase program to expire last March.  First, management purchased shares back from PMCM at $9.40 a share, a premium to the then market price.  Why didn't management do a tender offer so that all shareholders could have benefited?  Probably because they wanted to reduce the activist stake and reduce the pressure on themselves.  Second, Robby Tennenbaum is exactly right, there's almost no investment that Asta could make that would be more accretive to shareholders than to buyback shares.  I just have a hard time selling at these prices, and when I invest in a deep value stock like this, I go in with an intended holding period of 3 years which should give management or the market enough time to realize a firm's intrinsic value.

American International Group

One of my larger positions has been in AIG, and it has contributed significantly to my portfolio's success this year.  I believe that large financials in the US are one of the few places to find significant value.  AIG still trades at a meaningful discount to book value, despite it's great turnaround in both operational metrics and capital allocation.  The company remains overcapitalized and will have significant opportunities to return cash to shareholders, hopefully in the form of share repurchases if its market price remains below book value.  Increasing interest rates should also benefit AIG as their low yield fixed income holdings roll over generating a higher ROE and EPS.

Early in 2014, I plan augmented my position (with fresh cash) in the AIG common stock with the TARP warrants that were issued in 2011 with a strike price of $45 and a maturity date of 1/19/2021.  I probably should have bought the warrants initially, but despite the run up in 2013, they still represent a great risk/reward profile and one of the few opportunities to earn a high IRR for 7+ years (also potentially valuable tax deferral).  The warrants come with a few anti-dilution adjustments to protect holders from dividend payments (above $0.16875 per quarter, the current dividend is $0.10 per quarter), stock dividends, rights offerings, and above market tender offers.  With the ILFC sale approaching a resolution, AIG remains one of my highest conviction holdings and should be setup for another good year in 2014.

2013 was a great year for the markets, I'm pleased to have out-performed over the broad market, and eked out a small gain over many diversified mid/small cap value funds.  Thank you for reading during the past 12 months and Happy New Year.

Summary of 2nd Quarter Results

Below is a brief round up of a few names I've mentioned on the blog before and their recent results.

American International Group
AIG had another nice quarter, exceeding expectations and announcing the initiation of a $0.10 dividend and another $1B in share repurchases.  These moves were surprising given the drama surrounding the ILFC sale to a consortium of Chinese buyers, which has seen several deadlines come and go.  They're still working with the consortium to see if a sale can be completed, the deadline has been pushed back to the end of August, but AIG is also preparing for an IPO of ILFC later in the year that would de-consolidate ILFC (meaning they'd sell at least 51%) from AIG's financial statements.

AIG's book value is now $61.25, and its recently trading for just under $49, so the discount to book value has been closing fairly quickly.  While I still view AIG as a long term hold, I would consider selling for around 95% of book value which is still a little while off.  In the meantime hopefully book keeps growing with retained earnings and gets accelerated with AIG repurchasing shares at below book.

Calamos Asset Management
Calamos Asset Management's (CAM, but CLMS is the ticker) market value hasn't moved much since I initially profiled the company a few months ago, but the assets under management have taken a 10% slide to $27.4 billion as of 7/31.  As a result, pre-tax earnings are down over 30% from last year's run rate, proving the operating leverage in the asset management business works both ways.  Their flagship Calamos Growth and Calamos Growth & Income funds are suffering large outflows due to poor recent performance; the Calamos Growth Fund is in the bottom 92% of its peer group over the last five years, according to Morningstar, making it a dreaded one-star fund.  What financial advisor wants to answer the "why am I in a one-star fund" question from a client?

Calamos has been countering their growth fund strategy issues by introducing several new value and alternative strategy funds to diversify their revenue business model.  The alternatives segment is the one strategy where Calamos is seeing net inflows, and I think that it has the most potential as its not a strategy that's easily replaced by an index or passive fund.  Financial advisors are moving assets to index and passive mutual funds, traditional managed A share type funds are at best out of favor and might be in a permanent secular decline.  Alternative mutual funds are an easy sell after the past decade of volatility and given their complexity, one where the management fee is a more justifiable, maybe.

The value in Calamos is still primarily in the odd corporate structure that causes the operating company to be consolidated with CAM, but where CAM only owns 22.1% of the operating company.  This consolidation hides the assets that are attributable just to CAM, which are worth roughly half the market capitalization.  Based on the same assumptions as my original valuation, I put the CAM's current value at roughly $16.39 per share today.

The Calamos family has the right to exchange their ownership for CAM shares based on a fair value approach.  The above is the quarterly reconciliation that Calamos publishes based on the accounting quirk that's the primary reason its undervalued, but it could also be used as the reason for the Calamos family to dilute the CAM shareholders out of that value under the guise of a fair value exchange.  The shares issued line under the no recognition of other assets assumption is almost twice the shares in the full recognition assumption.  That's been hard for me to get comfortable with, so despite the CAM shares being materially undervalued, it's remained on my watch list.

Ultra Petroleum
My natural gas pick, Ultra Petroleum, had another good/boring quarter as they continue to keep capital expenditures within cash flow and just tread water until natural gas prices fully recover to a more normalized level.

One interesting takeaway from the conference call was when CEO Michael Watford said the following about how they value their assets:

"So a quick reminder of how we view our assets. At $4 gas, we restore all the value and volume to our proved reserves. That puts us at 5 trillion cubic feet of proved reserves and PV-10 value of $5.25 billion, which is approximately our enterprise value today. Looking forward a bit to $4.50 gas and ignoring the 5-year limit on PUDs, Ultra would have 9.2 trillion cubic feet equivalents of proven light reserves, with a PV-10 value of $8.1 billion. This translates into a $20 per share increase in stock price."

$4.50 gas might be farther away than it sounds as prices have moved back down to under $3.50 in the past few weeks.  On my favorite slide in their presentations, Ultra doesn't forecast $4.50 prices until 2016, but its a comment that I wanted to keep highlighted for future reference.  The other management comment I liked was the possibility of a share buyback or dividend in the future with their free cash flow, versus all the talk of an acquisition last quarter.  Given the high returns of their Pinedale asset, I don't see why they'd be looking to dilute those returns unless it was an acquisition for acquisition's sake.

I picked up some shares in the $16-17 range earlier in the year, and recently sold an equal amount of higher cost basis shares to reduce my position size to a just above average weighting.  I wanted to take some risk off the table and with Ultra's share price increasing with natural gas prices decreasing, seemed like a good opportunity.

Disclosure: I own shares of AIG, UPL, no position in CLMS

Summary of 1st Quarter Results

Instead of posting a whole series of short posts on the recent results of companies I've discussed on the blog, I thought I'd start summarizing and grouping my thoughts together.

American International Group
AIG posted first quarter results that the market absolutely loved, driving the stock price up considerably for a mega-cap name.  The big headline is AIG's combined ratio dropped below 100 for the quarter, meaning they're making an underwriting profit and not just relying on investment returns to drive profitability, which often leads to riskier investments.  This is significant because since 2005, AIG's P&C business has produced positive underwriting income in only two years (insurance expense has exceed premiums by about 4%).  AIG's Life and Retirement business also posted improved results, mainly as a result of the stock market performance in the first quarter driving up assets.  The improved housing market has also lifted their United Guaranty Corporation business, but with it being such a small piece of AIG, does it make sense to sell this unit or spin it off given the recent love for names like Radian?  I'm probably not smart enough to answer that question.

AIG's thesis is still intact, ROE is inching towards 10% and the book value is about $60 per share, the market price should keep grinding higher closer to book with the help of their debt reduction, stock repurchases, and the initiation of a dividend.

CEO Bob Benmosche appeared yesterday on CNBC to discuss their results, a few awkward Mario Rubio like water bottle moments aside it was a good interview.

Tropicana Entertainment
Tropicana posted relatively weak first quarter results citing continued negative impact from Hurricane Sandy at the Atlantic City property, company wide revenue was down over 8% compared to the same quarter in 2012, but net income was up as a result of their debt refinancing.  We know that gambling spending is down nationwide, but when will Hurricane Sandy no longer be a valid excuse and its instead its really just Atlantic City in terminal decline?  Tropicana also disclosed that in January they settled real estate tax appeals with Atlantic City.  Tropicana will receive $49.5 million in the form of future tax credits ending in 2017, a pretty significant number given AC revenues that should drop straight to the bottom line (the $49.5 million is front weighted towards 2013/2014).

Tropicana also announced an agreement to sell the River Palms hotel and casino for $7.0 million, with the closing happening in the third quarter.  $7.0 million sounds cheap to me for a 58,000 square foot casino, a hotel, and 35 acres of land, but Tropicana has been hinting at problems with the Laughlin market in the past and in particular with the River Palms operation, so it shouldn't have been a big surprise.

Overall, the thesis here hasn't changed, Tropicana's true value is being hidden by its low float and net cash position which should be used to either acquire or build new casinos.  Icahn Enterprises (IEP) has begun providing an Indicative Net Asset Value Calculation on their quarterly press releases; IEP raised its valuation metric from 8x EBITDA to 9x EBITDA, valuing its 67.9% stake at $551 million, making the entire company worth $811 million, or roughly $30 per share versus the $15.75 its trading at today.  But given its lack of liquidity, not a name for everyone.

Ultra Petroleum
No real surprises with Ultra Petroleum's results either, production dropped as they reduced capex throughout 2012 while waiting for gas prices to respond to a more normalized supply/demand environment, which is finally happening with prices now above $4.  The increase in gas prices have brought the PV-10 value of their reserves back up to $5.25 billion, but due to accounting rules, Ultra won't be able to reverse the write-downs on their balance sheet, but the assets are still there and quite valuable due to Ultra's low operating costs (cash flow margin @ 55%, net income margin @ 26%).

On the conference call there was more talk this quarter of looking to acquire an asset that would be a "third leg of the stool" to their Pinedale and Marcellus assets.  Ultra would use their free cash flow from 2013 and 2014, plus some additional debt to make the purchase, and they'd be agnostic to the commodity involved.  I'm a little torn on an acquisition, I think the market would like Ultra to make a more liquid rich purchase, but my thesis is based on Ultra being a pure play on natural gas and natural gas prices reverting to the mean.  Additionally, if Ultra's Pinedale field returns 40-60% IRR at $4 gas prices, why not focus on this property and return cash to shareholders by paying down debt?  Management has said they are a return focused, not a growth for growth's sake company, so hopefully any acquisition would have a high hurdle rate.

Disclosure: I own shares of AIG, TPCA, and UPL

AIG: "Bring on Tomorrow"

I was initially attracted to AIG because of the presence of a forced seller, the U.S. Treasury.  However, now most of AIG’s short-term catalysts have come to fruition in the last month and a half, including selling 80% of their airplane leasing business (ILFC) to a Chinese consortium, the Treasury selling their remaining equity stake for $7.6 billion, and selling the remaining stake in AIA for $6.45 billion.  They’ve also rebranded their Life Insurance & Retirement and Property & Casualty Insurance businesses back to AIG (from SunAmerica and Chartis respectively) and launched a prolific advertising campaign thanking America for the bailout.  Going forward AIG represents more of a post-reorganization that needs to execute the new business model for a period of time before investors will trust it again and revalue it alongside peers.

So the investment thesis for AIG is fairly simple, it trades at roughly half of book value and expects to earn 10% ROE by 2015.  If AIG is able to grow book value at 10% over the next 5 years and the valuation gap between market value and book value converges during that time, it implies a ~26% annualized return (or over 3 times the current price).  AIG has been accelerating the book value growth through buybacks recently, however these are likely to slow in the near term as the company is switching its focus to improving the company’s interest coverage ratio, by repurchasing or retiring outstanding debt.  A simpler capital structure should reduce interest expense, improve credit ratings, and reduce the overall cost of capital, all positives.  AIG has also mentioned its intention of paying a dividend in 2013, opening it to more income based managers.

There are two large risks in my mind, the first is the overheated bond market which is the primary asset class owned by AIG.  Interest rates are low, and insurance companies are leveraged due to their float, rising interest rates could be a double edged sword.  Rising interest rates will increase earnings on the float in the long term, but also put pressure on bond prices in the short term, so AIG will have to manage its duration and continue to diversify into other assets.

Secondly there is the regulatory overhang.  AIG is expected to receive designation as a non-bank systemically important financial institution (SIFI) in 2013.  If AIG is designated as a SIFI, it will be required to carry additional capital above other insurers, hampering their profitability and balance sheet flexibility to return cash to shareholders.

Robert Benmosche, CEO of AIG, should be congratulated for the job management’s done restructuring the company since the bailout.  As the business plan is executed and AIG repairs its image with the public, the shares should overtime move closer to book value resulting in a tremendous opportunity for the patient long term investor.

Disclosure: I own shares in AIG, another way to play this story is through the warrants