With the current pullback, I thought it'd be good to review the recent positions discussed:
VOYA's financials continue to improve. while not a home-run quarter, a positive GAAP result and improving operating ROE points to the normalization of business. The fee-based retirement services that VOYA provides are actually more stable (and marginally sticky given regulations, etc.). Compared to AIG, which is essentially a highly levered fixed income fund with relatively stable funding (due to ~100% combined ratio), VOYA should trade at a higher book/earnings multiple. I'm long both because both are cheap - but VOYA is more so relative to the underlying business. I have kept the same positions in each as a month ago.
The counterpoint to this is that GAAP financials still look weak on a TTM basis - underlying economics should show up more in subsequent quarters for the above thesis to be valid.
IBTX's growth makes it more expensive. A friend recently emailed about IBTX's most recent acquisition (BOH Holdings) at 2.5 tangible book - not cheap given that other regional banks range from 1-2.5x tangible book and large caps often at ~1x (e.g. BAC). Management was fair in paying with IBTX's own stock at 2.5x tangible. I, like many investors, remain wary with acquisitive managements because they often overpay for subpar assets. Size alone is not usually not a durable competitive advantage, especially when you are a community bank competing with WFC. Any advantage would be local, given relationships in the area and regional differentiators.
More generally, the portfolio has grown in size considerable due to more opportunities, and I have unfortunately ended up on margin (net long >100%). As a result, days like today can become problematic as I have little dry powder to buy. Nonetheless, nearly all of my positions have near-term catalysts and/or are compelling at current prices. The mental stops I have in place per position are still wide enough that the portfolio can swing even while not being stopped out. Given a choice, however, I have ordered current positions in order of conviction to sell (VOYA/IBTX are near the top, so won't be sold unless a severe disruption occurs). I don't anticipate current weakness to last past the Fed meeting next week.
Wednesday, December 11, 2013
Rage against the EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is often used by sophisticated investors to price companies. A sample valuation statement can be "XYZ company is trading at 5x mid-cycle EBITDA and presents a compelling opportunity." 5 times means its enterprise value (equity + net debt) divided by EBITDA is 5 (a 20% yield).
The traditional explanation is that EBITDA is a proxy for cash flow that is capitalization (debt) agnostic and allows for a less noisy picture of the earnings power. In more practical terms, a buyer of a company often changes the capital structure (by paying off/adding additional debt). The current debt structure is merely the financial decision by management and often has little to do with the underlying business.
The cynical explanation is that EBITDA, by ignoring capital expenditures, is often a misleading metric. Combined with metrics such as "adjusted EBITDA," these metrics are often used to justify high prices for transactions. 10mm EBITDA is really 5 mm if there is 5mm of maintenance capex expected.
More specifically:
1) Interest and Taxes are paid by the company and do not belong to shareholders. Sure, companies may choose a capital structure with less debt and pay less in interest. But that by definition means companies have less cash to deploy to make money. More fundamentally, companies profit from what is, not what could be. If a company is under/over-levered, is that not just a reflection of the company's management and should be evaluated? Other than in LBO situations, debt is part of what one buys. Such buyout perspectives should not be the main source of valuation, unless you are selling to a LBO sponsor!
2) Depreciation and Amortization (D&A from capital expenditures/goodwill from acquisitions) is actually a benefit to company financials. It allows the smoothing out of large expenses to buy equipment, etc. when the benefits of the expense is over the long term. Backing out D&A should also mean a car company doesn't need a factory to make cars. Now, if there is a one-time capital expenditure that will not repeat for many years (longer than the depreciation period), then maybe it is work considering. The workaround of EBITDA minus average (maintenance) capex is in fact D&A anyways. A similar analogy applies to amortization of goodwill.
Bottom line, using EBITDA can easily lead to overestimation of earnings power, which conveniently allows higher selling prices! EBITDA used and adjusted correctly usually results in roughly the same as averaging 10-year GAAP financials in most cases. As a result, I have little faith in EBITDA..
The traditional explanation is that EBITDA is a proxy for cash flow that is capitalization (debt) agnostic and allows for a less noisy picture of the earnings power. In more practical terms, a buyer of a company often changes the capital structure (by paying off/adding additional debt). The current debt structure is merely the financial decision by management and often has little to do with the underlying business.
The cynical explanation is that EBITDA, by ignoring capital expenditures, is often a misleading metric. Combined with metrics such as "adjusted EBITDA," these metrics are often used to justify high prices for transactions. 10mm EBITDA is really 5 mm if there is 5mm of maintenance capex expected.
More specifically:
1) Interest and Taxes are paid by the company and do not belong to shareholders. Sure, companies may choose a capital structure with less debt and pay less in interest. But that by definition means companies have less cash to deploy to make money. More fundamentally, companies profit from what is, not what could be. If a company is under/over-levered, is that not just a reflection of the company's management and should be evaluated? Other than in LBO situations, debt is part of what one buys. Such buyout perspectives should not be the main source of valuation, unless you are selling to a LBO sponsor!
2) Depreciation and Amortization (D&A from capital expenditures/goodwill from acquisitions) is actually a benefit to company financials. It allows the smoothing out of large expenses to buy equipment, etc. when the benefits of the expense is over the long term. Backing out D&A should also mean a car company doesn't need a factory to make cars. Now, if there is a one-time capital expenditure that will not repeat for many years (longer than the depreciation period), then maybe it is work considering. The workaround of EBITDA minus average (maintenance) capex is in fact D&A anyways. A similar analogy applies to amortization of goodwill.
Bottom line, using EBITDA can easily lead to overestimation of earnings power, which conveniently allows higher selling prices! EBITDA used and adjusted correctly usually results in roughly the same as averaging 10-year GAAP financials in most cases. As a result, I have little faith in EBITDA..
Saturday, November 23, 2013
Fannie/Freddie Preferreds - An Introduction
The Federal National Mortgage ("Fannie Mae") and Federal Home Loan Mortgage Corporation ("Freddie Mac") are government-sponsored enterprises which were created to provide liquidity to the mortgage market in the United States. They do this, in large part, by buying pools of mortgages from lenders, securitizing them, and selling/guaranteeing the resulting mortgage securities. While there are endless wrinkles to this description, these entities fed the growing demand for house ownership over past few decades and ate themselves nearly to oblivion during the crash.
After being left for dead in 2008 as they ("F&F") went into conservatorship, both have returned to profitability, to say the least:
(Source: Fairholme Funds)
The US Treasury has invested a total of 189.5$ billion in the GSEs to keep them afloat in exchange for 1) government control through warrants for 79.9% of equity and 2) senior preferred shares. By Q1 2014E all of that investment is projected to be repaid. In particular, 2013 Q3's payment was $30.4+8.6 billion and brings repayments within striking distance of the investment. To clarify, these repayments are the redirection of net income to the government- the majority equity holder.
As a result, both the equity and preferred have surged.
However, where exactly do the junior issues actually stand? The original investment simply diluted the equity and added another layer of debt, but a 2012 amendment siphons off any profits back to the treasury and prevents any nearly any equity ("net worth") from building up. Right now, there is no income/ownership which feeds to preferreds/non-govt common equity, even though the underlying business has dramatically improved and private investors still own 20.1%. In essence, the government has monetized its warrants without having to exercise and has crowded out the remaining owners.
This does open the door for private investors (Fairholme, Perry, etc.) to provide a more definite exit. There have been at least 2 proposals for the junior issues to get paid:
First, there is the legal approach to overturn the 2012 amendment by arguing it violates the Economic and Housing Recovery Act of 2008. Without that amendment, F&F can build up equity based on the billions it is making.
Second, Fairholme has proposed a broad recapitalization and split off of F&F operating entities ( 2nd version) using $50B+ of private capital.
Each approach requires the leaders to put significant time/resources to navigate both the political and legal hurdles necessary to change. This opportunity exists because of the haphazard manner of the F&F bailout, and its resolution requires those in charge to desire private sector involvement on generous terms.
As a miniscule fund, I cannot hope to influence such events. I could however, benefit partially from these efforts by buying at a slightly higher price. The downside is $0 for both common and preferred. Obama/Congress can choose to retain the status quo indefinitely and send all profits back to the treasury. Politically, this may be the easiest as it can produce profits while not angering either aisle. That would make the investment a total loss.
What if the private catalysts above succeed? Preferred could get paid off at par and common trades again freely. If the common is not liquidated, the treasury could get paid handsomely for its warrants in addition to making back all the money it invested (i.e. having its cake and eating it too).
The upside here is that investors can benefit in the strengthening business, as mentioned above.
Specifically, increases in guarantee rates, stronger underwriting standards, a recovering housing market and growth in market share (10k) have not only made the GSEs more powerful, but also more profitable than ever before. The specific merits of this business can be explore much more in detail, but the overall conclusion is that the Fannie & Freddie (F&F) are back, possibly better than ever.
The question is - what does this mean for private investors?
Disclosure: long FNMAS (Fannie Mae preferred S series).
After being left for dead in 2008 as they ("F&F") went into conservatorship, both have returned to profitability, to say the least:
(Source: Fairholme Funds)
The US Treasury has invested a total of 189.5$ billion in the GSEs to keep them afloat in exchange for 1) government control through warrants for 79.9% of equity and 2) senior preferred shares. By Q1 2014E all of that investment is projected to be repaid. In particular, 2013 Q3's payment was $30.4+8.6 billion and brings repayments within striking distance of the investment. To clarify, these repayments are the redirection of net income to the government- the majority equity holder.
As a result, both the equity and preferred have surged.
However, where exactly do the junior issues actually stand? The original investment simply diluted the equity and added another layer of debt, but a 2012 amendment siphons off any profits back to the treasury and prevents any nearly any equity ("net worth") from building up. Right now, there is no income/ownership which feeds to preferreds/non-govt common equity, even though the underlying business has dramatically improved and private investors still own 20.1%. In essence, the government has monetized its warrants without having to exercise and has crowded out the remaining owners.
This does open the door for private investors (Fairholme, Perry, etc.) to provide a more definite exit. There have been at least 2 proposals for the junior issues to get paid:
First, there is the legal approach to overturn the 2012 amendment by arguing it violates the Economic and Housing Recovery Act of 2008. Without that amendment, F&F can build up equity based on the billions it is making.
Second, Fairholme has proposed a broad recapitalization and split off of F&F operating entities ( 2nd version) using $50B+ of private capital.
Each approach requires the leaders to put significant time/resources to navigate both the political and legal hurdles necessary to change. This opportunity exists because of the haphazard manner of the F&F bailout, and its resolution requires those in charge to desire private sector involvement on generous terms.
As a miniscule fund, I cannot hope to influence such events. I could however, benefit partially from these efforts by buying at a slightly higher price. The downside is $0 for both common and preferred. Obama/Congress can choose to retain the status quo indefinitely and send all profits back to the treasury. Politically, this may be the easiest as it can produce profits while not angering either aisle. That would make the investment a total loss.
What if the private catalysts above succeed? Preferred could get paid off at par and common trades again freely. If the common is not liquidated, the treasury could get paid handsomely for its warrants in addition to making back all the money it invested (i.e. having its cake and eating it too).
The upside here is that investors can benefit in the strengthening business, as mentioned above.
Specifically, increases in guarantee rates, stronger underwriting standards, a recovering housing market and growth in market share (10k) have not only made the GSEs more powerful, but also more profitable than ever before. The specific merits of this business can be explore much more in detail, but the overall conclusion is that the Fannie & Freddie (F&F) are back, possibly better than ever.
The question is - what does this mean for private investors?
Disclosure: long FNMAS (Fannie Mae preferred S series).
Wednesday, November 13, 2013
On Bitcoin, Gold and Monetary Policy, Part 2
2) Misconception: Gold is a great alternative to the US dollar as well because it is not manipulated and is a hard asset. Gold prices are indeed not at the whim of the Federal Reserve, but can be influenced by non-stable factors as well -after all, isn't the gold supply determined by how much gold is mined? Buffett noted that all the gold in the world could fit inside a baseball infield (when melted down to pure gold, etc.). If one miner such as Barrick Gold finds a large deposit that would add 5%, 10% to the supply (exaggeration), is that addition to the money supply warranted?
This actually happened in the 16th century Spain, where gold from the New World led to inflation. Yes, gold - like any other currency - can lead to inflation. The point is this - the usefulness of gold as a currency is of stability, not because you can see/touch it.
3) Misconception: US dollar and most other currencies are fiat, not based off anything tangible and are therefore prone to manipulation, excessive printing by governments/politicians, and ultimately lead to fiscal/monetary instability.
The history of government printing can be bleak to review. Liaquat Ahamed's
---
The upside to this is that it continues to demonstrate that the market is far from efficient. More specifically, the level of ignorant vitriol directed at the Fed, the US dollar and economy means that the vanilla long equity trade remains viable. I hope to not be ensnared by my own ignorance, however, and will continually reevaluate the above.
From The Big Short/Tolstoy:
This actually happened in the 16th century Spain, where gold from the New World led to inflation. Yes, gold - like any other currency - can lead to inflation. The point is this - the usefulness of gold as a currency is of stability, not because you can see/touch it.
3) Misconception: US dollar and most other currencies are fiat, not based off anything tangible and are therefore prone to manipulation, excessive printing by governments/politicians, and ultimately lead to fiscal/monetary instability.
The history of government printing can be bleak to review. Liaquat Ahamed's
---
The upside to this is that it continues to demonstrate that the market is far from efficient. More specifically, the level of ignorant vitriol directed at the Fed, the US dollar and economy means that the vanilla long equity trade remains viable. I hope to not be ensnared by my own ignorance, however, and will continually reevaluate the above.
From The Big Short/Tolstoy:
"The most difficult subjects can be explained to the slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt,what is laid before him." —Leo Tolstoy,1897 [ix]"
Friday, November 8, 2013
On Bitcoin, Gold and Monetary Policy
This negative article on bitcoin indirectly brought together a few disparate thoughts for me. The article's position/bias is clear - the digital currency, which has grown significantly vs. the dollar is a speculatively bubble:
(source)
What is even more interesting, however, is the set of comments which mostly defend bitcoin. These online comments, to me, show exactly the misconceptions which drives bitcoin, gold and many arguments about US monetary policy. Let us begin!
1) Misconception: Bitcoin is a valid and perhaps best currency because it is not manipulated, transparent and free from government control. It is true that there is no government control and transactions are automatically tracked. What about manipulation? There may be no group trying to set a price, but the alternative is a currency that changes by 100%+ in a year. Is that what currencies are? A reminder: typical characteristics of a currency include 1) medium of exchange 2) unit of account and 3) store of value. The first two could arguable, but the store of value? While the currency has been gaining versus G10 currencies, its volatility could easily swing the other way by double digit % points.
Finally - no manipulation or adjustment also means no flexibility. There is a set formula that grows the supply until a specified limit in the future. Why that limit? If there are 100 dollars in circulation for 100 people now, and still 100 dollars for 500 people later, what will happen? Deflation. <- this, incidentally, makes a consistent price rise nearly rational, as deflation is literally designed into the system. As a result, speculation will override traditional usage (why sell goods via bitcoin when bitcoin will rise in value the next day?) Assuming more goods are sold/bought using bitcoin system, bitcoin value will rise - the result is what we see today, where most bitcoin usage is actually speculation vs. use in commerce.
This reflexive (ref: Soros) rally is self-reinforcing and may indeed reach new heights for sometime. However, bitcoin's ultimate usefulness is supposed to be its use as legitimate currency, which in my opinion will ironically be a smaller and smaller part of bitcoin usage as the currency rises. So, bitcoin gains in value are self-reinforcing in the short run but ultimately self-defeating in the long run (perhaps an apt definition of a bubble). If bitcoin mania continues and commercial usage lowers, there may very well come a point when the crowd discovers that they hold more money than there are goods possibly to buy it with.
... to be continued
What is even more interesting, however, is the set of comments which mostly defend bitcoin. These online comments, to me, show exactly the misconceptions which drives bitcoin, gold and many arguments about US monetary policy. Let us begin!
1) Misconception: Bitcoin is a valid and perhaps best currency because it is not manipulated, transparent and free from government control. It is true that there is no government control and transactions are automatically tracked. What about manipulation? There may be no group trying to set a price, but the alternative is a currency that changes by 100%+ in a year. Is that what currencies are? A reminder: typical characteristics of a currency include 1) medium of exchange 2) unit of account and 3) store of value. The first two could arguable, but the store of value? While the currency has been gaining versus G10 currencies, its volatility could easily swing the other way by double digit % points.
Finally - no manipulation or adjustment also means no flexibility. There is a set formula that grows the supply until a specified limit in the future. Why that limit? If there are 100 dollars in circulation for 100 people now, and still 100 dollars for 500 people later, what will happen? Deflation. <- this, incidentally, makes a consistent price rise nearly rational, as deflation is literally designed into the system. As a result, speculation will override traditional usage (why sell goods via bitcoin when bitcoin will rise in value the next day?) Assuming more goods are sold/bought using bitcoin system, bitcoin value will rise - the result is what we see today, where most bitcoin usage is actually speculation vs. use in commerce.
This reflexive (ref: Soros) rally is self-reinforcing and may indeed reach new heights for sometime. However, bitcoin's ultimate usefulness is supposed to be its use as legitimate currency, which in my opinion will ironically be a smaller and smaller part of bitcoin usage as the currency rises. So, bitcoin gains in value are self-reinforcing in the short run but ultimately self-defeating in the long run (perhaps an apt definition of a bubble). If bitcoin mania continues and commercial usage lowers, there may very well come a point when the crowd discovers that they hold more money than there are goods possibly to buy it with.
... to be continued
Wednesday, November 6, 2013
IBTX - An Investment in Texas
Independent Bank Group, Inc. (NASDAQ:IBTX) is a recently ipo'd regional bank with branches in the Austin and Dallas-Fort Worth areas of Texas. This is not cheap company on a past basis, trading at ~2x book and nearly 20 times ttm earnings. It is instead a growing, incentive-aligned financial company in an economically vibrant area at a fair price.
Consistent, profitably insider provides the catalyst. Many investors consider insider buying to be a strong signal to buy. Unlike selling, buyers typically have one goal in mind - to make money. By its very nature, it has potential to be a durable signal, as if future gains are already priced in there would not be a reason to buy.
There are some important caveats, however. Weak shares, especially in deteriorating companies (such as Dell in the last few years) often see insider buying as officers attempt to boost confidence. In Dell's case, a billionaire's token buys are far more likely a way to boost confidence and push up shares (versus just participating in the gains of the business).
The opposite has been the case here - a recent ipo (where by definition the company is selling) combined with buying as the shares move up and remain near 52 week highs. Among the numerous insider buyers (no sellers) is William E Fair, who has been at IBTX for 9 years, and Brian Hobart, the Chief Lending Officer who has spent 9+ years at IBTX as well.
It is reasonable to say that incentives are aligned at IBTX. But what about the underlying business?
Decent, though levered, operating metrics show an aggressive but efficient operation. I've typically approached financial institutions with a negative-bias- too many seem to be essentially put sellers of liquidity (lending long, borrowing short) and ultimately have weak returns on capital (that is, preleverage).
For a bank, IBTX has a decent financial showing, posting 1%+ roa for the last 3-4 years. The lack of data previous to 2010 is price of buying a new company, and is definitely worth investigating. It is fairly aggressive, levering equity to assets 9-10 times equity. That is a bit high in general, but compared to other regionals (HBAN) and even the top 4 (WFC/BAC), it is on the side. It does not quite have the same moat-like characteristics of WFC, but is a bit better than the rest.
Going forward though, what distinguishes IBTX for HBAN and the rest of the TARP-exiting regionals and indeed the huge money-center banks?
Economic opportunity. Bottom-line, a booming energy and now technology industry (1, 2) in TX will allow it to growth and reap better returns on capital than much of the country. Whereas many states are struggling with debt, Texas's conservative fiscal position combined with luck (oil & gas) will allow it to continue to grow.
Disclosure: long IBTX since the low 30s, but believe it is a good business to hold/buy in small size even at 38.
Consistent, profitably insider provides the catalyst. Many investors consider insider buying to be a strong signal to buy. Unlike selling, buyers typically have one goal in mind - to make money. By its very nature, it has potential to be a durable signal, as if future gains are already priced in there would not be a reason to buy.
There are some important caveats, however. Weak shares, especially in deteriorating companies (such as Dell in the last few years) often see insider buying as officers attempt to boost confidence. In Dell's case, a billionaire's token buys are far more likely a way to boost confidence and push up shares (versus just participating in the gains of the business).
The opposite has been the case here - a recent ipo (where by definition the company is selling) combined with buying as the shares move up and remain near 52 week highs. Among the numerous insider buyers (no sellers) is William E Fair, who has been at IBTX for 9 years, and Brian Hobart, the Chief Lending Officer who has spent 9+ years at IBTX as well.
It is reasonable to say that incentives are aligned at IBTX. But what about the underlying business?
Decent, though levered, operating metrics show an aggressive but efficient operation. I've typically approached financial institutions with a negative-bias- too many seem to be essentially put sellers of liquidity (lending long, borrowing short) and ultimately have weak returns on capital (that is, preleverage).
For a bank, IBTX has a decent financial showing, posting 1%+ roa for the last 3-4 years. The lack of data previous to 2010 is price of buying a new company, and is definitely worth investigating. It is fairly aggressive, levering equity to assets 9-10 times equity. That is a bit high in general, but compared to other regionals (HBAN) and even the top 4 (WFC/BAC), it is on the side. It does not quite have the same moat-like characteristics of WFC, but is a bit better than the rest.
Going forward though, what distinguishes IBTX for HBAN and the rest of the TARP-exiting regionals and indeed the huge money-center banks?
Economic opportunity. Bottom-line, a booming energy and now technology industry (1, 2) in TX will allow it to growth and reap better returns on capital than much of the country. Whereas many states are struggling with debt, Texas's conservative fiscal position combined with luck (oil & gas) will allow it to continue to grow.
Disclosure: long IBTX since the low 30s, but believe it is a good business to hold/buy in small size even at 38.
Thursday, October 31, 2013
Portfolio Management as Counterpoint
While my previous long bias remains, the recent market weakness after a strong October has finally given me pause. I had been insanely long (using significant margin) up until today because there were continual buy signals (technicals, insider buying) which lined up with the businesses and valuations I liked (durable competitive advantage/roe at less than 25 ttm earnings).
The business thesis for most of these investments remain, but my portfolio has simply gotten too large and often leads to a fundamental issue of my approach. A stock that falls is cheaper and often a better buy (value), but persistent weakness is often a signal of worse things to come (momentum). My bread and butter approach is to find businesses which I would like to buy as they get cheaper, but wait under the trend turns (or at least stabilizes) to prevent a Bill Miller-like 2008.
The corollary to the above then, is to not hesitate to cut positions when the trend turns or weakens, even if an investment has not reached what I believe to be fair value. This has happened now with HLSS, VOYA, AIG, (some of the largest positions) and have I reduced. I had recently added to HLSS on weakness because 1) the weakness was not panic-driven and 2) there was a nearby catalyst that could reverse the trend (earnings). The earnings driven pop has now weakened, so I have reduced the position to more manageable level, especially given the lower returns which I now believe is reasonable for HLSS.
As for specific numbers, I use a variation of the kelly criterion, described by another well-known blogger and money-manager.
*My approach remains value + trend-following, for the long-term. While minimizing activity is a goal, position-sizing and risk-management is necessary to ensure the portfolio can take advantage of long-term views.
The business thesis for most of these investments remain, but my portfolio has simply gotten too large and often leads to a fundamental issue of my approach. A stock that falls is cheaper and often a better buy (value), but persistent weakness is often a signal of worse things to come (momentum). My bread and butter approach is to find businesses which I would like to buy as they get cheaper, but wait under the trend turns (or at least stabilizes) to prevent a Bill Miller-like 2008.
The corollary to the above then, is to not hesitate to cut positions when the trend turns or weakens, even if an investment has not reached what I believe to be fair value. This has happened now with HLSS, VOYA, AIG, (some of the largest positions) and have I reduced. I had recently added to HLSS on weakness because 1) the weakness was not panic-driven and 2) there was a nearby catalyst that could reverse the trend (earnings). The earnings driven pop has now weakened, so I have reduced the position to more manageable level, especially given the lower returns which I now believe is reasonable for HLSS.
As for specific numbers, I use a variation of the kelly criterion, described by another well-known blogger and money-manager.
*My approach remains value + trend-following, for the long-term. While minimizing activity is a goal, position-sizing and risk-management is necessary to ensure the portfolio can take advantage of long-term views.
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