MSRs Redux (HLSS, OCN, ASPS)

The new year did not start out so well for one segment of my portfolio - those related to mortgage servicing rights (MSRs). Beginning with a general sell-off in January, non-bank servicing companies took a beating:

I was far from immune, though my risk-management stops did force some reduction late in January. However, the value in ASPS and OCN in particular led to me to slowly re-add in early February. This was premature:

• New York Department of Financial Services blocks Wells Fargo sale of MSRs to Ocwen
• Ocwen may be sued by multiple large investors

If the above were short-seller reports, this would have been a classic "bear-raid", especially given the black-out period prior to earnings (Feb 27/13th,  for OCN/ASPS). The first news item came out in the middle of the HLSS earnings call (Feb 6th), requiring management to deflect questions until the upcoming Ocwen call. Rumors of the above may indeed have been circulating previously, though the exact reason for the market reevaluation may be tough to see and moot at this time.

However, how does this affect Ocwen (OCN) and its related entities as a whole?  Buffett describes value as simply the discounted cash flows of a company, so the question, does this materially change those cashflows?

1) OCN's future prospects remain bright - New York's regulatory action should be temporary because OCN's best-in-class cure rate and delinquency trends make it the best for both investors and homeowners.

The principal reason for the growth of Ocwen is the competitive disadvantage that bank servicers now have in light of Basel 3. I detailed this in a previous post and showed how banks take capital charges if they service mortgages themselves.

This fundamental fact (which shows no signs of changing) has not changed - what may have is the rate of portfolio growth for OCN and others. The principal reason behind the government block is concern over the ability of OCN to service the mortgage. OCN, which outsources most of the work to india, has indeed be dogged by consumer complaints about improper/slow processing and related errors which may lead to excess fees and delayed payments. Given the sub-prime focus that OCN has, it can be difficult to figure out how much of this is simply from the sub-prime consumers' own mistakes and how much is legitimately OCN's fault. It may indeed be more of the latter, but industry data suggest that out of other servicers, OCN remains first-in-class when it comes to final outcomes.

OCN's cure rate - the rate at which it turns delinquent loans into current ones, remain the best in the industry. A higher metric for benefits both investors and homeowners, as it means that fewer foreclosures occur and more principal is repaid.

Source: December 2013 presentation by Ocwen

2) Investor lawsuits by PIMCO/BlackRock are also temporary and on weak footing. Both pushed for the ResCap's sale to OCN and have only recently turned against it. I believe that they are upset possible errors which occurred during the on-boarding process and/or lower investor returns than they anticipated due to foreclosures, etc. The above arguments apply to this as well, although detailed rebuttals will depend on the actual lawsuits filed.

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Portfolio-wise, I've focused on the highest conviction names and have therefore exited less direct exposure to this trend, namely HLSS.

Disclosure: long OCN/ASPS 

-Stanley

Winter is Coming

While my focus is individual companies, I've been positive on the US and negative on China (and really emerging markets as a whole) for the last 2 years. That was shown roughly correct last year in a resurgent rally in the S&P 500 which outpaced most equity rallies worldwide. I was fortunate in removing most (valuation) shorts while holding on to most long ideas/companies. I now believe the tide is reversing, and even the United States will not be immune to weakness. In short:

(Source: Game of Thrones, http://www.ifc.com/fix/2011/04/game-of-thrones-premieres)

Contagion is the reason why this sell-off is different (and similar to Europe in 2011) because losses are contagious even though they seem unrelated at first glance. From the Argentinian peso/Turkish lira devaluation to China credit contraction and Brazil slowdown, global markets have started falling in tandem again - the Fed taper is simply the catalyst. Animal spirits are rising again, and levered funds I believe have started to cover en masse, creating a self-fulling cross-asset linkage across the world. Cash (USD) remains the only true safe haven.

My hypothesis is that (US) investors are waiting for the Fed decision (Wednesday) to reduce more, hoping not to miss the post-fed pop.  However, given the weak pre-Fed price action, consensus on yearly gains by market professionals and rally into the New Year, I believe markets have already priced in the best scenario. As such, reducing risk going forward is my position.

Fund-wise, I've dramatically reduced long exposure while maintaining the China-related (e.g. levered commodity company) shorts from last year. I still hold my highest conviction domestic longs, but believe there are better prices ahead.

Disclosure: reduced NEU, IBTX and sold out of HLSS to get cash.

Stay warm,

-Stanley

NewMarket Corporation (NEU) - An Efficient Way to Capitalize on Oil

NewMarket Corporation (NYSE:NEU) is a chemical manufacturing company which specializes in petroleum additives. With pricing power on the product side and cost-advantages stemming from increased usa oil/gas production and refining, NEU is the prototypical "great company at a fair price."

1) Pricing power - NEU's relationships with customers allow them to raise prices to pass on costs of raw materials. There is, however, no requirement to lower prices. Given the oligopolistic nature of the petroleum additives business (NEU is top 4), NEU has the chance to participate as prices continue to rise, even in 2013. The (minor) competitor listed, Chemtura, cited raw material price increases. If smaller players are able to raise prices, what does that say about market leaders such as NEU?

That doesn't necessarily show the full story, however: gross margins have been increasing steadily in the past decade:

 (Source: Morningstar)

Price don't necessary follow costs, usually to NEU's benefit! The four top producers (90% total market share) form an oligopoly which compete on services/value-add versus price. Industry competition and pricing power with customers/suppliers all favor NEU. However, this is just the beginning, in my opinion.

2) Cost advantage due to USA oil & gas renaissance. In the past few year years, raw material prices for NEU have been rising, yet cost of goods sold have remained consistent (see 10-k pg 28). NEU's relationships and market allow them to pass on cost increases. Now, what if those costs decrease?

NEU lists "base oil (byproduct oil refining), polyisobutylene (isobutylene component is of component of nat gas/crude oil refining), antioxidants, alcohols, solvents, sulfonates, friction modifiers, olefins (byproduct of oil refining), and copolymers" (parentheses mine) as the inputs needed.

Most of these inputs are the result of oil/gas production, and oil output/refining capacity has been increasing dramatically:

Should those oil/gas products lower in price, NEU and the market leaders are not pressured to lower prices to compete because of the oligopoly. They might lower, but after a lag and usually conservatively. This scenario may not last forever, but as long as competitors focus on service rather than price, NEU will continue to earn economic profits.

Now, how does NEU protect itself from new entrants who would undercut? Customization and the same customer relationships above ("oil companies and refineries to original equipment manufacturers (OEMs) and other specialty chemical companies" from 10-k pg. 3) preclude an easy switch. A customer-stickiness combined with technological know-how (from the limitless types of additives) will at least severely delay new entrants. New entrants or substitutes would therefore be difficult to make.


3) Steady secular growth - requirements from the US government for increased fuel mileage force continued reliance on additives for that extra boost of efficiency. Because of sufficient barriers to entry from 2), NEU and its competitors can participate in the steady (albeit slow) growth.


4) ROC-focused management - from reasonable buybacks, special dividends (e.g. in 2012) and a conservative capitalization, NEU is run by management-like owners because they are, in large part owners (13%/$550mm of equity owned by insiders, per Morningstar). That is how NEU manages double-digit ROA/ROIC for past 5 years, even in 2008 when many firms were trying to stay solvent.


Risks:  the main risks to this thesis include 1) the beginnings of price competition given years of solid profits 2) lack of growth from end-user demand related either to engine/machinery usage and/or regulatory changes. If, for example, government lowered fuel mileage/composition requirements, then NEU's products would not be as useful. This is not a fast-growing market, so revenue growth even in the best cases would not be high and decreases could definitely re-rate NEU and its peers lower on a multiples' basis.    

These risks, however, I believe are mitigated by the above four points, and as such I have added more to NEU.

Careful investing to all,
 -Stanley

Is Capital a Barrier to Entry? (Property Catastrophe)

Greenwald's Competition Demystified focuses on the barrier to entry as the key competitive advantage. That is, the difficulty of new entrants to enter is the main factor to focus on when determining if a company can earn excess returns (i.e. high roic/return on invested capital).  

Given current investments in a variety of (re)insurers and experience in catastrophe modeling. I was struck by the stampede into reinsurance by traditional investors. Reinsurance as an industry may be losing its competitive advantage.

Estimates now show up to 15% of the industry as from traditional capital markets and thereby push rates on line lower. That is, the premium rates paid by primary insurers to reinsurers are coming under pressure by new investors. It seems like in age driven by low interest rates generally, investors are seeking yield again in areas - namely the relatively stable catastrophe reinsurance. As a result, a flood of money has broken through industry barriers. This, to me, is an ominous sign for reinsurers. Given the stable recent returns of catastrophe (ILS) indices, investors believe that stability and consistent 5-year performance means similar thoughts going forward.

The above graph, in my opinion, is exactly what has the capital markets salivating. It breezed through 2008 with problem! The catch? It is missing 2005's Katrina+ losses, 1992 insurer-busting Andrew hurricane. As a result, fund managers may be blindly running into this arena and are unfortunately supported by 2 erroneous beliefs:

1) Price volatility = risk. I already disagree with this for equities, but for property catastrophe reinsurance (the most popular) it is even crazier. Why would a hurricane care about previous price trends made by humans? The fact that many of indices quoted don't even reach back before 2002 show the lack of data that investors are using. Hurricanes rates are not stable even over decades, yet investors believe the returns from just one.

2) Models are accurate and precise. Catastrophe modeling as a quantitative industry has really only grown in the last decade as well. Major commercial vendors such as RMS, AIR, EQE produce very deep models with 100,000+ simulated events and output losses to the dollar. Most industry veterans recognize that this is just the starting point, but new investors can easily look at results such as standard deviation and expected value/loss to make decisions. 

More specifically, the problem is that most of the risk for higher layers happen in the 100+ year return periods, that is once every hundred years. Veterans use say TVAR 99% (tail value at risk, that is the expected value of the tail beyond 100-yr (1-1/100=99%) events). Even they are wrong.



Bottom line - oversupply in reinsurance (especially property catastrophe) will probably lead to subpar returns going forward. On the other hand, for the first few years (or shorter), primary insurers will get cheap protection and may get an additional boost in earnings.


Careful investing to all,
-Stanley

An update on positions (VOYA, IBTX)

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.

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..

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).