Portfolio update November 2014

Overall, my portfolio is down several percent YTD mainly due to a longshot bet on Yongye put options and mark-to-market losses on Altisource common shares.

On the short side, shorting common stock has worked incredibly well for me this year.  Unfortunately, my gains were offset by losses on Yongye puts.

On the long side, I made massive bets on Kinder Morgan warrants and Altisource common stock.  The former has been profitable while the latter hasn’t.  Altisource has been beaten down -53% YTD and I have been adding to my position on the way down.  While Altisource continues to have absurd earnings growth, its share price has fallen dramatically due to fears that regulation may hurt the company.

Altisource (ASPS)

Altisource is my largest position as I currently have more than half my portfolio in it.  I have written about the company many times on this blog.  I’m not particularly bothered by the mark-to-market losses on this position.  While Benjamin Lawsky has caused Ocwen and Altisource to suffer in the short term, his overzealous regulation (or extortion depending on your point of view) is somewhat of a positive in the long-term.  Higher compliance costs will provide a structural advantage to the largest mortgage servicers.  Altisource will benefit because mortgage servicers will have greater IT and technology needs as the industry shifts towards reducing the number of errors in mortgage servicing.

In the short term, the regulatory issues have allowed Altisource to buy back shares at attractive prices.  In the short term, Altisource’s earnings growth may pause since Ocwen has not been boarding new loans (Lawsky had blocked Ocwen’s purchase of mortgage servicing rights from Wells Fargo).  In the long term I expect Altisource to continue to grow its earnings at a very high rate.

Ocwen (OCN)

I started buying shares of Ocwen, which is now one of my largest positions.  I own significantly more Altisource than Ocwen because:

  1. Altisource has higher growth.
  2. Bill Erbey owns a greater percentage of Altisource than Ocwen.
  3. Altisource is less complicated and has less exposure to the macro environment.

Ocwen is difficult to comprehend because MSRs are very complicated.  See my post on what Ocwen and Altisource do.  However, I believe that Ocwen is also worth owning because it is a high quality business selling at a depressed valuation.

In the short run, regulatory issues have imposed additional costs on Ocwen.  This will slightly hurt Ocwen’s ability to generate cash in the short term.  In the long term, additional compliance costs will give large mortgage servicers an edge.

Going forward, I expect Ocwen to buy up MSRs.  It will ‘sell’ these MSRs to Home Loan Servicing Solutions (HLSS) and act as a subservicer.  This will allow Ocwen to generate very high returns on capital as the economics are somewhat similar to an asset management company.  HLSS essentially pays Ocwen to be an asset manager.  If there is cash left over, Ocwen will either invest the money into adjacent businesses (e.g. reverse mortgage originations) or repurchase shares.  Ocwen has recently begun to step up its share repurchases.

Yongye put options

This trade was an asymmetrical longshot bet that did not pay off.  If I were to continually make very large longshot bets, I would underperform the market in most years.

Short selling

I had short positions in over 100 different stocks.  I found the sheer volume a little overwhelming.  However, I am getting better at using shortcuts (e.g. G&A spending) and spreadsheets to become more time efficient.  Because of time constraints, I did not spend as much time on my shorts as I would have liked because I have been trying to become a better long investor.  I believe that I am much better at finding attractive shorts than attractive longs.  However, finding attractive longs should have more attractive risk/reward because short selling can be dangerous.

Excluding put options, the diagram below shows the distribution of mark-to-market returns in dollars YTD.  It does not include the cost of borrowing shares, which eats up slightly less than a tenth of the profits.

2014-october-31-short-portfolio-performance

My shorts generally fell into these categories:

  1. Mining.
  2. Oil and gas, mostly small independents.
  3. Chinese stocks, most of them fraudulent reverse mergers.
  4. Pharma.
  5. Retail.
  6. Bad businesses.
  7. Companies that pay for stock promotion.
  8. Egregious scams where insiders sell stock at inflated prices.
  9. Solar.
  10. Homebuilders.

Surprisingly, almost everything worked.

Chinese stocks were annoying this year.  Some of them were taken private.  Many of them because they had expensive borrows so I avoided those (e.g. WBAI).  Many saw some type of short squeeze where the borrow became incredibly expensive and/or unavailable.

Shorts that didn’t work

Some of my shorts were targets of acquisitions or going private transactions (e.g. ATHL).  These events generally lead to losses for the short sellers.  What I think is happening is that the management teams of bad companies often understand how bad their company is.  A great solution for their predicament is to find parties dumb enough to buy the entire company.  I believe that this is why so many great shorts end up being acquired.  While this phenomenon is frustrating, it is an expense worth paying.

Many of my put options have not performed well:  YONG, POT, AMT, CONN, RH, EBIX, IMAX, and PVG.
My CHK, MHR, NQ and COH puts were profitable.
GME puts were close to break-even.

Ruger (RGR)

Ruger call options are a big position for me.  Unfortunately, I did not correctly anticipate the boom/bust cycle in the gun market and the effect of discounting on Ruger.  In Ruger’s latest quarter, retail sell-through fell an astonishing 44% year-over-year.  Fifer seems to largely attribute this to extreme discounting by Ruger’s competitors.  I would highly recommend that you read Ruger’s conference call transcript for his analysis.

Since my original writeup on Ruger in Nov 2013, adjusted NICS checks fell dramatically during the three quarters from Q4 2013 to Q2 2014.  I did not foresee the drop in gun sales due to the unusual combination of an election and Sandy Hook in the year before.

Credit Acceptance (CACC)

I decided to sell my shares to free up margin.  We are currently in the dangerous part of the lending cycle as lots of easy capital is flooding into subprime lending.  Credit Acceptance has allowed the number of loans per active dealer to fall (-4.6%).  The risk/reward of its loans has gone down slightly judging from the decrease in its spread (down 1.1% year-over-year according to the latest 10-Q).  It has been able to offset fewer loans per dealer and slightly lower profitability by increasing the number of new dealers (+9.8%).  Overall, the number of loans increased by 4.7%.

Going forward, I expect the competitive environment to become more difficult for Credit Acceptance.  In the short term (the next few years), I think it will be difficult for the company to grow.  In the long term, I really like management and am very bullish on this company.  Currently, Ocwen and Altisource look more attractive to me because they trade at similar P/E ratios with much better growth prospects in the short term.  I may buy back into Credit Acceptance if the share price dips.

Liberty Media (LMCA/K)

Fundamentally, I believe that Liberty Media continues to do well.  Sirius XM and Live Nation continue to grow.  Charter has almost completed its digital transition (80% complete) and may soon see its free cash flow begin to increase.  While Charter has yet to demonstrate meaningful free cash flow, some of its metrics suggest improving operations.  It has staunched the loss of video subscribers while growing its voice and Internet subscribers.

Some of my mistakes in analyzing Liberty were:

  1. I believe I overestimated the discount to NAV when I purchased my stake.  My rough valuation spreadsheet on Google Drive shows that the current discount is around 10%.  Note that the spreadsheet may contain errors and depends on numerous assumptions.
  2. I underestimated Live Nation (e.g. I thought that it had reached fair value and that Liberty would be selling it).  I erroneously thought that its size was a disadvantage; I now believe that it is an advantage.  Building out Live Nation’s international footprint allows the talent to perform for larger audiences.  As well, scale is an advantage when it comes to selling (sponsorship) advertising.  The various scale economics make Live Nation an attractive long-term investment.  Management probably isn’t lying when they say that they will generate 30%+ annualized growth in adjusted operating income going forward.

What worked

My timing on my purchase and sale of Altius Minerals worked out quite well.  I think that my analysis of Altius was largely correct.  However, a lot of my gains should be attributed to luck.  The fundamentals have clearly become much worse for Altius due to falling iron ore prices.  However, the share price went in the opposite direction and I was able to sell everything at a large profit.

My bet on Kinder Morgan warrants worked out very quickly due to optimism over the KMI/KMP/KMR/EPB merger.  Looking at the fundamentals, distributable cash flow growth at KMI was slightly slower than I would have liked but was still satisfactory.

Strategy going forward

My current core longs are ASPS, OCN, RGR calls, and LMCA.  Because most of my portfolio is in ASPS and OCN, these two related stocks will largely determine the outcome of my portfolio.  Something that I am struggling with is whether or not I should diversify.

The big advantage to diversification is that it would protect me against a terrible mistake like QXM/XING.  On the other hand, the reason I am not diversifying is because ASPS seems so much more attractive than other stocks.  It has everything I want in a stock:

  1. Wonderful economics / sustainable earnings growth.  Altisource is one of the hottest growth stocks around.  Going forward, it is likely that these wonderful economics will continue given that the big banks will be selling their MSRs.
  2. A highly skilled CEO.  Bill Erbey is the most skilled CEO in the mortgage servicing space.
  3. Ethical management.
  4. Low valuation.
  5. Excellent capital allocation.  The company buys back more shares when the share price is low.

In my short portfolio, I will remain diversified.  I do not plan on blogging about 100+ short positions a year.  I may continue to blog on how I quickly screen through stocks.  For example, looking at a company’s G&A spending is a powerful shortcut as the companies with excessive G&A spending tend to be quite awful.

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22 thoughts on “Portfolio update November 2014

  1. Any thoughts on how long you plan to hold ASPS & OCN. I would think the thesis and regulatory climate will develop favorably, but not until 12 to 18 months pass.

    Great summary as always.

    • ASPS should be the kind of stock that makes sense to hold for a very, very long time. OCN I will sell when it gets close to fair value.

      I have no idea how the short-term price movements will work out. Ocwen’s settlement may be soon so that may theoretically be a catalyst for OCN, ASPS, and the other Erbey stocks to go up in value.

  2. Looking good, I too am bullish on both asps and lmca, though both represent 10-20% positions for me. Call me risk-averse, but I’ve found a lot of mental comfort from having MKL as my core/top holding.

    On paper it would definitely make sense to sell some to buy ASPS, but even though I really like and trust Erbey, It’s really hard company/empire to understand fundamentally. Otherwise it most likely would be my top holding – now the stake just represents more of my comfort level rather than need for returns.

    That being said, I think you’ll probably do fine by not diversifying your long holdings but you’ll have to put a price on how much you value comfort over the possibility of earning (slightly?) higher returns.

    A lot of that has to do with the amount capital that you have out there.

    Anyways, enjoying the blog as always.

      • I see I worded it like a “matter of fact”, but it’s mostly just personal preference. I can see someone having better comfort levels with bigger amount of capital and putting most of it into business they don’t necessarily perfectly understand.

        I’m not implying that Glenn or anyone else for that matter doesn’t perfectly understand Erbeys empire, but despite my own DD I haven’t achieved a satisfactory level of comfort to put more than 20% of my portfolio in it.

        If I’d have considerably less capital, I’d most likely be more inclined to put bigger percentage of my portfolio to ASPS because it may have the best returns going forward. The thesis is clear as water, but the business itself (mostly the products that ASPS sells and how much value they really provide) is still somewhat hazy to me.

  3. what’s the short thesis on ASPS? it seems to me that people are more negative on ASPS than OCN by just looking at the short interest. I understand it’s a low capital intensive business, but it’s got 1 customer, and defaults are going down hard, which will kill ASPS, and will benefit OCN. thanks.

    • 1- Regulation fears. If Ocwen is blocked from buying more MSRs (or limits placed on their growth), then that could be bad for Altisource.

      2- As you point out, falling delinquencies are bad for Altisource as default-related services are very profitable for Altisource.

      3- Related party transactions make up most of Altisource’s revenues. However, related party transactions as a % of revenue has been going down.

  4. what percent of ASPS’s business is related to defaults and is likely to fall off due to not being sustainable as the US consumer recovers (10%,30%, majority)?

  5. When you say management is ethical, what do you base it on? The things I hear from industry insiders about Ocwen is nowhere near ethical. Battle ground stocks require scuttlebutt analysis instead of armchair analysis.

    • Does management treat shareholders ethically?
      1- I like the accounting.
      2- I like how management communicates with shareholders. They provide a lot of information to help shareholders understand how well the business is doing. They aren’t promotional.

      Does the company treat consumers ethically?
      1- Fannie Mae gives Ocwen good grades for its servicing quality.
      2- Ocwen doesn’t seem to have engaged in robosigning.

      Does the company treat mortgage investors ethically?
      I’m not sure about this one but I think so. Ocwen seems to have generated a lot of value for mortgage investors by reducing delinquencies. However, I never figured out if Ocwen took kickbacks on force-placed insurance. If they did, then Ocwen would be just like the big banks. If Ocwen didn’t, then certainly they have acted with more integrity than their counterparts.

    • Falling delinquencies? default-related services are the most profitable part of Altisource. Delinquencies will fall as all the subprime mortgages from the US housing boom get older (e.g. option ARM resets, negative amortization periods ending, etc.).

  6. Another day, another 20% loss for ASPS.
    And on news I fully expected too. Strange times in Altisource land.
    You got any inkling of negative repercussions from this announcement beyond the straightforward reduction in forward EPS?

    • ?? It might imply that regulators might go after them for past actions at that business ??

      If you’re brokering force-placed insurance, you’re presumably facilitating the mortgage servicer taking kickbacks because most mortgage servicers want the kickbacks.

      • “?? It might imply that regulators might go after them for past actions at that business ??”
        That is true, but with the previous letter already attacking the force-placed insurance agreement, I don’t see how shutting down this business alters the existing regulatory risk. I guess I should have phrased my question better, however, as you answered precisely what I asked.

        What I meant to ask was about any changes to the regulatory risk equation implied by this announcement relative to what existed prior to the announcement.

      • Yes – that’s what I thought personally – which is why I wanted to ask you about it. Given that this announcement in my mind does not increase existing risk, I’m surprised to see a stock price movement outside of what would have been implied by the % reduction in expected earnings.

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