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.

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Most of the time nobody will explain the game to you

In many areas of life, the sharpest people in a given field often won’t explain the tricks of the trade to the general public.  Sometimes it’s the case that the publicly-available information on a subject is second-rate.  Take Warren Buffett for example.  His derivatives deals are brilliant because he is getting paid to borrow money.  Of course, he does not fully explain his deals because he doesn’t want others copying his trades. In shareholder letters, he does not explain how his counterparties were inappropriately modeling equity-equity correlations.  He only discussed the trades on a superficial level because GAAP accounting of the derivatives were causing people to misunderstand Berkshire’s intrinsic value.  Buffett likely avoids explaining Berkshire’s credit default contracts for similar reasons.

CACC Part 4: Will subprime auto lending end badly?

I think that the word “subprime” has an undeserved reputation.  The US subprime housing crisis was a very unusual situation caused by extreme levels of loan fraud and loans designed to blow up (e.g. ARM, negative amortization mortgages, etc.).  These excesses do not exist in other areas of subprime lending.  During the housing bubble, lenders did not verify income and allowed unemployed individuals to buy millions of dollars of housing.  In the current auto market, the lenders actually check that the information given to them is correct.  According to CACC’s training website, 75% of loan applications are initially rejected due to problems with the loan application (e.g. a utility bill to verify residence is too old).  The subprime lenders tend to perform the most loan compliance work (out of necessity) while prime lenders have fewer stipulations, looser loan compliance, and less onerous paperwork.

CACC Part 3: Why Credit Acceptance is brilliant

In my opinion, Credit Acceptance has excellent execution across all areas of its operations:

1. Creating value for dealerships.
2. Servicing loans efficiently and keeping costs low.
3. Learning how to underwrite well across a wide range of situations.
4. Being disciplined in underwriting.

Very few companies do all four of these things well.

CACC Part 2: The fundamentals of subprime auto financing

Originally, there was a segment of subprime auto financing that was a fairly low-risk for dealers extending credit to their customers.  If the downpayment is equal to what the dealer paid for a car, then risk management is much simpler and underwriting skill doesn’t matter much.  The dealer could lend money to even the riskiest customers.  Dealers could break even on the initial sale and hope to profit from the financing of the car.

CACC Part 1: A wonderful business buying back its shares

Credit Acceptance Corporation is a $2.7B company that finances and services subprime auto loans.  Brett A. Roberts has generated an impressive track record since becoming CEO in January 2002.  The share price, book value per share, and earnings per share (not shown) have grown at impressive rates.

The share count has dropped from 43.3M (diluted) at YE2002 to 24.0M at YE2013.  The company continues to repurchase shares through open market repurchases and tender offers, sometimes issuing debt to repurchase shares.

I’m very impressed by the way the CEO communicates with shareholders.  The company website contains the CEO’s letters to shareholders and answers to shareholder questions.  The shareholder letters explains the risks in the business, explains the CEO’s thinking on risk and underwriting quality, explains distortions caused by GAAP accounting, and helps investors to understand the business.  It is obvious that Brett Roberts is influenced by Warren Buffett in his writings.