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Annual Performance and Thoughts on Investing

January 11, 2012 Leave a comment Go to comments

2011 Performance

The year started out with great promise. The market was up double-digits in the first quarter. My holdings were up substantially to start the year. There were clearly many macro events that could have raised concerns for the market. I was aware of many of them, although I do not make investment decisions based on macro events. As uncertainty and fear took over, the market got hit hard. My investments weren’t immune to these concerns. In the end the market was basically flat for the year. My portfolio had a negative 20.57% return for the year.

Although I’m disappointed by the negative return, these are for the most part unrealized losses. I don’t see any one year’s return as having a big impact on the long run. Infact, years like 2011 (and 2009) are the best time to go shopping. And I was definitely shopping. I build up large positions in multiples companies that were hit hard (Yukon-Nevada and Bank of America). Although I suffered in the short-term from buying these positions, I believe in the long run they will help in substantial out-performance over the market. A big reason for the 2011 under performance is due to buying equities that kept getting cheaper. For example, we started buying Bank of America Warrants at $3.50. When it got cheaper, we bought more at $3. As it got even cheaper, we were buying more at $2.60. It got to all-time lows of $1.96.

Was I wrong in buying as it got cheaper? Well, only time will tell. So far, in the first 10 days of 2012, the warrants are back up to $3 (a 50% jump in 10 days). If I’m right, then my investments will work out over the next couple of years and the performance will show when compared to the index.

In 2011 the biggest detractors were Harvest Natural Resources, Yukon-Nevada Gold, Dolan Company and Bank of America Warrants. The big winners were ATS Corp, Harris Interactive and Taro Pharma.

In December of 2011, I sold out of Howard Hughes Corp and Tecumseh Products. I believe both of these companies are undervalued at current prices. Although some of my existing holdings were too cheap. I was buying more Yukon-Nevada and Bank of America. I expect to be buying more of both of these companies in early 2012. I would like to buy back both HHC and Tecumseh. It will depend on how my current holdings work out and where HHC and Tecumseh are at that time.

Year Performance S&P 500
2009  128.75%  26.46%
2010  8.85%  15.05%
2011 (20.57%)  2.1%
Cumulative 97.78% 48.55%

The funny thing about “New Year”

It is interesting to watch how a “New Year” has an impact on human behavior. Since my high school days, I never understood the circus around New Year’s. I understand it is the start of a new year but human behavior towards this event is mind-boggling.

You will see individuals acting as if the start of the New Year is an opportunity to start fresh. What they couldn’t accomplish in the past year, now with one change in the Earth’s rotation will make it happen. Individuals start acting as if the past is something that can now be forgotten and erased as they have now entered a new year. What they had procrastinated for years will be accomplished.

It is not only individuals that par-take in these bizarre actions. Companies are even more weirder. From an accounting perspective, the company closes its books and starts off fresh. The company creates a new budget and the entire company gets focused on these new numbers. The behavior from management is to forget the past year performance and start focusing in a new set of numbers that start from zero. The entire company starts working on these new set of numbers. It is a mindset that believes there is no continuity between last year’s performance and the new year. An amazing play on the mind happens that doesn’t allow for any connection between what happened in the prior year and what will be achieved in the new year. It is a belief that the worst from the prior year ended with the prior rotation of the Earth. The new rotation is a fresh start.

For insurance companies, the reserves and poor performance from last year is almost ignored as the company starts looking at the new year’s numbers. It is as if the premiums that resulted in poor loss ratios in the prior year, for some reason will not apply in the current year. Management creates new monthly variance reports to analyze current month and current year performance to prior year. The variances imply a distinction between prior year and current year. In reality these are bogus variances that actually don’t make any sense. These implied assumption that these set of numbers, from current year and prior year, have a distinct set of customers, economic conditions, different pricing, and a new weather condition.

In fact these type of fallacies happen in majority of companies and in all industries. The quarterly and annual numbers have an implicit assumption that there is actually a cut-off period. That the business starts fresh at each period and that prior year conditions will for some reason not carry forward.

Similarly, reporting annual performance implies that there is a certain cut-off for our results. As if, the investment performance from prior year doesn’t not impact the new year’s performance. In fact, it is the opposite that is true. The performance from prior year has a big impact on the new year. Companies that have been mis-priced in the prior year are still mis-priced in the new year. If a company has a fair value of $1 but ended the year at 20 cents, then the gap between the price and fair value doesn’t change at the start of year. Similarly, the difference between the fair value of my holdings and the market price continues to the new year. Although 2011 was a bad year for the holdings, I believe as long as these companies delivery on their plan the market will sooner or later react to this difference in valuation. I’m optimistic that the poor performance in 2011 will lead to much stronger results in 2012. To ensure that I don’t end up suffering from the same human behavior related to New Year resolutions, I will have to ensure companies that have suffered permanent decrease in fair value are dropped quickly.

Thoughts on current holdings

Harvest Natural Resources: This is company that has yo-yo’ed between loved-hated-loved-hated. I think the company and the management team is at the ‘hated’ phase right now. Although self-labeled “value investors” are quick to change their mindset. The company sells at a huge discount to its Venezuela assets, Gabon discovery, and cash position. Plus the Indonesia drilling is still a game changer based on what management has seen in their first drilled well. I expect 2012 to be the year that management either sells certain assets or starts development plan for assets outside of Venezuela. I expect to likely sell out in 2012 based on what management decides to do.

Yukon-Nevada Gold: This company and management have gone from obsure to loved to hated to fraud to loved in a matter of 18 months. The company had a superb late-2010. Then in 2011 the problems started to show. Many hedge funds that had bought in 2010 bailed out and cashed in the quick 3-bagger. Others started to question management, and some even started to talk as-if the company was a fraud. All this while, the management team kept working on delivering on the plan set out in 2010. The company finally will have put in the plant upgrade to get production to a stable state of 150K oz of gold. I think the company’s stock will rebound to 2010 levels and should even surpass those levels. Investors that believed the 2010 plan put out by the management will be rewarded.

Bank of America Warrants: The most hated company in 2011. For value investors these are the type of companies you want to look at. And value investors were buying big. Major value investors (Buffett, Berkowitz, Pabrai, Chou) were buying BAC. I think this company is getting an incredibly bad rap from the media. The management team is doing a great job cleaning up previous management’s mess. The company’s operating business is very strong and the reserves keep improving each quarter. The legal issues surrounding BAC are the major uncertainty. We saw one major settlement in late-2011. I believe 2012 we will see many more cases get settled. These settlements should take some of the uncertainty away from this company. I expect the stock price to do very good in 2012.

Taro Pharma: This was one of the few stocks in 2011 that was a winner for me. It was up almost 50% within two months of holding the stock. The company will likely get bought out by Sun Pharma. The only question is at what price. Sun’s offer is at $24.50 and the market is pricing the stock at over $29. So the market is expecting Sun to raise its offer price. I think the fair value is atleast $40-50/share. Although given that Sun already owns over 60% of the equity, it is unlikely we get the $40-50 range. Although this could get dragged out for a while, as minority shareholders have said the offer price is too low. We will wait and see how it plays out.

Palladon Ventures: 2012 is the year this company starts production from its concentrate plant. In February the company should start producing from the new plant. The stock price has jumped quite a bit since my initial purchase. It is up almost 3x since my initial price. I expect 2012 to be the big year, with plenty more upside in 2012 and 2013. I expect this company to be a likely buyout candidate

Heckmann Corp: Heckmann had a very good 2011. The company finally started to get the revenue potential that I expected. The company will likely end Q4 w/ an EBIDTA range of around 13-15M per quarter. I expect 2012 to be a major year for the company. I think the company should be able to do 60-70M of EBIDTA. Also, I expect M&A to pick up in this space.

Reed Resources: This has been a mistake on my end. I bought the stock without thinking enough about the illiquidity. In 2011, I saw many opportunities to buy other businesses at much cheaper prices. Although I wasn’t able to jump on them because I couldn’t get out of the stock at a fair price. Although I would like to invest this capital elsewhere, I won’t get impatient and sell without regard to price.

Dolan Company: The company had a tough 2011. The main business, NDEX, struggled due to the slow-down in foreclosures. The US government took a long time to come out with the procedures that banks can follow. In Q4 2011 we finally started to see some uptick in foreclosure processing. I believe the NDEX business should perform very well in 2012. Also, many competitors had to close shop in 2011 as they couldn’t meet the new requirements or couldn’t survive the slowdown. The company’s other major business, eDiscovery, did very well in 2011. The management team did a great job in doing a small acquisition to grow the business. The business is growing very well and 2012 should show very good growth.

Harris Interactive: The new CEO has just started the turnaround. I expect to start seeing the results of the turnaround in the second-half of 2012. Although the first couple of quarters should see the drop in expenses and the company getting cash flow positive. Overall, I’m very optimistic about this company and the upside.

The “Green” revolution

Living in the San Francisco area, you tend to get exposed to many technological innovations before they become mainstream. It was about 9 or 10 years ago that I started to see signs of a cultural revolution towards “green” products. The initial attraction to these products was from individuals that were conscious of their impact on the environment. They wanted products that would allow them to enjoy the benefits of certain products while be aware of their decision would not have a negative impact on the environment.

I visited many local conferences focused on this “green” revolution. Viewing different offerings and “green” solutions, I realized there was a major disconnect between what customers were looking for and what was offered. Infact the products offered did meet the “green” requirements. Although there was something missing in these products.

A few years later, I read the book “Cradle by Cradle” by William McDonough and Michael Braungart. McDonough and Braungart are innovators in the “green” revolution. They have designed many products and processes for companies to produce products that incorporate the environmentalists approach. The book discusses the entire lifecycle of products, from the materials used in the products, to transporting the products, to after-life of the product. The authors argue that true “green” products need to consider all aspects of the product lifecycle inorder to create products that will have the least negative impact on the environment.

Looking at “green” products today, you will see the “green” label used as if it was just a sticker to be placed on any product. In the market you can find products that have no major difference between each other expect that one product sports the “green” label. Also most of the “green” products in the market have no real thought given to the entire process for creating the product and its after life.

So what does this green revolution have to do with investing.

The “value investor” label

Value investing has lately become a fashion statement. You can read any mutual fund’s prospectus and the fund manager will say his goal is to purchase companies that are selling for cheaper than its true value. The fund manager wants to buy stock in a company when it is selling for cheap and then sell it for a large profit. But we all know that majority of these investors never make any profit. Infact they clearly fail in purpose. The question is why?

One of my investment, Yukon-Nevada Gold, has provided me with an interesting view into this reason.

In late 2010 I came across a SumZero write-up by Jared Levin on Yukon-Nevada Gold (YNG). I read through the write-up and found it as a compelling investment opportunity. After researching it for a week, I had a talk w/ a hedge fund manager who runs a “value investment” centric fund. I mentioned YNG to him. A week later I talked with him again and he mentioned their fund was going to start building a position. A few days later, I saw the manager post a message on his blog about the company. In the write-up the manager said YNG had a book value of atleast 60 cents but was selling for 30 cents. The manager was also extremely bullish on the company’s future production potential and considered the investment in a gold producing company as a hedge against the macro economic concerns.

For people aware with the YNG story they know that YNG quickly moved from 30 cents to 90 cents. Just fast as it moved up, it quickly descended back to 20 cents. This fund manager sold out of their position at 60 cents.

With the stock price today at 28 cents and the book value still at a huge multiple to current price, a friend had a conversation with the same fund manager. Interesting, the fund manager’s reaction to YNG this time was that they were not interested. Although if you look at the valuation and the business fundamentals, today the company is much cheaper and less risky than in 2010.

So why did this so called “value investor” get interested in 2010 in YNG but then lost interest when the same opportunity came back a year later?

In fact, I’ve talked to many so-called “value investor” hedge-fund managers about YNG. A few of these fund managers are well known in the investing community. Some of these managers bought the stock in 2010 and then got out at the highs. When the opportunity presented itself again in 2011, these “value investors” didn’t want to touch it.

One of the rules of value investing is to separate the business from Mr. Market’s valuation. The market tries to capture the reality of a company’s business but many times the market makes mistakes in trying to reflect this reality. One of the reason is that the market is short-term focused and much quicker to react than the operating business. This means that certain companies that have a difficult short-term operating environment will have its stock price suffer. The investor that can look beyond the short-term pain can gain from this mis-pricing.

In 2010, as is today, the investment opportunity in YNG was based on stable production of atleast 120K oz. If the company was able to delivery on this then the valuation of YNG would be multiples of 30 cent. The fund manager that focused on the book value of 60 cents missed the entire investment opportunity. Book value doesn’t mean anything for mining companies. If you believed in the company and the management’s ability to get to 120k oz production then it was worth buying YNG.

This so-called “value investor”, similar to many other value-based hedge funds, have been using the value investing label to basically market themselves. Similar to the “green” product revolution, these hedge funds are like the “green” products that claim one thing but are actually shams when you look in detail.

More recently, another value investor wrote a letter to the management of Monument Mining about a recent transaction proposed by the management. The investor basically did a valuation of what the company is worth without the transaction and what it is worth after the transaction. Since the calculation produced a higher number without the transaction the investor concluded the transaction would destroy value. If investing was as easy as elementary algebra then we would all be rich. There is a huge distinction between an investor’s approach to the stock and the management’s approach towards running a successful company. It is only when you look at the company as an operation that will have an infinite life, then you can start understanding which decisions will create value.

Books

In the last few years I haven’t been able to read as many books as I would like to. Although there are always some good books that leave an impact on you. In 2011, the books I would recommend are:

The Small-Cap Advantage by Brian Bares: This was a book that I recently read in December. The book covers all aspects of starting and running an investment management business. It covers topics ranging from the right structure (hedge fund, IRA, mutual fund, …), to back-office and compliance, to marketing and raising capital. It is mainly focused on individuals that want to run a fund geared towards the small-cap investing. If you are looking to start a fund this is a great book. If you are something that is interested in small-cap investing, I highly recommend the first two chapters of this book. Small-cap investing has proven to beat the indexes over the long run. The book won’t help you find and screen for small-caps but it is rather focused on arguing that small-cap is a great place for investors will small amounts of investment assets.

Mastery by George Burr Leonard: This book was written a while back. The topic of this book has grown in popularity over the years. In fact there are many great books recently written on this topic (Flow and Outliars comes to mind). Although this book has been exceptionally well written and can been used as a guide to start on your path to mastery in your chosen field.

The Crowd by Gustave Le Bon: A classic for all human behavior students. A few years back I read this book for the first time. I enjoyed it immensely. I have now made it part of my list of books that is worth re-reading every year.

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Categories: Performance
  1. David Landy
    January 12, 2012 at 1:25 pm

    Nice post.

  2. Bart
    January 25, 2012 at 2:10 pm

    Very good post indeed.

    Any idea on the stock Al Angrisani holds at Harris? Just to get an idea about his incentives…

    thanks!

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