Sharing one's investment ideas and process with other market participants can be a powerful method for money managers to advance their careers and practices. We built Seeking Alpha's editorial platform upon this opportunity, sourcing rigorous research from investment professionals and placing those contributors' ideas before a sophisticated investing community.
No case in recent memory demonstrates the upside of this approach as strongly as Cara Goldenberg's. Ms. Goldenberg, 29-year-old co-founder of hedge fund Permian Investment Partners, took the initiative to send Warren Buffett her ten top investment ideas in November. Buffett liked the unsolicited research so much he invited Goldenberg to Omaha to join him for a discussion and dinner. As Frank Betz of Carret Zane Capital Management commented to Bloomberg, "She hit the jackpot. It's praise from Caesar, of course. Boy, it must’ve been one heck of a letter."
We asked Ms. Goldenberg to share three of the ideas she sent to Buffett. Yesterday we posted part one, Goldenberg's thesis on Valeant Pharmaceuticals. Today, Goldenberg's research on two other investment ideas, part of our ongoing High Conviction series.
~ Mick Weinstein, Editor in Chief
Seeking Alpha: What are your three highest conviction positions in your fund - long or short?
Our three highest conviction positions are all longs. We know the management teams well. We have studied their track records, met them several times and appreciate their level of incentive and ability to drive value creation.
I shared the first idea yesterday. Picks two and three are Cowen Group common stock (NASDAQ:COWN), and a hybrid bond from Germany: Pfleiderer Preferreds (Pfleiderer 7 1/8% Undated Subordinated Fixed to Floating Rate Securities), ISIN XS0297230368.
With legendary bankers Peter Cohen and Tom Strauss in command, Cowen Group is transforming itself from a small boutique investment bank into a complete financial services company with >$7 billion in assets under management. Ramius, a privately-held alternative investment manager, recently acquired Cowen Group in a reverse merger that closed at the end of 2009. The Company has more net cash and investments than market cap despite a) stabilized asset flows on the Ramius side of the business, and b) a dramatic increase in leads and wins and on the investment banking side.
Having come from investment banking backgrounds, we firmly believe what one reference mentioned to us, “in banking it’s all about who you know, and Peter Cohen has a rolodex to die for.” We have a number of anecdotes where Peter has jumped on planes to fly to visit small rural towns for one day to win co-manager roles. COWN currently trades at a 0% EV/AUM and a discount to book value. Valuing Ramius at a paltry 2.5% AUM (versus peers over 7%) and the investment bank at 1.0x book (versus peers at 1.3x), Cowen would be worth >$9 per share (>75% upside). Assuming management actually creates value and generates returns from this level, the shares are worth a multiple of the current price.
And the hybrid bond?
The Pfleiderer hybrid bonds offer investors an opportunity to buy industry-leading assets at 50c on the Euro in addition to receiving coupon payments worth 43% of initial capital outlay within 18 months. The issuance is relatively liquid (available to U.S. investors through a broker), with €260mm outstanding. While this business is quite cyclical, we believe the severity case has been extinguished following the Company’s debt refinancing in January and equity offering in February. Pfleiderer is the lowest cost and second largest Particleboard (PB) and Medium Fiber Board (MDF) producer in the world. Pfleiderer’s management team is second to none in Germany both in terms of operational track-record and alignment with minority shareholders and bondholders. Management collectively owns 6% of the outstanding share capital. Furthermore, CEO Hans Overdiek has been accumulating the hybrid bond and currently owns >$1.1mm.
Pfleiderer’s end markets are primarily wood paneling and laminate. The Company serves Western Europe (51%), US (31%) and Eastern Europe (18%). The industry is characterized by regional oligopolies due to transportation and capital barriers, similar to cement. JPMorgan’s One Equity Partners and the Pfleiderer family own roughly 35% of common equity.
To what extent are these sector picks, as opposed to pure bottom-up picks?
We are not particularly bullish on financials or materials as sectors. We think Cowen and Pfleiderer bonds will generate significant absolute returns in just about any market environment, and at the very least, will generate significant relative out-performance. These securities appear extremely undervalued with clear market dislocations, which should provide a sufficient margin of safety with a 1+ year time horizon.
How would you describe Cowen's competitive environment and its positioning?
The competition amongst investment managers and advisors is fierce. Ramius’ track record since 1994 has been very respectable, compounding at 17% since inception. However, the last couple years have been much more difficult. Many of its struggling funds have been closed, and we are left with reputable managers leading fairly unique and successful franchises. Cowen Healthcare Royalty Partners, an $800M private equity fund that buys pharmaceutical royalty streams, has generated fantastic returns and has been a pioneer in its field.
Cowen’s credit book, fund of funds and small cap value have also generated fantastic returns and now account for almost all of AUM. On the investment banking side, we believe the relationships of Cohen and Strauss provide Cowen with a significant competitive advantage. Additionally, Cowen’s Healthcare and Technology research franchises are deeply-entrenched and highly regarded. We believe that both businesses have reached a relative and absolute inflection point and will begin to grow and outperform peers from current levels.
And Pfleiderer's competitive landscape?
Most of Pfleiderer’s assets are top quartile. The particleboard and MDF businesses are characterized by regional oligopolies. Typically EBITDA margins are fairly stable, but when demand falls by 40%, there is inevitably a profitability squeeze as players scramble to cover fixed costs (~20% of manufacturing costs), and those at the high-end of the cost-curve enter into administration/liquidation. To give you an example of Pfleiderer’s competitive positioning, despite industry utilization dipping below 60%, Pfleiderer will generate close to 9% EBITDA margins in 2009 (12.4% in 2008). These are trough figures. Meanwhile, the third largest player in Europe, Sonae Industria, is unlikely to break-even on the EBITDA line in 2009. As a result, Sonae has closed two facilities and four other players have shuttered capacity as well. Nearly 20% of capacity has either exited or is in the process of exiting the market.
What are your thoughts on Cowen's valuation? How does its valuation compare to its peer group?
Cowen trades at 0x EV/AUM, below book value and at about 5x normalized earnings. Peers trade at 7% EV/AUM, 1.3x-2.0x BV and anywhere from 6x-30x 2011 earnings. It is probably best to value this as a sum-of-the-parts as the business drivers are somewhat different and so are the peers. We think the shares are worth a minimum of $9 (shares were near $9 last summer and near $8 in November) valuing Ramius at 2.5% AUM and the investment bank at 1.0x book.
How do you assess valuation on the Pfleiderer bonds?
Ignoring the €350mm of equity value below us, the Pfleiderer bonds trade at 10x 2010 net debt less capex. On a normalized basis, the bonds trade at <5x net debt less capex (7x EV/(EBITDA less capex)). We are not aware of any comparable opportunities at this part of the capital structure at this price. From an equity standpoint, the shares trade at 11.5x 2010 free cash flow and 4x normalized. Peers trade at ~16x 2010 free cash flow, excluding the many that will not generate cash in 2010.
What is the current sentiment on Cowen and Pfleiderer? How does your view differ from the consensus?
Valuation suggests that sentiment is quite bearish on Cowen. Coverage is minimal (three small shops cover the name – one ‘Buy’ and two ‘Holds’), so it is difficult to gauge how we differ from consensus. I think the market is missing three key elements to the story: 1) Peter Cohen’s ability to drive investment banking revenues; 2) Ramius’ AUM stability driven by refocusing on its core, successful product offering; 3) negligible fundamental downside given the level of net cash and investments on the balance sheet.
Three analysts upgraded Pfleiderer equity following the refinancing and subsequent equity offering (two of these double-upgraded from ‘Sell’ to ‘Buy’). There is no coverage on the bonds, but most of the analysts who follow the equity also know the bonds quite well. Currently there are four ‘Buys,’ six ‘Holds’ and three ‘Sells.’ Due to the cyclical nature of the business, the shares fell from nearly €30 to the mid-teens at the outset of the housing/construction crisis. Subsequently, the shares fell from the mid-teens to low-to-mid single digits driven by solvency concerns.
The market does not appreciate a primary driver behind severity of the decline in profitability for Pfleiderer: management’s decision to cut prices to force competitors to close capacity. Thus, estimates do not reflect the benefits of capacity closure against slowly rebounding demand. Finally, the investment community doubted the probability and cost of refinancing, which is a major reason why the shares have outperformed the markets in 2010.
Does management play a role in these two positions?
Management quality is the key pillar behind our investment philosophy. We invest behind management teams with proven track records and incentives that are aligned with investors.
We offer an analogy to explain why we invest behind management: Imagine you could assiduously turn over an infinite number of stones only to select the most extraordinary ten. Those ten stones represent your highest conviction equity investments as measured by valuation, market dislocation, business quality, margin of safety and, of course, management quality. Now imagine that each of those management teams are themselves working diligently to turn over an infinite number of stones in order to pick pennies off the ground for investors, pennies that most management teams unknowingly step over, kick to the side of the road (probably en route to a major sporting event that they have elected to sponsor directly out of distributable funds to shareholders). This analogy represents Permian’s philosophical edge: the compounded effect of our team out-hustling our competition to source the most overlooked and non-consensus investment ideas, and the management teams we choose, in turn, out-hustling their competition.
There are of course an infinite number of ways to cut the deck when it comes to investing, but we believe our approach is unique and allows for the construction of an exceptionally original portfolio with a highly asymmetric risk/return profile regardless of market direction.
What catalysts do you see that could move Cowen stock? And catalysts for the Pfleiderer bonds?
Cowen and Ramius have only been together since November 2009. We believe that as the group illustrates stability and growth in AUM and a sequential increase in investment banking leads and revenues, the shares will not trade at a discount to the effective net cash on the balance sheet.
We believe that the Pfleiderer bonds are in the early stages of re-rating following refinancing in January and an equity issuance this month. As investors see prices rising on the back of significant and permanent capacity closures and start to see evidence of the permanent structural change in the industry, Pfleiderer will deliver strong cash (we forecast a 30% free cash flow yield to equity holders in 2011-2012) and the bonds should trade at or close to par. If the company decides to pay a dividend at any stage (and has a history of generous and consistent dividend payments distributed in accordance with the family and private equity sponsor’s demands), an immediate repayment of all coupons in arrears will commence (covering essentially the entire principal outlay given the current pricing of the bonds).
What could go wrong with these two investments?
At Cowen, disappointing performance at Ramius and/or the fallout from a potential cultural clash from combining Cowen and Ramius could result in AUM outflows and declining banking fees. This could result in a cash burn where your margin of safety provided by the balance sheet erodes.
At Pfleiderer, if less profitable peers find a way to survive despite tremendous mounting cash losses for the next couple years (debt matures at the end of 2013), then industry profitability could remain depressed. In reality, we are supported by JPMorgan’s One Equity Partners and the family below us in the capital structure. There could be near-term bumps in the road from PPI inflation against CPI deflation (rising oil and global commodities against falling prices and local demand for end-products in developed nations). This could pressure results in the somewhat near term, but will likely result in a quicker return to normalized earnings power as smaller, higher-cost peers are forced to shutter capacity.
Thank you very much, Cara.
Happy to participate.
Disclosure: Permian Investment Partners is long COWN and Pfleiderer Preferreds
If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett.