Once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling.
- Seth Klarman
In contrast to the speculators preoccupation with rapid gain, value investors demonstrate their risk aversion by striving to avoid loss.
- Seth Klarman
A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.
- Seth Klarman
The overarching theme of my portfolio is based, more or less, on asset plays and mutual conversions. In regards to the former, asset plays help to resonate a margin of safety. The asset plays within the fund are boring, unexciting and spoken by some of my critics as 'dead money'. I am not going to disagree with the critics, some of the companies within the fund could be dead money; however, the margin of safety within each asset-based investment is compelling. If the market decides to go into a bipolar spin, I will have confidence to hold the asset-based companies and self-assurance to buy more in a downward spiraling market. In regards to upside, eventually value will be realized - be it today, tomorrow or five years from now.
Mutual conversions - post-converted and second-steps - represent the other side of the fund. Historically, mutual conversions have outperformed the market - by a wide margin - with low volatility. Furthermore, mutual conversions allow me to invest in overcapitalized banks, at a steep undervaluation. Moreover, they help implant the margin of safety within the fund - allowing for attractive upside with downside protection.
As the fund evolves through time, some positions will be sold, some new ones will emerge and others will be held. Even though evolution will take its normal slow course of route within the fund and through the manager, the same elements of style will exist within the fund. Deep discounted asset plays and historically back-tested and statistically outperforming methods of investing (net-nets, deep value and mutual conversions) will represent the style throughout the theoretical portfolio.
The introduction to the theoretical portfolio proved successful amongst the Seeking Alpha community. Not only were there intellectual dialects exchanged, but a handful of investors found the theoretical portfolio enticing - urging me to construct a fund not based for research purposes but for actual practice. As with anything in business, I have dedicated a great deal of thought to the former inquires - developing plans going forward.
Publishing research online requires 'thick-skin' and one must be open and honestly take into consideration criticism - positive or not. Over the past year of publishing free research to the online community within Seeking Alpha, I have welcomed criticism as a way to improve my methodologies. The theoretical portfolio, not to my surprise, had valuable 'push-backs' in regards to the forward looking performance of the fund. The biggest concern many readers had was the lack of liquidity and overconcentration - though, there was one commentator who insisted the fund was overly diversified - yet, after reading more of his public comments, it became apparent that speculation was the nature of his business.
In regards to the lack of liquidity, it should first be mentioned that I do not view illiquidity as a risk. Think of it this way: does the local business owner view his business as risky because there is not a liquid market to sell the business? I'd think not! Liquidity should be viewed as more of a hurdle. If you find a company that is selling significantly below its asset value - yet has a low liquidity profile -the company is not risky, but rather has a type of hoop to jump through before an investment can be made. On the flipside, the lack of liquidity can make for an expensive investment and could be a huge hurdle if you need to raise cash quickly. Inclusively, I am looking to own cheap business. If liquidity is a hurdle, patience will be needed. Patience is a virtue - especially within the practices of my theoretical fund.
The age old question of what portfolio performs better; the concentrated or diversified fund? I have read numerous studies and books in regards to the construction of a portfolio and the pros and cons of concentration vs diversification. Is my portfolio too concentrated? The better question to ask; is the fund too concentrated relative to what? Relative to a broad market ETF, yes, the fund is concentrated. Relative to a portfolio that holds fifty percent of the aggregate assets in a single security; no the fund is well-diversified.
So what is better; a diversified portfolio or a concentrated portfolio? Well, it all depends on the confidence of the portfolio manager, the amount of risk one is willing to take and the magnitude of stress one wants to incur. If you feel confident to take a fifty percent position in a single security and willing to bear the risk of a potential black swan - which will probably be more prevalent in an over-concentrated fund - hats off to you. On the other hand, if you want the comfort of a diversified portfolio, would like to sleep well at night knowing one single black swan will not influence a magnitude of havoc and want 'wiggle-room' for un-calculable mistakes - diversification may be the funds forte.
I believe that the theoretical portfolio is well diversified - yet also has elements of concentration. In regards to the latter, there is concentration within asset plays and community banks - which could result in a significant amount of interest rate risk - more thought will be deployed into the inherent risk of the ebb and flow of interest rates. In terms of diversification, the fund is diversified across geographical realms, types of assets and one-single position does not make up an exorbitant size of the fund. By the same token, I am confident that the fund will not experience an absolute capital impairment from any one single position.
Capital preservation is the fund's fundamental goal. I am not looking for a 'hot' stock to propel the fund upwards by many of multiples. The goal is to preserve wealth and incrementally create affluence through value investing methodologies and a foundation based upon a 'margin of safety'. Through time and patience, buying cheap companies will yield rewards - just as in a tree planted decades ago will produce shade.
Building wealth is a marathon, not a sprint. Discipline is the key ingredient.
If you are looking for a shortcut to wealth, you have the wrong spirit. It's built gradually, layer upon layer.
Building wealth is the process of managing risk, not ignoring it.
- Joe Duncan
It has been around a week since the theoretical portfolio was constructed. As expected, nothing much has happened within a week. There were a few earning announcements, a company in the portfolio fell around -15% and two new positions were added. It may be counterintuitive to successful portfolio management to provide weekly periodical updates - though, it may be beneficial to the manager and regular readers. Only time will tell the pros and cons of updates.
On an aggregated basis, the fund had little action - up 0.07% since inception. However, there were a few interesting 'things' that happened within the fund in the past week that should be highlighted.
To encapsulate the next paragraphs in a sentence: there was a good earnings announcement from a 'core' position, a bad earnings report from a mediocre position, two companies look interesting from recent pullbacks and two new companies were added to the fund.
The Biggest Winner
Conrad Industries (OTCPK:CNRD) was the biggest winner this past week. Moreover, their second quarter results helped to drive the equity price upwards. Likewise, I was pleasantly surprised when the company posted net income of $1.3 million and EPS of $0.25/share, compared to net income of $1.2 million and EPS of $0.21/share YOY. Given the downturn in the O&G sector, I was expecting lower absolute and relative bottom-line results.
However, the first six month results do show the affect the downturn has had on the company - net income of $3.9 million compared to $5.2 million YOY. Despite the first six months draw-down, the most impressive item in the quarterly release was the big jump in backlog. At the end of the quarter the company had backlog of $248.7 million compared to backlog last year of $131.7 million. Even more impressive, backlog at 2015 year-end was $211.8 million -thus, backlog increased 17.42% in six short months. Finally, the company declared a quarterly cash dividend of $0.10/share or a 1.69% yield.
Overall, I think the company looks attractive at the current price and the increase in backlog suggests business is beginning to pick up again.
The Biggest Loser
The biggest loser was Tix Corporation (OTCQX:TIXC) which lost -15.00%. The reason for the big drop was due to weak and unexpected Q2 results. Thus, the change in product (tickets) resulted in reduced revenue earned per ticket. Moreover, there was also a -2% decrease in tickets sold that didn't help the problem. Why did this problem pop up? Well, one of the biggest risks has started to transpire - the recent closure of Cirque du Soleil.
Cirque du Soleil was a big customer for the company. The permanent closure of the venue shifted revenues in a downward fashion - revenues of $5,312,000 compared to $5,889,000 YOY. Net income also declined from the fall in revenues combined with an increase in SG&A - from $1,582,000 or $0.09/share from $530,000 or $0.03/share.
However, the company is focused on a growth plan with Expedia Local Expert - a division of Expedia (NASDAQ:EXPE). The agreement makes TIXC the Official Las Vegas Guest Services Partner. This will not only help leverage the existing platform TIXC has, but allow them to tap a whole new customer base within Expedia. The agreement with Expedia was started on June 15 th, 2016 and should start to generate further revenue streams for the company in the near-term. I am expecting SG&A to continue to be ramped up in the near-term to support the potential growth from the Expedia platform. If Expedia does not result in material benefits, there could be a cash flow problem - resulting from high SG&A expenses.
It's never good to see a company lose a major contract - resulting in top and bottom line draw-downs. However, TIXC has a huge cash position to work from, a controlled market and a new revenue stream that could be beneficial. I am not surprised that something happened like this - I have seen Murphy's Law more than once - but at the same time, I am disappointed. Good thing TIXC represents a low position in the portfolio. I will continue to hold and monitor the position.
Volatility to Take Advantage of
Otelco (NASDAQ:OTEL), ended up falling almost 8.0% in the past week. As many know, I was speculating that the recent downward pressure in OTEL's stock price was from the six banks selling the 230,000 or so shares they held. However, Stephen Spicer - who also wrote an excellent article on OTEL - made a great case in the comments section of my introduction article to the fund, stating why he believes the banks still hold a good majority of the shares. If true, we will most likely see further downward pressure, giving long-term investors a good chance to pick up more shares at an even steeper discount. I haven't bought more shares, but will be quick to grab anything below $4.00/share.
Another company that whose market volatility looks interesting is CKX Lands (NYSEMKT:CKX). In the past week, the stock price fell -7.39%. I am not surprised with the volatility - revenues are hit from a weak O&G environment and the bottom line has languished. However, my thesis relies upon the company's land base - which is pretty undervalued. Moreover, the company has a strong balance sheet and recently purchased 880 acres in Calcasieu Parish, Louisiana, giving the company more standing timber and mineral rights. If there is more downward pressure, I will welcome it with a chance to build my position.
Two New Positions
On Friday, I added two new positions to the fund. With an overall theme of assets plays and mutual conversion embedded in the portfolio, I decided to build a starter position in Forestar Group (NYSE:FOR) and Alamogordo Financial (ALMG).
FOR is a really attractive asset play and could be worth a substantial amount if and when further monetization happens. I think the company has attractive upside and absolute downside is minimal. I decided to buy a 2% position in the company and may continue to build it up. You can find my entire 'thesis' on the company here.
The basis of my thesis is as follows. First, the company has a new management team and a refreshed board. New management has rapidly sold non-core assets in the past year - paying off a substantial portion of high-interest rate debt. The company is now almost in a net-cash position and a significant amount of risk has left the table. Management's forward looking plan is to turn the company into a pure play lot developer. Not only will this rapidly increase the company's bottom line, but a substantial amount of shareholder value will be created in the process. FOR also has a significant amount of assets on the balance sheet that are worth a considerable sum on a SOTP basis. As more assets continue to get sold, I believe there is upside of 30-60% in the near-term. In the long-term, the company could be a 2-3xer.
ALMG recently announced a second-step conversion. Not only will this allow the company to raise a substantial amount of capital, but post-conversion, the company will have a P/TBV of 56-76%. The company is just another boring bank, but the second-step will give the company a significant amount of non-dilutive cash and put the company in a nice undervalued state. I like conversions. I like the historical returns they have done as a group. And I will continue to allocate more monetary assets to conversions as time passes.
The evolution of an investor would be interesting to study. When I became interested in investing - my sophomore year in college - I felt like I found the career path that made sense to travel down. As I read as many books on investing I could get my hands on, my thought process developed and I began to make decisions on how I wanted to form myself as an investor. The evolution of the investor continues to develop within me - in which I slowly begin to see the style of investing that makes sense on a personal standpoint, a theoretical aspect and in common practice. As I continue to develop, the practices and research I conduct today, they will eventually be put to work, in the world of high finance.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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