This article is intended for investors oriented towards value-deep, value-distressed asset investing. Those seeking high-risk value investments may have an interest in this article. Investments in this company at any level of the capital structure are unsuitable for those seeking retirement income, and I strongly discourage purchase of securities related to this company for retirement income accounts, where a focus on risk aversion should be paramount.
In the case of this specific article, I am not recommending any investor follow my lead on the design of their portfolio. However, I have been asked repeatedly what I hold in my portfolio, as well as ratios of securities; therefore, this article is a response to that specific request.
It does not represent a recommendation to other investors to follow my lead.
My Overall Investments:
I have two very distinct portfolios which are managed in two entirely different ways: retirement and non-retirement. These distinct portfolios are managed in entirely different accounts using entirely different criteria for security selection.
My retirement portfolio is targeted on conservation of capital and the creation of a low- to moderate-risk income stream with a secondary objective of driving modest (e.g., 2%) appreciation to offset inflation and grow income modestly over time. At this point in my life, this represents a significant majority of my investment assets as I will soon rely on this income to provide a substantial amount of the income on which I will live for the remainder of my existence, being a pretty boring portfolio as it was designed to be. Needless to say, I am investing this carefully as if my life depends upon it, which it does.
This article will focus on the other portfolio: a non-retirement risk portfolio focused on deep value/distressed investments to drive aggressive total return. The management philosophy of this portfolio employs a total return approach, relying on the combination of aggressive appreciation and very high income to accomplish portfolio gains. As the reader will see below, it is highly focused on those assets where there is a perceived high probability of failure (probabilities which this analyst believes is exaggerated, sometimes extremely so) resulting in unjustified discounts creating both opportunity for appreciation and very high current income. It is also focused on a small number of such investments, so the penalty for being wrong is high, but the reward is very high when one is correct. Readers of previous articles by this author will know many of the individual names; in this article, one will see the portfolio in aggregate in which I have invested.
This analyst has used often a "10-50-90" approach to analyze situations where the spread of possible outcomes is very broad. These terms are used in this article to denote less attractive (10), typical, median (50) and reasonable best (90) cases.
I emphasize yet again that this approach does NOT represent my approach for investing for retirement and no part of this approach should be used by the readers using anything other than risk capital which can be lost. Indeed, I am not necessarily recommending this approach to any reader for any portfolio; however, since I have been asked repeatedly how my risk portfolio is set up, I write this to respond to those requests.
This is my portfolio and a summary of the strategies behind its operation.
Here is my risk portfolio as it stood at the close of market on April 9th, 2019 (and the use of the term "current price" later in the article will refer to these prices at that April 9th date), using a "relative share" count to represent in proportion the securities making up my risk portfolio:
- It is highly concentrated, having only seven positions involving only four companies:
- Frontier Communications common (FTR) and Exchange-traded debt (PIY) along with a short position long-dated put position with a strike of $10 (essentially long FTR on 3,000 shares at a current market price of $2.05 as defined by the options market),
- JC Penney Exchange-traded Debt Security (KTP),
- CBL & Associates Properties Preferred E Shares (CBL.PE), and
- Wheeler Real Estate Preferred D Shares (WHLRD) and B Shares (WHLRP).
- It is invested completely in securities that the market had judged are all headed towards failure, focused exclusively on deep value/distressed investments,
- It is not diversified,
- It is focused aggressively on total return, utilizing on both appreciation potential and high income to deliver that return,
- It is highly volatile portfolio with large daily moves at times, and
- It is not constructed necessarily with a view towards optimization of tax avoidance.
Historically, this investor has sought to have six to seven companies in play at one time in contrast to the current four. Seven, equal-sized investments results in one having, about 15% of assets involved in each company; if one makes a mistake and has a total loss in one security, it represents a 15% hit to the portfolio. More than seven positions implies lower risk, but impact of the few good ideas become too dilute if one employs excessive "diversification".
A portfolio concentrated in a few names means that one really needs to want that 15-20% position sitting there in each particular name; if that troubles the investor that there is not confidence to hold that position, then a 10% position is not correct alternative, but rather a 0% position. This drives substantial, dedicated analysis on any single position in one's portfolio, given the substantial stakes for every individual position held. If one cannot find positions in which one has confidence, then cash looks to this investor as the better alternative decision until one finds the next name in which one can have high confidence on the reward-risk of that specific investment.
Underlying the construction of this portfolio is a belief that you make money when you buy, not when you sell. However, "buying at the bottom" is a very difficult thing to achieve. I confess that I am seldom ever able to do so; in honest moments with other investors, they confess to me the identical experience. Therefore, buying slowly over time is essential to secure the "best prices" on securities, as elusive at that is.
The impact of my inability to buy at bottoms is demonstrated in the next section.
My Portfolio Relative to Purchase Basis, Net of Income Received:
Here is my portfolio, now reflecting my cost basis, net of receipts of income for each security. The basis adjustment includes only income received; however, it does not include dividends that are being accrued, as in the case of the Wheeler preferred shares:
Those who have followed my articles on Frontier Communications common shares will not be surprised to find that I am significantly underwater on those shares; in addition, I am also underwater on the derivative short FTR puts (essentially long this amount of FTR shares) at a $10 strike for Jan 2021 expiration, but net of the premium ($4.67) received (or an equivalent long basis of $5.33/share). Finally, I am down by a third on the JC Penney exchange-traded debt instrument, a security about which I have written less frequently (but current plan a future article).
On the other positions, I am close to breakeven for the CBL.PE shares, the Frontier exchange-traded debt and the Wheeler D Shares (separately or in aggregate) . The Wheeler Preferred B Shares are up about 30+%.
For the entire portfolio at this moment, I am down about 28% in aggregate, net of distributions received, including both the short and long positions.
Of course, capital appreciation (or depreciation) is not close to being the entire story for this portfolio. Income will play a substantial role in the future success or failure of this risk portfolio, as we will cover in the next section.
The Income Generated by My Portfolio:
The income produced by this portfolio is found described here:
The first element that may be noted is that I have reflected Wheeler dividends as income. Of course, they are currently suspended and those who have read a previous article on Wheeler ("After a Suspension of the Dividends, Now What?") know that my expectation is that they will remain suspended at least until January 2021. We will examine income excluding Wheeler dividends below in the scenario analysis; however, in principle, these dividends will be paid or will be accruing, so I have included them in this estimate of potential income.
This portfolio delivers an 18.5% cash yield on the net assets of the portfolio (including income from Wheeler). The reader will be appropriately concerned about how quickly the capital backing that income will dissipate. What can be easily overlooked is that if the demise of the securities in this portfolio is delayed, the impact of even a modest delay is substantial on recovery as we will discuss below. The reader can appreciate, as perhaps they had not previously, that it is not merely whether a company will fail, but when it fails, that will impact the ultimate recovery and positive or negative returns from a distressed investment.
'A Portfolio Going to Zero':
All four of these companies are predicted by the market, as well as significant Seeking Alpha contributors, as going to zero in bankruptcy re-organizations. That is, each has been predicted to end up in bankruptcy where owners of equity or debt are predicted to get little to no recovery.
So the critical question that the reader is asking this author is the following: "Owl, why in the world would you or any responsible investor invest in these securities that are sure to go bankrupt?"
The answer is, because the investor investing in such securities does not believe the assumed premise; that is, this analyst does not believe that of the securities will end up in bankruptcy. Anything can happen, but there are three expectations of the author related to these positions:
- there will be fewer bankruptcies than expected at this moment,
- the fewer bankruptcies which materialize much later than expected, and
- the fewer number of bankruptcies happening later will deliver a greater recoveries than is reflected in the current fearful coverage of each of these securities at this moment.
With apologies to John Kenneth Galbraith, my experience over 45 years of investing is that the market routinely identifies twelve out of the next four bankruptcies. Not only do many companies sidestep that "eventuality", but those that do end up in that unhappy place long after it was expected and frequently, but not always, deliver better recoveries than have been expected by the consensus of analysts at earlier points in a given campaign.
But, to a point that the reader is surely asking at this moment, "What if you are wrong? Can you stay in the game if you have misjudged all of these securities?' For an investor in deep value or distressed investments, this always need to be the first evaluation of any investment: "Can you stay in the game if you are completely wrong?".
We evaluate that next for this portfolio.
"Staying in the Game":
"Owl, what happens if you hit a nuclear winter scenario?" "Owl, will you have the ability to stay in the game and invest beyond 2023 if you are wrong on every security?"
To answer these questions, let's evaluate the scenario posed. Assume every security goes to a price of zero, creating a 100% loss, at the point of the bankruptcy filing, using time that more negative commentators might suggest as probable. That is, every security will file for bankruptcy, one receives absolutely no recovery on the security at the point of filing and one absorbs an additional loss on the FTR puts at expiration in Jan 2021 as it has a value of zero, which is $2.05 below where it trades as of April 9th on 3 relative shares. The author reviewed Seeking Alpha articles to identify the point at which the current market view of timing on bankruptcy filings for each of the securities in this portfolio were suggested, identifying the timing of failure for each, as tabulated here:
In this scenario, the interest on the debt is paid to the period just prior to the period of the bankruptcy (otherwise, the filing would need to take place earlier) and it is assumed that the dividends on the preferred shares will suspended a year prior to the period in which the filing is made (in a last ditch attempt to stave off the filing by conserving cash). Given the suspension at this point on the Wheeler securities, it is further assumed no dividend income will be received from either of the two Wheeler securities in this particular scenario.
So, with no recovery on the securities themselves, a loss pending on the put position from the current pricing and with only income to provide any recovery, the recovery on this portfolio looks like this:
In a slightly better case, assume that Wheeler dividends are reinstated starting in January 2021 and continue through the first half of 2022, at which point they are suspended yet again one year prior to the filing, and the recovery looks like this:
It may surprise some readers that such a drastic "worst case evaluation" still allows a recovery of about 50% of the current market price and about 35-40% from my basis already 28% down from the point at which they were purchased. So while these are obviously unattractive returns, these rather draconian scenarios still provide some recovery and enable this analyst to stay in the game, even in what is arguably the "worst case" scenarios. These recoveries would represent a base of recovery from which the next portfolio could be developed even if every judgement made in the design of this portfolio is wrong.
Indeed, they represent in the view of this analyst "worse than worst case" scenarios, as we will discuss below, having assumed absolutely no recovery on any security itself. So, with these income recoveries as a base, we can now evaluate what happens if some of these securities turn out not to go to zero and some securities do better, as this analyst expects them to do.
Recovery Scenario Analysis:
Now let's consider the fate of this portfolio if not everything goes wrong.
This analyst views the likelihood of bankruptcy for the four companies in the portfolio to be, in going from most to least likely:
- JC Penney
- Wheeler REIT
- CBL & Associates Properties.
Let's start with considering what happens when recoveries improve from those companies more likely to avoid bankruptcy, proceeding to an evaluation of improved recoveries if those companies more likely to go into re-organization also avoid that fate.
1. CBL-E Shares: In the view of this analyst, CBL is the company least likely to encounter bankruptcy. In the article, "Should I Sell My CBL, CBL-D and CBL-E Shares", the authors pointed out the risks of CBL and the preferred shares, especially the encumbrance of the better properties in the recent secured debt financing. However, the company has degrees of freedom to respond to the current challenge, as described in the author's article, "I Am Buying What They Are Selling. Here's Why". In that article, I point out that the recent dividend cut, even in the face of the common dividend suspension, allows two more years of the current spending on property improvement and debt reduction to continue, equaling $535M with a continuing $170M in property sales. Suspend the common dividend in the third year and that total equals $800M.
Some authors and commentators believe that the real estate, even as the net tangible book value of their portfolio exceeds debt by $1B, could not be liquidated to secure much more than the current value of the debt. I am not of that opinion, but for the sake of argument, let's say the more negative view is correct. What the trends in this author's earlier article show is that CBL should retain the ability to have available $500M in the next two years and near $800M over the next three years. Incorporate the premise that the real market value of the current assets are equal to the debt, but then add $800M in debt reduction and asset upgrades beyond where we are today. Using balance sheet arithmetic, one has created $800M (minus depreciation) in assets net of liabilities by adding to assets and reducing liabilities in the three year period as one "approaches bankrutpcy", creating more net assets than needed to secure a full recovery, even if the "80% discount to every existing asset" is true. This $800M is 27% more than the amount of assets needed to provide the CBL preferred shares full, one hundred percent recovery.
So, using as a premise the recovery income secured above plus only a 90% recovery in CBL-E preferred shares of 90%, one still secures the recovery for the portfolio as seen here:
While some believe that CBL won't recover, I believe the leadership led by the Lebovitz family has a substantial incentive to drive recovery for the preferred shares to 100%. Otherwise, their common share position will dwindle in value that Mr. Lebovitz spend four-plus decades creating. Mr. Lebovitz's name in on the door (OK, his initials, but let's not quibble) and I believe that he does not want to leave as his life's legacy a failed real estate venture. CBL leadership and the board are taking action to create the cash resources needed to help improve properties and drive down slowly leverage, even if it will not happen soon enought to satisfy an impatient investing public. When the smoke clears, I expect that preferred shares will have recovered to pricing close to face value, which is a necessary but insufficient condition for Mr. Lebovitz (pere' and fils) to preserve their family fortune.
On current market prices, a small annual return on the entire portfolio would be secured with only the recovery income plus a 90% recovery on the CBL preferred shares, with all other securities continuing to be valued at zero. Furthermore, relative to the basis of the portfolio, the recovery would near the purchase basis of the portfolio. While no one's aspiration is to break even over five years, this demonstrates the lower risk and a much larger recovery, even with this unfavorable scenario, than may have been expected at the first look at this portfolio.
2. Wheeler Preferred B and D Shares: This author has argued in two articles in 2019, "After a Suspension of the Dividend, Now What?" referenced above, as well as the "Is There An Equity Restructure Endgame Possible?", indicating that a 90+% recovery on the preferred shares now selling at 60% discounts was very possible while also suggesting one approach that could deliver that recovery. Again, I believe the current CEO, Mr. Kelly, is fighting very hard and taking the steps necessary to get WHLR back into a solvent condition. While I believe that a recovery on the common shares will be both limited and difficult, I believe that the preferred shares are likely to see a sizable recovery, based upon the efforts of the management team over the next few years.
In that case, this improves further the outlook for the returns on this portfolio, as shown here:
Securing 90% recoveries on the CBL and Wheeler preferreds along with the recovery income, provides an 11% annual return for this portfolio relative to the 90% worst case and a 14% annual return for this portfolio if the somewhat less severe, 75% worst case scenario plays out. Again, this continues to assume that both Frontier common and unsecured debt goes to absolute zero in 2H'22 and that JC Penney debt goes to absolute zero in in 2H'23.
3. JC Penney Exchange-Traded Debt: It is worth noting that the income stream for JC Penney debt at the current market prices will essentially pay for the security at current market prices if continued through 1H'2023. That is, the relative shares of the JC Penney debt position in the portfolio is currently (April 9th, 2019) valued at $45 and the JC Penney debt will deliver $45.70 of income prior to the earliest expected bankruptcy. This is a particular case where bankruptcy timing is critical; if bankruptcy were still to occur, but arrive two years later, then the debt position would have delivered 150% of the current market value. Six years of interest income would equal the purchase basis in the portfolio, even if bankruptcy produced absolutely no recovery.
I don't happen to buy the "Sears and Penneys" argument, as I argued some time ago in an article ("Is JC Penney Really Comparable to Sears Holdings?"). Remember the "Circuit City just went bankrupt, so Best Buy is next?". That is now ten years ago and we are still waiting. There are other arguments: Penney is actually run by a retailer while no one would confuse Mr. Lampert, perhaps a brilliant financier, as a retailer. In the view of this analyst, Ms. Soltau did terrific work in running JOANN Stores, another retail chain that you would think would be under attack by on-line shopping. Finally, as weaker chains in the JCPenney demographic fail, this reduces the competition for the remaining chains, including JCP, which may be the "real" Circuit City affect.
I believe, at a minimum, that JCP will operate past the 2023 date, especially as Ms. Soltau has more opportunity to enhance JCP as a retailer. I will be revisiting JCP debt in a future article.
4. Frontier Communications Unsecured Debt:
One can infer from my articles on FTR common that, even in the case that Frontier files for bankruptcy, the recoveries should be well above the current market prices of the unsecured debt. One may get equity in the "new" Frontier, albeit a much less levered Frontier which has the same substantial cash flow as the current version, but the aggregate recoveries in cash, new debt and equity should total substantially more than the current discounts suggest.
For the sake of argument, use a 75% recovery on Frontier (I believe it will near 100%, including the equity) and you now get the following result for the entire portfolio, incorporating the premises used above (note that the Frontier common is valued at zero and an assumption that the puts will need to be redeemed with a value at zero remains in this assessment):
As one can see, this scenario provides exceptional 23-25% annual returns on the current basis and relatively decent returns (14-16%) on the purchase basis, starting from a point 28% underwater in aggregate for the portfolio.
"The 90% Upside Case":
It is a simple matter of arithmetic to calculate the "90% Upside" case, assuming all debt instruments and preferred shares return to face value, again excluding any value for Frontier common or puts on those common shares:
In the 90% upside case, one secures relatively outstanding returns of 29+% on the current market prices (actually higher as the income would continue well past that reflected in this table to hold the income constant across all cases for better comparison) and 20+% on my basis which is currently underwater.
The reader is likely to retort that this is unlikely to happen; my response to that comment would be to agree (thus it is the 90% upside case), almost as unlikely as every security going to zero.
This table provides a spectrum of reasonable, potential future outcomes. They range from a recovery of 32%, representing a 68% impairment of capital, to annual returns of 30% between now and mid-2023. From the perspective of April 2019, returns on this portfolio in the low- to mid-teens looks very reasonable. As time goes on, I believe at least three of these securities will be viewed more positively as their boards and management attempt to claw back from the brink. I remain concerned about the Frontier board and management remaining blissfully unaware of the risk of their actions, failing to respond effectively to the challenge as I believe that other three companies are. We will return to this point in future articles.
And these returns continue to use as a premise that Frontier common and the puts are valueless, headed to zero. What if they are not?
Potential Impact of a Recovery in the Frontier Common Shares FTR:
At this point, the probability for Frontier to need a re-organization is more likely than not, short of a deux ex machina from a large, attractive asset sale or Uncle Warren coming in to save the day.
The market appears to me to be factoring in a near certainty of a filing which zeros out the common equity. Consider the short interest:
The short interest of 54M represents a short interest equal to about 51.7% of the outstanding common share float.
Of note is that the "days to cover" metric reported by NASDAQ at the same time also continued to rise, hitting a new high. What represents a risk to those short is that the rise in the latter metric is resulting primarily from daily average volume dropping rather than an increase in short interest, even as it continues to hit new, incremental highs. The tide of average daily volume appears to be ebbing, as many investors appear to have simply give up and move on to a better opportunity, leaving fewer, but more experienced, value players lining up on either side of the upcoming struggle.
So one can reasonably expect that one of two alternatives for the common equity is zero. What would be the other possibility?
As this author has argued, one potential opportunity is to repurpose cash flow from growth, where none has been delivered, to delevering. Let's consider one potential scenario, for the sake of argument, if this decision were to be made.
Let's do a simple conceptual calculation:
- Take existing EBITDA (unadjusted) of about $3.4B, continue to degrade it at a 4% rate per year, then add back half of the announced EBITDA improvement (delivered about half of the announced target last time) to calculate an EBITDA of $3,150M,
- Calculate the EV/EBITDA Ratio currently, which is $16,358M long term debt, $814M short term debt, $354M in cash and $240M in market value (106M shares times $2.27/share) to generate a current EV/EBITDA ratio of 5, very low relative to most others but justified based upon the perceived risk to the equity,
- From the $1.8B in cash flow prior to capex, pull out $600M in annual cash flow (more than the $400M needed for maintenance) and use the remaining for deleveraging, with a reduction of $100M available each year for this purpose (2019: $1,200M annualized, but $900M remaining for the last three quarters, 2020: $1,100, 2021: $1,000 and 2022: $900M, summing to $3,900B, close to the $4B needed through 2022, using the revolver to mop up the remaining amounts necessary beyond the $3.9B.
- Using the calculated 5 ratio, calculate that the net assets increase (through reduction of debt) of $3.9B, reducing it from $16.8 to $12.9, and an EBITDA of $3,100 at that point yield a calculated market value of $2,850M, and
- On 106M shares, $2,850M calculates to a share value of $26.89/share.
On the 12 relative shares in the Risk Portfolio, $26.89, let's round down to $25/share, delivers a position value of $300, 20% higher than the current value of the entire portfolio.
So a 15% loss for the combination of the Frontier equity and the derivative may be in the works, equaling 3 quarters of average income; however, the Frontier equity has the potential to gain 1000+% and add 100+% to the value of the entire portfolio. The alternatives set up asymmetrically, with the potential for declining by a factor of 1 and increasing by a factor of 10-15. Of course, probabilities favor the loss, but it is less certain than I believe most analysts believe.
Beyond the immediate move, once it hits $25, it is likely to go higher as this would imply that the expectation for a filing will have been dissipated. This would imply that a real valuation on the cash flow would be made to reset the market value of this security, driving the EV/EBITDA ratio incrementally higher.
Therefore, this analysts views that Frontier will either be worth zero or be greater than the current value of the entire portfolio when the smoke clears and the issue of a bankruptcy filing has been resolved with a potential for significant gains beyond these discussed.
Finally, it is worth noting that, if there is any significant recovery in the equity of Frontier, then the exchange-traded debt instrument for that same company should regress to close to face value, providing excellent recovery on that investment along with a near 20% cash return on the current purchase basis of that security through 2046.
- The Risk Portfolio is a highly concentrated portfolio, with a small number of positions (7) in fewer companies (4), that is focused on deep value/distressed securities.
- The goal of the Risk Portfolio is to deliver aggressive, above-average total return, accepting some risk to accomplish that goal and expecting bumpy results.
- As a consequence, this portfolio appears on first examination to be highly risky and almost destined to create a near total loss for the owner.
- Upon closer examination, recoveries in reasonable worst cases still appear to be in the range of 32-50%.
- What is less obvious is a reasonable probability of attractive returns generated by this portfolio, even if only some securities return to a reasonable value while others are indeed "zero'd" out.
- Full recovery for the fixed income portion (preferred shares and exchange-traded debt) would provide outstanding returns even excluding any recovery in the equity portion.
- A full recovery is a lower probability outcome, but so it a full loss on all of the securities, with a probable outcome of the portfolio performance being somewhere in the middle.
- Recovery on the equity portion creates a possibility of strong upside additive to what the fixed income portion can provide.
- Only time will allow us to see for sure the degree to which recoveries are, or are not, obtained for the Risk Portfolio.
Additional disclosure: Disclaimer: No guarantees or representations are made. The Owl is not a registered investment adviser and does not provide specific investment advice. The information is for informational purposes only. You should always consult an investment adviser.
Disclosure: I am/we are long CBL.PE, FTR, KTP, PIY, WHLRD, WHLRP. 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.