Professional Documents
Culture Documents
NCANDESCENT
APITAL
January 27, 2014 Dear Investori: Our portfolio rose 10.75% in December of 2013, bringing our full year (unaudited) return to 60.68%. This compares to the S&P 500s gain of 32.39%.
Monthly Returns
14.00%
(2.00%) (4.00%)
Jan
Jul
Aug Sep
Incandescent
Year-to-Date Returns
70.00%
60.00%
50.00% 40.00% 30.00%
20.00% 10.00%
0.00% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Incandescent
Page |2 Although 2013 was Incandescent Capitals inaugural year, I have personally managed money for friends and family since 2009. Gross returns since inception are thusly:
Return 50.75% 18.78% 2.28% 16.38% 60.68% 27.92% S&P 26.46% 15.06% 2.05% 16.00% 32.31% 17.91% Difference 24.29% 3.72% 0.23% 0.38% 28.37% 10.01% HFRX1 13.40% 5.19% (8.88%) 3.51% 6.72% 3.73% Difference 37.35% 13.59% 11.16% 12.87% 53.96% 24.19%
And here is how $100,000 would have compounded versus those two benchmarks if it was invested at the end of 2008:
$400,000
$350,000
$300,000 $250,000
$342,465
$227,898
$200,000
$150,000 $120,069
$100,000
2008 2009 2010 2011 2012 2013
Incandescent
S&P
HFRX
All figures above are gross of fees (that is, before any fees are deducted). Since each investor in Incandescent Capital has the option to negotiate different fee arrangements, net returns will vary. For 2013, if you elected our standard 20% performance fee (no hurdle, no management fee) arrangement, your net return would be around 48% compared to your gross return of 60.68%. Also, depending on when your account was on-boarded, your results may differ from the main reference account reported above. It takes a bit of time to sync each account to the same exposure as I buy/sell according to the ebb and flow of the market. As always, your patience is asked for as I build your new portfolio up, but rest assured: what you own, I own. I am committed to eating my own cooking2.
The specific index here is the HFRX Global Hedge Fund Index, widely used index to praise or pan hedge funds in the press. The main reference account statement is available upon request from any investor.
NCANDESCENT
APITAL
Page |3
Position Size by %
Geographic Split
10.2% 32.7%
43.2% 67.3% 11.0% 13.1% Canada USA
As of the end of 2013, cash (that lime-green beveled slice) was 10.2% of our total portfolio. Our biggest position accounted for 43.2%, and our top three non-cash positions occupied around 2/3rds of our total portfolio.
NCANDESCENT
APITAL
Page |4 The constituents of our portfolio have largely stayed the same since I last shared this snapshot with you at the end of Q3. However, the percentages have shifted even more top-heavy (and Canadian) thanks to our largest positions 85% appreciation in Q4. Honorable mention goes to a smaller 5% position that appreciated 59% in Q4. All other positions averaged a modest 6% appreciation for the quarter. Needless to say, our book is concentrated. And since concentration is the antonym of diversification (practically canon law in asset management) I feel I have some explaining to do. Imagine a fund with the following performance over five years: -20%, -10%, 5%, 65%, 25%. Now imagine another fund that performs thusly: 5%, 10%, 6%, 8%, 4% The first would return $155.93 on $100 invested for an annual growth rate of 9.3%, while the second would return only $137.51, an annual growth rate of 6.6%. Which one would you prefer? This is not a trick question. Even though the first fund is more profitable, many people prefer the second, less profitable one because its less volatile. We humans are psychologically more sensitive to potential losses, and are willing to forgo potential profits in the spirit of loss aversion. Diversification, then, is touted as a way to spread out risk and minimize volatility across a portfolio. Investors gravitate towards smooth, predictable returns and shun lumpy, but possibly superior, returns. And Wall Street is all too happy to create products that cater to such preferences. Witness the explosive rise of ETFs 3 , which, according to Investment Company Institute, grew from $83 billion in net assets in 2001 to $1,337 billion in 2012. Even a small 0.50% expense fee applied to $1,337 billion results in $6.7 billion in revenues, with each incremental dollar representing almost pure profit. Its no wonder diversification is preached high and low. Investors who buy diversified funds are psychologically wired to sleep better at night, and Wall Street collects pure profit off the top. Best of all, there is no overt culpability! Instead of bearing the risks of the markets, wealth managers have surreptitiously transferred it onto the slumbering shoulders of diversified investors. Good year, bad year, whats the difference? Theyll take that management fee regardless, thank-you-very-much.
Exchange Traded Funds, which are basically mutual funds with the added benefit of intraday liquidity. Although an ETF is technically just a legal structure, it is most often associated as being an efficient way to diversify.
NCANDESCENT
APITAL
Page |5
Youd have to admire what a wonderful model that is if you d idnt wake up one day and realize your portfolio was suffering from mediocre performance. Because inevitably, the quality of ideas diminish the more one diversifies. Global capital markets are extremely competitive, and truly good ideas are scarce. I dont believe it makes much sense to invest equal amounts in our best idea as our hundredth best idea just for the sake of smoothing out our monthly P&L4. The truth is, the equivalence between volatility and risk is an imperfect one. Instead, the more appropriate equivalence is perhaps volatility and perceived risk. It is a relative measure, in which investors gauge riskiness based on how aggressively other investors are buying or selling. Here is where I ply my trade, where misperception begets opportunity. If such an opportunity is within my circle of competence and the misperception generates a level of volatility that creates attractive prices, I pounce. The trade-off is we will suffer volatility, and suffer the perception that we hold risky stocks. Our performance may resemble the peaks and valleys of imaginary fund #1 above. But if we do enough homework and double-check it diligently, it is a proven methodology that will result in outperformance in the long run5.
I feel obligated to note that diversification for folks uninterested in stock picking is an adequate strategy I would happily recommend ETFs of broad indices to those who do not have the inclination to invest with an active manager. My ire here is primarily directed towards funds that market themselves to be alpha generators, but yet are crawling with ETFs and end up inevitably correlated to the indices theyre supposed to be beating. Heres Buffett in 1998 speaking with University of Washington students: Youll see times when yo u get chances to do things that just shout at you. When that happens you have to take a big swing. That is no time to be reading a book on the theory of diversification. [] You take your thumb out of your mouth and barrel in. (http://youtu.be/ldPh0_zEykU?t=40m59s)
NCANDESCENT
APITAL
Page |6 So, I choose to concentrate. I do not choose to hide behind the veneer of diversification. My compensation and amount of kudos should be correlated with our long-term results. If I do poorly, it is my fault. I cannot blame the market, and I deserve to have capital pulled from my management. But hopefully, I will continue to do well, and we will all prosper. *** Happily, 2013 was a prosperous year for us all. However, it is unlikely I will be able to replicate 60% returns any time soon, much less on an annual basis. I consider this years results to be an outlier. My primary goals are and will always be: 1.) Dont lose money 2.) Outperform during bear markets 3.) Outperform over a multi-year horizon Gun to my head, The Number would be 20%, which represents a roughly 10% advantage over the long-term returns of the stock market as a whole. But rest assured, Im not about to take the year off to rest on my laurels. Investing is a business that has never failed to humble even the most brilliant, Einstein-esque IQ working 18 hours a day. I intend to build as big a lead as I can to buffer against the inevitability of an underwhelming year. Now lets talk stocks.
Founder & Chief Investment Officer of the famed investment company Oaktree Capital Management. One of the protagonists of the book The Big Short, who ran a successful value fund that made hundreds of millions shorting subprime mortgages in 2007-2008.
NCANDESCENT
APITAL
Page |7 The Yellow Media story actually ended up being two chapters. Initially it was simply conceived as a low-risk, low-return arbitrage play, but ended up being one of the most attractive opportunities I had ever seen.
The Arbitrage
The companys restructuring plan involved exchanging new common shares for a variety of different securities in their original capital structure. In plain English: imagine that you went and borrowed a bunch of money from a bunch of different people, and then woke up one day realizing you couldnt possibly pay all of them back. So you gather all of your debtors into a room and agree to garnish a percentage of your future salary to them to satisfy their claims. However, some debtors are more important than others. Maybe one of them is affiliated with the Dixie Mob, who demand a bigger cut of your salary or else. And maybe another is your grandmother, who kindly tells you to just pay her back whenever you can. As tongue-in-cheek as that example is, its basically how corporate restructurings work. The company is re-imagined as a pie that gets divvied up to people with claims, some of whom are contractually superior to others. Equity holders are at the bottom of the totem pole. They are the kindly grandmothers who, in most restructurings, get nothing. In Yellow Medias restructuring plan, however, everyone got a slice of the new pie. Even better yet, within the scrum, there existed an arbitrage opportunity. One could buy the preferred shares, which were allocated an X amount of the new pie, and then short an equivalent dollar amount of the common shares, which were allocated a Y amount of the new pie, and end up with a tiny slice that costs basically nothing. In other words, one could create X-Y = Z, where Z is a positive integer, for free (minus broker fees and short-borrowing costs). That was our initial foray into Yellow Media. By the end of 2012, the restructuring was approved8, and the new Yellow Media, with much of its debt shed, began trading as Y on the Toronto Stock Exchange.
We did not profit as much as we probably should have from this trade. I sized it conservatively because there was an outside chance the restructuring plan would be kiboshed by disgruntled convertible debenture holders. Not comparable with the $0.05 per share price mentioned above the share count was dramatically shrunken post-restructuring.
NCANDESCENT
APITAL
Page |8 multiple of its FCF10, and was astonished at the incredible negativity towards the company despite having scrubbed off $1.5 billion of debt. By then, I had become intimately familiar with its business operations. Its true that their print business was shrinking dramatically, but hidden in the miasma was actually a fast growing digital business already constituting 1/3rd of Yellow Medias revenues. All they had to do was to allow print to slowly die off and redirect its still-prodigious cash flows towards paying down expensive and restrictive debt11. Keep the momentum going on the digital side, and within a year or two, it would become quite clear that Yellow Media would survive, and perhaps even thrive, in its new incarnation. Bolstering my belief were the blueprints provided by the already successful print-to-digital transformations of Solocal and Eniro, the yellowpages of France and Sweden, respectively. Most importantly, it was nearly impossible for me to conceive of any scenario in which Yellow Media would go bankrupt, which is basically what their $6 per share IPO seemed to suggest. Even if I assumed their print business vanished overnight (2/3rds of their entire business) Y would still be a cheap stock valued at less than 10x FCF. There are slow floating 70 mph fastballs down the center of the plate, and then there are softballs perched on tee-ball stands. I swung and made Y our biggest position, putting 30% of our portfolio into shares at prices between $7 and $9. Y ended 2013 at $20.56, a ~150% gain from our cost basis. All the cash flows from their attriting print business has indeed gone towards paying down debt, which over the course of the year has been cut from $800 million down to under $600 million. Meanwhile, Yellow Medias digital business has grown to 43% of their revenues, and as a delightful cherry on top, they poached a top executive from Solocal to be their new CEO. We still own Y as of this date, although I have begun to book some of our profits. What was originally conceived as a simple arbitrage designed to siphon up a few nickels from a dark corner of the couch turned out to be a couch sitting on a gold mine. Be forewarned, ideas like this are rare. It is impossible to predict when (or if) we will have another softball like this teed up for us again.
10
FCF is a non-GAAP metric used by many investors to estimate a companys true, normalized earnings power when good old fashioned net earnings is polluted by one-time costs/gains. Which, in the spirit of a penny saved is a penny earned, is one of the su rest ways of building shareholder value.
11
NCANDESCENT
APITAL
Page |9
NCANDESCENT
APITAL
P a g e | 10
12
And repetitiveness a compliment, actually, because its a byproduct of how pervasive his philosophy is.
NCANDESCENT
APITAL
P a g e | 11
EchoStar Corp.
Our involvement in EchoStar (SATS) began back in 2009, one of our longest tenured names in our portfolio. The company was originally spun-off from Dish Networks13 (DISH) in 2008 to become the holding company for its satellite and set-top device business. Corporate events like spinoffs often create opportunities for several reasons. Often, investors will sell the spun-off stock because it doesn't fit their portfolio mandate, thus creating downward pressure on its price for no fundamental reason. Furthermore, a spinoff creates a more focused and transparent company, no longer relegated as a segment inside a larger company. That gives both investors and management more clarity, thereby raising its value over time. Two additional factors made SATS even more tantalizing: 1.) It was trading below tangible book value, and 2.) Charlie Ergen remained its chairman and largest shareholder, controlling over 50% of its stock. A sub-1x tangible book value spin-off with a captive customer like DISH and hard-to-replace assets like a fleet of satellites would arguably have been reason enough to warrant an investment. So would a rough sum-of-the-parts valuation exercise, whereby simply adding up its non-core assets (over $1 billion in cash and investments) and the present value of its earnings power equaled a per share fair value of roughly twice our cost basis of ~$20. But to me, the best part was having Charlie Ergen on our side. Ergen, who made his living playing blackjack and poker in his youth, is one of the great entrepreneurial stories in American history. Legend has it he started DISH with his poker buddy, his wife, a pickup truck, and two of those big ol C-band satellite dishes. On the way to their first installation, the truck hit a bump on the road and one of the satellites fell off and broke14. Thirty years later, through grit and guts, he is worth something like $12 billion and is ranked #32 on the Forbes 400. He could be retired on a mega yacht somewhere, but he remains heavily engaged in all his enterprises. Business schools typically teach people to discount stocks dominated by a controlling interest because it supposedly turns corporate governance into a de facto corporate dictatorship. But dictatorship can be a good thing if its benevolent. Warren Buffetts Berkshire Hathaway trades at a premium to where it otherwise might because hes the emperor. Likewise, if I can get in, discounted no less, on a Charlie Ergen investment, Id do it ten times out of ten in a cocaine heartbeat.
13 14
For my non-U.S. readers, Dish Networks is a major satellite TV provider here in the States. Sourced from a rare hour long interview here: http://lawweb.colorado.edu/events/mediaDetails.jsp?id=3866
NCANDESCENT
APITAL
P a g e | 12 We bought slugs of SATS for $20 in late 2009 and early 2010. I doubled down in 2011 when it pulled back to $20 again. And since then it has steadily marched up to $50, where I finally sold out last October because, alas, investing is a game of opportunity costs, and SATS had finally reached fair value. But I continue to keep tabs on Charlie Ergen, who has recently been making a push to enter the wireless arena to duke it out with the big mobile carriers. You better believe I am eagerly awaiting any future opportunities to bet with Charlie once again.
15
For FTR, it was actually collateral damage from a competitor, CenturyLink, cutting its dividend. FTR had reduced theirs already a year ago but skittish investors feared yet another cut. For CHR.B, it was a precaution against possibly losing an arbitration case. Why? Pissed off investors. Never underestimate the irrationality caused by heightened emotions. CHR.B then proceeded to win their arbitration case, after which management bumped up the dividend and the stock soared above $3.50. Cest la vie!
16 17
NCANDESCENT
APITAL
P a g e | 13 The miracle of compounding is such that steady gains in boring names like DIT, SATS, FTR, and CHR.B will guarantee you wealth over time. Home runs like Y and ADES are rare, and although of course welcome, one should approach the plate with the goal of not striking out. For those who follow Major League Baseball, the analogy is its better to be Joey Votto (high batting average, low strikeouts, occasional power) than Adam Dunn (low batting average, high strikeouts, but exceptional power). Of course, both are preferable over Mario Mendoza, whose sub-.200 batting average is taken to define the threshold of incompetent hitting, a.k.a. The Mendoza Line.
18
Real, money losing mistakes, not those humblebrag-ish mistakes of omission that so many fund managers cheekily trump, e.g. I knew it was a home run my biggest mistake was not buying more! It was impressive a 60+ slide deck chock full of numbers and graphs: http://www.scribd.com/doc/94429141/Bill-Ackman-s-Ira-Sohn-JCP-Presentation
19
NCANDESCENT
APITAL
P a g e | 14 Long story short, Ron Johnson failed to deliver. He emptied the companys cash coffers and embarked on a radical redesign of the entire store base. He made sweeping changes such as eliminating all coupons and discounts. On the surface, everything looked great. I mean, even I started to shop there. The problem, which is so obvious and simple in hindsight, was that folks like me are not their core customers! Penney instead served cost-conscious shoppers who cared more about their coupons than how pretty the stores looked. The company started to lose money with breathtaking speed. 25% of their annual revenues, about $5 billion dollars, disappeared during Ron Johnsons tenure. Their suppliers started freaking out. Under intense pressure, Johnson was ousted and the stock collapsed into the single digits. Other famous hedge funds like Perry Capital and Hayman Capital started getting involved and, emboldened by their implicit due diligence, I started buying JCP common shares. It is only by complete luck that I managed to sell out at breakeven after quickly realizing the danger of trying to catch that falling knife. But ever persistent, I thought I saw another cash proxy opportunity in JCPs unsecured bonds when the 5.65% 2020 20 traded down to 75 cents on the dollar, implying a yield of 11%. The company had brought back Mike Ullman, who immediately reimplemented the old couponing regimen. If he could avoid bankruptcy and stabilize the ship, surely the bonds are worth near-par. As of today, the story remains unfinished. Those bonds still trade in the 70-75 cent range, but thrash with astonishing volatility as investors and various press outlets continue to actively speculate on Penneys ultimate survival/demise. I lost my nerve and sold. Again, I credit fortune for escaping with just a small loss, but the lessons and scars I carry away are more moral than monetary. JCP was a story I got sucked into and thought I could play. But the truth is, I had no edge. Without an edge, I have no true conviction. And without conviction, I would be shaken out by volatility, the aftershocks of big hedge funds duking it out. Honestly, I have no idea if Penney will go bankrupt or if Ullman can ultimately save the company. I might as well go flip a coin a poor risk/reward not worthy of our precious capital.
Outlook
The broad stock market is, in my opinion, fully valued today. Pay no attention to those who claim the market remains cheap because the P/E of the S&P 500 is only 15x. The flaw in that argument is that the denominator, the earnings, are cyclically inflated. Corporate profit margins are at all-time highs thanks to ultra-low interest rates (companies are paying less for their debt) and political/economical forces that favor capital over labor (companies are paying workers less thanks to declining power of unions, outsourcing, technology, et cetera).
20
Bond shorthand for a security with a par yield of 5.65% maturing in the year 2020.
NCANDESCENT
APITAL
P a g e | 15 This has historically been unsustainable. The following chart, courtesy of research from mutual fund manager John Hussman, shows a strong correlation between corporate profits as a percentage of GDP (blue line, left axis) and their subsequent 4-year annual profit growth/decline (red line, right axis). Basically, the more corporate profits grow as a percentage of our total pie, the more they shrink in subsequent years a pattern that has repeated itself for the past 60 odd years:
If you think about it, rates that are already rock bottom can only rise, and underpaid workers in a capitalistic democracy will organize to regain their share of the GDP pie. Witness the demands of raising the minimum wage. Witness Barack Share The Wealth Obamas sweeping victory in 2012 over Mitt Private Equity Tycoon Romney. Witness the Occupy Wall Street phenomenon. CEOs and their 1% compadres are richer than ever, and the rest of America is fed up. Whether or not that is fair is irrelevant. Those are simply clear, common sense reasons why corporate profit margins inevitably revert to the mean over the long run.
NCANDESCENT
APITAL
P a g e | 16 I point this out as a general warning, not as a prognostication on how the stock market will perform this year. Its certainly possible the market will rip another 30%. Mankind is capable of bidding up anything, be it profitless tech stocks, CDOs, baffling Damien Hirst artworks21, and even tulips22. All I know is, stocks arent cheap, and I wont buy whats not cheap. Should the S&P replicate 2013s magnificent performance again, you should expect Incandescent Capital to struggle to keep pace. Nonetheless, I am confident in our current portfolio of securities. Besides Y and ADES, we hold several other names that have the potential to double, as well as a couple of boring-but-steady compounders that should grind out predictable earnings quarter in and quarter out. While it is extremely unlikely we will achieve anywhere near 60% returns again anytime soon, I fully expect our portfolio to handily outperform the broad market on an annualized basis over the next few years. I hope you will stay for the ride, however turbulent it may get. As always, I welcome any questions and/or feedback. I wish you and yours a prosperous and joyous new year.
Sincerely,
Eric Wu
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are gross of fees, unaudited, and taken from separately managed accounts (collectively, the Fund). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.
21
Check out this doozy that went for $12 million: http://en.wikipedia.org/wiki/The_Physical_Impossibility_of_Death_in_the_Mind_of_Someone_Living In 1637, one freaking tulip was going for more than 10x the annual income of a skilled Dutch craftsman.
22
NCANDESCENT
APITAL