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Week 177: Perspective

Five weeks ago I wrote that I was walking away for a while.  And so I did that.  It didn’t last as long as I had anticipated.

At the time I had taken my portfolio to about 60% cash and I had a number of shorts that helped hedge out the exposure from my remaining longs.  In early October I had basically stepped away because I had made some mistakes and lost confidence in my decisions.  It had started with the mistake of not looking closely at the oil supply/demand dynamic, which was compounded by the mistake of selling the wrong stuff when the bet began to go wrong.  As I lost money on a few oil and gas holdings, rather than reducing those positions I reduced other positions, presumably with the intent of reducing my overall risk.  Unfortunately this isn’t really what I was doing.  What I was actually doing was selling what was working while holding onto what wasn’t.  A cardinal mistake.

The consequence was that I saw my portfolio dip 12% from its peak by the second week in October.  More frustrating was that as stocks recovered in late October, I watched as some of the names I had sold near their bottom, in particular Air Canada, Aercap, and Overstock, recover their losses and were on their way back up.

I wrote my last post on a Friday afternoon after the market had closed.  Over that weekend I was virtually unencumbered by the markets.  My portfolio was cash, my blog was on hiatus, I had nothing to prevent me from thinking clearly. I don’t remember exactly when the moment came, but at some point that weekend I had a realization.

For those who have followed this blog over the past few years, you will remember that in December of last year I made a very large bet on New Residential.  The stock had gotten hit down to below $6 at the time.  I thought this was rather ridiculous and so I bought the stock.  I bought a lot of the stock.  I made it a 25% position in my portfolio.

In a narrow sense, the trade worked out.  By the end of December the stock had jumped close to $7 and I sold the position for a tidy profit.  But in the broader sense, it was an abject failure.

Looking back, this was probably the first investment decision I have made in 6 years that strayed away from a number of the basic tenets of my strategy.  Don’t initiate a big position until the thesis starts to play out in a positive way.  Don’t let one stock position become too large. Don’t add to a position that is not yet started to work.

It was the first few flakes that started a snowball.  This year I have taken a handful of abnormally large positions.  With some of those positions I have added to even as they didn’t work.  With others I have not reduced them even as they hit my mental stops.

I basically was taking on more risk.  And you know what, for the most part it actually worked pretty well.  I was up as much as 40% on the year at one point.  I even after the the dip in October I was up over 20%.

However the problem is that when that sort of strategy doesn’t work, it really doesn’t work and so its not sustainable on a goijng forward basis.  I had a few inklings of this; first when I continued to add to my magicJack position in May after it dipped from its then 52-week high in the $20’s, only to have to sell what had become nearly a 20% position at $14 per share and for a significant loss.  I had a second tremor early in September, when my extremely large gains from my extremely large position in Pacific Ethanol were reduced substantially as I watched the stock fall from $23 to $18 in a matter of days.

In October it was this rather sudden change in fortunes, which was followed by an equally sudden collapse of a few of my oil positions, that really shook me.  In particular it was Bellatrix, which I had taken a large position in through purchases in September and October, that was the breaking point.  I continued to buy Bellatrix even as it fell from my initially small purchase at $9, to increasingly larger purchases at $7, then $6.50, then $6, and finally into the $5’s.

Doing what I should never do

In addition to Bellatrix I made smaller but similarly poor decision with Swift Energy at $9.  My only saving grace there is that I eventually did realize my mistake and cut my loss at $7.  I didn’t added up exactly what the damage was from these two stocks but I would estimate that of the total portfolio drawdown in September-October that these two stocks made up a majority of it.

As I said I compounded these mistakes by selling other stocks in portfolio which would subsequently do well.  Looking back at this, I had no reason to sell these other positions but I sold them and not at their highs.  Stocks like IDT Corp, Overstock, DSP Group – none of these names were experiencing trouble that justified their sale.

The final element of the confluence was Ebola.  While I wasn’t terribly worried about Ebola’s impact on the overall economy, I was worried about what might happen to the airlines. I did some research into what happened with SARS and how air traffic plummeted as a result.  I mistakenly became caught up in the media hype, worried that Ebola might have a similar impact to SARS, and sold my airlines, in particular Air Canada in the $7’s.  Air Canada was my second largest position so selling at $7 when the stock was at $9 only a few weeks before was a big hit.

Looking back, the root cause of these poor decisions lay in the overly large position I had in Bellatrix and to a lessor extent Air Canada.  My clearly flawed thinking at the time was that given the risk I was taking with Bellatrix, which was falling to the $6’s and then to the $5’s, I needed to reduce risk elsewhere to limit my overall portfolio exposure.  In other words I don’t think I would have made any of these decisions had it not been for the first bad decision to average down and make a larger bet on a losing position.

What Happened Next

I would love to say that after my epiphany that weekend I bought everything back and ran my portfolio back to new highs.  But this is reality and in reality when your confidence is shaken you can only make baby steps.  What I needed to do was to get back to basics, take starter positions in everything that I felt was worth taking starter positions in and go from there.  So I added back Aercap, Air Canada, Overstock.com, Air Transat, DSP Group, etc, and I significantly reduced my position in Bellatrix (note that I did exit Bellatrix entirely a couple weeks ago, for the reason of tax loss purposes). I went back to what worked.

While I would subsequently add to some of these names, such as Air Canada and Overstock.com, it was only because they showed that they were working out positively from my original purchase.

I also started to work very hard researching new names.  One interesting thing that I found about taking on large positions is that they crippled me from looking hard for other ideas.  It creates what is almost like tunnel vision.  This is another problem with this sort of strategy – lost opportunity.  I had convinced myself that because the market had run up so far there weren’t opportunities out there and that is why I was being forced into the corner with only a couple of ideas that I really liked.  The truth is that I simply wasn’t working hard enough.

For the past month and a half I have put in hours every night looking for new ideas, listening to conference calls, creating spreadsheets, etc.  I have not slept that much.  But I was very angry with myself and I wanted to get things back on track.  As a result I have found a number of names that I have taken positions in and that I think hold out the possibility for price appreciation.  A few of these names have already not worked out, but you know what, that’s okay, that is part of the plan and the positions are small enough that no real damage is done.  Many though have begun to work, and I am going to give some explanation to each of the names below, as I will list out every stock I own right now and why.

So far my return to basic principles is working.  My portfolio has appreciated from its lows, though it is still off the highs.  Unfortunately my confidence a month ago was pretty shattered and so it took some time to put money back to work, to generate new ideas, and to get some momentum back to my account, and even longer to have the courage to add positions to some of the other accounts that I work on.  And not to forget that in the middle of this all my efforts were compounded by the debacle at Extendicare, which I will discuss briefly below, which led to a 2% drawdown in its own right, but for which my motivations and decisions were inline with my strategy and so I wouldn’t have changed the way I acted there.

Positions

Air Canada – As I already mentioned I unfortunately sold this stock at the height of the Ebola panic.  After putting my head back on straight I then bought it back a couple weeks later at a higher price.  I am fortunate to have done so because the stock has continued to move higher since that time.  I have added to this position.  The 3rd quarter results were in-line with my expectations, in particular cost per available seat mile (CASM) showed further improvement, the company is projecting significant capacity additions in 2015 which should lead to further growth, and they will benefit from falling price of oil (though this will be mitigated to some effect by the falling Canadian dollar).  I worry a bit about the economic sensitivity here; there are so many weak economies in the world, I find it concerning and the airline industry is going to be one of the first industries to be impacted by it.  But this hasn’t led me to sell my shares.  Yet.

Amdocs – I bought this company after reading this article written by Tschay Michel on SeekingAlpha.  Michel is very good with coming up with free cash flow ideas and this is one of them.  Given the solid business that they are in, their track record of operating success, it seems too cheap at roughly a 9-10% free cash yield.  The article is available and it says much more than I can write in a paragraph so I will leave my comments at that, only to say that I am looking at a second idea brought to my attention by Michel right now in the name of Higher One.

Axia NetMedia – not too much to say on this one.  I never sold it.  Third quarter was solid. Continue to hold on anticipation of build-out in Alberta and further expansion of Covage.

Aercap – I have bought back and added to the position on excellent third quarter results.  My biggest worry is that determining the free cash flow generation is not simple and so I’ve never been 100% confident in the valuation.  But I think its most likely in the $50’s somewhere.

Argonaut Gold – I made one small bet with a gold stock this week and that is Argonaut Gold.  My idea is this: when oil prices went up all the heap leach gold deposit costs went up significantly.  So with oil coming down all of those big yellow trucks are going to run much more cheaply.  Argonaut Gold owns heap leach mines that use lots of yellow trucks so their costs should benefit from the dynamic.  Only problem with this one, and why I am keeping the position small, is I really don’t have a lot of confidence in the price of gold.  I especially don’t know where gold goes after this weekend’s referendum in Switzerland, which is most likely to fail.

CGI Group – These are the guys that brought you Obamacare.  Well the software problems anyways.  Apart from that though, they are a successful software company trading at a reasonable price.  The company is growing at a decent clip yet it trades at a free cash yield of more than 10%.  Jason Donville has mentioned them numerous times on BNN, with the most recent being this Friday.

Dixie Group – Oh Dixie.  This stock got shellacked into the $6’s and I had to reduce my position some because it had fallen below my 20%ish loss threshold but then it promptly came back and that’s how it goes.  This is an ugly turnaround story that depends on a pick-up of residential and non-residential spending in the US, something that I think could happen in the next year.  This is the kind of stock that could easily double if things go right.  But right now the financials are really quite ugly, and with a myriad of acquisitions and discontinuations of businesses due to the restructuring, are confusing to say the least.  I clearly was too early here and have to remember to wait for the turn on these turnaround plays.

Earthlink – Earthlink has three declining businesses (consumer internet, small business internet, and wholesale internet) and one business, managed services, that is growing at 15% per year.  As the company restructures and leans down, together the businesses have been producing an increasing amount of free cash.  Ignoring changes to working capital I estimate that the company has generated about $40 million in the first 9 months of the year.  So the stock is partially a free cash story but is really a bet that management, which is very focused on that free cash flow metric, can continue to work out structural changes that add value to the shareholders.  I get the sense that what is in store here are sales of the declining consumer and small business units to someone like private equity that would appreciate a steady, predictable, declining cash flow stream.  Earthlink also has fiber assets that will likely to be sold. At the end of the day my hope here is that we will see the sale of most of the businesses and be left with the remaining growth business, managed services, little or no debt and maybe even a bit of cash left over.

Empire Industries – This was another stock I sold and added back.   I got this one at about the same price on both ends.  They just announced their 3rd quarter.  It was okay, better than the second quarter, but not particularly great.  But the stock is very cheap.  They have generated over $4 million in free cash flow in the last 9 months yet the stock has a market capitalization of less than $30 million.  Small position but waiting for some good news as an excuse to make it larger.

Extendicare – Holy god, what a debacle.  But while it has been a debacle, I stand by my original thesis, by my position sizing and by my decision making process.  I don’t believe I did anything wrong here.  I simply got screwed.   Extendicare announced the deal for the US operations about 10 minutes before I had to go to the airport on a Friday afternoon.  I think the last thing I saw before I went out the door was the stock in the $6’s.  I mean geez.  My take is that the deal itself wasn’t terrible; there were some that had expected a strategic buyer to pay up; by getting a private equity buyer they basically left enough on the table for them to still make a strong return.  But the sales price was still in-line with my expectation.  What wasn’t in-line with mine or anyone’s expectation was that they would keep the cash.  There was a question on the conference call, I can’t remember from who off hand, that summarized everyone’s dismay.  To paraphrase: you mean to tell me that you are sitting here dramatically under-leveraged in relation to your peers and yet you are going to keep the entire cash hoard to invest in the business?  Extendicare should be distributing the cash and leveraging up and if they had done that you would have a higher dividend and a much higher share price (inclusive of distribution). As it is I have to hurry up and wait again.   And there is risk associated with a management team that has shown pretty weak performance (the conference call was really pretty bad) will allocate their hoard of cash in an efficient way.  And that is why the stock is down.

Hooper Holmes – I took a small position on this one after reading through a Seeking Alpha article by Eric Burnside which is unfortunately on the other side of the wall now.  Another turnaround story with a CEO who has a lot of skin in the game.

Health Insurance Innovations – New position.  First of three stocks I owe to Mike Arnold.  He wrote a couple of really solid pieces on Seeking Alpha.  Health Insurance Innovations has a health insurance e-platform from which consumers can search through alternatives and find the best health plan to fit their needs.  The company takes a small piece of the premium whenever a sale is generated through their site.  The company is growing revenues at a healthy clip and the lower bottom line in the third quarter, which led to the drop in the stock price, is mostly due to the company beefing up to deal with that growth.   The bear case here, which I think misunderstands the business, is that a significant portion of Health Insurance Innovations revenues comes from short term medical plans, which is essentially the medical equivalent of taking a term life plan instead of a traditional life insurance plan.  These term plans aren’t covered by Obamacare and are subject to penalties, which isn’t really a problem because those folks buying these plans are doing so because the savings from the plan more than compensates for the penalty.  The problem is if something more punitive comes into effect at some point in the future, but given that we now have both congress and the senate run by republicans, I have some doubt whether that will happen any time soon.  A couple of Health Insurance Innovations businesses show seasonal strength in the fourth quarter, which I think will help the stock over the next few months.

Integrated Asset Management – I didn’t sell this position, it remains small, the story is still the same in that this is an asset management firm that trades cheaply on assets and cheaply on their cash earnings but because the main contributor to earnings, in the form of performance bonuses, is lumpy, they don’t get a lot of love.  I’ll keep waiting for it to play out positively.

Imvescor Restaurant Group – New position. By the time I turned my head around the right way and started looking for positive ways to play the decline in oil prices I had missed out on a lot of the simple opportunities like the larger restaurant chains.  However this one is Canadian and it is still cheap.  There is a pretty good summary of the business in this BNN segment.

magicJack – New position.  I got back into magicJack last week as it dipped to $8.50.  I don’t think their 3rd quarter was as bad as the 20% drubbing that the stock took.  The company is sitting on nearly $5 per share of cash, the Telefonica deal holds promise, they still generated free cash in the third quarter and they did sell 88,000 magicJack’s in October, significantly more than their monthly sales in the third quarter.  Not going to bet any farms here but I think at this price its worth a starter.

MGP Ingredients – This has been a great stock for me over the last couple of months as it recently passed the “double” mark with its move over $15.  Nevertheless I have been selling my position down and its about one fifth the size that it once was.  The quarter was okay, it did not blow me away though, I still don’t get how this excise tax works but it clearly can have a significant impact on results, but the stock has continued to do well.

New Residential – I got back in New Residential at $6, which is now $12 post split.  I think there is a good chance they do another special dividend, I think that they and Nationstar are probably positioned better than any of the other non-bank servicers to take advantage of the regulatory scrutiny by adding new bulk deals, and I kind of like the new investment in call rights, its just the sort of obscure back of the woods type of investment that managements expertise to exploit for some out-sized gains.

Nationstar – New position.  The first of the three mortgage servicer positions that I took after all were clobbered after their third quarter results.  Nationstar is probably the safest of the three (safe being a very relative term here) because they have had the least scrutiny from regulators, they have the best origination business for replenishing their servicing right assets, and they have Solutionstar, which is an excellent growing, higher margin business that is somewhat obscured within the servicing and origination segments.

Ocwen – Second of the three mortgage servicing plays.  Ocwen appears to be involved in some questionable actions, and that the Wells Fargo deal fell through is not a positive, yet even with that negative news the stock remains significantly above its low.  Its hard to argue that its not worth a lot more if the business model is intact.  As with all these servicing plays, I just don’t see the alternative – the banks have to reduce their exposure to servicing because of Basel III and there is simply no one else capable of running that business.  I think that as regulatory framework is clarified and Ocwen and the others adapt we see these stocks move up off of these distressed levels.  Maybe we don’t see the same heights that we did a couple of years ago, but I think there are gains to be had from these levels.

Overstock.com – This is the second idea I got from Mike Arnold.  He has a number of very good articles on SeekingAlpha that describe the idea in detail.  The company had a very good third quarter and hinted at a strong fourth quarter.  They have a growing online retail platform that is beginning to leverage its size and so marginal sales growth is going to flow in large part to the bottom line.  And now they have a tailwind with lower oil prices that one has to expect will lead to stronger retail numbers over Christmas.  On a backward looking basis though, I don’t consider this a cheap stock, so the company needs to continue to show growth to justify its valuation and that it deserves to be even higher.

Photon Control – I got this idea from a friend and I really like it.  Photon Control makes sensors.  Most of these are industrial sensors, for semi-conductor, power and utilities, life sciences, automotive, and oil and gas applications.  I like the idea as a way to play this “internet of everything” idea.  The internet of everything basically means that everything is connected and monitored, and to monitor something you need a sensor.  So I can see the business growing over time.  The stock is also cheap.  They have a market capitalization of $50 million, $11 million of cash, have generated between $1-$2 million of cash flow per quarter for the last 9 months with very little in the way of capital expenditures.

Pan Orient – So I own one oil stock right now and this isn’t it. Yes, I know, this is an oil play, but its really only kind of an oil play right now.  The stock is trading at only a few cents over cash level.  They have some okay oil assets.  The idea here is that the downside is presumably limited given that the stock is worth cash, and so any sale or positive news from any of the remaining assets and the stock goes up.  Presumably all oil assets are not worth zero yet.  I added this one in the oil carnage of the last couple days because it was basically at cash for a while.

ePLUS – I took this position a few days ago and its still small for me.  The company delivers contract IT services and has a fairly lucrative hardware leasing business.  The stock seems reasonable to me and is generating a decent level of free cash.  I have to dig into the business further before I add at all to the position.

Radcom – Been a huge winner for me, over a double in the last couple of months.  Radcom is finally beginning to how traction with its MaverIQ assurance solution.  The idea here is that the company has quite a low cost base and additional revenue above its $5 million per quarter expense base will fall to the bottom line.  I’ve been waiting for that uptick in revenue for a year and we finally got it in the third quarter, as revenues grew to $6 million.  A recent contract announced for $4.3 million is significantly larger than the one’s I’ve seen in the past, further bolstering the idea that revenues are set to rise.

Rex American – I bought Rex American at a higher price a couple of weeks ago and I am waffling about what to do about it here. I bought the stock because relative to Pacific Ethanol and Green Plains it hadn’t moved, I thought that would change, and with ethanol at $2 and corn at $3.80 they are going to deliver earnings in the $2 per share range. So the stock did as I expected for a while, moving up from $68 to $72, but has gotten caught up in the oil downdraft and is back to $64.  So on the one hand  lower oil prices mean lower gasoline prices which should be a negative for ethanol.  But on the other hand, the EPA has basically washed its hands of a lower blending mandate for the next few months and we are likely going to see higher blending of ethanol because presumably there will be more consumption at lower gasoline prices.  Indeed ethanol inventories continue to decline and the price of ethanol continues to hold up very well, spot CME closed at $2.09 per gallon on Friday and prices at the hubs far exceed that. So I’m not sure what to do with this one.   It’s not a big position so I will probably continue to hold unless something fundamental seems to be changing in the ethanol market.

RMP Energy – This is my only remaining oil stock and I took a hit on it the last couple days.  I might have to reduce if it falls below $5 but otherwise I plan to stick this one out because if anyone has the assets to make it through this war zone we call oil, its RMP Energy.  I mean, I do work in the industry so I have some idea what a good oil well looks like and RMP has some pretty, pretty, pretty good oil wells.  They operate in two areas in the Western Canadian Sedimentary basin.   The first, Waskahigan, has produced wells with decent results and there is the potential that those results will improve with the introduction of better completion techniques and understanding of the geology.  The second area, Ante Creek, has produced what I would call outstanding results, with some wells producing at 500+ boe/d, 60% oil even after 6 months of production.  The only concern about Ante Creek is how big the sweet spot is.  RMP has delineated at least 6 sections and owns a number of sections adjacent to the south that may or may not be as prospective. Only considering those 6 sections the company should be able to generate significant cash, even at these lower oil prices.

Rosetta Stone – The third and final Mike Arnold idea.  This is a turnaround idea that is a little bit further along the curve, hopefully right at the inflection point where things start to snowball.  The company is transforming itself from a legacy language learning product that was sold out of the box through retailers and call centers and into a software as service platform providing a variety of language and learning products on a subscription basis.  The stock popped after its third quarter as the company finally generated some positive operating cash flow and in the conference call suggested a strong fourth quarter was to come.  I think that this is a stock that falls under the radar because its legacy business (the well known Rosetta Stone language package) has been failing in its traditional retail outlets, which ignores the growth of its recently launched software as service on-line business and the potential for a better recurring revenue stream.  The company’s new revenue model from subscriptions also leads to a lot of deferred revenue which in turn has led to far better cash flow generation than the income statement suggests.

Sanderson Farms – This is actually a stock that I benefited from my little sellathon in early October. I sold Sanderson farms days before their analyst day, at which time the stock collapsed from the $90’s to the $70’s on comments from management that eventually the cycle will end.  I added the stock back in the $70’s after listening to the analyst day call and concluding that while the top of the chicken market may be close or in, its still going to be tight for some time.  This should be exacerbated by lower energy prices which, if this move in the restaurants is legitimate, will mean more chicken consumption.  I suspect the stock is probably up of late as an oil play.  I’ve reduced my position on this one some in the last week.

Supercom – I’ve been reducing my position in this one as I’m uncertain about how sustainable revenues are.  You can read all about it on a few Seeking Alpha articles that have been written of late.  I’ve read them, listened to what management has said, and I have to admit I’m still not sure.

United Online –  This company is a bit like Earthlink.  They own the NetZero brand, which has a legacy dial-up business that still generates cash but is obviously declining and they have a mobile broadband business that works through a USB device or hotspot and that has started to show growth.  They have a few social media websites, classmates.com and stayfriends.com, that also generate some cash but again have been experiencing some declines. They have an interesting loyalty e-commerce platform called Mypoints.com where consumers sign up for loyalty point programs with advertisers.  The stock trades at a market capitalization of $185 million and has $75 million of cash on hand.  What intrigued me into taking a position is that in the third quarter the company showed that it has the ability to generate free cash from its businesses, as they generated nearly $8 million of free cash and while that number might be a little high going forward given that some of that cash came from changes to working capital, it did suggest that maybe the market has been a bit too pessimistic about the prospects of the businesses.

Transat AT – I finally got a move up from Transat.  I actually sold out of Transat at the height of my ill-advised Ebola panic but was able to add the stock back after my senses returned at about the same price.  I mean the stock has to benefit from lower oil prices.  I ran through the numbers and the lower oil price more than offsets the fall in the Canadian dollar, so it should be a net positive.  Probably my biggest worry here is that a combination of higher prices (due to the Canadian dollar drop) and a slowing Canadian economy (due to the oil price drop) slows traffic in the winter and Transat has another weak winter season.  That could happen and is why I have not added to my position even as the fuel cost stars align.

Walter Investment Management – New position and the third servicer/originator that I have bought.  Absent some sort of fraud or problems that are yet to be disclosed, the stock is simply too cheap in my opinion.  The primary business lines are a mortgage servicing unit and an origination unit.  But the company also owns an insurance business that places both voluntary and lender placed insurance business and a consumer receivables businesses.  Both of these smaller businesses are quite profitable, though the insurance business faces some headwinds due to regulatory scrutiny of lender based insurance (there’s a good discussion on Glenn Chan’s blog about Ocwen and Altisource exiting their lender based insurance business).   While I expect more oversight in the servicing space, I don’t think this means that companies like Nationstar, Ocwen and Walter will have their business models dry up and in fact the higher cost of doing business should be beneficial for the large players.  Walter also seems to be suffering from guilt by association; while Ocwen and Wells Fargo recently had to give up on a $20 billion servicing deal because of the regulatory interference, Walter has closed or is in the process of closing on $18 billion in servicing and on their 3rd quarter conference call.

Yellow Media – This has been a big winner for me lately as the stock has taken off from $14 to $20 in the last month.  I was adding to the stock at $14 for no other reason than that if they are even moderately successful with the digital business the stock is worth more than $14.  At $20 they need to be a bit more than moderately, and while the third quarter was fine it wasn’t really an acceleration of the business plan, so I have been taking some off.

Final thought about oil

Ok, so I was basically stopped out of my oil positions weeks ago, and with the exception of RMP Energy I don’t own any oil.  So I don’t have much skin in this game and I can look at it with some perspective.  And here’s the point I want to make because I don’t see anyone making it.

Oil is a cash flow game.  The reason that no one looks at earnings for an oil company is because earnings don’t dictate future success.  Cash flow does.  You want to drill an oil well, you have to put up cash up front.  Let’s say its $5 million.  You drill that well and a couple months later you start getting that cash back.  That cash comes back in a declining stream.  So maybe if you are lucky you get $1 million the first month, then there is a big drop-off and you get $700,000 the next month, $400,000 the next month, and by month 6 or 7 you are getting maybe $100,000 plus or minus.  I’m not putting a lot of thought into the numbers I’m using here so don’t pay attention to the specifics, its the trend that I’m trying to get across.

Anyways, you get a declining cash flow stream.  Now at $100 oil you were maybe getting a net back of $60 on that well, and if you were doing pretty good you maybe got back that $5 million dollars in a year.  Now though we have $70 oil, or $65 or whatever stupidly low number you want to use. So that netback is $30 and with the cash flow you won’t get your $5 million back for two years.

Now there are two sources of cash for an oil well.  There is the cash flow from other oil wells and there is debt.  I have a hard time believing that the banks and high yield investors are going to be taking on much more oil debt.  And the cash flow that you are getting from the oil wells has just declined substantially.  Yes there are hedges but I don’t think there are that many company’s that are fully hedged for the coming year.

The point I’m leading to is that all this talk about the break-even price of oil is, in my opinion, not really meaningful.  Whether the well is ultimately profitable or not is irrelevant. What matters for supply is how quickly you can drill the wells and whether you can drill them fast enough to stay ahead of the natural declines.  And the speed by which you can drill a well is wholly dependent on the cash you have coming in.

Oil is not a widget factory, where you spend money up front and then produce at capacity as long as you are above break-even. Oil is a declining cash flow that requires continual capital infusions to keep that cash flow at the same level.  I don’t think there were many oil companies growing production significantly while staying within their cash flow at $100 oil.  The growth was fueled by debt.  At $70 oil and with debt marketing closing keeping that growth up seems to me to be an impossible task.

So we will see where this all ends up but if I were going to make a bet I would say that we are going to find that there was as much bogus, bullshit commentary to the downside in the last month as there was to the upside when oil was $30 higher.

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35 Comments Post a comment
  1. Thanks for the mention. Regarding Walter’s insurance business, they don’t seem to do any real insurance at all: they “neither underwrite insurance policies nor adjudicate claims” (10-Q). I believe that their insurance segment is 100% kickbacks. I think that all the mortgage servicers will see the same regulations.

    Or, you might subscribe to the theory that regulators pick on bigger players if they want to encourage the public to think that big=evil. So far, the NY DFS seems to be picking on all the mortgage servicers and insurance companies over force-placed insurance. They spoke out against kickbacks so I think they will go after the smaller players too because they’ve all done kickbacks. Nationstar also seems to have tried to do the same thing as Ocwen/Altisource.
    http://www.insurancejournal.com/news/national/2014/08/04/336633.htm

    November 30, 2014
    • I’m not sure where you are going with the comments – you seem to be responding to a comment that wasn’t made? Anyways, yes I believe that the changes will impact all the servicers. Their obligation as servicer is to insure that there is adequate insurance on the mortgage. I don’t know about the word kick-back? It implies guilt to me, and while that might be the case, we don’t know it is, at least not yet. Its a commission. It hasn’t been illegal to receive commissions and so why shouldn’t they receive commissions? If those rules change then the servicers adjust, which we are seeing. But in the mean time is it really wrong to receive commissions on directing business to certain insurers that you have relationships with? You see what I’m getting at? I just think there is a difference between wrongly placed lender-placed insurance and performing the the duty as servicer to make sure that a loan is insured and then receiving compensation for that. I guess the counter-argument is that the servicing fee is the compensation. But that is something that needs to be received and new regulations made. We’re seeing that.

      So far we have Fannie coming out and stopping commissions and in the case of Walter we have one of their hazard insurers ending commissions. Given that Altisource is getting out of the business you have to wonder whether they were experiencing pressure on their commissions. So no doubt there is a wide spread change going on.

      November 30, 2014
      • These “insurance commissions” are kick-backs. Regulators will almost certainly see them for what they are. I believe that these kickbacks are in a legal grey area (or they might be legal depending on the mortgage contract and servicing contract for the MSR). It’s just that the regulatory environment is changing. In the future they may not be allowed.

        Altisource’s press release on its exit stated that it was due to the current environment (regulation + lawsuits/litigation). The kickbacks should be close to pure profit. I don’t see why there would be any pressures on their commissions.

        2- The implication is that NSM and WAC profits may drop in the future when they are no longer allowed to accept kickbacks. Or, they may face liabilities if they continue to take them. This will reduce the NPV of their MSRs.

        Both NSM and WAC disclose insurance commissions in their 10-Ks. OCN and ASPS seem like they don’t do that.

        November 30, 2014
      • Dont disagree with any of that. WAC already saw a big drop in insurance income in Q3. I just think that investing in these stocks now, after the impact is being felt, estimates dropped, after the stocks have dropped another ~20% on earnings (I bought WAC at $16.50 and NSM at $26), and I mean everyone should by now have digested and adjusted for the dwindling earnings from insurance commissions, so it should be investing after the event.

        November 30, 2014
      • Well I guess the stock market disagrees with my thinking because on Nov 12, ASPS fell 16.9%. OCN and WAC flat, NSM down 2.27%.

        November 30, 2014
      • I dont know if the market disagrees with you. Both WAC and NSM got smacked down on earnings and in subsequent days. I didn’t add up how much but it was well over 20% I think. I believe this was in part because of realization of lower profitability from insurance as became clear from Q3. Isn’t the ASPS issue the worry that there is some other reason that they are exiting entirely? That was the impression I got reading your posts – that the market is spooked that there is a skeleton here.

        November 30, 2014
      • I never followed WAC or NSM much at all. Did either of them guide their “insurance commissions” on force/lender placed commissions to zero? Because my fear is that they will also have to give up that free money.

        I find the latest WAC investor presentation very interesting. I’ve never seen 2 pages of forward looking disclaimers. Most companies do 2. It’s also interesting that they’ve supposedly spent 37.2M on legal and regulatory matters even though their “insurance” segment still generates revenue.

        December 1, 2014
      • All these servicers are what they are Glenn. If there wasn’t uncertainty and concerns they wouldn’t be trading down here. You must feel that way about OCN and ASPS, that the negative news and potential is priced in if you hold positions in these names?

        December 1, 2014
      • Yes.

        1- My fear for WAC is that they will lose all of their insurance revenues.

        2- I think WAC has bankruptcy/blowup risk (high cost operator, high debt) while OCN/ASPS are the least likely to blow up. If I was a vulture, I’d circle over WAC.

        Anyways, I think I’ve said enough on this matter so I will stop beating a dead horse!

        December 1, 2014
      • when you say they have high debt are you referring to the recourse debt or including all the non-recourse debt like the securitization trusts that they have residuals in?

        December 1, 2014
      • I haven’t done much work on WAC… sorry.

        December 1, 2014
      • Quick question- what leads you to conclusion that commissions on the non-GSE servicing will go away? Have the regulators suggested that?

        December 1, 2014
      • It’s because Altisource walked away from it. Either the NY DFS made them do it (even though they didn’t take kickbacks in New York) or the CFPB may make them do it.

        Walter is regulated by the CFPB and has a CFPB monitor installed. It could be the case that all of the non-bank servicers will face the same regulatory scrutiny (as opposed to Ocwen/Altisource seeing more scrutiny).

        December 1, 2014
      • Thanks, thats helpful.
        I do really appreciate your work and in particular the work you’ve done on ASPS and OCN. I’ve learned from it and am still trying to understand ASPS enough, in part by reviewing your posts, to know whether I should be adding a position there.

        I do have to say though that I don’t really understand your negativity on WAC in concert with the comments that you haven’t really looked closely at them. I find that confusing. The reason I have kept probing your comments on WAC is because I wanted to know what you are basing some of these conclusions on.

        Thanks again

        December 1, 2014
      • For time-saving reasons, I analyze companies based on shortcuts. And sometimes the shortcuts are wrong.

        2- ASPS
        It’s clearly easier to understand, because MSRs are weird and very complex.
        It’s also where insiders are putting their money. (They like AAMC, then ASPS, then OCN, then RESI+HLSS.)

        3- WAC:

        Over long periods of time, GAAP retained earnings should reflect management’s skill. Clearly, WAC is not a great servicer.

        On a profitability basis, they don’t look so great. This is just a quick look at earnings without mark-to-market adjustments.

        Management seems a little promotional. Usually those companies are not good. (But GST, Barkerville, PEIX are far worse.)

        I’m not that bullish on non-bank servicers right now. The regulation has increased their costs so suddenly MSRs are less valuable. Regulation continues to affect their margins.

        In terms of borrowing stock, WAC is 5.5%, NSM is 5%, OCN is 0.8%, ASPS is 2.4%. These are IB rates that you can check from their FTP site. (Though sometimes I disagree with the shorts.)

        Ocwen management is surprised at the prices their competitors are willing to pay for MSRs. They don’t get why other people at bidding at low rates of return (based on what Ocwen thinks that their costs are). So my hunch is that the other guys are doubling down, hoping that they will get lucky and escape their predicament. As in, their actual earnings will then catch up to their reported earnings (which they inflated with mark-to-market gains or other mechanisms).

        December 1, 2014
      • Appreciate the response again Glenn but I could do without the passive aggressive digs. Mentioning PEIX and GST, which we both know I’ve held in the past, as examples as promotional management is unnecessary.

        December 1, 2014
      • 1- Didn’t you make money on those? What you did worked.
        2- I don’t mean to be passive aggressive. I mention those stocks because you would be familiar with them.

        Cheers

        December 1, 2014
  2. I like your point about how large positions decrease your motivations for new ideas. My experience is that supersized positions demand so much attention (especially if it is going down you’ll be double checking your thesis constantly) that they literally suck time away from other names. Same results – tunnel vision.

    Want to get your advice on something. I also try to get in with starter positions then gradually add in when things go right. But half the time prices go up with no fundamental reasons at all. Would you consider that “things going right” and add to your position? One problem I’ve had all year is getting in when names are reasonably priced (not screaming cheap) and when prices go up for no reason valuation look stretched… This is especially the case for large/midcaps names because they never get that cheap

    December 1, 2014
    • Sorry i think I missed your comment in all the back and forth with Glen. So yeah, that is an important point and one I am not always good with. Sometimes I am tempted to add when the stock starts going up but nothing has changed, and sometimes I do indeed do that. But its dangerous because you never know whether its legit or just fluctuating. So if I am inclined to add to a rising stock I try to be really careful to only add tiny bits at a time and at large price intervals, because I’ve gotten caught in the position before where I’ve doubled up or something to that end only to have the stock drop back down.

      December 3, 2014
  3. Lane – I noticed that you are looking at a lot of larger cap stocks. Is that deliberate?

    December 1, 2014
    • Not really deliberate but I do own a few smaller stocks that I haven’t talked about because they are small. If you have any good small stock ideas I am open to them.

      December 3, 2014
  4. Thanks for the mention. Thought the recent results corroborated the major points of my thesis. Expect 2015 to be an interesting year. If Dubois is still in place by mid-year next year, I would guess the company is on the block.

    December 1, 2014
  5. David McDougall #

    This was a very thoughtful, honest reflection of your portfolio and every investor should follow what you did and evaluate his or her mistakes. Thank you.

    As for your commentary on oil, despite having negative attributes of a declining cash flow stream from new wells, there certainly is the silver lining that poor prices will self correct the supply/demand imbalance faster than you or I may guess (barring there is continued OPEC cartel cooperation and no severe emerging markets recession – I know, near impossible to predict). Unlike mining commodities, the output for oil decreases rapidly with cuts in capital spending. I read an estimate somewhere that global oil producing decline rate has increased from 5% to 8% in a matter of a few years due to the growing supply mix from shale oil. That doesn’t seem crazy but in the context of billions of dollars required to maintain production it seems quite meaningful.

    I would also fully agree with you that break-even costs are less relevant compared to funding capability. The high yield market for energy companies has grown from 2% to 15% (!!!) over the last 10 years – that should demonstrate the severe reliance on external debt to fund growth.

    December 3, 2014
    • Thanks. There is a very good description of what to expect by Eric Nuttall on http://www.bnn.com. He was on market call early this week. I’ve never been a huge fan of his but he explains it as well as anyone I’ve heard.

      December 3, 2014
  6. Liz L. #

    Bravo for such thoughtful honesty. That’s why your blog is one of my very favorites.

    December 4, 2014
  7. Jack #

    Hooper Holmes was also written up on VIC. I think by Monte Sol Capital.

    December 6, 2014
  8. Aharon #

    On the same theme as Pan Orient, Eagle Energy Trust may be worth examining. Trading at 1.6x cash right now, and yielding over 30%, though I suspect and sort of hope the distribution will come down. Hard to know whether they were lucky or good with their major asset sale earlier in the year. I suspect the former, though the fact that they didn’t immediately redeploy the proceeds (and that they are well-hedged on remaining production through mid-2015) indicates at least a little of the latter. Chance of a bad acquisition looms large; if we are in early stages of distress any purchase now may look foolish. I’d love to see their distribution cut and price drop followed by an asset purchase.

    Possible upcoming catalyst with their 12/15 vote to allow purchase of Canadian as well as US assets. I have only been following for a little while, but it seems to me like the trust rallies on non-news news: essentially, the reiteration that they’re cheap(ish) and have a lot of cash.

    December 6, 2014
    • Aharon #

      And there we have it: a ho-hum acquisition that returns Eagle to being a leveraged producer…

      December 19, 2014
  9. BB #

    Did you sell RMP?

    December 6, 2014
  10. Happy to see the break was short 🙂

    Very interesting comments on oil at the end too, hadn’t thought about it too much but you seem to have hit the nail on the head there.

    December 8, 2014
  11. Brent Barber #

    Appreciate the work you put into your blog and thought you might be interested in this. Looked into IRG after reading your lists and am staying away.

    1. They tried to sell the company in 2014 and couldn’t. That implies the smart buyers were not seeing great value and also that no takeout is likely.

    2. It appears that the dividends trade mainly on their yields and their current yield is about 5.6%. Many other Canadian restaurant chains trade at similar yields, so if I was to go into that space, I’d probably lean towards KEG.UN(the steakhouse chain) as they have good growth both at the same store and number of store levels and IRG is struggling with both. KEG-UN is more expensive on other metrics, but the key metric, dividend yield, will probably grow faster.

    3. IRG has not grown business in years and is still decreasing sales. They are trying to offset selling branded products in supermarkets, which is smart, but the reality is IRG’s restaurant chains are in that weak area of the current restaurant market – the mid-priced dine in places as opposed to the quick-serves and high-end which seem to be doing well.

    4. Smart activist investor George Armoyan, who is also based in Halifax where IRG is located and well-connected, used to be a large owner of this stock and sold out a few years ago at a lower price. IF there was a good chance to turn this around and management was responsive, he’d probably be doing something.

    December 9, 2014
    • Those are good points. I did not know that about Armoyan. I see a couple things. First, they earned $10mm from operation in last 9M before working capital. Capex is minimal. Market cap is ~$90mm. So less than 10x FCF. Second, there is the gasoline trade, maybe lifting all boats to some degree. Third, if you look at their statements they have a really good franchise business and a fairly bad owned restaurant business. They simply need to get rid of or improve the owned restaurants enough to franchise them out.

      December 11, 2014
  12. Jack #

    You said you were waiting for good news on Empire Industries to add…does the increased backlog over the past week with the potential for the TMT kicker qualify, or do you have other ideas that you are pursuing? Just curious… (I am long EIL)

    March 4, 2015
    • I did add today. It seems to me like a pretty significant amount for the combined contracts.

      March 4, 2015

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