First Quarter Summary
In both our equity and balanced portfolio models we reported positive returns for the 1st quarter of 2005. Leading indices were down in the same period (see table below). Our cautiousness in selecting securities, our emphasis on demanding a meaningful discount to our intrinsic value calculation while paying sharp attention to the management teams we invest in, all contributed to maintaining positive returns in an otherwise lackluster quarter.
One of the issues we raise in our new company brochure is that “people matter”. When I think about the people that have mattered to me most in life, I feel surrounded by their goodness, strength and integrity. A teacher, a religious leader, a parent, a friend, or a therapist – individuals matter and individuals can make a difference. Most of us have at least one individual who we feel made a significant difference in our lives. When I think of public figures I’ve admired, it’s a disparate collection – they’re as varied as Mahatma Gandhi and Muhammad Ali. As an investor, I think about the influence and steadying hand of Marty Whitman’s clear thinking and character. People do matter…and they matter in business as well.
Roumell Asset Management strives to align itself with quality people in all of its activities. In selecting investments, we ask ourselves: Do we want to partner with this management team? Are they honest? Are they smart operators? If you can imagine making a private equity investment, you would probably do a tremendous amount of due diligence on the management team. However, for some reason, once a company trades on the public markets, investors often feel management isn’t worth trying to assess. Some investment managers (even some we respect), choose to “let the numbers speak for themselves” and avoid any real management inquiry. We are not looking for perfection, but we seek to go into business with people we believe we can trust. Often we have to wrestle with what appears to be cheap assets controlled by less than stellar operators. In such situations, a greater discount to our intrinsic value is required. Warren Buffet has said that the most important words written on investing (From Benjamin Graham’s, The Intelligent Investor), are: “Investment is most intelligent when it is most businesslike.” It’s hard to imagine a good businessperson not investing critical time in knowing who it is he/she is going into business with. We do just that, to the best of our abilities, with the sources of information available to us.
Our Three Top Purchases in the First Quarter
Freddie Mac, FRE. In recent Congressional testimony, Alan Greenspan succinctly described the Government Sponsored Enterprises (GSEs) of Fannie Mae and Freddie Mac in a way that easily explains why they have been able to compound earnings, dividends and book value at nearly 20% per year over the past ten years. The business model, Mr. Greenspan said, hinges on “a big fat gap.” The gap that Greenspan is of course referring to is the one that exists between the GSEs’ cost of funds (low because of perceived government backing) and the earnings generated from purchasing mortgages in their retained portfolios. Historically, it has been a license to create shareholder value year after year after year.
We purchased Freddie Mac because we believe the business model that relies on a meaningful gap (between its cost of funds and the earnings on those funds) will continue into the future, albeit at a smaller spread because of Congress’ apparent desire to slow FRE’s growth by raising its capital requirements. Moreover, the company appears to be significantly further along (as compared to Fannie Mae, FNM) in rectifying accounting procedures and a corporate culture that rightly has given investors pause (particularly at Fannie). We believe we purchased a powerful cash-generating business model on the cheap: roughly 8x earnings. Because FRE possesses significant amounts of preferred stock it renders a traditional price to book measure as less meaningful. However, adjusting for its capital structure offers compelling evidence that the company is cheap (certainly by historical standards). At the price we paid, FRE was purchased at about 1.3x adjusted market capitalization (includes preferred shares) to its core capital ratio. Since 1993 this metric has ranged from a high of 4.5x to a low of about 1.2x reached in 2003. In the first quarter, we paid under $61/share. At 1.6x to 1.7x, FRE would trade at $75 to $80 (about 11x-12x earnings).
What about all the headlines regarding the GSEs – accounting issues and looming regulatory changes? The GSEs together own about $1.5 trillion worth of mortgages. The accounting issues stem from the derivative contracts each company uses (quite successfully) to neutralize the effect of interest rate changes on their retained portfolios. It is important to note that the GSEs do not use derivatives as investment vehicles; they are used to hedge their portfolios. The accounting issues primarily stem from how to account for these contracts and whether changes in their values should flow through the income statement or be marked to market on the balance sheet. It is our belief that the accounting of these contracts (complicated for sure) does not impair the essential nature of the business model – currently, a big fat gap. Increased regulatory oversight (a good thing), and increased capital requirements to impede growth (probably a good thing as well) will certainly come to pass in some form. The result of such regulations will simply make the GSEs less profitable – becoming a “reasonable” gap business. That said, any drastic measures requiring the liquidation of their retained portfolios would result in serious consequences to the GSEs’ earnings power. However, such liquidation would likely result in a partial return of shareholder equity.
One business risk to the GSEs’ model worth noting is the contra-party risk to the derivative contracts – given the size of the GSE portfolios, could a company issuing the contract really make good on it (particularly in a time of crisis when they themselves might be challenged)? The GSEs restrict purchasing their hedging contracts to the likes of Goldman, Citicorp, etc. Nonetheless, this appears to be a real risk to the model. Actual credit risk appears to be quite manageable, which is typically the primary risk to leveraged spread businesses. In recent years, mortgage default rates have been less than 1%. The lower margin business of simply insuring mortgages that are securitized and sold off (the original GSE mission) is a pretty straightforward business insulated by the strength of the assets they are insuring (i.e., home mortgages). Finally, the GSEs seem to employ exceptional mortgage asset managers who have successfully steered their respective portfolios through many interest rate environments without major asset impairment. We’ll live with the headline risk to own such a business model…at the price we paid.
MBIA, Inc., MBI. MBIA, Inc. (“MBIA” or “the Company”) is a company that we are familiar with, as we have purchased, and subsequently sold profitably, its shares in the past. MBIA is engaged primarily in providing financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, selected corporate debt, and high-quality debt of financial institutions. The company has a long history of growing shareholder equity, generating real earnings and managing its credit risk. It is astutely managed by a solid team of corporate managers lead by Jay Brown.
As noted in our fourth quarter letter regarding fellow financial guarantor Assured Guaranty, since MBIA receives 100% of the premium for insuring a bond upfront, but earns it over the life of the bond, it has a stated book value and an adjusted book value. The company’s adjusted book value accounts for the present value of these future earnings that have already been received, but are carried as deferred revenue over the life of the bonds being insured. MBIA’s stated book value today is approximately $48/share and its adjusted book value is about $66/share. Theoretically, the company’s adjusted book is the present value of business already on the books (with no franchise value or value ascribed to its growth). We purchased the stock at about 0.8x adjusted book and 8.7x forward P/E. Historically, the median price to adjusted book value is 1.05 and average forward P/E is 11.9. We were able to purchase shares at these multiples for a company that has an ROE of roughly 13%.
In the first quarter, MBIA announced that it will restate its financial statements for 1998 through 2004 to change the accounting treatment of reinsurance it purchased in 1998. The impact on the financial statements is fairly immaterial. Since that announcement, the SEC has asked for additional documents. Some investors are also concerned about MBIA’s entry into insuring various types of non-municipal obligations, and the potential impact on the Company’s credit quality. Over its 28 year history, MBIA has insured debt exceeding $1.5 trillion and lost merely 0.03% of that amount given its strict underwriting standards and emphasis on debt that is already investment grade without any credit-enhancing insurance. The Company’s entry into new lines of business is worth noting, but we believe it provides a net positive by offering the company greater growth opportunities. We assume Jay Brown and his team will carry on the tradition of being excellent underwriters. With a credit rating of AAA, we believe MBIA is a solid business and investment.
Fairpoint Communications, FRP. Headquartered in Charlotte, NC, FRP is a leading provider of communications services to rural communities, offering a wide array of services to residential and business customers including: local voice, long distance and data products. As a rural telecom carrier, FRP seems as close to an old-line utility company as one could expect to find these days. Because the company operates in rural markets with low customer density (the majority of communities served by Fairpoint have populations fewer than 2,500), it experiences limited competition. Both large wireline players as well as cable companies have little incentive to push their businesses into small rural markets. FRP operates in eighteen states through twenty-six local exchange carriers. It has a presence in areas with higher-than-average population growth, such as Florida, its second largest market in terms of access line equivalents.
Fairpoint went public earlier this year at $18.50/share. We purchased the company’s shares at roughly a 20% discount to its IPO price locking in a yield of approximately 10.50% (based upon its current distribution rate). The dividend payment represents about 73% of the company’s free cash flow. The free cash flow yield actually equates to about 11.50%. Fairpoint’s growth prospects are limited: increased DSL penetration and incremental population growth appear to be the main triggers to its growth. That said, the company operates in what appears to be an insulated business environment, generates steady and predictable cash flows, is sufficiently capitalized and produces a generous dividend yield (based upon the price we paid). Finally, because of its net operating losses (NOLs) from the old telecom days, the company is not expected to pay taxes for several years.
In our opinion, the three investment ideas highlighted in this quarter’s letter share a few important characteristics: (1) persistent earnings power as a result of market leadership; (2) no need to worry about increased Asian capacity, which is a real threat to many U.S. manufacturers; and (3) purchased on the cheap principally as a result of various short-term company-specific considerations.
Once again, we want to thank you for the trust and confidence you have placed in us. We will continue to watch what the market appears to make cheap, diligently research those ideas and, in the end, select our investments cautiously. If you are aware of individuals who would benefit from our approach, we would welcome the opportunity to talk with them. You can always direct such individuals to our website, www.roumellasset.com. Additionally, as we have mentioned in the past, we have lots of terrific restaurants in our neighborhood and would be happy to take you and a friend(s) to lunch to discuss our investment approach. As always, please feel free to contact us directly about your account.
Investment Strategy: Roumell Asset Management, LLC (“RAM”) employs a value investment strategy in managing client portfolios. RAM Equity accounts can have up to 100% of assets invested in stocks; RAM Balanced Accounts typically have 35% of their assets allocated to fixed income investments (though the figure can range from 50% to 80% depending upon the needs of the client).
Calculation of Rates of Return: First and foremost, readers of this letter should recognize past performance is no guarantee of future results. Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter’s performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings. These returns are based on a composite of RAM’s accounts and therefore were not necessarily duplicated in any specific account. These consolidated performance numbers include all of RAM’s fully discretionary accounts within each category. Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.
Inclusion of Accounts: Currently, in the performance calculations for RAM Equity, there are 154 equity portfolios totaling $52.9 million. This represents 42.3% of total portfolios and 36.6% of total dollars under management. Currently, in the performance calculations for RAM Balanced, there are 126 balanced portfolios totaling $66.1 million. This represents 34.6% of total portfolios and 45.6% of total dollars under management. A complete list and description of the firm’s composites is available upon request.
Comparative Indices: Because RAM utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes. We have included two equity indices and two balanced benchmarks to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable.