Packer16

I am usually in the $100 m to $600 m space. I will go below $100m if I am comfortable with the management. There always seems to be bargains in the less than $50 m space but the issues of liquidity, control and finding adequate bargains in larger firms (less than 40 cent dollars) have kept me from this space. A question those who invest in micro-caps, how have you mitigated these issues and what types of long term returns have you generated? TIA. Packer

I think what this shows is more of an adoption of technology that was destroying the franchise than anything else. The outright slaughter of the newspaper by the internet has been stemmed and newspapers are learning how to use their content via the internet to generate incremental revenues. The same has happened in radio and TV. They have adapted to the new technology and are using the technology to their advantage. For radios and TVs, I don't think the stock market realizes this yet. The M&A market realizes this as evidenced by the multiples paid for these types of businesses (10 - 12x EBITDA) and the debt market is willing to lend to these businesses at low rates 5 to 6%s for B type credits (see TVL and GTN re-fis). The only market that is not inline is the equity market. Packer

I agree. I think Mark's book (The Most Important Thing) is about the best book on temperament I have read yet. Maybe that is why I have re-read it many times. It is putting temperament theory into practice that is the fun part. Packer

Welcome to the board. I see from your letter you have had and have an investment in an undervalued broadcaster. I have found a few of these including TVL, GTN, NXST, SALM and EMMS. What I have observed is the debt of these firms are at quite low yields versus the FCF of the equity. Same set of cash flows, two different valuations. What do you think could be causing this large discrepancy other than a market mispricing of the equity? Packer

Another way to look at it is you don't need an accurate compass just one that is more accurate than other market participants. The one thing that looking at history provides is a record of the emotional/sentiment aspect of investing that is not quantifiable from valuation models. I find utilizing the micro aspect of history (companies, securities and industries) to be more useful than the macro, as the macro has so many moving pieces. Packer

For some capital intensive firms (like Level 3 and Sandridge), the best place to invest may be in the high yield or convertible debt as most of the cash flow will accrue to these instruments before the common gets anything. Sandridge has a convertible preferred which may be better than the common as you get a great yield and the opportunity for upside with the conversion feature. I am invested in the common but in the future in this type of business I may take a hard look at debt/convertibles before I buy the common. Was just wondering if others feel this way also. Packer

Congrats all on great returns and thanks to this board for providing me some info on financials (BAC in particular). Packer

In terms of concentration, I think it is for me a function of where I find the value. I start with an industry (circle of competence) that I think is cheap (for example 2 yrs. ago radio broadcasters, 5yrs ago it was O&G) then I find the best positioned firms and the cheapest in the industry. I concentrate on the best value above the micro-cap level of firm. Since many of these firms are levered, I have learned a bit about HY analysis and use the bond prices to guide me to where there are discrepancies between the bond prices and the stock prices. I look for low yielding bonds combined with high FCF yielding equities. My current concentration is 60% in the top 5 and 85% in the top 10. The reason I don't hold all of my money in a specific firm/industry is I try to identify where the industry recessions are and invest in those segments. Currently I like media (TV/radio broadcasters), leasing firms, banks, autos and insurance. I currently have starter positions in gaming and telcos. If the market hits any of these sectors I will rotate from the more expensive firms to the cheaper firms. For example earlier this year I rotated out of some the radios and hospitality names into TV, banks and autos and from some leasors (containerships to MRI equipment and cargo planes). I think your style has to match your personality. Packer

WOLF was a buy-out earlier this year also with selling LNET before the collapse and FRE after the collapse and 100% losses in EXC and NRG LEAPs. I have added some of these during the year. My current top 10 include: TVL, SALM, ATSG, AIQ, GTN, SD, BAC, BAC-WTA, FFH, GM-WTB and RNK.TO. Packer

Up about 64% this year with a tailwind going into year-end. Some of it may be taken away next year. We will see. I made a mistake of purchasing Freddie Mac pfds before the nationalization announcement. The 10-yr returns are about 27% with mistakes which I find incredible. Packer

I am up about 20% over the S&P over the past 10 years with alot of mistakes (27% per year vs. S&P 7% per year). I think what has helped is not being diversified and selecting the spots were others are not. For example my top 5 positions are 60% of my portfolio and the top 10 85%. This performance has not come with a small amount of volatility. I purchased LEAPs and warrants so there is some non-recourse leverage involved. Over 10 years, I have has 4 in excess of 50% (5 in excess of 40%) with one down more than 50% (so I am not sure how many folks would be comfortable holding a portfolio like this). What I find incredible are some of my losses. If only I could remove them but I have tried to reduce my exposure to situations that I am attracted to that have caused most of these losses, Lodgenet is a recent example of getting out before it was too late but Freddie Mac pfds was an example of the opposite. Just some thoughts. Packer

It depends upon many factors including: the partition rights, what state the farm is in, does the interest generate any income, what form of business (S vs. C) is the interest a part of, what restrictions on transfer may be in any business incorporation documents. If it is a substantial size gift you may want to get it appraised and substantiated with an appraisal that can stand up to IRS questioning. An estate attorney should be able to provide you guidance on the risks and at what size should you get an outside appraisal. Packer

You are also going to want to discount the appraised value for lack of control and marketability in your valuation of the gift. Packer

wrister is correct. The devices are pretty sophisiticated as some people have tried to get into this market but it has been difficult due to supply chain issues and the perseption of a declining industry which keeps competitors away. My sister is a supply chain person one of these cos and provided the supply chain insight. Given the current price, the market doesn't think the market has changed and the HDDs margins will decline. If they do not or not very far this will be a winner. This is a higher risk bet than a bank or a TV firm but still a good bet in my book. Packer

A related issue is do young men need mentors to help them deal with the agression issues in a more productive way. I think in our data deluge and focus on me world the time to develop these relationships has been lessened and led to these tragedies. Guns are the faciliator but we need to deal with the underlying issue. Packer

The moat is the sophistication of the devices. HDDs are complex devices and with former national champions consolidated at this point the knowledge is in primarily 2 firms. Thus I think the pricing will be better than in the past. The other moat like characteristic is this is yesterday's technology (with a smaller portion of consumer devices) and thus will not attract folks who want to develop the next tech super company. Packer

You are right about how these can be value traps in a declinig market (as the FCF will decline going forward). However, each of these firms has had incerases in cash flows ove the past 5 to 10 years (except AIQ, which a bargain for other reasons). Another trap could be capital intensive businesses where the FCF will decline going forward. Given the coverage ratios at this point, I am not concered about restructing. For some of the firms with lower coverage ratios this can be an issue (CMLS is an example). Packer

Has anyone run into situations where the bonds and stocks of firms have large differences in yields or FCF yields for stocks? The following are current situations that I have found: Firm Bond Yield Coverage Ratio Equity FCF yield TVL 5.3% 4.5 33% GTN 6.3% 2.5 53% AIQ 6.6% 3.0 61% NXST 6.7% 2.9 34% SALM* 6.5% 2.8 28% * Refi assuming current yield on bonds Now either the bond market is wrong or the stock market is wrong. I have tendency to believe the bond market. Any other observations would be appreciated. TIA. Packer

As to negative NPV policies I have seen these in many pools. This is something that changes all the time as technology improves and is why the policies need to be re-underwritten often. So policies becoming negative or more negative is not uncommon over time as the insured conditions become more seasoned. In this case since we don't have the data we don't know. In theory these investments have no systematic risk but when you look at their stock prices they do because the other buyers if these securities are market participants. Look at the performance during the financial crisis (when having diversified sources of risk is more important). In your calcs you need to use total life (avg life *2) and include about a year to get the cash if the insurer does not have any problems. Based upon history it looks like the policies will be back-end loaded. In addition, you have to pay interest on loans used to pay premiums. I have done IRR calcs using average life (like you have) and you end up with significantly different results if you do a policy by policy calculation using MC and LEs to calculate payments. But by using these parameters and VTB 2008 LEs , the IRR will be less than 5% you calculated. I just do not feel less than 5% is a good return when I can get 20%+ FCF yield from some of stock we discuss here with fewer unknowns. I also do not see any information that would say that VTB 2008 should be used as a worst case especially since some of LEs have not been updated since origination. This claim has been made by many before who have had to change their story over time. The risk here is you get some folks that have genetically long lives. You just don't know. In my mind this a crap shoot where I don't know the odds. Packer

I am just providing observations I have seen in looking at these from the inside and outside and may not be obvious to someone with just outside (reporting) information. These are complex instruments whose value is based upon many unknowable factors to outsiders and some insiders as well (individual's health, genetics, LE, advances in medicine, changes in individual's habits, lack of periodic reporting and re-underwriting, insurance cos not accepting claim (no beneficial interest)). Management tries to make their best guess but that is all it is. Given all these unknowable factors that have a significant impact on value, the best investors underwrite very conservatively (always worse than the VBT 2008 tables). If you have an aggressive valuation, I would expect a write-down in the future. The problem in this case is there is not enough info (individuals health and lifestyle) to make an assessment that there assumptions are correct but I can tell you they are outside of the norm and compared to others aggressive using the discount rates they are using. Knowing a few of these from the inside, I would not invest unless I really knew management well and felt they had a process to weed out the valuation issues of the past (no beneficial interest, change in LE assumptions in 2011 (this had a huge impact on many NAVs but not on this one. Why?), lack of medical records to re-underwrite policies). At some point this asset class is a good buy but I don't think that there is enough information available to tell. This for me is truly a too hard asset class. The reason I bring up negative NPV policies is the origination of these policies from a skewed pool. Given the size of the pool there is bound to be a NPV policy. If management has not thought about this or developed a policy, it shows they are there to collect fees not to actively manage the pool as they should. In other words, they have an incentive to keep negative NPV policies in pool to collect the 2% fees they get based upon pool size. Look at it like this each of these polices have negative CF until the insured dies then they get the death benefit, therefore, there is a point where the policy NPV becomes negative. If you look at these globally I know of no fund that invests in these assets out there that has made more than 2 to 5% after fees. The origination and servicing fees are high and most of the origination is skewed vs VBT 2008. I agree that interest may not be relevant (but it may be if they need to use the LoC to pay premiums on policies) but expenses are. I know my approach depends upon valuation as a key input and given the uncertainties in LS settlement valuation, I would not invest in these. As a matter of fact, these have been great short candidates because management has an incentive to keep valuation high to collect fees. I am not saying that this is the case bu the incentive is there. One reason for the discount to the NAV is the lack of marketability and income. Even if management's projections are correct, you will not receive all the proceeds until 10+ years. So is a 20 - 30% discount enough for you to lock up your money for 10 years? I would rather invest in securities that have more certain values, whose value may be realized quicker and I don't have to pay 2% per year to own. Packer

Attached is the latest data I could find: http://doc.morningstar.com/document/fe1886096c1f960d429014e3465baecf.msdoc/?clientid=morningstareurope&key=b05d173f8e969ca1 http://doc.morningstar.com/document/03f558ebd04b3e30f3929645bf488727.msdoc/?clientid=morningstareurope&key=b05d173f8e969ca1 The semi-annual report shows a negative CF for 2010 and 2011 (after manager fee and loan interest) (see cash flow statement). So the pool may be CF positive before fees and interest but it is negative after fees and interest. I think the total fees are on the order of 2.0% so they are going to eat into any return. You can also look at historic NAV values which are not too impressive: http://tools.morningstar.co.uk/uk/cefreport/default.aspx?tab=1&SecurityToken=F0000008IB]2]0]FCGBR$$ALL&Id=F0000008IB&ClientFund=0&CurrencyId=GBP The use of shorter than VTB 2008 lives is an aggressive practice that most other LS funds have not done. What you are saying is these lives will die faster than the VTB 2008 curves. This may be true but I could find no data to support this - like disease diagnosis, etc. The biggest concern I would have is they don't appear to have an approach to let low/negative NPV policies lapse. There are bound to be some given the vintage of the portfolio (2006). I don't think you can get comfortable by doing a "static" analysis using the VTB 2008 tables. I know this from looking at both "inside" and "outside" analysis. In addition, this "static" analysis is what has led to massive write-downs in value of LS portfolio in the recent past. The "inside" analysis includes re-underwriting lives with modified mortality tables and using MC modelling etc. What concerns me is a significant portion of the portfolio has not been re-underwritten since 2008. Why? How would you know if you should let these policies lapse (low/negative NPV) without re-underwriting the loans? Are they not receiving updated health files to adjust the LEs? Just some thoughts. Packer

As to LS fund, the are not cash flow positive. The only reason they appear to be is policy sales. It looks like they needed cash to service the policies so they sold some policies to cover the funding gap. Given the timeframe they sold, they probably sold the best policies as they could readily obtain cash for these policies. So they have a CF negative position and the are using aggressive underwriting assumptions. Their normal case is what I have seen as an aggressive case (using the 2008 VBT tables). In addition, I could not find how these policies were originated. Most of the ones I have seen in pools are from "financial planning" exercises where middle-men take huge fees and the insured has more wealth and is in better shape then the what can be seen in the 2008 VBT tables. Another issue is the non re-underwriting of policies purchased. How do they know these policies have a positive NPV? Typically policies that have a low enough IRR are discontinued as the cash drain can be an issue. Without reunderwriting how do they know what to do with the policies? Just some observation. This area is a minefield and required a good "inside" look to even begin to get comfortable with some of the modelling assumptions in the NAV calcs. Packer

I would be very careful with life settlement investments. They are just about impossible to evaluate from the "outside" and there have been a few blow-ups and historical returns have been less than 8% with alot of unknowable risks (like extension of life expectancy due to better technology, changes in mortality tables that occurred a few years ago). They are very sensitive to life expectancy as you are paying policy premiums while the insured is alive. In addition, in few states some of these policies have been ruled void as the insured has no beneficial interest. The IRRs are based upon a mark to model value that can and has changed very quickly over time. Packer

I would put some into core growing "jockey" firms such as FFH, JEF and MIL, some into cheap segments like TV broadcast TVL, NXST and GTN, O&G like SD, LUKOY and UPL, lease finance like AIQ, SSW, ATSG and FLY, financials like BAC.WT, LNC.WT and BPOP and RE like BAM and Wheelock. This mix provides some diversity with a focus on value. Packer

I agree the Montier piece on financial repression provided an interesting way to look at valuation in the context of repression. His inclusion of the Ben Graham quotes are great as he experienced the last great repression we had. Packer