Far From the Madding Crowd
Avoiding the Noise
Occasionally the mute button can be an effective investment tool. Market and media clatter can be overwhelmingly loud, which can have the effect of inadvertently influencing ones decisions, many times, without improved results. The equity markets are especially noisy of late. For that reason, we have turned a deaf ear to much of the calamity and focused on strategies which are discernible, while paying extra attention to risk management.
There are a variety of methods we utilize for monitoring and managing risk, the following are just a few interesting examples. CDS spreads are an indicator that we follow on many of the companies we own. They tend to be more of a leading indicator than the general market for identifying changes in sentiment or structural concerns. As an example, the 5 year CDS spread on MGIC Investment Corp (a mortgage insurer we owned) began to rise significantly at the beginning of April. This rise coincided with a precipitous drop in share price. We viewed this, along with rising anxiety in the market and a few bad housing reports, as an indication to the sell the stock. We did in fact sell and the stock went on to fall over 50% from the end of March. We are now keeping an eye on the insurers for a re-entry point.
MGIC Investment Corp 5 year CDS
Another indicator that we monitor at times is the spread on US interest rate swaps. These spreads have been declining steadily since the 2008 crisis, except during periods of renewed concern in the financial system. Namely: May 2010, the second half of 2011 and May 2012. At the end of 2012, we saw these spreads tighten following the announcement of LTRO. We viewed these events as bullish for the markets and the first quarter did indeed go on to have a good run in the US. However, as LTRO faded in February and the European situation heated up again the spread on interest rate swaps widened. Although we are bottom up investors, we do keep an eye on macro issues when it comes to strategy allocation. Therefore, the culmination of deteriorating economic numbers, the widening of US interest rate swaps and ending of LTRO led us to increase our hedges and allocation to defensive strategies like M&A and yield. This proved beneficial heading into May which saw global markets sell of dramatically. Recently, US interest rate swaps have tightened considerably but some of this can be attributed to manipulation by the central banks, which is something to be mindful of.
May was perhaps the most treacherous month for merger arbitrage since the height of the financial crisis – on 3 out of 4 days a deal would break or be dealt a significant set-back. The long list of broken deals includes: the hostile bid for Illumina by Roche; the hostile bid for Avon by Coty; the hostile battle for Fibrek by Resolute and Mercer; the Telus multi-class share collapse; the failed private-equity bid for Pep Boys; the failed private-equity bid for Talbots; the failed auction of Second Wave; and, the failed auction of Ithaca Energy. The recurrence of the terms ‘hostile’, ‘private-equity’ and ‘auction’ in this list are reasons why we give these types of situations extra-wide berth. Fortunately, we characterized most of the broken situations as speculative and lower quality and we therefore had minimal exposure. For the month of May our positive contributions from closed deals such as Motorola and El Paso, and strong performance from TMX more than offset any losses in M&A. There is an old market adage that proved true this month: ‘Avoid losses and the gains will take care of themselves.”
Perhaps the highest profile situation that failed, at least in terms of market capitalization, was the hostile bid for Illumina by Roche. We found this situation interesting because Roche is a formidable acquirer, and has a history of patience in pursuing their quarry, as well as a willingness to ultimately bump to secure a friendly deal. In this situation Roche ran into a shareholder base much more entrenched and decided to quickly withdraw their bid when they couldn’t achieve meaningful success in trying to get nominees on the board. While we were wrong in our assessment of the outcome, our position was small, and the downside was mitigated because we had implemented the position as a buy-write that we rolled once and so we monetized the sale of volatility. In Canadian situations we were hurt in Fibrek. We felt this was a classic hostile battle where the highest price would ultimately win. However, the presence of a large lock-up with a significantly conflicted shareholder required the higher bidder to use a deal structure that ultimately was rejected by the Quebec courts. While we disagree that fairness prevailed, we respect the decision and moved on. We expect that other shareholders will seek remedy through dissenters’ rights. Once again, our position was small, in large part because of the small market float and therefore limited liquidity.
On the positive side of the ledger, May saw the successful completion of two of our largest situations: the Google bid for Motorola Mobility and the Kinder Morgan bid for El Paso. Additionally, in the Maple bid for TMX, draft orders were published by the provincial securities regulators and the Competition Bureau stated that if these orders were finalized it may substantially mitigate their concerns. The stock traded up approximately 5% on this news, and we remain optimistic that we should see regulatory approval around the end of July.
As a final thought, the most recent memo from Howard Marks of Oaktree Capital nicely summarizes how we think about risk management in arbitrage:
“Risk control isn’t an action so much as it is a mindset. It stems largely from putting at least as much emphasis on avoiding mistakes as on doing great things. In particular, risk control requires that we temper our belief in our opinions with acceptance of our fallibility. In the end, superior investing is all about mistakes … and about being the person who profits from them, not the one that commits them.”
For better or worse
Over the past month, the lack of stability in the market led to a few disruptions in corporate bonds. Community Choice, a payday lender in the US, was expected to IPO but was put on hold due to market conditions. As well, American Casino was expected to refinance their bond issue at a lower coupon but canceled due to market conditions. On the surface these hiccups appear to be negative for an investment, however, due to the quality of these investments we are content continuing to hold.
Our thesis on the payday lenders is that they will further right size their capital structure using an IPO to de-lever and issue publicly traded common equity. If an IPO happens, all of the bonds have an indenture allowing the company to call up to 35% of their bonds at a premium-to-par. This would be a nice pickup for the bondholders (us). However, we look at this more as a bonus since the real attraction to these investments is the risk/reward tradeoff in the sector and the current 10+% yield. Therefore, we’re content with either outcome as we hold the bonds.
American Casino (owner of the Stratosphere for any Las Vegas bungee jumpers) has been a good risk/reward tradeoff for our portfolio as we held the bonds during renovations and the advent of the Stratosphere Bungee Jump (adding almost $5m EBITDA per year on a $300m issue, so no laughing matter). We were anxious to participate in the anticipated new bond issue but as the market has now cancelled the issue we are satisfied with continuing to collect good interest on a decent credit.
until next time. . . @The Vertex Team
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