October 19, 2017

Big Value in Small Financials

Income Strategy 3Q 2017 Letter

The third quarter was another good one for the Income Strategy, which returned 3.80% (net of fees).1 In comparison, the Merrill Lynch High Yield Master II Index (the primary benchmark) returned 2.04%. The most recent quarter was the fifth consecutive one in which the Strategy outperformed its primary benchmark, which has led some investors and prospects to ask, “Given the strong recent performance, is it too late to invest?” We certainly don’t think so. Indeed, we believe we own a whole portfolio of undervalued income-generating securities. The rest of this piece will provide a brief summary of the investment thinking behind two of our more recent additions.

Maiden Holdings (MHLD) provides specialized, non-catastrophic reinsurance. Property and casualty insurance firms pay Maiden to assume risk beyond certain loss levels on their books of business. Because Maiden de-emphasizes less predictable catastrophic risks and other volatile types of insurance, profits should be relatively predictable, which investors like. However, Maiden announced in February that they had underestimated losses in their commercial automotive segment, an issue that has plagued most car insurers. Then in August, the company reported additional reserve charges tied to workers’ compensation and client-specific facultative contracts. The market, which at the beginning of the year priced the stock at a premium to book value, punished Maiden by driving the share price to almost half of book value. While we acknowledge the losses were unexpected and that additional adverse development is a possibility, we believe the valuation reflects significantly more losses than are likely to occur. Shares sported a qualified 8.5% dividend yield at the time of our initial purchase, and we think the dividend is sustainable. We also believe that, over time, shares should migrate back toward book value as the market realizes the company can earn close to its cost of capital over the long term.

Another financial company we added to in the third quarter is the boutique M&A advisor, Greenhill (GHL). The company advises generally on large, global transactions, which have recently been few and far between. When we first started buying the stock at the end of the second quarter, it carried a 9% qualified yield, and shares had fallen from an all-time high of almost $90 (dividend-adjusted) to our purchase price of $20. Near the end of the third quarter, the company announced a significant financial restructuring, whereby the company will use a bank loan to repurchase up to $285M worth of stock in an effort to maximize shareholder value. Both the Firm’s Chairman and CEO are personally buying $10M each of newly issued common stock, and the CEO has asked to forego 90% of his base salary in exchange for restricted stock that will cliff vest in five years. Management upsized the debt issuance, as demand from lenders was stronger than anticipated at the rate of Libor (3-month) + 3.75%, or approximately 5.1% at current rates. Demand from lenders was so strong that management upsized the transaction, which is worth noting because banks like to loan against hard collateral, which is largely absent in a business where the main assets are people and relationships. We liked the name prior to this transaction, but we like it even more now, as we believe this is a compelling signal about the company’s prospects. The people effecting this transaction make a living providing advice on maximizing shareholder value, and employees will own approximately half the firm after the transaction. As of this writing, shares currently trade close to the IPO price of $17.50. However, Greenhill is likely to have approximately 13M shares outstanding after this transaction, or 57% less than were outstanding shortly after the IPO, which is a rarity for financial firms that survived the global crisis. The recapitalization is likely to include the elimination of the dividend, which we think would have otherwise been sustainable, though we agree that the new capital allocation framework is likely best for aggregate shareholder value creation. This is a name with multi-bagger potential if the firm can return to any normalized level of revenues per managing director.

There is no assurance that we will make money on either name, but we very much like the risk/reward skew for each. We believe these are just two examples of many compelling opportunities we own and search for daily. As the largest shareholders in the Strategy, we are excited about our prospects to generate compelling returns and welcome any questions or comments.

Top Contributors

  • Carlyle Group LP (CG) was the top contributor rising 21.97% over the quarter. The company reported Q2 economic net income of $0.81 per share, easily surpassing analyst estimates of $0.41. The beat was driven by appreciation of 6% in real asset portfolios and 8% in private equity funds, both of which exceeded peer returns. The firm also reaffirmed their robust fundraising outlook and declared a $0.42 dividend (7.0% annualized yield).
  • Apollo Global Management LLC (APO) advanced 15.88% during the quarter. The company reported Q2 economic net income of $0.46, in-line with street expectations and declared a dividend of $0.52 per share (6.7% annualized yield). The firm also announced an up-size in their latest flagship fund to $24.7Bn, the largest private equity fund ever raised and indicated it would add roughly $200M to base management fees, or double the original guidance.
  • Abercrombie & Fitch Co. (ANF) soared 23.57% over the period after posting Q2 EPS of $(0.16) and sales of $779.3M, easily surpassing analyst estimates of $(0.33) and $758.6M, respectively. Same store-sales of -1%, mainly driven by the Hollister brand which saw positive same store-sales, beat consensus estimates of -2.1%. Management re-affirmed flat FY 2017 same-store sales and sees 2H17 flat-to-up. The firm also maintained their $0.20 per share dividend (6.1% annualized yield).

Top Detractors

  • Walter Investment Management Convert 4.5 11/19 was the top detractor during the quarter, falling 52.52% as the company said they may seek bankruptcy protection if they fail to garner enough creditor support for a restructuring deal on more junior fixed income securities. The deal needs 66.7% approval and will reduce leverage while extending maturities at the cost of dilution to existing holders.
  • Greenhill & Co. (GHL) fell 14.49% over the period after reporting Q2 EPS of $0.20 and revenue of $67.3M, both missing analyst estimates of $0.27 and $72.1M, respectively. The miss was largely due to fewer large transaction completion fees as M&A activity outside the U.S. weighed on results. The company bounced back nicely towards the end of the quarter after announcing they’re executing a leveraged recapitalization and buying back approximately half of shares outstanding.
  • Triangle Capital Corp. (TCAP) fell 12.37% during the quarter. The company reported Q2 net investment income per share of $0.41, just missing estimates of $0.42 and falling short of the recently lowered $0.45 dividend (12.46% annualized yield). Analysts on the street were bearish and noted that credit losses, in addition to problem loans, could cause the firm to cut their dividend 20%-30%.

1For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2017 Miller Value Partners, LLC

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