Income Opportunity Strategy: 4Q 2014 Strategy Update

Market Commentary

Last year proved to be disappointing for the Income Opportunity Strategy. We have been managing the Strategy since 2009, and 2014 was the second-to-worst year behind only 2011, when the Strategy lost almost 8%. In fact, 2014 reminds us a lot of 2011. In 2011, investor worries involved global macroeconomic concerns and deflationary forces. The 10-year yield on US government bonds fell from over 3% to less than 2% at the end of 2011. Similar fears helped push the 10-year bond from yielding almost 3% to nearly 2% at the end of 2014. Also similar to the end of 2011, which was followed by a year of Strategy outperformance, we now believe many of the securities in our portfolio trade at substantial discounts to their intrinsic value.

Today, we are very optimistic for the coming year, although others may not be. We recently attended a lunch with investors and research professionals from a prominent sell side firm. The idea was to discuss what might be in store for the market in 2015 and what names the participants thought could do well. The moderator asked everyone in the room for their market outlook, and most had muted expectations for 2015 – in aggregate, the room expected a flat stock market and relatively flat rates. We think the market could pleasantly surprise those with a similar outlook and that stocks are the best place for investors who can tolerate some volatility.

There has been a growing divergence between the valuations on stocks and bonds. The “equity risk premium” is a number that measures the excess return that investors demand from stocks in exchange for assuming the extra risk associated with stocks over bonds. We believe this is an important metric to follow, as it contains an immense amount of information about valuations and investor sentiment. Generally, a higher equity risk premium tells us that investors are especially nervous about owning stocks relative to bonds. The best opportunities to buy stocks have historically come at such times. Professor Aswath Damodaran at NYU is one of the leading experts on the equity risk premium and has tracked it over time. According to his data, there have only been 11 years since 1960 that began with an equity risk premium over 5%. These 11 years provided an average equity market return of over 19%, and only one of the 11 years had a negative return, which was in the low single-digits. This year began with an equity risk premium of 5.8%, among the highest ever.

Perhaps the most salient example of the growing disparity between stock and bond valuations lies in the S&P’s current dividend yield, which is now above the yield on the 10-year bond. Prior to the depths of the financial crisis, investors had not been able to buy stocks at a higher yield than bonds since 1958; both times proved to be a better time to buy stocks than bonds. We have discussed this in prior letters, but it is worth mentioning again: buying the 10-year bond at a 2% yield is like paying 50x earnings for an equity whose earnings are guaranteed to remain the same for the next 10 years. Instead, we’d prefer to tolerate a little more volatility and own stocks at a 2% dividend yield when analysts predict that dividends per share are likely to grow at 8% per year for the next two years¹. Stock investors also stand to benefit if the equity risk premium falls back to a more normal level.

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Strategy Highlights

During the fourth quarter of 2014, the Income Opportunity Strategy generated a total return of -2.44% (net of fees).² In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P 500 returned -1.07% and 4.93%, respectively.

The Strategy initiated six positions and eliminated 21 during the quarter, ending the quarter with 72 holdings.

Top Contributors

New Media Investment Group was the Strategy’s largest contributor to performance during the fourth quarter, rising 44.15%. The local newspaper company completed its acquisition of Foster’s Daily Democrat in early December and announced its intent to acquire Halifax Media Group in early 2015. The company’s third quarter results handily topped estimates. New Media also filed registration for an additional $150M worth of shares.
BGC Partners Inc. rose 24.82% during the fourth quarter. Strong profit growth resulted from expense reductions and commercial real estate revenue increases. The company completed one acquisition over the period for an undisclosed amount with three more acquisitions pending. BGC Partners raised $300M of debt to finance new acquisitions and strategic alliances, particularly the proposed purchase of all of the outstanding shares of GFI Group Inc.
While American Realty Capital Properties Inc. was down 23.02% during the quarter, our timely purchase of its shares resulted in the shares increasing 13.12% over the period that the Strategy held them. In October, the company announced the presence of accounting irregularities in its 2013 10-K and 1Q and 2Q 10-Qs for 2014. We purchased the shares after the stock declined in the wake of these irregularitiesbecoming public.

Top Detractors

Linn Co LLC declined over the fourth quarter, decreasing -62.76% as a result of the large drop in oil prices that negatively impacted Linn Energy LLC’s performance; shares of Linn Energy are Linn Co LLC’s sole asset.
Rhino Resource Partners LP ended the fourth quarter down -80.95%, impacted by the large decline in commodity prices over the period. In addition, the company announced a decline in its third quarter distribution, down 89% from the second quarter distribution.
Sberbank-Sponsored ADR was down -48.86% for the fourth quarter as third quarter EPS declined 27% from the second quarter. Although EPS were down, Sberbank announced that ROE was over 14% for the same period. Sberbank suffered from a spike in provisions, as well as the large drop in oil prices and the depreciation of the ruble over the period.

¹Source: Bloomberg’s EEO function. There is no guarantee that dividends will grow or continue at current levels.

²For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM 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 the LMM LLC (LMM) strategy’s 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 LMM 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.