Anything But Down

When we tell clients about the names we own and why we believe they are undervalued, one of the most common responses is, “So what is going to get people to care about these names and make them start going up?”

The answer typically catches people by surprise: while it would be nice for the names to go up, most investors would just be happy if they didn’t decline in value. The bulk of our return is likely to come from dividend and interest payments, and our assessment of the portfolio’s annualized gross cash yield, before expenses, is north of 9%. That means that any day where the portfolio is flat is a good day, as it implies a gross return of 9% per year from the cash that our holdings throw off (technically, the way the math works is that we need approximately 0.03% per day to account for the annualized accrual of cash across the portfolio, but the substantive idea stands). Stocks without a dividend ultimately require someone else to believe the stock is worth more than the buyer paid, if the owner is to make any money. Conversely, stocks that pay out a high level of cash only require that the stock not decline in value for the holder to make money.

High-yielding equities, while often less volatile than non-yielding equities, are more volatile than the present value of their future dividends. Though downside volatility disappoints in the short term, it sows the seeds for future outperformance by providing an opportunity to reposition the portfolio and concentrate in names that we think are most dislocated relative to their intrinsic value. We held 72 positions at the end of March 2014. As spreads have widened with volatility, we have pruned the portfolio to the 42 positions that we think are most undervalued relative to our predictions for future dividends and interest. This year’s volatility, in particular, has provided an opportunity to buy some compelling debt issues at significant discounts to par. We nearly doubled the portfolio’s allocation to bonds from 13.1% at the beginning of the year to 22.9% at the end of the second quarter, and almost all of the debt we purchased this year now trades significantly above our average cost, though we believe our debt holdings still have additional upside. The portfolio is relatively concentrated, with securities from the top ten issuers comprising 42% of the portfolio. We will continue to manage the strategy with high active share, meaning that it will be almost entirely different from its primary benchmark, the Merrill Lynch High Yield Master II index.¹ Performance will deviate from the benchmark, often significantly, but it is nearly impossible to outperform a benchmark if a strategy’s holdings are substantially similar with the only differentiator being higher fees.

We, the managers, remain the largest investors in Income Opportunity, so our incentives are very much aligned with investors’. We encourage investors to look at the weekly Income Opportunity update and to explore our blog for additional insight into our process and team. We appreciate your support and welcome any comments.

Strategy Highlights

During the second quarter of 2016, the Income Opportunity Strategy returned of 4.87% (net of fees).² In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned 5.88% and 2.46%, respectively.

We initiated five positions and eliminated eight during the quarter, ending the quarter with 42 holdings.

Top Contributors

Chesapeake Energy Corp 6.5% 8/15/17 was up 37.76% during the quarter, supported by improving oil prices. Over the quarter Chesapeake reached a deal with creditors to ease covenants and reaffirm its $4.0B borrowing base; in exchange, the company pledged additional assets as collateral for the facility. In addition, the company announced debt-for-equity swaps as well as asset sales.
VEREIT, Inc. (VER) maintained its ascent in the second quarter, rising 15.92% while it continued to report progress on its turnaround. The company printed $0.21 in AFFO per share, exceeding the consensus expectations by a penny. Management also reported $295M of asset sales at a 6.1% cap rate, implying values meaningfully higher than those embedded in the stock price. Management also reduced net debt to EBITDA from 7.0x to 6.7x, and maintained the $0.1375 dividend (5.4%), which is covered 1.5x by AFFO.
Chimera Investment Corp. (CIM) continued its rebound, ending the quarter up 19.14% on the back of strong first quarter results. Chimera reported $0.58 in core EPS, easily exceeding the $0.48 dividend (12.2% yield), and management said they expect to maintain the dividend for the remainder of 2016. Further securitizations seem likely, and repurchase funding remains readily available, which bodes well for future quarters.

Top Detractors

Calumet Specialty Product Partners L.P. (CLMT) stock fell 58.30%. The company eliminated the dividend in April while also announcing it borrowed $400M at 11.5% on a senior secured basis. In addition, the company reported poor Q1 performance far below expectations. The announcements suggest the business is in far worse shape than management had previously let on.
Seagate Technology (STX) ended the second quarter down -26.95% as the company announced a challenging first quarter with weak end-market demand, implying a lower near-term future profit outlook and potential risk to the dividend.
NorthStar Realty Finance Corp. (NRF) common equity declined over the quarter, ending the period down 10.22% despite strong first quarter results. NorthStar reported cash available for distribution of $0.58, easily covering the $0.40 dividend (14.0% yield). Management also repurchased $50M of stock during Q1 (2.1% of shares) and announced an additional $2.3B of asset sales, including the manufactured housing portfolio, at prices meaningfully above those implied by the current stock price. During the quarter, NorthStar confirmed a three-way merger with its manager, NorthStar Asset Management and Colony Capital. Management expects to pay a $1.08 starting dividend against ~$1.65 of core cash earnings, implying a payout ratio of ~2/3rds, which is in-line with peers, but implies a 9.1% dividend yield, while peers with higher leverage trade at 5.1%; if Colony NorthStar were to trade in-line with peers, this would imply upside of ~78% for the stock.

¹Active share represents the share of strategy holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the strategy and its benchmark, the greater the active share.

²Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For 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.