April 17, 2015

In Search of ‘Uncertainty Discounts’ – Income Opportunity Strategy Q1 2015 Review

Market Commentary

In our market commentary at the end of 2014, we wrote about why we thought stocks provided a much better income opportunity than bonds. Not much has changed over the past three months, as the dividend yield on the S&P 500 still exceeds the 10-year US bond yield. The equity investor not only captures the higher cash yield today, but also should benefit from dividend growth, which analysts expect to be north of 5% on a compound basis between 2014 and 2016. The equity risk premium, or the marginal return over bonds that investors demand from stocks, remains extremely high by historical standards. This suggests that investors are placing an abnormally high “certainty premium” on specific assets. Conversely, we believe the “uncertainty discount” is too high on many securities, which is where we continue to focus.

One group of stocks we believe contains an elevated “uncertainty discount” is alternative investment managers. These companies manage money for large institutions and wealthy individuals, and they receive fees for doing so, typically a base management fee on assets plus a portion of positive returns generated for investors. A significant portion of the assets managed are locked up for periods of seven years or longer — almost half of Apollo’s assets under management are in permanent capital vehicles. The extended time horizon on these funds allows alternative asset managers to employ a longer investment time horizon than can managers who provide more frequent liquidity to their investors. We believe this extended time horizon along with a hands-on management approach may continue to generate superior investment performance.

The managers’ limited partners also seem to appreciate the investment approach. Many of the publicly traded alternative managers have grown assets under management faster than more traditional investment managers and show no signs of slowing down. Despite faster asset growth, stickier capital and what may be a superior investment model versus traditional investment managers, the group trades at a significant discount to traditional managers on a price-to-earnings basis (after adjusting for tax discrepancies). We believe that the market places a very large “uncertainty discount” on the group’s limited trading history and its lumpy earnings, which bounce around unpredictably with realizations from the sale of portfolio companies. The partnership structure and its tax hassles may also have something to do with the discount.

Alternative asset managers trade at a similar discount to the broader market, even though the core business exhibits far better investment characteristics than does the aggregate market. Managing money is a capital-light business requiring very little reinvestment from the manager, allowing the companies to return the bulk of profits to shareholders. In addition, these companies have management teams whose interests are aligned not only with their limited partner investors but also with their general partner shareholders, as the group has extremely high insider ownership; some teams own shares worth billions of dollars.

Clearly, there is no guarantee that these companies will perform well. The market could decline and cause their performance to suffer, or a weak economy could cause their holdings to languish. However, we are constructive on both the market and the economy and think there is a strong probability the stocks will do well, which is why we ended the first quarter with a significant allocation to them.

Many of the other names in the strategy trade at similar “uncertainty discounts,” and these are the type of securities that we research and like to own – cash-generating securities whose prices we believe fail to reflect the present value of their future cash distributions.

As always, we welcome your questions or comments.

Strategy Highlights

During the first quarter of 2015, Income Opportunity Strategy generated a total return of 5.1% (net of fees).1 In comparison, the strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned 2.55% and 0.95%, respectively.

The strategy initiated three positions and eliminated eight during the quarter, ending the quarter with 67 holdings.

Top Contributors

  • While Home Loan Servicing Solution was down -12.26% during the quarter, Income Opportunity Strategy’s timely purchase of its shares resulted in the shares increasing 46.79% over the period that the strategy held them. We purchased the shares after the stock declined in the wake of worsening troubles for business partner Ocwen. The stock subsequently rebounded once Home Loan Servicing Solutions announced its acquisition by New Residential Investment for $18.25 per share in cash.
  • Abengoa Yield PLC rebounded in the first quarter, rising 24.61%. Fourth quarter results came in below Street expectations, but the company affirmed dividend guidance of $1.60 for 2015 (4.9% annualized yield) and between $1.92 and $2.00 for 2016 (6.0% annualized yield at the midpoint). The company continued to acquire accretive new assets over the quarter – 81 miles of Peruvian power lines, partial stakes in Spanish and UAE solar power assets and partial stakes in Algerian water desalination plants.
  • The William Lyon Homes 6.5% mandatory convertible preferred security was up 21.99% during the quarter supported by stronger pending home sales with new home sales rising 7.8% in February. Over the quarter, William Lyon Homes announced the formation of William Lyon Mortgage, LLC which will offer an array of mortgage banking services across its Western regional markets by the second half of 2015.

Top Detractors

  • Declining oil prices impacted both BW Offshore Ltd. and Nordic American Offshore Ltd. which declined -23.94% and -22.41%, respectively. BW Offshore cut its Q4 2014 dividend by a penny to $0.02 per share (9.0% annualized yield), citing the cause as the weaker outlook for the oil and gas market. Investors also fretted that weak gas prices could weigh on the rates at which Nordic American Offshore charters its vessels. The company declared a Q4 2014 dividend of $0.45 while covering roughly half of the dividend from operating cash flow.
  • Seagate Technology PLC ended the first quarter down -21.05%, impacted by lower PC demand and incremental pricing pressure. As a result, Seagate guided to lower first quarter sales than the Street had hoped. Seagate stated that share buybacks were a good use of capital below $60/share, which is above where the stock closed on 3/31/2015 at $52.03.

1For 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.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.