Income Strategy 1Q 2017 Commentary

During the first quarter of 2017, the Income Strategy returned 7.91% (net of fees)1, while the quarter’s dividend comprised 1.97%, or approximately one quarter of the Strategy’s total return. We continue to expect the bulk of the return to come from the dividend, which represents substantially all of the cash received from our holdings. However, our goal is to outperform the dividend yield over the long term by owning undervalued income-generating securities. If the market eventually agrees with what we think is a fair price for our holdings, we should be able to generate some capital appreciation in addition to the dividend.

Sometimes it seems like it would be nice if the market came around to our views in a smooth, linear fashion. However, the Strategy is far more volatile than the intrinsic value of its combined underlying positions, which is frustrating when the volatility is downward. The price action can work in the other direction too though, which is what we saw in the first quarter: the 7.91% return was significantly greater than the 1.97% contributed by the cash dividend in the quarter. Annualizing the dividend implies a 7.87% yield, which works out to approximately 3 basis points (bps) per day (0.03%).

When the Income Strategy outperforms its dividend yield, it could be due to other market participants increasingly agreeing with our view that certain securities we own are undervalued. It could also be due to other investors accepting lower returns for the type of securities we own. Other explanations include none at all, dumb luck or, most likely, some combination of all these things.

One example of investors coming around to our view of material undervaluation pertains to the alternative asset managers. At the beginning of the quarter, we had approximately 12.5% in this group between Apollo Global Management (APO)Fortress Investment Group (FIG) and The Carlyle Group (CG). These companies manage large sums of money for institutions, sovereign wealth funds and others. In February, SoftBank announced they would acquire Fortress Investment Group for $8.08 per share, or a nearly 40% premium to where shares traded prior to catching a whiff of the bid. SoftBank’s billionaire chairman, Masayoshi Son, would not pay $8.08 per share unless he thought the company was worth materially more than that. While the market bid up the shares of alternative asset managers in the first quarter, we still think the space remains materially undervalued relative to the cash they are likely to earn in coming years.

Another significant contributor was The GEO Group (GEO), the correctional facility operator. We began aggressively acquiring the position shortly after the Obama Administration’s Department of Justice (DoJ) announced they intended to phase out the use of private correctional facilities. This announcement caused the shares to crater by as much as half in just one day. However, a quick review of the contracts revealed that the federal government only had jurisdiction over a portion of the company’s facilities. In addition, the DoJ contracts had laddered expirations, meaning most would remain in force for years to come. We were also not aware of many functional prisons sitting idle, which meant that even a government phase out could have involved the purchase of facilities from the private operators. In addition, the upcoming election meant a possible change of stance toward private corrections firms, though we did not believe we needed Republicans to win for the stock to work. The position ended up working more quickly than we anticipated, generating a 31.1% total return in the first quarter.

Sometimes things don’t work out quite as quickly. As value investors, we are more likely to be early and catch a “falling knife” than we are to be late to the party. This quarter proved no exception, as we had some premature accumulation in the common shares of container-ship lessor Seaspan (SSW), which is down almost 75% from its peak. The company owns over 100 vessels and leases them to shipping companies, primarily under long-term contracts. The market hates the industry right now, as a surfeit of container ships has put pressure on rates and caused bankruptcies such as Hanjin, a Seaspan client. Shipping firms scrapped 3% of global supply in 2016 against very few new orders and continued to scrap almost 1% in just the first two months of 2017. Seaspan management has commented recently about possibly observing the bottom in rates. The Washington family, worth billions through the ownership of highly cyclical industries, owns half the company and expressed an interest to “fully participate” in the dividend reinvestment program this quarter, representing almost $7M of reinvestment by insiders. We started buying the shares before the dividend cut, which we anticipated as a possibility, though not a necessity. Shares now yield a qualified 7.4% at the reset level, and we believe the dividend will move higher over time as the market recovers. We have also purchased the preferred shares, which yield north of 9% and trade around 85% of par, despite what appear to be highly visible operating cash flows that should amply cover the preferred dividends. The preferred shares we own would generate a total return near 25% if they go back to par, including one year’s worth of dividends.

Only time will tell how Seaspan and our other investments work out. As Ben Graham pointed out, the market is a voting machine in the short run, but a weighing machine in the long run. We remain invested alongside you for the long run, and we welcome any questions or comments.

Strategy Highlights

The Income Strategy initiated six positions and eliminated one during the quarter, ending the quarter with 41 holdings.

Top Contributors

  • Fortress Investment Group LLC soared in the first quarter after the company entered into a definitive agreement to be acquired by Japan-based Softbank Group Corp. for $3.3B in cash. The acquisition price of $8.08 per share was a 38.6% premium from where the stock closed the day before the deal.
  • The GEO Group Inc. continued its climb in the first quarter ending the period up 31.1%. During the quarter the company hiked their dividend 7.7% to $0.70/share (6.0% annualized yield). The company also issued equity to help fund the purchase of Community Education Centers for $360M, which it expects to be accretive to adjusted EBITDA next year.
  • Apollo Global Management LLC rose 28.1% over the period. The company reported a strong fourth quarter beat with $0.98 in economic net income per share versus a consensus estimate for $0.80. The company declared a $0.45 dividend (7.4% annualized yield) against distributable (or “cash”) earnings of $0.55. Management pointed out that 2016 represented a six-year low for realizations due to timing of fund launches, suggesting that the trailing-twelve-month distribution of $1.42 (5.8% yield) likely represents a trough and that 2017 could produce a substantially higher dividend. Tiger Global Management also reported a 7% stake in the company.

Top Detractors

  • Walter Investment Management 4.5% 11/1/19 convertible debt fell -50.7% over the period. Walter posted disappointing 4Q results with larger-than-anticipated losses along with the disclosure of a material weakness in internal controls and a subpoena tied to its mortgage origination practices.
  • Seaspan Corp. ended the first quarter down -32.2% as the company reported solid fourth quarter results but cut its dividend by 67% to $0.125 (7.2% annualized yield). The dividend cut was largely anticipated and should improve the near-term liquidity outlook.
  • Frontier Communications Corp. 11.125% Preferred declined -27.3% during the quarter. The company announced a weak fourth quarter earnings report but maintained its $0.105 dividend (19.6% annualized yield). Subscriber losses were larger than anticipated, causing revenues and EBITDA to fall short of estimates. Investors worried that the subscriber losses and large amount of debt could put pressure on the dividend.