MAY PERFORMANCE SUMMARY AND LOOKING AHEAD TO JUNE
*This is a copy of my letter to investors summarizing the month of May.
April monthly report can be found here.
2012 Return: +58.61%
2013 Return: +4.89%
Portfolio May Performance: +13.22% S&P 500 May Performance: +2.08%
Portfolio YTD Performance: +4.89% S&P 500 YTD Performance: +14.34%
Total Return Since Inception (1/1/12): +67.33% vs. S&P 500 +29.67%
Portfolio Highlights For May
- SPNS was liquidated from the portfolios completely, in a process that started in April. The company was held in the portfolios for roughly 11 months. In that time the stock gained 40% from the time the position was taken in June of 2012. On a pure risk/reward basis SPNS no longer justified remaining in the portfolios when an increasing number of well defined risk/reward opportunities are becoming evident. It should be noted that from the point SPNS was completely liquidated from the portfolios, the stock has come down 7% as of the close Friday, further confirming that the decision to sell was a prudent one. I will revisit this name over the coming months as I continue to believe that the fundamental opportunity for long-term growth remains intact.
- WMIH has now been held in the portfolios for nearly 11 months, fluctuating between a mid to large sized position the entire time. Since the position was initiated in July of 2012, it has gained 76%. Perhaps more importantly than pure appreciation, the market for the stock seems to be developing recognition as monthly volume in May was eight times the amount of volume as July 2012. For the month of May, WMIH gained 47% contributing greatly to overall performance. The stock ended May as a large position due to both additions to the stock made early in the month and appreciation.
During the April summary, I pointed to the increasingly rich environment for mortgage insurers/reinsurers. The attention being paid to these names only seems to picking up steam as there are increased reports that some of the largest hedge funds are making significant moves into the space. Specifically, here is a Bloomberg article from May 20th outlining moves Paulson & Co, Maverick and Soros, among others, are making into the mortgage insurance/reinsurance space.
The consequences of this increasingly affable trend towards this sector does make a positive outcome for WMIH, whose only operating entity is a mortgage reinsurance company, that much more likely. The chances are becoming increasingly slim that the mortgage reinsurance company contained within the holding company that is WMIH will only serve as an entity that is meant to "runoff" prior obligations. The present Board of Directors is being handed a favorable operating environment for their sole possession on a proverbial golden platter. To squander such an opportunity, especially when you have tax incentives that leverage profits created in such an environment, would be modern capitalism's contribution to Shakespearean tragedy using sheer incompetence instead of swords.
- IWSY managed to post a strong performance in May, rising 52% for the month. The stock is now up 60% since the position was initiated in late-February. This is the second time I have taken an investment position in a biometric company focused on the mobile space with favorable results. If you will remember, last year AUTH gained nearly 100% from the time a position was taken and research report issued in May of 2012, up until the point Apple bought the company in late-July of 2012. I expect a similar result for IWSY in the coming 12-24 months, as biometric technology will replace the clunky, antiquated method of password verification almost entirely in the years ahead.
IWSY is not just an industry play, however. The company itself is doing everything right recently as expressed in a conference call announcing a new partnership the company has on May 10th. Keep in mind, IWSY has a senior management team that has been a part of this company an average of 16 years. These are no newcomers to the industry or the company. Furthermore, keep in mind that this was a company that for years didn't even have conference calls. Suddenly you have this happening:
Notes from IWSY conference call:
- JIM MILLER (CEO) - I'm pleased to report that we've achieved multiple milestones in product development and further penetrated the commercial and consumer markets.
- JIM MILLER (CEO) - We believe CloudID is the first offering of its kind and addresses the growing need to secure the cloud and mobile markets using multimodal biometric security solutions.
- JIM MILLER (CEO) - Our partnership with Fujitsu to utilize their secure global platform is paving the way for a swift entry into these markets, as evidenced by this agreement with Emida. Together with Fujitsu, we expect to see significant momentum in similar transactions as we work to collaborate on a global expansion model in the near future. In fact, we are currently enjoying discussions with several clients regarding licensing opportunities and we'll continue to target large enterprise business and emerging application.
- JIM MILLER (CEO) - We have reached a very exciting crossroads where the cloud and mobile computing have intersected with biometrics. The rapid expansion in availability and use of mobile devices presents an incredible opportunity.
- JIM MILLER (CEO) - As we have stated, we're not yet a quarter-to-quarter company. However, we recognize the importance of getting to that place. Now, the fundamental and transformational shift in our revenue model will take us there and will take us there quickly.
- JIM MILLER (CEO) - Thanks, Michael. I'd like to conclude by saying that as a company, we're pretty pumped up group at ImageWare these days. We sometimes say amongst ourselves that this is no longer your father's ImageWare, and I think that you're starting to see with announcements like we had out today the reason for that feeling and our enthusiasm. And as we said earlier, we're at an incredibly exciting intersection of three major market moving forces, the cloud, mobile computing, and biometrics, the opportunities are simply awesome. We're starting to see the transformation of our financial model and we have a number of discussions underway that we expect to significantly increase sales. The first of these was Emida, we expect more to follow.
An experienced staff of executives that were silent for years suddenly shouting from rooftops that good things are happening. It was following this conference call that the stock saw a majority of its appreciation for the month.
The most surprising part of the opportunity in IWSY is the fact that all of this occurring with the company receiving little to no recognition from investors. I believe the company is one or at maximum two most large contracts/partnerships away from this entire dynamic changing.
- CIDM gained 5% for the month despite issuing an earnings warning during the middle of month due to delayed delivery of software to a major film studio. The revised guidance was not substantial enough to warrant a reaction by market participants, especially in the face of the depressed stock price. As technology takes a greater leadership role in the market during the latter part of 2013, I expect CIDM to be a substantial winner for the portfolios. As it stands, the opportunity has a risk profile that is extremely attractive due to the substantial debt restructuring that has taken place, as well as the forward thinking nature of the company's product line.
- JMBA gained 12% during the month of May propelled by analyst comments regarding the growth opportunities for the name. JMBA remains a name that should be seen as an investment opportunity in the brand first, with attention to growth estimates taking a backseat. The growth will come naturally over time. However, it is the brand building that will propel the stock price, eventually leading to a hungry acquirer pulling the trigger on offering a premium for the company. The brand is being consistently built through repeated visibility in high profile arenas such as grocery stores, schools and hospitals. As the fresh juice industry continues its growth, JMBA has to be seen as a value given its $250 million market cap.
- HMPR and SBCF are new positions in the portfolios. The research report for both of these companies can be found here. Both Hampton Roads (HMPR) and Seacoast Banking (SBCF) are regional banks, with HMPR being in the Mid-Atlantic and SBCF being in Southeast. Both of these are, at their essence, bets on regional employment and real estate continuing their trend away from "distressed" territory, into more sustainable positive ground in the years ahead.
Both banks were near death at the worst of the credit crisis from 2009-2011 due to increased foreclosures and the resulting bad debt that accumulated on the balance sheets of both banks. Since 2011, both banks have made significant strides in reducing their foreclosure inventory and debt writeoffs. In fact, both companies now are seeing non-performing assets and net-charge offs back near pre-crisis levels. Any continued strength in the real estate market will benefit both of these banks tremendously, as they are still being priced at distressed levels.
HMPR is the more aggressive name of the two being that the company saw numerous bailouts from both the TARP program and eventually had to turn to private equity firms for multiple infusions of cash. The company is projecting profitability for 2013 in what will be their first year in the black since 2008. HMPR shares are 90% owned by the private equity firms that have been injecting capital into the company for the past few years. An exit from this investment for the private equity holders will require either a buyout of the company, share growth that creates demand from outside investors or a divestiture of assets, which doesn't seem like a possibility at this point.
What is especially attractive about both HMPR and SBCF is the tremendous risk cushion that has built into the share price as a result of 1) an improving economic picture 2) the failure of the markets to price in any improvement taking place at either company over the past couple of years despite a return to profitability at both institutions.
All the details are available in the research report.
- A medium sized position in TZA was taken on May 23rd as the first leg of a portfolio hedge. Bull markets of this nature tend to lend towards sloppy summer trading. I think we have seen the initial signs of this phenomenon taking place over the past couple of weeks, with expectations that it will continue through August. I will have details of my thoughts on this in the "Looking Ahead" section below.
- The portfolios ended May 85% long, 12% short (TZA), 3% cash.
Portfolio Lowlights For May
- MITL was liquidated from the portfolios for a loss of 6% since inception in January. MITL was a small position overall. The stock simply never gained traction despite market conditions being favorable to competitors in the sector. It wasn't a name I was comfortable adding to given the price action and leveraged nature of the company. Given the opportunities that are presenting themselves in other names, I could no longer justify the opportunity and capital cost of sitting in such an investment.
Looking Ahead To June
During the "Looking Ahead" comments of last month's report I spoke briefly about the markets being in what I like to term "responsible" hands. The responsible investor is one that weighs decisions carefully. Does not drive up stock prices irresponsibly. And generally, keeps the texture of the markets smooth enough to sustain the positive nature of the bullish trend. It is only when irresponsible investors become tangled within the market ecosystem that prices tend to move far away from anything resembling thoughtful value creation, instead giving way to momentum driven strategies that are only seeking to play a game of musical chairs, hoping that they won't be ones caught standing when the music stops.
Almost two and a half years ago I published an article to this website and TheStreet titled, "All Phase 4 Investors Gather Around, I Have News For You." In the article, I briefly outlined the 4 phases of a bull market and what each phase meant for investors. Phase 4 of a bull market is the apex or blowoff stage. In the article it was described as follows:
4. Phase 4 (utter, complete and total confidence in the bull market) – market participants begin pushing all-in. They become very aggressive and move into high-beta technology names. These are names that they buy at Phase 4 of bull markets every single time. Institutions begin joining in and allocating their money into more and more aggressive names at the behest of upper-management who doesn’t want their institution to fall behind the performance curve. Market participants have no tolerance for bearish opinions. Bullishness is widespread. Words or phrases like “secular bull market”, “generational low”, “booyah”, and “massive”, dominate the vocabulary of market participants. CNBC trots out bull after bull. They begin recommending small to mid-cap technology stocks, while smiling excessively and joking with the anchors. A love-fest ensues between all, with the exception of Mark Haines, who remains grumpy.
I bring this up because I saw some behavior during May that I wouldn't classify as Phase 4 of the bull market, but was nonetheless concerning. Instead, I think the Phase 4 argument should be isolated into a single or multiple events, in this case. There is no blanket euphoria taking place across a broad spectrum of sectors currently. There are, however, isolated incidents pointing to behavior that has taken on a decidedly speculative tone. Two incidents in particular peaked my alien antennae:
1. The explosion in price that took place in FNMA and quickly spread throughout mortgage related companies. By all accounts, there was no fundamental reason for the improvement in price in FNMA. At its high point, the stock was up nearly 550% for the month of May on pure speculation, driven by momentum traders who were piling onto what was being seen as an easy way to add exponential firepower to their portfolios. The fact that this rally was built on hot air quickly became evident when the stock hit an intra-day high of 5.44 and quickly reversed hitting a low of 2, before closing the day at 2.90. By any account, an absolutely monstrous intra-day range that is rare to see among actively traded stocks.
This type of behavior in a name that is infamously related with one of the greatest financial debacles of the modern age tells us many things about the mentality of current market participants. First, the perils that led to the former crisis are now a distant memory. Market participants have become eager to participate in the comeback in as speculative a way as possible instead of defending themselves against any perceived dangers. This is a marked changed of behavior versus any point over the past few years given the role FNMA played in the mortgage crisis.
Secondly, the rush into FNMA tells of an investor class that is convinced the real estate crisis has passed completely. While I think that the worst of the crisis is behind us, given this type of confidence, I expect there will be issues ahead that will cause some doubt to arise in the real estate comeback thesis in the months and years ahead. Yes, real estate will more than likely appreciate in the years ahead. No, it won't be as smooth a ride as many perceive. Both the equity and real estate markets have become prone to sudden, quick and dramatic shocks that quickly reconfigure the prevailing psychology. This is due to the events of the past several years creating a quick trigger finger among investors as well as the ability for investors to access pieces of information simultaneously, deriving conclusions from the information that is typically identical in nature.
2. The volatility, fanfare and devastation of the bearish case in shares of TSLA. I have no argument with TSLA as a company. In fact, I believe that long-term it can very well be a tremendous growth story. However, the level of appreciation along with the accompanying recent fanfare should cause the astute market observer to become aware that the newest attendees of the bull party are quite a bit more rambunctious and daring than their predecessors. With a rambunctious, daring crowd comes certain realities. These realities are grounded in the fact that caution is being set aside for outright aggression regardless of price. The appreciation in TSLA from 35 a few months ago to over 100 recently is not just a case of Wall Street being slow to grasp onto the realities of a revolutionary company, but a marketplace that has become lubricated to the point of providing participants with the comfort necessary to abandon caution completely. The last 20-30 points of appreciation in TSLA are a result of that abandoning of caution. It is not a coincidence at all that both TSLA and FNMA witnessed a bulk of their gains during the second half of May given that the mentality necessary to witness such levels of appreciation seems to converge at points that yield spectacular results among names that carry either an aura of revolutionary creation (TSLA) or out of this world appreciation potential (FNMA).
What we have witnessed here recently then can be classified as a Phase 4 event, but not a Phase 4 of the entire bull market. While it is certainly not a reason to pull back equity exposure when taken as a single data point, it should be kept in mind as we proceed through the summer trading months. The trap door of an illiquid summer trading session paired with the return of some members of the speculative trading class will likely result in some abhorrent trading conditions ahead. In my case, I define "abhorrent trading conditions" as choppy, listless and grinding price movement that leaves traders exhausted until the markets are able to level out the mental state of participants to a more even keel.
Given the increase in portfolio exposure recently, my default stance is weighted towards defense here until some of the froth comes off the top of the market. Defense will come in the form of raising cash levels in the months ahead and adding to the TZA hedge I initiated this month. I can see the portfolios taking on a 75% long and 25% short stance going forward. I don't see the necessity to become any more defensive minded than this, however, lowering long exposure to say the 50% level. Of course, performance of the portfolios and markets will dictate exposure. The essential takeaway here is that light defense is preferred over a heavily defensive minded and certainly an outright offensive minded approach going forward.
Regards,
Ali Meshkati
