PORTFOLIO UPDATE: AN ISSUE OF SELF-DYNAMICS
IMH was liquidated from the portfolios this week in the 20-21 range for what was a roughly 14 point profit since inception in Q4 2014. This leaves us with the most significant cash position we have had in years, which opens the doors to pursuing new opportunities as 2015 progresses. While discovery, research and initiation of long positions should normally be systematic, repeatable process. The decision to sell is much more dynamic in nature. It is rare that I will sell a position because of concerns regarding changing fundamentals. It is true that by the time concern rolls across my consciousness, it will also be persuading others who hold the position to reduce exposure. Fundamental data then is a lagging indicator, not being necessarily useful to sell decisions. Or at least sell decisions at an advantageous price. Impac certainly hasn't experienced any fundamental changes worthy of notice. If anything, the stock remains dramatically undervalued. Not to mention it being a great way of participating in nonqm loans, which is the future of alternative mortgage financing. What the decision to sell IMH comes down to is an issue of comfort and the fact that once comfort in a position becomes compromised even slightly, an investor becomes vulnerable to decisions that carry a negative expected value. I can't be uncomfortable in a company like Impac and efficiently sit through the volatility. Inevitably, I will become vulnerable to that volatility, being forced into a poor decision with a large position that will be difficult to liquidate. Rather than having the market force my hand at an inopportune time, I would much rather be proactive in recognizing points in the life cycle of price when I don't properly grasp risk vs reward. Or you could also say, points in time when an investor embraces their confusion through defensive measures. And that"s all I've done here. It's an issue of self dynamics as opposed to market dynamics. At a certain point, knowledge of self while investing becomes equally if not more important than any knowledge of the markets that can be...
SO IMPAC DECIDES TO RAISE SOME CASH…..
T11 Capital is currently long shares of IMH. Original research report outlining the opportunity can be found here. Unfortunately, a majority of investors don't listen to conference calls that pre-announce a capital raise as being forthcoming. Additionally, a lot of funny money has become involved in Impac on both the long and short side, causing the tremendous spike in volume and volatility over the past couple of weeks. When a cash raise comes together with the sudden onset of volatility brought about by a gaggle of new speculators, you are bound to have the challenges of misinformation. Here is some clarity: 1. In the Q1 conference call that took place in late-April management said, "we are currently in discussions with various parties to provide between $25 million and $50 million of debt and/or equity capital." 2. They announced on Friday that they are raising $25 million in a convertible note offering at 7.5% convertible in January 2016 at a conversion price of $21.50 per share. Mandatory conversion takes place if after January 2016 the stock trades above $30.10 for 20 consecutive trading days. 3. Why do they need this money? The company is facing skyrocketing origination volume. As a result they face increased "warehouse haircuts." A warehouse haircut is essentially the portion of the credit line advance that the originating lender is responsible for. It typically falls in the 1-2% range. Warehouse haircuts increased from $20 million in Q4 to $30 million in Q1 as origination volume increased dramatically. This is the cost of doing business as a lender. As cash flows continue to increase warehouse haircuts will take care of themselves. However, given that the company is facing growing pains of a sort at the initial onset of their new business model a cash infusion is necessary. Additionally, the cash will be used to "retain mortgage servicing rights and working capital to fund the growth of origination volumes and contingent consideration payments associated with the acquisition of CCM." With the growth of CashCall into a total of some 40 states from 11 in Q1, advertising expenses will rise dramatically. Initially, the capital outlay to secure advertising in all of those new states will be substantial until those states begin producing mortgage origination revenue to offset the advertising costs. As the additional states begin producing revenue, the overall efficiency of their advertising model increases because of the volume discount they receive by increasing advertising basically nationwide. Dilution is only a bad thing if management can't achieve returns on capital they receive via dilution. Impac is in a stage of its business growth where high returns on capital are not...
CONSERVATIVE ARROGANCE IN A BULL MARKET
In browsing through the noise with a focus on discovering the rare signal that emanates from within, I made the mistake of reading a blog posting from a financial advisor in which he unabashedly advocated a significant cash position in this bull market. I skimmed through the remainder of the article which cited various elementary arguments for remaining conservative in the face of an extraordinary bull market. There is a certain degree of arrogance that comes with the opinion of maintaining a significant cash position in this market. Cash is not a position. It is, in fact, an opinion. The degree to which you remain in cash is the degree to which you disagree with the act of equity appreciation. For example, a 10% cash position with a 90% allocation towards equities is significantly bullish opinion about future prospects for a bull market. A 50% cash position within a secular bull market, on the other hand, is a significantly bearish opinion with respect to the prospects for future appreciation. The arrogance disguised as conservative stewardship of capital comes from the act of disagreeing with a bull market that has been as consistent and steadfast in its appreciation as any of the past 100 years. It is always easy to argue bearish points because they appeal to the pseudo-intellectual crowd who grasp onto seemingly sophisticated measures of value or pending disaster that are predicated on data points subject to massive range expansions during a bull market. As an example, it was about two years ago that nearly everyone was clamoring about margin debt levels being sky high. Voila! Two years later we are at record highs and margin debt levels have expanded even higher. The "normalized" range has expanded. Everything from simple valuation measures to more sophisticated monetary measures are subject to expansion during a secular bull market. What you consider normal at the beginning of a bull market becomes stretched, contorted and disfigured to the point that it is unrecognizable by the time it all ends. In other words, it is all noise, with no signals. As this bull market continues, more seemingly influential investors will sound the warning bell that all is not Le Beurre d'Echiré butter and warm French Bread at the dining table. They will argue that what we are in fact being served is a steaming plate of merde. This consistent hum of noise will do its job to either dissuade investors completely or jostle them out of their existing positions. Despite the powerful tool for wealth creation that a secular bull market provides, very few actually take appropriate advantage. The sole reason behind this...
CLIENT LETTER: MARKET OUTLOOK
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. The theme of small-cap outperformance is one that I highlighted specifically in the October client letter. Numerous statistical studies were presented at that time pointing to a small-cap market that had a tremendous amount of reward in exchange for an insignificant amount of risk going forward. Since the beginning of October the Russell has gained 13.71% vs. the S&P 500 which is up 4.87% On a purely technical basis, the Russell is equivalent to the Nasdaq in its demonstration of strength thus far in 2015. These are all signs of a healthy market advance that is predicated upon rotation among asset classes by investors. The fact that investors continue to remain discerning in their portfolio choices throughout the current bull market indicates a level of responsibility that should not be overlooked. It is in responsibility among investors that sustainable advances take place. It is in irresponsibility on the part of investors that unsustainable advances turn into intermediate to long-term market tops. The thinking behind this is that when you have all classes of investors simply throwing their cash at every asset class regardless of risk/reward then investors are disregarding risk, thus setting up the market for increased volatility that typically results in a mass realization, at some point in the near future, that an exit should be made from stocks into safer assets. There is not even an inkling of this foolhardy behavior among the current class of investors. For example, the technology sector is successfully separating robust business models from business models that are questionable in their ability to provide long-term growth. There is no blanket mentality towards investment that demands social media, software or mobile names regardless of price, growth prospects or management ability. Companies that deserve to experience growth in share price are experiencing growth in share price. Companies that do not, have been lagging behind. Additionally, the appetite for portfolio hedges remains undaunted despite one of the most steady increases in major averages over the past several decades. The combined put/call ratio is sitting at levels that aren't too far off where we started this bull market, in terms of the voracious hunger for put buying over exposure to calls. In the chart above, the 50 day moving average of the put/call ratio is at its highest point in more than 2 years. The longer-term 200 day moving average is at its highest point in nearly 3 years, with only the European crisis of...
HIGHLIGHTS FROM IMPAC MORTGAGE CONFERENCE CALL & EARNINGS
For those looking for background on our investment in IMH, please see the research report published in January here. In the final paragraphs of the research report I cited the fact that the CashCall acquisition was a game changing development that allowed IMH to market their Alt-QM product, which is in its infancy, to a vast audience. The good news is that the marketing of the Alt-QM product to the vast number of borrowers who require such flexibility in borrowing hasn't even started yet. IMH's substantial growth is coming from originations of the traditional variety. The growth taking place is at a very early stage given where the company is within its own reformed life-cycle along with where the mortgage industry is as a whole. This was once a $2 billion company in terms of market cap. The current market cap of $125 million is not the end game for management that has been at the helm for 20 years. Why do I say that? Take a look at this commentary from CEO Joe Tomkinson earlier today: "With the addition of CashCall Mortgage, we have a scalable, centralized retail platform that is able to efficiently expand and retract during market fluctuations. By using this marketing to generate leads internally, we expect CashCall to be able to compete with some of the large internet lenders across the nation. In addition, we intend to leverage the same marketing platform to expand the volumes of Impac's new AltQM products as well as its government loan products such as FHA and VA. CashCall Mortgage will also be able to make use of our state licenses to expand its national lending footprint into more than 40 states." Currently, Impac only services 11 states. They are expanding int0 more than 40 states in the next 60 days. Basically, nationwide coverage. Additionally, the fact that the marketing presence of CashCall allows them to push their high margin Alt-QM product means that profitability can soar over the next few years. Deutsche Bank in a recent report on the potential for Alt-QM pegged potential upside growth at $200 billion annually within a mortgage market that sees $1.2 trillion in annual volume. The percentage that Alt-QM can command within the total mortgage market is substantial and IMH is basically the first one to the plate, as they were with Alt-A loans in the mid-90s. "Consistent with our strategy to expand total originations, the company also rolled out its non-QM loan programs last August marketed as the AltQM and we funded its first originations during the third quarter. In the first quarter of 2015 the company's AltQM pipeline was approximately...
KFS IS BRILLIANCE UNDISCOVERED
There is no magic in the formula KFS is utilizing to turn what was once a wart infested pariah of a company in the insurance industry into a gleaming, ornate demonstration of success through proper management paired with smart activism on behalf of a majority shareholder. If you haven't already done so, please review the research report I wrote on KFS in April of 2014. You will notice a couple of trends that were taking place at the company a year ago. Namely, debt was in the process of being reduced in dramatic fashion (pg. 6 of research report). Meanwhile, the insurance underwriting sector which nearly torpedoed the company several years ago was near profitability (pg. 5 of research report). Fast forward to the 10K the company released on Friday. Insurance underwriting is now profitable for the first time since pre-2008/2009 crisis. Insurance services remains profitable with a more than 100% increase in operating income year over year. Underwriting segment was the reason for the calamity this company faced years ago. The company has emerged from the calamity with the following: - Underwriting now profitable - Lean, with significantly reduced debt - New operating units with the services segment experiencing steady growth - Management completely revamped and proven to be highly capable, creative financial artists. See former units AFH and PIH that are now public, as examples of their artistry. - Significant tax benefits in the amount of $14.68 per share that haven't even started to be explored yet The cream on the puff cake here is that debt is planned to be reduced entirely over the next 18 months or so. The company has LROC preferred securities principal due at the end of June for the amount of $13.6 millon. Also, there is the issue of Trups that are in deferred interest status with the 20 month limitation expiring in early 2016. There is $22.7 million in interest due there. The interest on the Trups is accounted for as an accrued expense on balance sheet, which is why it doesn't show in the table below. As you can see, the level of income that will be generated past 2016 will rise dramatically as debt burden will be all but gone at that point. This should coincide with a sweet spot in the growth for both their services and underwriting segment. The sum total of all these events is (1) nearly no observable risk in KFS shares at this point. It is at worst a sideways performer going forward (2) a near guaranteed future date of significant share price appreciation as Wall Street plays catch up with earnings growth that nobody...
THEY DON’T RING BELLS AT MARKET TOPS
I'm not certain if the sell-off we experienced on Friday was the beginning of a multi-week or even multi-month bear raid on the markets. However, I am certain of the fact that they don't ring bells at major market tops. There will be a growing voice in the months ahead, as we embark on a Federal Reserve that will be raising rates for the first time in forever, that the markets cannot properly contend with a tightening stance. That the bull is an old, decrepit, worn out shell of its former self that can't lift itself off the ground with Janet Yellen's foot firmly implanted on its genital region. Not only does that opinion lack historical relevance when compared against other periods of tightening, where the market has gone onto much greater heights throughout the tightening cycle. But it buys into the fact that market tops are announced in bright lights and booming voices. In fact, major market tops are announced in quite the opposite fashion. It is the lack of chatter you see opposing the view that the indices are moving infinitely higher that accompanies major market tops. It is an abundance of news justifying the group mentality that sees endless prosperity ahead. It is a lack of tangible bearish information that short-sellers or general pessimists can hang their hat on as a reason to remain gloomy. The prospects of a series of rate hikes moving forward gives bears everything they want from which to hang their raggedy hats. Eventually others will join that are not quite in the bearish camp, but are persuaded by seemingly logical misinformation. That very prospect of quickly rising bearish sentiment that has a seemingly fundamental basis for its pessimism is exactly why we won't see a major market top on Fed news. When the day comes that this secular bull ends, it will be marked with absolute conviction that the markets will remain solid indefinitely without one shred of fundamental evidence to dissuade the faithful. This isn't...
THE PATH TO DISCOVERY OF NEW OPPORTUNITIES
The Roth Conference in Laguna Niguel kicks off this weekend. I rarely attend conferences. However, this one I am always torn about because it is literally walking distance from my house. To know that there is a large group of individuals talking small-cap stocks within spitting distance makes me feel that I'm missing something. I'm a bit of stock market hermit, if you will, when it comes to surrounding myself with individuals that want to provide me with information from which I will make an investment decision. I keep that circle of influence extremely tight, rarely allowing for anybody new. In fact, my new ideas are mostly generated from a series of market screens I run on a daily basis. If an idea doesn't come up on my screens, then it simply doesn't exist in my world. The prevalence of opinions and ideas that is the hallmark of conferences such as the Roth Conference is actually frightening to me professionally. Let's think about what occurs at these conferences logically: Fund managers are there hungry for opportunities to capital gains. Companies are there to promote themselves to these managers being hungry for investment capital and recognition. So you essentially have two eager individuals of equal hunger coming together countless times over a span of several days. The possibility of erroneous decisions being made within such an environment are extremely high due to both the salesmanship that is taking place on a corporate level and the desire to justify reams of information being digested on an investment management level. Emotionally overwhelming circumstances abound, in other words. If there was a record of the success investors had at these conferences in finding viable candidates it would extremely valuable in proving my point. The point being that these conferences are equity busters. Meaning that on a net-net basis the expected value of decisions made as a result of these conferences are negative. If anything, there may be a positive curve in favor of the companies presenting because they are able to garner a short-term boost as a result of the attention gained. However, from an investor standpoint, being sold on an investment by management is not the ideal path towards investment discovery. The path towards discovery of opportunities should be unbiased, unsalesman like and process driven. I'll just stay...
THERE IS NO EXIT POINT
If you are an investor in a company, you cannot have an exit point unless it is on the downside. In other words, the only time you should be concerned about an exit strategy is when you are in the process of consistently evaporating equity at the hands of a particular stock. By consciously having an upside target to sell your stock you are creating an expectation that will often times not initially be met, thereby justifying selling the stock at a lower price when your disappointment turns to despondency. Eventually you watch as the stock blows past your initial exit point, going onto further gains above and beyond anything you, as an investor, expected. This becomes especially true in a secular bull market. I started my career on the retail trading desk for Waterhouse (now TD Ameritrade) in the mid-90s. You don't know how many investors I saw sell names like AMZN and YHOO when these names went onto create absolute fortunes for investors into the 2000 top. To loosely quote Jesse Livermore, "There are lots of early bulls in a bull market, but the man who can be right and sit tight is rare." I consistently remind myself of the lessons learned two decades ago in order to properly capitalize in this bull market. Exit points are amateur-hour. Control your downside and allow the upside to flourish unencumbered. ...
CLIENT LETTER: IF AT FIRST YOU SUCCEED, QUIT TRYING
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. I have created an email list that sends this report out at the beginning of each month to those interested. The full report contains commentary about the general markets and individual positions held in managed portfolios, as well as overall performance. To be added to the list email me at mail@T11Capital.com I thought it appropriate to rename this section after feeling that the obligation to "Look Ahead" was preventing me from discussing various thoughts, analysis and philosophies that are an important parts of my process. It is also true that as an investor in the markets, I don't want to necessarily be sidetracked by short-term analysis, although I have been relatively immune from confusing short-term thoughts with long-term objectives. I have no desire to risk my immunity, however. Just as there are various imperceptible laws that govern human affairs, it can only be assumed that similar laws will also dictate the affairs of the financial markets. After all, financial markets are simply a reflection of the perception of a particular group at any given moment. This group, as opposed to the popular perception of seeking a balanced state, remains in the constant realm of disequilibrium. Markets are never balanced in nature, as balance inherently suggests predictability of an outcome. Proportionately as it applies to the financial markets dictates that disproportionate cause will lead to disproportionate effects. There has been no better proof of this law at work than what we have experienced with the near vertical run that has taken place since the 2009 bottom. The current bull market was born from a disproportionately negative circumstance that was singular in its scope and breadth. The accompanying reaction that took place in terms of monetary policy was also disproportionate and singular in nature. The law of proportionately will dictate that the effect of such disproportionate negative circumstances should be equally disproportionate on the positive end. This is simply how proportionately works. The further you stretch the rubber band to one side, the more powerful the reaction will be to the opposite side. The greater force you use to hit a tennis ball into a wall, the greater force it will exert on its return to your racket. This is proportionately in its simplest terms. Already we are seeing clues in the form of the extraordinary persistence this market has had on the upside. There have been numerous reports of record stretches without a 5% pullback in the major averages. There has been a record stretch of months without a touch...