Welcome to the latest issue of the PRO Weekly Digest. Every Saturday for Seeking Alpha PRO subscribers and Sunday for all other Seeking Alpha users, we publish highlights from our PRO coverage as well as feature interviews and other notable goings-on with SA PRO. Comment below or email us at email@example.com to let us know what you think. Find past editions here.
Dichotomy Capital is a value-oriented, absolute return fund and a long-time Seeking Alpha contributor. Notable calls include Enanta Pharmaceuticals (NASDAQ:ENTA) and Heritage Insurance (NYSE:HRTG). We emailed with Dichotomy Capital about the always controversial TSLA short thesis, the due diligence required for pharma stocks and the bearish outlook for the Florida insurance market.
Seeking Alpha: How does running a value-oriented, absolute return fund differ from a PM at a value-oriented mutual fund (who is probably judged on a benchmark) in terms of the idea gen process, how you ultimately decide on whether to take a position (and how big) and portfolio management (e.g. hedging, shorting, holding cash)?
Dichotomy Capital: My Fund has increased flexibility to go into different asset classes, short securities, and turn over a lot of rocks. A big part of the research process is to compare public and private valuations. I interview private owners and hear what they have to say about the business and our research. Every so often you find an investment opportunity that is not public but is far cheaper and better than the public entity you started out researching.
Concentration and portfolio management depend on a number of factors, but in the past up to 25% of the portfolio has been in one position. That’s extreme though – typically long ideas range from 4-10% in size. The portfolio has 15-25 long investments (two or three of which are not publicly traded).
The Fund actively shorts and does short to hedge. In general, I do not execute pair trades. If I am not convinced about a long idea, I will reduce the position size in favor of holding cash. Shorts are sized smaller than longs.
SA: How do you measure intrinsic value? Which valuation approaches are the most/least credible for the investing style you employ and the fund you run?
DC: I like stupid-cheap businesses. Names that look cheap if the valuation is scribbled on the back of a napkin. A DCF can help refine expectations, but it has to be acknowledged that your starting data can throw everything off a lot. Ultimately, we like businesses that produce a lot of cash flow so I can be off in my predictions but still be correct. My assessment is probably most similar to that which a private equity fund employs.
On the short side, I like inflection points. Big changes in earnings power that the market has not discounted in yet.
SA: You go beyond the numbers with on-site visits and expert interviews – can you give examples of how this validated (or invalidated) an idea or even caused you to reverse the position entirely?
DC: There have been a number of times where an idea was invalidated after an expert interview – too many to name. Hopefully this happens before a position is started, but often it is discovered after. Each position is a never-ending quest to learn more. The Fund exited a very poor investment in Emergent Capital (NYSE:EMG) after a series of expert interviews led us to figure out that the (our) long thesis was total nonsense. It was a complex business that I simplified to a severe NAV discount that would eventually close. I failed to properly account for how that discount would close. Experts told us that the NAV discount was warranted. I finally listened.
On the other side, site visits to plants and mines are a great way to see a business and the mood of the employees there. The Fund owns and operates several power plants, which gives us access to power experts on a daily basis.
I depend on interviews with doctors when assessing pharmaceutical companies. The Fund’s short of Signet (NYSE:SIG) involved a number of store visits and employee interviews.
SA: David Einhorn recently compared the enthusiasm for Tesla and other bubble-basket stocks to the dot-com bubble – do you agree there is a bubble? If so, what causes it to burst if it’s not simply valuations? Are there any actionable takeaways?
DC: I would say he’s correct in general. There seem to be a number of stocks that have egregious valuations. It’s hard to make a valuation of TSLA work. To be fair, I would have said he was correct if he said the same thing three years ago about TSLA. Tesla has never been “cheap.” I have no idea if it will get more expensive or closer to what David thinks is the right value, nor do I know what will cause it to correct. This is what makes shorting so difficult. As far as actionable takeaways – avoid story stocks regardless of the valuation.
SA: You made a great call on Enanta Pharmaceuticals as it reached your price target in <3 months – are value investors missing out by writing off the pharma space as “too risky” or assuming there aren’t typical value investment characteristics? From a general standpoint, what do you look for in a pharma stock? What are red flags?
DC: I think it’s wise that most investors write off the pharma space. I have an advanced degree in chemistry and worked as a lab chemist before getting into finance. Compared to the average investor, I have a good handle on patents, chemistry, and plant design. I also have a number of contacts in the industry that I can rely on to answer questions.
When assessing a pharma stock, the considerations are the same as any other company assessment. What does the balance sheet look like? How much cash flow can they produce? How good is their IP? What are their assets? Assets are the toughest to determine because there are so many hurdles to FDA approval. What made ENTA so intriguing was the fortress balance sheet, multiple cash flow streams, and a disciplined management team. Add in the pipeline and it’s still an attractive investment today.
With that said, our fund has many more pharma shorts than longs. On our shorts, I look for a shaky balance sheet, undisciplined management, and shoddy science. The latter is the best indicator and it’s the part that most investors spend the least amount of time on. There are a plethora of excellent pharma shorts out there now.
SA: Is Heritage Insurance a buy after the pullback (it rose ~30% in six months following publication of your long thesis last year)? How does the market look for P&C insurers in Florida? How does the end of the zero interest rate environment impact earnings power and valuations for insurers?
DC: I have exited all Florida insurance companies. To put it simply, there is too much capital chasing too few opportunities. Premiums are compressing in many areas and reinsurance rates can’t go too much lower. The opportunity for excess returns has gone away, as has our long position. It does not seem like any of these names are shorts right now as the opportunity for good (but not excessive) returns still exists. Well-run Florida insurers are diversifying their policy base to other states, reducing risk, while increasing book value.
SA: What’s one of your highest conviction ideas right now?
DC: The independent power producer (IPP) space is fascinating now. It’s distressed, really hated, and still produces a lot cash flow with good visibility into that cash flow for a number of years. Our ownership of private power assets has given us a unique view into the IPP space and what it looks like over the next few years. Right now our favorite IPP is Dynegy (NYSE:DYN).
Thanks to Dichotomy Capital for the interview. If you’d like to check out or follow their work, you can find the profile here.
PRO idea playing out
Celadon Group (NYSE:CGI) is down ~75% (which exceeded the target price) since Jay Yoon said it was a “tremendous short” due to accounting concerns and possible insolvency (due to the slowdown in the trucking industry, its weak competitive position and high leverage) in July 2016. Two weeks ago, the stock dropped ~55% in a day after saying prior financial reports should no longer be relied upon.
Call from the archive – CHRW
C.H. Robinson Worldwide (NASDAQ:CHRW) is down ~5% since Non-Correlating Stock Ideas presented their short thesis in January 2017. However, the stock dropped after reporting 1Q results in April despite beating earnings estimates. In an update article, Non-Correlating Stock Ideas noted that earnings were inflated by two one-time items and said the miss on “normalized” earnings validates the primary thesis that transportation margins/pricing ex-fuel are declining. Also, management appears to have changed its tone re the impact of the implementation of ELD while the Street is now focusing more on the competitive threats from Amazon (NASDAQ:AMZN). As there is still ~15% further downside to the target price of $60, this may be worth another look.
Noteworthy PRO articles
We wanted to highlight a few of our PRO editors’ favorite PRO ideas this week:
SA Editor Jeffrey Fischer, CFA: Refinancing challenges for aging, low-quality assets, point to upcoming struggles for Gladstone Commercial Corporation (NASDAQ:GOOD). Recent forced index buying has indiscriminately bid up the share price, resulting in a short-sell opportunity according to Old Time REITster.
SA Editor John Leonard, CFA: Afanti Arbitrage makes the bullish case for Liquidity Services (NASDAQ:LQDT) as the headline risk and temporarily elevated costs are masking its high growth technology platform; asymmetric risk/reward profile due to strong balance sheet and high probability of nonlinear growth over next 3-5 years.
New Seeking Alpha contributors to watch
Angry Uptick shared a bullish thesis on OCI Partners (NYSE:OCIP) earlier this month that is already playing out (+20%) exactly as predicted – that the expected rebound in methanol prices would result in a reinstatement of the cash distribution and with it a higher, yield-based valuation. When OCIP reported earnings less than a week later, it noted methanol pricing increased 87% and reinstated a quarterly $0.23 per unit cash distribution. In an update comment, Angry Uptick said the current conservative distribution run rate supports a stock price >$10.
John Bay, CFA makes a compelling case that Credit Acceptance (NASDAQ:CACC) bonds are a low-risk way to pick up yield as auto loans are much safer than mortgages; he questions whether CACC should even be considered a high yield credit given the strong (but often misunderstood) fundamentals. CACC debt trades 378bps above DFS even though consumers are less likely to default on their auto loan than credit cards and trades 311bps above CIT despite similar leverage/cash flow – not to mention CIT operates in the highly competitive banking industry and faces margin pressure while CACC operates in a niche market with resilient margins.
Idea screen of the week
Each week, we use the PRO Idea Filter to find potential ideas based on a recent news event. This week, PRO Editor Daniel Shvartsman looks at the telecom industry, which was in the spotlight at the recent Sohn Conference.
One of the common themes from the Sohn conference this week was telecom. Keith Meister of Corvex Capital made the case for long Century Link (NYSE:CTL) while Josh Resnick of Jericho Capital talked up short Frontier Communications (NYSE:FTR).
The broader industry has also been in the spotlight. The widow-making short Straight Path Communications (NYSEMKT:STRP) trade seems to have played out with the announcement that Verizon (NYSE:VZ) has won the bid. Smaller firms like Lumos Networks (NASDAQ:LMOS), General Communications (NASDAQ:GNCMA), and NTELOS (NASDAQ:NTLS) have been taken out over the last year. We are in a consolidation phase, which may be a fitful effort to stave off obsolescence (I found John Hempton’s blog on the decreasing competitive power of major telcos very interesting even though it’s focused a little differently).
I’ve owned one telecom company for a while, and find the space really interesting. With the consolidation theme in mind, I wanted to look at a few ideas that could be of interest for readers.
To simplify things, I pulled up all PRO ideas on telecom services – domestic, wireless communications, and Internet service providers – then filtered for the last year. 13 came up, and I found three especially interesting:
Long CBB – Cincinnati Bell by Vince Martin – This was a finalist for our 52-week high/low contest. CBB is on the low end and saw a bit of schizophrenic trading after its Q1 report. Martin’s story highlights how CBB has lowered its debt and thus interest load, is decreasing cap-ex, and is still growing its fiber optics business (though revenue overall declined in Q1). Trading under 8x EV/EBITDA and likely to generate significant FCF in a couple years, it is an interesting bottom-fishing play with an actual transformation under way (LMOS sold for 10x and GNCMA for 9x).
Long SHEN – Shenandoah Telecommunications by John Zhang – SHEN had trouble integrating NTLS (mentioned above), which led to an opportunity according to Zhang. Zhang has been on top of a lot of telecom ideas, including long LMOS, and the case here has started to work, but there is still some upside. Worth digging in deeper.
Long SIFY – Sify Technologies Limited by Cubento Capital – We get into a little bit more of a speculative idea. SIFY has an ugly-looking chart but grew revenue by 23% and net income by 47% in the year ended March 31st, in Indian Rupee terms. Of course, that is the key point, as the stock has suffered from the rising dollar to the rupee, but the rupee has actually risen year to date, supporting SIFY’s stock. If these currency issues stabilize, Cubento Capital argues that the underlying performance supports a much higher price.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Check with individual articles or authors mentioned for their positions. Dichotomy Capital is long DYN and ENTA.