December 2016 update – Single Names

It’s been a while since I last wrote. Here I will just give a quick update then sketch out a couple stock ideas I’m still in. I will leave the forward looking macro view for the next post.

It’s been a good month for all investors and I’m no exception. Post the Trump win I loaded up on financials (SLM and WFC), and tripled my holdings in Sterling Constructions (STRL). These are concentrated 7%-12% positions. I also went long the US dollar against yen and euro, riding USD/JPY from 105 to 115. A week ago I cut back on STRL, exited WFC completely, then went long Russian rubles.

This series of frantic trading and macro maneuvers paid off. In the last month I did better than the S&P index even with all my large cash holdings/shorts/hedges. I started taking chips off the table as the market looks extended again.

Single Names I'm still Bullish On

I’m still very bullish on Salle Mae and Sterling Constructions over the next 3 years. FNF is another that can double. Below are a just some bullet points.

Sallie Mae (SLM)

So the stock trades at $10.8 at the time of writing. Downside is $10-$10.5. Upside could be $15+ and a highly probable one.

This is a company that was doing well even before the election – strong growth, strong ROE, and solid capital levels. Management is also trying to improving cost efficiency. The only thing that held back the stock was Democrats’ various attempts to undermine the private student loan market (free college, student loan forgiveness, and general hostility toward lenders…etc).

After November, all the sudden we have 1) decline in regulatory risk, 2) potential market size expansion as Republicans might scale back government funded student loans, 3) higher rates and steeper yield curve driving higher net interest margins, 4) a big tax cut (SLM pays a high 35-40% and their preferred dividend further leverages EPS to tax cuts). The last point alone could juice their earnings by 30%+.

Here’s how I roughly think about floor value and upside. The stock was trading in the $7-$7.5 range before election. Republican president and congress removes an existential threat to the business and should make this worth $8-$8.5. Tax cut improves earnings by 30%+, so add another $2/share and we’re already at $10-$10.5 as floor value – not far from where the stock trades now.

And that’s before factoring in better net interest margin and market size expansion! All together, there’s a high probability that SLM earns $1.5/share within 3 years. At a fair 10x multiple SLM could easily be worth $15/share.

We have a nice bet here. SLM represents 7-8% of my portfolio and I will look to add on weakness.

Sterling Construction (STRL)

Although a construction/infrastructure stock, this is not really a “Trump Trade”, as I wrote about Sterling Construction back in July here. The thesis has not changed much, but the emphasis has shifted from company specific factors to the industry and macro pictures, which has gotten much better.

The company is highly leveraged to gross margins, which was already improving back in July, but now will likely go higher due to 3 factors. First, management has stated their intention to go after higher margin, non-highway projects (commercial, airports…etc), and have in fact started to win them. Second, the local projects passed during November 9th will be supportive for industry competitive landscape and margins.

Finally, Trump’s $1 trillion infrastructure plan threatens to take margins, and by extension STRL’s stock, to a whole new level.

So both the probability and magnitude of a win are much higher now. Right before the November election, I would say STRL’s floor value is about $6.5 and ceiling about $8.5. Now I would say the floor is ~$7.5 and the upside is uncapped until the teens’ or even $20’s.

The key is to not get ahead of ourselves too much though. I’m looking for improved quarterly results, new contract wins, or legislative progress on Trump’s plan to add to my positions.

Fidelity National Financial (FNF)

This is the largest title company and the most profitable one. The company operates in an oligopoly with captive customers - title insurance is mandatory purchase. At $34 per share, the stock is acting incredibly bearish right now. But a catalyst has surfaced.

Currently there are 2 negatives holding back the stock in my opinion. First is structural complexity. FNF consist of the core FNF title insurance company, a publicly traded subsidiary Black Knight Financial (BKFS) and the FNFV tracking stock (which represent a portfolio of side bets like restaurants). The second problem is commercial title revenues are slowing down.

There's a catalyst coming next Fall. Management announced they will address the structural complexity issue by cleanly splitting out core FNF title division, BKFS, and FNFV. This would allow the core FNF business be included in indices.

The core FNF title business then has a path to double once commercial revenue stabilizes. Here's what could happen with some back of the envelope math:

• Home sales picks up. Perhaps because millenials are reaching the 30-40 age zone for peak home buying, or because Trumponomics puts more money in peoples pocket. Say home sales up 5% and housing price up 5%, that's a 10% revenue gain. With operating leverage you get to 15% gain pretax.
• 3 years from now pretax grew by 1.15^3-1 or 50%.

• Tax rate cut from 35% to 20-25%. That means EPS could be 70%+ higher in 3 years
• Just making up some numbers - right now $1 pretax get you 0.65. In 3 years you have $1.5 pretax at 25% tax rates. That results in an 70% higher EPS.

• P/E multiple of core title business re-rates from 12-15x because revenue outlook reverted to growth. Removal of structural complexity in the FNF complex also helps. That's another 25% gain.

Compounding these effects get you a double. I already have a solid position on this. But I could really go big (thinking like 20% position) if I see commercial title revenue to stabilize.

Week Ending 5/2/2015: Random Notes and Portfolio Review

I missed a home run last month and it hurt. Impac Mortgage (IMH) was the one. I’ve been following that stock on and off for 3 years. A week before earning came out, I had a hunch 1Q15 was going to be a good quarter, so I sat down, went through a rather detailed model and looked over my projected 1Q15 earnings. I passed, thinking the was not worth the risk and reward. When the actual earning came out it was a multiple of my forecast!! I was stunned  (I got the volume pretty much right on but was way off on the margin!). The stock ran up 100%+ in past month alone. Never have I put in that much work in a stock and turned out that wrong before. I mean if I was a portfolio manager at some fund and had a hunch about this stock, and I got my sector analyst to take a deep dive. He comes back saying it's a no go, then the stock goes up 100%...this is the sort of stuff that could get you fired.

So that hurt my confidence. That and the fact that I’ve been very uneasy with the market made me go through my portfolio again.


Healthcare portfolio.  This is a multi-leg investment to capture the long term trend in America’s aging population. I have a mix of managed care, hospitals, pharmaceuticals, and supply chain players that balance out each other.

Managed care ran up a lot in 1Q15 and was a major contributor to my out performance year to date. I decided to cut this down a little bit due to full valuation. I also see near term risk in the next year as we get closer to election year and Republicans will undoubtedly make some noise about Obamacare. But overall this healthcare portfolio is a very long term play and there’s nothing here that I would think of selling if the overall market drops 50% tomorrow.

That said, after a very successful run the past year, my expected return in the next few years is not great – maybe mid/high single digit annualized return. So if something with better risk and reward comes alone I could pare this down further.


Housing portfolio.  This is really more like housing finance and is a mix of title insurance, originator/servicers, mortgage REITS and mortgage heavy banks. The big picture idea is to go long household formation and existing home sales in the next 5-10 years. Unlike the healthcare portfolio, there are some pretty speculative names in here like Nationstar, PennyMac Financial, AGNC…etc. But I’ve cut them down to a point where I’m pretty comfortable for all remaining positions, and certainly on a portfolio basis. 

The core group here is title insurance, which I went through recently thinking about adding. Unfortunately the group look fairly valued. In terms of technicals, Fidelity National Financial (FNF) is a name showing some weaknesses. It is hovering around its resistance level and could see a big break on the downside if next Monday’s earning turn out to be a bust. If that happens I will simply take it on the chin. 

Tankers. I cut down some TNK and bought some more DHT. In the past few weeks TNK stock price has moved up to a point it became too large of a position. I'm also worried that Aframax sector (which TNK is heavy in) will not benefit as much as say VLCC or Suezmax sector. Hence the rotation into DHT, which owns mostly VLCC and Suezmax ships. Luckily, I did this adjustment right before TNK stock took a beating the past few days. The tanker trade is ~6% of my total portfolio and I have 4 stocks sharing the risk. What's preventing me from getting bigger here? 1) This is obviously a very speculative trade and cannot be long term. 2) Global crude oil demand is highly dependent on China, so the tanker trade is to some degree a long China trade -- and I'm already very long China in the portfolio.


Beijing Enterprises Holdings (392.HK). This ran up some 20% and I kept adding to my position on the way up. Although the gain is mostly due to extremely lucky timing, this is a very long term investment for me. I would consider adding more Chinese gas distributors, but only at the right price.


One big China/HK trade basket. Welling (382.HK) has ran up dramatically and I also added on the way up. But I see less upside here and will likely take my profit if the HK market takes a turn for the worse. In recent weeks I piled in and added a mix of indices and (mostly infrastructure) stocks to capture an expected spike in liquidity as well as A-H share premium.

But now that H-shares momentum has flattened out, I’m very worried about the A-share bubble popping and how that might spill over to H-shares. I'm actually investigating ways to short China as a whole while staying long in my current H-share positions, which are all reasonably valued if not outright cheap. I have tight stop losses on every one of these trades and will let the market decide for me.

Updating my views on Apple and Google:

Apple. I’m kind of surprised that the stock did not move that much given the very strong quarter. Demand for the stock could be exhausted. Part of my thesis is a "short squeeze" for those who still don't own AAPL and lags the index as a result. I now see that even a $200bn capital return plan cannot scare the implicit shorts. My original thesis could be flawed and I may cut down or exit instead.

Google. I’m holding on despite the temptation to exit given the persistently negative market sentiments here. I did some rough numbers again. My timeframe is 5 years for this. What’s the worst case? Conservatively, I think EPS can grow 8% a year. It is unlikely to be less given the solid top line growth runway and how much room they have to cut cost, and everything I know of Google.

• 5 years from now EPS would be up 47%. But let’s say 1yr forward multiple (ex-cash) goes down to 17, that would be roughly an -18% hit. Combine EPS gain and multiple loss yields ~29% total return in 5yr, which would be about 5-5.5% CAGR. That is my worst case. 
• On the other hand I think the upside is double in 5yr or about 15% IRR. 
• Given the strong expected EPS growth, forward PE would have to drop to 12x at 2020 for me to lose money. 
• So I’m holding on to this. But maybe get smaller if price moves against me.

The exposures I listed above add up to almost 70% of my portfolio. I’m in the process of revisiting my entire investment approach and don’t expect to add new names. If the market crashes 30% tomorrow, the exposures I'm less sure about (roughly half of what I listed above) would be stopped out, leaving the real long term positions intact. 

Risk Control and my Mortgage and Housing Portfolio

I mentioned my mortgage/housing portfolio a few months ago and here’s what it looks like now:

• Title insurance: FNF/FAF/STC
• Asset pools: AGNC/MTGE/ HLSS
• Origination and servicing: PFSI/WAC. A short put position in OCN that is fully hedged 
• Builders: UCP
• A tiny position in Freddie Preferred.

Combined, these are more than 20% of my portfolio. My housing exposure is actually more if I count Wells Fargo, Citibank…etc.

Since that last post, I have traded in and out of STC with incredible luck, and it looks like my patience in title insurers are now paying off. I’m not so lucky in OCN however. This one killed my returns this year. Analysts are bound to make wrong fundamental calls at some point, but you have to control your losses with sound portfolio management and this is where I failed. 

Getting Scalped by Gamma

Among the many lessons I learned (and paid for), a more interesting one is the negative convexity of shorting options. I got into OCN with short put positions thinking I can subsequently adjusted my net exposure up and down by going long/short stocks. That turns out to be naïve. A simplified example using fake numbers go like this.

Time 1

Stock trade at $34.
My long position: sold 100 shares of puts strike $35, this is now in the money so I’m net long.
My short position: short 100 shares of stocks.
Net exposure:  zero; I’m hedged right?  right?

Time 2

Stock spikes to $37.
My long position: now 0. That 100 shares of $35 puts is now out-of-the-money
My short position:  still short 100 shares of stocks.
Net exposure:  all the sudden I’m net short, when stock is making a run upward! I close my short stocks to bring net exposure down to 0.

Time 3 

Stock goes back down to $33.
My long position: Those sold puts struck at $35 went In-The-Money again.
My short exposure:  0. I closed my shorts in time 2
Net exposure: long 100 shares, but stock is plummeting.

So basically, that short put positions goes in and out of the money at the worst times. What I thought was a fully hedged position could turn into a net short exposure when stock is making a run upward; and vice versa, it turns to net long when stock is tanking.

People talk about “gamma scalping” by going long call option and shorting stock. With my set up I was short gamma and got scalped instead. 

Controlling Risk with Technical Analysis

FNF, and to some extent FAF, are core positions I plan to hold through the cycles. The rest however are not what most people would consider “quality” companies and my positions in them fluctuate greatly. When the fundamentals are shaky and information dissemination is sparse, I learned to use technicals to control my risk. That means buying things near some technical support level (ideally around 52 week or all-time lows), and cut my losses when they drop below that support level. Since that doesn’t always work (some of these stocks are known for taking a big gap downward), I further control risk by diversify my sector bets into multiple names, and look for cheap valuation (low P/Es or P/B multiples) 

Blending of Risk across Sub-sectors

Some of these sub-sectors offset each other with respect to specific risk factors. 

For example, my positions in title insurers could be hurt if mortgage transactions get lower. A partial hedge to that is a position in AGNC. This agency mortgage REIT benefits in that scenario because lower MBS issuance would drive its asset valuation higher. On the other hand, the mREITs have duration risks and could be hurt when rates go higher. The mortgage servicers provide some offset here with their MSR holdings. And so on. 

This is not an exact science because it’s hard to quantify the effect of various risk factors. Nevertheless, it’s good to think through what you’re trying to bet on and the risk you’re exposed to. For now, this portfolio is a bet on household formation, higher mortgage volumes, regulatory environment stabilizing, and various company specific factors such as operating efficiency, low valuation…etc.

Finally, I just started positions in PFSI and WAC this week. Those are for a separate post.

Staying Patient on Title Insurers

2014 has been a tough year for title insurance stocks (as it has been for many mortgage stocks in general) as the group lagged the broader market. However, I believe that title insurers remain the best way to get exposure to housing recovery.

A 30 second thesis on the industry

·         Good industry structure and pricing power. The top 4 players have over 80% of market share. Customers are essentially captive because banks require title insurance for mortgage transactions.

·         Volumes are near historical troughs. Even without any boosts from household formation or homeownership rates, insurance premiums can go up from housing churn and more relaxed lending standards.

·         Expense restructuring. Title insurers had to control expenses through the latest cycles, as well as meet demands from activist investors. Operations are more efficient post-crisis and margins are poised to increase with any volume uptick due to high fixed cost.

Industry Characteristics

·         Product.  Title insurance is generally required by lenders whenever one purchases or refinances a property. Premiums are some percentage of loan amount or property value, with purchases generating higher premiums than refinances. The mortgage industry does not expect much growth in refinance volumes going forward, meaning purchase mortgage volumes will be the biggest driver in the coming years.

·         Players. Top players are Fidelity National Financial (FNF), First American Financial (FAF), Stewart Information Services (STC), and Old Republic (ORI). These 4 traditionally have 80-90% of the market.

·         Pricing. Pricing is regulated by the states and there is very little price competition. As opposed to true pricing power where firms can get away with price hikes, I would say the industry enjoys stable pricing that is very much fixed across the market. The firms also has upside from home price appreciation (remember premiums are a percentage of loan/property amount).

·         Value add. Title insurers are closer to labor intensive service companies than true “insurance” risk pools. “Insurance” in the typical sense of the word is about protecting against future losses yet to incur. However, title insurer actually guard against historical events that ALREADY occurred. As such title insurers can actually minimize losses by just doing a better job upfront (more thorough title search for example).

o   This puts sell side coverage in a weird position. Does the housing analyst cover this?  Or does the insurance analyst cover this? How about the business services analyst?

·         Cost structure. Personnel cost (semi-fixed) are the largest component of expenses, rather than the more unpredictable losses. The combination of fixed cost and relative low margins means earnings can have maximum leverage to volumes gains.

Upside 1:  Macro Narrative

Both total home sales and purchase mortgage volumes are near historical troughs. The current housing environment is marked by 1) low household formation and 2) a shift away from home ownership toward rentals. The mainstream narrative says young people are staying home due to student debt; and when they do move out (thus forming households), they rent instead of own. While that argument has merit, my personal view is household formation will eventually have to pick up, while home ownership rates will have to plateau as rental vacancies decline to more normal levels.

But keep in mind, household formation and home ownership rates are not the only driver of mortgage volume!  In fact, mortgage volume should be more related to total existing home sales (which is a multiple of new home sales).  This means that housing churn and mortgage access can actually be more important than household formation and home ownership rates.

o   Churn measures housing turnover (shown in chart 1 as total home sales as % of year end number of households). Since the late 1960’s this number has trended up with economic growth, dropped during the great recession and now trending up again. Intuitively, as the economy gets better, people will buy and sell houses and move around more, even if the total number of households remains constant.

o   Average mortgage sizes (shown in chart 2 as purchase mortgage volume divided by total home sales) are still at depressed levels even though home prices have recovered. This means either a) lower percentage of buyers taking out mortgages, or b) people take out smaller mortgages (lower LTV loans). Lenders are already in the process of expanding access, so that will help mortgage volume and by extension title insurance volumes.

Title insurers will likely see their premium revenues increase if either, or both, churn and mortgage sizes increase. This is better than say, homebuilders that are depend on new constructions, which goes back to household formation and home ownership rates.

Chart 1:  home sales activity can increase without the benefit of household formation

Chart 2:  mortgage size has room to grow when lending standards normalize

Upside 2: Expenses and operating leverage

The expense picture will be different from each firm and I encourage investors to dig deeper on their own. Just reading through the transcripts though, expense control is clearly a focus for the industry. This is particularly true after the great recession then the refinance boom-bust in 2012- 2013. First American, for example, has condensed its 103 claim centers, 30 accounting centers and 30 data centers in 2006 to 4, 2, and 2 respectively today (source: conference transcript). These are structural costs that are not expected to come back when purchase volumes come back. As a result, FAF now sees a 10% pre-tax margin as the new floor, as opposed to the ceiling it was during pre-crisis days.

Expense initiatives are hardly limited to FAF. FNF and STC have both attracted activist investors in the past couple years and management teams are on tight leashes regarding expenses.

It’s not just the level of expenses improving either. Expense will be easier to manage going forward because purchase volumes are more predictable than refinances. Refinance volumes are very sensitive to rates so companies had to quickly ramp up and ramp down their staff. The transmission goes something like this:  rate volatility -> refinance volume boom/bust -> difficulty in staffing  -> inefficiencies  -> earning volatility. Going forward though, a primarily purchase driven market should be more predictable and thus costs will be easier to manage.

A better blend of risk vs housing related subsectors

Why title insurers versus other housing/macro plays? The table and discussion below will outline how I mentally think of the various housing sub-sectors.

·         Competitive risk. Housing subsectors like home builders, loan origination, mREITs are typically fragmented and competitive. Title insurers and non-bank servicers are the only subsectors with highly concentrated players.

·         Regulatory risk. Non-bank servicers are currently fighting through a host of regulatory issues. Title insurers could have some risk here also, as the uninitiated tend to think of it as a sham product. However as one does more research they realize the protection is necessary.

·         Consumer credit risk. Credit losses are currently minimal but are bound to increase as lenders fight for market share by expanding credit boxes. If you don’t like the idea of normalizing losses (or already have enough in your portfolio) you can screen out origination, mortgage insurers, as well as some of the nonagency mREITS.

At this stage of the cycle, competitive and regulatory risks are my primary concerns. By process of elimination this leaves title insurance as the least risky way to get housing exposure.

Recap

I will leave off at this point. You have an industry with concentrated market power, volumes at a trough but normalizing, and expense running at efficient levels. Note that I have not discussed valuation. However, if you have a positive view on housing in the long term, this should be the best sub-sector to look into, given the better risk blends compared to other housing plays.