Wednesday 15 February 2017

Fortress Investment Group; buying breakouts; position sizing; and perpetual self-loathing

I woke up to a pleasant but also slightly bittersweet surprise today over my morning coffee – overnight (I reside in Asia) Softbank had announced a bid to buy out Fortress Investment Group (FIG US) Class A shareholders @ US$8.08 a share. This was an approximate 40% premium to the stock’s previous price, and 66% above the levels prevailing at the commencement of 2017. 

FIG was a 1% position in the primary portfolio I manage (larger in some others), and was acquired in stages over the past six months at a US$5.21 average. I bought my base position (about half) at approximately US$5.00, and I then bought the break-out in January, doubling my position in the US$5.30-5.50 range. A 50-60% gain in less than six months is nice. But it's much nicer on a 5-10% position than a 1% position. I didn't know whether to celebrate or beat myself up for not buying more. More on that later.

The fundamentals

The fundamental investment thesis on FIG was pretty straight forward (I like simple theses). The company has US$4.25 a share in cash, investments, and accrued but yet to be realized incentive fees (net of associated taxes and employee profit share, and net of all debt). You weren’t paying a lot (about US$1 share, or US$400m) for the core business, which manages US$70bn. Indeed, you were paying less than 1% of FUM. The core biz generates about 35c a share in base fees net of all costs, with any performance fees on top of that being cream. The future flow of performance fees is of course uncertain, but you weren’t paying anything for them.

Furthermore, the company pays out all base fee earnings via regular dividend, and has returned 100% of realized performance fees over time via special dividends and buybacks. The company had also recently committed to paying out half of its cash and investment hoard (about US$2.75/share) in the next few years as well. Consequently, cash flows over the next three years were likely to be about $1.00 from base dividends, US$1.30 from capital returns, and up to US$1.50 from the distribution of accrued incentive fees as they were steadily realized (assuming no major intervening market drawdown) – as much as US$3.50-4.00 a share. Not bad for a stock that was trading at $5.00. Insider ownership was also high (45%), increasing alignment.

There were things that could go wrong. The market could swoon, reducing both the value of their accrued incentive fees, investments, and FUM. And the stock would likely go down with the market and so correlate with your other positions. And on the upside, prior to distribution, the US$4.25 in cash, investments, and incentive fees wouldn't make you much, reducing the stock's upside leverage somewhat. Nevertheless, the stock seemed like a solid value long on a risk/reward basis.

Buying the break-out

After buying a base position in 2H16, I also bought the break-out in January (but not enough evidently), roughly doubling my position size. This decision - or at least the basis for it - will no doubt make many value investor purists puke. Value investors are supposed to ignore the market action and focus on fundamental value considerations alone. 

I’m not a purist; I’m a realist and a pragmatist. The core thesis was based on the fundamentals – I would never buy a breakout in a stock I didn’t already like fundamentally. However, quite often, breakouts mean something, and are relevant information. What they mean is that other smart investors have begun to bid the stock up aggressively to get filled quickly, instead of accumulating slowly with limited market impact, and there could well be a good reason why.

As an outsider, it’s usually difficult to know what that reason is, and in the case of FIG, I had no idea. It could have happened for a variety of reasons - maybe something as simple as a large investor capable of moving the market seeing the same thing I saw above. Breakouts often fail, as well. But I knew there was value in FIG, and the breakout signaled two things: (1) that the probability that there was good news in the offing that was still unbeknownst to the majority of the market had risen; and (2) that the probability of swift value realization had increased. It also meant that the opportunity to accumulate more stock over time at levels close to US$5 may not present itself again. That justified a larger position and paying a 5-10% higher price.

We learn today why the stock was breaking out – a takeover bid was in the offing, and news had clearly started to leak. Sadly, this sort of thing is far from uncommon in markets, despite the putative outlawing of insider trading. I didn’t have inside information or the faintest inkling that a takeover offer was looming. But I suspected that some sort of good news may have been afoot, because the market action was telling me that.

In my view, investing is better played like a game of poker than a game of chess. In a game of chess, you can see all the pieces, but in a game of poker you cannot see all the cards. Sure, you need to do sound analysis based on the cards (information) you can see. But you also need to pay attention to the actions of other players at the table (e.g. pricing action; directors buying and selling, etc). Indeed, you would be a fool to ignore such 'tells', and the inferences that can be drawn from other players' behaviour. Buying the breakout is doing just that.

Position sizing

Too bad it wasn’t a larger position (this was the 'bittersweet' part of this morning's good news). A 60bp portfolio performance kicker off an original 90bp position (by cost) is nice, but the payoff could and perhaps should have been higher. I can hear many investors here taking the opportunity to espouse the conventional wisdom of the benefits of portfolio concentration.

The problem with that conventional wisdom is this. FIG was a good idea, but it was not in my top 15-20 ideas. If I had insisted on portfolio concentration, I would not have owned any of it. But none of my top 15-20 ideas are up 60% calendar year-to-date. The same can be said for Macmahon (MAH AU), where I held a 70bp position until recently. Late last month CIMIC announced a takeover bid at 14.5c, which sent the stock up 50%. It made 30bp for the fund in January and I sold on market at 15c. MAH was also well outside my top 20 ideas, but I still made more than 100% in 12 months of ownership, outperforming my overall portfolio (which on a gross basis was up 55% in 2016, and is up 12% in calendar 2017 YTD, in USD).

Of course with the full benefit of hindsight, both of these stocks should have been in my top 15-20 ideas based on their ex post outcomes. But it was much harder to determine that ex anti. They certainly were not cheaper than my top 15-20 ideas, and while I will pay some attention to breakouts, I will only use it at the margin, not as a primary basis for position sizing decisions.

It is hard to predict in advance which value ideas will play out quickly and which will require a much longer work-out time. The cheapest stocks don't necessarily re-rate the quickest. Sometimes they do, sometimes they don't. This is one advantage of having more positions with smaller position sizes. I can now take my FIG and MAH profits and recycle them.

Perpetual regret and self-loathing

Nevertheless, it is difficult to not feel at least a pang of regret for having not bought more. 
This is one of the problems with being an investor – the inevitability of perpetual self-loathing. Your actions will always appear sub-optimal in hindsight to at least some degree. You can find a good stock and make a 60% return in 6 months, but then still end up beating yourself up for not buying more rather than feeling any sense of jubilation.

Jeremy Grantham likes to say that investing is a game of regret minimization. I like that framework. We will always be revealed to have made a tonne of mistakes in the harsh light of 20/20 hindsight. The best we can hope for in this game is to try to minimize the degree of regret when the forever-uncertain future arrives and the dice have fallen. Some regret is inevitable.

So I'm trying to look on the bright side with FIG.