Sunday, 23 July 2017

The 'ick factor', and Ambac as an interesting long

I have found that a fruitful place to look for good investment ideas is amongst stocks that suffer from what might best be described as the 'ick factor' - i.e. it feels too icky to touch. And I have found that the more immediate and visceral the revulsion to the very idea of looking at a particular stock/industry/country, the better. The ideal reaction you want when you float an idea to most people is immediate disgust/dismissal. If you get that you're quite often on to something.

This is so for many reasons. For a start, it goes without saying that growth & fashion-chasing investors are unlikely to be interested in picking over dead carcasses, but the ick factor also means that a lot of otherwise intelligent and contrarian value investors, who generally act as the buyers of last resort in out of favor industries/stocks/countries, are also unlikely to even bother looking at it. This can result in larger-than-average degrees of undervaluation.

Furthermore, institutional investors will also generally shy away from such stocks due to the greater-than-average degree of career and reputation risk such corners of the market carry. It is easy enough to understand why: if you buy something acceptable to own like Facebook and lose money, well then Facebook negatively surprised everyone; but if you buy something unpopular and maligned and lose money, well then you are obviously a complete idiot and should be fired.*

What the above means is that the potential shareholder constituency for such stocks is likely to be extraordinarily limited, and therefore that the level of demand for the stock likely to be very low. And in my opinion, forced selling aside, share prices are usually determined more by the level of demand than the level of supply, as the level of the latter (the number of shares outstanding and potentially available for sale) is relatively fixed. Low levels of demand therefore generally mean low valuations. In addition, with less eyes on the stock, signs of positive change can sometimes be reflected in prices more slowly than they would be in other industries.

There is also an advantage from a technical standpoint, in that such stocks represent the mirror image of the so-called 'crowded trade' which can be subject to periodic violent pullbacks. It is often forgotten that share price movements are driven by changes of opinion, which then drive changes in investor positioning, not what is currently well known and already reflected in investors' portfolios. This is a fundamentally important truth to understand and internalize.

This is the reason why markets have a tendency to confound and confuse most investors and commentators. If everyone already believes something, they are likely to have already expressed those beliefs in past buying and selling decisions, which have already impacted market prices. Once everyone is bullish and long, prices are liable to top out because there is no one left to buy. Consequently, another advantage of owning stocks that suffer from the 'ick' factor is that they are often heavily under-owned, and hence have relatively few potential sellers left. This means the stocks are often (but not always) comparatively resilient to negative news.

Lots of value investors like to bottom-fish and buy stocks that are or have recently fallen sharply. I do that too sometimes, but I prefer to buy something that has not only already dropped a long way, but which has also already 'bounced along the bottom' for an extended period of time on low volume. This process tends to steadily sift-out all the weak/impatient holders, while stock is slowly accumulated by strong hands - usually hard-core contrarian, longer-term holders like myself. Particularly bullish is when such stocks fail to elicit much reaction to bad news, and a very strong buy signal comes when such companies exhibit early signs of positive fundamental change.


One possible example of an 'ick factor' stock at the moment is bond insurer Ambac (AMBC US). (This is far from the best example, but I just happen to have been researching the stock this weekend and felt like writing about it; much better examples hail from Greece and Russia, where I've made a tonne of money in the past couple of years, as well as mining & mining services in early 2016). The stock's current market capitalization is about US$900m.

There are few stocks that investors as instinctively recoil from as bond insurers - particularly bond insurers that went bankrupt during the global financial crisis underwriting securized mortgages that defaulted in large numbers (the company was restructured, emerged from bankruptcy and re-listed in 2013). Hence, there is potential opportunity here worth investigating.

The Holding company distinction

The first point to emphasise when looking at Ambac is that what you are buying is actually a holding company called Ambac Financial Corp (AFC), not the bond insurance operating company Ambac Assurance (AAC). The latter is merely a wholly-owned subsidiary of AFC, and it is this entity that houses all of the Ambac Group's financial guarantee obligations.

This is not a trivial distinction, because it is AAC not AFC that is regulated; is required to maintain a certain amount of regulatory capital; and which is subject to the risks its US$70bn in outstanding bond guarantees represent. AFC is not obligated to put more money into AAC if its reserves prove inadequate to cover bond insurance losses, due to typical limited legal liability and an absence of cross-company guarantees from the holding company. Consequently, the minimum value of AAC to AFC is zero, which is very important because it caps the size of AFC's potential losses.

The holding company currently has three key sources of value. Firstly, it has cash and investments of US$347m (as at 1Q17). In addition, it has entered into clever tolling agreements with AAC regarding the utilization of tax losses that the company expects will allow it to upstream an additional US$165m in cash in the next few years from AAC without regulatory approval (AAC needs approval for all distributions/dividends to ensure it has sufficient claims-paying resources to meet future obligations, in the eyes of regulators). If and when these additional tolling payments are received, the holding company will have about US$500m of cash & investments.

Secondly, AFC has US$1.4bn of tax loss carry forwards (separate to the US$2.6bn that exist in AAC - both of which are off-balance-sheet), which expire during 2029-33. Based on the US current tax rate of 35%, if fully utilized, these US$1.4bn in tax loss carry forwards would be worth US$490m (gross, undiscounted), and AMBC management has said it is investing various commercial transactions which would allow these NoLs to be utilised.

The NoLs are worth considerably less than US$490m. Firstly, any reduction in US corporate tax rates will reduce their value, and such a reduction is currently under discussion. If we assume tax rates are reduced to 25%, this will reduce their gross value to US$350m. In addition, further discounts are needed for (1) the risk that they will not be fully utilized prior to expiration, and (2) for the time value of money. However, even if we adopt a conservative approach and take a 50% discount for both (i.e. a 75% cumulative discount), these NoLs would be worth a little under US$100m. Together with the cash and investments above, this would value the holding company at US$600m, or about US$12/share, excluding AAC. Meanwhile, the shares recently changed hands at US$17/share (although have popped in the last few days to US$20/share).

The above is important because it reduces the downside risk by two-thirds. Most investors likely assume that the downside is to zero if a bunch of AMBC's insured bonds blow up and wipe out the bond insurance company's equity, but that is not the case. The ability of this ex-AAC holding company value to reducing the potential downside by two-thirds, while investors still have full exposure to the AAC upside, is a very important valuation nuance that is lost on many observers.

Including the value of AAC

The third and final source of value to AMBC is the option value embedded in the eventual value of its wholly owned subsidiary AAC, which houses all of the group's financial guarantees and the majority of the group's capital and investments.

The value is potentially significant. Indeed, after AMBC's recently announced negotiated settlement with creditors of its rehabilitated segregated account, the company's consolidated adjusted book value will rise to about US$40/share, or about US$30/share excluding the cash to be held at the holding company level as previously discussed. Furthermore, using the same methodology as above, AAC also has an additional US$160m worth of deferred tax assets (US$2.4bn in gross NoLs) that are off balance sheet, or about another US$3/share.

In other words, including off-balance-sheet DTAs, AAC's adjusted book value is worth about US$33/share, and with the AFC holding company worth an estimated US$12/share excluding AAC, this implies a total valuation of about US$45/share. Meanwhile, the stock is currently trading at about US$20/share.

What is AAC likely to ultimately be worth? I don't know. But at US$20/share, the market is implying that AAC is worth only US$8, or about 26-27% of adjusted book value, and about 24% of adjusted book value including the value of its deferred tax assets. Let's call it a round 25%. The market is therefore effectively saying there is a 75% chance AAC is worth zero, and only 25% chance the assets are worth adjusted book.

That appears much too pessimistic. The company is currently in run-off mode (i.e. is not writing any business), and has delevered since emerging from bankruptcy in 2013 from at 35:1 ratio of insured obligations to claims paying resources, to just 13:1 at present. It's total insured par has shrunk from a peak of US$550bn immediately prior to the GFC, to just US$70bn today.

This run-off and deleveraging dynamic is important, because as the company's leverage declines, the company will release regulatory capital, and this capital will then become available to upstream to the holding company level, and be used to buy-back shares - something that would be very accretive at the current share price. In addition, the risks attached to the company's adjusted book value decline as leverage declines, which should also lessen the discount the market is applying.

Most of AMBC's remaining exposure is US municipal obligations, with its structured finance and real estate exposure having been significantly reduced. With real estate prices rising and the US economy doing quite well, most of AMBC's remaining run-off exposures are in good health at present, with the notable exception of Puerto Rico (see below). In addition, the company has been having success with R&W (representation and warranty) litigation against the big banks for false representations made by the banks to Ambac on pre-GFC-era real estate securitisation guarantees made (as a serial bank shareholder, it is nice to own a stock on the other side of the litigation divide!) The company has already included an estimate of future litigation settlements on balance sheet, but we believe those estimates are likely to be on the conservative side, which creates additional upside risks to adjusted book value in coming years.

Puerto Rico

Puerto Rico's troubled finances have been in and out of the financial press, and significantly pressured the share prices of all the major US municipal bond insurers earlier this year. AAC has US$2bn of par exposure, but has already reserved for a one-third loss, which appears sufficiently conservative (i.e. they could restructure with PR to reduce the face value of outstanding bonds by 1/3rd and this would not impact net book value). The US$1.3bn of unreserved exposure represents about US$26/share, and US$20/share net of available tax deductions (which may or may not be utilizable). At US$20/share the market has already written down AMBC's US$45 adjusted book value including DTA assets to a degree that assumes a 100% PR loss which seems highly unlikely.

Indeed, one of the genuine sources of value bond insurers provide is their ability to renegotiate problem loans in order to mitigate potential losses, as well as engage in litigation where necessary, which is something most bond investors are loathe (or simply unable) to do. In addition, the company is sometimes able to buy the bonds it has insured in the secondary market at sharp discounts to par for loss mitigation purposes (if the bonds default, they pay out less than 100c in the dollar as they have bought them on the secondary market at a discount, and if the loans are successfully worked out, they trade back up to par and AMBC is able to sell out at a profit). Much of the company's PR insured exposure is also not to general obligation bonds, but to specific revenue bonds (which entail claims against specific infrastructure assets, for example, or sales tax income streams), which - provided the rule of law is upheld - cannot be simply repudiated by PR (which they have attempted to do; they are being taken to court by bondholders). It is likely, on an expectancy basis, that AAC is adequately reserved for its PR exposure at this point in my view.


All told, AMBC looks like an interesting value long. It is the sort of situation, however, where you cannot have 'high conviction' in the outcome - only high conviction that the risk/reward is attractive - and therefore it makes sense to adopt a basketed approach. I currently have a 30bp position in AMBC, 15bp in MBI, 80bp in AGO; or an aggregate sector exposure of slightly more than 1%. I also have a 65bp position in GNW, which has some mortgage bond-insurance operations (which I'm uncomfortable with to be honest), but this is more of a merger-arbitrage play with a deep-value value backing if the deal falls through, than a monoline play).


*Incidentally, I am a huge fan of Bill Miller, and Bill Miller has been an obvious casualty of this career risk asymmetry. Despite beating the S&P 500 for 15 consecutive years up until the GFC; 5 consecutive years again recently; and beating the market throughout the 1999-2017 period cumulatively (i.e. including the GFC losses)  by 200-300bp - all-time hall-of-fame type numbers - he is widely regarded as being a reckless & failed investor because he fared very poorly during the GFC betting on bombed-out financials that went to zero. It was a risky bet, to be sure, and one that in hindsight was mistaken, but it is seldom considered that had Lehman had not been allowed to fail and had other US institutions not been subject to forced nationalizations, he would likely have made an absolute fortune. We will never know what the true ex ante probabilities were.

Bill Miller is proof of Keynes' admonition that 'it is better for reputation to fail conventionally than to succeed unconventionally'

The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.