When Porter first suggested I do a newsletter several years ago, I thought, “I’ve just spent ten years being a hedge fund manager and a fund of funds manager and a venture capitalist. I’m done”
I love what I write. I love what I send to my newsletters readers and premium readers. I write about finance but also about other topics that are world-changing that I think people need to know about in order to make their lives better.
But I have to admit: I miss writing about investments sometimes. I miss writing about the scams on Wall Street and how people can take advantage of them.
I’m not going to accuse anyone else. I’m going to accuse myself first.
I ran a fund of hedge funds.
A hedge fund is a fund that can go long, short, make all sorts of weird trades that take advantage of anomalies in the market.
Each hedge fund has their own particular way of finding anomalies in the market. And some of them actually work.
I did due diligence on probably close to 1000 funds. I invested in 13.
Which meant I was a “fund of hedge funds”.
DON’T EVER invest in a fund of hedge funds. Here’s the deal: I charged 1% off the top and 5% of the profits.
Then every hedge fund I invested in charged 2% off the top and 20% of the profits.
Then every hedge fund, and also my fund, charged for “expenses”, like accounting (tack on an extra 1% from me and another 1% underneath me) and legal and due diligence expenses, and so on.
So if you put money into a fund of hedge funds, I don’t have a calculator in front of me, but if all of my hedge funds returned in raw profits 20% (a very good year), then your fees would be altogether about 8%, give or take on the expenses.
Which meant you would give your hard working money, have a great year, pay 8-12% on your money in fees, and you would get about 8-12%.
Which seems great but why pay all of those fees?
It’s because most investors don’t have access to the enormous information and millions of dollars of research that hedge funds have access to.
That’s going to change with this newsletter.
Did I like running a fund of funds? No. I shut down the money, returned the fund, and started a company, Stockpickr.com which I eventually sold to thestreet.com. Then I occasionally wrote about stocks but I kept in touch with all of the hedge funds just to see what they were up to.
Now I want to share what they are up to. It will be as if you were investing in a fund of funds, but without ANY of the fees.
I’m going to get you into as many good and weird anomalies as possible in the market, but you don’t pay me any fees except the subscription fee on this letter.
My average investor gave me about $2,000,000. That means right off the top (my fees plus the management fees of the funds I invested in), they gave me $60,000 on day one that they never saw again. Then probably another $60,000-$100,000 in other fees.
You pay none of that. No fees.
But because I still know all of the hedge fund managers and their friends and their friends friends (the ones that are not in jail) I still call them regularly and see what they are up to.
I want to get you into the best trades and investments that the hedge funds are circling around.
Often I can even get you into better trades than they are getting into.
Because if I see a trade that is good for a few million dollars worth of investing it is too small for almost all of the hedge funds that are smart enough to find it. They won’t do it. They are looking for bigger anomalies.
But you and I can do them. This is the SINGLE MOST IMPORTANT ADVANTAGE that you and I have over hedge funds.
We’re nimble. We can play smaller. We can get out of a trade more quickly. We have a wider range of trades that we can do to make a lot of money, often a lot more money than the big sluggish funds that are obsessed with fees.
Why did I like the fund of hedge funds strategy in the first place?
A) it’s the best diversification. It’s not like these guys were just buying IBM and holding on for dear life (although sometimes they might). They were going long. They were going short (betting against a stock). They were making options trades. They were buying bonds. They were buying stocks that never appeared in the news and nobody ever heard of. They simply knew more than anyone else.
They were diversifying in ways that the average investor can’t possibly diversify.
B) My favorite strategy in life: stand next to the smartest guy in the room.
Steve Jobs stood next to Steve Wozniak and created Apple computer. Harold Ramis stood next to Bill Murray and created a Ghostbusters franchise and billions of dollars worth of movies.
I stood next to incredibly smart investors who had a dozen PhDs in some cases working to find trades for them. A “trade” being some weird anomaly that might only appear in the market for a short time, an eclipse that you have to see outside your window at just the right moment or you would miss it.
A fiery asteroid flaming across the sky, beautiful, lighting up the stars, you want to reach out and grab it and touch it and eat it before it disappear. You want to show your friends. You want to photograph it. Beauty.
I would see these trades they would do and think to myself. Beautiful.
So, I guess, I was sad to get out of the business. Sad, but lucky. I shut down my fund of hedge funds near the end of 2006.
I can’t claim at all to time the market. But if I had waited just six months I would’ve been in big trouble.
Because here’s the other things about hedge funds – you can’t get your money back when you ask for it. Often you can only ask for a little bit out of a time. Or they have up to a year to give it back to you.
All sorts of ways to steal more fees from you.
None of that in this newsletter.
Each month I’ll send out one-two letters. I’ll scour the hedge fund universe to find the two-four best trades I can find each month.
Ways to take advantage of something that millions have missed. Asteroids screaming across the market for only a brief moment, a week, a month, who knows.
Two-four ideas a month that are yours to do with what you wish. Maybe you just want to watch from your window with me. Maybe you want to make the trade and invest with the best of the hedge funds. Maybe you want to find ways to improve on the trade. Because we are nimble and smaller we can do that.
– the best trades from the smartest people
– total diversification
– save $100,000s or more on fees
– you pick and choose
– your money is totally yours: liquid, transparent, and you can alter the dynamics of the trade as you wish, not beholden to anyone hanging on for your extra fees.
– trades that you would never normally see in mainstream media which tends to focus on Apple, Google, Tesla, etc. We might have trades related to those companies but we will be more likely found in the dusty crevices of the market where the other 8000 companies are playing. Many stocks that go up 1000%+ or more in a year are never reported in the news.
– Every trade will be tradeable on the major markets by any trading platform. Nothing so fancy that can’t be done by an individual sitting at home.
– Some of the strategies that we will be playing: closed end fund arbitrage, asset arbitrage, dividend recaptures, all sorts of option strategies, spin-offs, micro-caps that nobody is paying attention to, index rebalancing, my favorite – the activist remora trade, distressed debt, bankruptcy plays, the well-known in quant funds – first day of the month strategy, convertible arbitrage, Warren Buffett arbitrage (great to trade around the slowest and least nimble but best investor out there), “Swine Flu” arbitrage, country long/short, new technologies, and many many more plays.
Some of these trades we’ll aim for a huge return. Some we’ll aim for a safe return. Diversification of return and strategy is perhaps more important than the standard definitions of diversification taught by unsophisticated bank managers.
Now…I have to warn you:
some of these trades I might write about later in my regular newsletter. Or in other platforms. But that will be months after I write about here on this “fund of hedge funds” newsletter if at all. You will get the first call.
I’ll also share many of the scams and ways that the financial industry typically tries to fool you. I can write an “Encyclopedia of Scams” but I don’t really think that’s interesting.
Better to make money.
Because there is often a limit to how much money can be put into each of these trades I am severely limiting the number of people who will get this newsletter.
This newsletter is about making money. If a million people pour money into one trade then nobody will make money.
So I’m limiting this newsletter to a very small number.
Typically in each newsletter I will outline two trades. I might not outline every detail of the trade or how I know about it.
I will outline as much as possible about the trade including when to get in, when to get out, how long the trade is, etc. I might not list all of the particular strategies being used for a trade but often before a trade gets from me to you it will have multiple strategies behind it.
These are three ideas told to me in the past day by top hedge fund managers.
Closed End Fund Arbitrage:
Royce Micro-Cap Trust (RMT) is a high quality closed-end fund.
A closed-end fund is basically a mutual fund that trades on the various stock exchanges. Because its price is determined by how it trades it often trades lower than the amount of assets it holds.
If I say, “XYZ fund is trading 10% below it’s “net asset value” (NAV), that’s like buying a $100 bill for $90.
Most closed-end funds trade below their NAV. The trick is to buy them when they are irrationally trading lower than their normal discount to NAV. If you understand their history and the WHY of their current price, you can find very safe opportunities (i.e. it’s ALWAYS safe to buy a $100 bill for $90 if you make sure the $100 is not counterfeit).
Royce is a well known mutual fund family. Well known because they keep their assets under management tiny relative to the big mutual fund families and they have a strong history of positive returns in up and down markets due to their value investing style. Charles Royce has been running the company for 40 years and is often mentioned alongside Warren Buffett as among the best investors in history.
So when a hedge fund mentioned to me RMT was trading for “90 cents on the dollar” and they were loading up, I had to take a deeper look.
As early as last December, it was only trading at 4% discount to NAV. So even if none of the stocks they own move, there is potential for a 7% gain. Right now it’s near the lowest discount to it’s net asset value in almost two years.
The current dividend is 9.7%. So again, if the underlying stocks don’t move, there is the potential for a 7% gain due to the discount, plus another 10% annual gain due to the dividend.
Why did it trade this low compared to what it has in the bank?
“The market has been selling off microcaps lately. So all microcap funds have traded down. But here’s the catch, almost 50% of RMT is simply in cash and safe bonds. So you really are buying 90% on the dollar on at least half the fund. The other half the fund is high quality companies.”
For instance, one of their top holdings is Atrion (ATRI), a $650 million market cap company (not a microcap) that has $20 mm in cash, no debt, and trades for just 12 times cash flow.
Their top equity holding is Integrated Electric Services (IESC) which has $37 million in net cash, trades for just nine times cash flow, had a $2,000,000 insider PURCHASE by one of its largest shareholders a year ago, and Renaissance Technologies, the most successful hedge fund in history, is a large shareholder.
So you get to buy these companies and the other companies in their portfolio at a discount while you collect the dividend and wait for the discount to net asset value to close.
Meanwhile, the average five year return of RMT over the past five years of the stock in it’s portfolio is 15.23%.
When you can buy $100 for $90, and understand why it’s there, and can dig down on the stocks in the closed-end fund’s portfolio, AND get a dividend while you wait, it’s probably a safe and lucrative buy.
IDEA #2: SUM-OF-THE-PARTS
Often a company that is successful in several divisions has a problem with “unlocking value” in the market. What that means is: the market values different industries differently. An Internet company might trade at 100 times earnings. A gas utility might trade for 5 times earnings. If a company was both an Internet company and a gas utility, the market will often value the company at the lower common denominator.
The way to solve this problem is to split the company in half and have two stocks instead of one, so this way the market will value each division relative to its competitors as opposed to be confused to how to value the company.
For example: this is the reason why the old bloated Time Warner spun off Time, Inc, spun off it’s cable companies, spun off AOL, spun off it’s music business, etc and became more of a pure play on video content (Warner Brothers and HBO).
LSB Industries (LXU), is a relatively unknown but successful mini-conglomerate for over 40 years, has been operating two separate divisions that are both doing well but the market is confused how to value them. Hence, it is trading for less than the “sum of it’s parts” (i.e. if you treat each division as a separate company, it would trade higher).
An activist hedge fund, Starboard Value, has gotten involved, bought an enormous number of shares, and is pushing for a division of the company into its separate parts.
You might not have heard of LXU. It’s not sexy. It’s not Apple, Google, or Tesla so won’t appear on the front page of the Wall St Journal and none of the talking heads on CNBC will talk about it. People get fired for talking about companies as boring as LXU. But that’s why there is money potential here.
Start paying attention to the name now. It’s generally operated as a family business since the 60’s – and came public in the mid-90s, right during the middle of the Tech boom.
No one paid attention to a sleepy conglomerate, even still today no one really caries…but a few hedge funds that I talk too do care very much.
The insiders of the company still own around 15% of the stock – but there are several catalysts ahead to drive value materially higher. I recent sat down with of the top 10 shareholders who laid out his/her analysis of the stock to move the name higher:
LSB Industries has two main businesses: a chemical business and a climate control business.
The latter is really heating, ventilation, and air conditioning – it accounts for 38% of the companies revenue. The chemicals business provides 60% of the revenue. Additionally, there i also a smaller engineering business that contributes about 2% of the revenue of the firm.
Most of the chemicals LXU makes are nitrogen-based and they are used in applications ranging from agriculture to industrial assets.
This business has heavy international exposure. To make these chemicals, one needs natural gas as a feedstock, and because of low natural gas prices in the United States, LSB Industrials has a tremendous cost advantage vis-a-vis companies in other nations.
Even large chemical companies like Bayer and DuPont buy these chemicals from LXU. Georgia Pacific buys from the company. International Paper buys from it as well. Due to these competitive and structural advantages, LXU is substantially expanding its capacity in 2015 and 2016.
This competitive advantage for the chemicals business has led to a 27% operating margin. The climate control business, on the other hand, has an 11% operating margin. The climate control business basically sells HVAC equipment to large buildings and some residences, and that business is currently operating below its historical norm.
The logic of the separation would be the chemical business could grow a lot over the next two or three years, and without the drag of climate control, it could probable be awarded a much higher multiple than its current 13.5x
Let’s dive a bit deeper into the name: Founded in 1968 by Jack Golsen, the company’s Chairman and CEO, LSB Industries is an industrial manufacturer with two principal businesses: Chemicals and Climate Control. LSB’s chemical business is engaged in the provision of nitrogen-based agricultural, mining and industrial chemicals, and is the #1 merchant marketer of nitric acid in the United States. Its climate control business provides specialty HVAC (Heating, Ventilation and Air Conditioning) products to the commercial and residential market. IN particularly, it is the leader for water source and geothermal heat pumps.
The Chemicals business manufactures and sells nitrogen-based products that are used primarily as fertilizer for agriculture products, including wheat, corn, and cotton. These products include: anhydrous ammonia, fertilizer grade AN (ammonium nitrate), urea ammonium nitrate, and ammonium nitrate ammonia, all of which are designed to provide nitrogen, an essential nutrient for growing food crops. The company sells the products to farmer, ranchers, fertilizer dealers, primarily in the ranch land and grain production markets of the US.
Sales of chemicals for agricultural uses account for approximately 48% of chemical sales. Of this, the largest component of sales is attributed to urea ammonium nitrate followed by ammonium nitrate.
The Climate Control business manufactures and sells a broad range of heating, ventilation and air conditioning products focused on the niche market of geothermal and water sourcemheat pumps, air handlers and related equipment. As a result of this focus, LSB Industries has developed a leadership position in these markets. Geothermal HVAC systems are considered “green” technology and a form of renewable energy. They are among the most energy efficient systems available in the market, which makes it especially attractive for commercial construction, although such systems are also used in single family new construction as well. To date, the company has installed over 4 million units, including in a multitude of iconic locations, such as the Bellagio Casino in Las Vegas, the Statue of Liberty, Trump Tower in New York City, Atlantis Hotel in the Bahamas, the Peninsula Hotel in Hong Kong, and Rockefeller Center.
Despite the high margins, the chemicals business itself is cyclical. In 2011, the chemicals business had $511 million of sales and in 2013 it had $380 million of sales. This is headed for a very large expansion in revenues both from building more capacity and from cyclical trends. The company has $311 million in cash and $459 million of debt. The major capital expenditures to enhance the chemical business are going to come to an end in the next 12 to 18 months, so it could be an interesting spin-off if the company chooses to do it.
So what is a breakup of the company worth: Daniel Mannes, an analyst at Avondale Partners, notes in a report that he sees “a lot of common ground between management and Starboard.” He “suspects that a settlement will come” with more board representation for Starboard, rather than a proxy fight. Mannes puts LSB’s sum-of-the-parts value at $63 to $74 a share.
The company CURRENTLY TRADES AT $42. So a separation into two can be an immediate 50% gain. The Fund I speak with thinks upside in the name is over $90 over the next 3-5yrs. Options include forming a master limited partnership for the chemicals business, and spinning off or selling climate control, as the HVAC unit is known.
On April 26, Starboard Value entered into a settlement agreement with LSB regarding, among other things: increasing the size of the board to 13; electing five members to the board while accepting resignations from board members Gail Lapidus and Robert Henry; separating LSB’s Chemicals and Climate Control business and exploring a master limited partnership structure for the chemicals business (which would ensure huge dividends); forming a special committee to oversee the search for a new executive for the chemical business; expanding the role of that committee to include “an evaluation of [LSB’s] corporate governance and management structure, related party transactions, and any other governance practices deemed appropriate,” with any recommendations that are approved by the board to be announced simultaneously with LSB’s public announcement of its financial results for the six months ending on June 30.
Starboard disclosed ownership of 1,725,000 shares (7.6% of the company’s total voting stock).
Distressed Fixed Income:
In 2005 I wrote a book about Warren Buffett. I sent it as a gift to a friend of mine who was running the largest distressed debt hedge fund in the world.
“Distressed debt” is when investors are afraid a company won’t pay back its debt, they start selling it and the debt “trades down”.
So my friend told me a story. He said when Worldcom declared bankruptcy in 2002 it was trading at around 20 cents on the dollar. At the time he was literally at a party with the Queen of England. But his analysts had determined that even though Worldcom was bankrupt because of the corruption of it’s CEO, they had the assets in a liquidation to pay back it’s debt in full (100 cents on the dollar). They were the phone network for the US government. They weren’t going to disappear.
So he was trying frantically in the middle of this party to buy as much of the debt as he could. If a bond is trading for 10 cents on the dollar because everyone thinks it will disappear, and you buy it, and they end up paying back 100 cents, it’s like buying a stock for $10 and selling it for $100. A 900% return.
“I couldn’t get the debt, though, James,” he told me, “Warren Buffett bought all of it.”
So on the rare occasions where you can find a good distressed debt deal, it’s worth taking. When you buy debt, it puts you in front of the line in case a worst-case scenario (a liquidation) happens. Any money that comes out of the liquidation goes first to the debt-holders. The shareholders usually get nothing.
Typically in a bankruptcy, the debt will trade from 100 cents on the dollar down to 20-40 cents on the dollar.
Here’s situation just described to me over dinner by a prominent hedge fund manager.
Sabine Oil & Gas: Few fixed income instruments are as distressed as Forest Oil Corporation, 7.25% 15-JUN-2019 (SOGC3670900-OTC). The bonds are trading at 23 cents on the dollar (almost as if the company were already liquidating), which is as distressed of a credit I have seen since the 2001/2002 corporate credit blow-up.
The rating agency S&P ranks the bonds D (according to FactSet), and the bonds have a YTM of a whopping 59.82%. Yes, you read that right…59.82% YTM – compare that with the average High Yield paper yielding around 5%.
“YTM” is yield to maturity. Which means, if the company pays it’s debt (and note: it’s not in liquidation at all at the moment), then it’s as if you own a stock that is guaranteed to make you a safe 60% between now and June 2019
I had dinner with a fairly well known distressed investor who told me he started looking at the name as a possible long idea. Why you might ask? Energy is sub $60, a lot of the fracking is unprofitable at current levels, and the distressed players in the space – are well distressed for a reason!
However, this fund manager’s investment case was much more corporate in nature. He is playing a possible corporate action that could move the bonds back to par. Here is the story: Sabine Oil & Gas is an exploration & production company with core operations located in the East TX Cotton Valley, Eagle Ford Shale, and the Granite Wash Formations. It now has the largest footprint in East TX, Cotton Valley footprint. In December 2014, Sabine Oil & Gas completed its merger with Forest Oil Corporation – resulting in the pro forma company holding the largest leasehold position in the Cotton Valley formation.
This is where things get really interesting: The largest equity investor in the company is famed private-equity firm: First Reserve, which founded Sabine Oil & Gas a portfolio company. Since inception, First Reserve has funded $1.3B in equity commitments into the company.
In May of 2014, Sabine announced its intent to merge with Forest Oil and acknowledged a trigger a ‘Change of Control’ in Forest Bonds as a result of the transaction. In Dec 2014, Sabine announced closing of the merger with. In February of 2015, Wilmington Trust (‘Trustee of Forest 2019 Notes) filed a suit against Forest Oil/Sabine Oil & Gas exerting its 101 change of control payment right.
What this means is: because the Forest Oil bonds had a “Change of control” provision in it – as soon as the company sold, their debt holders wanted the money back. Always look for the reason why debt is trading down irrationally. This is the reason.
If the scenario can’t be worked out, then Sabine has to find the money. The big question is: can they? Forest’s bondholders last month claimed they were being deprived of $584 million after First Reserve Corp – backed Sabine structured a merger to avoid redeeming their debt. The value of their holdings has continued to plummet. The debt is down about 80% since December 15th, the day before the completed merger was announced with revised terms eliminating the need to repay bondholders.
On the asset side: On 11/17/2014: FST divested its Arkoma dry gas asset for $8,409/Mcfe/d. Since Sabine has a strong hedge book that insulates a large percentage of cash flows into 2015.
Specifically the company is 83% hedged on gas in 2015, at $4.22/Mcfe/d and is 75% hedged on oil in 2015 at $87.30/bbl. Some have valued the hedge book worth $200MM alone. Sabine had a fully drawn its $1 billion dollar revolving credit line as of March 15th, with about $300 million of cash on hand.
It’s not important to understand every term here. Suffice to say: Sabine has hedged it’s oil and gas position so it can’t be hurt by falling prices. It’s managed to sell off some land at a high value. And it basically has (without selling any more properties), at least $1.3 billion at hand it can use in a WORST CASE SCENARIO to pay back the Forest Oil debt holders.
Meanwhile, Sabine legally does not have to pay back the debt because of the way they structured the acquisition in the first place. Either way, the debt should trade back to “par”, meaning “100 cents on the dollar”.
In the likely scenario it trades back to par, that’s a 300% fairly quick return plus the 59% mentioned above.
How can one buy a bond? Bonds typically don’t trade on any exchange. But if you call the broker at your primary bank, he can help you buy a bond from their bond trading desk. For these bonds, I’d try to buy for less than 30 cents on the dollar.