Whitebox "We Are Short Essentially Every Market Favorite"VW Staff
Whitebox Tactical Opportunities Fund commentary for the second quarter ended June 30, 2015.
Whitebox Tactical Opportunities Fund – The Quarter In Brief
- For the calendar quarter ended June 30, 2015, the Fund posted a return of -4.49% for investor shares (WBMAX) and -4.28% for institutional shares (WBMIX), compared to its designated benchmarks, the S&P 500 Total Return Index and the Barclays Capital U.S. Aggregate Bond Index, which returned 0.28% and -1.68%, respectively.
- As in the first quarter of the year, negative returns remain concentrated in the area of our strongest conviction: shorts on current “glamour” high-growth US stocks that the market loves but we believe to be overpriced.
- Other detractors to performance included long positions in specialty financials and energy.
- The Fund’s “E-trade,” wherein we are short European sovereign debt and long US corporate bonds, continued to perform and was the quarter’s biggest contributor.
- Our shorts in real estate investment trusts (REITs) were modestly positive contributors for the quarter, while our large cap vs. small cap theme and gold miners delivered flat performance.
Whitebox Tactical Opportunities Fund – Market Perspective and Investment Conviction
The pain that the Fund has endured over the past 12 months, and especially this summer, has exceeded our expectations. Yet the sources are not hard to identify. On the equity side, we are short essentially every market favorite, and we are long out-of-favor investment styles.
As most investors know, our short equity book is focused on glamour stocks with popular stories and attractive revenue growth but valuations that, in our view, could not be justified even if current growth rates could be sustained for many years, which seems implausible to us. It is not surprising that we have experienced pain on these shorts; the reason we are short, after all, is that investors are, wrongly in our view, infatuated with these stocks. That infatuation has not reversed. More on this subject below; for the moment, suffice it to say that our conviction on these stocks has not changed; we firmly believe in our convictions regarding this trade and have no intention of abandoning it.
We had hoped our long book would help defray the cost of staying with these shorts; in recent months that has not happened. The vast majority of our long book, both the thematic portions and that section given over to idiosyncratic stock selection, is driven by value. Lately, the market has hated value almost as much as it has loved glamorous growth.
Consider our financials book, our leading loser on the long side in the second quarter. Nearly all our long positions in the sector are value plays. Many of our positions trade at a discount to book value while delivering solid earnings. Moreover we have been very careful to populate the book with firms we believe would have relatively little sensitivity to dramatic events in Europe, China, or the strong dollar. We are long mortgage servicers such as Ocwen Financial and Nationstar Mortgage Holdings. It is hard to see how weak exports or Chinese difficulties would have a serious impact on the business of servicing existing US mortgages. Nor do we have any fears that the servicers might turn out to be value traps. Value traps most often show up in declining lines of business. The servicers are in a business that likely will continue to expand as regulators push banks to get out of the servicing business themselves. Yet this year both Ocwen and Nationstar have been roughed up by markets. Ocwen was damaged by regulatory difficulties that turned out to be less serious than first appeared. During the quarter, Nationstar missed earnings per share (EPS) estimates substantially, and the stock was crushed.
Also in financials we are long a large mortgage REIT that we believe has exhibited exceptional capital allocation skills; New Senior Investment Group Inc. (SNR), a REIT focused on senior housing; several banking groups; and Ally Financial Inc. (ALLY), the former financial arm of General Motors, all acquired at what we believe were attractive prices. We believe that as a group these positions have relatively little sensitivity to global distress or even to the domestic economy. Most have attractive earnings yields.
The fund’s energy book was another long-side negative performer for the quarter. We view our energy book as including an option on modestly higher crude prices, but not being dependent on such a rise. We own two of the major global integrated firms that we believe have excellent records as asset allocators and which we hold at what we consider attractive prices. Given their modest valuations, we believe they will continue to deliver attractive earnings yields even at today’s crude prices. Yet they would likely benefit from an increase. Similarly, we like some of the largest contract drillers and service firms, again driven by a combination of long-term business strength and current valuation. We believe all these firms would do better on more expensive oil; we also believe the ones we own offer strong value today. Transocean Ltd. (RIG), for instance, is modestly valued in part because it has had to write down a number of rigs that, with the declining price of oil, no longer bring the lease rates that supported previous valuations. The write-downs have rendered RIG unprofitable for several quarters. Yet gross margins have been fairly stable, and revenues have slipped only marginally since the collapse of crude prices. Write-downs aside, the firm is profitable even at current crude prices, and we believe it would deliver much stronger earnings in a price rebound.
Reflecting our value vs. glamour bias has been our large vs. small theme, which had been represented in the portfolio for several years. Recently, this theme has included a long position in an exchange traded fund (ETF) billed as focused on emerging markets but including a number of global large caps vs. short positions in IBB, a biotech ETF. Biotech shares as a group seem grossly overvalued to us, though of course any given firm could strike gold with a new drug. In our view investors are insufficiently wary of the large number of pre-initial public offering (IPO) firms developing products similar to those their public counterparts are developing. These still-private firms could emerge as competitors either for customers, or for investor dollars. We substantially trimmed both the long and short sides of this theme during the quarter. After the quarter ended, we closed our long position in the emerging markets ETF, believing it to be fully valued and exposed to global turmoil including China. At the start of the quarter, we were also short the S&P Midcap 400 and the Russell 2000 via ETFs; those positions have been covered. Covering these positions terminated the large vs. small theme. We retain a portion of the IBB short in line with our general “short glamour” positioning.
Few sectors, in our view, currently offer a broad swathe of value. As a result the long book includes a number of idiosyncratic positions not driven by any theme but which we believe to be good businesses available at a reasonable price. For some time, most of these stocks had sufficient beta to the S&P to help moderate the down-drag of our short equity book. More recently some have become detached from the S&P, perhaps because of their value status, and have failed to move up with the market.
We also continue to be long gold miners, which we continue to believe is the most economic way to be long gold. The gold position is not large, about 3% of fund NAV, and was flat for the quarter.
In Q2, all of our long equities combined produced a negative contribution of 1.6%. This made the pain of holding our short equity positions, where we were prepared to see continued negative returns until the market reversed sentiment, considerably worse than it had been in previous quarters. Unfortunately this trend has continued.
See full PDF below.