Senvest Capital 2015 Annual LetterVW Staff
Senvest Capital annual letter for the year ended December 31, 2015.
Senvest Capital – Overall Performance
The fourth quarter began with equity markets increasing in October and the S&P 500 having its best monthly performance in four years. After tepid August and September U.S. macroeconomic data, job growth surged for October with a gain in payrolls far greater than expected (271k jobs vs. 180k according to a Reuter’s poll of economists). Unemployment declined to 5% and perhaps more significantly, wages gained at an annual pace of 2.5%. Domestic markets reacted adversely to the good news, however, as equity indices initially dipped lower during November. After hitting monthly lows about half way through November, stocks rallied and the S&P turned slightly positive while the Russell 2000 gained enough to push into positive territory for the year albeit for only a brief time. There was no “Santa Claus” rally during the month of December and stocks, especially small caps, sank to finish the year on a negative note. The on-again, off-again Fed “lift-off” of short term interest rates was finally settled with an interest hike in December. Rather than settling the markets, the rate hike seemed to elicit a negative reaction with the market slide continuing into the 2016 year.
The “crash” in oil prices has certainly resulted in a depression in the US domestic energy exploration and production market. Shale oil producers have dramatically curtailed capital investment spending. This drop in spending, coupled with a strong U.S. dollar which makes U.S. manufactured products less competitive globally and decreases exports, have together resulted in an industrial decline in the U.S. The effects have also been borne out in weak manufacturing data reported in the last part of the year. While low oil prices have had an immediate negative effect on the industrial economy and the industrial labor market, over time the positive effects of lower oil prices on the broader economy will emerge principally through higher disposable income for consumers. A positive factor to consider is that the shape of the yield curve remained upward sloping (and had not inverted) at the end of the year. Since the 1950’s an inverted curve has signaled every recession (Federal Reserve Bank of Dallas). Also employment growth, at an average of 280,000 jobs added per month in the fourth quarter of 2015 has remained quite strong.
Senvest Capital Inc. (“Senvest” or the “Company”) had a difficult year in 2015. Most of the major benchmarks were flat to down for the year but our decline was significantly greater. The bulk of our losses in 2015 were unrealized, mark-to-market losses. Most of our 2015 loss occurred in the third quarter. Our fourth quarter yielded a small profit however the market volatility that started in the middle of 2015 carried over into the first quarter of 2016. Some of our largest holdings as at December 31, 2015 were, Tower Semiconductors, Depomed, NorthStar Realty Finance, Deckers Outdoors, Radware, and Ceva. Of these, Northstar Realty and Deckers both declined over 40% in 2015 and Radware declined 30%. The fourth quarter saw holdings both increase and decrease with the net result being a small increase in profit.
In light of the continuing market turmoil since August, we have made a conscious effort to focus on those investments that we felt offered the strongest bounce-back and risk-reward opportunity. As a result, we sold down some holdings, eliminated some remaining stub positions, trimmed certain core investments that hadn’t suffered from declining prices and added selectively to other core positions. We also partly covered certain short positions as their stock prices traded lower. We continue to focus the portfolio on those investments that have suffered from declining stock prices and in which we have high conviction in their upside potential.
Investors often overreact and are prone to alarm and drastic pessimism at times, focusing entirely on negative news flow and creating a negative feedback loop in the market. A common reaction for investors is to continue the negative trend by selling, while ignoring key variables and fundamentals that may indicate a company (or industry) will endure and be stronger in the long run. Our research strives to determine whether a company’s prospects are actually better than what investors in the market are currently predicting, and whether conditions will improve significantly within our longer investment time horizon.
Senvest recorded a net loss attributable to the common shareholders of ($99.8) million or ($35.39) per diluted common share for the year ended December 31, 2015. This compares to net earnings attributable to common shareholders of $117.3 million or $41.26 per diluted common share for the 2014 year. The significant appreciation in the US dollar versus the Canadian dollar in the year resulted in a currency translation income of about $134 million to the income attributable to common shareholders. This amount is not reported in the Company’s income statement rather it is reflected in the Comprehensive income. The Company remains committed to being profitable over the long-term. However the volatility and choppiness of the markets will result in wide profit swings from year to year and from quarter to quarter.
The Company’s loss from equity investments in 2015 was the biggest contributor to the net loss recorded. The net loss on equity investments and other holdings totaled ($225.1) million in the current year versus a gain of $233.1 million the prior year. The Company continued its use of currencies in 2015 to both protect and enhance the portfolio’s returns. Due to the continued appreciation of the US dollar over other major currencies, our foreign exchange gain for the year was approximately $33.4 million.
The Senvest Partners fund is focused primarily on small and mid-cap companies. The fund recorded a loss of 17.3% net of fees for 2015. It is up over 2200% since inception in 1997. With most of the long portfolio invested in small and mid- cap stocks, the fund underperformed its most relevant benchmark the Russell 2000, which was down 12% for the year. The fund also underperformed the S&P 500 index for the year although it does not consider that index as a benchmark. The Senvest Israel Partners fund was initiated in 2003 to focus on investing in Israel related companies. This fund recorded a gain of about 6.6% for the year. The two funds had a total of over $1 billion of net assets under management at December 31, 2015. Both of these funds are consolidated into the accounts of the Company.
Senvest Cyprus Recovery Investment Partners, LP fund (“SCRIF”) owns an investment in the Bank of Cyprus (“BOC”) which was purchased in 2014. In 2015 the Cypriot economy came out of recession and Cyprus GDP grew quarter over quarter over the last nine months of the year. The 2015 economic data was better than many analysts expected. Structural measures have been taken by the Cypriot government to help banks reduce non-performing loans (NPLs) with the implementation of a foreclosure law and an insolvency framework. There were also signs of significant investments in Cyprus by foreign investors in the last year. BOC’s management continued to deliver on its strategic plan of increasing its capital levels as a result of reducing its risk weighted assets, producing organic capital generation, and disposing of non-core assets.
Despite a number of positive developments for the BOC and the Cypriot economy in 2015, there continues to be a considerable disconnect between the fundamental improvements of the BOC and the economy versus the performance of the BOC stock (down over 30% in 2015). Capital flight out of emerging markets seems to continue to affect market appetite for BOC shares and that has likely kept the shares trading at low levels. The Greek market turbulence continued to affect sentiment for Greek assets and for the BOC, despite the fact that the Bank has little exposure to Greece. However, we believe that management’s plan to list BOC shares on the FTSE in 2016 will greatly improve liquidity of the shares and attract institutional investors. Together with investor recognition of continued improvements of its fundamentals (continued restructuring and reduction of NPLs, asset disposals, and a stronger Tier 1 capital ratio) as well as a new listing on the London exchange, could form a catalyst that may lift any overhang on the bank’s stock price.
The Company has a portfolio of real estate investments, investing as a minority partner in selected properties. Real estate investments totaled $49.4 million as at December 31, 2015. About 60% of this amount represents investments in different US REITs. These REITs are not publicly traded and there is no established market for them. The most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties of the REITs and the distribution to its holders. The remaining amounts are minority interests in private entities whose main assets are real estate properties. As described above for the REITs, the most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties.
From time to time the Company enters into derivative financial instruments consisting primarily of options and warrants to purchase or sell equities, equity indices and currencies. All contracts are denominated in US dollars. There is deemed to be no credit risk for the options that are traded on exchanges. The warrant contracts are not exchange traded and allow the company to purchase underlying equities at a fixed price. The maximum exposure to credit risk associated with these warrants or with non-exchange traded options is their recorded amount.
The Company has made significant investments in its US operations, primarily in people, systems, technology and new office space. This investment represents a significant effort in a short amount of time to raise the quality of its infrastructure and personnel. As a result the Company’s operating costs have been increasing in the past year from historical levels.
The Company consolidates the Senvest Management LLC (formerly called Rima Senvest Management LLC), entity that serves as the investment manager of the Senvest funds. The portion of the expected residual returns of the entity that does not belong to the Company is reflected as non-controlling interest on the statement of financial position. This non-controlling interest is owned by an executive of the Company and totaled $80 million as at December 31, 2015 from $83.7 million as at December 31, 2014.
As part of an internal reorganization, in October 2015 the Company wound up its Senvest International LLC wholly-owned subsidiary and transferred significantly all of the net assets to a new wholly owned entity called Senvest Global (KY) LP. This new entity is now managed by Senvest Management LLC. As a result all of the employees of Senvest International became employees of Senvest Management. The results of Senvest Global will be consolidated into the accounts of the parent company the same way that Senvest International was.
At the end of December 31, 2015, Senvest had total consolidated assets of $2,146.4 million versus $2,020.1 million at the end of 2014. The main reason for this was the change in equity investments and other holdings. Equity investments and other holdings increased to $2,036.3 million from $1,770.5 million last December. The Company purchased $1,408.2 million of investment holdings in the year and sold $1,274.9 million of such holdings. Both amounts were more than the prior year. The Company’s liabilities have correspondingly increased to $1,290.1 million versus $1,198.4 million at the end of 2014 primarily because of the increases in due to brokers and liability for redeemable units. The proceeds of equities sold short were $1,834.5 million and the amount of shorts covered was $2,116.9 million in the year. Both these figures were more than the amounts for the prior year.
Items included in the financial statements of each of the Company’s entities are measured using the currency of the primary economic environment in which the entity operates (the functional currency). The functional currency of the parent company is the US dollar.
The Company has adopted the Canadian dollar as its presentation currency, which in the opinion of management is the most appropriate presentation currency. Historically, the Company’s consolidated financial statements have been presented in Canadian dollars, and since the company’s shares are listed on a Canadian stock exchange, management believes it would better serve the use of shareholders to continue issuing consolidated financial statements in Canadian dollars. The US dollar consolidated financial statements are translated into the presentation currency as follows: assets and liabilities – at the closing rate at the date of the consolidated statement of financial position; and income and expenses – at the average rate for the period. All resulting changes are recognized in other comprehensive income (loss) as currency translation differences. Equity items are translated using the historical rate.
Financial risk factors
The Company’s activities expose it to a variety of financial risks: market risk (including fair value interest rate risk, cash flow interest rate risk, currency risk and equity price risk), credit risk and liquidity risk.
The Company’s overall risk management program seeks to maximize the returns derived for the level of risk to which the Company is exposed and seeks to minimize potential adverse effects on the Company’s financial performance. Managing these risks is carried out by management under policies approved by the Board.
The Company uses different methods to measure and manage the various types of risk to which it is exposed; these methods are explained below
Fair value and cash flow interest rate risks
Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate as a result of changes in market interest rates.
The majority of the Company’s debt is based on floating rates which expose the Company to cash flow interest rate risk. The Company does not have a long-term stream of cash flows that it can match against this type of fixed debt, so it prefers to use short-term floating rate debt. The Company does not mitigate its exposure to interest rate fluctuation on floating rate debt. If interest rates spike, then the Company could enter into interest rate swaps or more probably just reduce its debt level. As at December 31, 2015, the Company has listed sufficient equity securities that it can sell to reduce its floating rate debt to zero.
Currency risk refers to the risk that values of financial assets and liabilities denominated in foreign currencies will vary as a result of changes in underlying foreign exchange rates. The Company’s functional currency is the US dollar. The following are the main financial assets and financial liabilities that have items denominated in currencies other than the US dollar: cash and cash equivalents, due from/to brokers, bank advances, equity and other holdings, real estate investments, other assets, equities sold short and derivative liabilities and accounts payable.
Equity price risk
Equity price risk is the risk that the fair value of equity investments and other holdings and equities sold short and derivative liabilities will vary as a result of changes in the market prices of the holdings. The majority of the Company’s equity investments and other holdings and all of the equities sold short are based on quoted market prices as at the consolidated statement of financial position date. Changes in the market price of quoted securities may be related to a change in the financial outlook of the investee entities or due to the market in general. Where non-monetary financial instruments ? for example, equity securities ? are denominated in currencies other than the US dollar, the price, initially expressed in a foreign currency and then converted into US dollars, will also fluctuate because of changes in foreign exchange rates.
Equities sold short represent obligations of the Company to make future delivery of specific securities and create an obligation to purchase the security at market prices prevailing at the later delivery date. This creates the risk that the company’s ultimate obligation to satisfy the delivery requirements will exceed the amount of the proceeds initially received or the liability recorded in the consolidated financial statements.
The Company’s equity investments and other holdings have a downside risk limited to their carrying value, while the risk of equities sold short and derivative liabilities is open ended. The Company is subject to commercial margin requirements which act as a barrier to the open-ended risks of the equities sold short and derivative liabilities. The Company closely monitors both its equity investments and other holdings and its equities sold short and derivative liabilities.
The impact of a 30% change in the market prices of the Company’s equity holdings with quoted value, equities sold short and derivative liabilities as at December 31, 2015 would be as follows (in thousands):
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