In today’s immensely expensive stock market, it is important to find non-correlated investments that are undervalued. In year nine of a bull market, we have no idea who out there is swimming naked. Tens of billions of dollars have piled into index funds, which pay zero attention to valuations. Many market participants are using increasing amounts of leverage to further turn investing into speculation. Housing prices have surpassed their 2007 highs, while wage growth has remained relatively timid. Unemployment is down, and lower corporate taxes are helping earnings on the positive side. Recent positive investing experiences have greatly diminished the miserable memories of the Financial Crisis. Many thought that those memories would prohibit the same risk-taking activities that led up to the crisis, but it is becoming increasingly clear that greed is as present as ever. On that basis, our focus at T&T Capital Management is on protecting and growing our clients’ hard-earned capital through intelligent investing.
“Our focus at T&T Capital Management is on protecting and growing our clients’ hard-earned capital through intelligent investing.”
One thing that I learned from reading Warren Buffett’s partnership letters was a strategy that he called “workouts.” When the stock market is expensive, Buffett would overweight his portfolio into special situations such as mergers that would have returns that are not highly correlated to the stock market. This allowed Buffett to post very strong returns during those early years, even on years when the overall market was negative. These investments discussed in this letter are our version of workouts. Our utilization of selling cash-secured puts further insulates us from just being 100% long stocks at current values, while still allowing us to be bullish on our favorite securities. This means having the willpower to not start speculating on overvalued stocks just because momentum has been working well. Many market participants don’t realize that if you own the S&P index right now at current valuations, there is a very real chance you could see a 25-35% loss on your money to get closer to fair value. That is incredibly risky, but because so many people are doing it, it doesn’t feel like risk. Our returns will come as price converges with value as will be the case for other market participants as well. I believe being 100% long the market will lead to considerable disappointment, which is why we are positioned very differently. One example of this is our investments in bond insurance companies and distressed bonds.
“Our returns will come as price converges with value as will be the case for other market participants as well. I believe being 100% long the market will lead to considerable disappointment, which is why we are positioned very differently.”
2017 was a nightmare for Puerto Rico and anything associated with the commonwealth, due to hurricanes on top of previous financial turmoil. I can tell you that I’ve spent an enormous amount of time and energy analyzing the financial and legal situation on the island and how things can play out. What is important to understand is that many of Puerto Rico’s problems stem from enormous corruption, fiscal irresponsibility, and an overall lack of transparency. Residents of the island will tell you that choice jobs are given out as political patronage, which leads to incredible inefficiency and waste. Puerto Rico has a very large black market and collections on taxes and billings on things such as electricity, are far lower than the mainland. Many of PR’s problems would be solved if they improved collections, reduced government waste, and increased transparency via posting all contracts online as required by Promesa law. That isn’t to say that Puerto Rico wouldn’t benefit from the rescinding of the Jones Act, which increases transportation costs, but that is relatively minor compared to the bureaucratic waste that permeates the government.
20-30% of Puerto Rico’s bonds are held by residents of the island. Almost all of the bonds are held by U.S. taxpayers. Populist politicians advocating for debt relief goes back at least as far as the Roman Republic, and I’m sure it goes back much further than that. Property rights are not a negotiable aspect of Western Civilization and laws must be respected. If you look at economies such as Venezuela and Cuba, which show little regard for property rights, you can see the devastation that this attitude causes. Without respect for laws and contracts, there won’t be the much-needed money to pay for new roads and energy projects that will be essential to fueling a stronger future Puerto Rico.
The situation is so bad that Puerto Rico hasn’t even published their 2015 audited financials, despite paying millions of dollars to major accounting firms to procure them. This isn’t because they can’t do it. They are attempting to be as evasive as possible to cloud the true economic picture. Puerto Rico is the only municipality that has increased spending after declaring bankruptcy. This would be proven by the release of audited financials.
“Puerto Rico is the only municipality that has increased spending after declaring bankruptcy.”
Fortunately, Puerto Rico’s true economic picture is actually showing pleasant and truthfully, unsurprising improvement. Tens of billions of dollars in federal stimulus is coming into the commonwealth as it is in other disaster-hit areas in the U.S. Another $15-25 billion should be coming in from private insurance. This money is being spent to rebuild homes, businesses, and infrastructure. Whether you look at data from major banks operating on the commonwealth or credit card processors, Puerto Rico’s economy is doing far better than just about anyone would have predicted, given the devastation caused by the hurricanes. If you are a passive observer that just hears about Puerto Rico via the news, you probably aren’t aware of these positive signs. As a negotiating tactic, the government of Puerto Rico and the Oversight Board do everything in their power to make things looks as dismal as possible.
“Whether you look at data from major banks operating on the commonwealth or credit card processors, Puerto Rico’s economy is doing far better than just about anyone would have predicted.”
The purpose is to reduce recoveries for creditors. Now the sole purpose of Promesa is to instill fiscal responsibility and to reinstate access to capital markets, but bizarrely, the Oversight Board has chosen to enable the government’s wasteful and corrupt ways.
• There have been numerous examples of bribery to reinstate electricity. This includes PREPA workers demanding free passes to a strip club to fix the electricity of the area.
• There was the discovery of over $6 billion in hundreds of accounts when the governor and the Oversight Board said they would run out of money in months, which proved to be absurdly false.
• There was also the discovery of a warehouse of brand new and much needed parts and supplies to fix the utility that weren’t being used.
Despite all of this drama, the tides are slowly starting to turn a bit.
In December, Puerto Rican bonds hit all-time lows with many trading at between 10-30 cents on the dollar. After doing strenuous research, we realized that this was likely a point of maximum pessimism. The legal claims that the bonds have is very strong on issuances such as General Obligation, sewer, and utility bonds. While it will take time to work itself out, we believe that many of these bonds are likely to double or triple in price. Starting in January, these bonds have rallied substantially and have been the top performing bonds in the market. Most bonds are down on the year due to higher interest rates, but an index of PR bonds is up 14% YTD. There is much more upside to go. Some of the bonds are up between 30-100%. We are far from peak optimism on Puerto Rico so returns should be quite good and importantly, they should not be correlated to the overall market.
“There is much more upside to go. Some of the bonds are up between 30-100%.”
Our other more significant investments with exposure to Puerto Rico are in bond insurance companies such as AGO, Ambac, and MBIA. These companies are deeply undervalued, and, in most cases, we have owned the stocks for years. Despite all 3 companies showing very positive signs, the stocks have yet to build sustained positive momentum. These are complicated companies with fairly small market capitalizations, so it is not unsurprising that most market participants don’t do the homework on them. I can tell you that the upside potential is over 100% on AGO and Ambac, and I have a high degree of confidence that we should see a lot of that realized in the next 2-3 years even if the overall market isn’t all that great.
“I can tell you that the upside potential is over 100% on AGO and Ambac, and I have a high degree of confidence that we should see a lot of that realized in the next 2-3 years even if the overall market isn’t all that great.”
The dirty work of dramatically increasing reserves for Puerto Rico is over. 2018 will provide a great deal more clarity on the major legal cases. I expect adjusted book value per share to grow for both companies this year and next year, which is not the market’s expectation based on the prices of the stock. As we are proven right, we should make really good money that should hopefully separate us from the overall market. These companies’ businesses aren’t reliant on a buoyant economy or stock market. They are special situations, which is a major attraction to us given our pessimism on the overall market.
Below is a Wall Street Journal article that outlines the strong performance of PR bonds YTD. Lastly, you may have received a form from TD Ameritrade to file claims regarding your ownership of PR bonds to be able to vote in a plan of adjustment, when one finally occurs. This is usually handled by the Trustee, but Peter and I are filling them out for everyone just in case to be on the safe side.
Thank you very much and as always if you need anything, please don’t hesitate to contact me directly at 805-886-8140.