Earnings Developments

Earnings season is finally getting close to winding up for the 4th quarter of 2017. It has been a busy couple of weeks for companies that we are invested in. Below you’ll find some updates on key positions. We are seeing a lot of market volatility, but I wouldn’t overthink things. Part of the drama is from reports that the U.S. will impose tariffs on imported steel. This is not anything that hasn’t happened before, and I wouldn’t expect it to lead to a real trade war by any stretch of the imagination, despite what the media will tell you. It certainly can impact companies like Boeing and CAT, but we don’t own those companies and feel that they are dramatically overvalued anyways.

AGO reported solid 4th quarter and full-year 2017 results. Book value per share grew to $58.95 per share, from $50.92 at the same time last year. Adjusted book value grew to a staggering $77.74, from $66.46 at the same time last year. That is 17% growth to the company’s most important metric. This performance was achieved despite the company adding materially to reserves for Puerto Rico. If you look at Warren Buffett’s annual reports, you will find a page which outlines book value growth with stock performance. On individual years, there are huge swings and divergence. Over time, the stock price and the fundamentals converge. I’m optimistic about our positions because the businesses are performing well and are incredibly undervalued, despite an overall expensive stock market. The stock has sold off a little bit since earnings after a decent rally, but I don’t see for any fundamental reason for the decline. It may seem odd, but a lower stock price actually benefits us long-term. The company will likely once again buy over 10% of its shares this year. The lower the price they buy the shares the more accretive it is to shareholders. Here is an article that goes into much more detail on our largest position: Assured Guaranty At 45% Of Adjusted Book Value Is Too Good To Ignore

AMBC reported a nice 4th quarter too. Most importantly, the company completed an exit to the rehabilitation of its segregated account. This company is a complicated investment that I intend to write a research report on in a few weeks. The key thing to know is that this exit will increase adjusted book value per share by $7, which is considerable. In addition, the company has bought large amounts of its insured bonds, which offer high yields and reduce long-term risk. The insurer is fully-reserving for its exposures but isn’t offsetting them with a reduction based on its extensive investment holdings of insured debt. The relevant part for investors is that it is very likely that adjusted book value is materially understated. The company has a large amount of cash at the holding company and huge potential upside as it resolves a few legal settlements, which it should most definitely win. Like AGO but even to a greater extent, Ambac is hardly covered by Wall Street and very few take the time to understand the company. We could see it double in value over the next 3 years.

Macy’s reported a fabulous 4th quarter and generated an enormous amount of cash flow. The stock has rallied considerably and now trades over $30 per share as I’m writing this. That is up from the high-teens late last year. Macy’s is a great example of a company that people like to consider as being completely dead, but when you look at the finances it is clear that the company is quite healthy. The stock still offers a 5.5% dividend that looks quite secure. Earnings are expected to grow in 2018, including comp sales, which would be the first year in quite some time that same store sales grow. We wrote the following article last summer when the stock traded around $21: Hold Your Nose And Buy Macy’s

Real Estate
Over the last 3-6 months, we have been adding positions in deeply undervalued real estate names. Earnings for this group have mostly been positive. We are obtaining dividend yields of 4.4-18% on these names. Real estate firms have seen pressure from rising interest rates, which can increase the cost of financing, and which also offers income alternatives to real estate. I believe those concerns are overdone in some specific names and I’ve been ecstatic to be able to buy quality companies at huge discounts to any conservative estimate of net asset value. Our investments vary from office buildings, multi-tenant, and malls. These stocks offer a minimum of 50% of upside potential in addition to the yields that we are getting. In 2000, when the stock market collapsed, real estate outperformed dramatically and posted great gains. They were laggards in the late 1990s. I see a somewhat similar dynamic as a possibility in today’s environment.

We are much less heavily invested in the banks than we were in years past, although they are still present in most portfolios. Earnings were very good across the sector. ALLY financial has been a big winner for us via stock ownership and sold put options. The company’s business continues to improve, and the valuation is still attractively priced. We wrote this article in April on Ally when the stock was trading around $20 per share. It has rallied to the high $20’s after hitting $31 earlier in the year: Ally Financial Has 50% Upside In Spite Of Auto Loan Issues

Citigroup & Bank of America
The other banks such as Citigroup and Bank of America are in great shape financially and future prospects are bright. With that said, the valuations no longer represent a massive discount to intrinsic value. When we built these formerly-huge positions, the stocks traded at prices where we couldn’t see a way that we would lose money. That is how we feel about our large investments now on stocks such as AGO and AIG. We still collect attractive and growing dividends, and, in most cases, we hold covered calls on these positions, which will enhance our investment income as the year progresses.

Optimistic on our investments
Hopefully these updates are helpful and I’m quite optimistic on our investments over the next couple of years, even though I’m definitely not optimistic on the overall equity or fixed income markets. Valuations in the S&P are the highest that they have ever been historically on an inflation-adjusted basis, except for 2000. We are clearly invested using a very different strategy to counteract these risks, but we feel the strategy will pay dividends both figuratively and literally as time goes by.

Thank you very much and as always, please let us know if you need anything at all!



Tim Travis