To view this letter in PDF Format please click here: 2021-Q4 PBCM Investor Letter.pdf
Welcome to our new investors and thank you to our existing investors and partners for their continued support. As the books close on 2021, we would like to take a moment and celebrate our firm’s recognition of two significant milestones. First, Pelican Bay Capital Management celebrated its three-year anniversary on November 1st, marking the inception date for our boutique portfolio strategies. Second, our firm ended the year with approximately $114 million in assets under advisement. As we reflect on these two achievements, we are even more enthusiastic about the future for our investors and our firm as we continue to grow and manage your capital with integrity and discipline.
Turning to results, our investment strategies performed very well in 2021. Both of our portfolios outperformed their relative benchmarks. The Concentrated Value portfolio finished the year up 33%, outpacing the S&P 500 and Russell 1000 Value indices. The Phoenix Fund was up 23%, Outpacing the Russell 2000 index. We will provide detailed analysis of each portfolio’s results in the pages that follow. The returns net of fees for each portfolio for the fourth quarter and full-year 2021 are presented in the table below.
This last year was an excellent time for investors as most asset classes produced positive returns as investors cheered the introduction of vaccines, significant monetary and government stimulus, and a strong rebound in economic activity. The first quarter was characterized with an explosion of “meme” stocks and initial public offerings of profitless tech stocks and SPAC’s. The S&P 500 marked 70 days of record highs in 2021 led by mega-cap tech companies (affectionately better known as FAANG stocks). However, with valuations stretched and market sentiment weakening, we are not anticipating a repeat performance in 2022.
In fact, we believe the market began transitioning to a new phase in November 2021 following the announcement from the Federal Reserve that they would begin slowing their accommodative monetary policies with an eye towards shrinking their balance sheet in 2022. The Fed is shifting their focus from battling the negative shock associated with the pandemic, towards fighting elevated levels of inflation that are far above their comfort levels. This change could present serious consequences for investors. It is not entirely surprising that November also marked the highs for expensive and/or speculative assets such as the technology-driven NASDAQ index, the Small-Cap Russell 2000 index, and crypto currencies such as Bitcoin. We believe investors are embracing a renewed focus on company-specific fundamentals including profitability, balance sheet strength, and most importantly, valuations.
Readers of our prior letters will know that we have been calling for more market volatility and a reversal of the investor euphoria we have observed over the past several quarters. The choppy market conditions that we have observed since November have carried into the new year. Equities have seen significant selling pressure with many of the major stock indices moving into correction territory (as measured by a decline of 10% from highs).
We believe our portfolios are well positioned for the current market environment and we are proactively managing risk levels should asset prices come under more severe stress. Because we deploy a “bottom’s up” investment philosophy that emphasizes company fundamentals and attractive valuations, it is conceivable that our strategies could benefit on a relative basis during this transitionary period for markets. While it is still early in the year, thus far our portfolios are outpacing their benchmarks year-to-date as of January 24th with Concentrated Value and Phoenix Fund down -0.7% and -2.6% respectively. Over the same twenty-four-day period, the S&P 500 has slide -7.5% and the Russell 2000 has fallen -9.4%.
As always, if after finishing this letter you have any questions or would like to discuss any topics in greater detail, please do not hesitate to call us at 239-738-0384 or send an e-mail to email@example.com. We welcome your feedback and look forward to your correspondence. Additionally, we encourage you to share this letter with as many friends and colleagues as you like.
We are pleased to report that for the full year 2021, the portfolio generated a total return of 32.8% net of management fees. This compares to the S&P 500 with a 28.7% total return and the Russell 1000 Value with a 25.1% return. Our outperformance for the full year was driven by stocks that benefited from the reopening of the economy following the pandemic in 2020. Areas of strength included energy companies, cruise lines, home builders and other consumer cyclicals. We had few detractors to performance with the exception of gold miners.
Turning to the fourth quarter, the portfolio increased 7.5% net of fees. Our performance was in line with the Russell 1000 Value index that returned 7.8%. However, we trailed the 11.0% return of the S&P 500 as mega-cap growth stocks did quite well in the quarter.
When we analyze the individual contributors to our results, there were no dominant themes in the quarter. Half of the stocks in the portfolio were up over 10%. However, we did see some weakness that we believe was a result of tax loss selling. Altice (ATUS), Fleetcor (FLT) and Fidelity Information Systems (FIS) were some of the few stocks with negative year-to-date returns heading into the November, making them popular targets for other investors looking to offset capital gains taxes. Cumulatively, these three names were a 2.2% drag on our performance. Below is a table of our top and bottom contributors for the fourth quarter.
As a reminder, we acquired our positions in ATUS and FIS at the tail end of Q3 (please see our Q3 Investor Letter available on our website for the detailed investment cases for both ATUS and FIS). It is not uncommon for new names to detract from performance in the subsequent quarter. This is because the stocks have typically been under-pressure prior to our purchase which is also what creates the opportunity to purchase them at what we believe is an attractive discount to our estimate of their intrinsic value. As tax-loss selling abated in the end of the 4th quarter, we chose to capitalize on the opportunity to add to ATUS, FIS, and FLT at even more attractive valuations.
The largest contributor to the quarter was Capri Holdings (CPRI). The company benefited from a blowout quarterly report in November as their restructuring initiatives have boosted their pre-tax operating margins back to 20%, a level not seen since Michael Kors first started having struggles in 2017. The business also benefited from an increase in luxury good sales. Despite the 34% appreciation in Q4, CPRI remains significantly undervalued at an 11x price to earnings multiple.
Toll Brothers was a winner once again returning 31% for the 4th quarter and 68% for the year. Home builders are benefiting from strong demand and pricing fundamentals. We believe the strong housing market should sustain for several years as the work-from-home trend persists and there is a significant deficit of homes following nearly a decade of underbuilding. However, the market believes the strength of the housing market will be short-lived as the stock currently sells for just 5.8x this year’s estimate of $10 per share in earnings.
Our other big winners in the quarter were CVS and Nutrien. Both are long-term positions that we have held since our inception. CVS benefited from elevated store traffic and revenue due to an increase in vaccine administration driven by the approval of Covid-19 Booster shots combined with a spike in both Delta and Omicron variants. Nutrien is the largest fertilizer company in the world with world-class potash mines and advantaged nitrogen production facilities. They also operate the largest retail agriculture supply network in both the US and Australia. The company benefited from higher fertilizer costs and elevated crop prices that are encouraging more planting.
Turning to trading activity in the quarter, we decided to exit our position in PG&E Corp (PCG) a regulated utility serving Northern and Central California. Our estimate of intrinsic value changed materially this fall after the Company announced intentions to bury all their electric lines in wildfire prone areas of their service territory (10,000 miles in total). The company estimates the cost of this endeavor would be between $15 and $30 billion. This compares to their current market capitalization of only $22 billion.
Given the safeguards and wildfire insurance mechanisms put in place following the prior year’s deadly wildfires, the cost-benefit analysis of this project to both the rate payers and shareholders does not make sense. Additionally, because of the animosity between PCG and their regulators, we are not confident that the utility would be allowed to earn a fair rate of return on this major investment. As regular readers of investment letters already know, when the facts change, we change too. Our $16-$20 estimate of intrinsic value for PCG could be seriously impaired if this mega-project advanced. Fortunately, we still managed a 15% profit in a little over a year on our average purchase price of $10.43 per share.
During the fourth quarter we initiated a new position in Rio Tinto PLC (RIO). The company is a global mining behemoth with a $120 billion market cap. RIO primarily mines iron ore, aluminum, and copper accounting for 65%, 21%, and 12% of revenues respectively.
Like oil and natural gas, metals prices have been depressed for most of the last decade. This was the result of too much new mining capacity being developed during the commodity super-cycle of the mid-to-late 2000’s. This excess capacity overwhelmed demand, resulting in a significantly oversupplied metals market. As prices declined, new projects were halted, high-cost mines were closed, and miners underinvested for the last eight years.
However, the metals market began to recover in 2020 as global growth boomed following the pandemic. Additionally, demand for metals has accelerated above prior trendlines dur to the transition to electric vehicles and clean energy initiatives. The metals market has quickly flipped from an oversupplied condition the last decade to an undersupplied position now. Market prices for commodities such as copper, aluminum, and iron ore have risen accordingly. Given the multi-billion-dollar price tag and multi-year period required to develop new mines, we believe these markets could remain undersupplied for several years. RIO is poised to be a major beneficiary if this scenario unfolds.
More importantly, we believe that RIO meets many of the criteria we seek out in investment candidates. The company has generated a return on invested capital of approximately 16% over the last 5 years as management maintains a disciplined capital allocation strategy. They also benefit from owning mines on the lower half of the cost curve for the respective commodity, which gives RIO the capability to earn windfall profits in good years and still earn their cost of capital in bad years. The balance sheet has a net cash position (a rarity for a miner) with $16.9 billion in cash and $14.9 billion in total debt. This is a significant improvement from their $14 billion net debt position just five years ago. The company is also returning significant cash to shareholders and their stock has generous 10% dividend yield.
We estimate that normal earnings power is between $5-$8 per share. Amazingly, RIO is experiencing windfall profits this year and analysts estimate they may earn over $13 per share in 2021. We believe a 12-15 multiple is appropriate for RIO, resulting in an intrinsic value of $60-120 per share. We initiated our position at $66 per share. If commodity prices remain elevated near current price levels for a sustained period, our estimates of earnings power and intrinsic value will prove to be far too low.
Lastly, we wanted to revisit the Investment Philosophy of the Concentrated Value Portfolio. We utilize a value investment strategy that seeks out companies for investment which the Portfolio Manager deems to be high quality companies. Quality is defined by possessing business operations with durable competitive advantages, allowing for high returns and growing cash flows streams. We want these high-quality companies to also have solid balance sheets, preferably with a net cash position. We also prefer that their management teams make decisions with an emphasis on maximizing shareholder returns.
Once we find these high-quality companies, we generally only invest in their stock if they trade at a steep discount to our estimate of their intrinsic value. This is necessary to provide our investors the opportunity to generate an above market return and protect capital. This discipline creates a wide margin of safety if an undesirable scenario plays out in the future. Pelican Bay Capital Management believes that identifying a significant difference between the daily market value of a security and the intrinsic value of that security is what defines an investment opportunity.
Please note: The Phoenix Portfolio is only available to “Qualified Clients” pursuant to section 205(e) of the Investment Advisors Act of 1940 and section 418 of the Dodd-Frank Act.
The fourth quarter results for the Phoenix Fund were a tale of two halves. From October 1st through November 12th the portfolio quickly gained 12%. For the remainder of the quarter the portfolio slowly surrendered these gains as the market went into a “risk off” mode. The Phoenix Fund finished the quarter flat with a marginal -0.25% loss. Our Benchmark, the Russell 2000 had similarly disappointing results with a small gain of just 2.1% for the fourth quarter. However, for the full year the Phoenix Fund performed very well with a 23% return net-of-fees. This is a strong result on an absolute basis, but was also more than 8% ahead of the Russell 2000’s 14.8% total return for 2021.
Despite the flat results, the portfolio experienced a lot of volatility across individual names with big winners and losers. In particular, RR Donnelley (RRD) and Urban One (UONEK) had significant moves. Unfortunately, they were in opposite directions. Our top 5 and bottom 5 contributors to returns can be found in the table below.
For the last two quarters, Urban One had been the largest contributors to our return and had grown to be the largest holding in our portfolio. In November, the company lost a referendum in Richmond, Virginia to build a new Casino. We believed the Casino when completed was worth $8-12 per share in value to Urban One. However, the company narrowly lost the referendum as a surge in Republican voter turnout to support the contentious Governor’s race which ultimately doomed their effort. Shares fell from $7 to $4.50 the next day and we chose to exit our position, as the remaining business was worth less than $4 per share. This share price decline dragged the portfolio down by -4.3% for the quarter.
The election result was disappointing and hurt our Q4 results, but our ownership of Urban One was ultimately a very profitable investment. We acquired our shares for $2.12 in April of 2021 and exited at $4.47 in November for a 111% gain.
On the other side of the spectrum, RRD’s stock price jumped 80% this quarter as a bidding war for the company broke out after an activist investor (Chatham) made an unsolicited stalking-horse bid of $7.50 per share. A few weeks later, their management accepted a bid from a private equity firm for $8.52 per share, and Chatham counted with a bid for $9.10. Despite the higher bid from Chatham, we thought it was possible that management might move forward with the lower bid as they had a contentious relationship with the activist investor. We exited our position in Q4 for an average price of $9.29 per share, a premium to latest acquisition proposal.
Like Urban One, RRD was also an enjoyable experience for our investors. We acquired our shares in March 2021 for an average price of $4.30, representing a 116% total return over a nine-month period.
In addition to our sales of Urban One and RRD, we also exited our positions in PG&E Corp (PCG) and Kinross Gold (KGC). Our rationale for selling PCG can be found in the Concentrated Value section above. We made the decision to sell Kinross after management announced an acquisition that was destructive to value.
One of the central tenants of our investment case with Kinross was that their management team had exercised a very disciplined capital allocation strategy since they joined the company several years ago. In December, Kinross announced plans to acquire Great Bear Resources for almost a 100% premium to where the stock had been trading for most of 2021. Moreover, Great Bear owns undeveloped resources and Kinross would have to invest substantial CAPEX to bring their mines online. Considering that Kinross’ own shares were trading for a 50% discount to our estimate of fair value, that money would have been much better spent buying back their own shares. We made the decision to move on for a small profit.
Two of the other top five winners this quarter were new investments in the portfolio: MoneyGram (MGI) and Verano Holdings (VRNOF). MoneyGram was the second-best performer in the portfolio as the stock price appreciated 34% since our purchase.
MoneyGram is in the money transfer business that primarily facilitates the remittance of cash across international borders; often involving migrant workers sending money back to their family members in their home country. MoneyGram is the smaller player in what until the last few years had primarily been a duopoly with larger peer Western Union. These companies had traditionally provided payment services through a network of agents and took 3-7% of the value as a fee.
Despite being the smaller player, MoneyGram has taken a substantial lead in the transition to digital transfers that reduces the need for an agent intermediary on one or both sides of the transfer transaction. This allows MoneyGram to keep a higher portion of the 3% transfer fee, which has resulted in EBITDA margins moving from 10% up to 17-18.5%. The elevated profitability has also caused a significant boost to free cash flow. The digital business currently represents 25% of revenues and is growing 40% annually. As more legacy business moves to the digital network, margins could increase to 20% or higher. Additionally, should interest rates increase, MoneyGram will be able to realize higher interest income on their cash float, which has effectively been zero for the past decade.
MoneyGram is also benefiting from several other tailwinds. Most importantly, in April they concluded their deferred prosecution agreement for prior violations of money laundering laws. Free of prosecutorial oversight, MoneyGram has been able to forge new partnerships with other financial intermediaries. For example, they have signed a new deal with Visa for transfers to debit cards.
Additionally, MoneyGram has formed a new partnership with Stellar and Circle that allows for an immediate transfer of cash to and from stable-coin cryptocurrencies. This compares to the typical crypto transaction process that could take 4-7 days to purchase crypto and move back to fiat currency. The MoneyGram solution represents the fastest way to move in and out of crypto and fiat currency. Their solution also has lower fees than more poplar crypto exchanges like Coinbase. While this business in its infancy and we give it no credit in our valuation, it is a nice call option that could represent real value in the future.
We believe MoneyGram has the potential to generate $100-$150 million in free cash flow annually over the medium term. When we purchased our shares for $5.70 in November, the company had a market cap of just $500 million and enterprise value of $1.2 billion. We believe shares are worth $10-$15 each. Insiders agree as they have been heavy buyers of the stock in the past few months. In mid-December the stock jumped to $8 as rumors of a buyout from a private equity firm began to circulate.
Verano (VRNOF) is a leading Multi-State Operator (MSO) in the emerging US cannabis market. They are a vertically integrated producer and retailer of adult-use and medical branded cannabis products, with operations in 14 states.
After studying the industry, it became clear to us that Verano is the best operator amongst the public MSOs. They have the highest margins, least levered balance sheet, and what appears to be the best management team in the industry. Management has shown more discipline when allocating capital and acquiring growth. Most importantly, we believe their strategy of only pursuing operations in states that are legalizing marijuana utilizing a limited-license model has resulted in their superior financial performance relative to peers, many of whom are still losing money.
The granting by the government of a small, limited number of operational licenses to cannabis dispensaries in affect creates an oligopoly structure in these states that results in less price competition, elevated sales throughput per location, and higher profit margins. More States going down the path of legalization are electing this limited-license model, as it gives them more control of regulatory oversight, minimizes the market share retained by the illicit black market, and maximizes tax revenues. Early on during the push for legalization, states initially pursued an open competition model without limits on operators or locations. Unfortunately, these cannabis markets have not developed in a positive manner as tax revenues fell short of forecasts and illicit players continue to dominate the market share. Having a dispensary on every corner also creates its own negative societal issues. Dispensaries with large operations in states without licenses such as California, Oregon, and Colorado have not been able to generate profits.
Verano by contrast has been able to generate gross margins of 60% and adjusted EBITDA margins of 45%. Sales are growing rapidly with expected growth of more than 50% in 2022 versus 2021. The company is financing their growth from operating cash flow and the balance sheet carries only $158 million of net debt (EBITDA is $358 million). Frankly, the financials look more akin to a fast-growing software company than a cannabis retailer. Yet despite this rapid growth and high profitability, shares are currently trading for just 8-12x our estimate of normal earnings power over the next 3 years. We think Verano could generate normal earnings power of $1.00-$1.50 per share. We believe the stock is worth $20-$30 per share, and we acquired our position for $12.25. Additionally, should federal legislation pass that cannabis companies to access banking and capital markets, we believe the rush of institutional money into the industry could drive shares well above their intrinsic value. As it stands today, most money managers can’t own shares in Verano, which is one reason they trade at such a large discount to our estimate of fair value.
In addition to adding MoneyGram and Verano to the portfolio, we also initiated a new position in Loan Depot (LDI) at the very end of the fourth quarter. Loan Depot is the second largest direct-to-consumer non-bank retail mortgage underwriter. The company has grown quickly over the last two years as they increased marketing spend during the wave of refinancing associated with low rates during the pandemic. They have boosted their market share from 2.0% to 3.5%, representing quarterly loan volumes of approximately $30 billion. Besides more marketing spend, the company has also increased their wholesale partner channel that is increasing their sales funnel.
Most importantly, Loan Depot has rolled out a digital underwriting product for the retail market called Mello that is similar to Rocket Mortgage’s offering. The digital mortgage software provides two major benefits. First, consumers prefer the ease of applying and submitting documentation through the digital app. Second, it lowers underwriting costs while also increasing the percentage of loans closed, a critical metric for financial performance. We believe that Loan Depot and Rocket Mortgage’s digital technologies are well ahead of competitors, and both should continue to take market share from other underwriters.
The company makes most of its revenue from reselling mortgages it underwrites and generating a gain on these sales. They have also launched a new initiative to retain mortgage servicing rights, which has quickly added a second revenue stream that is steadier than the traditional underwriting business. Revenues for 2021 will be approximately $3.7 billion, with 90% coming from gain on sale of mortgages.
The mortgage market is benefiting from a boom in refinancing due to the low rates driven by the Fed’s super accommodative monetary policies. Loan Depot should earn almost $2 in EPS this year. We believe normal earnings are closer to $1.00-$1.70 per share as industry underwriting volumes decline and Loan Depot increases their market share to 3.5-5.0%.
We acquired are shares at the end of the year for just $4.63 per share, representing a 2.7x-4.6x multiple of our estimate of normal earnings. This doesn’t make much sense to us. To put this in context, Rocket Mortgage trades for 10x next year's EPS. We believe Loan Depot should trade for a similar multiple which would represent a stock price $10-17 per share. Loan Depot came public in February of 2021 at $14 per share and jumped as high as $31.
The stock has been falling for most of the year as investors fear that mortgage volumes are unsustainably high and will revert to lower levels in the medium term. We agree with the notion that underwiring volumes will decline and we have incorporated lower volumes into our estimates of normal earnings power. However, we believe the market is being overly pessimistic, and tax loss selling at the end of the year is leading to additional negative selling pressure as the stock has fallen 41% from November 1st. We believe the downside to earnings might be $0.50 in the event the mortgage market comes to quick halt and Loan Depot isn't able to adjust their cost structure in a timely manner. But even then, if shares traded for a 10x eps multiple, shares would be worth $5; above today’s price of $4.60, giving us plenty of margin for error in our analysis. In the meantime, we will enjoy a 6.8% dividend yield while we wait for shares to close the gap with our estimate of intrinsic value.
Finally, we wanted to revisit the investment philosophy of the Phoenix Fund. The portfolio takes advantage of structural biases against institutional ownership of financially levered companies with low-stock prices. We seek companies that have had their stock prices fall 70% or more in the last two years and are priced below $10 dollars per share. This outcome typically leads to forced selling from their institutional shareholders, creating the opportunity to make outstanding investments for less constrained investors.
Generally, these companies are under distress from poor performance caused by what we believe are temporary factors. These companies typically have elevated levels of debt, and any prolonged period of business stress could cause stockholders to endure substantial losses. The Phoenix Fund is a high-risk, high-return investment strategy. Please see the Risk of Loss Section of Part 2A of Form ADV referenced below.
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In closing, we would like to thank our investors for their continued support. We also want to extend a warm welcome to our new investors. We are looking forward to the future and achieving your investing goals with integrity and discipline.
Tyler Hardt, CFA
This letter is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions.
We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time.
Hypothetical performance has many significant limitations, and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.
For more information, please see Part 2A of our Form ADV available on the SEC’s website at www.adviserinfo.sec.gov. You may also request a copy from Pelican Bay Capital Management by e-mailing us at firstname.lastname@example.org.
Additional information about Pelican Bay Capital Management, LLC also is available on the SEC’s website at www.adviserinfo.sec.gov.