To view this letter in PDF Format please click here: 2021-Q2 PBCM Investor Letter.pdf
We would like to begin by welcoming our new investors to our funds and thanking our existing investors for their continued support. We are pleased to report our returns for the second quarter of 2021. We built on our positive results in the first quarter as the market continued to display a wide dispersion in performance across sectors and individual stocks that we believe have benefited stock-pickers like us.
The results for each portfolio for the second quarter and year-to-date are presented in the table below.
While it is early in the third quarter, we have seen many of the beneficial tailwinds driving our recent performance carry over into July. We believe our portfolios are well positioned for the current market environment and we are proactively managing risk levels should asset prices come under pressure. After strong gains for equities in the first half of 2021, we would not be surprised if markets got choppy in the third quarter.
The layout of this quarter’s letter will start with a general market commentary, followed by individual reviews and analysis of each of our portfolios including Concentrated Value, Dynamic Income Allocation, and the Phoenix Fund.
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.
Asset valuations continued their unrelenting march higher in the second quarter with U.S. equity markets achieving new all-time highs. The S&P 500 finished the quarter at 4,300 points, representing a 15.3% total return year-to-date, and well ahead of many predictions at the start of the year. Bonds also performed well as interest rates moderated, following the sharp rise in yields experienced in the first quarter, and corporate spreads continued to tighten. The high yield spread fell to a record low of just 2.9% above “risk-free” treasury rates.
Despite most asset classes finishing the quarter with respectable returns, it was very much a tale of two distinct periods. The reflationary or “re-opening” trade that had driven markets in the first quarter continued to influence the market through April and May. Value oriented stocks with exposure to the energy, cyclical, and financial sectors led the markets higher in this period. Similarly, commodities continued their run with copper and lumber reaching all-time highs.
However, in June we saw these trends reverse as value stocks fell and growth stocks rocketed higher, closing much of the gap of their relative underperformance thus far in 2021. Growth stocks outperformed value stocks by a spread of 7.9% in June. This marked the worst month of relative performance for value versus growth since 2001 according to data from Bloomberg.
One month certainly does not make a new trend, nor herald the end of the reflation trade. We think it is more likely that this is a temporary pause following value’s strong period of outperformance since November of last year. We would also point out that pullbacks like these are quite common during these transition periods. As you can see in the chart above, the last time we saw a reversal like this was during value’s strong rebound between 2000-2003, following the collapse of the internet bubble. As we have said in prior letters, we believe there are a lot of similarities between today’s frothy markets and the period surrounding the late 90’s tech bubble.
The pause in the “reflation trade” in early June came after the Federal Reserve meeting where policymakers succeeded in persuading markets that inflation would prove “transitory”. Additionally, some members of the Fed took an unexpected hawkish stance. They indicated the Fed could start tapering their accommodative policies as early as next year. Interest rates on 10-year treasuries immediately fell from 1.65% to 1.45%, the yield curve flattened, and commodity markets fell sharply.
While the market’s strong reaction to the Fed’s pronouncements struck us as misplaced, it clarified one major assumption for us. The future path of inflation will likely be a key theme for investors and the dominate driver of asset values in the coming quarters. The market’s response to the Fed’s statement appears to endorse their forecast of transitory inflation pressure. Conversely, we would not be so quick to discount the probability of a sustained inflationary environment.
Recent Levels of Elevated Inflation May Not Be Transitory
To be certain, we are not macroeconomists. We do not make any attempts to forecast future inflation rates or economic growth, as we believe it to be a futile exercise. None the less, we do think about a variety of future potential economic outcomes that may unfold, and how these various scenarios could likely impact our investments. For example, will economic growth be mid-single digits, low single digits, or negative? Will we experience inflation or deflation? Will interest rates continue their secular decline or reverse course and enter a new phase of increasingly higher rates?
While no one knows what the future holds, we can make educated guesses about the probability of each of these various scenarios unfolding and update these probabilities as new information becomes available. We can also deduce the market’s potential views on these matters by observing existing asset prices and interest rate movements.
For example, the recent market strength in growth stocks and shrinking treasury yields suggest that the market may be pricing in a short period of transitory inflation followed by a return to our prior environment of low growth, low interest rates, and no inflation. In other words, the status quo of the prior decade’s macroeconomic environment. This should not be surprising as this is what the Fed and popular financial press are largely conveying to the public.
But our observations of the incoming data suggest that the probability of the “status que” outcome of low growth and low interest rates is decreasing, and the potential of sustained levels of higher inflation are rising. Most importantly, recent data from various government reported price measures reveal that inflation is currently running at concerning levels around 4-8%. The U.S. has not experienced inflation readings this high since a brief period in the summer of 2008 and a more sustainable period in 1988-1990. The table below shows the key measurements of prices reported by government agencies between January and May of this year.
The most recent readings from April and May are significantly above many estimates and forecasts from the beginning of the year. More importantly, these figures widely exceeded the Fed’s own estimates from their March meeting where they had forecast PCE Inflation (their favored measure of inflation) would be between 2.2-2.4% in 2021. We believe the large gap between recently reported numbers and their earlier forecast is what led to the Fed’s surprisingly “hawkish” tone following their June meeting.
The Fed has responded that they are confident these troubling inflation indicators - which were almost double their “expert” forecast - will ultimately be transitory due to “base effects”. We agree that “base effects” associated with large disparities in year-over-year prices swings due to the economic shutdown and reopening are partially responsible for elevated inflationary readings in the second quarter data. This is a common occurrence when economies exit recessions and consumer demand temporarily rebounds ahead of a cautious supply response.
However, we would question the Fed’s confidence that inflation readings will moderate as soon as the second half of 2021 as these “base effects” wear off. Firstly, the Fed’s inability to foresee the recent surge in prices should raise doubts about their capability to forecast near-term inflation. They significantly under-estimated inflation for Q2 and may be doing so again in their second half 2021 forecast. Secondly, many recent data points and qualitative observations suggest to us that it is likely that future inflation readings could persist at elevated levels even as “base effects” lessen. These key datapoints are housing price gains and employee wage increases.
In our estimation, the primary factor that could lead to sustained readings of elevated inflation is the recent strength of the housing market. Changes in the price of housing or shelter account for 32% of the CPI index and 16% of the PCE index. The input prices for shelter in both indices are estimates provided by the staff at the Bureaus of Economic Analysis and Labor Statistics. This method of calculation is unique as most other categories in the CPI and PCI indices are tabulated using real-world observed prices from surveys of retailers and service providers. This increases the chance for errors and human bias.
Additionally, the use of estimates versus observed prices in the real economy has resulted in lags between reported housing market data and their corresponding estimates incorporated in both the CPI and PCE. Recent inputs for housing inflation in the CPI and PCE appear to be materially under-reporting real world conditions. For example, the Bureau of Labor Statistics has calculated that the year-over-year change in owner equivalent rent was 0.7%, 1.0%, 1.6%, and 2.1% for the months of February through May.
Of course, these figures seem laughably low considering the huge gains in housing prices we have experienced this year. The US is currently undergoing a major housing boom. The Case-Shiller National Home Price Index reported year-over-year increases of 11.3%, 12.1%, 13.3% and 14.6% over the same period (February-May). Surveys of rental rates saw similar increases. The Census Bureau’s Asking Rent Index calculated a year-over-year increase of 18% in the first quarter of 2021 (please note their Rent Index is only released quarterly), while median national rent climbed 9.2% in the first half of the year according to Apartment List.
Sooner or later the modest increase in housing-related inflation being reported in the CPI and PCE will catch up the reality of a surging home and rent prices. With shelter prices representing large inputs in the calculation of the overall indices, it is possible that rising calculations for shelter could by itself support a continuation of elevated inflation figures though the fall and into early next year.
The other economic factor contributing to the specter of persistent inflation is the recent jump in labor costs and wages. Because wages tend to be “sticky” to the upside, they are seldom characterized as “base effect” inflation. Simply put, employees tend to react negatively to salary or hourly wage decreases by quitting or decreasing their efforts. Therefore, it is highly uncommon for a company to carry out pay cuts, particularly after instituting pay raises. More often wages stagnate rather than decline, thus they are “sticky” or upwardly biased.
Like home prices, wages and salaries also experienced accelerated gains in the first half of the year. The number one complaint we hear from companies is that they can’t find qualified labor and they need to boost salaries to compete for available talent. Major US employers have made public announcements dramatically increasing employee pay. Below is a sample of some recent announcements on hourly pay raises.
- Target increasing starting wage to $13-15.
- Starbucks giving 10% wage boost to all employees.
- Costco boosting minimum wage to $16 and average to $25.
- Walmart increasing minimum wage from $11 to $15.
- McDonalds increasing minimum wage from $11 to 17.
- Bank of America increasing minimum wage to $25.
- Amazon increasing minimum pay to $15.
- Chipotle increasing starting pay to $14-18.
According to the Bureau of Labor Statistics, as of June, the total U.S. labor force is still 7.1 million jobs shy of pre-pandemic levels. None the less, the labor market appears to have tightened dramatically in the first half of 2021. According to the Bureau of Labor Statistics, job openings are at an all-time high of 9.3 million positions. This compares to their estimate of 9.5 million total unemployed workers in the US. Which begs the question, why can’t companies fill these positions without resorting to large wage increases and signing bonuses?
This has surprised many observers as there is typically significant slack in the labor force following recessions. It is difficult to assign causation to the tight labor market. We have heard economists propose several rationales including excessive supplemental unemployment benefits, fears of workers contracting covid, need for childcare when schools are closed, and accelerated retirements. Each of these factors will slowly resolve themselves and we would expect that more workers will return to the labor force, easing the current tightness. However, this could take several quarters or perhaps longer. Year-over-year wage increases may sustain at levels above 3% resulting in upward pressure on inflation indicators as businesses seek to pass on these higher costs via price increases.
Despite falling interest rates and a return of growth-stock momentum, we think it is far too early to declare that inflation will prove “transitory”. The Fed has indicated that inflation will fall back to 2% in the second half of this year. Unfortunately, as we just described above, there is growing evidence that inflation could remain elevated near current levels of 4-8% into early 2022. The longer that this “transitory” period of higher inflation persists, the greater likelihood that future inflation expectations will rise. This could cause a negative feedback loop where businesses feel more confident to raise prices and labor demands even higher wages to sustain their purchasing power. The consequences of this outcome would likely result in higher interest rates and lower valuations for many stocks and bonds.
Ultimately, we believe that it is unrealistic to assume that our economy can be shut down for several months and trillions of dollars can be conjured out of thin air without any negative repercussions. History is replete with similar examples, and in each of these instances the bill always comes due.
The total return for the Concentrated Value portfolio was 4.0% in the first quarter, bringing our year-to-date return to 26.7%. We trailed the S&P 500 this quarter, primarily because of the strong performance of large-cap growth stocks, a sector where we currently have no exposure in our portfolio. However, for the year-to-date period we remain well ahead of the S&P 500’s 15.3% total return. Our portfolio continues to benefit from the “reopening trade” that emerged in November of last year. Economically sensitive stocks such as energy and consumer cyclical stocks were once again a source of strength.
Our energy holdings represented slightly more than half of our gains this quarter with the sector contributing to 2.4% of our total return of 4.0%. Diamondback Energy (FANG) is the second largest holding in the portfolio and was simultaneously our best performer in the quarter. The stock price increased 26% leading to a contribution of 1.8% of our total return. After the second quarter, we trimmed our position in FANG to a more moderate position size as the price had increased to the upper end of our estimate of its fair value range.
Similarly, EOG Resources (EOG) - the largest shale oil player in the US – saw its stock gain 13.5%. Despite this appreciation, EOG continues to demonstrate a healthy valuation discount relative to other U.S. shale drillers. We would expect to see this valuation gap continue to close as the company has lower operating costs than the industry, better acreage, investor friendly capital allocation policies, and arguably the best management team in the industry. EOG should not be trading at a discount to its peer group. We believe shares are worth $90-$100 when factoring in current oil prices. This represents an attractive potential upside from the current price of $80. In hindsight, our decision to swap our position in Texas Pacific Land (TPL) for EOG turned out to be successful – at least in the short-run - as TPL’s stock was flat in the second quarter.
We are still believers in the potential for even higher energy prices for the remainder of year as covid-impacted economies continue to reopen and normal transportation activity resumes. Our analysis suggests anywhere from 3-4 million barrels of pre-pandemic oil production capacity has been materially impaired and can’t be brought back to the market for years. Moreover, evidence continues to mount that global oil demand is on track to rebound to pre-pandemic levels by as early as the fourth quarter of this year. Oil inventories have already fallen below their five-year average in developed markets. Should oil demand recovery to 101 million barrels per day, the world oil market will be materially undersupplied. The estimated oil supply shortage combined with already normalized inventories could drive crude oil prices much higher in the coming months. As we wrote in our January investor letter, we believed energy stocks could be one of the best performing stock sectors in 2021. At the halfway point, we have seen this play out.
The second largest contributor to our quarterly results was Capri Holdings (CPRI). Capri was our largest holding coming into the quarter and its stock appreciated 11% and contributed 1.2% of our total return. The company continues to see improving financial results as consumer demand for luxury apparel and accessories have skyrocketed because of the economic reopening and generous stimulus payments. Their business also continues to benefit from management’s restructuring initiatives put in place prior to the pandemic. Their inventory levels remained healthy throughout the crisis, and they have been able to expand gross margins from 60% pre-covid up to 65% post-pandemic. We believe the shares could be worth as much as $75. Capri’s stock is currently $54.
Utilities continue to be our largest source of weakness as PG&E’s share price continues its downward momentum. Their stock price fell 14% in the quarter. We believe PG&E shares remain significantly undervalued as they currently trade for just 10x our estimate of their normalized earnings power of $1.00-$1.20 per share. This is despite their regulated-utility peers trading nearly twice that much at 19x forward earnings. We are not alone is this view as the average analyst price target for the company is almost $15. This would represent almost a 50% return should the stock appreciate to this level.
Investors are avoiding PG&E following its emergence from bankruptcy due to the astronomical damage claims for igniting wildfires several years ago. Post-bankruptcy, California legislation has improved by limiting the size of future wildfire liabilities to more reasonable levels. Based on the legislation, we believe that PG&E’s wildfire risk is capped at $2 billion unless they are found grossly negligent.
PG&E has also improved their operations and wild-fire mitigation strategies through accelerated tree pruning initiatives and pre-emptive blackouts. They had no major wildfire incidents in 2020 or thus far in 2021 despite dry fire-prone conditions in their service territories. We believe the market is penalizing the company too much and not carefully considering the favorable post-bankruptcy wildfire litigation regulations. We added to our position in the quarter.
We found no new attractive investment opportunities this quarter and this should not be surprising to our investors as the S&P 500 is making all-time highs. We continue to monitor several companies that we believe could make attractive investments should they fall to more appealing valuation levels. With 19 positions in the current portfolio, we have the cash and capability to add one more name.
Most of our trading activity this quarter consisted of trimming our position in Capri Holdings as its weight in the portfolio became too large following a run-up in valuation. We reinvested the proceeds from Capri, as well as dividends received from other investments, into some of our names that remain undervalued. The only stock we own that we believe is nearing the upper end of our fair value estimates is Diamondback Energy (which we trimmed in July). We have plenty of existing holdings with attractive investment characteristics where we can reinvest our excess cash should we not have the opportunity to add a new position soon.
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.
Dynamic Income Allocation
We were pleased with the risk-adjusted performance of the Dynamic Income Allocation Portfolio (DIAP) this quarter. The total gain for the DIAP including dividends was 3.3%. The portfolio generated low levels of realized volatility with average daily moves of just 0.05% and a daily standard deviation of 0.36%. Despite a return of just 3.3%, which trailed the S&P 500, the portfolio delivered a Sharpe Ratio relative to the S&P 500 of 2.3x.
The portfolio has now demonstrated 5 straight quarters with a Sharpe Ratio greater than 1.5x the S&P as we delivered positive returns with low volatility. Since April 1st, 2020, the DIAP has achieved a Sharpe Ratio of 2.03% when compared to the S&P 500. We believe the changes we made to the portfolio construction methodology in the first quarter of 2020, particularly new rules around position weights for smaller asset classes with higher idiosyncratic risks, have enabled us to deliver these results. We are enormously proud of this performance, and we believe we have delivered on our mandate of providing elevated income while minimizing volatility.
We have made no changes to our target allocation this quarter. We are maintaining our portfolio’s tilt towards the “reflationary” trade. This includes a lower exposure to fixed-income assets and a 25% weight towards international non-dollar denominated asset classes. We also continue believe income will become more important as interest rates fall in the near term, and our holdings should perform well if the current decline in treasury yields persists.
Turning to performance, Mortgage REITS (REM) were the top returning asset class. This is the third quarter in a row where these assets generated the largest returns. Our Mortgage REITs gained 7% contributing to 0.35% of the quarter’s total gain. Mortgage REITs were tremendously undervalued at the time of our purchase, and we believe they are poised to benefit from a potential steepening yield curve and continued economic recovery. After a long period of outperformance, we would not be surprised if mortgage REIT’s surrender their lead versus other undervalued asset classes.
Our position in US Dividend Stocks (VYM) was the largest contributor to our total return with 0.9% impact to the portfolio. However, the absolute return of VYM lagged other assets in the quarter as the value-oriented stocks surrendered earlier gains in June. Conversely, our non-U.S. high dividend stocks (EFAV) picked up the slack as European value stocks outperformed their U.S. counterparts in the second quarter. Our Non-U.S. equity assets returned 5.2% in the second quarter, with a contribution to the portfolio of 0.75%. Emerging market bonds (EMB) also recovered following their weakness in Q1. The performance of each asset and its contribution to the portfolio can be found in the table below.
The only real laggard in the quarter was our TIPS spread asset class (TIPS are US treasuries with coupons indexed to CPI inflation). As inflation concerns and volatility declined in June, the IVOL ETF fell 2.5%, resulting in a 0.12% reduction in the portfolio’s total return. Otherwise, our utilities (VPU) were marginally down and had negligible impact on the portfolio’s results.
The current yield on the DIAP stands at 3.7% as of this writing. The dividend yield for the DIAP remains at a healthy premium to US treasuries which are currently yielding just 1.4%, representing a 2.3% spread over treasuries.
Lastly, it is important to reiterate the investment philosophy of the Dynamic Income Allocation Portfolio. The DIAP is designed to function as the core foundation of an investor’s portfolio by operating with the dual mandate of generating the highest current income possible while preserving capital.
Pelican Bay Capital Management attempts to achieve this dual mandate by only investing in asset classes that by themselves offer a current dividend yield that is greater than either the dividend yield of the S&P 500 or 10-year U.S. Treasury. In our view, elevated income can add stability to a portfolio and maximize the benefits of compounding through reinvestment.
We then construct a portfolio of these high-yielding asset classes with an emphasis on minimizing correlation of the overall portfolio and maximizing its diversification beyond the typical 60/40 stock/bond portfolio. We finally add a valuation overlay that we utilize across all our portfolios. We allocate a larger position weighting to the most undervalued and attractive investment opportunities, while avoiding owning overpriced assets.
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 Phoenix Fund had a total return of 5.9% this quarter. The entirety of our quarterly return was driven by a single stock, Urban One, that increased 138% and added 8.3% to the portfolio return. Conversely, our equity hedges were the primary offset to the large gains in Urban One. The remainder of the portfolio was choppy with equal wins and losses. Our top 5 and bottom 5 contributors to return can be found in the chart below.
The largest detractor from our performance this quarter was once again our hedges. Our Russell 2000 short hedge reduced our performance by 2.9%. Additionally, Village Farms (VFF) was a drag on performance as third-party Canadian cannabis retailers reported negative first quarter sales growth as pandemic-induced lockdowns north of the border curtailed retail sales of marijuana products. As one of the largest producers in Canada, Village Farms saw lower than expected sell-through rates because of these lockdowns. As Village Farms fell to a recent low of $9 per share we added to our position. We had trimming our position during the prior run-up in its share price between $14 and $20. Our original cost was just $4. We still believe the intrinsic value of Village Farms is between $16 and $24 per share.
We completed our exits on success of our positions in Endo Pharmaceuticals (ENDP) and Rayonier Materials (RYAM). We made good profits on both investments but exited our remaining positions as near-term prospects dimmed in the second quarter. Both investments had returns of more than 200%, and each spent meaningful time in our Tier 1 bucket. Interestingly, Endo’s stock price has continued to fall after heightened opioid ligation risks. Its stock price recently fell below $4 per share. Should shares continue to drift lower, we would be inclined to reinstate the position in our portfolio. We estimate that the intrinsic value of Endo is between $8 and $12 per share.
In the second quarter we initiated new positions in Urban One and Orion Marine Group. Urban One (UONEK) is an African American focused media company. Their primary business consists of operating 54 radio stations and the “TV One” cable TV channel. The radio stations were severely impacted by covid as local advertising was mostly suspended during the pandemic, and national advertising also declined. The company was able to sharply cut operating expenses and offset lost revenues with gains from political advertising and increasing subscriber growth in their cable franchise. The company expects their media profitability to increase in 2021 as advertising spending returns and they retain some of their costs cutting measures. We also expect the company to benefit from increasing advertising dollars targeting the African American community.
Urban One entered 2020 with a precarious balance sheet with strict covenants and large near-term maturities. This caused the stock to fall significantly when covid hit as investors were concerned the collapse in advertisement spending could result in the company breaking these covenants and potentially filing for bankruptcy. In January of 2021, Urban One was able to successfully recapitalize their balance sheet on favorable terms with a new $825 million note that matures in 2028. This new note eliminated all their prior debt and reduced their interest expense by $13 million annually. In February, the company secured a new revolver from Bank of America with $50 million in untapped capacity.
The most interesting aspect of our investment case for Urban One is the recent announcement that the company was awarded a casino license by the City of Richmond, Virginia. It will be finalized with a ballot initiative in November that is anticipated to widely pass.
When we acquired our stake in Urban One, they were in a two-way race for the casino license with a private casino operator called Cordish. We believed Urban One had decent odds of being awarded the license as Cordish’s bid had been met with growing pushback from local residents. The location of Cordish’s proposed casino was in a wealthy part of the city that would have required substantial infrastructure improvements. Conversely, Urban One had chosen a more favorable location in Richmond in a defunct industrial park adjacent to I-95 where there had been no pushback form neighbors or concerns around traffic and congestion. Additionally, we recognized if Urban One was awarded the license, they would be the first African American owned business to have a casino license in the US. Given a heightened awareness nationally around racial inequality, we believed this could have swayed the decision makers to favor Urban One’s application.
Investors appear to be either unaware of the potential casino license or have assigned it little value as Urban One’s stock price is currently trading for only small premium to their radio and cable TV assets alone. We believe shares are worth $2.50-4.00 for the existing media assets by themselves, and as much as $10-16 with the Richmond Casino license. We acquired our shares for $2.10.
Despite the recent runup to $5.00 per share, the stock appears to remain substantially undervalued. The stock is not covered by Wall Street Analysts and there has been no reporting in the popular business press concerning their selection for a casino license. We think the Q2 earnings call scheduled for July 30th could be the catalyst that propels the stock higher as management should spend a large portion of the call on the economic benefits of the casino license and perhaps issue some financial guidance for the property.
We also acquired a new stake in Orion Marine Group (ORN) in the final days of the quarter. We have held a position in Orion in the past. Orion is the largest contractor for marine construction services in North America. The have specialized equipment for dredging major shipping channels and constructing port infrastructure and bridges over coastal waterways. Several years ago, the company was challenged by cyclically weak end-markets, poor project execution, and an overleveraged-balance sheet. In the past few years, they have substantially reduced their balance sheet and divested non-core real estate. After having $100 million in debt just 4 years ago, they now have $0 net debt.
More importantly, they have improved their project bidding process in the marine unit and sold off inefficient and uneconomic dredging and construction equipment. This has allowed the marine services business to return to a profit after years of losses. The company also acquired a cement business that builds prefab cement structures. This cement business operates in Texas where infrastructure projects that utilize prefab concrete such as parking decks and large distribution centers are in high demand.
We believe the culmination of these changes should allow Orion Marine to earn between $0.50-$1.00 per share in normal earnings power. Given their return to profitability and clean balance sheet we believe shares should trade for 10-13x normal earnings. We estimate the intrinsic value of Orion is between $5-$13 per share. Additionally, the company may get a tailwind from a potential federal infrastructure bill that would likely allocate significant funds to marine infrastructure. We are not accounting for this possibility in our valuation framework. We acquired our shares for $5.
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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On the operational front, Pelican Bay Capital Management has brought on Yash Rajani as an Equity Research Intern for the summer. Mr. Rajani is a Sophomore at the University of Pennsylvania intending to major in Mathematical Economics and minor in Healthcare Management and Statistics from The Wharton School. Outside of class, Mr. Rajani serves as a member of the Wharton Undergraduate Finance Club, represents his student body on the Undergraduate Assembly, and coaches tennis in Naples, Florida. This summer he will be tasked with researching publicly traded companies in the retail industry for potential investment.
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.