Kinnaras Capital Management ("KCM", "Kinnaras", or the "Firm")
Separately Managed Accounts ("SMAs") returned -9.4% in Q2 2010.
Table I presents KCM SMA performance relative to key indices.
Investors should note that individual returns will vary based on
the time one invested and that the composite return presented below
is net of fees and is the time-weighted return ("TWR") of Kinnaras
SMAs. TWR is one of the most comprehensive and accurate ways of
gauging investment performance for managed accounts but can be
skewed at times due to the timing of new portfolio openings. As a
reference, SMAs that were open since the start of the year are down
approximately 7.5% through Q2 2010.
Table I excludes performance of smaller, highly concentrated SMA
portfolios. Exclusion is based on two main factors. The first is
that these accounts are not reflective of the total deep-value
framework used in the main strategy. Some of these accounts
literally hold 1-3 stocks which can lead to results that do not
accurately reflect the performance of the main strategy. These
portfolios were not included in Q1 2010 figures because they skewed
performance upwards to a degree not reflective of the overall
strategy and are excluded in Q2 2010 for the same reason (albeit
because the results in Q2 2010 would skew downwards).
TABLE I: 2010 Managed Account Performance
The first half of 2010 could be characterized as
manic-depressive with sharp rallies and drawdowns occurring in
nearly every month. Similar to Q1 2010, Q2 2010 started off nicely
for the first few weeks with equity markets possibly impounding a
V-shaped recovery only to quickly reverse course as market
participants questioned valuations in the context of expected
outcomes for the economy. Perhaps more importantly, the market
eco-system received a massive shock during the "Flash Crash" in May
which coincided with the European sovereign debt crisis. We also
were faced with the [[BP]] disaster which understandably would add
to our collective negative psyches. By the end of the quarter,
expectations for a double-dip recession were beginning to be
broadly discussed by a number of economists and market
These fears continue to manifest themselves in fund flows.
According to Trim Tabs, $10.7B fled US Equity mutual funds through
July 2010 (at the time of the report, July was still in progress),
following $3.8B that was liquidated in June. Those funds are
stampeding into the perceived safety of bonds with $27.8B of
inflows through July and $25.7B in June. While retail investors are
doing this, PIMCO's Bill Gross is launching a set of equity mutual
funds. In a recent Bloomberg article, Gross noted that he felt that
the thirty year bond run may be coming to an end and equities may
be a better place to be.
Without question, there are many challenges confronting the
global economy. Every item I read and every person I speak with can
present a litany of obstacles. However, since everyone knows about
these problems and fund flows are mainly headed towards bond funds,
I feel a bit more constructive about investing. In Q2 2010, a lot
of good news was snuffed out of certain stock valuations and that
gave us the chance to add to existing positions as well as
establish new ones.
For example, Kinnaras did well in 2009 through investing in
various consumer discretionary companies, particularly some
mall-based retailers. These retailers were able to rapidly close
underperforming stores, bargain with landlords for rent relief,
achieve lower sourcing and transportation costs (cotton, oil,
etc.), and aggressively rationalize their workforce. These cost
controls led to positive cash flow and earnings surprises despite a
massive drop in sales - and those earnings propelled shares.
Heading into 2010, I felt the consumer discretionary space was
played out/fairly valued and spent my time on other opportunities.
However, in Q2 2010 a few of these consumer discretionary companies
had 50-60% of their market capitalization wiped out in a matter of
weeks. We started to buy one of these in Q2 after the majority of
its decline (knock on wood) and also have been nibbling on another
The first retailer ("Retailer 1") is a $400MM market cap
mall-based women's retailer catering to a specific age demographic.
One of its competitors has been shifting its focus to a younger age
group which actually improves Retailer 1's competitive dynamic and
opportunity set. Kinnaras actually owned its competitor in 2009 so
there was some good familiarity/sector intelligence that could be
leveraged, and it didn't take long to get up to speed on Retailer
Retailer 1 lost about 33% of its value from April to early June
before reporting earnings that outperformed Street estimates.
However, due to some concerns regarding Q2 sale softness and market
pressures in June, shares further sank another 40% or so from that
point. Kinnaras began buying in mid to late June and we're still
accumulating shares for managed accounts and the Fund, which is why
I haven't unveiled its name yet.
Retailers can be interesting investments when they trade at high
forward multiples. This may sound counter-intuitive but what
happens is that the Street and investors tend to get very negative
in terms of sentiment. When a retailer has current depressed
earnings, investors sometimes extrapolate the growth expectations
and persistently low margins are impounded into valuations. So for
2011, the Street may assume no sales growth and maybe even lower
margins - 0.5% net income margins, leading to $0.10 per share. The
stock may trade at 30.0x those depressed 2011 EPS estimates or
trade at $3.00 per share.
Now if this retailer has a solid balance sheet and an investor
can get comfortable with the company's competitive dynamics and
strategy, there could be an interesting opportunity. As previously
mentioned, I had followed and invested in this specific niche last
year and I think the problems facing Retailer 1 are short-term in
nature. This means there's a lot of room for earnings upside which
could lead to impressive stock performance in the next year or
CHART I: Retailer 1 [click to enlarge]
One thing to note is that many mall-based retailers have largely
made their IT infrastructure upgrades and supplier changes over the
past two years, leading to streamlined corporate costs and supply
chains. This means that the real driver for earnings lies mostly in
merchandising and inventory management. Inventory management will
probably be the biggest challenge facing discretionary-focused
retailers for the next few years given the reining in of US
Order too much of a product and risk an inventory write-off
which results in a charge against earnings in the following
quarter. Conversely, order too little off a popular product and you
lose out on crucial sales that can leverage earnings during a key
selling period for the year. Retailers can be risky from this
standpoint but if you buy them when there's a lot of negative
sentiment and the valuation is attractive enough, they can make for
With our prior example, perhaps sales which are expected to
languish in 2011 will actually move up 10%. This sales growth is
leveraged through the company's tight cost structure leading to,
say, 2% net income margins (which is still below this company's
historical average). This would yield EPS of $0.44. With just a
10.0x EPS multiple, this company could be worth $4.40 down the road
or nearly 50% above the current price. The challenge is riding out
the volatility and being willing to be long potential good
This approach basically encompasses most of our holdings whereby
an investment is made in companies and sectors with cheap
valuations/negative sentiment and accompanying skepticism for the
investment thesis ("yeah, there's value there but..."). While I
think the broader market is fair to slightly overvalued, we've seen
a number of sectors and industries decouple in terms of
correlations. For example, while a number of technology sectors
have been trading at 52 week highs, industries like refiners are
not that far removed from their 52 week lows.
I like the refiners because they are cheap across a number of
metrics. Refiners scrubbed their balance sheets over the past few
years as oil prices declined. With the decline in oil prices, the
carrying values of a number of their intangible and hard assets
were impaired. Yet even with aggressive write downs of their asset
values, share prices of some refiners are still very cheap.
Reviewing the balance sheet of Western Refining (
) can help illustrate this embedded value.
EXHIBIT I: WNR Balance Sheet
Exhibit I applies a Liquid Adjustment whereby WNR's assets as of
Q1 2010 are written down similar to a liquidation scenario. It's
important to note that like many refiners, WNR had already gone
through asset write-downs in recent years due to the economic
decline so the above liquidation value estimates may be a bit
In addition, most of WNR's inventories are oil products. Oil
products, like many commodities, are pretty liquid and can be sold
at prevailing market values. It's unlikely in a liquidation
scenario that if WNR had $460MM of oil or refined products like jet
fuel and diesel in inventories, these assets would be sold at a
huge discount. Nonetheless, I still assumed only 70% of the
carrying value would be realized. This exercise yields about $4.36
in liquid book value yet the stock trades for about $5 per share
There are challenges facing the refining industry but many of
the stocks in this sector are at five and six year lows, suggesting
that the market has more than impounded these problems into their
valuations. This makes me feel optimistic about the longer term
performance of stocks such as WNR. Further, with capacity
continuing to be stripped out, eventually even a slight uptick in
demand will yield outsized EPS results which can drive share price
Many cyclical industries are characterized by over investment in
boom periods and under investment and overzealous capacity
reduction in bad times. During the peak oil years, refiners were
making significant investments in more expensive refineries that
had the ability to process sour and heavier crude. This was because
at a certain price it was cost effective to refine what were
typically less desirable classes of crude oil. However, since oil
prices have collapsed, refiners have been closing a number of
refineries including some of the most recent, high cost ones. The
industry has been downsizing itself over the past two years and
while there is still work to be done, I suspect that refiner
executives have made the 180 degree shift to the view that ultra
high oil prices are the "new normal" to the new "new normal"
whereby demand will be so tepid there are far too many refiners out
Both cases are probably wrong, and what I anticipate is that the
industry reduces capacity to the point where acceptable utilization
rates are achieved based on the current, weak economy. This will
lead to little excess capacity if the economy has even a slight
uptick in the coming years, which will result in much higher
capacity utilization - leading to big EPS figures which could
result in meaningful share price appreciation.
The concept of having a solid level of asset protection and
riding out some tough current times also led us to an investment in
Seahawk Drilling (
). HAWK was spun off from Pride International (PDI) in August 2009.
Kinnaras investors know that I am a big fan of spin-offs, as are
most investors that are familiar with Joel Greenblatt's 'You Can Be
a Stock Market Genius'. Spin-offs can be excellent investment
opportunities which is why I track upcoming spin-offs. Kinnaras has
invested in its fair share of spin-offs over the years and once
HAWK was spun out, I kept an eye on it.
HAWK is a shallow water natural gas driller in the Gulf of
Mexico ("GOM"). Like many GOM drillers, HAWK saw its share price
crumble once the BP disaster and drilling moratorium occurred.
Shares peaked shortly after the spin-off at roughly $35 per share
and commensurately lost about 50% before the BP oil spill. Once the
BP spill and moratorium occurred, shares plunged from $18 to as low
as the mid $8s. Shares are now at about $10 and Kinnaras began
buying in the $10-12 range.
HAWK has attracted the attention of other value investors such
as Corsair Capital but the best analysis of HAWK comes from Toby
Carlisle, founder of Eyquem Fund Management. Anyone that wants to
get fully up to speed on HAWK should check out his
, which contains a number of excellent posts on HAWK.
The basic thesis with HAWK is that it provides tremendous
operating leverage to an upswing in natural gas prices. Natural gas
prices are low due to economic weakness and a lot of supply that
has been discovered in recent years. Right now, the world is awash
in natural gas due to weak economic activity and new gas
discoveries. However, if one can look past a one year time period,
HAWK can begin to look really exciting.
Dayrates - or what drillers charge for their services - are
correlated with natural gas prices. So with natural gas prices so
low, dayrates for drilling rigs are low. The cost of operating
these rigs is fairly fixed, however, so assuming HAWK can make it
through a weak economic period, there should be the potential for
upside over the years. If natural gas prices increase, the drilling
rates will as well.
The challenge is making it through a slow period. Right now, the
GOM drilling market has been very depressed but there are signs of
some life with more rig activity occurring and more inquiries
regarding rig availabilities being made. But even in the event that
drilling activity remains extremely poor in the Gulf region, HAWK
should be able to make it through this slow period.
HAWK has a very attractive balance sheet with about $67MM in net
cash. More importantly, HAWK's drilling rigs have considerable
value but are being severely discounted by the market. In fact, the
market value of drillings rigs has declined to levels below even
2004 market values. There have also been some recent transactions
by Hercules Offshore (
) and Ensco (
) that suggest HAWK has much more value solely based on the value
of its rigs than its current share price implies.
At $10 per share, HAWK's market cap is $118MM. HAWK has about
$164MM in total liabilities so the market is saying HAWK's total
assets are worth $282MM. Out of the $282MM in asset value implied
by the market, $73MM is cash, leaving $209MM in implied asset
value. Another $67MM is accounted for by current and other assets
so that leaves $142MM in asset value for its rigs. HAWK has 20 rigs
and its current share price implies that the average value of its
rigs is about $7MM each. HAWK's CEO has mentioned in the past that
the scrap value of a rig is about $8-9MM each and rig transactions
over the past year have implied rigs similar to HAWK's support
higher rig values.
As with Retailer I, WNR, and HAWK, our approach is really about
reconciling valuation to expected future outcomes. Sure, things are
bad but if they remain status quo, then we still have a valuation
cushion. But If things improve even slightly, we have the chance to
make some pretty solid returns.
That also applies to our larger holdings like Citigroup (
) and Sprint Nextel (
). C has explicit government support whereby it cannot fail and
still trades at a discount to its P/B and P/normalized earnings
power. Trends continue to move in the right direction for C with
net credit losses declining sequentially and on a comparable
quarterly basis per C's Q2 2010
In addition, C realized a Loan Loss Reserve Release in Q2 2010.
This is a point of criticism by some skeptics that will say the
earnings are juiced to some extent by these reversals. These
critics say the swipe of an accountant's pen is leading to these
reserve releases which artificially boost earnings. This is an
unfair and inconsistent criticism because these same skeptics in
prior quarters would point to the high level of loss reserves these
banks were setting aside in anticipation of future losses as a
warning to investors.
What I had noted when Kinnaras first started looking at
financials was that banks were likely over-reserving for future
losses. For example, one regional bank that Kinnaras owns has about
$100MM in non-performing loans ("NPLs"). However, $31MM of those
NPLs were still current on principal and interest through Q1 2010.
If one assumes that the period from late 2008 through 2009 was the
zenith of the financial crisis, as the economy recovers, even at
this anemic pace, those $31MM in NPLs could eventually be
classified as performing. Basically, if those loans which are
current on principal and interest did not kick out during the worst
of the recession, they are likely good money.
What this means is that a number of loss provisions for banks
could be reversed across the board. This is consistent with
historical bank crises, whereby loss provision reversals are
recognized as the realized credit losses come in well below prior
expectations. This expectation was what led me in January to
present the notion of a bank-only investment vehicle to some
investors, with a specific emphasis on regional banks. While C is a
money center bank, the same phenomenon of loan loss reserve
reversals will occur throughout the year and have the most
pronounced impact on regional banks. We own a few regional banks
and I think we will be pleased with their performance.
S is also continuing its impressive turnaround. In late Q2 2010
it released its new phone, the HTC EVO 4G. I bought one, electing
to pay the penalty to cancel my T-Mobile bill and drop my
Blackberry to sign up for S and get the new phone. This phone is
powered by Google's (
) Android Operating System ("Android OS") and is the real deal.
It's a major iPhone competitor and I would know considering my
household has gone through two iPhones.
S released its Q2 2010
which were very strong. Churn was under 2%, with S reporting its
best churn figures in its history. It added postpaid subscribers
for the first time in three years and CEO Dan Hesse mentioned that
this would be the case even without the EVO. The EVO was released
late in Q2 so I expect the full EVO impact will likely be felt in
Q3 2010. S continues to generate strong cash flow and has no
significant near term debt maturities. In addition, its customer
service metrics continue to improve. The company is doing just
about everything right and I expect the stock to eventually reflect
these positive developments, albeit with the typically high
volatility associated with S.
These quarterly missives can sometimes be a challenge because
the reality is three months is a very short time period. There may
be a lot of noise within 90 days but not a lot of news. It's also
difficult to reflect on what's happened over just a few months when
most of your time is focused on the fundamentals of the companies
and a 1-2 year time horizon for catalysts to materialize.
In addition, my sensitivity threshold to market volatility is
pretty low whereby our holdings may swing heavily, but it doesn't
really register with me. For example, June was a vicious month for
Kinnaras but that was largely due to S, one of our largest
positions, declining about 20% on no news. In fact, S reported
impressive Q2 2010 results a few days before the end of July and
the stock but sold off about 12% in the last two days of the
quarter - which dinged what would have been stronger July numbers.
S is doing the right things but short-term market fluctuations are
part of the game.
Overall, I feel pretty good about what we hold. For marketing
benefits I'd certainly love it if Mr. Market hurried up and
assigned better valuations to our holdings but I feel that what we
have is well positioned to do some great things for us. In fact, I
would love to deploy more capital in some of our regional bank
names as well as one very interesting microcap. I'll save that for
the next quarterly letter.
Long C, S, WNR, HAWK
Durable Goods Report: Mixed Signals from Tech