We wanted to provide you with an update on the performance of our SMid Cap portfolio, which we introduced on 9/3/09. As a reminder this is a “mock” portfolio with an initial value of $100 million. We plan to manage the portfolio like a long/short equity hedge fund.
Performance Update
The PAA Research SMid Cap Portfolio is off to a solid start for 2010. A combination of a reasonably conservative configuration of the portfolio (30-40% net long through January), strong relative performance of our long ideas, and solid contribution from our short names have led to outperformance to start the year. Here are some of the performance highlights:
- On a year-to-date basis, the PAA Research SMid Cap Portfolio has returned 2.5% compared to a (-3.3%) and (-3.7%) decline for the S&P 400 and Russell 2000, respectively. The table below outlines the performance of the PAA Research SMid Cap Portfolio on a year-to-date basis compared to its most relevant benchmarks: the S&P 400 and the Russell 2000.
Source: PAA Research
- The portfolio has generated a 9.3% return since inception, compared to a 10.4% return and 8.3% gain for the S&P 400 and Russell 2000, respectively.
- Inception to date, long ideas have contributed 9.7% to performance, while shorts have detracted 40 bps.
- There were no meaningful contributors to performance over the past two weeks from our long positions, although we were pleased that many of our names delivered strong relative performance and enabled returns from our short positions to preserve year-to-date gains.
- Our top contributors to performance from our short positions over the past two-weeks were: NILE (down 10.5%), DM (down 17.0%), SCOR (down 14.5%), and SFN (down 16.5%).
Changes to the PAA Research SMid Cap Portfolio
We are making some changes to the PAA Research SMid Cap Portfolio. We have taken profits on a few short positions and added selectively to a few long positions. The net effect of these changes is to increase our net exposure from 38.5% as of 1/19/10 to 45.8%. Our gross exposure of $164 million, or 148.8% is a reduction from $174 million two-weeks ago. As a reminder, we do not manage the portfolio to a specific net position, rather the portfolio weightings and net exposure are determined by our stock specific analysis. Here are the changes we are making to the portfolio for this week:
Long Positions:
Our largest long holdings after giving effect to these changes are as follows: IPSU (8.6%), BCO (7.8%), THQI (7.9%), GLG (6.4%), and GCA (6.3%).
Increased Positions: GLG, AYI, ERII, POOL, RICK, and BGG
We continue to add to GLG as it trades off despite what continues to be an increasingly compelling earnings story for 2011. The company recently started marketing a few new funds, has received awards in Europe for some of its alternative funds, and has earned key buy recommendations from a few critical pension consultants in the US where GLG Partners has yet to achieve strong penetration (less than 5% of AUM). The combination of enhanced marketing efforts and greater receptivity should lead to strong funds flow over the next 12-18 months for GLG. Additionally, we estimate that more than 50% of the company’s alternative funds are now above their high water marks and another 10-20% could start to earn performance fees in 2010. GLG shares remain overlooked relative to other alternative asset managers and we think could see significant upside as funds begin to flow and investors start to discount the earnings power of an alternative asset manager with 70% of its funds above their high water mark.
In our report Shedding Some “Light” On a New Pair Trade Idea: Long AYI/Short HUBB, we outlined our excitement about the appreciation potential for AYI shares. In general the company has delivered strong earnings result over the past several quarters given the downturn in non-residential construction spending. Additionally, the company’s recent bond offering has left AYI well capitalized to pursue “tuck-in” acquisitions that could enhance the diversity and breadth of LED and lighting controls product offerings. The company’s recent partnership announcement with Samsung to pursue LED products is yet another example of AYI’s efforts to expand its presence in the rapidly growing LED market. AYI is now a 5.2% position.
We have modestly added to our positions (25-50 bps) in ERII, POOL, RICK and BGG. The market downturn has not changed our thesis on these names.
Closed Out Positions: PCX
As consistent followers of the PAA Research SMid Cap portfolio know, we have been taking profits in PCX throughout its rapid rise. It has been one of the biggest contributors to performance since inception. However, we always had our doubts about the sustainability and longevity of a recovery in natural gas and coal prices in the US given ample supply and a relatively tepid recovery in demand. We are closing out of our position in PCX entirely until we identify a more compelling entry point.
New Positions: AKS and LOOP
We are starting AKS and LOOP as 2.0% and 1.5% positions in the portfolio, respectively. Materials stocks have performed the worse during the downturn in the market in the past two weeks. We attribute the rapid selloff to concerns about global economic growth characterized in part by rising CDS spreads for sovereign debt and increased doubts about the sustainability of commodity demand in China given recent policy actions. We think some stocks have already started to reflect a demand response beyond what policy actions from Chinese authorities imply. We will continue to look for other materials names like AKS that are reasonably well capitalized and have overreacted to economic headlines.
In the case of LOOP, the company is the leading transaction marketplace in the commercial real estate sector. We are by no means bullish on the prospects for price appreciation in commercial real estate over the next 12-18 months. It is our sense that bid/ask spreads are poised to narrow and we should start to see a pickup in transaction activity. As a result, we think LOOP could witness stabilization in its subscriber base, if not an outright increase. The company has no debt and more than 30% of its market cap in cash. We think this positions the company well to take advantage of opportunities during the downturn. We also think LOOP could be an interesting acquisition target for any number of service providers in the commercial real estate space.
Short Positions:
Our largest short positions after giving effect to these changes are: NILE (3.6%, paired against a long position in SIG), HNI Corporation (3.2%, paired against a long position in MLHR), ESI (3.5%), LINC (3.2%) and WLRD (3.1%).
Decreased Positions: COCO, NILE, JCG, SFLY, RRC, SCOR, and AM
Just as we do with our long positions, we generally like to “scale” in and out of our short positions, unless the catalysts we have targeted have been achieved. In the case of COCO, the company will report earnings this week and the results of our recent survey of privately held for-profit postsecondary education institutions indicates COCO should deliver strong results. We want to have “dry-powder” to add to our short positions in the event that investors misconstrue positive short term earnings results from COCO as a favorable development for the company’s longer term earnings prospects. We still think COCO shares will trade to the $8-$10 level as the company struggles with the transition from a 2-year to a 3-year cohort default rate calculation and faces fundamental headwinds from economic stabilization. We will look to add to our short position at any level above $15.
Increased Positions: WRLD and ZION
Shares of WRLD rallied this past week following what were strong earnings relative to consensus. We still think this payday lender is underreserved and employs some questionable business practices which otherwise mask losses from its core constituency of sub-prime borrowers. Additionally, we think it is highly likely that the federal government will pass legislation that could effectively impair WRLD’s business model. Several agencies within the federal government have expressed their concerns about the practices in the non-banking lending industry. In the case of ZION, the company continues to post losses and could be woefully under-reserved if substantial declines in the commercial real estate market materialize. ZION and WLRD are both 3.0% short positions.
Closed Out Positions: DM
We are closing our our short position in Dolan Media following a 17.0% gain. We think the stock now reflects the negative impact mortgage modification programs such as HAMP could have on the company’s core default services business. We will continue to look at strength in DM shares as an opportunity to initiate a short position. We are concerned about the company’s mix of assets (beyond default processing services) and the nature of its relationships with the law firms that serve as the life blood of its mortgage default processing services.
