DENALI INVESTORS, LLC

Transcription

1 January 16, 2008 To: Re: All Limited Partners Fourth Quarter and Calendar Year End 2007, Letter to Partners Dear Partners: Please find below material information regarding Denali Investors funds. Performance For the two-month period from November 1 st returned -1.7% and the S&P 500 returned -5.2%. to December 31 st, 2007, Denali Investors, LLC As I have hoped, the markets appear to be falling apart and fear, for the time being, trumps greed. This is great news for us, as the market seems willing to offer us increasingly attractive values, and we are willing to wait. General Comments The fund holdings currently include four special situation investments. Each of the funds holdings has 1) price at a wide discount to intrinsic value and 2) a favorable eventdriven probability to reach intrinsic value. The following section will describe our special situation investments. What Are Special Situation Investments? Special situations include misunderstood and mispriced companies, spin-offs, restructurings, bankruptcies, distressed securities, distressed bonds, merger arbitrage, etc. The advantage of allocating capital to these special situations is two fold: 1) The risk reward ratio can be highly favorable. In many cases, a special situation unlocks preexisting value that has been embedded or ignored by the market. 2) The value unlocking is not correlated to the stock market, but rather through company level actions and outcomes. Special Situation 1: Spin-Out 1

2 In this situation, Parent Co. (PCo) will spin out Subsidiary Co. (SCo) to shareholders. PCo owns over 80% of SCo, which is already public. PCo trades at $10 per share. The value of the spun out shares is $5 per share. Hence you are getting the PCo business for $5 per share. When one does the math, it becomes apparent that a fair valuation for the PCo stub is over $8 per share, which represents 60% upside. Again, the gain results from the spin out of SCo shares, and is an unlocking of preexisting value rather than a creation of new value. To our benefit, we have isolated the PCo through various hedging techniques which allows us to gain direct exposure to the unlocked value, and simultaneously mitigates our downside risk. The end result of the investment has resulted in an opportunity with a risk-reward ratio highly skewed to the reward side. Special Situation 2: Value Activist In this situation, the company (Co) is trading at a price that is far below its intrinsic value. Co is at $10 per share. There are three main drivers of embedded value in this situation. 1) Given an incredibly valuable real estate portfolio, there is about $10 per share in real estate value available for sale-leaseback. 2) The company owns almost all company units and can refranchise the majority for $10 15 per share. The residual royalties for just the refranchising alone are worth about $0.50 per year, or say $5 in conservative present value. 3) Operations are substandard and have much room for improvement. The changes that will take place at the operating level are of material importance and will be led by a highly successful team (not the previous management team). Incremental margin expansion creates additional value, but let s assume this results in $0 value if not successful to $5 if there is some value created. The combined results unlock and create value in the range of $20 35 per share. These changes are being driven by a highly successful team that has shown a demonstrated track record of outstanding value creation in situations just like this one. Special Situation 3: Restructuring In this situation, the company (Co) is undergoing material structural changes. Co has three main businesses and has sold two of them. Co trades at $10 per share and the company will return, via a special dividend, $7 to shareholders. After the fact, Co will still have $2.50 per share in net cash. This means you pay $0.50 for the remaining business. At $0.50, this implies a price of only 1 2x EV/EBITDA. But there is more. Not only do you get the business at only 1-2x EBITDA, you also get $12 per share in NOLs. A conservative present value calculation yields $3-4 per share. Therefore, you are getting paid $ to take the business! Special Situation 4: Negative Stub Pair Trade 2

3 In this situation, the Parent Co. (PCo) trades at $10 per share. PCo, however, owns $20 per share in a majority controlled and publicly traded subsidiary, SCo. If we assume PCo (ex SCo value) is worth absolutely nothing, this implies PCo stock, due to SCo value, is worth $20! In order to unlock value, management is pursuing a sale of its largest PCo segment, which has been losing money. The chairman owns a very large stake in the PCo and has recently revealed a very large stake in the SCo. My sense is that the SCo stake was taken to maintain control in the event of a spinout of SCo. The unfolding of these events will unlock the tremendous embedded value in PCo. As such, we are long PCo and short SCo in order to earn the collapsing spread. To summarize, each investment is a special situation with a defined time table that has a risk-reward ratio highly skewed to the reward side. As a result, the probability for achieving excess returns is in our favor. Investing in these special situations goes back to the core of our investment framework. These examples should help demonstrate that Denali's results will be determined based on the outcome of these individual opportunities, not the noise in overall stock market indexes. Again, it is not the short term performance of the stock market that matters to us. This is especially relevant in the current environment, one in which investors are concerned about subprime and looming recession. It would be more like gambling, and less like investing, to put money blindly into broader indexes. The only reason Denali was started was to provide absolute returns and beat the market over the long term. I believe these types of investments position us very well to do just that. A Special Thanks to Our Investors Denali Investors is fortunate to 1) be extremely selective in the manner we make investments, and 2) have partners with a long-term value perspective in combination with outstanding professional and personal character. The firm is lucky, and rare, in this regard. One of the most important differences is that our investor base understands that a stock at a 75% discount to intrinsic value can change to a 70% or 80% discount, simply due to short-term noise. The short-term 20% move from the entry point is understood as largely meaningless and that the eventual realization of intrinsic value is our focus. It is a true pleasure to go to work everyday on your behalf. I thank you for your trust and support. And thank you for the referrals! Next Opening 3

4 Openings for both the Denali Investors Accredited Fund (DIAF) and Denali Investors Offshore Limited (DIOL) are on a monthly basis and for the upcoming quarter are: February 1, March 1, and April 1. Existing partners of either fund can add assets in increments of $50,000 at each opening. The minimum initial investment for DIAF is $250,000. To invest in the fund one must be an accredited investor as defined by the SEC. The next opening is on the 1 st of each month. The minimum initial investment for the DIOL is $250,000. To invest in the Offshore Fund, one must be a non-us accredited offshore investor or tax-exempt accounts such as IRAs. The next opening is on the 1 st of each month. Please note that all new assets received are subject to the two-year lockup period. Funds received by February 1, 2008, for example, will be open for redemption on February 1, Recommended Timetable if Considering a Subscription Subscribing assets into a partnership is fairly simple, but does require some lead time. Our professional associates at Citi are very knowledgeable and can help facilitate with the finer points of the transfer and subscription process. Please allow at least a one-month window to provide Ajay Desai, Qui Lam, and Thomas O Connell with ample time to work through any issues. The team can be reached at Website Update I have posted letters and documents to the site so that you may refer to them at your discretion. There has been a healthy addition to the About tab and the addition of a Frequently Asked Questions (FAQ) sub tab. To view the new content, please visit The user id is "mister" and the password is "market" Thoughts on Volatility In the last quarterly letter, we revisited the risk-reward relationship. This quarter, Appendix B contains the next phase of the discussion and discusses volatility. As mentioned, should you have any questions or follow up, please feel free to contact me anytime at or kbyun@denaliinvestors.com. Respectfully, 4

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6 Appendix A: Performance History Denali Investors Accredited Fund Date NAV 10/01/2007 $1, /01/2008 $ Denali Investors Offshore Fund Date NAV 10/01/2007 $1, /01/2008 $

7 Appendix B: Thoughts on Volatility In the last investor letter, we established that: Conclusion: Cheap stocks have lower volatility (beta) and higher returns and expensive stocks have higher volatility (beta) and lower returns. The resulting relationship looks like this: Return = Reward Cheap Expensive Vol = Beta If the statement does not resonate right now, then please refer to The Risk-Reward Relationship Revisited from the third quarter investor letter before continuing. The document is available on the website at Haugen s research tells us that when we have a choice between cheap vs expensive and low beta vs high beta, we should choose cheap and low beta to achieve the highest expected returns. This would look something like this: Low Vol (Beta) High Vol (Beta) Cheap HAUGEN (1) Expensive I agree it makes sense to buy cheap stocks and avoid/short expensive stocks. But what about high beta stocks? Can these be good value investments? 7

8 Low Vol (Beta) High Vol (Beta) Cheap??? (2) Expensive Traditionally, volatility is defined as a measure of risk, or otherwise known as beta. Beta is a numerical measure of how much the stock price has moved (not will move) relative to the market. It is supposed to provide a sense of the level of movement (standard deviation or variance), not so much in the intrinsic value of a company, but rather in the stock price. So if a stock has a high beta, then it is supposed to be risky. This is a fallacy in common thinking and here is why: First, if we assume that we can form a reasonable estimate of intrinsic value for a company, then volatility is our friend, not our enemy. Does it not make sense that an investor makes a better investment when paying less for a business (a bigger discount from intrinsic value)? And if paying less for a business, doesn t that necessarily make the investment less risky, not more? But still, how is it that a stock can have a higher beta, but be less risky? This might be counter intuitive, so let us walk through a hypothetical example. For example, perhaps the market has fallen in love with a stock and you agree it is a good business. However, you are looking at the fundamentals and cannot figure out even to save your life how the valuation gap from your estimate of intrinsic value could be justified, even if the company performs exceedingly well over the next few years. Then either you can do nothing (which is often the case) or perhaps decide to short the stock if you feel strongly enough about pending negative catalysts. Now, six months later, this company has unfortunately missed quarterly expectations and the once burning market love has now become a seething hate and the stock has been crushed. However, now it trades at a price you believe is far below the longer-term intrinsic value of the company, even though the market is saying otherwise. The volatility, driven by market fear and greed, has allowed for a substantial gap in the stock price and its longer term intrinsic value. In this case, volatility is our friend, because it has created an opportunity to invest at an attractive price. Second, a stock s future performance may or may not have any correlation to the past performance that formed its beta. If there are catalysts to drive change at the company level, then this should be reflected in the price at some point as a result of the catalysts, not of the historic price movements. 8

9 Third, risk is not short term price movements or beta. We are able to make our money because of the availability of these discrepancies. Risk, rather, is better defined as a permanent loss of capital. Permanent capital loss occurs because of incorrect analysis or negative outlier outcomes. Again: Risk: A permanent loss of capital, NOT short term price movements or beta Therefore, we can see that: Conclusion: If a stock is cheap (measured against intrinsic value), high volatility can produce high expected returns with low risk The hypothetical example above is just one particular hypothetical scenario. But I hope it clears up a common misperception about the common thinking about volatility. The take away from this writing is that volatility is not necessarily a characteristic to be feared, but rather welcomed, if the price offered by the market as a result of the volatility is at a steep discount to intrinsic value (based on strong analysis and compelling investment thesis). This example above is noticeably different from the speculator attracted to the price movements that feels compelled to buy when a stock is going up (with no regard to the real value of the stock), and sells when a stock is going down (again with no regard to the value of the stock). To our advantage, in this situation we have established a high level of conviction about the longer-term intrinsic value of the business. If we do not, then we are merely speculators. Part of the difficulty lies in mentality of the investor. It goes against human nature to be attracted to a stock that has fallen and that everyone is telling you how absolutely unattractive it is. If some people start screaming and running for the exits while you are watching a movie, can you really stay calm and enjoy the rest of the movie? Similarly, if a purchase is made at a certain price and the stock falls another 20%, what do you do then? After all, a stock will not stop falling just because you buy or stop rising just because you sell. The same hysteria that offered a, say 75%, discount to intrinsic value could become even more hysterical. Is the market proving you are wrong and it is right about the company? Perhaps so. Or is the market still providing an even better investment opportunity? At that point, is it time to sell, hold or buy more? The main thing to keep in mind is that You are neither right nor wrong because the crowd disagrees with you. You are right [or wrong] because your data and reasoning are right [or wrong]. Keeping this in mind, our understanding of risk as a permanent loss of capital, not short term price movements, gives us a distinct advantage. We have provided a case that high volatility stock can be attractive investment opportunities. The common factor is that in both low and high volatility stock groups we are considering only the cheap stocks (whether by traditional metrics or in relation to a high conviction intrinsic value reached through strong analysis). In summary, in the Q3 and Q letters we have established several important conclusions: 9

10 1) Conclusion: Cheap stocks have lower volatility (beta) and higher expected returns and expensive stocks have higher volatility (beta) and lower expected returns. 2) Conclusion: If a stock is cheap (measured against intrinsic value), high volatility can produce low risk and high expected returns 3) Risk: A permanent loss of capital, not short term price movements or beta Given these conclusions, which we can use as guideposts to head in the right direction for fertile investments, how do we think about potential investments once we narrow down the universe to a group of possible investments? In the next investor letter, I ll include a section entitled The Ratio which will address this situation. 10