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Intelligent Cloning: The Winter 2017/2018 Edition

February 15, 2018 in Letters

This article is authored by Peter Coenen, a value investor based in the Netherlands.

There are some great investment minds out there. Don’t even think about trying to beat these guys. Just copy and profit from them. I mean, these ideas made it through the exhaustive due diligence process of one of the best investors on the planet. It’s called “cloning”.

If you are unfamiliar with that, 13F filings are the portfolio reports that institutional-size investors (anyone with a portfolio of over 100 million dollar) have to make to the SEC each quarter. They’re public, and include any long US equity positions, so they give great insight into the portfolios of large and successful investors. You can find the initial write up on Intelligent Cloning over here, and the autumn 2017 edition over here.

In this Winter 2017/1018 Edition on Intelligent Cloning, let’s dig a little bit deeper in the autumn 2017 results, have a look at the current portfolios of Seth Klarman, David Tepper and Lou Simpson and finally enjoy lunch for free.

Looking back

In the previous edition on Intelligent Cloning I identified 10 companies with a market cap below 5B USD. These are companies that have their Value Creation Engine (VCE) up and running and are trading at a price that makes sense. The next step is the “quick fit”.


Figure 1: The process of intelligent cloning.

During the “quick fit” phase I look at the business activities of the company and then decide if there is a fit between my investment experience (circle of competence) and the company. Here are my “quick fit” considerations.

DSW Inc., Dillard’s and AutoNation are retailers. DSW Inc. is a footwear retailer. Dillard’s, Inc. is a retailer of fashion apparel, cosmetics and home furnishing. AutoNation, Inc. is an automotive retailer. I don’t want to touch the retail sector right now. It’s one of the scarier ones to be in, I think. The fear, perhaps unjustified, is that these companies will be “amazoned”. Let me put it like this: I do not have the expertise to identify the retailers that will not be “amazoned”. So I just skip this sector.

Emcor is a leading specialty construction, building and industrial services provider, with significant expertise in project execution and delivery and excellence in managing skilled labour. It’s a very impressive diversified group, but it is not the exceptional niche player I prefer to look at. The same holds for MSC Industrial.

A company I like more is Tegna. Tegna has spun-off Car.com and sold Career Builder to focus on its TV-Stations, moves that could appeal to a buyer. Its streamlined focus on TV-stations may invite activist interest. David Einhorn’s Greenlight Capital recently acquired a 1.1% stake in the media company, heightening speculation that activists may be scrutinizing Tegna for a takeover.

USG Corporation is a manufacturer and distributor of building materials. It’s a Berkshire Hathaway holding and Warren Buffett himself stated that USG overall has been disappointing because the gypsum business has been disappointing. “Just put that one down as not one of our brilliant ideas” (quote Warren Buffett).

The Boston Beer Company is a craft brewer in the United States. Although the competition is intense, keep an eye on Boston Beer. It has, I think, a lot of staying power, but it also could turn out to be a great take-over target. I was really surprised to find out that Allan Mecham sold this stock after just one quarter. I still like it though. I mean, in this world nothing can be said to be certain, except death, taxes and drinking beer.

Monro is the largest chain of company-operated automotive car facilities, with 1,136 stores across 27  states. There is a long runway with the company only operating in 27 states. I like the company, because of their customer loyalty. And there isn’t an industry riper for consolidation than the car care industry. I mean, who doesn’t like a good roll-up strategy?

And then there is Valmont. They are stewards of agricultural and economic growth around the world:  from equipping Ag producers in third-world countries to expand their production to fabricating and installing some of the world’s most complex steel structures. It is an interesting company to watch. Allan Mecham recently sold part of his Valmont holdings and that makes it less attractive for now.

The two companies I like most from the autumn 2017 edition are Tegna and Monro. The latter one doesn’t look cheap from a traditional P/E multiple valuation. In this case I prefer to focus on the (certainty of the) future free cash flows, in combination with the current low 2.4% risk-free yield on the ten-year treasury rates. That makes it attractive, even at this high P/E multiple. And sure, I would applaude a lower stock price. For now, I add both companies to my watch list and start the in-depth due diligence.

Cloning Klarman, Tepper & Simpson

There are two ways to calculate the Value Creation Engine (VCE). In the autumn edition on intelligent cloning I used the more conservative approach, which is actually an adjusted ROC version. In this winter edition I use the more aggressive version of the VCE, which is ROC times GROWTH.

If I do just that and then rank the stock from the portfolios of Klarman, Tepper & Simpson with a Joel Greenblatt type of ranking system, I end up with the following companies.

1. Apple (David Tepper ↑)
2. Express Scripts (Seth Klarman)
3. AmerisourceBergen (Seth Klarman ↑)
4. Allison Transmission (Lou Simpson ↑)
5. Centene (David Tepper ↑)
6. McKesson (Seth Klarman ↑)
7. Avis Budget (Seth Klarman ↓)
8. HCA Healthcare (David Tepper ↑)
9. CBS Corp (David Tepper ↑)
10. Twenty-First Century Fox (Seth Klarman ↑)

If I had to pick just one stock from each of these super investors, my choice would be Express Scripts, Allison Transmission and Centene.

Express Scripts believes in practicing pharmacy smarter. They put medicine within reach of tens of millions of people by aligning with their customers, taking bold action and delivering patient-centered care to make better health more affordable and accessible.

Allison Transmission is the world’s largest manufacturer of fully automatic transmissions for medium- and heavy-duty commercial vehicles and is a leader in hybrid-propulsion systems for city buses.

Centene is committed to improving the health of the community through health insurance solutions for the under-insured and uninsured, and through specialty services that align with their focus on whole health.

Lunch for free!

Have you read the Forbes article “The 15-Stock ‘Free Lunch’ Portfolio” by Mohnish Pabrai?

In my initial write up on Intelligent Cloning I wrote that you can probably boost the returns of the “shameless cloning approach” even further by using a specified set of 5 criteria. Let’s do just that. Mohnish came up with 15 stocks in the Free Lunch Portfolio. Thank you, Mohnish!

If I use the first 4 criteria I end up with the following list of companies: Lowe’s, NVR, Sleep Number, The Hacket Group, Alibaba, British American Tobacco, Fiat Chrysler, Micron Technology, Lamb Weston Holdings, GCP Applied Technologies, Synchrony Financial and CSRA.

I don’t like the tobacco company, so I just skip that one. And if I apply the fifth criterion, an attractive price, I end up with these companies (random order):

1. Sleep Number
2. The Hacket Group
3. Micron Technology
4. Synchrony Financial
5. GCP Applied Technologies
6. CSRA

I guess that makes the 2018 conservative Free Lunch Portfolio. In January, 2019, I will publish the updated “conservative Free Lunch Portfolio”. The idea is to sell the companies that do not make the new year’s picks and invest the proceeds equally in the “newbies”.

It has been 10 years now since the publication of “The Dhando Investor” by Mohnish Pabrai. And Mohnish is sharing all his knowledge and experiences with us. For free. If you are a believer in the Free Lunch Portfolio, as I am, why not send Mohnish a “thank you gift”. No costs involved.

Here is how it works. Just start an account with e.g. Interactive Brokers and make your pick which strategy you want to follow: the Free Lunch Portfolio or the more conservative version of the Free Lunch Portfolio that I just described. Both approaches will do fine in the long run. For the next 30, 40 or 50 years I want you to follow that approach and then wire the money to the Dakshana Foundation. Even if you take out “your initial capital adjusted for inflation times two” just before wiring, I am quite sure Mohnish will be pleased with this small gift for his foundation. On 8 January 2068 I have some “wiring” to do.

That’s it for this edition on Intelligent Cloning. In the spring 2018 edition we will have a look at the portfolios of Bill Miller, Leon Cooperman and some of the Barron’s Roundtable stock picks of Meryl Witmer.

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This presentation and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. Responses to any inquiry that may involve the rendering of personalized investment advice or effecting or attempting to effect transactions in securities will not be made absent compliance with applicable laws or regulations (including broker dealer, investment adviser or applicable agent or representative registration requirements), or applicable exemptions or exclusions therefrom. The Value Firm® makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.

Thesis Update on Senior Notes of MVC Capital

February 15, 2018 in Fixed income, Ideas

This article is excerpted from a letter by Jim Roumell, partner and portfolio manager of Roumell Asset Management, based in Chevy Chase, Maryland. The following discussion focuses on MVC Capital’s 6.25% senior notes due November 2022.

MVC Capital, Inc. is a publicly-traded business development company (BDC) that makes private debt and equity investments. The Company seeks to build shareholder value by making yielding, equity and other investments in middle-market companies across various industries, with flexibility to invest across the entire capital structure. MVC Capital generally targets companies at the lower end of the middle market, with annual revenue ranging from $10 million to $150 million and EBITDA of between $3 million and $25 million. Since these companies tend to be overlooked by traditional lenders and investment banks, MVC has a greater opportunity to positively influence the financial and operational outcomes of these organizations.

The 6.25% senior notes, purchased at par, are a new issuance of notes. The notes will mature on November 30, 2022 and pay interest quarterly, beginning January 15, 2018. MVC Capital may redeem the notes in whole or in part at any time on or after November 30, 2019, at its option, at par plus any accrued and unpaid interest. MVC Capital disclosed that it will use the proceeds from this offering to redeem outstanding indebtedness under its 7.25% notes due 2023. RAM held these notes so, in essence, the new notes will replace the old notes.

Regulatory restrictions under the Investment Company Act of 1940 limit the amount of debt that a BDC can have outstanding. Generally, a BDC may not issue any class of indebtedness unless, immediately after such issuance, it will have assets covering its debt by at least 200%. Put another way, debt can only be 1x the equity at a BDC. For example, if a BDC has $1 million in assets, it can borrow up to $1 million, which would result in assets of $2 million and debt of $1 million. If MVC Capital were to breach this regulatory limit it would be forced to take action to come back into compliance. The company would not be able to pay any common stock dividends until it was in compliance. These actions could include the sale of assets and repayment of a portion of the debt or the issuance of new common equity, all of which protect us as noteholders.

The 1940 Investment Company Act debt limit restriction brings us a great deal of comfort that our notes are well protected by significant, and persistent, asset coverage. As referenced in our prior quarter letter, with over 50% of ten-year rolling periods for the S&P 500 (including dividends) failing to generate an 8% annualized return (calculated on a rolling monthly basis beginning in January of 1926), we are satisfied with securing this relatively safe 6.25% return.

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The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

Portfolio Commentary

February 15, 2018 in Letters

This article by Matthew Haynes is excerpted from a letter of 1949 Value Advisors, an absolute return-oriented global value investment firm based in Mahwah, New Jersey. Matt is a valued contributor to The Zurich Project.

As bottom-up investors, individual security selection will often be the most important driver of quarterly portfolio performance. Positions that had the largest negative impact on performance during the quarter were Birchcliff Energy (-1.8% contribution), Industrias Bachoco ADRs (-0.7% contrib.) and Global Brands Group (-0.6% contrib.).

Shares in Birchcliff Energy declined 26.8% during the period under review on persistently weak western Canadian AECO natural gas prices. The confluence of production growth (including “associated gas” from oil producers) was met by warm temperatures and resulting stagnant demand. Weak demand and increased supply leads to lower spot prices. Simple stuff. While a deep freeze across Canada would certainly help, predicting seasonal weather patterns isn’t part of our investment thesis.

Birchcliff Energy is among the lowest cost producers in Canada, enabling positive cash flow generation even amidst depressed natural gas prices. We remain focused on Birchcliff’s immense latent asset value which we expect to be either slowly realized over time as they execute on their organic growth strategy, or more quickly unlocked through a catalyzing corporate event. Certainly, at the current depressed valuation, Birchcliff is an attractive target for a much larger company with the financial resources to develop its vast reserves on a faster track than the current plan.

After being mentioned in last quarter’s letter as one of our top contributors, American Depository Receipts (ADR’s) of Mexico’s largest poultry producer Industrias Bachoco were among our greatest detractors during Q4, declining 13.8%. For the full year, Bachoco ADR’s gained 18.6%. Recent weakness can be attributed to the weak Mexican peso and worries over NAFTA negotiations. The recent weakness belies Bachoco’s long term record of creating value, its already discounted valuation and its rock solid balance sheet and free cash flow generation which we expect to drive future capital returns and bolt-on acquisitions.

Global Brands Group Holdings shares declined 14.7% during the fourth quarter following the release of its fiscal 2018 H1 results. Once again, the results were actually quite good amidst a very challenging business environment for all retail companies. Global Brands Group (GBG) is one of the world’s leading branded apparel, footwear, fashion accessories and lifestyle product companies. Traditional bricks-and-mortar platform companies – the department stores and specialty retailers – are very challenged today by online platform companies like Amazon, and other major discounters like Walmart. GBG operates an asset light and scalable business model, escaping the challenges plaguing traditional retailers. The new three-year plan is focused on reaching $5 billion in sales (up from $3.9 billion in fiscal 2017), expanding margins by 150 basis points and increasing EBITDA by 50%. They’ve already exceeded the 150 bp margin goal during the H1 results just announced, and we expect them to over-deliver on the other objectives too.

Positions that helped performance during the third quarter include Michael Kors Holdings (+1.2% contribution), Anglo American plc (+0.6% contrib.) and Berkshire Hathaway (+0.6% contrib.). Michael Kors Holdings again reported better than expected results, driving its shares 32% higher during the period for the second consecutive quarter. CEO John Idol said, “This is a transformative time for Michael Kors Holdings as we established our global fashion luxury group with the recently completed acquisition of Jimmy Choo.” While investors continue their fascination with this transformation, we will remain disciplined about the great expectations that are becoming baked into its rapidly rising share price, especially considering its newly acquired billion dollar debt burden.

Shares in Anglo American plc rose 15.7% in GBp during the quarter, bringing its full year return to +37.4%. Against a backdrop of synchronized global growth, a weaker US dollar and a Chinese economy seemingly on cruise control, commodity producers have enjoyed a good year. While we consider Anglo’s original restructuring efforts largely complete, the company continues to deleverage its balance sheet and could attract potential acquirers.

Finally, Berkshire Hathaway shares contributed positively by rising 8.3% during the quarter and 21.9% for the full year. The company is expected to be a major beneficiary of US corporate tax reform, as well as stabilized pricing in P&C insurance following a very active year for catastrophe losses. Cash continued to build on Berkshire’s balance sheet, amounting to over $100 billion at September 30, 2017. The deployment of excess capital in value accretive ways remains a big part of the optionality embedded in Berskhire’s modest valuation of approximately 1.5x book value.

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The performance results for the 1949 International Value Strategy set forth herein are model results and not based on the performance of actual portfolios managed by 1949 Value Advisors (the “Investment Manager”). The performance results were obtained through the use of Bloomberg’s proprietary software and represent the simulated returns of a secondary strategy the Investment Manager is honing alongside its primary strategy. The results do not reflect fund or account-level investment expenses, administrative, operating expenses or management fees. A fund or account managed by the Investment Manager will be subject to asset based management fees, and would incur significant investment and administrative/operating expenses; these fees and expenses would significantly reduce the returns of an actual investment due to compounding and other effects. These performance results do not represent actual trading and are not an indication that the performance of any fund or account managed with this strategy will be similar in any way. This summary does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made to qualified investors and only by means of an approved confidential private offering memorandum or investment advisory agreement and only in those jurisdictions where permitted by law. This summary reflects select positions of the current portfolio of a managed account advised by 1949 Value Advisors. There is no guarantee that a commingled investment vehicle or another investment account managed by 1949 Value Advisors will invest in the same investments set forth in this summary. The investment approach and portfolio construction set forth herein may be modified at any time in any manner believed to be consistent with the managed account’s overall investment objectives. While all information herein is believed to be accurate, 1949 Value Advisors makes no express warranty as to the completeness or accuracy nor does it accept responsibility for errors appearing in the summary. This summary is strictly confidential and may not be distributed.

Charlie Munger’s Remarks at Daily Journal Annual Meeting in 2018

February 14, 2018 in Curated, Daily Journal Annual Meetings, Full Video, Transcripts, YouTube

Charlie Munger, the 94-year-old vice chairman of Berkshire Hathaway and chairman of the Daily Journal Corporation, spoke to shareholders and answered questions at DJCO’s annual meeting.

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What Good, in the Practical World, is the Thought System Indicated by the List?

February 14, 2018 in Human Misjudgment Revisited

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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What good, in the practical world, is the thought system indicated by the list? Isn’t practical benefit prevented because these psychological tendencies are programmed into the human mind by broad evolution so we can’t get rid of them? By broad evolution, I mean the combination of genetic and cultural evolution, but mostly genetic.”

“The answer is the tendencies are partly good and, indeed, probably much more good than bad, otherwise they wouldn’t be there. By and large these rules of thumb, they work pretty well for man given his limited mental capacity. And that’s why they were programmed in by broad evolution. At any rate, they can’t be simply washed out automatically and they shouldn’t be. Nonetheless, the psychological thought system described is very useful in spreading wisdom and good conduct when one understands it and uses it constructively. –Charlie Munger

Carl Braun’s communication practices – All Braun communications had the “Five W’s” (Who? What? Where? When? Why?) and if you left out the “why” you got fired.

Pilot training in simulators – abilities attenuate with disuse

Clinical training in medical schools – Watch one, do one, teach one.

The U.S. Constitutional Convention – “Totally secret, no vote until the whole vote, then just one vote on the whole Constitution. Very clever psychological rules, and if they had a different procedure, everybody would’ve been pushed into a corner by his own pronouncements and his own oratory and his own… And no recorded votes until the last one. And they got it through by a whisker with those wise rules. We wouldn’t have had the Constitution if our forefathers hadn’t been so psychologically acute. And look at the crowd we got now.”

Granny’s Rule – eat your carrots or you don’t get your ice cream; “[people should] organize their day so they force themselves to do what’s unpleasant and important by doing that first, and then rewarding themselves with something they really like doing.”

Harvard Business School’s emphasis on decision trees – “high-school algebra works in real life”

“One of the advantages of a fellow like Buffett is that he automatically thinks in terms of decision trees.” – Charlie Munger[71]

Post-mortems at J&J – “At most corporations if you make an acquisition and it turns out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You’ve got denial, you’ve got everything in the world. You’ve got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. And by the way, I do the same thing routinely.”

Charles Darwin – the great example of avoiding confirmation bias, which “has morphed into the extreme anti-confirmation-bias method of the ‘double-blind’ studies wisely required in drug research by the F.DA.”

“Sam Walton won’t let a purchasing agent take a handkerchief from a salesman – he knows how powerful the subconscious reciprocation tendency is.”

The Warren Buffett Rule for Open-Outcry Auctions: Don’t Go. – “We don’t go to the closed-bid auctions too.”

Update

Granny’s Rule in the military – make your bed. “If you make your bed every morning you will have accomplished the first task of the day. It will give you a small sense of pride and it will encourage you to do another task and another and another. By the end of the day, that one task completed will have turned into many tasks completed. Making your bed will also reinforce the fact that little things in life matter. If you can’t do the little things right, you will never do the big things right. And, if by chance you have a miserable day, you will come home to a bed that is made—that you made—and a made bed gives you encouragement that tomorrow will be better.”

Granny’s rule at work: Read the SEC filings (or other independent, original-source document) first thing in the morning. Set the right tone for the day, make sure something is accomplished. Then get your crossword puzzle with breakfast while you read some news – that part may be more enjoyable but it’s not as important. Also, remember that the order of the research process’s steps matters greatly. And rub your nose in your mistakes. Do a pre-mortem and a post-mortem.

What special knowledge problems lie buried in the thought system indicated by the list?

“Now we’re talking about a type of human wisdom that the more people learn about it, the more attenuated the wisdom gets. That’s an intrinsically paradoxical kind of wisdom. But we have paradox in mathematics and we don’t give up mathematics. I say damn the paradox. This stuff is wonderfully useful. And by the way, the granny’s rule, when you apply it to yourself, is sort of a paradox in a paradox. The manipulation still works even though you know you’re doing it.” –Charlie Munger

Don’t we need more reconciliation of psychology and economics?

“My answer is yes, and I suspect that some slight progress is being made. I have heard of one such example. Colin Camerer of Caltech, who works in “experimental economics” devised an interesting experiment in which he caused high I.Q. students, playing for real money, to pay price A+B for a “security” they knew would turn into A dollars at the end of the day. This foolish action occurred because the students were allowed to trade with each other in liquid market for the security. And some students then paid price A+B because they hoped to unload on other students at a higher price before the day was over. What I will now confidently predict is that, despite Camerer’s experimental outcome, most economics and corporate finance professors who still believe in the “hard-form efficient market hypothesis” will retain their original belief. If so, this will be one more indication of how irrational smart people can be when influenced by psychological tendencies.” –Charlie Munger

If the thought system indicated by this list of psychological tendencies has great value not recognized and employed, what should the educational system do about it?

A mystery…to be continued

*****

What causes smart people to do dumb things? Adam Smith, author of the book “The Money Game,” interviewed Warren Buffett and asked that question. Buffett replied, “That’s the big question. Why do they do it in investing? Why do they do it in managing businesses? Because you have all these smart people out there. The money doesn’t go to the people with the highest I.Q. There would be a very poor correlation between I.Q. and investing and results. And you say to yourself why does somebody with a 500-horsepower motor only get 100-horsepower out of it? And I would say that if you look at the intellect as being the horsepower that’s available, but you look at the output as reflecting the efficiency of that motor, it is rationality that causes the capacity to be translated in output. Now what interferes with rationality? It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it. We try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.”[72]

*****

More questions:

  • What psychological factors and tendencies are missing from the list? What helpful examples are missing?
  • What are the 10-12 microeconomic models that, combined with these psychological tendencies working for good, can produce lollapalooza business results?
  • What absurdities that exist today – likely caused by a confluence of psychological tendencies – will be exposed as misjudgments over the next 5, 10, or 20 years?

Updates from the work of Kahneman and Tversky, et al.

Other useful concepts to consider:

  • System 1 and System 2
  • What You See is All There Is (WYSIATI)
  • Base Rate Neglect
  • The Planning Fallacy
  • Narrative Fallacy
  • Anchoring
  • Availability
  • Substitution
  • Loss Aversion
  • Framing
  • Sunk Costs
  • Divergent measures of happiness / remember self vs. experiencing self

I particularly try to use a “second look” to engage System 2. Putting down a file or pausing the research process has a lot of value to me, just as does when I come back to a stalled crossword puzzle after some time doing something else. There is a reason why great ideas often happen in the shower.

Other ideas:

  • Address complex problems by sub-dividing them
    • Israeli military’s practice of subdividing personal performance into smaller bits to find officer candidates
    • How should we evaluate investors, managers, etc.? Buffett wants managers who are energetic, honest, and smart. So take each of those three categories and evaluate them individually.
      • I might add humility, an attitude of partnership, frugality,

My “favorite” factors to try to avoid:

  • Sunk costs
  • Commitment and consistency
  • Narrative fallacy

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[71] May 5, 1995 edition of “Outstanding Investor Digest,” p. 50
[72] http://www.prnewswire.com/news-releases/buffett-warns-on-level-of-stock-prices-margin-of-safety-has-vanished-in-exclusive-interview-with-adam-smith-77907392.html

Update on Medley Capital

February 13, 2018 in Ideas

This post is excerpted from a letter by Jim Roumell, partner and portfolio manager of Roumell Asset Management.

Medley Capital Corporation (MCC) is a publicly-traded business development company (BDC) primarily engaged in providing debt capital to a wide range of U.S.-based companies. We wrote about MCC in our 3rd quarter letter. Our 4th quarter purchase was an add-on investment as MCC’s shares weakened and we took advantage of an even deeper discount to the company’s reported net asset value, NAV, as compared to our first purchase.

The investment thesis on MCC is pretty straightforward. MCC is now trading at approximately a 40% discount to its most recently reported NAV (as of 9/30/17). MCC is comprised of roughly 68% 1st Lien Notes, 16% 2nd Lien Notes and 16% Equity. MCC’s discount is unusually high, and pays a dividend of $0.16/quarter, which it is currently earning, resulting in a yield exceeding 12%. Importantly, MCC’s bal-ance sheet is well constructed with an average maturity of 2.8 years on the loans it holds and a weighted average maturity of liabilities of 5.1 years. Moreover, the portfolio is also well-positioned if interest rates rise —84% of its loans are floating-rate while 66% of its debt is fixed-rate.

Although we do not have access to underlying financial statements of the privately placed Notes inside MCC’s portfolio, we believe aggressive stress-testing and default scenarios allow us to sufficiently to conclude that MCC is a real bargain-priced security.

MCC has a credit rating system as follows:

Class 1 – Credit is performing better than expected.

Class 2 – Credit is performing as expected.

Class 3 – Credit is performing below expectations, but no loss is expected.

Class 4 – Credit is performing materially below expectations and while MCC does not expect a loss of principal, there could be a loss of interest payments. In many cases payments are delinquent, but normally not more than 180 days.

Class 5 – Credit is performing substantially below expectations, risk of loss has increased substantially, most or all covenants have been breached and payment is substantially delinquent. Some principal loss is expected.

If we assume dramatic credit degradation—Class 4 and Class 5 assets have a total loss ratio of 100%— the NAV drops from $8.45/share to $6.10/share compared to a current price of about $5.30/share, i.e., still a discount of 13%. As noted earlier in the MVC write-up, the 1940 Investment Company Act restricts the amount of leverage a BDC can have to 2x equity ($1 of equity can be leveraged by $1), thereby structurally protecting the equity from the effects of outsized leverage often found in other financial vehicles. If we go a step further, and wipe-out 25% of Class 3 assets, the NAV falls to roughly $5.50/share (still above the most recent market quote, but roughly 8% below our average purchase price). This most draconian stress test, and resultant NAV loss, would be offset by the quarterly income generated by the portfolio and still result in an ultimately positive investment return. Based on this analysis, would we take MCC private “in a heartbeat”? Absolutely.

MCC is not without “hair”, as is commonly found in our investments, although, in our opinion, it’s more than accounted for in its price. First, the company’s NAV is not derived from public marks as are found in closed-end funds holding high-yield bonds. The marks are independently derived and are audited, but nothing can take the place of a liquid public mark. Second, the restriction on leverage (an attribute we very much like about BDCs), could put MCC in the position of being a forced seller. Third, these are primarily smaller, riskier issuers, albeit 68% are 1st lien. It should be noted that roughly 40% of MCC’s portfolio is comprised of post-2014 loans as the company moved away from 2nd lien and direct small company lending and began buying pieces of larger syndicated loans issued by much larger companies with sturdier financial profiles.

That said, some of the mispricing of MCC’s shares is likely the result of investors not properly under-standing the company’s balance sheet and the amount of flexibility management has in managing it if losses meaningfully rise from current levels. MCC’s $150 million loan from the SBA (not due until 2023) is not counted toward regulated debt. Thus, MCC’s regulated debt is roughly 75% of equity, not the 108% GAAP number. MCC’s losses would have to drop roughly 15% more in order to hit the regu-lated debt limit of 100%. In this scenario, MCC could sell some of its Class 1 asset level loans to reduce leverage.

Moreover, few investors seem to understand that the ’40 Act leverage restriction only has to be met if the company wants to pay a dividend. The company could choose to temporarily suspend the dividend (Pimco did this on some leveraged loan funds during the financial crisis) if it believed the marks were not properly reflecting the underlying value of its loans. Shareholders would be better served by being patient for recoveries to occur (either through maturities and/or better marks), than being forced sellers. Interest would simply accrue to MCC’s balance sheet during this suspension period and could be distrib-uted at a later date. To be clear, the suspension of the dividend would in all likelihood result in a drop in the share price, but if done for the right reasons, this event would be a temporary mark and provide another opportunity to average down.

As we go to print, MCC just announced a material debt issuance conducted in Israel at a yield of 5.05%, maturing in 2024. The Note issuance interest rate and maturity are attractive terms that will allow the company to, among other possible uses, pay down existing higher cost debt while extending its maturity schedule. The Note was rated A+ by S&P Global Ratings Maalot, Ltd. MCC simultaneously announced that its common stock will have a dual listing on the Tel Aviv Stock Exchange.

Finally, in the past several months there has been meaningful inside buying by MCC’s investment man-ager, Medley Management, Inc. (MDLY), which is controlled by MCC’s CEO Brook Taube, at signifi-cantly higher prices than today’s, i.e., purchases were done at roughly $6.35/share versus today’s price of about $5.30/share. We recently sat down with Brook at MCC’s headquarters in New York and found him to be open and honest, forthcoming and non-promotional. MCC is not “out of the woods” yet, but we believe its price more than factors in significant credit stress testing while providing high current income and an opportunity for a meaningful closing of the discount to its underlying NAV over time.

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Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

MOI Global