Redwood Trust - Part I

First, before talking about Redwood I must disclose that I own shares in the company.  Second, I’m not providing investment advice, so make sure you do your own due diligence. 

Redwood Trust (ticker RWT) is a unique type of Real Estate Investment Trust (REIT).  REIT’s are companies that own physical real estate or real estate securities; Redwood is the latter.  Importantly, REIT’s have the advantage of not paying corporate taxes on qualified sources of income as long as they payout 90% of their taxable income.  The way Redwood is setup some subsidiaries are taxed while others are not.  Redwood has an interesting business model and generates profits through various activities.  However, I am going to simplify their business model in this post into two segments: investments and securitization platform. 

First let’s talk about investments.  Redwood is well known for investing in Credit Enhancement Securities (CES), also known as the equity tranche, or the first or second loss tranche in jumbo residential mortgage-backed securities (jumbo RMBS).  These assets are the riskiest assets in a securitization; however, they also have the highest expected return.  Now let me back up for a second.  RMBS is simply a collection of mortgage loans that have been pooled together and then sold to investors.  Pooling these mortgages reduces the risk of any one default having a sizeable negative impact on the investors return.  The “jumbo” in jumbo RMBS means that these loans are too large to qualify for government guarantees from any of the government sponsored enterprise (GSE’s), think Fannie Mae or Freddie Mac.  The GSE’s in essence protect the RMBS investors from any defaults.  However, since jumbo RMBS don’t qualify for the GSE’s, jumbo RMBS investors must find protection from somewhere else.  This is where Redwood steps in. Since they buy the first and second loss tranches they are providing insurance to the jumbo RMBS investors, but they only do this for a price.

I will explain this by giving an example.  Let’s say Redwood has pooled together several hundred jumbo mortgage loans and is creating a jumbo RMBS.  This RMBS will have two classes or levels, called tranches.  The first tranche makes up 90% of the securitization, is the first to get paid principal & interest, and is rated AAA.  We will call this the AAA tranche as it is the safest tranche.  The second tranche makes up 10% of the securitization, and will absorb all credit losses (bankruptcies) until the tranche is wiped out.  This is the equity tranche.  The AAA tranche will only see credit losses after the equity tranche is gone.  If there are zero bankruptcies then the equity tranche is paid in full.  For taking on this risk the equity tranche gets paid a higher interest rate than the AAA tranche.  Below is a diagram of a more complicated securitization; the equity tranche would be at the bottom of the illustration in the “unrated” section.

Redwood Trust will also purchase mezzanine (most junior) commercial loans or the most junior tranches in a CMBS, (Commercial Mortgage Backed Security).  CMBS is just a pool of commercial (business) mortgages.  Again, Redwood is looking at the riskiest, yet highest expected return assets.

Redwood will also invest in investment grade RMBS, IO’s (interest only), MSR’s (Mortgage Servicing Rights), and other types of real estate securities. 

Since Redwood wants to purchase risky assets it is important that they are mindful of how much they are being paid to take on these risks.  Since they can purchase various types of assets (RMBS, CMBS, IO, MSR, etc.) it is also beneficial to change the mix between assets in order to move from securities that are fair-to-over valued and into securities that are undervalued.  They can also create these securities themselves (see below) or buy them from a third party.  In essence they have to be good capital allocators to be successful. 

The second part of their business is their securitization platform.  Redwood earns fees from securitizing loans.  They primarily securitize jumbo mortgages, but will securitize commercial mortgages and are looking to securitize agency backed mortgages as well.  The securitization platform also is beneficial as they typically buy the junior most tranches in their own securitizations as well as IO’s and MSR’s that are created.  Since they are the company that is creating the securitization they have already completed the due diligence on the loans and should know the details intimately. 

In a post to come I will explain some of the pro’s and con’s of Redwood Trust.

 

Capital Allocators

I’m about to talk about one of my favorite types of companies, so first I must confess that I own several of them including Berkshire Hathaway (BRK.B), Leucadia National (LUK), Redwood Trust (RWT), Markel Corp (MKL), White Mountains (WTM), Seacor Holdings (CKH), and Loews (L).  I have owned Brookfield Asset Management (BAM) and Canadian Natural Resources (CNQ) in the past and I have Alleghany Corp, (Y) and Fairfax Financial Holdings (FRFHF) on my wish list. 

As some of you may have realized from my disclosure above one of my favorite types of companies is what is sometimes referred to as a “capital allocator”.  These companies focus on generating strong returns through allocating their capital wisely.  The most well-known capital allocation company is Berkshire Hathaway which is managed by legendary investor Warren Buffett as well as Charlie Munger.  Other popular companies include Loews and Leucadia National.  Capital allocation decisions involve whether to grow organically by plowing money into current businesses, purchasing new companies, selling businesses or business units, paying dividends, buying back stock, and I would also include financing decisions.  I love these types of companies because a good capital allocator is a great investment to own over 5, 10, or 20+ years as they are constantly looking to add value for shareholders.  Also, they are somewhat like a focused mutual fund only without the annual expenses.  Most good capital allocators look to grow organically, but they do so in an intelligent and disciplined manger.  Most projects they undertake should create strong returns using conservative estimates.  These companies will do M&A transactions, but are very selective and pay a lot of attention to valuation and industry fundamentals.  There are quite a few capital allocators that also focus on buying back shares; however, they do so differently than your typical company.  Most companies that buy back shares do not pay enough attention to valuation and often over pay.  Capital allocators only buy back their shares if they feel that they are undervalued using conservative estimates.  The biggest waste of capital is to buy back shares when they are trading at a premium to the actual value of the company, but on the other hand buying back shares at a discount to intrinsic value is highly beneficial to shareholders over the long-term.  Some capital allocators do pay regular dividends, while others only pay them when they cannot find enough organic growth, M&A deals are being over priced, and the stock is trading at too high of value.  Dividend payments create taxes for shareholder so it is more efficient to use capital in other ways if possible.  However, some companies do use dividend payments as a way to force capital discipline which is a laudable goal. 

Many capital allocation companies are diversified holding companies, such as Berkshire, Leucadia, and Loews.  However, a company does not have to be a diversified holding company to be a strong capital allocator.  Redwood Trust, for example, is in a niche business although they do have more than one source of value generation.  Capital allocation companies also have a tendency to own large financial services business.  For example Berkshire Hathaway owns several large insurance companies and Loews also owns a large insurance company.  Leucadia National just purchased an investment bank and has owned insurance companies in the past.  Markel, White Mountains, Alleghany Corp, and Fairfax Financial Holdings Ltd are primarily insurance companies, although some of them do have non-insurance business such as Markel with their Markel Ventures businesses.  Redwood Trust is a unique mortgage REIT and Brookfield Asset Management is a physical real estate firm.  So, trying to build out a diversified portfolio can be difficult as you may end up with a large allocation to the financial sector.  There are capital allocators out there that do not have financial businesses, such as Seacor Holdings which owns shipping services (inland marine, offshore service vessels, oil tankers) and a few other businesses.  I have also had people argue that Canadian Natural Resources is a good capital allocator in the energy sector. 

Just like any other company, however, they can become overvalued so you still have to pay attention to the price you pay for them.  That being said if you can buy one at a fair valuation you should be able to generate strong future returns.  If you can get your hands on a capital allocator at a cheap valuation then allocate a lot of capital to it.  Also, just because a company says they are a good capital allocator doesn’t mean you should trust them.  I have found several companies that were supposed to be the next “Berkshire” but after digging into them there is no way I would invest in them.  Make sure to verify that potential capital allocators are growing book value/share and cash flow at above average rates.  If you are interested in a more detailed look at many capital allocators you should vies the Brooklyn Investor Blog (http://brooklyninvestor.blogspot.com/).  The author does a superb job on just about every post and he mostly covers capital allocation companies.

 

The Institutional Imperative

The Institutional Imperative

What is the institutional imperative and why is it important?  This is a term that is often attributed to Warren Buffett.  In The Warren Buffett Way by Robert Hagstrom Jr., Buffett is quoted as stating that the institutional imperative exists when “(1) an institution resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”  The urban dictionary simplifies this by describing the institutional imperative as “any company’s inherent propensity to do dumb things (or avoid smart things) simply for the sake of doing them.” 

The reason I bring up the institutional imperative is because of what I wrote about in the last post with the Contrarian Manager strategy.  If it is such a great strategy why don’t more institutions implement it?  One reason would be that, unfortunately, the institutional imperative is alive and well in the investment management industry.  Many investment companies are not led by investment people, but by sales and marketing people who put an emphasis on what is selling right now and what is hot.  I’m sure there are some good leaders with a sales background in the investment industry; I just haven’t met one yet.  I have met people with a strong investment pedigree that never-the-less ended up being all about sales.  Salesmen and women want to use 4 & 5 star rated funds or popular types of funds because that is what sells.  Their focus isn’t on the client or investment returns, but on selling whatever they can.  Intelligent investment personnel realize that star ratings measures past performance, that markets have cycles, and that a fund that is rated 5 stars today is likely to be 3 stars in a few years.  Good investment firms understand that if a fund is 5-star rated today that means that everything has went right for that fund in the past, so the chances of doing it again over the next 3-5 years are slim.  High-quality institutions will ignore star ratings as they are not a good predictor of future performance.

Another reason is “what if the strategy doesn’t work right away?”  The Contrarian Manager strategy is used to increase the odds of succeeding, but it doesn’t mean you will succeed.  If it goes badly then people may say “why would you invest with a manager that clearly lost his mojo” or “everyone can see why that wouldn’t work”.  Going against the crowd can be difficult especially when something doesn’t work out right away.  For an institution they don’t want the reputation risk.  Think about a manager that wanted to own AIG after it crashed or BP after the oil spill.  People hate(d) these companies, so owning them is certainly going against the crowd, but both would have been good investments if bought/sold at the right valuations.  However, if they wouldn’t have worked out well just try explaining why you held a company that everyone hated and “knew” was a bad investment.  Try to explain why a manager you hired would own these companies.  The reputation risk can be difficult to bare.

Sometimes institutions get caught up in the moment as well.  A company I used to work for held the Fairholme fund in two separate strategies in 2010.  At the end of 2010 I was able to convince the group to completely sell out of the fund in the smaller strategy, but it remained in the larger strategy.  In 2011, the Fairholme fund lost about 32% when the S&P 500 was up 2%.  At the end of 2011 I was able to convince the group to add the Fairholme fund back to the smaller strategy, but was unable to convince them to even maintain its weighting in the larger one.  Instead the group decided to cut the allocation in the larger strategy in half, despite my objections.  The argument was that the volatility and amount of underperformance was too great.  The amount of underperformance was one of the reasons to add it back to the smaller strategy and in my experience returns trump volatility as volatility can actually be your friend.  In 2012, Fairholme was up about 35% which almost beat the S&P 500 by 20%.  In the end it was the clients that were hurt as the investment group followed the herd, on the larger strategy at least, keeping a manager after great performance and selling them after poor performance. 

Just like individuals fall into many behavioral traps, investment firms tend to fall into the institutional imperative trap.  I’ve been involved with a company where just about all the people understood that the company had major issues that needed fixed, but inertia dominated and change was almost impossible to accomplish. Another firm was dominated by sales people who made foolish investment choices.  Another firm seemed to make decisions based on internal politics.  So, when thinking about the institutional imperative it not only applies to individual businesses that you may be analyzing, but is also something to consider when you are purchasing a mutual fund, hedge fund, or hiring a financial advisor.

 

 

The Contrarian Manager Strategy - One Method of Outperforming Over the Long-Term

The contrarian manager strategy is composed of several key steps.  The first step is to decide what types of assets to purchase.  I tend to look at asset categories that have underperformed compared to others and that have experienced cash outflows.  These are prime areas to search for potential investments and as Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”  Just because an asset class has underperformed does not mean that I will invest in it, but it does make it more likely that I will find an attractive investment.  While I think diversification is important, you also have to be wary of diworsification as well.  There is such a thing as too much diversification so I don’t feel like I have to own every asset class; I just want to own the most attractive ones and then weight them according to their attractiveness. 

The second contrarian decision is to purchase money managers that are truly contrarian managers.  Many portfolio managers claim to be contrarian, but a true contrarian manager will purchase assets when everyone else hates them.  They will buy unpopular stocks with depressed prices when everyone has “sell” or “hold” ratings and sell them when everyone loves them and all of the analysts have “buy” ratings. These are the types of managers that outperform.  Now going against the crowd is not always a wise decision as the crowd is sometimes right, so you good managers selectively go against the crowd.  But to outperform you have to do something different and be somewhat unique.

The third contrarian decision is to purchase the good contrarian managers after they have had poor performance.  A really good manager will bounce back and typically bounce back strong.  Good contrarian manager underperform for several reasons: sometimes their style is out-of-favor, sometimes they are too far ahead of other investors and it takes a while for the investor community to recognize the value of the assets they purchased, and sometimes they made a big mistake that hurt results but which they have learned from.  When these managers have bad performance and experience cash outflows I’m there to give them some cash inflows. 

Finally, the fourth contrarian step is to trim or sell the managers that have done extremely well since they have been purchased.  One of my rules is that if a manager I own becomes a 5-star Morningstar fund then I sell it.  5-stars means that everything has worked out well for that manager over the past 3 years, but that is very unlikely to continue to happen going forward.  I will also sell if a fund has had large cash inflows which usually happen after a period of very strong performance.  One issue with selling managers in a taxable account is that you create taxes, so to reduce this factor you can always reduce the turnover by the amount of trimming you do.  Also, instead of selling out of a manager completely, just trim. 

Now you may be asking how bad does a manager have to do and over what time period for it to be a candidate for purchase?  Also, how good does a manager have to do and over what time period for it to be a trim or sell candidate.  The short answer is, “it depends”, so let me give you an example.  Prior to 2011 the Fairholme fund (Ticker: FAIRX) had outperformed the S&P 500 in 10 of the previous 11 years. Bruce Berkowitz had definitely shown a contrarian streak and his performance had been excellent.  Performance had been so good that if you follow the contrarian manager strategy you wouldn’t have had an entry point.  That is until 2011 when the wheels came off and the fund lost 32% when the S&P 500 was up 2%.  That’s 34% of underperformance.  In this case while it was only over a 1-year period the amount of underperformance was so large that it would qualify as a potential purchase.  In 2012 Fairholme returned almost 36% compared to the S&P 500’s 16% return.  That is quite a bit of pain to avoid and a significant amount of outperformance to obtain by showing some discipline.  Now should you buy, sell, or hold since the fund performed by so much.  This is really quite subjective, but in my opinion rebalancing the allocation and maybe trimming the overall allocation is warranted since it outperformed by so much. However, I would not sell out entirely because you are talking about a good long-term contrarian manager that has a high likelihood of performing well in the years to come.  Although the contrarian strategy does create some turnover the ideas is still to hold these manager for long periods of time, so I wouldn’t sell out of a manager unless it’s performance was very strong over a multi-year period or off the charts over a short time period. 

Another fund that may qualify for use in the contrarian strategy is the First Eagle US Value fund (Ticker FEVIX). The current PM’s of the fund are relatively new, but the fund strategy isn’t and neither are the firms’ contrarian roots.  For three of the past four calendar years the fund has ranked in the 3^rd or 4^th quartile and YTD, as of 04/30/13, ranks in the bottom decile.  The one year they outperformed they were in the top decile.  In 2009 and 2010 they underperformed by modest amounts and in 2011 they outperformed by an ok margin but nothing extreme by any means.  However, over 2012 and YTD they have underperformed by over 11% cumulatively.  This has been an extended period of underperformance.  If you do believe they are good, contrarian managers then this may be a good time to purchase a moderate allocation as they have had an extended period of underperformance which I would argue increases the probability that they will outperform going forward.

Now this strategy is subjective and is not perfect as there is no such thing in the investment world.  But the idea behind it is to increase the probability of picking good assets, from good managers when they are most likely to outperform, and increase the chances of long-term outperformance.