market folly

In his recent hedge fund letter to investors, Third Point LLC's Dan Loeb said that he feels like a kid in a candy store. Why, might you ask? Well, it's because of all the opportunities he is seeing in distressed debt these days. And, he anticipates even more options going forward. Just last week we covered Dan Loeb's recommended investing books and now we're back to cover his latest take on the markets, as per his investor letter.

Investment Outlook

In the letter, Loeb comments on their take on the economy and markets by writing, "our view that the robust governmental response to economic problems here and abroad had averted a global financial meltdown led us to become more constructive about the investment climate. With such doomsday scenario off the table, we put capital to work during the second quarter in a number of significantly undervalued turn-around, distressed debt, and other compelling special situations." Later on we'll look at the specific positions Loeb is referring to. But for now, let's continue to focus on his macro outlook. As we hinted in the beginning of the piece, Loeb is seeing a ton of opportunities in distressed debt. A lot of Third Point's gains thus far were from buying bonds when they were oversold. However, while Loeb has already been profiting from such plays, he believes the most enticing opportunities are yet to come. He specifically notes that restructuring of defaulted securities will be the most compelling stage of this distressed debt cycle. While he has already been busy in this arena, it looks like the best is yet to come (at least according to him). And we don't doubt that, seeing how Third Point has an excellent reputation as an event-driven fund. This echoes what Loeb was recently saying in a video where he discussed Third Point's investments during the crisis.

Portfolio Positions

Fortis:
Turning now to some of their specific positions, we see that Third Point has played Fortis very nicely. Loeb details their rationale behind picking up Fortis equity, convertible securities, and 'other hybrids' and reveals that they are up about 160% on their investment. They continue to hold common stock and mandatory convertibles as they seem them as very undervalued. This is an event driven play in numerous iterations. Third Point capitalized on the April 29th shareholder meeting and next they will look to capitalize on the release of half-yearly financial statements.

Automotive Industry Plays:
Third Point has numerous plays in this sector as 12% of their current portfolio is auto-related and it is 25% of their overall credit exposure. They have positions in the following plays: Ford Motor Credit, Ford Motor Company, Dana Holding, Delphi, and Lear. We highlight this because in one of David Einhorn's recent investor letters, he revealed that his hedge fund Greenlight Capital liked Ford debt as well.

Third Point also invested in Chrysler Financial 1st and 2nd lien debt. These positions were among some of the biggest gainers for Third Point as they took advantage of the complex situation there. They took profits on their 2nd lien position after the bankruptcy (they initially picked them up in the 30's). Then, more recently, Third Point was able to repurchase the 2nd liens as they saw another catalyst. Loeb writes that, "We believe (Chrysler Financial) has generated a significant cash balance since entering run-off and will use this cash to repay a large portion of the 1st lien (thereby also increasing the value of the 2nd lien) or possibly seek to repurchase 2nd lien paper at a discount during the next six months. Either of these events should result in meaningful appreciateion for both loans." Additionally, the automotive industry as a whole has piqued Loeb's interest as he cites numerous figures in automotive seasonal-adjusted annual rate of sales. He cautions that this is a risky industry right now and there will most definitely be landmines hidden within. He believes his firm can navigate the sector safely though.

Bank of America:
Third Point also picked up BAC preferred stock at 57 cents on the dollar and then converted it into common stock at $10. BAC shares now trade north of $16, so you do the math on that play... it's a healthy profit. They continue to hold the equity as they see it as undervalued here. Also, we've been hearing that John Paulson's hedge fund Paulson & Co is a large BAC shareholder these days too after he also took BAC up on their share offer.

Distressed Mortgages:
We mention Paulson above simply because Loeb's next play is also a Paulson favorite. Third Point has started to make investments in the mortgage securities arena. However, they are still cautious on CMBS (commercial mortgage backed securities) due to further expected declines in commercial real estate and the like. They have made limited investments in that area. But, for the most part, they are targeting mortgage plays that will yield a 17-20% return under their main economic assumptions. In their extreme scenario, Third Point argues that with 100% defaults and another 20% decline in home prices, they want to purchase securities that still yield 10%. So far, they've invested $160 million in this arena. We mention Paulson again simply because after notoriously profiting from the decline in housing in the years prior, Paulson's hedge fund has now begun buying distressed assets and has started a real estate recovery fund as well, so Loeb could be in good company here.

Deutsche Boerse:
Lastly, we also see that Loeb is bullish on the one-time hedge fund favorite Deutsche Boerse. They like the fundamentals again and note their 50% EBIT margins and high market share as attractive. Curiously enough, Loeb also cites the fact that two major shareholders dumping their long positions as as a reason to be bullish on the name. It looks like even prominent hedge funds themselves like to keep track of what other firms are holding... imagine that. This is what we here at Market Folly strive to do on a daily basis. We are simply aiming to shine the light on the dark investment corners where hedge funds are quietly building positions. Avid hedge fund followers will remember Deutsche Boerse because hedge fund Atticus Capital previously had a very large position in the name.

Performance & Portfolio Metrics

For the second quarter and year-to-date for 2009, here is how Third Point's funds fared:

Partners: +8%, +5.6%
Partners Qualified: +7.9%, +5.5%
Offshore: +10%, +7.1%
Ultra Funds: +12.2%, +8.5%

Additionally, you can view Third Point (and many other funds') June performance in our performance numbers post. Third Point's portfolio exposure flows along the timeline as follows: They were net short in April and then became dramatically net long by the end of June. Their allocation to both risk arbitrage and credit expanded significantly, up to 20% and 40% of the portfolio, respectively. Loeb wasn't lying when he said he's seeing a lot of opportunity.

Closing Remarks

It appears that Loeb's main fancy right now is obviously distressed debt in general, with a focus on the automotive industry. He also likes risk arbitrage here, although he did seem to take a swipe at the Citigroup Preferred/Equity exchange that many hedge funds were burned by. He laments the fact that there were (and we quote), "usurious rates charged to borrow the stock." But that debacle aside, Loeb likes risk arbitrage plays here. Last but not least, Loeb also touches on some firm changes as they have modified their lock-up period and have eliminated the '3% off-Anniversary Redemption fee.' Those interested in the details of this can read up on it in Third Point's investor letter embedded below. For more resources of Third Point, be sure to check out Dan Loeb's list of recommended investing books that we just posted. This list is derived from comments he made in a recent video we posted where Loeb detailed Third Point's timeline throughout the crisis, among other topics. Additionally, you can check out our previous coverage of Loeb's portfolio here.

Attached below is Third Point's second quarter 2009 hedge fund investor letter. RSS & Email readers will need to come to the blog to view the embedded document. Alternatively, you can try to download the .pdf here while the link lasts.

Third Point Q2'09 Investor Letter