HHC: An Interpretation of the Recent Warrant Buy-backs

As you may have seen, HHC entered a few transactions to eliminate the outstanding warrants  from certain of its sponsors in the original spinoff transaction:  Blackstone, Fairholme, and Brookfield. I view this as a favorable event given the fact that shareholders now own ~10% more of the company on a fully diluted basis.  With my most recent NAV estimate of $152/share, the net effect of these transactions was to increase fully-diluted NAV by 4.5% to $159/share (the cash outlay for the transaction + reduction in cash receivable from now eliminated warrants explains why NAV/share doesn't also go up by 10%). 

 

As will be explained further on in this post, HHC will be "in-the-money" on the Blackstone and Fairholme warrant cancellations when the share price breaks $80.  Even at my low-end NAV/share estimate of $100, this deal is accretive.  However, I believe it will take time for the market to wake up to HHC's intrinsic value; as Grant Herlitz stated in the webcast from the JMP Securities presentation (Sept.'12), HHC's goal is to convert itself into a cash flow vehicle from one that is currently asset based.  Until then, the market will not have any straightforward way to value the stock. Where I stand to be surprised is in how quickly lot sales and thus cash flow from Summerlin and Bridgeland can pick up steam in the coming quarters.

 

Fairholme and Blackstone sell warrants for $30 each.  With a strike price of $50, this implies a breakeven share price of $80 before HHC is in-the-money.  I can only speculate as to why Fairholme and Blackstone would want to give up now and on terms so favorable to HHC.  Perhaps they see better opportunities to benefit from the housing recovery and view this as an opportune time to rotate their capital.  In Fairholme's case, exercising the warrants and then holding the stock would have entailed a cash outlay of $96 million, whereas instead they received $57.5 million in selling the warrants now to HHC. 

 

Brookfield enters net settlement for its 3.8 million warrants.  By agreeing to a net settlement wherein Brookfield exercised 1.5 million warrants (would have resulted in $76 million outlay to HHC) and allowed the remaining 2.3 million warrants to be bought back and cancelled by HHC for $89 million, Brookfield received the net difference of $13 million and thus avoided the need to inject further capital. For HHC, the per-warrant cost of $38.69 in this transaction implies that HHC will be in-the-money when the share price breaches $88.69 (cost + $50 strike price). It is unclear why Brookfield received a buy-out price 29% higher than what Fairholme and Blackstone acheived.

 

The word on the street for more than a year has been that Brookfield was planning to eventually exit its HHC position. We already saw the departure of David Arthur from the board of directors (Brookfield's only representative) in 2011 and last week, the first 13D filing confirming Brookfield's first sales of HHC stock on the open market. I do not believe this was pre-empted by Ackman's recent conflict with Brookfield over General Growth. Brookfield simply doesn't like to own stock in companies it does not have a direct influence in.

 

The recent clean up of sponsor warrants implies the following:

• HHC management is very bullish about 2013 and beyond and believes that mopping up these warrants would otherwise be more expensive in the future, as the housing recovery progresses and HHC's development projects continue to move forward.
• The company has no financing worries regarding capex needs for the Summerlin Center,Ward Village, Riverwalk Marketplace, South Street Seaport, and Maryland. Instead of receiving a potential $304 million from warrant excercises, HHC in fact outlayed $80 million of cash to buy them back from Brookfield, Fairholme, and Blackstone. A slide from the investor presentation posted online details how in a JV scenario, the cash requirement to fund construction is diminished via a combination of HHC's contribution of land for its consideration of equity into joint ventures, and furthermore debt financing. So it must be the case that management figures HHC's cash needs for construction are not significant, or alternatively the deal it got in cancelling the warrants was good enough such that it took precedence over intermediate project funding needs.
• Pershing Square now the sole remaining sponsor with warrants.  With Bill Ackman as Chairman of HHC, I would have expected no less than for Pershing Square to maintain its warrant position.  HHC represents only a nominal percentage in Ackman's $10 billion plus hedge fund portfolio, and I am sure he would like to increase its weighting.  Exercising his 1.9 million warrants would help in this regard ($96 million), albeit still insignificant in comparison to some of his other investments.

Howard Hughes Corp - A Textbook "Greenblatt" Spinoff?

It is becoming increasingly evident that I am obsessed with The Howard Hughes Corporation. The vast majority of my net worth is riding on this one company, even though I have no real edge over the average retail investor - nor will I likely ever meet management. 

From the current price of ~$73, this idea does not have the multi-bagger potential that General Growth Properties once had at its low of $0.30.  Indeed, one can say that a lot of the easy money has already been made since the discount to book value has disappeared since the price exceeded $58.  Theoretically, I should be swapping my funds into plays with similar merits and a large margin of safety like HHC once had. Despite being one of the more difficult companies to value, I have vowed to hang on for at least a few more years.

This is the first and last time I will say this: If you haven't read Joel Greenblatt's "You Can Be A Stock Market Genius", get yourself a copy.  The book's intrinsic value is far greater than its retail price as you will be introduced to a life-long, potentially lucrative facet of investing. Anyway, Greenblatt's book was written in 1998, and it is evident that his teachings regarding spinoffs are as relevant today as ever. In this brief note, I will highlight pointers from Greenblatt's book and how HHC has fit the box in textbook fashion. But before I begin, you may wonder why I promote know-how that could reduce my changes of investment success should more people catch on to spinoffs.  First of all, I think of this as my diary. Secondly, value investing doesn't resonate with the majority of investors to begin with, and spinoffs furthermore appeal to only a portion of the value crowd.  So I'm not convinced at all that a few more participants will reduce my chances of success.

 

 

Greenblatt Spinoff Pointers

 

The following are spinoff attributes from Greenblatt's book that I found applied directly to HHC:

• A high distribution ratio can lead to forced selling
• In spinoffs, management has an incentive in the beginning to hide rather than advertise value
• The spinoff may not immediately attract sell-side analyst coverage
• Entrepreneurial spirits are freed, but operations may not gain momentum until the new company's second year of existence

 What Has Played Out So Far

• A high distribution ratio can lead to forced selling
• I believe this is what happened with HHC. I know that at least one hedge fund shorted it out of the gate in Nov. 2010 at around $40 - on the first day of trading. What on earth was he/she thinking??!  
• In spinoffs, management has an incentive in the beginning to hide rather than advertise value
• Management has opened up since the November 2010 spinoff; warrant exercise prices were set based on the first several days of trading, and thus management had no incentive to advertise the firm's value in a bullish light before the exercise prices are set (to management's advantage). President Grant Herlitz made the company's first webcast available on the Howard Hughes website in September 2012, almost two years after the start of trading.  There are no quarterly conference calls, which is not inappropriate for a development company. However, CEO David Weinreb has had no media presence; besides his annual letter and the odd quote found in either press releases or articles, the public has had no way of getting to know the big boss. Is David working hard and fully engaged, or is he out of the picture?
• The spinoff may not immediately attract sell-side analyst coverage
• It has been two years since HHC began trading on the NYSE, and still no coverage has been intiated by of the bulge bracket brokerages, despite a market cap approaching $3 billion.
• HHC is a development-focused company, which does not naturally fit with sell-side REIT analysts who already covered General Growth.  How troublesome would it be to write an initiation report claiming expertise in a diverse collection of property types (MPCs, mixed use development, acreage of varying stages of development, retail, office) spread across the U.S.?  Does this neatly fit into a category for sector coverage?
• Entrepreneurial spirits are freed, but operations may not gain momentum until the new company's second year of existence
• in a little over two years of existence as a public company, HHC has made the following notable steps: (1) bought and gained Morgan Stanley's part interest in the Woodlands, thereby allowing for acceleration of development, (2) announced plans for South Street Seaport (though I'm sure the flooding caused by Superstorm Sandy is having an adverse effect in marketing to prospective tenants), (3) recommencement of Summerlin Center - Macy's and Dillard's already signed as tenants, (4) announced Ward Center plans, and (5) increased shareholder ownership by ~10% on a fully diluted basis after negotiating the  reitrement and conversion of warrants with Brookfield, Blackstone, and Fairholme

Why the sell-side should want to build a strong relationship with HHC now (this part is me talking my own book - but the logic is sound)

• The company will need funding to develop its projects; agents will also be needed to find buyers for percentages of projects after full ramp-up.
• HHC's team is highly competent and a breeding ground for CEOs of future companies
• I predict that within several years, at least one company will spin-off of HHC. Young talent will branch off into other firms in senior management positions with a highly credible deveopment track record. By covering the stock now, you will also get access to less senior management who will eventually be the trigger pullers.  Think beyond the next quarter.
•  Despite the price appreciation, HHC is still a good stock pick and will be beneficial for an analyst's career.

 

Bill Ackman's True Genius: Hyper-Alignment

Anyone who follows Bill Ackman's investment career can see that he is a great investor.  If you had bought GGP when he did at $0.40, you would have made more than 80x your original investment in a little over three years (including the current market value of the HHC and RSE spinoffs). Of course, opportunities like that rarely come along, and I certainly don't expect Ackman's or any investor's future picks to yield such results. Furthermore, Ackman is not right 100% of the time, as can be seen in some of his retail mishaps such as Target and Borders.

One aspect of Ackman's activist approach that I believe is widely overlooked is his creation of a system to align CEOs he hires into companies. I have discussed this method of Ackman's in an earlier post, so this may sound a little repetitive to those who previously read it. The reason why I think his true genius is on display through the technique of having the incoming CEOs invest in warrants is that, when the writing is on the wall in a few years, I believe we will see the benefits in the stock prices of Howard Hughes Corp. and JCPenney.  So how, you may ask, does this intangible factor guarantee success? The answer is that it doesn't. But given the importance I place on having a good management team in place, if you give me a great CEO and further have incentives in place that amplify his long-term up- and down-side, you have my close attention for at least a few hours!

Howard Hughes Corp. Warrants - Purchase Terms

• Weinreb and Herlitz ("W&H") bought 2.7m warrants for $17m, or ~$6.30 per warrant on Nov. 19, 2010
• Strike price is $42.23 (closing price on 11/19/2010)
• Breakeven price is therefore $48.53 ($6.30 + $42.23)
• 7-year life; if share price is not at least $48.53 by Nov. 19, 2017, Weinreb and Herlitz stand to lose 100% of their $17m investment

My take on this: At the current price of $65.39, W&H are already beyond their breakeven price by $17.16 or $46 million (272% gross return!!). It is true that both are technically safe as long as the housing recovery keeps trudging along and nothing too adverse happens.  One must wonder then what incentive either manager has to continue working hard prior to the warrant expiries.  Well, for one thing, the warrant terms are such that they "are not exercisable for six years except in the event of a change of control, termination of the executive without cause, or the separation of the executive from the company for good reason. In addition, for the first six years of the warrants’ term, each executive is prohibited from selling, hedging, or otherwise reducing his net long exposure to the shares underlying the warrants."  The only phrasing in the above terms that makes me queasy is "separation of the executive from the company for good reason".  But chances are that, if for example, Bill Ackman ever wanted to get rid of W&H, by that point the couple would have failed and their warrants out of the money anyway. 

I believe W&H will continue to do their best to surface value by Nov. 2017 because of the leveraged upside both still have from this vantage point.  If they are able to build the value of the company to $100 (my intrinsic value estimate for HHC), this would mean a $139m profit [(100-48.53) x 2.7] or a 817% gross return.

Thus far, management has been quietly working away on advancing developments at the South Street Seaport, Riverwalk Marketplace, Columbia MPC, Bridgeland MPC, Woodlands MPC, and the Ward Centers in Honolulu. My bet is that W&H will really pick up the steam in 2015, and by 2017 we will have seen various value realization moves (e.g. spin off a segment, sell partial interests for more than people expect).  Don't forget that you also have Bill Ackman, the financial engineer of all financial engineers, to ensure than as much value by then is surfaced.

J.C. Penney Warrants - Purchase Terms

• Ron Johnson bought 7.257m warrants for $50m, or ~$6.89 per warrant in June 2011
• Strike price is $29.92 and breakeven price is therefore $36.81 ($6.89 + $29.92)
• 7.5-year life; if share price is not at least $36.81 by December 2018, Johnson will lose 100% of his $50m investment
• The warrants cannot be sold or hedged for the first six years of their term

My take: Just to get to Ron Johnson's breakeven price on his investment, an investor today would experience a 49% gross return (36.81/24.65).  To me, this is the riskier bet as the thesis depends on Johnson's turnaround strategy playing out successfully. Unless an investor is 100% that his/her downside is protected by the real estate value of the stores, there exists a possible binary outcome.  That is why I have committed only a small portion of my portfolio to this name.  Still, Johnson's fortitude in executing the turnaround (e.g. not caving in after a terrible quarter and reverting back to coupons) suggests that he is running JCP like a private company, which is the purpose of the executive subscribed warrants: setting the CEO's eyes on the long-term prize rather than quarter-to-quarter targets.

Key Takeaways

• Executive Subscribed Warrants are a great tool to align the long-term interests of management
• Under this incentive, the CEO must build value over the next six years or risk losing his entire investment
• Implications: He is much less likely to make decisions for the short term
• Evidence: JCP going against grain of giving back in to couponing to meet quarterly expectations

Concerns

• Okay, so what if this system is a success? What happens after the 6th-7th year? How is the CEO aligned after this point when the stock is up several hundred percent?
• Answer: I don't, but for the next several years you can bet the CEO will do everything he can to surface value.
• I don't expect this system can be done for every company, so therefore it is not the answer to alignment problems at most companies
• Answer: That is very true. For this warrant system to work, (1) a competent CEO with the financial means to invest a convincing sum must be available, (2) the company must be undervalued and thus be perceived as a great investment by the incoming CEO.  So we should not expect to see this implemented well too often. However, if other activist investors do copy Ackman's approach, close attention should be paid to the opportunity.

Disclosure: I currently own positions in all the stocks mentioned above: HHC, GGP, RSE, JCP

JCPenney - worth considering

I initiated a small position for myself in JCPenney yesterday at $20.50. If Bill Ackman is correct, investors stand to make 15-20x their money at the current price (see Pershing Square's May 2012 presentation here). 

Just for those hailing from outside North America, JCPenney is a department store chain in the U.S. with ~1,000 locations.  It was at one point (in the 1960s) the 2nd largest company in the U.S. by market capitalization, but has since fallen into disrepute because of mismanagement and intense competition. The following points outline why I believe this could be a good investment:

1) Downside protection from real estate value.  If we take Ackman's statement that the replacement cost of the real estate is $11 bilion, then after subtracting the $3 billion of debt (not even considering the company's ~$800 million cash balance), we arrive at $8 billion for net asset value.  This would work out to a little more than $36.50, or 77.5% above the current price. Using $36.50 as the floor price, of course, assumes that in a worst case scenario of bankruptcy and liquidation, we will be able to realize market value in a bankruptcy sale (which is unlikely).  I have come up with something a little more conservative for my own crude calculations.   Given JCP's outright ownership of 49% of its stores, this works out to ~55 million square feet of ownership.  Using Sears' sale of 11 stores to General Growth in April 2012 as a precedent transaction, the price per square foot was $150 ($270mm paid for 1.8mm sq ft).  Applying $150 to 55 million square feet gives us a value of $8.25 billion.  Now subtract $3 billion of outstanding debt from the $8.25 billion and you get $5.25 billion ($24/share), which is still a 16.5% premium above the current price.

2) Strong insider ownership.  With Pershing Square's 26% ownership stake, we have patient money backing the company's new strategic initiatives, which would have no chance of success if a quarter-by-quarter investor were to be in control.  Bill Ackman (founder of Pershing) actually sought out and effectively installed Ron Johnson, who is the current CEO of JCP.  Upon taking the helm, Johnson invested $50 million in warrants with 7.5 years to expiry that are not excercisable until year 6.  He paid approx. $8 per warrant with a strike price (market price at the time) of $29 - thus his break-even point is $37.  Hence an investor entering in today would experience ~80% capital appreciation just to get to the point where Johnson breaks even in year 6 of his investment!!   This compensation structure, which no doubt gives the CEO a leveraged outcome (and leaves no room for error on the downside) is unique and present in only one other company I know of called the Howard Hughes Corporation, where Bill Ackman serves as the company's chairman.  While this warrant ownership scheme is no guarantee of success and by no means protects you against management misjudgement, one thing is for certain:  the CEO is more likely to think for the long term versus appeasing investors quarter-to-quarter. 

3) Management's reasoning makes sense.  While JCP's earnings are likely to continue hurting for the next few quarters, Johnson's new intiatives make a hell of a lot of sense. I would encourage you to read the presentation (linked to above), as it walks through what management plans to do over the next few years.  In a nutshell, JCP was terribly mismanaged by previous leadership through extreme couponing (average of two sales per day at up to 60% off normal price) which led to the perception among suppliers of a lack of price integrity.  As a result, most brands refused to sell their wares in JCP and this led to a cycle of decreasing price points.  Johnson's strategy is to use JCP's structural advantage, being its low cost ($4 per sq. ft.) leases and direct ownership of stores, to offer incoming (and higher value) brands the opportunity to set up their own mini-stores within each location and thus acheive nationwide distribution.  He labels this his "mall within a mall" concept. Secondly, Johnson has targeted $900 million of cost cuts.  Considering that $1.8 billion of costs would need to be chopped in order to reach Macy's efficiency level, $900 million hardly sounds unreasonable. 

I would argue that the current valuation is already pricing in a grave level of pessimism.  However, giventhe fact that this turnaround will take time, I would not be surprised if the share price tanks again on August 10th when the next quarter of earnings is reported.  This of course depends on how disappointing sales are.  Sales were down 20% in the most recently reported quarter; if an even greater decrease is reported in August for Q2, it could be a sign that the situation is getting out of control and that JCP's previous customer base is running for the exits. In this scenario, Johnson may be pressed to sell some stores to raise cash for working capital to make ends meet until his plans work out.  If however the year-over-year sales decrease is less than expected, we could in fact see the share price pop as investors decide to price in a lower level of pessism.  The truth is that I don't know whether we have reached the bottom on JCP... if the next quarter is worse than expected, I wouldn't be surprised if the stock crumbles another 50%.  However, as I believe the odds of doing well (from the current price) on this bet over the next 5-6 years are good, I have decided to invest ~50% of a full position now vs. speculating over the next earnings release.  In other words, I am not letting my long term speculation to be influenced too much by my short term speculations.

Negative feedback loops and financing risk

So it appears my first pick on this blog (Tigray Resources) has thus far been an utter stink bomb.  Perhaps it goes to show just how important some of Mr. Buffett's concepts are, being Margin of Safety and Circle of Competence. I violated both for three reasons: 1) I have a fascination for spin-outs and thought this was a case wherein management was trying to get in on the best asset of Canaco for themselves, 2) I previously met management at  a retail investor's conference and trusted them, and 3) I was lured by the prospect of quick profits.

In hindsight, this was a very expensive way to reinforce things I knew beforehand.  By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism.  Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).

Tigray has lost more than 80% of its value since I began investing in it.  At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even.  Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have.  So where did I go dead wrong?  Well, there are two main places.  First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources).  Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news.  As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.

But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk.  In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling.  The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero.  It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%!  And equally frustrating is the fact that the $10 million raised would not even last one year.  But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...

The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3?  Certainly out of any market participant's control.  2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program.  Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing.  If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.

U.S. Housing - Excerpt from JPMorgan Annual Letter

The following is a great summary of the current U.S. housing situation from the 2011 JPMorgan shareholders letter.  A must read:

There has been a tremendous focus on the fact that housing prices remain depressed and, in fact, are still going down some. The large “shadow inventory” of homes in delinquency or foreclosure that has not yet hit the sale market adds to the fears that this will continue for a long time. New home construction still is very depressed – so, to most, the future looks bleak. However, if one looks at the leading indicators, all signs are flashing green – the turn is coming if it is not here already. We don’t want to be blindly optimistic, but the facts are the facts:
• America has never stopped growing. The United States has added 3 million people a year since the crisis began four years ago. We will add 30 million people in the next 
10 years. 
• This population growth normally would create a need for 1.2 million additional housing units each year. Household formation has been half of that for the past four years. Our economists believe that there is huge pent-up demand and that household formation will return to 1.2 million a year 
as job conditions improve.
• Job conditions have been improving, albeit slowly. In the last 24 months, 3.45 million jobs have been created. 
• On average, only 845,000 new U.S. housing units were built annually over the last four years – and the destruction of homes from demolition, disaster and dilapidation has averaged 250,000 a year. The growth of new households, even at a reduced rate, has been able to absorb all of this new supply, 
and more.
• The total inventory of single-family homes and condos for sale currently is 2.7 million units, down from a peak of 4.4 million units in May 2007. It now would take only six months to sell all of the houses for sale at existing sales rates, down from 12 months two years ago. (This low of an inventory number normally would be considered a positive sign for future housing prices.)
• While the shadow inventory mentioned above still is significant, it has shown a visible declining trend since peaking at the end of 2009, when the number of loans delinquent 90+ days or in foreclosure was 5.1 million homes. It now totals 3.9 million, and we estimate it could be 3 million in 12 months. The shadow inventory also may move more quickly as mortgage servicers get better at packaged sales and short sales and as real money investors start to buy foreclosed homes and rent them out for a good profit. Home prices still are going down a little bit, and they will stay depressed for a while. Distressed sales (short sales, foreclosure sales, real estate-owned sales) still are 25% of all sales, and these sales typically are priced 30% lower than non-distressed sales. As the percentage of distressed sales comes down over the next 12-24 months, their negative effect on housing prices will start to diminish.
• Housing is at an all-time high level of affordability due to both low home prices and low mortgage rates. 
• It now is cheaper to buy than to rent inhalf of the markets in America – this has not been true for more than 15 years. Relatively high rental prices can be a precursor to increasing home prices. 
• At the same time, American consumers are finding more solid financial footing relative to their debt. The household debt service ratio, which is the ratio of mortgage plus consumer debt payments to disposable personal income, stands at its lowest level since 1994. This is a result of rapid consumer deleveraging – household mortgage debt now is down $1 trillion from its 2008 peak. (Reported U.S. mortgage data do not remove mortgage debt from an individual’s debt obligations until there is an actual foreclosure. It is estimated that $600 billion of the $9 trillion in currently outstanding mortgage debt is not paying interest today and effectively could be removed now from these numbers.) 
• Recent senior loan officer surveys by theFederal Reserve show that, while there are not yet clear signs of credit loosening for new mortgages, at least the rush to tighten 
mortgage lending standards has abated.

• Over the last two years, $2 trillion of mortgages have been refinanced, substantially aiding homeowner burdens. We expect another $2 trillion to refinance over the next two years, with approximately 10% coming from recently announced government programs, and, at that point, we estimate that only 15%-20% of Americans will be paying interest rates over 6%.


More jobs, more households, more Americans, good value – it’s just a matter of time.

HHC and BRP: Two U.S. Housing Ideas for the Backburner...

I would like to introduce two new investment ideas that have increased significantly in price since I bought them, but that I would increase my position in if their valuations were to fall back in the short term.  Rather than write a full out thesis on each (which I do not have time to do), I will release tidbits across time.  I firmly believe both are worth significantly more than their current trading prices. However, due to the recent run up in each stock and the markets in general, I would hold on to cash for the time being and wait for a better entry point - perhaps in the summer months when housing related stocks tend to lag.

The two ideas I am proposing to put on your radar are The Howard Hughes Corporation (NYSE: HHC) and Brookfield Residential (NYSE: BRP).  The following investment characteristics make both compelling investments:

• strong alignment of management interests through insider buying and ownership
• hidden value in the form of either overlooked real estate assets or acreage recorded in book value under valuations recorded up to a few decades ago
• inevitable upside leverage to a housing recovery in the U.S.

As time goes on, I will pick certain aspects of each stock to explore, which perhaps may be expedited in the event that prices sharply fall for whatever reason and thus create an opportunistic entry point.  In this post, I will pick one theme that is common between the two: strong alignment in the form of insider ownership.

The Importance of Management Alignment


One thing I usually require in an investment is that management own a meaningful percentage of the company.  Though not a guarantee of success, I believe it reduces the likelihood that the CEO makes decisions that are adverse to shareholders but yet can benefit himself.  A common example of such a decision would be a CEO's decision to acquire another company with weak strategic fit that also carries a high price tag, thus decreasing per share intrinsic value.  How could low ownership by management result in bad decision making?  Can't hired managers with little or no ownership in the company still do a stellar job?  The answer is absolutely.  To make it clear, low ownership by controlling management does not translate into poor performance. However, it so happens that there tends to be a strong correlation between public company size and management compensation, and so often times CEO's are incentivized to grow the company for the sake of growth rather than make decisions based on building long term, sustainable per share value. This is especially so if the CEO was hired from outside the company, given a wack load of free five-year options, and not required to invest in the company from his own pocket.  In contrast, a CEO or founder whose net worth is fully vested in the company shares in the downside with you as well as the upside.  

A Look at Alignment in The Howard Hughes Corporation


The Howard Hughes Corporation was spun out of General Growth Properties in late 2010 as a development company.  Contained in it are 34 assets in the U.S., including three master planned communities, the South Street Seaport shopping area in lower Manhattan, and the Ward Centers in Hawaii.

The alignment technique in HHC is shared by JC Penney, thanks to a strategic hedge fund investor named Bill Ackman (of Pershing Square) who is a cornerstone investor in both companies.   In both HHC and JCP, the incoming CEOs committed substantial personal investments in the form of seven year warrants that will expire out of the money if the share price is not above a certain point by the sixth year of their investment.   The CEOs of Howard Hughes and JC Penney are thus hyper aligned.  That is, unlike you or me whose investment will be tied to whatever the share price is in six years, if HHC's share price is not at least $53 between 2016-2017, CEO David Weinreb stands to lose his entire $15 million investment.  On the contrary, his upside will be leveraged if he can in fact redevelop the properties as planned.

Another positive sign in HHC is the record of insider buying.  Numerous directors have made significant purchases since the stock began trading in November 2010, which is a vote of confidence especially given the real estate expertise and caliber of the company's directors (their profiles can be read on www.howardhughes.com)

A Look at Alignment in Brookfield Residential Properties


In the case of Brookfield Residential, the parent company (Brookfield Asset Management) opportunistically increased its ownership stake by buying shares in the open market last summer when the price was under $7 (now >$10).  Why would the parent company want to increase its stake when it already owned 72.5% of BRP at the time?   I think we all know the answer.  Brookfield Asset Management's investment track record is legendary, and when it buys shares in anything that trades in the open market - especially its own subsidiaries -  it is certainly worth paying attention to.

In the latest annual report, it was disclosed that a "certain executive" purchased two million shares within the last year through an escrowed share purchase program via the parent company.  I believe this is why the insider purchase was not reported through the typical channels (e.g. INK Research, SEDAR).  I do not know which executive purchased the shares, though I suspect it was Allan Norris, the current chief executive.

It must be remembered that strong alignment is no guarantee of investment success; however your  downside is more protected from management stupidity with characteristics such as those mentioned above.

New Beginnings

Welcome to my blog. This website will serve to identify value investment opportunities and build on the knowledge base of companies under consideration over time. As the name suggests, I have a strong inclination for contrarian themes and spinoff stocks, two facets of value investing which require one to be comfortable with going against the crowd for a prolonged period of time. I wish everyone luck in their investment endeavors and hope that information provided in this site will prove useful for someone, somewhere in the world.