Our trading activity in the first quarter was elevated as would be expected given the heightened market volatility. We added one new position, increased eleven existing positions and closed eight positions.

Mortgage REITS suffered during the quarter on fears of rising interest rates and credit market dislocations. We closed our positions in PennyMac Mortgage Investment Trust and in the equity REIT Equity Commonwealth to increase our investment in Chimera Investment. We have been involved with Chimera for three years and have come to view them as the best-in-breed of non-agency mortgage REITs. The management team has not only navigated through the credit markets with intelligence and prudence, but has consistently behaved in the best interests of shareholders. Chimera remains our largest position given that it trades below book value, yields 14% and employs modest leverage.

We exited our position in Apollo Education Group with a modest gain. We invested in both Apollo and DeVry Education in the fourth quarter of 2015, viewing both firms as survivors in the for-profit education market. We sized the Apollo position smaller than DeVry for two reasons: first, Apollo’s focus on more generalized undergraduate degree programs seemed like a less defensible franchise than DeVry’s focus on technical graduate degrees. Second, Apollo has a dual class structure which gives management outsized control over the company.

This second factor became a significant issue during the quarter when Apollo agreed to sell itself to a private equity firm at a price that we – and several other investors – viewed as grossly insufficient consideration. The challenge we faced was if shareholders approved the deal, we would forfeit our expected upside potential, but if shareholders rejected the deal, we would be leaving our capital entrusted with a management team that we viewed as hostile towards our interests. We elected to vote against the deal and liquidate our position. We remain invested in DeVry and increased our position during the quarter.

We were not so fortunate with our investment in Horsehead Holding. Horsehead produces zinc and had invested in a new plant that was expected to dramatically lower their production costs while being more environmentally responsible. Unfortunately, Horsehead experienced the perfect storm of adversity over the last year: cost overruns on plant construction were followed by repeated difficulties in ramping the plant up to capacity. In the meantime, the macroeconomic environment for all commodities was rapidly deteriorating putting increased pressure on their balance sheet. In hindsight, we were late to recognize the liquidity trap that was surrounding the company. We exited our position in January recognizing a significant and permanent capital impairment. Horsehead was forced into default in February by a creditor who is likely to profit handsomely from taking ownership of a new zinc plant for a fraction of the construction cost.

We took advantage of the volatility in oil prices during the quarter to adjust our energy exposure by migrating to higher quality companies that are well positioned to endure at the low energy prices seen during the quarter and thrive as energy prices recover to more normalized levels. We continue to believe that energy prices should rebound in 2016 because capital available to fund new drilling has declined sharply allowing the steep production decline curves to become visible in the marketplace.

 


This post has been excerpted from the Aquitania Capital Management Q1 2016 Letter.

Disclosure: The discussion of portfolio investments represents the views of the investment manager. These views are current as of the date of this commentary but are subject to change without notice. All information provided is for information purposes only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation purposes and are intended to illustrate our investment philosophy and its application. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented. Portfolio composition will change due to ongoing management of the portfolios. References to individual securities are for informational purposes only and should not be construed as recommendations by Aquitania Capital Management or its members. Past performance is no guarantee of future results. Actual returns may differ for each client from the returns presented.