Steamboat Capital Down 5.3 Percent Despite Gains On Valeant Short

he first quarter of 2016 was a period Steamboat Capital Partners would rather forget.

For the period, the fund returned -5.3% gross and -5.9% net as short positions to lag down the portfolio. At the end of March 2016, the fund has total gross exposure of 135.2%, 49.4% short and 85.8% long. That’s according to the fund’s first quarter letter to investors a copy of which has been reviewed by ValueWalk.

During the first three months the year the long portfolio produced a return of -1.1% and the short portfolio produced a return of -4.3%. Since inception (July 2, 2012) Steamboat has produced an annualized return of 14.2% net compared to 14.1% for the S&P 500 and 4.3% for the Credit Suisse Hedge Fund Index.

Steamboat Capital

Steamboat Capital suffering from shorts

Steamboat’s short book suffered in every way possible during the first quarter. While there were a few short positions that generated a positive performance for the fund, including Strayer Education, Valeant Pharmaceuticals, and Flower Foods winners were more than offset by losers.

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One of the main themes that hit Steamboat’s short book during the first quarter was short covering.

The fund speculates that the short sellers who entered the fray during the second half of 2015, rushed to buy back their positions and book profits during the first three months of 2016.

This rush to cover shorts created the same temporary mispricing that panic-selling does for longs, "in that regard, short-covering differs from the rational buyer seeking future profit." Steamboat continues:

"We believe that many of our losses are temporary due to short-covering that has distorted the true price of the stocks we have bet against. It is our deep fundamental analysis that gives us confidence that the purchasers of these stocks are wrong in seeking certainty by exiting, rather than maintaining their bearings. We have given considerable thought as to whether short-selling is a good use of our resources and concluded that it is a valuable practice for our firm measured over the long-term." – Steamboat Capital Q1 letter to partners

Many of Steamboat’s open shorts had high levels of short interest going into the quarter. When the market rallied towards the end of the quarter, a violent "short-squeeze" that caused "demonstrably inferior stocks to increase sharply" caught the fund by surprise.

Hedge Funds Were Up 0.88% In April; Gaining 0.39% YTD

Still, Steamboat remains convinced that its shorts will pay off in the long-term, around the time the central bank sponsored market rally runs out of steam.

Steamboat Capital – The benefits of short selling

On the topic of short selling, Steamboat Capital made some very interesting comments about the practice in its 2Q 2015 letter to investors:

"We believe that honest short selling is a vital and necessary part of fully functioning capital markets and a positive contribution to society. The societal purpose of finance is to allocate scarce resources to their most efficient uses and it is often short sellers who help direct these resources away from inefficient, inappropriate or deceptive areas. In fact, short sellers are frequently the first or only watchdogs who sound the alarm, often before more formal regulators are involved. It was Jim Chanos, not the Securities and Exchange Commission, who warned about Enron’s immensely deceptive business and financial practices. It was Steve Eisman, not the Department of Education, who shed light on the abusive marketing tactics of for-profit education companies. There were many short-sellers who warned about the fictitious existence of US-listed Chinese reverse takeovers, most notably Andrew Left of Citron Research and Carson Block of Muddy Waters Research. Most recently, it was short sellers who exposed the dangers of Lumber Liquidators’ products, not the Consumer Product Safety Commission." – Steamboat Q2 2015 letter to investors

And they have some words for Martin Shkreli:

Ironically, our two biggest losing positions (McKesson and Express Scripts) were large-cap healthcare stocks, which are traditionally very defensive investments. The healthcare industry has rightfully come under tremendous scrutiny in the past year given the troubling behavior that significantly increased the cost of pharmaceutical drugs from companies such as Valeant Pharmaceuticals (VRX) and individuals such as "pharma-bad-boy5" Martin Shkreli. The topic of drug prices is an immensely complex and polarizing issue that is beyond the scope of this letter, but we believe that companies such as McKesson and Express Scripts (along with CVS, Walgreens and others) help lower costs6 by encouraging patients to use cheaper generic drugs7 instead of expensive branded drugs and by using their size and scale to

negotiate significant discounts8 from drug manufacturers:

And:

In our last quarterly letter, we discussed our views on the influence that William Thorndike’s book, The Outsiders, has had on the investing community. We agreed with many of the common characteristics outlined in the book (large stock ownership, long-term orientation, unconventional approach to capital allocation) but we had doubts10 about some management teams that were highly-regarded by many other investors, specifically Valeant Pharmaceuticals (VRX) and Altice (ATC.NA). The objective of the book (and investing in general) is to find CEOs who significantly outperform the market over the long term, but we want to find them without resorting to excessive leverage or deceptive business practices. In the first quarter of 2016, we found three new investments that illustrate what the "right" management team truly looks like.

But they do not like Valeant, stating further regarding their successful shorts among which are "Strayer Education (STRA), Valeant Pharmaceuticals (for the second time) and Flower Foods (FLO)"

Steamboat Capital on the market outlook

On the topic of the market outlook, Steamboat is quite simply worried about the current state of the market.

During the second half of 2015, we saw how the markets would react without central banks providing stimulus to keep them afloat. Investors panicked and central banks stepped back in to keep the peace.

Why Hedge Funds Still Exist

The perverse implications of the actions by central banks are illustrated in investors’ reactions. Stocks with exceptionally poor fundamentals suddenly became highly desirable with one equity strategist advising clients to buy stocks in the S&P 500 Low Quality Ranking Index as these equities would benefit disproportionately from further easing. And as result of the dovish tone from central banks, the best performing stocks during the first quarter were companies such as U.S. Steel (+101%), 3D Systems (78%) and Consol Energy (+43%). Steamboat was short Consol during the entire quarter, short 3D Systems for the last third of the quarter, and not short U.S. Steel, but its peer Arcelor Mittal.

Only time will tell whether these stocks are good investments over a long period.

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One of the most underappreciated investing books, in our view, is What’s Wrong With Wall Street

, by Louis Lowenstein, a close confidant of Baupost Group President Seth Klarman and the father of Roger Lowenstein (author of When Genius Failed

You can find a full list of Rupert’s positions on his blog. This should not be interpreted as investment advice, or a recommendation to buy or sell securities. You should make your own decisions and seek independent professional advice before doing so. Past performance is not a guide to future performance.

ValueWalk is always on the lookout for candidates for its Value Fund Interview Series. If you’d like to see a particular fund manager interviewed, or if you’re a value-orientated fund manager looking to put yourself forward for an interview, please do email Rupert at Previous interviews in the Value Fund Interview Series can be found here.. Additionally, we are a member of Yahoo Finance’s exclusive Contributors network and typically post our interviews on our Yahoo Finance Tumblr Blog.

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