August Review

Portfolio Update
After Our Man’s recent comments on the lack of portfolio activity, it goes without saying that August proved to be one of the portfolio’s busiest months!  The following changes were made during the course of the month, and are listed in chronological order:

- NCAV:  The position in LAB (now under ticker COWN) was sold during the month, as a result of COWN’s takeover of LAB, which completed while Our Man was on vacation.  Due to incompetence, Our Man didn’t sell the position before the takeover closed, and as the ticker symbol changed (as LAB became part of COWN), he was forced to wait before selling it.

- Currency: Our Man increased the Short position in the Euro (i.e. a bet on the US dollar strengthening versus the Euro) by around 1/3 in the early part of the month.  While the Euro has remained resilient despite the sovereign debt concerns (centred on the PIIGS countries) and has been bolstered by countries (especially China) buying French and German bonds, Our Man is wagering that this resilience will not last.  The price of this transaction was slightly above the August-end price, and as such this additional exposure cost a small amount of money in August.

- Value Equity: Our Man doubled the DRWI position during August, as the stock suffered heavily.  This move was only possible due to the undersized nature of the position (it was c1% before being doubled) and the attractive entry price, especially given the company’s fundamentals were unchanged.  While the entry price for this additional exposure was well above DRWI’s lows for the month, it was also below the month-end price and hence contributed positively.

- Bond Funds: When Our Man added DLTNX to the portfolio, back in January, he said it was a medium-term replacement for VBIIX.  The sharp fall in US Treasury Bond yields, provided an opportunity to exit the VBIIX position at an attractive price (though well-below the highs of the month).

- Put/Hedges: The start of August was exceptionally volatile, and as a result Our Man’s index puts (on SPY and IWM) saw both their implied volatility increase and their delta.  Given the speed of the move, in the middle of the month, Our Man despite suspecting the market was headed much lower was worried about the possibility of a short-term (1-3month) sharp rally in the markets and so sought to hedge this (and the likely resultant fall in medium-term volatility) out.  He did so through taking a position in XIV, which is a complicated instrument that seeks to perform the opposite of short-term futures on the CBOE Options Volatility Index, or VIX.  In essence, it is profitable when markets start calming down (i.e. being less volatile) AND people expect them to remain at these calmer (less volatile) levels.  As you know, August did not calm down (and we certainly seem to have no expectations of reduced volatility) and thus the position suffered heavily (20-25%) in the second half of the month.  The only good news was that its size was limited (to an initial 2% NAV), and it remains to be seen/is up for debate whether Our Man was merely early or foolishly crossed one of his own risk tenets (see number 6).

- Treasury Bonds: The volatility in the market resulted in a large move towards “safe” assets during August.  Despite all the naysayers, and an S&P downgrade, US Treasury bonds proved to be both a safe asset and largely under-owned, resulting in a large fall in Treasury Yields (and rise in price of Treasury bonds!).  With Treasury Bonds representing the largest part of the portfolio, Our Man took advantage of this to sell his Aug-29 US Treasury bond (at a 2.87% yield to maturity).  While Our Man still thinks yields, especially at the long-end of the curve (i.e. the furthest into the future, such as bonds maturing in 20-30yrs time) may continue to fall, the risk-reward is less attractive at this point.

Performance Review
As regular readers will know, Our Man has not been a buyer of the recent market rally and isn’t much of a fan of QE2, and thus his portfolio has had a slight bearish tilt to it.  This tilt was fully visible during August, with the portfolio up +4.2% for the month (YTD: +4.1%).  Despite the positive performance, the portfolio was not immune from the market’s volatility and saw its 2 best days (+1.5% on 8/4 and 8/8) and its worst day (-1.4% on 8/11) since inception.

Unsurprisingly, August’s performance was driven entirely by the Treasury Bond book (+436bps) and the Bond Funds (+45bps), which both benefited from the large decline in US Treasury Bond yields.

The Equity books, on the other hand proved to be a mixed bag.  Other Equities (+12bps) performed admirably, despite the market, while the NCAV book (-24bps) underperformed, hampered by its micro-cap makeup and falling over 8%.  The Puts/Hedges book (-6bps) was disappointingly down for the month, though this was entirely the result of a c40bp negative contribution of the XIV investment.  The Value Equities book (-42bps) was also negative for the month; DRWI’s performance (+1bp) was helped by the additional investment in mid-month while THRX (-42bps) was not so fortunate.

The Short China book (+6bps) benefited slightly during the month, though with uncertainty over a global slowdown yet to fully spread to copper prices it struggled to contribute significantly.  The Energy Thesis book (-5bps) and Currencies book (-5bps) were small negative contributors.

With the adjustments to the portfolio, the make-up is somewhat changed compared to recent months.  While the most noticeable difference is the increase in cash, the portfolio retains a smaller bearish tilt and should not suffer heavily in a market rally.  This reflects Our Man’s concern that the FED, much like the drunken gambler who keeps losing, will not view the economic uncertainty/weakness as reflection of their abject failure with QE2 but as a sign that they did not bet big enough in QE2.  If circumstances (in Europe) do not overwhelm them first, Our Man expects to hear more and more about QE3 (most likely under another guise, Operation Twist, or the like) as the coming weeks progress, and the market to rally on expectations of its announcement.  Expect Our Man to further add to the puts/hedge book should this come to pass…

Portfolio (as at 8/31 - all delta and leverage adjusted, as appropriate)
25.4% - Treasury Bonds (TLT, and 158bps premium in TBT Jan-13 puts)
15.2% - Bond Funds (DLTNX and HSTRX)
5.2% - Value Idea Equities (THRX, and DRWI)
2.4% - Other Equities (NWS, CMTL and SOAP)
2.2% - NCAV Equities
0.3% - Energy Efficiency (AXPW)

-0.6% - China-Related Thesis (15bps premium in FCX put)
-4.2% - Hedges/Put Options (34bps premium in S&P Dec-11 puts, 37bps in IWM Jan-12 puts, and 15bps SLV Jan-12 puts, all offset by a position in XIV)

-8.5% - Currencies (EUO – Short Euro)

49.2% - Cash


Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, TBT puts, DLTNX, HSTRX, THRX, DRWI, NWS, CMTL, SOAP, AXPW, FCX puts, SPY puts, IWM puts, SLV puts, XIV and EUO).  He also holds some cash.