In fact, by the time this decade is done, I believe that corporate exploitation of NOLs will be one of the great legacies of the financial crisis, creating an outcry from Congress that will be as great, if not greater than what we are seeing currently with respect to corporate inversions. In the meantime, it is fair to assume that corporate profits in the U.S. will continue to increase in the face of limited options for tax efficiency. As a result, I expect NOL shells or corporations with an operating structure that preserves an inordinate amount of NOLs to become increasingly valuable, in proportion to growth in U.S. corporate profits. This is well ahead of the curve thinking that I feel will benefit our portfolio returns going forward. Our two largest holdings – WMIH & KFS – are both NOL shells. In the case of WMIH it is a pure NOL shell without an operating entity (WMMRC is a legacy operation in runoff) and KFS is a revitalized shell, with a vast majority of its operations being newly formed entities that had no part in creating the NOLs in the first place. In other words, the structure of the balance sheet and operational profitability has been deliberately set around the NOLs. The eventuality in the case of both KFS and WMIH is a much larger entity taking shape that eats through the NOLs in 3-5 years, resulting in a tremendous surge of profitability for both companies going forward. The potential for maximum utilization of NOLs through reinvesting tax free profits into ventures that will further provide outsized returns will best be experienced by financial companies that have the expertise to seek out a diversified portfolio of active or passive investments while possessing a history of providing a high internal rate of return. While a company involved in technology or industrial manufacturing will divide an inordinate amount of corporate profits brought by NOLs in a variety of ways, financial companies, in particular Property & Casualty Insurers, tend to focus investments on areas that provide a high internal rate of return within their area of expertise. This type of leveraged, compounding return scenario can very well turn into a virtuous cycle of profitability for financial companies, especially when tax liability is nullified. The CEO of Kingsway Financial (KFS) in a recent shareholder letter commented on this type of potential by saying: “We believe in the power of compounding. Insurance companies provide unique vehicles to compound investment results. The unfortunate history of Kingsway has resulted in hundreds of millions of dollars of tax losses (for which we have reserved from an accounting perspective) but provides us the opportunity to not pay federal income tax so long as the losses remain available to offset gains. This enhances our compounding. He goes on to say: “So you could sum up our value-building philosophy as: Compounding capital in the long-term with investments/acquisitions/financings that offer asymmetric risk/reward potential with a margin of safety support by private market values.” It can’t be understated and in fact should be emphasized clearly what a powerful business model this is in a highly-lubricated economic environment that is filled with opportunistic companies searching for an enhancement in their possibility for achieving returns. There is no shortage of capital that is looking for deals. And there is no shortage of deals that are looking for capital. Private equity firms are raising record amounts to put together creative acquisitions in a variety of industries. Venture capital is running at two hundred miles per hour. And hedge funds are becoming increasingly creative in their ability to structure deals that resemble a hybrid between private equity and venture capital. In essence, it is a deal environment that has no shortage of opportunities or capital to make those opportunities reality. This will benefit our portfolio investments that are concentrated in NOL plays for Property & Casualty Insurance (I have little doubt that WMIH will eventually merge into a P&C insurer) tremendously going forward as I expect the maximum benefit possible to flow into these names."
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