Second Curve’s Bets on Small-Caps Lead to Huge Losses

Second Curve Capital LLC is a long/short hedge fund firm founded by former U.S. bank analyst Tom Brown in 2000. Prior to founding his own hedge fund, Mr. Brown worked as a sell-side analyst for Donaldson, Lufkin & Jenrette as well as other firms for ten years in the 1990’s and also served as a manager at well-known hedge fund Tiger Management. Although Mr. Brown touts his proximity to bank management teams that dates back to his service as a bank analyst at various sell-side firms, this advantage does not seem to be reflected in the recent performance of his hedge fund, which invests solely in financial services companies.

Named after Ian Morrison’s book “The Second Curve”, the flagship fund of Mr. Brown’s firm declined by 24% this year through the end of June, after losing a disturbing 20% in 2015 and 33% in 2014. With that said, the following article will discuss the performance of several small-cap bets held by Mr. Brown’s Second Curve Capital throughout the past year which have not turned out well for the fund.

Through extensive research, we determined that imitating some of the picks of hedge funds and other institutional investors can help generate market-beating returns over the long run. The key is to focus on the small-cap picks of these investors, since they are usually less followed by the broader market and are less price-efficient. Our backtests that covered the period between 1999 and 2012, showed that following the 15 most popular small-caps among hedge funds can help a retail investor beat the market by an average of 95 basis points per month (see more details here).

#5. Consumer Portfolio Services Inc. (NASDAQ:CPSS)

 – Shares Owned by Second Curve Capital LLC (as of March 31): 2.55 Million

 – Value of Second Curve Capital LLC’s Holding (as of March 31): $10.81 Million

 – One-year Return Through June 30: -39.7%

Second Curve Capital upped its position in Consumer Portfolio Services Inc. (NASDAQ:CPSS) by 1% during the first three months of 2016, to 2.55 million shares. The upped position was worth $10.81 million on March 31 and accounted for 6.5% of the value of the hedge fund’s equity portfolio. The specialty finance company that targets consumers with limited credit histories or past credit problems has lost 22% of its market value since the beginning of the year. The company’s business involves purchasing and servicing retail automobile contracts originated by franchised automobile dealers and independent dealers in the United States. Consumer Portfolio Services recorded revenue of $104.9 million for the second quarter, which was up by 18.8% year-over-year. The company purchased $319.1 million of new contracts during the quarter, compared to $312.3 million of contracts during the first quarter. Jim Simons’ Renaissance Technologies owned 476,000 shares of Consumer Portfolio Services Inc. (NASDAQ:CPSS) at the end of the first quarter.

#4. Stonegate Mortgage Corp (NYSE:SGM)

 – Shares Owned by Second Curve Capital LLC (as of March 31): 2.12 Million

 – Value of Second Curve Capital LLC’s Holding (as of March 31): $12.19 Million

 – One-year Return Through June 30: -66.6%

The hedge fund firm run by former bank analyst Tom Brown also increased its holding in Stonegate Mortgage Corp (NYSE:SGM) by 5% during the March quarter, to 2.12 million shares valued at $12.19 million at the end of March. The shares of the non-bank mortgage company that focuses on originating, financing and servicing U.S. residential mortgage loans are down by 29% thus far in 2016. In 2015, the company decided to dispose of certain retail branches to cut some costs associated with retail originations, as increased regulatory and counterparty oversight on the mortgage servicing industry led to higher servicing costs. As a result, Stonegate Mortgage closed 62 retail branches and sold an additional 14 retail branches during 2016. Eight hedge fund managers that we track were invested in Stonegate Mortgage at the end of the first quarter. Andy Redleaf’s Whitebox Advisors cut its stake in Stonegate Mortgage Corp (NYSE:SGM) by 91% during the June quarter to 20,146 shares.

The second page of this article will discuss the performance of three other small-cap stocks held by Second Curve Capital over the past year.

#3. Bancorp Inc. (NASDAQ:TBBK)

 – Shares Owned by Second Curve Capital LLC (as of March 31): 2.33 Million

 – Value of Second Curve Capital LLC’s Holding (as of March 31): $13.34 Million

 – One-year Return Through June 30: -35.1%

Second Curve Capital had 2.33 million shares of Bancorp Inc. (NASDAQ:TBBK) in its portfolio at the end of the first quarter, a mere 8,392 shares more than it did at the end of the final quarter of 2015. The 2.33 million-share stake was valued at $13.34 million at the end of the January-to-March period. The financial holding company that operates the Bancorp Bank has seen the value of its stock plunge by 23% since the start of 2016. In December 2015, the bank agreed to pay $4.3 million to settle charges of unfair and deceptive practices. Specifically, the company violated a section of the Federal Trade Commission Act by failing to protect consumers against account errors or provide promised rewards from a debit-card program, as well as by charging deceptive fees on a prepaid card. Donald Yacktman’s Yacktman Asset Management reported owning 109,000 shares of Bancorp Inc. (NASDAQ:TBBK) through the current round of 13Fs.

#2. New Home Company Inc. (NYSE:NWHM)

 – Shares Owned by Second Curve Capital LLC (as of March 31): 1.27 Million

 – Value of Second Curve Capital LLC’s Holding (as of March 31): $15.53 Million

 – One-year Return Through June 30: -44.6%

Tom Brown’s hedge fund firm cut its position in New Home Company Inc. (NYSE:NWHM) by approximately 6% during the first three months of 2016, ending the March quarter with 1.27 million shares valued at $15.53 million. The company’s new home deliveries increased meaningfully to 43 for the second quarter of 2016 from 12 recorded for the same period of the prior year. As a result, New Home Company’s home sales revenue jumped to $78.84 million from a mere $19.20 million recorded a year earlier. The increase in home sales revenue reflects both an increase in the number of homes delivered and a 15% increase in their average sales price. Royce & Associates, founded by Chuck Royce, had 474,336 shares of New Home Company Inc. (NYSE:NWHM) in its portfolio at the end of March.

#1. NewStar Financial Inc. (NASDAQ:NEWS)

 – Shares Owned by Second Curve Capital LLC (as of March 31): 2.65 Million

 – Value of Second Curve Capital LLC’s Holding (as of March 31): $23.18 Million

 – One-year Return Through June 30: -23.5%

NewStar Financial Inc. (NASDAQ:NEWS) represented the largest holding in Second Curve Capital’s equity portfolio at the end of the March quarter, accounting for nearly 14.0% of its value. Mr. Brown’s hedge fund upped its NewStar position by 2% during the first quarter to 2.65 million shares, worth $23.18 million on March 31. NewStar Financial operates as a commercial finance company focused on meeting the financing needs of companies and private investors in the middle market, usually providing financing commitments that range in size from $10 million-to-$50 million. Loan yields in both the large corporate market and middle market decreased during the second quarter, whereas the overall middle market loan volume increased to $27 billion from $26 billion recorded for the final quarter of 2015. However that was down from the $41 billion-figure posted for the second quarter of 2015. NewStar Financial’s shares are down by a little less than 2% year-to-date, but by a much heftier 23.5% during the 12-month period ending June 30. Corsair Capital LLC was the holder of 9.54 million shares of NewStar Financial Inc. (NASDAQ:NEWS) at the end of the first quarter.

Disclosure: None