More Q2 Letters, Costco’s Genius and Aswath Damodaran

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Happy August! We hope you’re staying cool and your portfolio remains hot. We’re nearing the end of our Q2 letter analysis. After this week we’ll head back to more topical coverage of various investing related articles, videos and blogs.

In other house-keeping news, we’ve got a killer line-up of podcast guests this month. Can’t wait to bring you new episodes every week.

Our Latest Podcast Episodes:

Here’s the letters we cover this week:

    • Alluvial Capital
    • Greystone Capital
    • Alta Fox Capital

We also feature a newsletter article on Costco (COST) business model and the latest Aswath Damodaran YouTube video.

Let’s dive in!

August 5th, 2020

Chart Of The Week: ANET completed an inverse H&S on the weekly chart last week. Breakout members were alerted to this trade a week before the breakout. The company has great qualities: net cash, growing revenues, expanding pre-tax margins and high ROIC.

The stock broke out above the 50MA and 200MA, giving us stronger belief in a newly-formed uptrend. We’ll see how prices follow through this week.

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Investor Spotlight: More & More Q2 Letters!

GIFs by tenor

Many fund managers released their Q2 letters over the weekend. We’re profiling three this week. Let’s start with Laughing Water Capital.

Alluvial Capital: +14.80% Q2 2020

Dave Waters runs Alluvial Capital. If you don’t know who he is, check out my podcast with him here. I love Dave’s letters because he cuts right to what matters: the Fund’s holdings and investing-related concepts.

You can read his Q2 letter here.

Here’s Alluvial’s top five holdings:

1. P10 Holdings Inc: 15.4%

Dave’s Take: “I believe P10 shares are currently worth between $3.50 and $4.00, and potentially far more in future years depending on the company’s ability to acquire additional highmargin, predictable fee streams from alternative investments managers. COVID-19 has not slowed down P10’s ability to form relationships with new clients”

2. Intred S.p.A: 8.5%

Dave’s Take: Shares have more than tripled since our initial purchases. This fiber-optic network operator continues to sign up new clients for its ultra-high-speed network, and recently acquired a competitor. The company is no longer an obvious value based on free cash flow yield, but Intred continues to enjoy a strong set of investment opportunities, both internal and external. What’s more, Intred has created a negative working capital cycle where it gets paid in advance for its services, effectively creating investment “float” and subsidizing its investment needs.”

3. Bredband2 i Skandinavien AB: 8.0%

Dave’s Take: “Unlike Intred, Bredband2 is largely non-asset-based, providing its services on networks owned by other parties. Like Intred, Bredband2 generates substantial cash from advance payments by customers. The magnitude of these payments allows Bredband2 to operate with negative invested capital and fund all its capex needs from customer pre-payments.”

4. LICT Corporation: 7.4%

Dave’s Take: “LICT is in prime position in the telecom industry. LICT has invested heavily over the years and now boasts a fiber-heavy, state-of-the-art network that is well-positioned to deliver broadband to rural Americans for decades to come. The company enjoys a substantial net cash position, enabling it to return virtually all its earnings to shareholders via share repurchases.”

5. Nuvera Communications 7.1%

Dave’s Take: “The company will benefit from increased need for quality consumer and business broadband connections in its Minnesota and Iowa service territories. I am hard-pressed to find a better combination of robust free cash flow generation, low risk operations and a healthy balance sheet. The company is not exactly exciting or communicative (despite the name) and perhaps that is why Nuvera shares languish at 8.3x free cash flow and 7.4x cash earnings (net income plus intangibles amortization).”

Negative Working Capital Analysis

Dave spends the rest of the letter discussing the power of negative working capital. For starters, working capital is current assets minus current liabilities. Here’s Dave explaining why a negative working capital model is attractive:

“For a firm that operates with negative working capital, growth actually provides a capital subsidy as additional cash rolls in. Instead of requiring incremental capital to support its working capital needs, the firm is free to use excess cash to subsidize investment in fixed assets, perform acquisitions, or return capital to shareholders without sacrificing growth opportunities.”

You can see the power of a negative WC cycle. It’s like an insurance business. Generate float. Reinvest the float before you make payments. But there’s a caveat: you need to grow to maintain the benefits.

I’ll let Dave explain (emphasis mine):

“If revenues fall, working capital consumes cash rather than providing it. The long-term benefits of a negative working capital model only accrue to companies offering products and services that will experience long-term growth in demand with minimal cyclicality.”

Greystone Capital Management: -5.1% Median 1H 2020

Adam Wilk runs Greystone Capital Management. The firm officially launched this year. Adam’s blog Pound the Rock Investing is one of my favorite reads. I’m stoked to see him launch his firm.

You can read his 1H 2020 letter here.

Alright, let’s get to his ideas.

CRH Medical Corp (CRH): -32% YTD

Business Description: “CRH Medical Corporation provides various products and services to gastroenterologists in the United States and Canada. It offers CRH O’Regan system, a single use, disposable, and hemorrhoid banding technology for treating various grades of hemorrhoid. The company also offers anesthesia services for patients undergoing endoscopic procedures.” – TIKR.com

Adam’s Take: “CRHM is now a $120mm market cap business that is set to generate $25-$40mm in free cash flow per year over the next several years growing at a high single digit rate. With a new management team in place focused on growing a complementary segment of the business, increasing the pace and volume of acquisitions, and continuing to grow free cash flow per share, CRHM has the potential to double or triple from our current cost basis. While short term results will without a doubt be impacted by the length of the coronavirus quarantine, over the long-term we should see a return to normal activity levels followed by both free cash flow increasing as well as multiple expansion.”

Hill International (HIL): -54.1% YTD

Business Description: Hill International, Inc. provides project and construction management, and other consulting services primarily for the buildings, transportation, environmental, energy, and industrial markets. – TIKR.com

Adam’s Take: “Clearly, the market is not believing in the turnaround. The share price reflects a business in decline, assuming A/R and cash collection will be difficult, and new business will continue to decrease. I’d argue that once we return to some normalized business environment, investors should see the share price rebound in line with improved operating results. As a sanity check, HIL continues to win new business despite project deferments and the current difficult environment (this includes $30m in new bookings during one week of Q2 alone).”

RCI Hospitality (RICK) — New Position, -41% YTD

Business Description: RCI Hospitality Holdings, Inc., through its subsidiaries, engages in the hospitality and related businesses in the United States. It operates through Nightclubs, Bombshells, and Other segments. – TIKR.com

Adam’s Take: “As somewhat a combination of special situation (a few nonpermanent, fixable events have led to a sharp stock price decline) and good business, RICK should be able to continue to grow it’s earning power and free cash flow per share at a solid rate over time. RICK is a business that I’ve followed for a few years now, and the current price seems to represent a very favorable risk/reward provided the business can remain structurally intact throughout COVID-19 shut down, and the management team continues to run the same playbook they’ve been running for the past few years.”

APi Group (APG) — New Position, +32% YTD

Business Description: APi Group Corporation provides commercial life safety solutions and industrial specialty services. The company offers specialty contracting services and solutions to the energy industry focused on transmission and distribution in the United States and Canada; and industrial services, including the retrofit and upgrading of existing pipeline facilities. – TIKR.com

Adam’s Take: “APi has a differentiated business model (discussed a little more below) consisting of targeting service related work first (where each dollar of service work sold leads to leads to 3-4x more service dollars and ultimately relationship based new construction opportunities) that is not dependent on new facility construction activity given their focus on non-discretionary maintenance spend. As a result, a large portion of Safety Services revenue mix is recurring at 40% up from just 21% in 2008. Management has called this recurring revenue high margin business. This helps insulate APi from downturns and gives visibility into revenue/earnings. Furthermore, company filings mention Fire & Security end markets as acyclical.”

This isn’t the first time we’ve seen APG in an investor letter. In fact, the name’s becoming somewhat of a value-based hedge fund hotel.

Terravest Industries (TRRVF) — New Position, +19.3% YTD

Business Description: TerraVest Industries Inc., together with its subsidiaries, manufactures and sells goods and services to energy, agriculture, mining, and transportation markets in Canada and the United States. – TIKR.com

Adam’s Take: “Terravest is illiquid, (as a sub-$300mm market cap business with over 30% of the float owned by insiders), has no analyst coverage, and the management team has historically been unwilling to give earnings guidance or host conference calls. As a result, Terravest is right up my alley in terms of investment criteria I look for; a boring, underfollowed microcap operating a niche business with a phenomenal management team, trading at a cheap valuation. The above factors can occasionally invite mispricings, and despite shares being up over 200% since 2014, TRRVF still appears to be undervalued relative to its long-term potential and strong capital allocators at the helm”

Alta Fox Capital: +60.5% (Net) Q2 2020

Connor Haley runs Alta Fox Capital and is quickly becoming one of my favorite investors. I had the privilege of chatting with him on last week’s podcast (listen here). Connor crushed Q2, returning over 60% net of fees.

Since inception he’s returned an annualized 32.1% net of fees. Incredible results. Connor attributes these returns to structural advantages embedded in a smaller one-man shop:

    1. More nimble than the average fund: “Alta Fox has an investment committee of one and I was able to quickly exit our most vulnerable positions while simultaneously initiating and adding to long positions in which we had deep conviction.”
    2. Greater investable universe: “Far too many funds have ignored the “obvious winners” over the last 5+ years because they wanted to emphasize their “uniqueness” as a marketing point. I have 80%+ of my net worth invested in Alta Fox and I am going to invest where I see the greatest opportunities irrespective of any marketing narrative”

These are important advantages that individual investors have, regardless if they run a fund. Small individual investors can invest in areas that larger managers can’t touch. This gives you the edge over other market participants.

It’s not enough to fish where the fish are. You must find spots where no other fisherman will venture.

Alta Fox’s New Idea: Enlabs (NLAB)

Macro Ops Collective members are familiar with this name. We presented it to our members over a month ago. It’s nice to see Connor find the idea of equal value and quality.

Business Description: It offers entertainment through various products, including casino, live casino, betting, poker, and bingo under various brands. The company is also involved in the performance-based marketing activities; and delivering of sports results and technical solutions in the online gaming industry. – TIKR.com

Connor’s Take: “Enlabs trades at 7.5x what we believe are conservative estimates for 2023 earnings and an even more staggering 3.8x earnings ex-cash. We believe shares of Enlabs are conservatively worth 100%+ higher than current prices and that the company has several realistic call options that could lead to significantly greater upside over the next five years.”

There’s three reasons why Connor likes the NLAB investment (via letter):

    1. Online gambling in the Baltics is growing rapidly (20%+ per year) with a long runway for growth
    2. Enlabs is likely to enter new geographies with 5-10x the collective online gambling TAM of the Baltics
    3. [Alta Fox] is very bullish on the company’s recent purchase of a 29.9% stake in Global Gaming (GLOBAL SS)

You can read Connor’s full research report here.

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Newsletter of The Week: Costco & Cannibalization

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Adam Keesling writes Napkin Math, a Substack newsletter that’s quickly becoming one of my favorite reads. His July 15th edition, How Costco Convinces Brands to Cannibalize Themselves, demonstrates the power of Costco’s business model.

Here’s the main idea according to Keesling: [Costco] gets the best manufacturers in the world — who already have products on Costco shelves — to make Kirkland products.

That’s insane.

But suppliers buy-in. Why? Suppliers generate a ton of sales through Costco. Costco knows it, and so do their suppliers. Keesling mentioned a reddit user who used to work for a major Costco supplier (emphasis mine):

“As a supplier, you jump on it, because the data is clear that it jacks your sales. Usually your product sits right next to theirs on the shelf. So the consumer has 2 choices. Yours, or yours (at slightly worse margin).

You can be assured that the Kirkland brand is always the best, because it literally is.”

It’s a great deal for the supplier — and the math backs it up. Keesling assumes that under normal circumstances, suppliers make 16% margins (after subtracting marketing/non-marketing expense).

Under the Kirkland supplier deal suppliers make 14% margins. But remember, they generate more sales. So how does Costco justify suppliers making Kirkland products? Simple. Suppliers save on marketing expense, which raises margins to slightly lower than their own branded products. Higher volumes make up for 200bps lost margin.

Everyone wins.

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YouTube Video of The Week: COVID Lessons For Investing/Business

Aswath Damodaran’s back with a video on COVID Lessons for Investing/Business. It’s one of his quicker videos (40 minutes). I plan on watching it this morning. I always get a little smarter after listening to Aswath.

He’s an excellent teacher. Still can’t believe his education is free.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Greenhaven Road, Laughing Water and Tao Value Q2 Letters

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Hope you had a great weekend! Can’t believe we’re almost through July. Where did the month go? Is it me, or does it feel like months fly-by when the market goes up? Anyways, we’re halfway through 2020 and things get weirder each day.

As a reminder, the Pentagon said they’d release proof of alien spacecrafts soon. That’s incredible. I can’t wait for someone to create a SPAC and pitch investors on harnessing its technology.

We’ve got a good edition for y’all!

Our Latest Podcast Episodes:

Here’s the letters we cover this week:

    • Laughing Water Capital
    • Greenhaven Road Capital
    • Tao Value

We also feature the best podcast we listened to last week and a wholesome tweet.

Let’s dive in!

July 29th, 2020

Chart Of The Week: Intel’s (INTC) chip delay sent the semiconductor market spinning. A $44B swing in company valuations took place within one trading day. INTC dropped 16.24%. AMD rose 16.51%. It’s clear which company Mr. Market thinks will win the chip game.

We alerted our members to a possible AMD breakout a week before its initial surge. Our members that took the initial breakout are sitting on decent profits. We’ll see if AMD can follow through.

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Investor Spotlight: More & More Q2 Letters!

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Many fund managers released their Q2 letters over the weekend. We’re profiling three this week. Let’s start with Laughing Water Capital.

Laughing Water Capital:

Matthew Sweeney runs Laughing Water Capital (LWC). The fund returned 29.50% during Q2, bringing the YTD total return to 3.6%. Sweeney spends the entire letter talking about investments and businesses. I love it.

No fluff on COVID-19. Pure business and investing commentary. You can read the entire letter here.

LWC’s Top 4 Disclosed Positions

1. Aimia, Inc. (AIM.TSX)

Sweeney’s Take (emphasis mine): “While there is still more to be done, in the few short months they have been in control, the new team has been moving at a blistering pace to transform Aimia from a loyalty company whose board and management had zero economic incentive to do anything other than allow the company to flounder, to a holding company managed by a group whose ~25% and growing ownership of the company strongly incentivizes them to create value for the benefit of all shareholders”

New management is getting their hands dirty quick. Since joining, they’ve reduced corporate costs by 50%, moved loyalty assets off the balance sheet and laid the groundwork for a $2.00/share dividend recap.

Air travel remains a concern in the short-term. But there’s real value in airline loyalty programs. Heck, American Airlines might use their loyalty points as collateral for new debt!

Here’s AIM’s chart:

The stock’s gone nowhere for three years and remains in a downtrend (below 200MA). A new sell-side analyst placed a $9.50 price-tag on the company’s shares. Any breakout above 200MA would be a good sign towards that figure.

2. API Group (APG)

Sweeney’s Take (emphasis mine): “APG is a holding company with multiple specialty contracting businesses under its umbrella. Most notably, APG is the largest provider of fire safety systems in the U.S., with a focus on service, which is mandated by law. Regardless of whether there is a recession, building owners must maintain the fire safety systems in their buildings, which provides defensive cash flows in an industry that can otherwise be cyclical.”

APG is a London-based SPAC formed by Martin Franklin. According to the letter, Franklin has a history of building great businesses. Jarden (JAH), for example, compounded capital at 30%/year for fifteen years.

APG’s recession-proof business trades less than 1x revenues and <10x EBITDA. You can read their 2019 Annual Report here.

Given the boring and mandated nature of the business, I’ve added APG to my watchlist.

3. Benefytt Technologies (BFYT)

Sweeney’s Take (emphasis mine): “A discussion of BFYT is moot at this point because after the end of the quarter and prior to the completion of this letter the company was acquired. The short version is that BFYT fit our criteria well in that it was a recession proof business with clear reasons to explain why we might be so lucky to purchase it cheaply.”

The company was acquired for roughly $31/share. A near 40% premium from its early July trading price.

4. PAR Technology Corp (PAR)

Sweeney’s Take (emphasis mine): “… the bulk of the value is in the company’s cloud-based Point of Sale (POS) system, which to date primarily serves fast casual and quick serve restaurants. While overall COVID has been disastrous for restaurants, it seems likely that independents will be the big losers, while larger, more established chain brands will take market share going forward, which benefits PAR. Importantly, fast casual and quick serve are recession resilient as consumers tend to trade down during difficult times.

The company’s currently burning money as they invest in growing total restaurants served. The strategy’s working as the company’s grown top-line revenue 13% and 22% over the last two quarters.

Let’s take a look at the charts:

PAR must break the $35 overhead resistance to reach new highs.

Greenhaven Road Capital: +50% Q2 2020

Scott Miller’s fund returned over 50% during the second quarter. This came off the heels of the fund’s worst quarter, so YTD returns remain in the single digits. You can read his letter here.

Miller highlights three new investments made during Q2:

    1. Gogo, Inc. (GOGO)
    2. Lands’ End (LE)
    3. IAC/Interactive Corp (IAC)

Let’s break ‘em down.

1. Gogo, Inc. (GOGO)

Business Description: Provides inflight broadband connectivity and wireless entertainment services to the aviation industry in the United States and internationally. It operates through three segments: Commercial Aviation North America (CA-NA), Commercial Aviation Rest of World (CA-ROW), and Business Aviation (BA). – TIKR.com

Miller’s Take: “If air passenger travel remains depressed for five years and we are in a prolonged recession/depression, Gogo is unlikely to be a profitable investment. However, with $200M in cash, a valuable private aviation division, and a highly incentivized CEO, there are several paths to a positive outcome, many of which likely would lead to multiples of our original investment.”

GOGO generates 50% gross margins and over the previous four quarters generated ~5% operating margins.

The company has loads of debt (6.7x Net Debt / EBITDA) and negative core free cash flow (excluding write-downs and changes in “other operating assets”).

Given the non-zero possibility of bankruptcy, Miller’s made it a 1.50% position at cost.

Here’s the chart:

The stock remains in a clear downtrend below the 50MA and 200MA.

2. Lands’ End (LE)

Business Description: Lands’ End, Inc. operates as a uni-channel retailer of casual clothing, accessories, footwear, and home products in the United States, Europe, Asia, and internationally. – TIKR.com

Miller’s Take: “Historical financials were negatively impacted by the company’s withdrawal from Sears stores and investments in online infrastructure, and were thus not necessarily indicative of their future profitability. The last Sears store closed in January, winding down almost $200M of unprofitable sales from a few years prior. With just 25 physical stores compared to +$1b in sales, Lands’ End is well-positioned versus peers who are battling much higher fixed costs and aged inventory collecting dust on the shelves.”

A big part of the bull thesis is the current CEO’s (Jerome Griffith) ability to turn the company around. Miller notes a couple recent turnaround projects within the company:

    • Increase distribution through Amazon (AMZN)
    • Launching partnership with Kohl’s

Yet there remains clear headwinds for the company going forward. LE is 4x leveraged on an EBITDA basis and 7x on a FCF-proxy basis (EBITDA-capex). The company’s increased inventory and cash conversion cycle, two things you don’t want to see in a retailer. On top of that, gross margins are roughly 300bps lower than five years ago.

LE can change all that if they execute on their strategy and become an omni-channel powerhouse.

Let’s take a look at the chart …

LE looks close to a trend reversal on the daily chart. It’s above the 50MA and forming a tight symmetrical triangle (notice the low volume). A breakout above the 200MA would confirm the new bull trend.

3. IAC/Interactive Corp (IAC)

Business Description: “IAC/InterActiveCorp, together with its subsidiaries, operates as a media and Internet company in the United States and internationally. The company’s Match Group segment provides subscription dating products under Tinder, Match, Meetic, OkCupid, Hinge, Pairs, PlentyOfFish, OurTime, and other brands. Its ANGI Homeservices segment connects consumers with service professionals for home repair, maintenance, and improvement projects.”

Miller’s Take: “By investing in IAC, we also receive Vimeo – a global video sharing platform with ~1.3mm paid subscribers, Dotdash – an online publisher with 90mm+ monthly users, and Applications, which is comprised of 40 mobile applications and 155 browser extensions. The Applications basket includes Apalon (mobile development company with 25M monthly users), Ask Applications (distributor of desktop applications with 60M monthly users), Daily Burn (membership-based fitness platform with 1.7K curated videos), iTranslate (more than 100M app downloads), Mosaic Group (3.8M paying subscribers), and RoboKiller (blocks over 1.1M telemarketers).”

The bull thesis for IAC is well-documented and the stock’s venturing on Hedge Fund Hotel status. Seemingly every value investor letter I read mentions an investment in IAC.

For those interested in more IAC commentary, check out my second podcast with Richard Howe of StockSpinoffInvesting.com.

Tao Value: +36.45 Q2 2020

Anonymous Tao Value reported 36.45% returns in the second quarter. This brings the partnership’s YTD total to 18.76%. Since inception, Tao Value’s returned an annual 17.11% return, far outpacing MSCI ACWI index. You can read the investor letter here.

Tao’s largest benefactors in Q2 were Sea, Ltd (SE), Pinduoduo (PDD) and Joy Inc (YY). The only detractor in the portfolio was an ACWI index ETF short.

The letter highlights two new investments in Tao’s portfolio:

    • Avalara (AVLR)

Business Description: Avalara, Inc., together with its subsidiaries, provides cloud-based solutions for transaction tax compliance worldwide. The company offers a suite of compliance solutions that enable businesses to address the complexity of transaction tax compliance; process transactions in real time; produce detailed records of transaction tax determinations; and reduce errors, audit exposure, and total transaction tax compliance costs. – TIKR.com

Tao’s Take (emphasis mine): “ I believe AVLR has built a narrow moat by closely integrated with over 700 business applications (e.g. ERPs, Marketplaces). Management also see the importance of “partnering with all applications that create invoices”, which will create superior streamlined user experience. This also explains why Sales & Marketing expenses has been high as AVLR had been aggressively establishing such partnerships and sharing referral fees.

The moat can be visually seen from the 110% average net revenue retention rate, which means existing customers a year ago, after adjusting for termination, pricing change & upsells, pays AVLR 10% more on aggregate today. The churn rate is consistently lower than 5%, implying customer life of 20+ years. Both metrics speak for the stickiness of the products. “

The company’s grown unearned revenue from $48M in 2015 to $165M in 2019. Over time AVLR should recognize this revenue, which we’re starting to see in the cash flow statement. The company collected $42M and $38M in unearned revenue over the last two years respectively.

AVLR’s growing top-line revenue at a 30% 5YR CAGR. But at the current price, you’ll have to pay up for that growth. The company trades near 20x forward revenues.

It’s a great, sticky, boring business with high incremental margins. Let’s go to the charts …

A breakdown below the 50MA could present a buying opportunity and a chance to pick up some shares at much lower EV/Sales valuations.

    • China Index Holding (CIH)

Business Description: China Index Holdings Limited operates a real estate information and analytics service platform in China. The company offers promotion services, including a number of online and offline themed campaigns, industry forums, periodic updates, and online promotions to its customers to promote their brands. – TIKR.com

Tao’s Take: “CIH’s core business is to collect, clean and sell real estate data & research to all RE participant in China, a good asset-light business. The business has high 40+% operating margin, and still growing at 20~%. Yet it was traded at some absurdly low valuations, like 4x PE or 3x EV/EBIT. One reason for such low valuation can be attributed to the poor governance under the Chairman Vincent Tianquan Mo and his valuation destruction history at SFUN. Another reason is possibly that Mo 4 decided to use direct listing (which was only successfully pulled off by a few very well-known companies, like Spotify & Slack), and without any financial advisor. As a result, CIH still have no institution equity research coverage yet.

CIH immediately piqued my interest. It checks a lot of my boxes:

    • Small and obscure
    • International (less fished ponds)
    • Capital-light business model that can reinvest at high rates of return
    • High margins
    • Not expensive on a forward-looking basis

CIH remains the leader in real estate data analytics via SaaS platforms. Their closest competitor, E-House, is more of a broker than a data analysis company.

Let’s check out the chart …

The stock’s pulling back towards its 50MA on low volume. This looks like an ideal pullback buying set-up. But we’ll need further consolidation and a strong breakout to the upside to confirm our hypothesis.

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Podcast of The Week: Eric Vishria, SaaS & Software

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Eric Vishria joined Patrick O’Shaughnessy’s Invest Like The Best podcast to chat all things software and SaaS. You can’t go wrong listening to someone at Benchmark Capital. Gurley and company sure know how to pick ‘em.

If you’re interested in software and SaaS businesses, this podcast is a must listen.

One day I’ll have Gurley on the podcast. One day!

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Tweet of The Week: Don’t Take Life Too Seriously

I love tennis and this tweet is pure wholesome fun. It’s a friendly reminder to all not to take life too seriously. We get one shot at this thing. Laugh at yourself. Joke. Have some fun!

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Q2 Letters, SPAC Analysis and Michael Mauboussin’s Latest Podcast

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Hope you had a great weekend! We’re in the dog-days of Q2 investor letter season. And we love every minute of it. If you haven’t had the chance, check out Part 2 of my series, Cash Flow: It’s All That Matters. Part 2 discusses two cash-flow frameworks that changed my investment process:

    1. Operating Cushion
    2. Core Growth Profile

You can read it here.

Our Latest Podcast Episodes:

Here’s the letters we cover this week:

    • Curreen Capital Q2 Letter
    • Upslope Capital Q2 Letter
    • Silver Ring Value Partners Q2 Letter

We also feature a white-paper on warrants and Michael Mauboussin’s latest podcast interview.

Let’s dive in!

July 22nd, 2020

Chart Of The Week: Here’s a great-looking cup-and-handle pattern on a strong, profitable HVAC company. I featured this stock last week’s Breakout Alerts.

I’m diving into the building products space this week. S/O to Harris Kupperman (a.k.a., Kuppy) for tipping me off to this space.

Be on the lookout for a write-up on my favorite companies / set-ups in that space .

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Investor Spotlight: More & More Q2 Letters!

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This week we’re analyzing three investor letters (mentioned above). Let us know if there’s any investor letters you’d want profiled. We’ll include them next week.

Let’s start with Curreen Capital

Curreen Capital: +32.86% Q2 2020

Christian Ryther runs Curreen Captial. The fund returned nearly 33% in Q2 but remains down 26% YTD. Ryther did two things during the most recent quarter:

    1. Sell Garrett Motion (GTX)
    2. Buy more Kontoor Brands (KTB)

Why Curreen Sold GTX

Anytime an investment has a non-zero chance of going bankrupt, it makes you rethink such an investment. That was the case for Ryther and GTX. Here’s his thoughts (emphasis mine):

“The pandemic-related shutdowns made me reassess my view of Garrett’s ability to overcome its challenges. While I believe that Garrett Motion has an attractive upside-to-downside ratio at current prices, the downside is now bankruptcy, and the probability of that downside has risen.

Garrett’s asbestos liabilities were always an overhang on the bull thesis. Bulls (myself at the time) concluded that the liability payments weren’t as bad as originally thought. That Honeywell would work with Garrett on those payments to make them affordable.

Throw in COVID and the whole idea of a “not-so-bad asbestos liability” flies out the window.

Curreen sold their remaining stake in GTX for a little over $5/share.

Why Curreen Bought (More) KTB

There were a few reasons Curreen increased their stake in the denim company:

    • Dynamic CEO making intelligent decisions
    • Less-likely chance of bankruptcy
    • KTB got covenant relief
    • More durable business (people probably won’t stop wearing jeans)

Given the choice between the two investments, Curren concluded the upside/downside ratio was more attractive with KTB. Here’s Ryther’s thoughts (emphasis mine):

“Kontoor does not have quite as much upside if things go as I expect, but there are more ways to lose with Garrett, and losing with Garrett is more likely to involve a wipeout for shareholders. Comparing the two, Kontoor appeared to be a better bet than Garrett, so I sold our Garrett shares and used the proceeds to buy more Kontoor.”

Trusting The Process

Ryther ends the letter with a great reminder for any investor:  “I believe that the thing to do in extraordinary times is to stick to our core beliefs and long-term strategy. This means that we continue to look for attractively priced businesses that meet our three key criteria.”

Whatever your own criteria is for stock picking, the important thing is to stick to those tried and true principles. Of course you should confirm those principles are based on sound logic and profitability.

But when crisis strikes and correlations go to 0, there’s a strong desire to throw everything out the window. To follow the “fast-money” and the hottest new trend. Fight that feeling. Stick to your process.

Silver Ring Value Partners: +5.7% Last Twelve Months

Gary Mishuris is the managing partner and CIO of Silver Ring Value Partners (SRVP). The partnership returned 5.7% over the last twelve months. Let’s see what he holds and why. You can read his full Q2 letter here.

Current Holdings

SRVP’s portfolio is a collection of equity, debt and derivative instruments. It’s one of the more unique portfolios I’ve seen and provides insight into the many ways one can make money in markets. Here’s Mishuris’ top five positions (as of Q2 end) as % of portfolio:

    1. Covetrus, Inc. (CVET): 22.4%
    2. “Undisclosed Position #4”: 13.5%
    3. Discovery Communications (DISCK): 11.6%
    4. Charles & Colvard (CTHR): 10.9%
    5. Owens-Illinois (OI): 10.2%

The fund also has a “Hopes and Dreams” short basket. It’s a collection of long put-options on the following names: TSLA, ROKU, SNAP, WORK, and BYND. The puts expire January 2021.

Investment Thesis Tracker

Mishuris has an Investment Thesis Tracker in Excel that looks real productive. Take  look at it below:

The tracker follows each investment thesis to see if it’s in-tact or defunct. The color-coding goes as follows:

    • White: thesis is tracking roughly in-line with my base case
    • Orange: thesis is tracking somewhat below my base case
    • Red: thesis is tracking significantly below my base case
    • Dull Green: thesis is tracking somewhat better than my base case
    • Bright Green: thesis is tracking significantly better than my base case
    • Black: Investment exited

If the base case involves a roughly-right range of intrinsic value, using the daily stock price is a helpful measure.

Extreme Options Discussion

The letter dives deep into “extreme options”. Think of these as lottery tickets. The kind of trades you see on r/WallStreetBets. But in this market scenario, Mishuris thinks certain situations warrant a closer look at these lotto-tickets. One of those times is now.

Mishuris distills options into the following example (emphasis mine):

“So imagine a stock with a price of $100. Picture a vertical line on a chart at the $100 mark on the x-axis. Now imagine that someone draws a normal probability distribution (aka a “bell curve”) around that vertical line. How wide or narrow this bell curve ends up being is determined by how volatile the market perceives the stock to be, which is usually based on how volatile it has been in the past. The wider the curve, the more expensive it is to buy an option at a given strike price. This makes intuitive sense – the more volatile we perceive the stock to be, the more likely it is to reach any price that is not $100.”

Here’s the kicker: bell curves are drawn based on the current price. It doesn’t matter where the stock traded a few weeks (or days) ago. Mishuris explains (emphasis mine):

“What happens if the $100 stock price changes drastically? Let’s say that for some reason the stock price goes from $100 to $20. The option model adjusts by drawing a new bell curve, this time around $20. It could care less that the stock was just at $100. The model assumes random movement around the current price, so if that is now $20, then that’s where the model’s bell curve will be. In most circumstances, the curve will also widen, since option market participants will expect higher future volatility than before the drop from $100 to $20.”

As business analysts, we know a company’s actual value doesn’t change as often as it’s quoted market price. Maybe that $100 to $20 drop in price reflects a mere $20 change in intrinsic value estimations? If that’s the case — and the stock’s worth $80, not $20 — call options look very attractive. Let’s head back to the letter for more clarity:

“Buying such an option can produce [a] 20x-40x return if the price to value gap closes before the option expires. In other words, our fundamental value for such an option based on our intrinsic value estimate for the company is much higher than the market price for that option.”

I’ll leave the options talk with this: Even if intrinsic value is higher than the current stock price, there are many ways to lose in options trading.

Alright, back to more stock talk. The letter offers insight into a few holdings:

    • Carnival Corp (CCL)

Mishuris’ Take: “We do know that this is an industry leader with ~ 50% market share which has earned slightly more than its cost of capital over the full economic cycle. Structurally the business has not changed, and once demand is restored the industry economics are likely to be similar to the past. If we look at the company’s balance sheet, the replacement cost of its fleet is over $40 per share after taking into account the debt. So as long as this business is a going concern and demand is restored to prior levels, a base case value of around $40 is reasonable. Without any cash burn the business would be worth north of $50, and we can treat the cash burn and the time value of money as getting us to around $40 of equity value.”

How He’s Playing CCL: October 2020 senior unsecured bond, September 2020 $22.50 call option

    • Covetrus, Inc. (CVET)

Mishuris’ Take: In the depths of the March/April sell-off I was able to add a large number of shares to our CVET position in the $5-$6 price range. This was less than either of the two businesses within the company are worth and a small fraction of my $28 base case value estimate. When the stock tripled quickly and became a very large part of the portfolio I began gradually reducing the position in order to comply with my risk management parameters on position sizing. I did so reluctantly since I think the business is still substantially undervalued and the company remains our largest position.

CVET Presentation: You can watch Mishuris’ CVET pitch at MOI Global Wide Moat 2020 here.

    • Undisclosed Position #4

Mishuris’ Take: “This has clearly been an unsuccessful investment thus far. What’s more, the company’s business positions it squarely in the path of the economic fallout from the COVID crisis, delaying any progress we might otherwise have seen. Offsetting these facts are the following:

    • The stock is currently trading at/below cash per share with no debt
    • We have a founder-CEO most of whose net worth is in the company’s stock who is working incredibly hard to create value for all of us

Given the events, I re-underwrote the business value from scratch. I believe this presents a very unusual asymmetric value opportunity where the probability of meaningful capital loss from here is small, and it is very easy to see returns in the 100%-300% range from these price levels. I have been gradually moving the position size from medium to large to reflect the opportunity.”

    • Owens-Illinois (OI)

Mishuris’ Take: “This is still one of the more undervalued companies in the portfolio with very strong upside once the business stabilizes. I know that cheap small-cap companies with leverage are currently extremely out of favor, but as long as I am approximately right on the cash flow stream we should benefit from the company’s substantial free cash stream over time.”

How He’s Playing OI: Reduced equity and increased out-of-the-money call options

    • Gilead (GILD)

Mishuris’ Take: “The stock rallied to ~ 90% of my Base Case due to optimism for the prospects of revdesimir, the only approved drug for COVID. On a call the CEO was asked multiple times about the economics for the drug and dodged all questions with platitudes. Finally, an analyst asked him point blank if he expects to make a profit for the company on this drug. He dodged that question as well. The combination of these circumstances and the price/value ratio led me to conclude that it is time to move on, and I exited our position during the quarter.”

Upslope Capital: +1.2% Q2 2020

George Livadas runs Upslope Capital and returned 1.2% for Q2. The fund’s roughly breakeven on the year (down 0.7%). Upslope’s ethos is to, “deliver attractive, equity-like returns with significantly reduced market risk and low correlation versus traditional equity strategies.”

You can read his Q2 letter here.

Here’s a snapshot of Upslope’s current portfolio:

Upslope’s a mid-cap focused fund, so its no surprise to see 39% of their portfolio in mid-cap stocks. The remainder of the portfolio includes small-cap stocks (34%), large-cap stocks (24%) and micro-cap stocks (3%).

New Long: Ritchie Bros (RBA)

Upslope’s Take: “Ritchie Bros. is the world’s leading auctioneer and operator of marketplaces for the sale of used heavy equipment (construction, farming, energy, etc.). Through in-person and online auctions, as well as brokered transactions, RBA facilitated the sale of $5+ billion worth of equipment in 2019.”

Their thesis hinges on five key points:

    1. Clear, durable competitive advantages:As the clear leader in facilitating used heavy equipment sales, RBA enjoys significant competitive advantages – similar to those of a dominant financial exchange (e.g. stock market)”
    2. Potential inflection point with parallels to financial exchanges: “When financial exchanges have shifted in the past from floor- and/or phone-based trading to purely “electronic” (online) trading, volumes have generally moved higher.”
    3. Financial results tell a consistent story: “RBA has historically grown GTV (global transaction value, a key metric used to track the health of the business) in the high-single-digit range. Even in the financial crisis, GTV only fell ~8% from peak to trough (over two years).”
    4. Potential cyclical upside: “RBA has indirect exposure to infrastructure spending (and odds for some kind of stimulus on this front in the next 12 months appear higher than normal) and could be a beneficiary of distress in the energy sector (liquidation auctions).”
    5. Strong balance sheet: “We may be nearly out of the woods with regards to the COVID-19 crisis (from a market perspective), but a strong balance sheet is still highly desirable today. RBA is levered just 1.0x net and has good access to liquidity.”
    6. Key Risks: “(A) New, unproven CEO, (B) lumpy quarter-to-quarter performance and (related) potential for losses on inventory deals (i.e. part of RBA’s model involves actually purchasing inventory to be sold in auctions), (C) uncertainty regarding long-term impact of COVID-19, (D) general and unpredictable cyclical nature of the business.”

New Short: Basket-o-SPACs

It’s no secret I love the land of SPACs. The financial market wasteland where pump-and-dumpers thrive, Robinhood traders rejoice and fundamental investors get slaughtered.

Livadas discloses a short in Tattooed Chef (FMCI). If you’re like me, the first thing you think of when hearing “Tattooed Chef” is Guy Fieri. Here’s Livadas’ take on the company (emphasis mine):

“FMCI, on the other hand, simply sells pretty standard, “plant-based,” pre-prepared frozen foods. Some examples: $13 bags of frozen vegetables and $16 cauliflower-crust frozen pizza – hardly exciting or unique stuff. Despite an obvious lack of competitive advantages and the long list of typical SPAC headwinds/risks, FMCI shares appear very richly-valued.”

Take a look at the chart below …

Speaking of SPACs … let’s get to our Whitepaper of The Week.

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Whitepaper of The Week: Stock Warrants & Stock Performance

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Soku Byoun wrote the 2014 paper Stock Performance following Seasoned Stock‐Warrant Unit Offerings. In it Byon dives into the world of warrants. Why is this applicable today? Many SPACs (see above) issue warrants plus plus common stock.

There’s a reason companies offer warrants to shareholders, as Byon notes (emphasis mine):

“A desirable feature of warrants in unit offerings is that they generally bring in funds only if they are needed. If the company grows, it will probably need new equity capital. At the same time, growth will cause the price of the stock to rise and the warrants will be exercised at the latest by expiration. The firm will then not need to tap the capital markets through seasoned offerings to complete their financing requirements. The second stage financing should be accomplished by the exercise of the warrants.”

That’s an attractive option for public companies and shareholders.

Warrants are like call options. If the stock reaches its strike price, the company exercises the warrants. Investors in those warrants profit. If the stock doesn’t reach its strike price, investors sit on a fat zero.

Therefore, warrant investors should expect higher return for that investment. Byon expands on this idea, saying, “Therefore, the average long-run performance of unit offerings must be greater than that of share offerings to make up for the higher risk undertaken. This is also consistent with the Chemmanur and Fulghieri (1997) model, which implies that, for a given level of risk, highquality firms use units to signal their quality.”

Here’s a rough outline of the average SPAC statistics. It holds clues into what one can reasonably expect from the average SPAC IPO:

Finally, I’ll leave you with data on excess returns for SPAC-related unit offerings. Spoiler: they’re not good!

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Podcast of The Week: Michael Mauboussin, What Got You There

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As I write this sentence, I’m finishing Michael Mauboussin’s latest podcast on What Got You There. It’s one of his best podcast interviews. Many gems on myriad topics including:

    • Writing
    • Thinking
    • Sports and business
    • The importance of reading

Give it a listen. You won’t regret it.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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More Q2 Letters, 13F Regulations and Bill Miller Podcast

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Hope everyone’s off to a great week! We’re smack in the middle of Q2 Letter Season (one of our favorite times at Value Hive). As always during this month, we’re heavy on investor letters and new ideas.

If you have any new ideas you want shared with the Value Hive community, let us know! We’ll feature your submitted idea in the Idea of The Week category. We’ll give you props and a shoutout while we watch your recommendation rocket to the moon (we can only hope!).

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Bill Miller Q2 Letter
    • Massif Capital Q2 Letter
    • Akre Focused Fund Q2 Letter
    • Vlata Fund Q2 Letter

Onward!

July 15th, 2020

Chart Of The Week: This week we’re featuring a potential breakout from a long-term rectangle consolidation. It’s a Japanese company that manufactures medical apparel used in hospitals, nursing homes and clinics. Given Japan’s aging population, I like our odds. Below is the weekly chart:

If you want to learn the name of this company, share this newsletter with your friends! Here’s what you need to do:

    • Share this newsletter on Twitter
    • Tag @marketplunger1 in the tweet

We’ll reach out and send you the name of the company.

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Investor Spotlight: More & More Q2 Letters!

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This week we’re analyzing four investor letters (mentioned above). Let us know if there’s any investor letters you’d want profiled. We’ll include them next week.

Get a pen and pad ready! Let’s start with the OG Bill Miller.

Miller Value Partners: Performance Not Disclosed

Bill Miller’s quarterly letters go heavy on philosophy and light on actual investments. That’s okay because Miller’s thoughts on the philosophy of markets is an education unto itself.

He spends the first half of the letter relating markets to casinos (an analogy I love):

“Unlike many (most?) investors, casinos don’t shut down and refuse bets if they lose money at the roulette wheel. Knowing the odds are in their favor, they keep at it and ignore losing streaks (unless they think cheating is going on).”

Miller notes that stocks (and the general economy) go up about 70% of the time. Think about those odds in terms of a casino. Many casinos are lucky to get 1% edges in certain games. The market (aka, the largest casino), goes up (i.e., wins) about 70% of the time.

Record Dry Powder on Sidelines

The current “v-shaped” recovery we’ve seen in markets just might be the beginning. Why? There’s billions of dollars on the sidelines (dry powder) waiting to enter markets. Miller explains (emphasis mine):

“The result of the panic out of stocks in March is that there is now all-time record cash in money market funds, and bond funds have seen huge inflows even as rates hover at levels not seen for thousands of years. In the US, bonds have never been more expensive in US history than in 2020. The S&P 500 yields 3x what the 10-year Treasury does, and dividends grow over time while treasury payouts do not. This is similar, in my opinion, to what happened around the bottom in 2009: People became risk and volatility phobic and most missed the great 10-year bull market.

Rummage corners of FinTwit and you’ll find this exact sentiment. Investors assuring themselves the market will crash. Keeping loads of cash on the sidelines for “the inevitable reversion to the mean”. But what if that never comes? What if Miller’s right and this is the start of another 10YR bull market?

But there’s a reason why some investors remain in cash. There’s a reason why so many remain bearish. It’s called economic data.

Forward-Looking vs. Past Performance

Markets are forward-looking vehicles designed to discount future events into today’s prices to reflect long-term changes. Economic indicators and data are historical figures designed to show what has happened in the past. Not what will happen in the future.

So when you hear people ramble about how disconnected markets are from the real economy, you know why they think that. They don’t understand the dynamic, forward-looking nature of markets.

Miller elaborates on this idea below (emphasis mine):

The market predicts the economy; the economy does not predict the market. Stocks went down in the first quarter of this year and the first quarter of this year was a quarter of growth. Stock prices typically lead the economy by 4 to 6 months so it is, or ought to be, no surprise they have been headed higher. Why should they not be: Things are getting better not worse, earnings are bottoming and should begin to recover in Q3, the Fed has said they do not expect to raise rates for years, inflation is non-existent, interest rates provide no impediment to higher stock prices, and even valuations are not demanding at around 20x 2021 earnings given levels of inflation and rates.

It’s a great reminder that markets try to predict the future as best they can. If we focus on current (or past) economic data to make future investment decisions, we’ll lose. It’s that simple.

Oh, also forgot to mention: Don’t fight the fed.

Akre Focused Fund: +21.66% Q2

Chuck Akre’s fund returned 21.66% in Q2 and is up a little over 8% for the year. That’s not bad considering the S&P’s -3% total return on the year.

What does Chuck hold going into the second half of the year? Compounders, bro! Here’s his top five:

    1. American Tower (AMT)
    2. Mastercard (MA)
    3. Moody’s Corp (MCO)
    4. Visa, Inc. (V)
    5. SBA Communications (SBAC)

I love Akre because he’s true to his mantra of buying great businesses and never selling. He commented on his quarterly activity below (emphasis mine):

“With the rapid recovery off of the March 23 bottom, we were much less active buyers in the second quarter. However, we did put cash to work opportunistically in several names which, in combination with the strong recovery, helped reduce our cash weighting to just over 8% by the end of June.”

Akre’s cash position shifted from 17% at the start of the year to 8% today. That’s putting capital to work during distressed times. Greedy when others are fearful.

My favorite section from Akre’s two-page letter is the following paragraph (emphasis mine):

“This example underscores why market forecasts play no role in our investment process. Our focus is on individual businesses: their quality, prospects, and the valuations at which we would consider initiating or adding to positions. We endeavor to manage the fund in such a way that our decisions to buy or sell are entirely specific to each individual business without regard or reference to general market conditions and forecasts.

I love that. Focus on individual businesses. Let them guide your capital allocation decisions. Mark Minervini talks about this all the time on his Twitter page. He lets individual stocks determine his capital allocation policy — NOT the overall market.

If you’re finding great companies with durable advantages trading at discount prices, what difference does it make whether the index is up, down or sideways?

Massif Capital: +18.3% Q2

We love Chip Russell & Will Thomson’s work over at Massif Capital. We always find an idea or two that we can’t find anywhere else. And that’s really the point of stock-picking, isn’t it? Finding original ideas.

Massif returned 18.3% during the quarter and over 21% for the year. That’s far better than the S&P negative 3% total return on the year. How did they do it?

    • Basic Materials
    • Position Sizing

Russell and Thomson attributed 100% of their quarterly return to the long book (emphasis mine):

Our long book drove 100% of the results this quarter. This is a hard pivot from our first-quarter results, which were driven by our short book and tail risk strategy. Mining firms led the performance with Equinox Gold, Lucara Diamonds, Turquoise Hill, Barrick Gold, Lithium Americas, and Ivanhoe Mining, each contributing more than 2.5% to the portfolio’s return.”

It’s hard to lose betting on gold when the underlying commodity chart looks like this:

Basic Materials gained nearly 25% for the Fund during the quarter. But more important than what went right for Massif was what they adjusted going into 2020.

Position Sizing Matters

Most value investors approach position sizing as an afterthought. Not in the sense that they don’t know how to position size. Rather they take a basic approach like 10% of their capital into each position. While it saves mental capital and simplifies the process — what are we leaving on the table if we do that?

Here’s Chip’s take on position sizing (emphasis mine):

“For many managers, sizing decisions are driven by judgment and intuition, making it a tricky area of an investment practice to improve upon. However imperfect, we have attempted to develop an empirical framework to understand the impact of our sizing decisions better.

What did this dedicated position sizing effort bring in terms of returns? We’ll let Chip explain (emphasis mine):

“When we duplicate this analysis for positions sized according to our post fourth-quarter 2018 framework our winners now have a 2.48x greater impact on the portfolio vs. our money-losing positions. We are beginning to see directional evidence that adjustments to our process are leading to improved portfolio performance.”

In other words, position size matters. It’s something a lot of value investors can learn from the best traders. Things like R multiples, notional vs. actual risk.

Massif’s Current Positions

The fund’s finding it harder to find value in the gold and basic materials space. Chip notes that, “The present challenge with gold mining equities is that all the easy buys of the last two years have disappeared. Our previous successes in Barrick, Continental, and our yet to be realized success in Equinox (currently up ~100% for us) were all the result of purchasing stock at rock bottom prices when the world had no interest in gold.”

That’s a good problem to have.

Besides Bakkafrost (BAKKA), the Fund remains heavily invested in gold, uranium and basic materials.

That said, Massif is looking at Europe as a fertile ground for the next wave of energy investments. Here’s a few reasons why (from the letter):

    • Europe is further along in imposing climate change-related regulations on industry participants
    • Potential tailwind in the form of a vastly more thoughtful COVID19 related stimulus than investors will find in the US, a significant percentage of which is directed at the energy industry and productive investment.
    • S. electricity markets are still too dominated by utilities operating in an uncertain regulatory environment, and energy markets are also plagued by fracking firms in which we have little interest or enthusiasm.

I’ll keep my eye out on any European electricity companies. If I find any I like, I’ll include them in a future Value Hive!

Vlata Fund: Performance Not Disclosed

I love reading Daniel Gladis’ work at Vlata Fund. Though he doesn’t disclose performance figures in his letters, the amount of ideas and names makes up for it.

Gladis mentions a lot of stocks, so we’ll cover the ones which he offers commentary. As always, I encourage you to read the entire letter. Here’s the stocks we’ll cover with commentary from Daniel below:

    • Magna (MGA)

Daniel’s Take:Magna is showing itself to be more resistant to recession than we had counted upon. Its operating leverage is lower than in the last recession, its balance sheet is strong, and it very probably will boost its market share during this recession, whether organically or by acquisitions”

    • BMW (BMW)

Daniel’s Take: “BMW, meanwhile, is the only large car manufacturer to remain profitable, pay out its dividend in the originally intended amount, and not need to fall back on using credit lines from banks”

    • Samsung (005930.SK)

Daniel’s Take:Samsung recorded a drop in mobile phone sales, which was to be expected. On the other hand, its main and most profitable segment, which is producing semiconductors and memory devices, is doing better than we anticipated. This may in part be caused by the greater shift of people’s activities and transactions on-line during quarantine.”

    • Humana (HUM)

Daniel’s Take: “Humana is benefitting from a lower number of visits to physicians, which means lower insurance pay-outs for health care. This trend will most probably return gradually to normal by the end of the year.”

    • Markel (MKL)

Daniel’s Take: “Markel is on the one hand expecting higher pay-outs for damages caused by the pandemic (this relates mainly to insurance in the categories for event cancellations and business interruption). On the other hand, it will benefit from rising insurance premiums, which is already visible.”

    • Sberbank (SBER)

Daniel’s Take: “Profits at Sberbank will fall significantly this year. This is probably inevitable for banks during a recession. Despite this, its return on equity at the bottom of the recession will be higher than those of most large western banks in times of expansion.”

Fundamentals (Always) Matter

Gladis ends the letter with an ode to fundamentals. I know. We’re at that point in the cycle where we’re defending not only value investing — but fundamentals. Yet the rise of daytraders, nasty SPACs and unprofitable companies got us to this point.

Here’s Gladis’ take (emphasis mine):

“The speculative mantra of these days is “Fundamentals don´t matter.” Imagine that you went shopping in your supermarket and you were greeted by a large sign “Prices don’t matter.” Would that seem normal to you? I think that prices (and fundamentals) always matter.”

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Movers & Shakers: Bye, Bye 13Fs?

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The SEC proposed new legislation removing the requirement to file quarterly 13F reports for funds under $3.5B AUM.

Why are they doing it? One argument is to compensate for the tremendous growth in the asset management business (from the article):

“The SEC said a $3.5bn threshold would reflect how much the US equity market had grown since the 13F rules were set up: from a total capitalisation of $1.1tn in 1975 to $35.6tn today. The agency added the 10 percent of managers that would still be filing 13Fs accounted for 90 per cent of the value of the stock holdings disclosed.”

Think of it as an adjustment for the inflation of assets under management in the industry. Which makes sense.

Yet some investors and regulators aren’t so happy (go figure). One unhappy camper, Allisson Herren said, “This proposal joins a long list of recent actions that decrease transparency and reduce both the commission’s and the public’s access to information about our markets.”

I don’t know what I think of this idea. As someone that wants to run a fund one day, I wholeheartedly welcome the initiative. Yet as an investor looking for new ideas and gleaning from those much smarter than myself, I don’t like it. Most of the funds I follow house <$3.5B. They wouldn’t have to disclose positions (save for investor letters). I’m undecided.

What about you? What are your thoughts?

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Podcast of The Week: Bill Miller on Masters in Business

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I had a 10 hour car ride from SC back to MD on Saturday. Safe to say I listened to a lot of podcasts. One of them was Barry Ritholz interview with legendary value investor Bill Miller.

I love listening to Bill Miller. He’s one of the best value investors in the game. He doesn’t fit in a box. He invests in non-traditional value companies with a dogged focus on free cash flow.

Value investing isn’t in ratios multiples. It’s paying less today for something that will be worth more in the future. That’s it.

Give the podcast a listen. It’s a bit over an hour long. I listened at 1.5x speed and had no troubles.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Q2 Letters, Jim Chanos and An Undervalued Student Loan Play

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Hope all our American Hive members had a great Fourth of July weekend. I spent mine driving to Hilton Head, SC. Which reminds me. If anyone’s in this gorgeous part of the country, let me know! Would love to meet up for some coffee to talk stocks, investing and why I haven’t moved down here permanently!

We’re on HOLIDAY mode at Value Hive!

Q2 Letters poppin’ off left and right. We’ll dive into each of your favorite manager’s letters over the next few weeks. You’ll receive loads of new investment ideas.

Grab a coffee, get a pen and paper. It’s time to learn!

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Andaz Private Investments Q2 Letter
    • Tollymore Investment Partners Q2 Letter
    • Buffett Buys Dominion Energy
    • NelNet (NNI) Write-Up

Let’s get it!

July 08th, 2020

Chart Of The Week: This week we’re featuring a recent inverse head & shoulders breakout in Finland. We featured this company in a recent Breakout Alerts Report. The Finnish company makes beers, ciders, snacks and energy drinks. They trade around 20x earnings and have $100M in net cash on the balance sheet.

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Investor Spotlight: Q2 Letters Galore!

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This week we’re analyzing two Q2 letters: Andaz Private Investments and Tollymore Investment Partners. As always, we’ll discuss each idea in the letter along with the manager’s individual commentary.

Andaz Private Investments: +14.3% YTD

Andaz is a performance-oriented specialist investment manager. They focus on one strategy. And it’s worked well. Andaz sports a 31.9% compound annual return since inception (2018). I know, it’s a small sample size. But they’re killing it.

Another has an 81% win-rate on the long-side. 73% win-rate on the short side.

You can read their Q2 letter here.

Lots of Q2 Action: Buys, Sells and Exits

I was surprised to see so much turnover in the Andaz portfolio. Here’s a brief outline of their activity (from the letter):

    • We entered into Bank of America (BAC) in increments at $21.95, $21.75 and $19.83on March 10,14, and respectively. We purchased a meaningful amount in one transaction at $18.95 on March 24.  We exited at $23.53 and $24.65 on April 9 and April 13 respectively.
    • We re-entered Bank of America at $22.66 on May 20 and again exited eight days later at $26.11.
    • We entered into Twitter (TWTR) at $26.15 on March 25 and added at $25.25 on March 31. We trimmed the position at $29.77 on May 11 and exited completely at $31.95 on May 22.

This style of trading/investing clearly works for Andaz — as shown in the results.

Let’s review three of their unique holdings during the quarter:

Zscaler (ZS)

    • Business Description: Zscaler, Inc. operates as a cloud security company worldwide. The company offers Zscaler Internet Access solution that connect users to externally managed applications, including software-as-a-service applications and Internet destinations; and Zscaler Private Access solution, which is designed to provide access to internally managed applications, either hosted internally in data centers, and private or public clouds. – com
    • What’s To Like:
      • Net Cash on balance sheet
      • >50% 5YR Revenue CAGR
      • 80% Gross Margins
      • Declining Days Sales Outstanding
    • What’s Not To Like:
      • Negative FCF
      • Loads of Stock-Based Compensation
      • Trades at 27x Revenues

Qantas (QAN)

    • Business Description: Qantas Airways Limited provides passenger and freight air transportation services in Australia and internationally. The company also offers air cargo and express freight services; and customer loyalty programs. – com
    • What’s To Like:
      • Durable 30% Gross Margins
      • Consistent Share Buybacks
      • 14% 5YR Avg. ROC
      • Conservatively Leveraged (Net Debt/EBITDA: 1.13x)
    • What’s Not To Like:
      • Low Operating Margins (recently growing)
      • Little insider ownership

Zillow Group (ZG)

    • Business Description: Zillow Group, Inc. operates real estate brands on mobile and the web in the United States. It operates through three segments: Homes; Internet, Media & Technology; and Mortgages. The company’s platform offers buying, selling, renting, and financing services for residential real estate. – com
    • What’s To Like:
      • 50%+ 5YR Rev. CAGR (100% growth in 2019)
      • Historically high Gross Margins (one-off 50% GM in 2019)
      • Minimal debt on the balance sheet
      • Dominant market position in niche category
      • Trades at 3x revenues
    • What’s Not To Like:
      • Lost $1.5B in operating income on $2.74B in revenue
      • Increasing share count
      • Not yet close to FCF positive
      • Hefty Stock-Based Compensation

Tollymore Investment Partners: +18.9% YTD

Tollymore’s Q2 letter didn’t discuss individual investment ideas. And usually I don’t include letters without ideas in these weekly newsletters. But what they lacked in investment ideas they made up in wisdom.

Mark highlighted four unconventional truths about investing. Let’s break each down.

1. Holding Cash is Imprudent

Mark’s Take: “Yet misdirected intellectual energy in the form of market commentary tends to accelerate in periods of market dislocation. The inability to act decisively in these periods, due to capital redemptions, inappropriate capacity constraints, committee-led decision making models, lack of conviction or other source of self-doubt is a barrier to value creation and one of the great shames of our industry.”

2. Dispassionately cutting unprofitable investments is consistent with long term ownership

Mark’s Take: “In the absence of clear and substantial overvaluation, selling due to valuation implies an ability to predict near term price movements.In addition, selling a familiar business making positive fundamental strides for an unfamiliar one creates reinvestment risk. We are not playing for 20% upside; we will continue to own businesses which we believe will be worth a lot more in five to ten years. We expect Tollymore Aggregate Long-term results to be determined by a small number of outsized winners and a strong tail of (many) below opportunity cost mistakes.”

3. ESG ≠ sustainable investing

Mark’s Take:Investors last year ploughed a record $21bn into ‘socially-responsible’ investment funds in theUS, almost quadrupling the rate of inflows in 2018. The surge in popularity of companies with the best social,environmental,and governance scores in recent times has resulted in a crop ofESG funds, eager to attract some of the cyclical capital flows to this bucket.Attempts to quantify art through an obsession with measurement create bubbles, dis incentivise first principles thinking, and make capital allocation and manager selection processes less efficient by making them more data driven. But data can be falsely empowering, unaccompanied by thoughtful qualitative review of a manager’s capacity and incentives to do a good job”

4. Successful investing requires intuition

Mark’s Take:We believe a behavioural advantage is possible by coordinating the disposition of the firm’s principals, the mentality of its investment partners, physical working environment, methods of internal communication, the time horizon of the strategy, and the implementation of the programme.We spend time thinking about the complementary nature of these aspects of the ecosystem. We spend less time thinking about the individual merits of concentrated vs.diversified portfolios, noisy vs. quiet offices,or short vs. long term decision making.”

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Movers & Shakers: Buffett Buys Dominion Energy

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Buffett finally woke up from his nap to spend some money. CNBC announced yesterday that Buffett’s conglomerate, Berkshire Energy, purchased Dominion Energy. The price tag? $10B ($4B + debt assumption).

The move comes after months of questioning if Buffett would ever make another transaction.

But this isn’t a cannonball into the markets. Berkshire spent $4B of its $137B cash pile. That’s a 3% position. Yet the significance of the move isn’t in the dollar amount. Rather the percentage of the energy market Berkshire now owns.

Here’s what the deal means for Berkshire Energy (from the article, emphasis mine):

    • “For Berkshire, the move greatly increases its footprint in the natural gas business. With the purchase, Berkshire Hathaway Energy will carry 18% of all interstate natural gas transmission in the United States, up from 8% currently.

It’s a big splash in the energy space for a small $4B investment. Honestly, I’m not shocked Berkshire dove into the energy space. Everything’s bombed out. And if you can find a utility-like play that’s conservatively leveraged, that’s interesting.

Here’s what Buffett gets with his Dominion purchase (emphasis mine):

    • “Under the deal, Berkshire Hathaway Energy will acquire 100% of Dominion Energy Transmission, Questar Pipeline and Carolina Gas Transmission and 50% of Iroquois Gas Transmission System. Berkshire will also acquire 25% of Cove Point LNG, an export-import and storage facility for liquefied natural gas, one of just six in the U.S.”

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Write-Up of The Week: Nelnet, Inc. (NNI)

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Mindset Capital published a long thesis on Nelnet, Inc. (NNI). We’re always looking for new ideas to share with our readers. NNI grabbed our attention for a few reasons:

    1. Durable business with large market share
    2. Cheap purchase price
    3. Boring business

Here’s Mindset’s take on the company (emphasis mine):

“With its stock stuck in the mud, virtually no analyst coverage and a quiet management team, few have heard of Nelnet and even fewer understand that Nelnet’s run-off student loan portfolio is winding down and is poised to deliver over $10 per share in cash over the next seven quarters, or close to a quarter of the current market cap and will enable Nelnet’s true technology colors to emerge.”

Messy Student Loan Business Masks Hidden Gems

The main driver behind Mindset’s thesis is NNI’s hidden assets. There’s three of focus:

    • NelNet Business Service (NBS): Tuition payment plans, online payment processing and information systems for school administrative functions

Mindset’s Take: “As a standalone company, NBS could be worth anywhere from $39 per share to $58 per share. Imagine what this company could IPO for in today’s market. Investors currently get it for free.”

    • Allo: End-to-end fiber optic network for businesses and residences in Nebraska and expanding into Colorado with a specific focus on under-served markets

Mindset’s Take: “A publicly traded small cap comp to Allo would be Tucows (NYSE: TCX), which is only growing at about 6% a year, but trades at 14 times EBITDA. Cable One (NASDAQ: CABO) is another rural cable play and trades at 20 times EBITDA! Even using a conservative traditional cable multiple of 8- 10 times off the drastically higher EBITDA in 2-3 years, it’s very easy to see how much more valuable this business will be in the future.”

    • Hudl: Provides digital tools to coaches and athletes to review play, scout talent and analyze competition across professional, college and youth sports.

Mindset’s Take: “Nelnet started Hudl a few years ago with a $100K investment. Along the way they only brought in three external investors, Accel Partners, Bain Capital, and Jeff Raikes (one of Bill Gates closest business lieutenants). Hudl currently has 2,300 employees in twenty countries, is making several acquisitions, especially internationally, and is growing very fast.”

Student Loan Portfolio Beneficiary of Low Interest Rates

NNI’s main business, student loans, benefits from low interest rates. Mindset explains how (emphasis mine):

“Nelnet is a prime beneficiary of the Federal Reserve holding interest rates at zero until 2022, as the underlying students continue to pay fixed rates while Nelnet pays the interest on their securitizations based on LIBOR.”

In other words, as long as interest rates stay low, NNI pays almost nothing.

Low rates propelled the company’s expected FCF figures over the next few quarters. To the tune of $2.18/share per quarter. The company’s expecting over $300M in FCF by YE2021.

What’s It Worth: $90-$114/share

Mindset walks readers through his valuation method (see below):

It’s an interesting Sum of The Parts (SOTP) story with loads of long-term tailwinds. The company has a portfolio of 35 “Hudl-like” venture investments. The current valuation allows investors to buy both the venture portfolio and the loan servicing business for free.

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Slide Deck of The Week: Jim Chanos — Hiding in Plain Sight

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I’m a big Jim Chanos fan. When people think of short sellers, he’s the first name that comes to mind. His podcasts, YouTube videos and lectures are a masters class in financial accounting shenanigans.

One of my favorite Chanos slide decks is Hiding in Plain Sight: PRO FORMA FINANCIAL METRICS IN THE POST-TRUTH AGE.

The 17-page slide deck covers a range of topics, including:

    • Where to look for true financial data
    • The dangers of adding-back “one-time” expenses
    • Stock-Based Compensation
    • Executive Compensation
    • Insider Selling

And more.

Take a half hour and read the deck. Your portfolio will thank you.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Career Risk, Sports Stocks, Li Lu and What Makes Stocks Go Up

, ,

Hope your week is off to a great start! We’ve got a lot to cover this week. But before we do, I want to briefly discuss the Macro Ops Collective.

The Collective is our premium service offering. It’s unlike any other investing resource on the market. We’re a group of people dedicated to the craft of investing, trading and getting smarter every day. As iron sharpens iron, so one investor sharpens another.

As a Collective member, you’ll gain access to this growing group of traders via a private Slack channel, as well as institutional-quality investment research.

You’ll receive real-time trade alerts, weekly stock ideas from the most under-followed corners of the market and invaluable briefs on market trends.

If any of this sounds interesting to you, click here to learn more.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Genetic Defects in Active Investors
    • Sports Investing in a Post-COVID World
    • The Anatomy of Stocks That Go Up
    • Li Lu Speech at Columbia University

I love curating this content for you guys. Let’s dive in!

July 1st, 2020

Chart Of The Week: After taking 2/3rds profit on our PTON position (see last week’s Value Hive), we’re back this week with a new short trade. This chart was featured in a previous premium Breakout Alerts report.

I got short around $100.52. I’m expecting a pullback towards the 200MA before another leg down (or if I’m wrong, a reversal above the 200MA).

I’m seeing a lot more short set-ups. You can find one of them here.

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Investor Spotlight: Do Active Managers Have A Genetic Defect?

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Institutional Investor published an article on a “genetic defect” found amongst active fund managers. This defect wasn’t underperformance, nor was it some sector-specific bias.

It was over-diversification.

The article begins by saying (emphasis mine), “Research has shown that active managers produce persistent excess returns on their best ideas — but they squander these returns by relying on overly diversified portfolios.

This isn’t breaking news by any stretch of the imagination. So why is it in the news now?

Finance veteran Tim Mullaney developed a new RIA designed to eliminate this defect.

Killing “Beta Anchors”

Mullaney’s project (Melius) isn’t groundbreaking. Take only the best ideas from multiple portfolio managers and remove each manager’s diversification efforts. The logic being each manager’s combined best ideas provides enough diversification while removing the beta anchors, or stocks added to reduce risk (but also reduce return).

Melius relies on ensemble methods to capture this alpha. Ensemble methods take in multiple predictive models which (hopefully) spit out a more predictive model. We see this idea in Michael Mauboussin’s Wisdom of Crowds paper.

The Real Reason: Career Risk

Managers over-diversify to protect themselves from career risk (getting fired). This makes sense. The incentive structure of most money managers isn’t to out-perform an index. It’s to keep their job.

Inevitably this leads to closet-indexing, or managers constructing portfolios similar to the S&P 500. The article explains the phenomenon well (emphasis mine):

“Take the Janus 20 fund,” he said. “It did well for a while, but when that manager’s approach goes out of style, even if short term, what happens? The investors gets hurt, the consultant gets embarrassed, and the manager gets fired. So that’s why you don’t see highly concentrated portfolios.”

Have Your Cake & Eat It Too

Mullaney wants to have his cake and eat it too. Combining the top ideas from multiple managers has worked in the short-term (as the article notes). But what about long-term performance? This story reminds me of the Charlie Munger anecdote on the “best ideas portfolio”. Here’s Warren’s partner on the endeavor (emphasis mine):

“We’ll get the best ideas from our best people and we’ll make a portfolio just of our best ideas from our best people. Nothing could be more plausible. They’ve done it three times and it’s failed every time. Now, how would you predict that?

Well I can predict it because I know psychology. When you pound out an idea as a good idea, you’re pounding it in. So by asking people for their best ideas they were getting the stuff that people had most pounded in, so they believed. So of course it didn’t work. And they stopped doing it because it didn’t work. They didn’t know why it didn’t work because they hadn’t read the psychology books, but they knew it didn’t work so they stopped. And it’s so plausible.”

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Movers & Shakers: The Shake-up In The Sports World (An Investor’s Guide)

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Andrew Walker is back with Part 6 (six!!) of his Yet Another guide to media stocks. This week he focuses on team sports investing and the changing landscape post-COVID.

If you’re looking for Andrew’s favorite two sports team stocks, look no further than:

    • Madison Square Garden Sport (MSGS): Owns the Knicks & Rangers and trades for <$4B EV.
    • Liberty Media Corporation (BATRA): Owns the Atlanta Braves + some real estate and trades for roughly $1B EV.

According to Andrew, the above valuations are massive discounts to what a private buyer should pay (emphasis mine):

Those are mammoth discounts to the private market value of the sports teams underlying those assets; the Knicks alone would likely go for ~$5B if they were put for sale (or more than MSGS’s entire enterprise value, implying you get the Rangers thrown in for more than free!), and I would guess the Braves would be close to $2B in a sale (implying you get the very valuable real estate around the Braves’ stadium plus a few other goodies for more than free).”

COVID Clouds on The Horizon

Today’s market prices are cheap. But how cheap are they in a post-COVID world? Andrew does a great job answering this question (emphasis mine):

“The impacts of Covid on sports teams are going to be felt for decades to come, and I would not be at all surprised if Covid creates some permanent impairment in sports team values. Probably not enough impairment to justify close to today’s discount, but if you asked me if you offered me the exact same sports team at $2B pre-Covid or $1.5B post-Covid, I would almost certainly prefer to invest at the higher price in the pre-Covid world.

What are these long-term effects Andrew’s referencing? He mentions a few:

1. Acceleration of Cord-Cutting

Andrew’s Take: “So when Corona shut down every sports league, it created a really weird cable TV offering: cable TV was effectively an overpriced sports bundle that no longer had sports. The results were pretty predictable: cord cutting accelerated.”

2. Increased RSN Blackouts

Andrew’s Take: “If I was a cable company, I would absolutely be looking to blackout the RSN. Why am I going to be given them $5/sub/month when they aren’t providing a product? Sure, the RSN could offer to take no or seriously reduced fees until baseball returns…. but, again, if I’m a cable distributor, I’m looking to tighten the screws on the RSN right now. If I blackout an RSN during a lockout, basically no one will care. But the RSN will suffer enormously.”

3. Decrease in Revenues, Salaries & Salary Caps

Andrew’s Take: “Lebron James is already making more per year in endorsements than he is in NBA salary; if the league tries to cut salaries 20% across the board, could James and a few other super stars band up and create their own league (Kyrie Irving already floated the idea, though Irving can be a little wacky….)? In normal times, I’d consider that laughable. But with the whole world on pause, a fresh league could have some advantages: there are plenty of suboptimal things about the NBA that could be improved with fresh thinking, and obviously the players could cut out the owners (who don’t really provide much) and keep the equity capital for themselves.”

The Rise of eSports

Andrew must’ve read last month’s Macro Ops Consilience Report. We dove deep into the rise of eSports and its long-term runway.

He mentions an interesting point about the second-order effects of COVID in sports: generational fans. In short, Andrew argues that kids (the next generation of potential fans) will opt for other forms of sport and entertainment (primarily esports). Why? Here’s Andrew’s answer (emphasis mine):

A big part of being a fan as a kid is going to a stadium and experiencing a game. Kids aren’t going to get that for the next few years. Sure, they can watch the game on TV…. but they could also just go play fortnite. I would bet a significant number of kids chose fortnite over watching games on TV, and that can break the lifelong fandom bond.”

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Newsletter Of The Week: The Anatomy of Stocks Going Up

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Dave Portnoy taught us stocks only go up. Fair enough. But why do they go up? It’s a trivial question at face value. But think about it. What really makes a stock price rise? Is it macro liquidity? What about margin expansion?

According to Dubra Stocks research findings, only two things mattered:

    1. Revenue growth
    2. Earnings growth

That’s it. While helpful, those two things aren’t useful to us as investors. We already know that.

Dubra dove deeper into these Stocks That Go Up (STGU) to determine what made them rise in addition to revenue and earnings growth.

Five Groups of Stocks That Go Up

Dubra broke these STGU into five groups:

1. The Early Innovators: “Exceptionally high revenue growth companies that generally run at lower margin. These companies are growing at all costs.”

My take: Early stage companies at the beginning of their growth curve. They have no earnings, generate massive losses. They only care about growth.

2. Maturing Innovators: “Very high margin businesses that grow somewhat slower than The Early Stage Innovators.”

My take: Companies continue to grow rapidly but are starting to lose less money, potentially making minimal earnings.

3. Mature High Moat: “Moderate revenue growth and strong margins. Far higher margins than The Early Stage Innovators but lower margin than the Maturing Innovators.”

My take: Companies now make consistently high profits and are reinvesting less of their cash-flow back into the business (R&D, etc.) and using it to pay dividends, raise cash balances or buyback stock.

4. Defensible & Predictable: “Stocks with relatively low revenue growth and margins, but have strong moats and competitive advantages (regulated oligopolies, etc).”

My take: This is your run-of-the-Dempster-mill Buffett company. Massive, strong moat and durable earnings power.

5. The Survivors: “This is a group that is otherwise unremarkable in terms of revenue growth and margins whose returns are predominantly the result of surviving major periods of uncertainty in the markets.”

My take: Lackluster group with no real place in the study. Goodwill, in other words.

Invert, Always Invert

We’re closer to a working formula for finding STGU. One last step, invert.

Dubra inverts his question and asks, “What are characteristics of stocks that go down (STGD)?”

He outlined another five groups (from the newsletter):

These five groups combine to make one terrible stock (unless it’s 2020 — then that’s to the moon). Dubra notes the common traits of STGD (emphasis mine):

“What we find is that STGD generally suffer from combinations of financial leverage (too much debt), operational leverage (too much overhead) and cyclicality (not enough revenue when they need it). These characteristics amplify negative developments and create scenarios of irrecoverable loss for investors.”

Bringing It All Together

Dubra gives us a TL;DR of his research. And yes, it is as simple as you think.

Stocks That Go Up: “generally coincide with high revenue growth and the ability to grow at high rates over long periods of time. Better said, STGU tend to benefit from open-ended growth opportunity that enables both high growth and high durability of that growth.”

Stocks That Go Down: “exhibit characteristics of financial leverage, operational leverage and cyclicality. Those things are to be avoided in a thoughtful way.”

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Lecture Of The Week: Li Lu at Columbia University, 2006

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Li Lu is one of my investing heroes (behind Burry). Lu’s approach to investment is logical, straightforward and produces incredible results. He’s one of the few (if only) man Charlie Munger trusts with his capital.

Check out this lecture Lu gave at Columbia University in 2006. Lu’s words of wisdom penetrate time, creating evergreen content.

It’s an hour and 46 minutes and worth every second.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Activism, Financials and Why IPOs Suck

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We hope you had a better weather weekend than we did in MD. Rain, rain and more rain. I can’t complain, though. I finished one of my newest favorite books: Amarillo Slim in a World Full of Fat People.

If you haven’t read it, buy a copy. Brad Hathaway (you can find his podcast here) turned me on to the book. He even bought me a copy. Great dude — can’t thank him enough.

Next on my to-read list is Creating Shareholder Value and The Bond Book. What’s on your reading list?

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • A Framework For Understanding Financial Companies
    • Investing in Cloud Computing
    • Alta Fox’s Latest Activist Position
    • Why IPOs are Rip-offs

Ooo I’m excited for this one! Let’s get after it.

June 25th, 2020

Chart Of The Week: This week’s chart was featured in a prior Breakout Alerts report. So far it’s working in our favor (I have a position). Profit target is around $59-$60/share. Here’s what I like about it:

    1. Breakout from horizontal boundaries
    2. Established uptrend
    3. Continuation pattern from bullish inverse H&S breakout

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Investor Spotlight: Alta Fox Raises Voice in Activist Campaign

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Alta Fox Capital went activist last Friday. Connor Haley, managing partner of Alta Fox, disclosed an activist position in Collector’s Universe (CLCT). You can read the letter here.

Connor is one of the sharpest investors in the game. I read his letters like religion. This public activist stance got FinTwit’s attention real quick.

Before diving into the letter, let’s take a look at CLCT.

CLCT By The Numbers

    • Market Cap: $305M
    • Enterprise Value: $296M
    • Gross Margins: 60%
    • Unlevered FCF Margin: 19%

We can see why Connor would like CLCT. A durable, high FCF generating business with a strong competitive moat.

Armed with our figures, let’s breakdown Connor’s letter.

Not Your Typical Activist Stake

Alta Fox didn’t initiate its CLCT investment with the intention of going activist. The fund bought shares because CLCT displayed common characteristics found in many Alta Fox investments (from the letter):

    • Strong competitive advantages
    • Long runway for growth
    • Attractive reinvestment opportunities
    • Low investor awareness

But after talking with past executives, employees, customers, etc. Alta Fox smelled an untapped value creation opportunity.

The activist campaign centered on one company problem (from the letter, emphasis mine):

“In our opinion, CLCT’s lack of innovation and margin improvement is primarily attributable to a complacent and disengaged Board that has not demonstrated or executed on a thoughtful capital allocation plan.”

Not The Best Board

Reading further, we see why Alta Fox wants to change CLCT’s board. Take a look at the current board’s rap sheet (from the letter):

That’s a recipe for complacency and lackluster capital allocation. And when Alta says the board’s equity ownership is minimal — they mean it. The board owns (a collective) 1.5% of common stock.

Three Ways Out

Alta Fox sees three paths for CLCT’s future (from the letter):

    1. Bring in a new and rejuvenated Board to work with current management in improving the core business (Alta Fox’s preferred plan)
    2. Slash public company costs and go private
    3. Maintain the status quo (which the board has elected to do)

Alta’s Final Thoughts

Alta Fox sums up its thesis in the following paragraph (emphasis mine):

“With reasonable growth and margin expansion assumptions, CLCT’s base grading business is severely undervalued by the market today. Furthermore, the market today is assigning CLCT no credit for any digital efforts. Our nominees would work tirelessly with management to fix the bottlenecks in the core grading business, introduce valuable new digital services, and bring increased transparency to both investors and customers …

We believe our nominees have the experience and track record to work collaboratively with management to deliver $100/share in value to CLCT’s shareholders within the next 3 years ($50/share in core business + $50/share in new digital initiatives).

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Movers & Shakers: Frameworks For Financials

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I struggle analyzing financial companies. In fact, I have yet to invest a dollar into financials or insurance businesses. Not because I don’t think they’re good businesses. But because I don’t understand them. I want to change that. That’s why we’re covering Marc Rubinstein’s newsletter post, Front Book, Back Book: A Framework for Understanding Financial Companies.

The Benefits of A Large Back Book

Banks and insurance companies have “old” assets on the balance sheet. Each year, those assets grow because you can’t replace the duration of those assets today, with the returns you’ve generated from the old asset until now.

In short, a long-tail premium written decades in the past has had time to accumulate decades of premiums. That’s not the case for newer premiums.

Here’s Marc’s take on the benefits of a large back book (emphasis mine):

“A financial company doesn’t have to start all over again on 1 January each year. Before it even opens its doors it can bank on a stream of income coming in (although a stream of charge offs or claims could very well go the other way). Unlike other businesses a back book makes money during the night and over the weekend. It’s a melting ice cube of course, the asset won’t stick around forever, but as long as it was priced correctly, the back book can provide a stable stream of earnings to finance new business growth.

Did you catch that last part? “As long as it was priced correctly …”

That’s critical. Marc explains why (emphasis mine):

“Just as no-one priced in the possibility of large-scale terrorism losses in 2001, no-one priced in the possibility of pandemic losses in 2020. Lloyd’s of London estimates that insurance industry losses will exceed US$100 billion this year. That’s around twice what 9/11 cost (US$40 billion or US$55 billion in today’s money).”

What does this mean for financial companies’ business models? They become quite capital intensive enterprises.

That makes sense. The back book of business took a lot of expense to win upfront. But after that, it’s an annuity stream until losses and claims come in. It’s at this point we find the distinction between front and back books.

Front vs. Back Books

I love the way Marc bifurcates financial companies’ two main business segments (from the article):

This creates a problem for newer financial companies, like insurance. Take Lemonade, Inc. for instance. We covered them in last week’s Value Hive. Marc notes an important distinction in their business model that allows Lemonade to eliminate the need for a back book (emphasis mine):

“Lemonade details in its S-1 prospectus how beginning 1 July it will cede 75% of its business to reinsurers. Like most fintechs it does not have the capital to cultivate a back book.”

Again, this makes sense. The back book is a highly capital intensive operation (but with high margins). What new company wants to go through the trouble of developing a back book of business when they can offload it to reinsurance companies?

A major problem with doing that is lack of skin in the game. Marc explains (emphasis mine):

“The problem of course is that it removes skin in the game. If you’re not going to retain some interest in the long-term performance of the book, there is little incentive to underwrite it properly at the outset.”

Benefits of Having Two Books

The newsletter ends with a defense for two books of business (emphasis mine):

“When capital is abundant, pricing goes down. At times like those, a well-underwritten back book can sustain the business until the cycle turns. If the entire business is built around flow it’s harder to withstand competitive forces … But when capital is depleted, like it is after large losses and pricing goes up — that’s really the time to dance.

Marc observes two ways to make money with both books:

    1. Front book: follow the pricing higher (works best in a consolidated industry
    2. Back book: Value the book higher than the market

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IPO Of The Week: IPOs are (actually) Rip-offs

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Last week we covered Lemonade, Inc. LMND wants to go public via IPO. Bill Gurley thinks that’s a terrible idea. And we should listen to him. Gurley’s a GOAT in the venture capital space. He’s invested (via Benchmark) in companies like Uber, Zillow and Stitch Fix (to name a few).

What makes IPOs such a rip-off? Simple: it’s all about the underwriters making money. Gurley elaborates with a story on Elastic’s public offering (emphasis mine):

“We suddenly realized that the investment banks were way underpricing the shares, and that the market cap would jump by $70 [million] to $80 million the first day.”

When investment banks underprice a company’s shares, there’s usually one direction the stock trades post IPO. Up. Gurley noted that in Elastic’s case, the underwriters took home a cool $200M in gains from the share price increase. None of that went to original investors (like Benchmark) nor the company’s bank accounts.

A 2019 CNBC article revealed the largest underpricers in the underwriting game (Hint: it’s who you think it is).

What’s the solution? Gurley suggests direct listing.

Benefits (and Drawdowns) of Direct Listing

The main benefit of a direct listing is insiders and employees retain most of the equity ownership in the company. There’s less dilution and you remove the underpricing with investment banks.

It’s also never been easier to directly list on a stock exchange. The article notes, “There’s no technical reason why companies can’t list themselves. The technology already exists. Companies can essentially plug right into the stock exchanges, and the share price gets determined by a standard market-matching process.”

There are clear drawdowns with direct listings. IPOs are an easy way to raise cash for a business. Direct listings don’t have a clear way to raise capital (if companies need it). Another common drawdown people mention about direct listings is there’s little/no momentum going into the listing.

I don’t see that as a big issue with social media and digitization of road shows.

If you’re interested in learning more about direct listing vs. IPOs, Patrick O’Shaughnessy did a great podcast with Gurley. You can find that here.

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Whitepaper Of The Week: Investing in Cloud Computing in 2020

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JPM released a 106-page CIO survey on IT investment spend. It’s a great primer for understanding where chief allocators put their money in that space.

Here’s the TL;DR if you’re pressed for time:

    • IT budgets remain cloudy (see what I did there) amidst COVID-19 uncertainties
    • Microsoft dominates the cloud game (commands 3x mindshare as #2 opponent)
    • Spending on cloud computing remains robust
    • Top five companies include: Microsoft, Amazon (w/ AWS), Google, salesforce, and ServiceNow.

Spending Plans For CIO’s in 2020

One of the coolest parts about the survey was seeing how CIO’s planned to spend their IT budget. And more importantly, which product companies CIO’s plan to invest in. Check out the graph below:

There’s a few things to notice from this graph:

    1. Microsoft only has 0.8% of the market left to conquer
    2. CIOs plan to maintain investment in Adobe
    3. Almost 50% of CIOs plan to invest more in Microsoft products

Also not a huge fan of Slack’s numbers in this report. Looks like deterioration of the bull thesis.

Let’s take a look at another graph (warning to Box.com shareholders):

Almost 50% of CIOs expect to increase their spending in Microsoft products/services. On the other hand, CIOs plan to spend 10% less on Box.com and 4.6% less on Dropbox. But don’t tell that to DBX and BOX shares. Both companies’ stock prices are hitting new highs.

Next is one of my favorite charts in the survey. If you’re looking for actionable investment ideas this is your chart:

Take a look at the top left of the chart. It shows companies which CIOs spending intentions are high and company market penetration remains low. In other words, there’s a lot of demand for these products with long runways for growth.

That’s not a bad combination.

If you don’t want to squint your eyes, here’s the list:

    • Elastic (ESTC)
    • Pure Storage (PSTG)
    • CrowdStrike (CRWD)
    • Coupa (COUP)

Find a hour to read the entire report. You’ll get smarter and learn about a few businesses you might not otherwise.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Ackman’s SPAC, Intangible Assets, Insurance IPOs and Mauboussin’s Whitepaper

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Hope you had a great weekend and a good start to your week. Isn’t it funny how a ~8% drop in the S&P feels like nothing after March? Just another day in the markets.

There’s people saying we’re in a recession/depression. There’s people saying we’re in the early stages of a bull market. Whichever side you’re on — it doesn’t matter. All that matters is finding great companies that trade at crazy discounts to intrinsic valuation, ripe for a breakout.

Speaking of new ideas … our latest podcast is loaded with em’!

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Bill Ackman Writes Blank Check
    • The Math of Value & Growth
    • Lemonade S-1 Analysis
    • Accounting For Intangible Assets

This newsletter has a mix of in-depth analysis, company research and investor news. Let’s get after it.

June 17th, 2020

Chart Of The Week: I’m featuring the chart below in this week’s Premium Breakout Alerts Report. I’ll give you a few hints:

    • Well-known company
    • Robinhood favorite
    • Technology-based

I really narrowed down the list, didn’t I? Anyways, it’s a beautiful cup-and-handle pattern.

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Investor Spotlight: Bill Ackman Cashes In (Again)

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Bill Ackman officially signed a lease in the pages of this newsletter. We can’t get rid of him! This week he wants to issue a Special Purpose Acquisition Company (SPAC). A big one: $1B.

There’s a lot we don’t know about the Ackman SPAC. But for those unfamiliar with SPACs, check out this slide deck here.

In short, a SPAC is a holding company that has a certain amount of money to acquire an existing business to take public. The SPAC has ~2 years to find a candidate. Often, early SPAC investors have no idea what business the company will buy.

SPACs also come with warrants or rights. Think of these as call options on the future of the SPAC and the acquired company.

SPACs in Vogue

The article also mentions the popularity of SPACs in 2020. Here’s some stats:

    • SPACs have raised $9.8 billion through U.S. IPOs so far in 2020
    • SPACs have been behind some of the most high-profile public listings of the last 12 months, with the likes of space tourism company Virgin Galactic Holdings, sports betting platform DraftKings Inc and electric truck maker Nikola Corp
    • Social Capital CEO Chamath Palihapitiya and Starwood Capital Group CEO Barry Sternlicht each raising hundreds of millions of dollars for them this year.

Flaming Dumpster Fires

As one Reddit user once said (and I’m paraphrasing), “SPACs are large dumpster fires full of s**t.” And they’re not entirely wrong. We don’t have a large database of SPAC return research. But what we do have isn’t good.

Anytime you find a place people call “dumpster fires”, stop. Remember the words of prophet Michael Burry: “If my initial reaction to a stock is ‘ick’, I dive deeper.”

Here’s two great resources for further SPAC Research (not sponsored):

    1. SPAC Alpha
    2. SPAC Research

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Movers & Shakers: Accounting For Intangible Assets

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Last week we reviewed stock-based compensation and its effect on underlying profitability. This week we’re staying in the weeds with intangible assets. Let’s dive into FootNotesAnalyst’s review of intangible assets and their effect on traditional value metrics.

Value Factors: Assets-in-place vs. Cheapness

The article argues that there’s two ways to measure the value characteristic of a stock (from the article):

    1. Assets-in-place: “The value of a company can be thought of as the sum of the value derived from business activities already in place and the current value of expected future investment and growth opportunities. Furthermore, the value of existing business activities can itself be thought of as the current balance sheet value of (net) assets plus the added value derived from the way those assets are utilised i.e. their profitability.”
    2. Cheapness: To further confuse matters value can also be regarded as the characteristic of cheapness based upon one or more valuation metrics. This obviously overlaps with the idea of assets-in-place but the emphasis is on selecting stocks with low multiples rather than necessarily high assets-in-place.”

Indices and algos use book-to-price as the standard value “cheapness” factor. But there’s three issues with that approach (from the article):

    1. Measurement: “Financial reporting uses a mixed measurement model with some assets reported at cost and others at current value. In addition, measurement choices available to companies mean that comparability within asset classes may be affected.”
    2. Goodwill:While goodwill is regarded as an asset for financial reporting purposes, the question for investors seeking to identify ‘value’ stocks is whether it is an asset-in-place and, if so, whether balance sheet values are relevant.”
    3. Intangible assets:As we explain above, the recognition of intangibles is generally limited and often inconsistent, primarily due to the very different treatment of those assets that are purchased and internally generated.”

Why You Can’t Trust Stated Book Value

Intangible assets highlight another important aspect of value investing: you can’t trust book value. There’s two instances where book value matters: asset-heavy firms and financial institutions. After that, you shouldn’t use it.

The article offers a perfect explanation why (emphasis mine):

“The problem is that, in effect, a cash rather than an accrual basis is used to account for them. Investment in intangibles produces an expense in the current period but the benefit may predominantly impact profit in future periods. Equally, past investment in unrecognised intangibles that was expensed in prior periods may now be contributing to higher profits, but there is no amortisation charge to reflect the ‘consumption’ of the asset.”

A great way to think about this is through software-based businesses and customer acquisition cost. Businesses expense the acquisition cost of a customer upfront. But recognize revenue and profits in the future. This dichotomy between expense and revenue timing creates opportunity for individuals. Devastations for quants and algos (emphasis mine):

“However, if your approach to investment and portfolio construction is based on ‘factors’, ‘styles’ and data-driven analysis then intangible asset accounting may be much more of a problem, particularly if you favour (or wish to avoid) ‘value’ stocks.”

Hidden Value Stocks

Inverting the intangibles problem we can ask ourselves, “how much are quants and indices under-reporting stated book equity for companies?” Remember, the lower the stated book value, the higher the P/B ratio. Which leads to fewer value stocks and more growth stocks.

Scientific Beta tried to solve this problem by adjusting for intangible assets and removing goodwill. Here’s their results:

The study normalized standard book equity at 1. As the graph shows, adding omitted intangibles significantly increases the company’s book equity.

Note goodwill’s impact on book equity, too. Removing goodwill almost balances the gains from intangibles by 2017.

How To Use This Information

We threw a lot at you. The next logical question is, “great, how do I use this to get better?” There’s a few ways:

    1. (Unless analyzing asset-heavy/financial businesses) Don’t pay attention to book value and ROE
    2. Remove P/B from your stock screens
    3. Screen for companies with high P/B as a way to find hidden value stocks

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IPO Of The Week: Lemonade’s S-1 Analysis

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I like combing through new and upcoming IPOs. Not because I think there’s tons of bargains in the mix. But because I learn about new businesses and new revenue models. It’s also one of the few places you can gain an information edge in markets.

One such potential IPO is Lemonade, Inc (ticker to come LMND). I found the idea from Byrne Hobart’s Substack newsletter. Byrne does a great job analyzing the bull case and risks as Lemonade hits public markets. You can also read the entire S-1 filing here.

What is Lemonade, Inc.?

LMND is a fully-digital renters and homeowners insurance company. Their mission is to quote, “Harness technology and social impact to be the world’s most loved insurance company.” How Silicon Valley of them.

The company’s goal is also simple: capture early/first-time insurance users at the beginning of their life-time spending cycle. Hold on as they earn more money and buy bigger houses. Add high-margin insurance products like pet and life as their customer matures.

Insurance is a great business. That’s why I’m interested in Lemonade. Let’s see what Byrne has to say.

A Bundle of Bets

Byrne claims Lemonade is a bundle of three bets:

    1. The theory is that small insurance claims are a market for lemons.
    2. The big tailwind is that reinsurers are overcapitalized.
    3. Lemonade thinks the industry doesn’t acquire enough customers online, and that this locks them out of low-premium policies.

Entry Market & Risk Mitigation

Byrne reaffirms Lemonade’s go-to-market strategy saying, “Lemonade’s entry point into the market is renter’s insurance.” He then describes how customers enact with the business (emphasis mine):

“[Lemonade] underwrite[s] through a chatbot, accept[s] claims through another chatbot, and offload[s] the vast majority of their risk to reinsurers through one- to three-year contracts.”

Everything’s done through an AI-powered chatbot. Straightforward enough.

How To Measure User Behavior

Byrne later explains how Lemonade wants to analyze their customers’ behaviors at three separate time periods:

    1. When they get a customer, to know how much to charge them
    2. When they get a claim, to know whether or not it’s legitimate.
    3. When Lemonade upsells or cross-sells.

That third period, “when Lemonade upsells or cross-sells” is vital to the bull case, as Byrne notes (emphasis mine):

Their renter’s insurance product is incrementally cost-competitive only because overhead dominates their competitors’ costs, and Lemonade’s cost structure is more fixed. But in 2019 they spent $175m in operating expenses to produce $13.1m in gross profit, which is not a sustainable model. At their current operating cost run-rate, they’d break even on renter’s insurance if they had 8.6 million customers, or 20% of all households that rent.”

Why Now?

Lemonade burns through cash and reports negative net losses. Today’s market loves that kinda stuff! In seriousness, Byrne thinks the IPO is more a marketing strategy than anything else:

My suspicion is that this is yet another marketing channel. Lemonade doesn’t need cash, but they do need attention. IPOs tend to increase name recognition, and the daytrader market is in the middle of a bubble.”

Regardless, I’m going to read the entire S-1 and learn all I can about their new-wave insurance model. Who knows, maybe they’ll crash post-IPO and present an opportunity!

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Whitepaper Of The Week: The Math of Value & Growth

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Michael Mauboussin’s latest work, The Math of Value and Growth made it into this week’s letter. As always, read the whole piece. It’s short (13 pages) and full of knowledge bombs. Here’s a few of my favorite snippets (emphasis mine):

    • “But in recent decades investments have shifted in form to intangible assets, which are expensed on the income statement and are typically absent on the balance sheet (except for when one company acquires another). This is important because companies that invest heavily in intangible assets and have high returns on those investments often produce poor profits, or may even lose money. As an investor, you want that kind of company to invest as much as it can. The income statement looks bad, the balance sheet looks better, and the value creation looks great.”
    • “The fundamental principle is that growth only adds value when the company earns a return on its investment that is above its cost of capital. The higher the return, the more sensitive the business is to growth. Growth is of no economic significance if a company’s returns are equivalent to the firm’s cost of capital. As a consequence, companies should focus not on growth per se but on value-creating growth.
    • “Investors often calculate the P/E multiple using the current price and next year’s earnings. As a result, they sometimes believe that the market overreacts to what appear to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified”
    • “Here, next year’s earnings are revised down by just 2.6 percent, but the warranted P/E multiple is 25.3 percent lower. When ROIIC’s are well above the cost of capital, the value of the business is highly sensitive to changes in the growth rate of NOPAT.”

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Emerging Markets, Stock Based Compensation & DIY S&P Valuation

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Markets don’t make sense. The Druck is as confused as the rest of us. Nobody knows why companies with $0 in revenue trade at $20B valuations. And like that, the S&P is back to where it was before the COVID-19 sell-off.

Just as everyone predicted.

If there’s anything we know about markets it’s that we can’t predict. We shouldn’t spend time thinking about predicting them. Nor should we banter over Twitter about where the S&P will trade by the end of the year.

Nobody cares and it doesn’t help us make money on individual stock selection / investment.

Anyways, off my soapbox and on with the regularly scheduled programming.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Stock-Based Compensation in Tech Companies
    • A DIY S&P 500 Valuation
    • GMO Q1 2020 Letter

We get technical in this issue so both hands inside the cart at all times!

June 10th, 2020

Winner Of The Week: Some of you know I run a premium Breakout Alerts service. Each week we send 6-7 potential breakout trades for the week(s) ahead. We recently closed on our largest winner yet: Credit Acceptance Corp (CACC).

Here’s the chart. Those that took this trade rode it for a near 5R (5% return on risk capital):

I’m sure Robert Vinall of RV Capital is thrilled with how CACC’s played out.

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Investor Spotlight: GMO Q1 2020 Letter

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GMO Capital released their Q1 2020 letter and it’s a doozy. I love their Focused Equity portfolio and their thoughts on global valuations. Here’s the link to read the entire report.

Ben Inker, head of Asset Allocation at GMO starts the letter saying (emphasis mine):

“Our job is to try to understand the impacts of those scenarios on the assets we forecast and put together a portfolio that gives an attractive outcome in as many scenarios as we can manage.

I can’t stress enough how important it is to ponder alternative realities to the ones we’re currently facing. From there, we can probabilistically weigh those alternative realities and determine how to profit.

Inker then reveals GMO’s equity forecast from March 23, 2020:

There’s a few things to note:

    • Emerging stocks look like they’re about to crush it
    • S&P 500’s returns going forward look abysmal
    • Value-based stocks in all categories should do better than their counterparties

But then the rally came. This recent rally pulled equity returns forward. In some cases almost a decade forward. Inker explains in more detail (emphasis mine):

“To put the rally in perspective, the group that went up the least, International Value stocks, earned the equivalent of 4.4 years of an “equity-like” return for a fair-valued group of stocks. U.S. large and small cap stocks rose the equivalent of 6 years of “equity-like” returns.”

The GMO re-ran the equity projections after the run-up. Check out the difference:

Now we see a few things:

    1. S&P 500 forward returns are negative
    2. US stocks projected to significantly underperform their global counterparts
    3. Value stocks should provide decent returns across US, international and emerging markets

Here’s Inker’s thoughts on this (emphasis mine):

“But while the ability of some of these economies to handle the crisis well is helpful, the primary reason we believe emerging stocks should give a higher return is simply that they are trading at much lower valuations, which leaves significant room for normalized earnings to fall while still providing a good return to shareholders. Emerging market value stocks are far cheaper still, and today seem priced to offer a double-digit expected return in a GFCx2.”

Finally, Inker highlights the massive disconnect between value-based valuations and other indicators:

The above chart shows value stocks at their largest discount relative to the overall market since the 1999-2000 dot-com bubble.

How To Play This:

    • Look overseas (Italy, Portugal, France, Spain, Poland, etc.)
    • Look for value stocks (beaten down YTD returns, cyclicals, left-for-dead)
    • Have the stomach to buy them

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Movers & Shakers: Accounting For Stock-Based Compensation

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I stumbled upon Tanay Jaipuria’s Substack this week and I’m glad I did. His newsletter focuses primarily on tech and business/investing. If you’re going to read Tanay’s newsletter, start with his post on stock-based compensation.

Tanay’s Claim: Stock-Based Compensation Hides Unprofitability

For starters, stock-based compensation is simply compensation in the form of options on company stock or restricted stock units (RSU’s). These compensation packages are contingent on certain internal factors like revenue growth, customer growth, etc.

Tanay describes three main benefits of stock-based compensation:

    1. Offer employees and management skin in the game
    2. Help retain employees since most SBC vests in four years
    3. Allow cash-poor companies to preserve cash while offering compensation to key employees

To Expense or Not To Expense

It wasn’t until 2004 that GAAP required expensing stock-based compensation. Here’s how the expense works (from the article): Value stock options based on their fair value and record them as an expense on their grant date.

Easy enough. Yet most high-flying tech companies choose to report non-GAAP financials which remove stock-based compensation from the income statement.

Does It Even Matter?

A natural question follows: “Does SBC even matter to overall profitability?” In the case of popular tech-stocks the answer is yes!

Check out the graph below where Tanay shows the SBC as a % of revenues for various tech companies:

Workday (WDAY), Okta (OKTA), Splunk (SPLK) and Coupa (COUP) all have SBC that’s over 20% of their revenues.

For these companies, SBC inclusion/exclusion is the difference between profitable and not-profitable (from the newsletter):

What Should We Do?

Faced with a value-investing conundrum, I ask myself WWWD? What Would Warren Do? Expense it of course (emphasis mine):

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

Tanay includes excerpts from companies like Facebook (FB) and Alphabet (GOOGL) that encourage the use of SBC in their profitability reports.

When in doubt — include the SBC expense. Even if the company doesn’t have to pay the employees options today or issue them restricted stock today, they will at some point. So you might as well start modeling for it.

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The Weekly Dam: A DIY Valuation of S&P 500

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Our valuation OG is back with another great blog post! This week Aswath Damodaran breaks down a do-it-yourself valuation of the S&P 500.

Step 1: Start with earnings

Damodaran starts with the earnings estimates for the S&P over the next two years (see below):

No surprise in 2020’s drop.

Step 2: Focus on Cash Returns

Let’s go back to the blog post (emphasis mine): “As with earnings, this crisis will result in cash flow shocks, and dividends and buybacks will drop this year. Given that dividends tend to be stickier than buybacks, the drop will be lower from the former than the latter. Analysts vary on how much, though, with a range of a drop of 30-70% in buybacks and 10-30% in dividends.

Step 3: Estimate Risk Premium

Check out this graph for risk premium dating back to February 2020 (the beginning of the crisis):

According to Damodaran’s estimates, the equity risk premium is down to 5.81%.

Putting It All Together

The final step is to put numbers behind each part of our story. Damodaran does this for us:

The result: “With these assumptions, I can value the index and I capture the valuation in the picture below. My estimated value for the index is about 2926, which would lead to a judgment that the index was over valued by about 6% (based upon the level on June 1, 2020).”

An overvaluation of ~6% isn’t much. But that was as of June 1st. The market’s risen almost 6% since then. All things equal we’re looking at ~12% overvalued now.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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New Ideas From Telecom, Healthcare and Salmon Farming

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Seemed like May flew by (along with the rest of 2020!) didn’t it?

The markets continue to confuse professional managers. Robinhood investors are minting money. Riots in the streets, S&P futures up pre-market. Nothing really makes sense.

If there’s one shred of consistency in your life, it’s a fresh new copy of Value Hive in your inbox every Wednesday.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Massif Capital Long Thesis on Bakkafrost (BAKKA)
    • Bonhoeffer Capital Q1 Letter
    • Interview with RA Capital on Healthcare Companies
    • Bill Ackman Sells Berkshire

Let’s dive in!

June 3rd, 2020

Meme Of The Week: 

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Investor Spotlight: Bonhoeffer Capital & Maran Capital

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This week’s Investor Spotlight features Bonhoeffer Capital Q1 Letter and Massif Capital’s latest long idea: Bakkafrost (BAKKA).

Bonhoeffer Capital (-33.7% in Q1)

Keith Smith of Bonhoeffer Capital returned -33.7% in Q1. It was a rough quarter for value investors. I love reading Keith’s letters because his fund is so different. As of the letter, his top countries (by allocation) are:

    • South Korea
    • Italy
    • South Africa
    • Hong Kong
    • United Kingdom
    • Philippines

Don’t see the US on that list do ya? That’s because Keith fishes where the fish are!

Keith spends most of the letter discussing Strategic Framework Investing.

What is Strategic Framework Investing?

Here’s Keith’s take: “Valuation models have evolved over time from valuation multiples—which work well with mature companies (Graham)—to discounted cash flow models—which work better for growth companies (Buffett)—to distress-weighted models for declining businesses (Damodaran), and finally to strategy/business models—which focus on market size, growth (including network effects), customer lock-in, economies of scale, and probability of survival for young growth companies (venture capitalists).”

Valuation changes over time. So, the framework through which we view our valuations should change with it.

It doesn’t make sense to value a money-losing start-up company based on P/E ratios. An investor that only uses one valuation method is the same as a man wielding only a hammer. To him, every company looks like a nail.

Why does it matter that we adjust and adapt to the constantly changing business environment? Let’s tap-in Keith for this one:

“With the introduction of disruptive internet capital-light models by young growth companies, current profitability (under the assumption of the presence of either large unreproducible investment or network effects) has been less important than future profitability supported by a business model that can generate strong customer growth, recurring revenue with small amounts of customer attrition due to customer lock-in and/or creating network effects.”

Issues With New Business Models

Keith reeles off a few issues with these new network-effect businesses:

    • LTV, CAC and Churn are hard to estimate
    • Some of the business models are dependent upon outside financing when they are in the growth phase of development

The letter shifts focus to discuss the multiple (P/E, EV/EBITDA) valuation method and mean-regression. I encourage you to read the whole thing — it’s great.

But we’ll end with two ideas from the letter: Telecom Italia (TIT.IT) and KT Corporation (KT.US).

Telecom Italia (TIT.IT)

Business Description: Telecom Italia S.p.A., together with its subsidiaries, provides fixed and mobile telecommunications services in Italy and internationally. The company operates through Domestic, Brazil, and Other Operations segments. – TIKR.com

What’s To Like:

    • 54% Gross Margins
    • Long history of profitability
    • ~$2B 3YR FCF average
    • Trades <6x EBITDA
    • Owns most extensive telecom network in Italy

What’s Not To Like:

    • Low normalized net income margin
    • Net Debt/EBITDA is 3.69x
    • France’s Illiad may cause price war

What’s It Worth:

Let’s assume the company grows to $17.2B euros by 2024. Using historical EBITDA margins (40%) we get almost $7B euros in EBITDA, 2.5B euros in FCF and $37B in Enterprise Value.

Subtract net-debt and you’re left with around $12.7B in market cap (0.60 euros/share). That’s assuming a 9% discount rate and 3% perpetuity growth. If you take a multiple approach (EBITDA or FCF) you’d realize a higher per-share value.

Chart Analysis:

TIT’s showing sideways consolidation below the 50MA. Our price-action base case is a breakdown below support and further price decline. But we’re looking for a reversal given the fundamental background.

KT Corporation (KT)

Business Description: KT Corporation provides telecommunications services in Korea and internationally. The company offers local, domestic long-distance, and international long-distance fixed-line and voice over Internet protocol fixed-line telephone services, as well as interconnection services; broadband Internet access service and other Internet-related services; and data communication services, such as leased line and broadband Internet connection services. – TIKR.com

What’s To Like:

    • Strong FCF generation
    • 40%+ Gross Margins
    • Declining SG&A % of Revenue
    • Improving Current Ratio
    • Net Debt/EBITDA: 1.18x
    • Largest amount of 5G Infrastructure in South Korea

What’s Not To Like:

    • Legacy business still dominates revenues
    • Tensions with North Korea
    • Declining real estate values in KT’s portfolio
    • Failure to spin-off non-core (non-teleco) businesses

What’s It Worth:

KT is a sum-of-the-parts (SOTP) story. They have a hodgepodge of businesses, each with varying degrees of value.

Keith summarized his view on KT’s value in a 2018 post with MOI Global (emphasis mine):

“The shares recently traded at a “look-through” FCF multiple of 5.8x, and look-through EV/EBITDA of 1.5x …  If the shares traded at 6x EBITDA with a holding company discount, the stock would be more than a triple, not including dividends, buybacks or cash flow gains from a growing telecom business.”

Someone call Dave Waters, he loves this stuff.

Chart Analysis:

There’s nothing we can glean from this chart right now. Look for the 50MA to act as resistance over the next few weeks.

Massif Capital: Bakkafrost (BAKKA) Long Thesis

Massif Capital’s back with their latest long thesis: Bakkafrost (BAKKA). You can read their entire report here.

Let’s dive in.

Business Description: P/F Bakkafrost, together with its subsidiaries, produces and sells salmon products under the Bakkafrost and Havsbrún brands in the United States, Europe, China, and internationally. The company operates through four segments: Fish Farming FO; Fish Farming SCT; Value Added Products; and Fishmeal, Fish Oil, and Fish Feed. – TIKR.com

What Massif Likes:

    • Family owned and operated with 19% ownership
    • Consistent 70% Gross Margins
    • Ideal location for growing salmon
    • Commands 15% pricing premium against global competitors
    • 20%+ Operating Margins

Risks:

    • Long-term erosion of salmon prices
    • New diseases / pandemics affecting salmon health
    • Consumer taste changes

What Massif Thinks It’s Worth: BAKKA’s balance sheet has a long-term interest-bearing debt of 𝑘r2.3 billion vs. a cash balance of ~𝑘r1.3 billion. Gross margins are remarkably steady at around 70%. A discounted cash flow analysis, assuming a 10% discount rate, results in a valuation of ~𝑘r741 NOK per share, producing an expected return of 32% at current prices.

Chart Analysis:

BAKKA broke out of its ascending right triangle last week. A brief pullback has us up against the new-found support line. Price remains above the 50MA and 200MA, a bullish sign. __________________________________________________________________________

Movers & Shakers: Bill Ackman Sells Berkshire!

GIFs by tenor

Bill Ackman isn’t afraid of the spotlight. We’ve heard his name referenced numerous times during this COVID crisis. Who could forget his live-action sob story on CNBC?

This time, he’s in the news for selling Berkshire Hathaway (among other investments).

My reaction: Who cares? There’s tons of ideas out there that are better than the BRK thesis.

Ackman brought up some good points during the interview (emphasis mine):

The one advantage we have versus Berkshire is relative scale. Berkshire has the problem, if you will, of deploying $130 billion worth of capital … Pershing Square, on the other hand, has about $10 billion of capital to invest and therefore can be more nimble … We should take advantage of that nimbleness, preserve some extra liquidity, in the event that prices get more attractive again.”

And that’s my biggest issue with the BRK bull thesis. Buffett is so capital constrained it makes it damn near impossible to find deals. Meanwhile, there’s plenty of opportunities for less capital constrained investors/funds. Look at Poland, Egypt or Italy (to name a few).

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Interview of The Week: Healthcare Investing with RA Capital’s Peter Kolchinsky

GIFs by tenor

Evercore describes RA Capital as, “ one of the leading dedicated healthcare investment funds and has been built over nearly two decades with a unique approach to analyzing therapeutic categories.”

My circle of competence in the healthcare space is pitifully small. This interview helped expand it a bit.

Let’s dive into the meat of the interview (emphasis mine on the responses).

Q: How have your private company investments changed your view of the field?

RA Capital: “The public markets don’t get to see how the sausage 4 is made, which is just as well because it can be harrowing. But we have come to appreciate the way driven, talented people can work through most any challenge to keep programs going. That makes us more patient public investors.”

I loved this quote. We’ve heard similar things from Scott Miller in some of his past interviews. Working in the belly of a company makes you a better investor. Period.

Q: How do you choose which companies or fields to drill into?

RA Capital: “We’re always mindful of the risk that we might overlook a great investment and are constantly refining our methodology to minimize that risk. For example, because we have someone tracking everything that’s going on in lupus, we know which companies in that landscape are working on something potentially compelling. Either we’ll reach out to those companies about financing them, even if they aren’t talking to investors yet, or, when they reach out, we’ll know to assemble a team of people, including senior members of our investment team, to get a deep update and make a rapid decision.”

Q: What do you see as the biggest risks/opportunities for the sector?

RA Capital: “I think that the risks of drug development are shifting from probability of technical or clinical success, which quantify the risks of – for example – a clinical trial failing, to those of strategic complexity. Historically, the chessboards have been so empty that making any drug that works has been considered a win. However, with more and more drugs coming to market, it’s no longer enough to make a drug that simply works.

If this interview made me realize anything, it’s that I will always be the patsy at the poker table in that space.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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