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The “Next Big Thing” Just Might Be Hiding in Plain Sight

January 2, 2018 in Best Ideas Conference, Diary, Ideas, Letters

This article is authored by MOI Global instructor Barry Pasikov, the founder and managing member of Hazelton Capital Partners, a value-oriented investment fund. Barry is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Question: What is going to be the most dramatic change to our society over the next 10 years and which company is going to benefit from this “next big thing?”

It is believed that if an investor can answer correctly with an investment, he stands to make an enormous amount of money. Many investing strategies focus on the search for the “next big thing” — the company or asset that is not only going to disrupt an industry’s status quo, but leave an improved and streamlined business model in its wake. These are “story stocks,” companies whose share price is based on the narrative of their expected future potential, rather than their current earnings or assets.

The key to capitalizing on this investment strategy is to be early, before the company’s full potential is recognized and begins its parabolic growth, and to be right. Investors need to extrapolate what the company’s true disruptive power will be by forecasting the total addressable market, the company’s revenue growth rate, and potential market share. Of course, this assumes that these metrics are not only accurate and sustainable, but will continue to grow at a predictable and brisk pace. However, the main challenge when investing in the “next big thing,” is to invest in a company at the exact time when the company’s survival is the most uncertain.

There are numerous variables and unknowns that need to be considered for a company to not only be sustainable but profitable: Is the industry growing and are margins healthy? Are the barriers to entry significant enough to keep “outsiders” at bay? Do industry members act rationally? Just as important is the company’s management team which plays a significant role in its success: Does management have a laser-like focus on execution? Are they able to pivot from setbacks and react to direct attacks on its business model? Of course, during this time, a healthy portion of luck also contributes to the company’s fortunes.

One of the most disruptive company in recent history began by operating in the retail space, eventually migrating to a brick and mortar presence. By providing outstanding customer service, quick home delivery, and low prices, this company became the go-to shopping experience. As you probably have guessed, I am talking about Sears – Not the Sears of today, but the Sears of the 1930’s. Amazon did not write the book on disruption, it just borrowed a few chapters used by Sears over 80 years ago.

Founded in 1906, Sears began as a mail order, catalog company and transitioned into a brick and mortar retailer in 1925. By 1929, Sears had grown to over 300 stores nationwide and marketed itself as the everything store, selling clothing, footwear, bedding, furniture, jewelry, beauty products, appliances, toys, housewares, tools, auto supplies, and gardening equipment. The key to Sears’ success hinged on upscale store design and fanatical customer service (I know, hard to believe), leveraging its operational efficiency and logistics, including home delivery, and its ability to get below market prices from manufactures and wholesalers. Starting in the 1930s, Sears expanded beyond its retail footprint by adding Allstate Insurance to its products. Change the dates and swap out Whole Foods for Allstate, and we could easily be talking about Amazon. I am not suggesting that Amazon is going to end up like Sears, but I do not think that Sears ever imagined it would end up like Sears.

Maybe a better approach to investing in the “next big thing” is to invert the question: What is not going to change over the next ten years and which company will benefit?

Even though uncertainty has not been completely eliminated, this is a much easier question to answer. One of the companies that quickly comes to mind is Sherwin Williams (SHW), the leading global manufacturer of architecture paints and industrial & special purpose coatings. Sherwin Williams began its operations one year after the end of the United States Civil War. Except for ongoing technology upgrades, supply chain improvements and cost reductions, the company continues to operate in much the same manner as it has for the past 100 plus years. The biggest change to the company’s operation has been a much improved logistics operation which is responsible for its global procurement and distribution.

Disrupting Sherwin Williams or the paint and coatings industry would not be easy. It would require a massive amount of upfront capital to build out a national manufacturing and distribution network, and even doing so would not guarantee sales or profits. Paint and coatings represent a very small portion of the overall cost to build/remodel a house, manufacture a car, or protect industrial machinery, and that is why trusted brands truly matter. It takes years to build a brand’s reputation and in Sherwin Williams case, it has been working on its brand’s image for over 150 years. Leveraging that reputation and infrastructure is a competitive edge the company maintains and why it is the leader of its industry.

With the news media’s insatiable appetite for reporting on the “next big thing,” it is easy to see how investors can easily be preoccupied and overlook a high caliber, hidden in plain sight company like Sherwin Williams. Some of the best long-term investments are often cloaked because they do not fit within a particular investing “style.” They trade at too high a multiple to be considered a value stock, and their revenue growth rates have long since returned from the stratosphere to more mundane but sustainable level.

Sherwin Williams is an “anti-story” stock, operating in an unexciting, overlooked segment of our economy that attract little to no attention. But what investors also tend to overlook is the significant amount of cash a company like Sherwin Williams can continuously generate over a long period of time – Cash that can be reinvested back into the company, used for acquisitions, pay out dividends, reduce debt, or repurchase common shares. Add to that a management team that is focused on reducing costs, and you have a recipe for long-term success. Even though Sherwin Williams has received little to no fanfare the stock has returned 680% over the past 10 years, surpassing Apple’s 603% return of over the same period of time.

Although some treat it as a competition, investing is not an Olympic sport. An investor does not get extra points for his willingness to buy shares of a highly volatile “story stock.” For those addicted to the adrenaline rush and the need to react to every news item and price change, the lure of “the next big thing” is just to great too ignore. But for the long-term investor, the “next big thing” might just be hidden in plain sight.

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The author is not recommending the purchase of Sherwin Williams shares or shorting shares of Amazon. These companies were used purely for illustrative purposes.

Nathaniel’s Beautiful Mind

January 2, 2018 in Best Ideas 2018 Featured, Best Ideas Conference, Diary, Letters

This article is authored by MOI Global instructor Nathaniel Leach, co-founder and portfolio manager at LBW Wealth Management, based in Madison, Wisconsin. Nathaniel is an instructor at Best Ideas 2018, the online conference featuring more than one hundred expert instructors from the MOI Global membership community.

My partners, Tim and Dan, like to tell prospects and clients that they can meet with me anytime and ask any questions that they may have or simply see what I’ve been thinking about lately. In the same breath, they then caution the listener to carefully consider whether or not they want to go down that rabbit hole. They say this all in good fun, but unfortunately it is quite true. I can talk someone’s ear off for hours on end about a single company that we may own for our clients or that I have done research on and is on our monitoring list waiting to be purchased at the right price.

For your reading pleasure, I’m going to write about one intriguing aspect in particular about the tracking stock[1] Liberty Ventures (“Ventures”) that most people may not be aware of: their exchangeable debentures. This particular tidbit will take up quite some space, but consider this – if Ventures’ exchangeable debentures are going to take up this much paper, consider what Ventures in all its glory would take up, and then convert that from paper length to speaking time. Now, ask yourselves: do you really want to know what’s on my mind?

I gave you a little taste of the Liberty entities in last quarter’s commentary about the Liberty Media trackers. As I mentioned in that commentary, Liberty Media rested in the “too hard” pile for quite a while. I should have also mentioned that anything related to John Malone, Liberty Media’s Chairman, lay in the “too hard” pile. That all changed after I read a quarterly commentary piece for the first quarter of 2014 written by Drew Weitz, of Weitz Investment Management, Inc., about Liberty Media (in its pre-tracker form, before the spinoff of Liberty Broadband) titled “Analyst Corner – A Perspective on Liberty Media Corporation”[2]. After reading it, I realized that I wanted to learn more about the company and what it was comprised of. This, in turn, spawned my interest in the other Liberty entities, hence, Liberty Ventures.

By 1999, Ventures (actually, Liberty Media in a past form performed these transactions, and Ventures is the entity that holds the Exchangeable Debentures today) had invested in various companies’ shares over the past few decades that they didn’t really want to keep and also thought were trading at overvalued prices, but needed a way to monetize those shares’ value without having to incur capital gains taxes by selling the shares. They decided to issue Exchangeable Debentures.

An exchangeable debenture is an exchangeable security that is convertible at the holder’s option and delivered at the issuer’s choice in the form of either the “reference shares” (e.g. the aforementioned unwanted shares), the reference shares’ value, or a combination of both. From 1999 to 2001, Ventures enjoyed preferential tax treatment for these issued debentures (I’ll get into more detail on this “preferential tax treatment” later), until the IRS put a stop to it.

For example, let’s say Ventures wanted to realize the value of an asset, one share of publicly-traded Company A, that is priced at $100 per share, and therefore the asset’s total value is $100. Ventures will issue an exchangeable debenture based on this one share of Company A for $100, and in turn will pay 1% interest per year ($1) of the face value ($100) for the next 30 years to the debenture’s holders. Ventures now has the ability to use this $100 for other investments, and with their investment track record, most likely be able to earn greater than the 1% interest they’re paying the debenture’s holders.

At the debenture’s maturity 30 years later, Ventures has to pay the debenture’s holders the reference share’s value, whatever it may be. This can be a risk if the reference share’s market value is less than the debenture’s face value because Ventures would be liable to pay capital gains taxes for the difference, due to Ventures redeeming the reference shares at a price lower than the face value that they initially issued the debentures for 30 years prior. This scenario is perhaps preferable to the opposite, that is, if the reference share’s market value is greater than the debenture’s face value because than Ventures would have to either give up the reference share or its equivalent value in cash, which would be a greater hit to its balance sheet than the former scenario.

On the surface, these exchangeable debentures look like your typical bond, but they actually have significant tax benefits for Ventures. Using the previous example, if Ventures instead decided to issue a “fixed-rate debenture”[3] in the corporate bond markets, they most likely would have had to pay a higher interest rate, say 5%. We’ll call this 5% the “comparable interest” rate and the 1% the “cash interest” rate. Here is where the genius of Ventures’ management truly shines. At the time of issuance (1999-2001), the IRS allowed Ventures to deduct the fixed-rate debenture’s “comparable” interest rate of 5% on the exchangeable debenture’s beginning value ($100 * 5% = $5) for tax purposes despite actually paying only 1% cash interest ($1). The difference between the comparable interest amount ($5) and the cash interest amount ($1) is called the “contingent interest” ($4). Assuming a 38% corporate tax rate, Ventures can save $1.52 in taxes ($4 * 38% = $1.52) that is then counted as a deferred tax liability on Ventures’ balance sheet that would be payable when either the debenture would mature or be retired.

In the meantime, the $1.52 would be invested alongside the original issuance amount of $100. The issue price of the bond (the face value stays the same) would be adjusted by adding the contingent interest ($4) to the year’s beginning value ($100) to equal $104. This cycle would repeat for the next 29 years. Year 1’s end-adjusted issue price of $104 would become Year 2’s beginning-adjusted issue price, and would be multiplied by the comparable yield of 5% to equal $5.20. This, in turn, would equal $1.60 saved in taxes, and subsequently be applied to future investments. At the end of the 30 years, assuming that the debenture was not called by the debenture’s holders, these tax benefit flows (e.g. $1.52 and $1.60) would have compounded and have accrued to $100.99 in tax savings!

Now, one may ask how is this a good deal? Ventures not only owes whatever the reference share is trading at in 30 years’ time, but also owes a huge $100.99 deferred tax liability. In the meantime, that debenture’s face value and deferred tax liability are burning huge holes on Ventures’ balance sheet. I would argue an investor should ignore the face value of the deferred tax liabilities, and instead discount the future value of the annual contingent interest’s tax benefits and deferred tax liabilities back to the present value utilizing appropriate discount and growth rates for the annual contingent interest tax benefits and an appropriate discount rate for the deferred tax liabilities.

This is the proper way to value these tax benefit cash flows and deferred tax liabilities. The chosen discount rates and growth rate can be extremely subjective, but an investor must be realistic in their assumptions. Once a realistic set of assumptions have been applied, one finds a drastically different valuation for Ventures than simply subtracting the face values of its liabilities from its assets.

Another interesting use of exchangeable debentures is the instrument’s ability to be used as a tax shield. For example, as it stands today, Ventures and QVC are tracking stocks of Liberty Interactive. Ventures is not an income-generating entity, but QVC has annual taxable earnings of ~900-1,000 MM. Via an intergroup tax sharing agreement, Ventures’ exchangeable debentures’ contingent interest provide a tax shield for QVC’s taxable earnings for which QVC compensates Ventures in a cash payment equal to the amount that QVC saves in taxes. As of 2015’s tax year, Ventures has a $1,129 MM deferred tax liability[4], and at the end of Ventures’ three remaining exchangeable debentures’ maturities (maturing in 2029, 2030, and 2031, respectively), Ventures will have a total deferred tax liability due of ~$5,368 MM. In the meantime, they have annual cash payments from QVC starting at ~$136 MM in 2016 and increasing to ~$440 MM by 2029[5].

That’s a total amount of ~$4,239 MM of almost-certain cash flows over the next 13-15 years to be invested at growth rates that will most certainly be greater than the cash interest rates that they are actually paying on the exchangeable debentures (3.5% – 4%). One could argue that Ventures is already seeing success with the investment of these cash payments in deals such as their $2,400 MM investment in Liberty Broadband (related to the Charter & Time Warner Cable merger that closed May 18, 2016), and they always have their eyes out for the next deal that has historically returned double-digit annualized returns to shareholders. Time will tell if Ventures’ can pay its exchangeable debt and deferred tax liabilities upon maturity, but we have confidence that they will invest the proceeds appropriately in the meantime and most likely come out ahead at a sizeable profit.

[1] You remember last quarter’s write up on Liberty Media’s tracking stocks, right? Same thing with Liberty Ventures.
[2] https://weitzinvestments.com/resources/documents/Literature_and_Publications/Reports/Annual-Reports/AnnualReport0314.pdf?1475958323656
[3] because Ventures’ exchangeable debentures were backed by another company’s shares that they owned, they were able to pay lower interest rates whereas if they had issued fixed-rate debentures with no underlying assets, the risk to the debentures’ holders would increase and thereby Ventures would have incurred a higher interest rate
[4] this is the amount in tax benefits that Ventures has already received and invested
[5] this amount will subsequently decrease in 2030 and 2031 due to those debentures’ respective maturities

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Why Bother With Deep Research in Investing?

January 2, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Serge Belinski, chief executive officer of Value Holdings, based in Paris, France. Serge is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

This is a lesson I learned the hard way, certainly paying too much for it. However, as an optimistic slow learner, I hope that this investment in myself will become very profitable in the future, and that it will at least benefit some MOI Global members.

Every investor should certainly do his best in order to avoid losing money and I believed for too long that trying to know as much as possible about the companies I owned was one of the best things I could do to achieve that goal. Quite surprisingly, my experience in investing showed me how wrong I was.

Let me put that statement in perspective: I only invest my own money and don’t have billions of dollars under management, so I can invest in any public company, anywhere in the world. As a consequence, my statement above perhaps doesn’t apply so well to big institutional investors with tens of billions of assets under management.

Nevertheless, I sincerely believe that anyone should aspire to have the simplest possible investments in his portfolio as, in my opinion, the simpler the investments are, the less risky a portfolio is, and the greater becomes the likelihood of getting satisfactory results.

Willing to improve my investing skills and hoping for better results in the future, I recently reviewed all the investments I made in the last 14 years, trying as hard as possible to eliminate the bias that the outcome of each investment is known today and to focus only on the process of investment selection only using the data available at the time I made my investments.

My conclusion is that my biggest mistakes have been the following:

1) I made too many investments,

2) The smartest looking investments never yielded a satisfactory result (at least not yet).

A great example of my failures has been an investment in a holding company, where I spent years to analyze and gather data on each of its subsidiaries in order to calculate the net asset value of the company as a whole as correctly as possible… The current outcome is an annualized performance worse than -20% per annum. Talk about being rewarded for deep research…

I also had some bad adventures with commodity producers in the past, where I had placed bullish bets on some commodities by buying what I believed to be best in class companies. It turned out that buying the commodity outright would have been a much better idea, although certainly not as rewarding as just concentrating on my simpler investments.

To be honest, I can’t find any single instance in my investments when trying to be smart payed off for me: in the best cases, the performance of these investments was really low when compared to the simplest investments I owned.

But there is also a very positive finding in the analysis of my past investments: I can’t yet find any single instance when making obviously cheap investments did not pay off outrageously well.

Let me give some examples of those to clarify what I mean by obviously cheap investments.

In the beginning of 2016, Picanol, a Belgian company, had its operating assets appraised at EUR 811 million, and anyone (even me!) could read and understand the appraisal report.

Meanwhile, shares of the company where trading at a price of EUR 40, giving the company a market cap of EUR 708 million, less that the appraised value of its operating assets alone. In addition to these assets, the company had a significant net cash position and owned almost a third of Tessenderlo Chemie, a public company in Belgium that had a market cap of EUR 1.2 billion at the time (which, by the way, I also believed to be significantly undervalued, but this wasn’t even important).

How on earth could all of this be valued at only EUR 708 million when the operating assets alone where worth significantly more than that?

Well, the market only briefly disagreed with the above statement, as the price of the Picanol shares quickly more than doubled.

In similar vein, I had been lucky in to invest last September in Japanese companies trading significantly below their net cash position, with very profitable operations coming in for free. In addition, these companies were brilliantly buying back huge amounts of their own shares, thus significantly increasing their net asset values per share. Annualized returns on those investments are currently all well above my wildest expectations, while the thesis cannot be any simpler to formulate and follow.

In the same vein, I would sometimes stumble on short duration senior bonds of companies with solid balance sheet with yields to maturity above 30%. The companies would also be buying back their bonds in the open market to profitably reduce their debt… It didn’t require an MBA to understand that lending at such a rate to creditworthy borrowers can indeed prove a very profitable endeavour.

A list of similar simple patterns could go on for a while, but I think my point is clear at this stage: I believe that the simplest and easy to follow investments are certainly the best way to reduce the likelihood of losing money and these investments tend to provide great returns.

As the wise Charlie Munger once said: “There are no points for difficulty at work or in life.”

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Operating in the Grey Area

January 1, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Abhay Deshpande, founder and chief investment officer of Centerstone Investors, based in New York. Abhay is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Value investors tend to be an odd lot. On the one hand, they may find themselves attracted to assets that are out-of-favor, whether a company, industry, geography or asset class. At the time many of these potential opportunities may appear to be fraught with risk, perhaps justifying their low market valuations. On the other hand, value investors are often associated with a risk-averse nature, which can seem to be in conflict with the types of businesses they are attracted to. From a 30,000-foot perspective, value investors may seem inherently contradictory; sometimes interested in businesses that others have discarded as risky but at the same time being risk-averse.

Value investing often operates in the “grey area” where potential opportunity and potential impairment risk are more tightly bound than usual. In the heat of the moment, typically surrounded by negative sentiment and headlines, beaten down prices can sometimes be justified from a long-term perspective and sometimes not. For instance, in the 2000s a variety of companies from the New York Times to Kodak had significant price drops and traded at statistically attractive levels, at times less than 10x earnings.

In hindsight, the price drops were justified as digitization redefined the marketplace for such companies. Conversely, global markets have also been characterized by rolling bear markets in individual industries that accompany the normal cyclical patterns inherent in any marketplace. The key has been to sort out those companies affected by cyclical causes from those affected by structural ones.

Value investing often operates in the ‘grey area’ where potential opportunity and potential impairment risk are more tightly bound than usual.

At Centerstone, our goal is to provide equity-like returns over the long-term with minimal material capital impairments. In our experience, price and value tend to converge over time and we seek to avoid having that convergence at below our cost, i.e. a capital impairment. Our goal is to have zero impairments, but in practice it is difficult not to make any mistakes. Minimizing impairments or errors is crucial to long-term investment success, which is why so much of our analysis is oriented that way. Within our margin of safety framework, our approach evolves as lessons are learned and the landscape changes. For instance, for several years we have distinguished between cheap and undervalued as a consequence of the era of digitization. After all, Kodak was statistically cheap at $40, $30 and even $10, but the earnings power and intrinsic value1 continued to deteriorate showcasing the difference between cheap and undervalued.

Recently, companies from industries such as retail, auto parts and grocery stores have suffered. A common thread among companies drawn into what has become the latest rolling bear market is the so-called “Amazon threat.” I am not downplaying the severity of Amazon’s influence but sometimes bear markets take the good with the bad. In this case, the “grey area” for value investors is not only quite large but also quite challenging to analyze because of the historical baggage of what happened to other companies displaced by digitization. With the knowledge and perhaps fear of the past, can one separate the good from the bad? Are these businesses potentially undervalued securities or simply cheap but impaired businesses?

The Centerstone Playbook

Just in case you are tempted to skip to the end, as we say “the future is uncertain.” With that in mind, I do not have a definitive answer, but I can share our playbook. When looking at any business, our analytical framework has three pillars:

(1) balance sheet quality, (2) management quality and (3) business quality. In order of subjectivity, the balance sheet is least subjective and can be quantified. Management quality can partly be quantified as management teams tend to have a measurable history of capital allocation. Business quality used to be reliably measurable as well because the past was indicative of the future, however, times have changed and we have adapted.

Not only has online commerce blossomed, but demographics are changing rapidly along with long-standing consumer behavior. Our current assumption is that we should not completely rely on the past when judging the business quality of some of these beaten down companies. Instead, we spend a great deal of time on “what could go wrong” with the business than we did years ago. What filters through our process is a small selection of businesses among those beaten down names that we believe seem to have balance sheet strength, hidden assets, hidden earnings and/or other sources of strength that can help to offset what we believe to be manageable problems.

We understand there are outcomes where we could ultimately be wrong and therefore we seek to limit the aggregate exposure to this idiosyncratic risk2 to a reasonable size. In the case of the Amazon threat, this aggregate exposure of six holdings in the Centerstone Investors Fund (CENTX) totals 7.47% and one holding in the Centerstone International Fund (CINTX) totals 1.51%, as of September 30, 2017.

Real-Time Experiment

What filters through our process is a small selection of businesses among those beaten down names that we believe seem to have balance sheet strength, hidden assets, hidden earnings and/or other sources of strength that can help to offset what we believe to be manageable problems.

Two examples of the companies we own in the midst of this “real-time experiment” are Target3 and Ahold Delhaize4. In the case of Target, it is a company which owns the vast majority of its real estate and where the stores tend to be free standing. Over 20% of the company’s sales come from groceries and even in the best of times, grocery retailing is a tough business with razor-thin margins and an often-fickle customer base.

Demographic changes have meant that the average consumer continues upgrading to organic and fresh foods and is increasingly open to e-commerce to fulfill their grocery needs. Target’s e-commerce sales have been growing at double-digit rates (albeit a small portion of the business) and with the recent entry of Amazon into the traditional brick-and-mortar grocery space, concerns have only heightened over the future of all grocery retailing. At the same time, food deflation for the past 18 months has been a severe headwind—as food prices decline a store’s operating costs do not.

The fixed cost nature of retail means that food deflation has a magnified effect on operating margins and earnings. Currently, this is likely the greatest worry and Target has responded by taking the margin hit and repricing much of the typical customer’s shopping basket. Encouragingly, there are some signs that this headwind is fading but other risks remain. In particular, two German competitors have announced plans to roll out hundreds of low-cost “hard discount” stores, which may add to price pressures in many parts of the US.

While we acknowledge we are walking a fine line, we believe we are most likely early, rather than wrong.

Target’s real estate ownership helps us make a case that the market has valued the core retail business below its intrinsic value. We believe the real estate is valuable based on publicly available information and is worth well more than half of Target’s current market capitalization at the time of this writing. In that case, little value is ascribed to the operating entity. Valuation is further supported by the fact that the company throws off a dividend yield5 of over 4%. In recent years there has been slight growth in the retail business as well.

At our average price the stock is priced to potentially deliver respectable returns, much of it in dividends. The company is conservative in its accounting as well, with earnings power well above stated GAAP (generally accepted accounting principles) earnings. Compared with the FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks, which need to spend up to half of their free cash flow in order to offset stock compensation, Target is considered a poster child of accounting conservatism.

Ahold Delhaize is a Dutch-listed company with significant operations in the US. It is the market-leading grocery retailer on the East Coast and operates under such banners as Stop & Shop, Hannaford, Food Lion and its e-commerce entity, Peapod. E-commerce grocery is more popular in dense cities like mine (New York) where route density economics can most successfully meet the biggest challenge of the online grocery business—last mile delivery cost. Outside of dense cities, online grocery is a difficult business due to its low margins and lack of route density. By analyzing Peapod and its peers, I believe the only way online grocers, which includes Amazon, can be successful is to focus on perishable items and limit their exposure to dense urban markets. Our analysis indicates that perishable items tend to have high enough gross margins to possibly offset a big chunk of the last-mile costs in that scenario.

In addition to the limitations of online grocery competition and Ahold Delhaize’s own long-standing online presence, another positive factor for us is that Ahold Delhaize is the number one or number two player in all of its markets in the US. Notwithstanding the above I am under no illusions here—the Amazon threat is real as they could operate at losses for years in order to grow and therefore pressure the entire industry. However, I also see the grocery business as already competitive (online and offline), with sufficient local differences in shopping habits and with a natural limit to online market penetration due to last mile economics.

Both Target and Ahold Delhaize highlight the current dichotomy between online and “non-line” companies in many industries. Cash generating enterprises with conservative accounting managed by prudent shareholder-oriented management teams are in many cases being tossed aside by Wall Street for what they deem is a certain future where all business is done online forever. As much as Wall Street sees endless storm clouds for Target and Ahold Delhaize, it sees nothing but blue skies for online competitors. More likely, the outcome will be something in-between.

Cash generating enterprises with conservative accounting managed by prudent shareholder-oriented management teams are in many cases being tossed aside by Wall Street for what they deem is a certain future where all business is done online forever.

This “grey area” between the extremes is where we often find values. In the end, the potential value of a business is a function of the cash flows it generates over time. Our growing “Amazon threat basket” is a collection of cash-generative companies with good balance sheets, management teams and businesses— albeit not without their respective short-term issues. We believe over time that this basket may be a positive influence on portfolio returns but you never know when the returns will arrive as it can be gradual or sudden. As we have built out this bucket, the US allocation within the Centerstone Investors Fund (CENTX) has not contributed to positive performance, which is not unusual given that we tend to buy early. In fact, the non- US stocks and currency exposure have almost solely driven performance. Possibly then, there may be latent performance potential building within the portfolio, from a three-to-five-year view, provided we have chosen correctly. While we acknowledge we are walking a fine line, we believe we are most likely early, rather than wrong.

1. Intrinsic value refers to the price a knowledgeable investor would pay in cash to control an asset.
2. Idiosyncratic risk is the risk that is endemic to a particular asset such as a stock and not a whole investment portfolio.
3. 1.53% position in Centerstone Investors Fund as of June 30, 2017.
4. 0.03% position in Centerstone Investors Fund and 0.03% position in Centerstone International Fund as of June 30, 2017.
5. Dividend yield is a financial ratio that indicates how much a company pays out in dividends each year relative to its share price.

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The Centerstone Funds are new and have a limited history of operation. An investment in the Funds entails risk including possible loss of principal. There can be no assurance that the Funds will achieve their investment objective. Value investing involves buying stocks that are out of favor and/or undervalued in comparison to their peers or their prospects for growth. Our value strategy may not meet its investment objective and you could lose money by investing in the Centerstone Funds. Value investing involves the risk that such securities may not reach their expected market value, causing the Funds to underperform other equity funds that use different investing styles. Investments in foreign securities could subject the Funds to greater risks including, currency fluctuation, economic conditions, and different governmental and accounting standards. Foreign common stocks and currency strategies will subject the Funds to currency trading risks that include market risk, credit risk and country risk. There can be no assurance that the Fund’s hedging strategy will reduce risk or that hedging transactions will be either available or cost effective. The Funds use of derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. Domestic economic growth and market conditions, interest rate levels, and political events are among the factors affecting the securities markets in which the Funds invest. Large-Cap Company Risk is the risk that established companies may be unable to respond quickly to new competitive challenges such as changes in consumer tastes or innovative smaller competitors. Investments in lesser-known, small and medium capitalization companies may be more vulnerable than larger, more established organizations. In general, a rise in interest rates causes a decline in the value of fixed income securities owned by the Funds. There is a risk that issuers and counterparties will not make payments on securities and other investments held by the Funds, resulting in losses to the Funds. The Funds may invest, directly or indirectly, in “junk bonds.” Such securities are speculative investments that carry greater risks than higher quality debt securities. Investors should carefully consider the investment objectives, risks, charges and expenses of the Centerstone Funds. This and other important information about the Funds are contained in the prospectus, which can be obtained by calling 877.314.9006. The prospectus should be read carefully before investing. For further information about the Centerstone Funds, please call 877.314.9006. The Centerstone Funds are distributed by Northern Lights Distributors, LLC, Member FINRA/SIPC. Centerstone Investors, LLC is not affiliated with Northern Lights Distributors, LLC.

The Four Questions of an Investment Candidate

January 1, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Matthew Sweeney, founder and managing partner of Laughing Water Capital, based in New York. Matthew is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

“All man’s miseries stem from his inability to sit in a room alone and do nothing.” –Blaise Pascal, c/o Mohnish Pabrai

The above quote has been popularized in investing circles by super-investor Mohnish Pabrai. It is especially relevant to our portfolio at the moment due to the previously referenced increased level of activity. Our strategy is largely based on buying good businesses during moments of weakness, and giving our skilled management partners the time they need to work through their problems. Focusing on price is extremely important during the buy process, but once we have purchased shares, the stock price can do whatever it wants to do in the near term as irrational sellers weigh on shares. Our ultimate success will be based on our ability to weather the short term volatile stock action, and patiently wait for the true economics of our businesses to shine. Patience is key to the strategy: frequently trading in and out of businesses will not help our long-term results.

While our “busy” quarter would represent a slow hour on most hedge fund trading desks, relative to 2016 when we made one meaningful investment all year, the 3rd quarter was a flurry of activity. This activity level meant that entirely too much time was spent staring at screens thinking about price, and not enough time was spent simply thinking about our businesses, their management teams, their problems, and their opportunities. In order to help tip the scales of my focus away from short term market action, and back toward the fundamentals of our investments, I spent a week in September “off the grid” on a backcountry archery elk hunt.

From my perspective, spending a week in the middle of no-where is perhaps the best way to conduct a portfolio review. With no access to the internet or cell phones, and no possibility of getting distracted by new ideas, one is forced to focus entirely on the present opportunity set. Additionally, there are a lot of parallels that can be drawn between hunting in the backcountry and concentrated value investing.

For starters, it is not for everyone; in fact, it is basically anti-social. There is a certain confused/skeptical look that most people give when they learn that our strategy is based on the belief that one person with limited resources willing to dig through the hidden corners of the investment universe searching for anomalies has massive advantages over Wall Street and its infinite resources. This look is basically the same look I get when I explain to people who are panicked by the idea of a dead cell phone battery that my idea of a “mental-reset” is not a trip to some exotic beach location. Rather, I much prefer spending a week by myself sleeping in a tent in bear country while hiking through the mountains 10,000 feet above sea level, hours from the nearest paved road and wi-fi signal.

Second, well known hunting personality and author Steve Rinella often comments that successful backcountry hunting is dependent on, “being comfortable with being uncomfortable.” This quote bears a striking resemblance to two of my favorite investing quotes. The first, “you can have comfort, or you can have value. You cannot have both,” and the second, “the capacity to suffer is essential for successful investing.” The point is the same whether you’re talking about hunting or investing; if you want to seek out the best opportunities, it is not going to be easy.

Third, whether you are talking about backcountry hunting or investing, the proper approach is to spend 99% of your time planning, preparing, and waiting, and 1% of your time taking decisive action.

Fourth, in both hunting and investing, it pays to be very selective. If you take your shots at middling opportunities, you will never have the opportunity for tremendous success.

Lastly, and perhaps most importantly, in order to be successful in either hunting or investing, you have to enjoy the process, not just focus on the endgame. Just like most hunts end without a shot, almost all research ends without a buy decision. The only way to eventually succeed is to continue to iterate the process.

The Importance of Process

“Gamblers bet on possibilities. Pros bet on probabilities.” –Bob Dancer, Professional Gambler

Our investment process entails identifying companies that pass a four-part framework before we ever consider the fifth piece, which is price. The four questions I seek to answer are:

1) Is it a good business? (what will it look like in 5-10 years)

2) Who are we partnering with? (is management capable and properly incentivized)

3) Why does the opportunity exist? (are sellers irrational or shortsighted)

4) What happens when something goes wrong? (because it will eventually)

Each of these questions is deliberately open-ended, and meant to encourage careful analysis and deep thought, not quick answers. When followed properly, this process should lead us to better than average companies, with better than average management teams, that we buy at better than average prices, that will do better than average when the economy hits a rough patch. While nothing is guaranteed, if we can simply stick to this process, the result should be a portfolio that has a high probability of performing better than the averages (ie the SP500 or R2000) over time.

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This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.

What Compels Us to Invest

January 1, 2018 in Best Ideas 2018 Featured, Best Ideas Conference, Diary, Featured, Letters

This article is authored by MOI Global instructor Keith Rosenbloom, founder and managing member of Cruiser Capital, based in New York City. Keith is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Listen to Keith’s session at Best Ideas 2018.

At Cruiser Capital we pride ourselves on being differentiated value investors. We have presented five times at online conferences hosted by MOI Global in the last four-and-a-half years, and our coming presentation on January 8th will be our sixth. Our previous discussions have related to investments we were making in attractive businesses with sound protective moats. The investments discussed with the dates of the presentations and the share prices at the time of presentation and at December 12, 2017 are shown in the chart below:

Recently we closed out of one of the investments, we intend to close out of another one and have reiterated our enthusiasm and positioning on the others. We will address each of those in our discussion on January 8th prior to discussing another investment and our thinking on various market opportunities.

What Compels Us To Invest:

Four key characteristics ultimately drive our willingness to invest in a given company.

1. Management Credibility
2. Clearly Defined, Easily Understood Growth Plan
3. Well Utilized Balance Sheet
4. Organic Exit Strategies

Management Credibility

At the core of every investment is the capability of the people who are going to execute the plan. We believe great managers make average situations great and poor managers make great situations poor. We’re quite aware that the definition of “great” can be backward looking and hard to evaluate prior to a manager doing “great things.” This is why we think it’s critical to research the backgrounds of the management teams you are investing with. We are consistently surprised (and often amused) when we see investor presentations and research reports that fail to discuss the qualifications of the management team.

One objective item we find useful in our evaluations of determining the caliber of management is whether their compensation is aligned with shareholder success. We like investing with teams who win when the shareholders win. A case in point is when Sealed Air Corporation (SEE) hired Jerome Peribere to become CEO 4 ½ years ago. When Jerome became the CEO of SEE the company’s stock price was under $15 per share. He took the vast majority of his compensation in 3 and 4 year RSUs exercisable only if the stock was $30, $35 and $40. When he retires on December 31, 2017 the stock will be close to $50.

We are motivated to invest with management teams who are motivated with an owner operator mentality.

Clearly Defined, Easily Understood Growth Plan

We find it’s important to remember basics: an aphoristic rule is that it’s hard to make money when you don’t know what you’re trying to do. We like to evaluate business plans that require straightforward blocking and tackling. And ultimately we like to invest when the “degree of difficulty” is low.

Frankly, one of the benefits of investing in turnaround situations is you get the opportunity to invest with great, new managers who are articulating a clear path to improved profitability. The bonus is that in turnarounds you are often getting those opportunities at value prices.

Well-Utilized Balance Sheet

At Cruiser we believe that balance sheet’s drive income statements, not vice-versa. We know that is an “old school mentality” – particularly in today’s environment of “easy money” – but today’s access to capital only underscores the point. With money cheap, you want to invest with managers who can generate a tangible Return On Invested Capital.

For those of us in the US who question how easy money is, we point to the European capital markets. For example, on November 23rd the French company Veolia Environnment SA issued three year zero coupon debt with a re-offer price above par. Per Grant’s, “…three year bonds priced to yield negative 0.026%%. Even better: Investor demand for the Veolia issue was such that the offering was oversubscribed by more than 4:1.  Said another way, three out of four investors who wished to lose money on a yield-to-maturity basis were left disappointed.”  The reality is when there’s $11 trillion in sub-zero/negative yield debt in the world, and the average dividend yield on the S&P 500 is below 2%, it’s easy to conclude we are still in a low rate environment. It’s our view that we will continue to be for some time.

Organic Exit Strategies

We invest with companies that often compete with larger players either directly or in adjacent markets. It’s clear often, particularly given the ultra-low cost of capital, that these companies should be a part of those larger players.

We like to clearly understand the competitive field so that when a company gets to a certain size, or achieves a particular milestone, it becomes evident that multiple paths to continued success exist. Sometimes that is becoming a part of a larger entity, often it is by buying a division or operating unit from someone else. And sometimes it means entering an adjacent market with an inherent competitive advantage.

How Today’s Capital Markets Impact Our Thinking

Literally every day for the past 8 years there is an article or talking head speaking about the risk to markets from impending rising interest rates. And yet, the data from May 1963 until today supports that measured increases in interest rates from low bases, specifically below 5% have historically been associated with rising stock prices.

An intriguing potential outcome in the current economic and political environment is the real possibility that for the first time in many years the US economy will have fiscal spending to accompany its easy monetary policy. With the backdrop of Hurricane’s Harvey and Irma, the devastation in Puerto Rico, bi-partisan discussion on intermodal infrastructure spending, etc., should fiscal spending occur, the earnings outlook for many of the companies we follow and like will dramatically improve.

An integral part of our mission at Cruiser is to determine the difference between value opportunities and “value traps.” When we find value opportunities we want to own them, and when we find value traps we usually short them.

But “value opportunities” are much more than companies simply trading at “cheap multiples.” They have inherent characteristics which computer driven algorithms cannot screen for; specifically we believe that quality people executing on well determined business plans can create enormous value.

We actually think it is advantageous to Cruiser that the majority of public companies with market caps under $10 billion have 30% or more of their shares held by rule based index funds who – by their mandates — don’t meet with management teams or model out businesses. We think this provides a target rich universe of potential investment opportunities for Cruiser.

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Please note that per the Cooperation Agreement Cruiser Capital executed with A. Schulman (SHLM) in September 2017, we ask you to please appreciate that nothing contained herein is intended to be derogatory, or critical of, or negative toward Schulman or any of its past or present officers or directors. All information provided herein is for informational purposes only and shall constitute an offer to sell any securities or constitute a solicitation of an offer to purchase any securities. Any such offer to sell or solicitation of an offer to purchase shall be made only by formal offering documents, which include, among others, a confidential offering memorandum, limited partnership agreement, subscription agreement and related subscription documents. Such formal offering documents contain additional information not set forth herein, which such additional information is material to any decision to invest in Cruiser Capital, LLC (the “Fund”). The confidential offering memorandum contains additional information, including information regarding certain risks of investing which are material to any decision to invest in the Fund. Performance data and risks are historical and are not indicative of future returns and is no guarantee of future results. The performance reflected herein and the performance for any given investor may differ due to various factors including, without limitation, the timing of subscriptions and redemptions, applicable management fees and incentive allocations, and the investor’s ability to participate in new issues. Much of the performance results reflected herein is unaudited, is based on incomplete information and is subject to change. Actual results, when available, may differ. There is no guarantee that the Manager will be successful in achieving its investment objectives. All investments involve risk including the loss of principal. Past performance is not necessarily indicative of future results. This transmission is confidential and may not be redistributed without the express written consent of Cruiser Capital Advisors LLC. The Standard & Poor’s 500 Index (the “S&P 500”), the Russell 2000 Index and the HFRX are referred to only because they represents indices typically used to gauge the general performance of the U.S. securities markets. The use of these or any other index is not meant to be indicative of the asset composition, volatility or strategy of the portfolio of securities held by the Fund. The Fund’s portfolio may or may not include securities which comprise the S&P 500, will hold considerably fewer than the number of different securities which comprise the S&P 500 and engages or may engage in strategies not employed by the S&P 500 including, without limitation, short selling and utilizing leverage. As such, an investment in the Fund should be considered riskier than an investment in the S&P 500. Furthermore, indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

The Phillips Conversations: Jeff Matthews

January 1, 2018 in Audio, Full Video, The Phillips Conversations, Transcripts

The following interview is part of The Phillips Conversations, hosted by Scott Phillips of Templeton and Phillips Capital Management.

MOI Global has partnered with Templeton Press to bring you this exclusive series of conversations on investing and the legacy of Sir John Templeton, one of the greatest investors of the 20th century.

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Thank you for your interest.  Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:

About the interviewee:

Jeff Matthews, CFA, has 22 years of investment experience, and has run Ram Partners, LP, a Greenwich, Conn.-based hedge fund, since 1994. Ram Partners is a $65 million fund focused solely on U.S. equities and open only to individual investors. Previously, Matthews served as an analyst and portfolio manager at Rocker Partners, an oil analyst at Merrill Lynch, an energy and capital goods analyst at Aetna Life & Casualty, a mergers and acquisitions analyst at Penn Central and a consumer products analyst at Warburg Pincus. He holds a bachelor’s in finance from Lehigh University.

Value Investing Has Never Been More Relevant

January 1, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Naveen Jeereddi, CEO and portfolio manager of Jeereddi Investments, based in Los Angeles, California. Naveen is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

The following is an excerpt from a Jeereddi Partners letter dated January 25, 2017.

“Difficult to see. Always in motion is the future.” –Yoda

The political landscape exploded in 2016. The change was not predicted by most and feared by many. Regardless of one’s political leanings, the current torrent of change will have substantial long-term financial implications. We are perhaps at the beginning – not the end – of a significant geopolitical cycle. Investors across the world should prepare for a wild ride. Many won’t. We will.

History portends that investors react irrationally to strong change and fear. Value investors capitalize on such irrational behavior. Whether we like it or not, strong catalyzing and unpredictable change is coming down the pike – right now. It is going to hit the global economy and markets in unimaginable ways. The instability may last a long time. As a result, we believe that there is a compelling investment opportunity set developing for our particular strategy. It could be substantial and promising. We look forward to unearthing it as the landscape shifts underneath us.

Some large-scale, macroeconomic imbalances and risks – sovereign debt, aging demographics, massive unfunded entitlement programs, increasing inequality, declining productivity, undisciplined global fiscal and monetary policies, a surging US dollar, and rising nationalism – are here and growing every year. These risks will impact the long-term earning power of many businesses and industries. Fundamental investors must tread carefully. Highly leveraged investors and short-term, speculative investment platforms should be terrified. It is a potentially lethal investment landscape.

Value investing has never been more relevant. It offers us a tried-and-tested system – rich in heritage and logic – to navigate and profit from the potential upheaval and change. As you all know, true value investors assume the markets are unpredictable – in good times and in bad times. We are not disturbed when the environment changes. We are contrarian and confident in our Graham-and-Dodd investment processes. Such resilience and adaptability are part of our ethos. So, we are right at home in this environment.

We evaluate businesses undergoing “special situations” and consequences (or events that create meaningful discounts in a company’s valuation). There will be an abundant supply of such “special situations” given the current political and macroeconomic backdrop. Our investment system requires specific experience in evaluating these complex “special situations” (including financial distress events). This type of work is not for everyone. It is nuanced and hard. A firm must have a true, long-term mindset, and structure to execute this strategy correctly.

Human nature and the structure of the asset management industry (including incentive systems) make such a long-term orientation extremely rare. This paradigm creates structural inefficiencies and opportunities for disciplined, long-term investors. Just peruse the daily news cycle or published letters of various investors to see evidence of market participants’ short-term biases and fluctuating convictions. A majority of people in the news media and asset management industry believe they can assess and predict many things – the markets, the economy, politics, and even quarterly earnings. They cannot.

Our specific investment process is grounded in a long-term foundation that has three essential parts. The first is the understanding of the circumstances that cause other investors to shun a particular security. We must understand that “situation” and all its potential effects on the underlying business. The second task is the quiet contemplation and thorough assessment of a company’s business model, industry dynamics, competitive position, future earning power, and likely operating scenarios. These processes require us to filter out distractions and opinions of others and focus on the fundamentals of the business, the nature of the apparent discount, the price, and the catalysts in place for unlocking of future value. Finally, we must manage the risk and reward of our entire group of investments as a whole portfolio. This specific portfolio-management process includes the sizing of our positions, determining various risk exposures, and hedging unwanted risk.

We apply this contrarian, three-part filter on a consistent basis – without recourse leverage – to optimize the value of our portfolio. Also, we are always questioning our initial entry price, key assumptions, and our overall value thesis for each investment. We maintain a conservative and fact-based orientation – adjusting the portfolio as we go along, security by security, to optimize profit potential and reduce risk. We systematically execute this process and grow our investment competency every year – regardless of the short-term results. We are that confident in the effectiveness of our process and the compelling, timeless nature of this type of value investing. In fact, our conviction grows when it fades in others.

The following is an excerpt from a Jeereddi Partners letter dated October 24, 2017.

During the quarter, we initiated three positions in the retail sector – Tuesday Morning (or “Tuesday”), Michaels Inc. (or “Michaels”), and Ross Stores (or “Ross”). The recent distress in the retail industry provided a reasonable entry point for these investments. We have utilized appropriate hedges and left plenty of room to add to these positions given the recession risks endemic to the industry. We believe that in all three cases, investors fear a growing list of short-term issues (including Amazon’s competitive disruption). As a result, investors are unable to recognize the discounted price and attractive call option embedded in each investment. In Tuesday Morning’s case, we also saw an opportunity to catalyze the value potential ourselves.

Tuesday Morning (Nasdaq: TUES)

Tuesday Morning is a small off-price housewares retailer undergoing a turnaround. The stock is distressed and heavily shorted having fallen nearly 90% since December of 2014. We believe investors misunderstand the optionality and value potential of Tuesday Morning’s business. Investors, exasperated by several years of operational missteps and the resulting abysmal share price performance, are too focused on the current negative operating metrics and the competitive retail environment.

The market is missing the significant opportunity within Tuesday Morning’s business. We believe that many of the company’s issues are solvable with proper management. Tuesday Morning has a loyal set of frequent shoppers. The off-price retail category is in fact growing and is resistant to online competition due to its hands-on treasure hunt dynamic. Tuesday Morning’s same-store sales are increasing. We also believe that many investors are underestimating the math and significance of Tuesday Morning’s excess real estate holdings and a batch of non-recurring charges (running through the accounting ledger).

There are several risks with Tuesday Morning’s business including a housing or consumer recession, a group of suboptimal store locations, short-term operating losses, an older customer demographic, and a transitioning business model. We believe these risks, while significant, are priced in Tuesday Morning’s shares given the disastrous share price performance (previous to our purchase) and the current malaise in the retail sector. Investors in offline retail stocks, hammered by sharp losses, are throwing away their calculators and running for cover. Tuesday Morning shareholders are no exception. We are thankful that our predilection to look for distress kept our exposure to traditional retail at de minimus levels going into the current disruption unleashed by Amazon and other online entrants in the space.

At our purchase price, Tuesday Morning trades at less than half its tangible book value and a 0.1x multiple to revenue (with competitors that trade at more than 1x revenue). Tuesday has excess real estate value and operates in a growing industry (off-price retail). Tuesday Morning has a decent balance sheet (at the moment). As mentioned, there are also extraordinary operating charges relating to its distribution center (which management has spoken about during its recent quarterly calls) that we believe will reverse in due course. Investors are not correctly evaluating these factors.

We have modeled many detailed operating cases for Tuesday Morning. There are several base-case scenarios with modest assumptions that create substantial shareholder value (multiples of the current stock price). With prudent management, we believe the company could mitigate some of the risks of the business in the event of a recession or a significant operating setback. The resulting asymmetry of the investment is compelling.

We are taking a hands-on or activist approach to our Tuesday Morning investment. We see an opportunity to work with a management team and board of directors to build substantial shareholder value. As you would expect, we conducted in-depth, comprehensive due diligence including multistate store visits and numerous meetings with operators and executives in the industry to construct our thesis and vision.

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Please be reminded that this information regarding Jeereddi I LP is provided to existing and potential investors under conditions of confidentiality. This shall not constitute an offer to sell or the solicitation of an offer to buy any interests in any fund managed by Jeereddi Partners or any of its affiliates. Such an offer to sell or solicitation of an offer to buy interests may only be made pursuant to definitive subscription documents between a fund and an investor. References in this presentation are made to the S&P 500, the NASDAQ Composite, the Russell 2000 and the Dow Jones Industrial Average for competitive purposes only. Jeereddi I LP (the “Fund”) may be less diversified and/or more volatile than the stock market indices presented above. Additionally, the stock market indices may reflect positions that are not within the Fund’s investment strategy. Stoxx Europe 600 data reflected in Euros. The above performance data for the Fund represents the net results for a Class B investor in Jeereddi I net of expenses including management fees and performance allocations. Accrued performance allocations are calculated utilizing a high water mark carried over from 2008. Net results reflect the net realized and unrealized returns to a limited partner after deduction of all operational expenses. Past performance is not necessarily indicative of future results and investors risk the loss of their entire investment in the Fund. All returns presented are estimated and unaudited and assume the reinvestment of all distributions. Actual returns will vary from one limited partner to the next in accordance with the terms of the Fund’s limited partnership agreement. Net performance for Jeereddi I LP is calculated by the Fund’s third party administrator and audited by Walsh, Jastrem & Browne, LLP.

Preview of Medley Capital: Middle Market Lender at Discount to NAV

December 31, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Ideas

This article is authored by MOI Global instructor Jim Roumell, president of Roumell Asset Management, based in Chevy Chase, Maryland. Jim is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

MCC is a closed end fund that has elected to be regulated as a business development company (“BDC”) under the 40 ACT. MCC is externally managed by MCC Advisors, pursuant to a management agreement. MCC Advisors is controlled by Medley Management Inc., a publicly traded asset management firm, which in turn is controlled by Medley Group LLC, an entity wholly-owned by the Taube brothers (more on corporate structure below).

MCC’s objective is to generate current income and capital appreciation by lending to privately-held middle market companies ($25 million to $250 million enterprise value), primarily through directly originated transactions. The portfolio generally consists of senior secured first lien term loans and senior secured second lien term loans.

Key statistics and peer comparisons as of Sept 30, 2017 ($ in millions)

Investment positives

Discount to NAV – MCC trades at a large discount to NAV. As shown above and discussed in detail in the valuation section below, MCC’s stock currently trades at a 36% discount to reported NAV. I apply certain incremental losses to arrive at a base and stress case NAV. MCC currently trades at a 32% and 29% discount to my base case and stress case NAV’s, respectively. Even if we assume there is a 10% permanent BDC discount, it appears MCC shares are undervalued on an NAV basis.

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The Key Pillars of Our Investment Framework

December 31, 2017 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Francisco Olivera, president of Arevilo Capital Management. Francisco is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Our goal at Arevilo is to successfully invest in businesses by taking concentrated positions with long-term holding periods.  Our goal is not unique and many value-oriented investors have similar approaches, but by breaking down our goal into pieces, we’ve created an investment framework that is unique to Arevilo.  In this article I will share our investment framework.  At best, I hope you gain some insight from our framework, and, at worst, that you read a refresher on several investment principles.

Business Profile

To successfully invest in businesses, we approach investing as private business owners would.  For us, assessing the quality of a business is our most important job.  If we are to invest in a business for five to ten years, why would we invest in a bad business?  Even if we are able to purchase a business at a bargain price, our long-term horizon (5-10+ years) would not truly benefit us.  If we purchase a bad businesses at a bargain price, we would need to sell the investment at (or close to) fair value as quickly as possible.  Over the long-term, we would not consider our purchase price a “bargain” if the business’ performance deteriorates – what one would expect from a bad business.

Few businesses are truly in the business quality hall of fame.  Many of the businesses we invest in are in the “pretty good” camp and have the potential for strong long-term operating performance.  When analyzing a business’ quality, we mainly worry about the sustainability of the given business.  As Warren Buffett recently said, “there is nothing that we own that doesn’t have something in the future that might affect it.” 1 The vast majority of businesses can face significant challenges over time, which is why it’s important for us to understand the sustainability of a business over a reasonable timeframe.

A business’ sustainability can be gaged by its competitive state relative to current competitors, potential competitors, suppliers, and customers.  We ask ourselves: “who has the high ground?”; “who has leverage over the given business?”  Consensus today believes (and rightfully so) that Amazon has the high ground in practically every new business segment it enters.

An assessment of a business’ free cash flow profile adds further context to our analysis.  We prefer to invest in businesses that can easily generate high-margin free cash flow, especially if cash flows are growing rapidly.  However, we are willing to invest in businesses with high capital expenditures or in businesses that are investing significant capital to grow.  As long as we believe those expenditures create value for shareholders, we are patient enough to wait for higher levels of free cash flow in the future.

The last question we ask in assessing a business is, can this business become more meaningful?  It’s a question that we ask in order to think about a business’ upside.  When asked why Time Warner once viewed Netflix as a weak competitor,2 Reed Hastings, Netflix’s CEO recently said: “what happens to people is that they associate you as you are, not as what you can become.” 3 We at Arevilo are not fortune tellers, and we probably wouldn’t have forecasted Netflix’s potential any better than Time Warner, but we certainly believe it’s important to attempt to estimate a business’ upside potential.  If a business’ best case scenario does not provide a huge upside for shareholders, “a base case” scenario probably won’t be attractive enough for us to invest.

Management / Board of Directors / Major Shareholders

If we concentrate our portfolio in a few businesses that we expect to hold for five to ten years, should we risk our clients’ capital on businesses with bad CEOs?  Excellent CEOs still make mistakes and our assessment of their performance will not be perfect, but investing in A-grade CEO’s is at the heart of our investment framework.  Our long-term horizon brings a CEO’s capital allocation ability front and center to our analysis.  In Berkshire Hathaway’s 1987 shareholder letter, Warren Buffett writes about the importance of a CEO’s capital allocation ability: “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”4 The longer you own a business, the more important a CEO’s capital allocation ability becomes.  Assessing a CEO is almost as important as determining the quality of the business.

Many investors understand the power of incentives with management teams.  We agree that incentives are extremely important for manager-shareholder alignment, but we also look for “shared downside.”  Many of the companies we invest in have large influential shareholders with board representation.  If we suffer losses on our investment, these shareholders suffer as well and they will be highly motivated to preserve the value of their investment.  Investing in these type of companies can add an additional margin of safety to our investment that doesn’t manifest itself in the numbers or any businesses quality analysis.  In the late 1970’s, when Berkshire Hathaway made a large investment in GEICO, Warren Buffett viewed himself as the margin of safety if GEICO’s financial performance deteriorated further.”5  This is why we always ask: can the CEO, board of directors, and/or a major shareholder be a margin of safety?

Capital Structure

A company’s capital structure can be an immense source of value for long-term shareholders, but it can also lead a good business into bankruptcy.  Businesses in the high quality hall of fame camp have to worry more about their “cash structure” versus “capital structure.”   However, that doesn’t mean good businesses shouldn’t use their capital structure to enhance shareholder value.  We believe it’s important to understand whether the capital structure can risk a business’ equity value and, conversely, whether the capital structure can provide additional upside for shareholders.  Management teams that tie a strategic mindset to their capital structure with a prudent capital allocation approach are likely to create value beyond market expectations.

Valuation

We don’t anchor ourselves to strict valuation rules or methodologies.  As business owners, the most important question we ask ourselves is, are we getting a good deal?  It would be unusual to have the opportunity to invest in a business with the characteristics that I described above at a dirt cheap valuation.  If the same opportunity is available at an adequate yield on future free cash flow, we believe long-term shareholders can earn above average returns.  Our choice to invest in a company with an “adequate” free cash flow yield is contingent on an attractive upside scenario.  As I mentioned above, if the upside scenario for the business does not provide very high returns, the said business would not garner our interest.  In other words, we are willing to pay fair value, but we require potential upside “kickers.”

Arevilo’s portfolio contains businesses such as Charter Communications, Restaurant Brands International, and Liberty Media’s Formula One Group.  All three businesses contain the characteristics we find attractive to make long-term investments.

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1 Source: https://www.bloomberg.com/news/articles/2017-10-03/buffett-s-berkshire-hathaway-acquires-stake-in-pilot-flying-j
2 Source: www.nytimes.com/2010/12/13/business/media/13bewkes.html
3 Source: https://m.soundcloud.com/a16z/reedhastings-netflix-entertainment-internet-streaming-content
4 Source: http://www.berkshirehathaway.com/letters/1987.html
5 Source: The Snowball: Warren Buffett and the Business of Life.

MOI Global