This article is authored by MOI Global instructor Matthew Sweeney, founder and managing partner of Laughing Water Capital, based in New York.
Broadly speaking, our portfolio is comprised of two major investment archetypes: compounders and special situations.
In brief, compounders are businesses that can achieve supranormal returns on invested capital for long periods of time due to some combination of competitive advantages and/or extraordinarily talented management teams. Compounders typically justify a high multiple due to some combination of a predictable business, a longer runway to reinvest in the business at high rates of return, or the ability to return capital to shareholders. Identifying a compounder that is suitable for investment typically depends on identifying a great business and management team that are even better than the market realizes. As these are great businesses by definition, they will rarely appear cheap on any traditional metric outside of recessionary periods.
Special situations are investments where the business and management may be of lesser quality, but the opportunity exists less because of identifying a gap between the quality of the business and management vs. expectations, and more on identifying some failing in human nature or market structure that creates a mispricing. In the best cases, we will be able to find future compounders today, when they are available at special situation prices.
In the long term, I expect that our portfolio will increasingly tilt toward compounders. However, at the moment, our portfolio is tilting increasingly toward special situations. There is nothing wrong with this per se, but special situation investing will be less tax efficient, and has the unfortunate problem of requiring re-generation because unlike compounders, special situations are best sold when the temporary conditions that led to the mispricing have passed.
There are a number of reasons for the current tilt. First, in my view it is often more difficult to successfully identify compounders than special situations. Betting on a compounder can be thought of as betting that a company can defy the destructive forces of capitalism. Betting on a special situation can be thought of as betting that irrational behavior will eventually be replaced by rational behavior. I believe that betting on the return of rationality is simply a lower bar to step over.
To illustrate how difficult it is to successfully identify great businesses that are better than the market realizes, consider that in a recent interview, John Malone, Chairman of the Liberty Companies and easily one of the greatest investors of all time, told a story of how he advised Warren Buffett, literally the greatest investor of all time, to not invest in Microsoft, one of the greatest companies of all time led by one of the greatest entrepreneurs of all time, during its early days. If you are keeping score at home – that is one of the greatest, telling the greatest, NOT to invest in one of the greatest, led by one of the greatest. Buffett himself admits this was a colossal error of omission, and should be enough to cause any mortal to think twice before claiming they have found a business and management team so good that they are worth paying up for.
Second, special situations often resolve themselves over a defined – often short – period of time, independent of what the broader market does. To be clear, time is the friend of great businesses, which allows one to pay higher prices, but in today’s environment where we are likely closer to the end of the economic cycle than the beginning (although it can certainly continue longer than anyone expects), I believe it makes sense to tilt the portfolio toward shorter duration opportunities that are likely to be somewhat removed from broader market action.
Third, investing in special situations ties well with the competitive advantages we have as a small firm. For example, while Buffett evolved to focus primarily on compounders, when he managed smaller amounts of capital, he largely focused on special situations. Simply stated, there is often less competition investing in small special situations than there is when investing in larger compounders.
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.
About The Author: Matthew Sweeney
Matthew Sweeney is the Founder and Managing Partner of Laughing Water Capital. The firm employs a concentrated equity strategy while focusing on companies that are dealing with some sort of structural or operational difficulty that is judged to be easily solved by an incentivized management team if given enough time. Matt began his career at Cantor Fitzgerald where he focused on equity idea generation for institutional clients. He received a Bachelor of Arts degree in History from the College of the Holy Cross, and a Masters degree in International Relations focused on the Middle East and Terrorism from Seton Hall University. Matt is a Chartered Financial Analyst (CFA), and former Vice Chair of the New York Society of Security Analysts (NYSSA) Value Investing Committee.
More posts by Matthew Sweeney