VIA UNION SQUARE RESEARCH GROUP 2013 YEAR IN REVIEW – NOTE TO CLIENTS
As we look back on our first full year as a firm, we would like to thank our clients and our many helpful friends in the investment community for making this such a rewarding experience. We find the search for great investments more exciting than most and we would like to thank you all for your interest and input over the last twelve months.
Over the course of 2013 we had 10 active recommendations, four of which were initiated late in 2012. Of these recommendations, seven were long, two were short, and one was a special situation in which we recommended the purchase of options. The average return of these ten diverse recommendations in 2013 was a gain of 98.6%.
Of course holdings are almost never equally weighted in a portfolio and we believe that in both investment selection and portfolio management, the focus must be on protecting against downside. With this in mind, we have created a model portfolio of our recommendations in 2013, with longs weighted at 5%, shorts weighted at 2.5% and the special situation option recommendation weighted at 1.25%. While these weighting might seem high to some investors, our unrelenting focus on finding high conviction investments with minimal downside leads us to believe that these position sizes are appropriate. As shown below, this portfolio returned 35.9% in 2013, which is slightly ahead of the 32.4% total return of the S&P 500. However, as shown, our model portfolio achieved this gain with an average cash position of 75%.
We are very pleased with this performance, while acknowledging that an ebullient market as well as our careful security selection contributed to our gains. Our focus is on our batting average, not the score board, and we are happy to have gone one-for-two on our short recommendations in a momentum driven market that has been particularly unkind to short sellers. After a year in which every long investor looks like a genius and every short seller like a fool, we thought Howard Marks’s year-end letter held some great insights into the importance of luck in investing. We highly recommend reading the full letter (http://www.oaktreecapital.com/MemoTree/Getting%20Lucky_2014_01_16.pdf) but we have excerpted two particularly excellent sections below (emphasis his):
Investment success isn’t just a question of whether the investor put together the “right” portfolio, but also whether it encountered a beneficial environment. Thus being successful requires a significant degree of luck. No one gets it right every time. (That’s why even the best investors diversify, hedge and/or limit their use of leverage.) But the skillful investor is right more often, over a long period of time, than an assumption of randomness would permit. We say about such investors, “it can’t be luck.”
At that point, an uncle pulled him aside and doled out some advice. “Jim, I wouldn’t spend my time getting better,” he advised, “I’d spend my time finding weak games.”
But I also believe some markets are less efficient than others. Not everyone knows about them or understands them. They may be controversial, making people hesitant to invest. They may appear too risky for some. They may be hard to invest in, illiquid, or accessible only through locked-up vehicles in which some people can’t or don’t want to participate. Some market participants may have better information than others . . . legally. Thus, in an inefficient market there can be mastery and/or luck, since market prices are often wrong, enabling some investors to do better than others.
In short, it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer. Thus, in general, I think it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller.
Our goal is to maximize our exposure to the potential for a beneficial outcome in both the market and for the individual businesses we invest in, while minimizing our exposure to the potential for loss in the event of an adverse outcome. In order to accomplish this we seek to find some of the most boring, hated, misunderstood, or unfollowed investments available. We don’t want to be buying from (or selling to) someone who has done as much work as we have.
As you will see on the following page, all of our investments are either unfollowed or have some defect; a lawsuit, an out-of-favor industry, or a great division obscured by a terrible division that is getting all the headlines. We would like to own great businesses with great management teams and have had the opportunity to purchase a few at bargain prices over the last year. However, we are also happy to find great assets at a great price, which we believe will provide for a beneficial outcome without the benefit of great management.
On the short side, we believe there must be some catalyst to justify the increased risk in these positions. To make matters more complicated, we believe this catalyst must be largely unknown to the market. We don’t recommend many short sales for this reason, but when we do, we do so with conviction.
Over the course of the last year, we spent a lot of time on and did extensive analysis of investments in which we were ultimately unable to gain a high enough degree of conviction to put out an official recommendation. These include Take-Two Interactive Software, Inc. (NASDAQ:TTWO) (TTWO $19.05), the debt of Nuverra Environmental Solutions Inc (NYSE:NES) (NES $14.17), EXCO Resources Inc (NYSE:XCO) (XCO $5.48), PBF Energy (PBF $26.09), Suntech Power Holdings Co., Ltd. (OTCMKTS:STPFQ) (STPFQ $0.57), and Rowan Companies PLC (NYSE:RDC) (RDC $31.59), among many other investments which were less compelling.
Going forward, we see opportunities in a number of less-efficient areas of the market. Notably, we are looking at two attractive long investments in Argentina, a number of attractive short selling opportunities, and a couple of conglomerate-type investments that we believe are misunderstood and undervalued by the markets. In addition to these opportunities, we have will be putting out research on a couple of very actionable investment opportunities in the coming weeks and months.
While we have not put out research on Chesapeake Energy Corporation (NYSE:CHK), we remain long the stock and look forward to the company releasing its 2014 outlook next Thursday, February 6th. We believe this company continues to be misunderstood by the market and our extensive thoughts on the matter are available at Outstanding Investor Digest’s new website, www.oid.com.
We published two articles on Sears Holdings Corp (NASDAQ:SHLD) over the last year. The first was on our belief that we will see a significant downsizing of the brick and mortar real estate operation in 2014 (Has Sears Holdings Reached the Tipping Point?). We would note that Sears has already announced the closure of 30+ stores this year. We also wrote about the redevelopment of one of Sears “crown jewel” properties at the King of Prussia mall (A Visit to the Front Lines of the Sears Holdings Cold War), which the company announced