Meson Capital 2014 Q3 Partnership Letter

Oct 6, 2014

2014 Q3 Partnership Letter

Dear Partner,

Our net performance for Q2 was 12.1%, bringing our YTD results to 14.2% vs. YTD indices (in order of relevancy for comparison) of: 4.2% Barclay Hedge Fund Index, -5.1% Russell 2000 and 7.1% S&P 500. Our portfolio was approximately 75% long and 75% short for the quarter with longs contributing approximately 2% to our returns and shorts contributing 10%. I am pleased with our results to date and the balanced manner in which they have been achieved. The market rally over the last two years has often rewarded the most speculative stocks while punishing cautiously positioned investors.

Meson Capital: Monthly return data is more noise than signal

With our strategy, monthly return data is more noise than signal given that companies report information on a quarterly basis. We only focus on longer term 1-3+ year stock price discrepancies from our estimate of intrinsic value when making investment decisions. That said, it is interesting to observe that we have been negatively correlated with the market on a monthly basis – i.e. we do well in ‘melt down’ months like September and not well in market euphoria months like August.

The general reason for this is that we invest in fundamentally good businesses that are undervalued and unpopular with Mr. Market: they lack excitement but should do quite well and improve with time. These companies steadily chug along creating capital but will decline with everything else when the market does. Declines for even high quality small companies can occasionally be sharp, a hazard (and opportunity) inherent to investing in small companies where short term liquidity can rapidly evaporate.

Meson Capital’s strategy to hedge out liquidity risk

To balance this, our short book consists of similarly sized companies (to hedge out the general small company liquidity risk) that are fundamentally weak and deteriorating long term, but at the moment are popular in the market. These stocks really fall out of bed when the market declines as Mr. Market loses his appetite for more speculative upside as risks become more visible. The true beauty of the short book is actually not the returns it can directly produce, but the large increase in purchasing power it enables during sharp market declines. Being in a position of strength at exactly the time when others are overextended and forced to liquidate is the source of greatest upside over the long term and sounder sleeping in the interim.

The goal of this approach is not to minimize monthly volatility, which is meaningless noise, but to allow long term results to be a product purely of business specific entrepreneurial factors that are uncorrelated with the broader market. In a world where: 1) The broad equity markets are at all-time high median valuations ever and 2) Investors can gain equity ‘exposure’ for a 0.15% fee from a Vanguard Index fund, it is essential that we produce a differentiated source of returns.

Our results provide validation for our revamped strategy implemented this year, enabled by our activist experience and investment sourcing software, both of which required years of upfront development.

Meson Capital – Lump of the Quarter: Bankruptcy Coils the Spring

The bullet points of a position we have held for some time:

  • Pharmaceutical company with unique scientific achievements in a large potential market
  • A paying customer, little to no scientific or research risk (i.e. the product is proven)
  • Cash in the bank exceeds the market cap and liabilities are nominal trade payables
  • TTM free cash flow exceeds the market cap of ~$80mm (i.e. P/E of <1)

I believe this stock is too cheap and have believed so for some time. It will not show up on a standard stock screen as a growing company with an excellent balance sheet with a P/E <1 for a very specific reason. SIGA Technologies, Inc. (NASDAQ:SIGA), a defense contractor that developed a working cure for smallpox, has been in a lawsuit since 2005 after they reneged on a nonbinding merger agreement with PharmAthene, Inc. (NYSEMKT:PIP) after having sellers remorse. They have deliberately (legally) been using highly conservative accounting to mask earnings and look ugly during this lawsuit.

Meson Capital

See full Meson Capital 2014 Q3 Partnership Letter in PDF format here.