Nishkama Capital commentary for the second quarter ended June 30, 2016. For background see the following:
- Nishkama Capital Q1 Letter: Short Alphabet‘
- Ravee Mehta On Emotions And Investing
- Nishkama Capital On GARP Investment Management
- The Emotionally Intelligent Investor: How Self-Awareness, Empathy Intuition Drive Performance.
Net performance of 7.49% in Q2 2016 outperformed all the major indices. In the first half of 2016, our Series A share class returned 5.95%. This was also better than all the major indices despite relatively low market risk. As the table on the previous page illustrates, an average of close to 40% of our long book has been in cash this year. Average net and gross exposure during the first half of 2016 was only about 28.5% and 93.0%, respectively. We have made money the hard way – by picking good specific longs and shorts. Year-to-date, we have generated positive contribution and alpha from both our longs and our shorts. We generally do not make big macro economic bets. Our gross and net exposure is mainly a function of ideas we are able to find on a bottoms-up basis. We use ETF’s from time-to-time as hedges to balance various factor risks. ETF hedges currently represent less than 15% of our short exposure. We exited a couple of large winning long positions in June. We also entered into some new alpha shorts. As a result, our net exposure declined further in July. While we continue to generate alpha with individual stock selection, this lower net exposure has impacted relative performance in July. As we stated in prior letters, we should not be expected to keep up in sharp market rallies given our relatively low level of risk. However, we do expect to outperform during corrections. Since inception over three years ago, we have outperformed the S&P 500 while having meaningfully less downside volatility than the market.
When reflecting upon our performance in Q2 2016, we believe our biggest lessons (both successes and mistakes) had to do with scenario analysis. A stock’s price is a function of the market’s calculation of expected value based on an infinite range of potential scenarios. Only one scenario will wind up being true, but the market’s perception of the possibility of other scenarios is what often moves stocks. We always consider multiple cases when deriving a target price. At a minimum, we model at least 3 cases – base, upside and downside with associated probabilities. However, we usually try to think about and model out many other potential scenarios. While we always ascribe the highest probability to the base case scenario and compare that scenario versus consensus expectations, our investment thesis can sometimes be predicated on the probabilities of other scenarios. This is especially true in the technology sector that is constantly changing and is currently in the process of rapidly consolidating. Our analytic differentiation is not just a function of our base case scenario compared to consensus. We will sometimes get involved in longs when we are only in line with or even below the Street in our base case. Long opportunities are often created when too little probability is being assigned by the market to upside scenarios or when too much probability is being attributed to downside scenarios. The reverse is often true when shorting. As we have written about in the past, we generally stay away from shorting bad businesses since they tend to be crowded trades with high borrow costs. We would rather short OK or even good quality companies, but where there is negative marginal change that is causing shareholder transitions. Very often, fundamental factors such as slowing growth or increasing competition are the sources for negative marginal changes with our shorts. However, there are other situations when the negative marginal change is simply an increasing probability for downside scenarios or a decreasing probability for upside scenarios. We provide some examples below.
LinkedIn Corp. (“LNKD”)
LNKD was a relatively new core position in Q2. In June, the company announced that it would be acquired by Microsoft Corp. (“MSFT”) in an all cash deal. It was our biggest winner in the quarter. We exited the position following the takeover announcement. While we had no idea MSFT or any other company would acquire the company, the market assigning very little to no probability for such an outcome played an important role in our decision-making process to buy the stock. We consider ourselves generalists with a focus on the Technology, Media and Telecom (“TMT”) sectors. As the investment management industry continues to become more institutionalized, we increasingly talk to counterparts that are subsector specialists. Many of the buy-side and sell-side analysts that covered LNKD did not follow the TMT sectors broadly. As a result, LNKD was mainly compared to other Internet stocks when it should have been compared to software-as-a-service (“SAAS”) companies. Unlike most internet stocks that derive a substantial amount of revenue from advertising, most of LNKD’s revenue was based on highly predictable subscription contracts. SAAS companies deserve higher multiples because of this higher predictability. The software industry is also consolidating, which increases the likelihood of a takeover for all companies involved. When we compared LNKD’s valuation to other SAAS companies, LNKD’s valuation was very depressed. Its enterprise-value-to-recurring-revenue multiple was much lower than SAAS companies that were growing recurring revenue at a much lower rate. A very low probability was being assigned to a potential takeover. At the same time, LNKD’s data was becoming more valuable. Most of the world’s big technology companies are betting their future on artificial intelligence (“AI”). AI depends heavily on data to be effective. This means that companies that have proprietary data are becoming increasingly valuable and strategic. Our base case scenario for earnings power of LNKD was about the same as the Street. Nevertheless, we made LNKD a core position because the market was assigning almost no probability to a takeover scenario or to scenarios that further monetized LNKD’s valuable data in new markets or business opportunities. The valuation also implied almost no probability ascribed to growth reaccelerating due to new products the company recently introduced. We increased the position after hearing LNKD’s management talk optimistically about these new products at a conference. After listening to the presentation, we decided to increase the probability for the upside case. Luckily, the takeover announcement came just a couple of weeks afterwards.
Ellie Mae Inc. (“ELLI”)
We discussed ELLI in our last letter. It remains our biggest position and one of our top winners year-to-date. The stock is up nicely this year and we have supplemented gains through trading. Last quarter, we discussed how flexibility of mind allowed us to violate one of our rules – we decided to add to ELLI even though it was down following a strong quarter. Following the distribution of our last letter, the stock weakened further and we continued to add. At its peak, ELLI was about a 13.5% position. Management presented at conferences during Q2 and projected a very confident tone. Datapoints with respect to the mortgage market were also strong forcing analysts to raise expectations. This caused the stock to rebound strongly during Q2 and it made a new all-time high. We decided to trim the position back to about 8.5% before the company reported Q2 results on July 28th. Similar to last quarter, the stock sold off following strong results. We again added on weakness on July 29th and plan to continue to add on any further weakness. Our base case earnings power for the stock continues to be much higher than the Street. We continue to think 2019 base case EPS power is about $6 per share. A 25x multiple implies a base-case target of about $150 in a couple of years vs. the current price of $92.11 as of July 29th. However, we believe that the expected outcome is even higher since the probability of upside scenarios greatly outweighs downside scenarios. Our base case assumes relatively low penetration of mega lenders. Most of the top banks in the United States use their own software developed in house. Our research points to increasing openness by mega lenders towards outsourcing. Analyzing transcripts of public statements made by ELLI’s CEO and CFO over the last couple of years also reveals increasing confidence by the company’s management with respect to winning a top 5 bank as a customer. There are also upside scenarios associated with the facts that ELLI has very strong management and is in a consolidating industry. ELLI is the clear leader in software for the mortgage origination market, which is still very fragmented with many small solution providers. The company has been making small acquisitions and will continue to do so. These technology acquisitions can be highly synergistic given ELLI’s brand recognition and large sales force. Furthermore, ELLI can eventually leverage its technology and foothold with customers by expanding into other markets either organically or through partnerships and M&A. For example, we believe a merger with Black Knight Financial (“BKFS”) which is the leader in mortgage servicing could be highly synergistic. Finally, there are several large Fintech companies such as Fiserve Inc. (“FISV”) and Fidelity National Information Services, Inc. (“FIS”) that have historically been very acquisitive. These companies could potentially acquire ELLI. Since they already have existing salesforces that sell to ELLI’s customer base, expense synergies could be high.
Paypal Holdings Inc. (“PYPL”)
PYPL was our biggest winner on the short side in Q2 and in July. We have trimmed the position significantly but it is still a modestly-sized core short. We have been long Visa Inc. (“Visa”) for over 1.5 years. Our conversations with Visa management pointed to increased frustration with Paypal. After analyzing PYPL, we felt that it was a great business but certain downside scenarios were not being appreciated by the market. PYPL’s profitability is highly dependent on its funding mix. It historically would steer customers to fund via ACH, which is a very low cost funding source but is not in the best interest of consumers. Visa had leverage to change this. In July, PYPL and Visa announced a new agreement in which PYPL agreed to not steer to ACH. This introduced a fair amount of uncertainty for earnings power in 2017 which has impacted PYPL’s multiple. There are also downside scenarios with respect to increased competition from both traditional payment companies and new players in payments. Visa and Mastercard are aggressively signing up online retailers. We also expect them to aggressively promote these offerings in Q4 ahead of the Holidays. Consumers will be offered cash back on purchases. PYPL will either lose share or need to match promotional offers. Mastercard also recently announced partnerships with several large banks that automatically enable over 80 million accounts into its offering that is competitive with PYPL. This critical mass of consumers should give Mastercard more clout with signing up even more online merchants. Moreover, technology companies such as Apple, Samsung Electronics and Alphabet are becoming more competitive with PYPL. These companies have the potential to leverage their strong positions in hardware and operating systems to make paying using a smartphone a much more seamless experience than PYPL can offer. Furthermore, they do not need to even make money with their payments offerings. Payments can just be a differentiating feature that allows them to take smartphone share. There is a wide range of potential outcomes with Paypal, and to be fair, it is also a potential strategic asset that could be acquired. Increased competition could also accelerate overall market growth. Nevertheless, it is owned by many growth-oriented hedge funds and, until there is more certainty on the impact of this new agreement with Visa and the impact competition may have, we think the stock is more likely to continue to have more incremental sellers than buyers.
Aphabet Inc. (“GOOGL”)
We wrote about GOOGL in our last letter. At the time, we were short because we thought that the there was some risk to consensus expectations in Q4 2016 and 2017 because of tougher compares due to business model changes that the company made towards the end of 2015 that accelerated growth. Constantly being mindful of various scenarios allowed us to have the flexibility of mind to cover our position for a gain at prices that are now much lower than where the stock is. One upside scenario we had been worried about involved the company introducing new business model changes to offset the tougher compares. Shortly after our last letter was distributed, the company started experimenting with physically larger mobile text ads, ads within maps and a 4th mobile ad unit. Our conversations with industry experts confirmed that these changes would be meaningful for incremental revenue generation. Consequently, we felt that we no longer had an analytic edge to be short.
DIRTT Environmental Solutions Ltd. (“DRT”)
We have previously written about DRT and have been long this small cap Canadian stock for over 1.5 years. It was one of our top winnners in 2015 and has been one of our top losers so far in 2016. The weakness over the last couple of quarters is largely due to a large project the company had with CononcoPhillips (“COP”) that stalled due to the collapse in the energy sector last year. Like ELLI, we have traded the stock relatively well. We trimmed on strength last year and bought back on weakness this year. It is currently our second biggest position. DRT is revolutionizing the construction industry by offering software that allows one to virtually design commerical interiors. Everytime a change is made in DRT’s software, the total cost of construction is automatically updated. Cost overruns are very rare. All the building materials are prefabricated in DRT’s factories. Labor costs are significantly less than normal construction and construction time is at least three times faster. While the company has been growing fast and has an open-ended opportunity in commercial construction, there are a number of upside scenarios that are currently being ascribed low probabilities by the Street. First, the company has recently introduced products for the residential market. While sales into this market have been minimal so far, we think it is possible that one or several large homebuilders become significant customers. Homebuilding companies would benefit greatly from faster time to market that DRT’s technology would offer. Those that operate in markets with rising labor costs may be most interested. Second, after the COP project stalled, consensus became overly cautious by not factoring in any other large deals in its projections. There is the possibility that the project from COP goes back on line now that energy prices have rebounded somewhat. Our checks with distrubutors indicate optimism about other potential large deals especially in the healthcare vertical. The sales cycle for large projects is long and it is unclear when, or if, anything may come in, but we believe there is almost free optionality with respect to this scenario. Third, the company is exploring ways to monetize its intellectual property. It has invested over $50 million in R&D and has many patents. It may be able to collect licensing revenue or royalties from companies that are not competitive with it in construction. This is another free option with the stock at this price.
Q2 Holdings Inc. (“QTWO”)
QTWO is a $1.2b market cap SAAS company that has been a new core position for a few months. It provides software that helps banks offer consumers internet and mobile banking solutions. The company has been growing revenue over 35% and we think there is an upside scenario of acceleration next year that is not appreciated by the market. The Street is currently forecasting deceleration. The company’s traditional customer base consists of regional banks and credit unions. However, in 2015 QTWO announced several large wins with tier-1 banks. Implementation times for these larger banks are much longer than the company’s bread-and-butter 2nd-tier and 3rd-tier customer base. Consequently, very little revenue is currently being recognized from the big customer bookings. Most of the revenue from the recent top-tier wins will start being recognized at the end of 2016 and in 2017 even though the selling effort happened in 2014 and 2015. Assuming sales cycles do not change and the company continues to do well with 2nd and 3rd tier banks, we think there is a good chance for acceleration vs. deceleration. Revenue ramping from these larger customers should also lead to operating margin expansion. QTWO generally is conservative with recognition of costs during implementation of a new contract. Margins from new contracts usually expand meaningfully as the client moves from initial implementation to full-scale deployment. Furthermore, like ELLI, the company could be a target for larger FinTech companies that are acquisitive and have overlapping sales and marketing coverage. The founders of QTWO previously ran and sold a FinTech company. We believe that management is excellent. Strong management generally increases the probabilities of upside scenarios. Finally, like ELLI, the company could leverage its existing customer relationships in adjacent areas either organically or through acquisitions.
Nishkama Capital – Missed Opportunities
We fortunately did not have any meaningful losing positions during the quarter. Since the end of March, our biggest loser cost us less than 50 bps. Our biggest mistakes were ones of omission. There were many companies that we knew well that were acquired or went up in value because of dramatically revised probabilities for upside or downside scenarios. One stock that has been especially frustrating to miss was NVIDIA Corp. (“NVDA”), which is up over 73% year-to-date through July after a strong 2015. While earnings expectations have been revised somewhat, most of the stock’s rise had to do with multiple expansion. This multiple expansion occurred because the market revised up the probabilities of success with respect to upside scenarios of new addressable markets. The company traditionally made graphics processors for the computer industry. While this is still the company’s biggest business, it has become increasingly clear that these same graphics processors will likely be used in data centers to power AI. They will likely also be used in autonomous vehicles. Its traditional computing business may also benefit due to increased interest in virtual and augmented reality.
We appreciate your continued support and interest in Nishkama. For a better understanding of our approach, we encourage you to read The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance. As always, feel free to contact us with any questions or concerns you may have.
Sincerely,
Nishkama Capital LLC
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