Artko Capital commentary for the second quarter ended June 30, 2016.

Dear Partner,

For the 4th fiscal and 2nd calendar quarter of 2016, a partnership interest in Artko Capital LP returned 5.7% net of fees. At the same time, an investment in the most comparable market index alternatives Vanguard Russell 2000 ETF, iShares Microcap ETF, and the Vanguard S&P 500 Index ETF–gained 3.8% 4.0%, and 2.4%, respectively. For the last 12 months of our fiscal 2016, an interest in Artko Capital LP returned 12.9% net of fees while investments in the most comparable aforementioned market index alternatives were down -6.7%, -12.0%, and up +3.9%, respectively. Our gross, quarterly, and cumulative results, as well as those for the comparable indexes, are available in the table below. We are happy about our first full year performance and will focus the letter on discussing how we got there.

Artko Capital

Artko Capital On Catalyst-Driven Investing

A big part of our investment process is not only identifying undervalued quality securities but also figuring out the events that will lead them to appreciate in price within our target holding period. Buying something just because its undervalued is unlikely to result in high long-term returns and, generally, we look for catalysts that will get us there. However, we would not call this particular strategy “event driven,” as we consider soft catalysts (e.g., continued high ROICs and growth) just as value creating as hard catalysts (e.g., special dividends or spin offs).

One of the most difficult aspects of this particular strategy is getting comfortable with “not knowing.” Can we predict with 100% certainty whether a company is going to keep paying special dividends or divest a business to unlock enterprise value? Of course not. We have to be able to act with less than perfect information. But just as a good chef knows that combining certain ingredients and cooking them under a specific heat and using proper cookware will result in a quality meal, our job involves researching the specific company or industry ingredients ensuring that external economic or regulatory environments are the proper “temperature” for those ingredients to create value.

The most important ingredient in forecasting catalysts is making sure that the people who are in charge of making economic value-creating decisions are properly incentivized to make them. Sometimes answering the most basic questions, such as “What is management’s motivation to make this event happen?” or “Is this person going to get stinking rich if he/she does what we think needs to happen?” can shed some excellent light on figuring out the likelihood of certain events. Unlike in large caps, where management usually has already accumulated significant wealth and is likely more concerned with ego and reputation than earning an extra few million, we find that most management teams of small-cap companies are still very much in the wealth accumulation stage and are hungry to grow it.

Other ingredients we consider are the balance sheet, historical actions by the company and management team, and industry dynamics. The balance sheet is perhaps the second most important ingredient in catalyst driven investing. Does the balance sheet have hidden assets that can be monetized or spun off? Does it have the capacity to undertake value-creating events? Does it make sense to have the current capital structure? Thinking through the answers to these questions helps us to narrow down our potential investment candidates and likelihoods of catalysts happening.

Finally, we tend to look for answers to questions like “Has this company, board, or management team done this sort of transaction before?” or “Are there industry events or dynamics that make a catalyst likely?” via our due diligence process. In the end, there are no “sure thing” events in investment management and investing involves high degrees of uncertainty, but we’ve found when buying uncertainty at a high margin of safety with the research process focused on ascertaining the likelihoods of value creating events tends to work very well over the long term.

We had a good first year and out of the 15 securities in our fully invested portfolio, a significant portion of the positive performance in the down small-cap markets came from 7 securities that had realized some sort of catalyst or event. We’d like to review what happened in our portfolio over the last 12 months below:

  • USA Technologies – This was a 7% position for us that has appreciated over 48% from our initial buying levels and close to 30% from our dollar cost average price this fiscal year as we continued to add to the position as our confidence in the thesis increased. The company began to convert on its significant growth opportunity of increasing its vending machine connections by 32% to add to its installed base and ending the 1st quarter of 2016 with over 400,000 connections. With the increasing value of transactions, as well as transactions per connection, it was able to grow its recurring revenue base by over 34% for the 9 months of its fiscal 2016. More importantly, by converting the financing for its transaction equipment from internal capital to external capital, the company has begun to show consistent free cash flow generation which we expect to increase exponentially going forward. We’re encouraged that our thesis is panning out and still consider this a strong conviction idea within our portfolio. Longer term, we believe this company would be a better fit within a larger financial transaction processing company and still expect over a 100% upside from today’s levels in the intermediate future.
  • US Geothermal (HTM) – HTM was a 10% position in the portfolio for us this year and it has appreciated over 55% from our buy-in levels and 40% from our dollar cost average price, on the back of a number of transactions and announcements. We expected the company to continue to convert the 200 megawatt (MW) project pipeline to grow its current 40 MW geothermal base. Some of the key announcements this year included:
    • A purchase of 35 MW of capital equipment for $1.5 million, or a 95% discount, saving the company $28 million on future capital expenditures.
    • Operational progress on a 28 MW project in Geysers, CA, by attaining the necessary permit and connection agreements. The company is currently looking to sign a Power Purchase Agreement (PPA) prior to starting construction. We believe an expected near term announcement of a PPA should be received well by the markets.
    • A $5.1 million buyout of Goldman Sachs’s minority interest of the Raft River, ID, plant. The buyout enabled US Geothermal to announce an immediate $3 million expenditure project to increase the plant output from 9 MW to 13 MW by 3Q 2016, and increase its annual free cash flow by another $1.5 million, or approximately 25% over last year.
    • A project to increase the output of its Neal Hot Springs, OR, plant by 3 MW by building a cooling tower. The company is currently testing well flow in the area to provide water for the tower and we expect it to move on this project in the near future.
    • Obtaining financial capacity to borrow up to $50 million from Prudential Capital Group, removing a major overhang with respect to the uncertainty surrounding
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