Greenhaven Road Capital Q2 2016 letter to investors
Dear Fellow Investors
The fund was up just under 6% in the second quarter, which brings YTD performance to just under 3%; this compares favorably to the Russell 2000 return of 2.2% and is approximately 1% below the S&P500, an index with which we have minimal overlap. This letter covers a lot of ground, please sure to read about some operational changes we are making in the housekeeping section near the end. Our results this quarter were aided by the performance of our largest position: the timeshare company Diamond Resorts International, which was discussed in great detail in the last letter. I outlined the possibility of a buyout taking place before management’s options for 5 million shares had to be exercised in July. At the end of June, a private equity firm made an offer to buy the company for a 25% premium.
As part of the investing process, I look at multiple companies each day. To gain access to investing communities such as Sum Zero where dozens of ideas a month are presented, members have to contribute ideas every six months. Since I had already written the thesis for owning Diamond Resorts in the letter, I posted it to Sum Zero to keep my access to the site. I knew that Diamond Resorts and timeshares were controversial, and I knew that there was a high short interest in the stock. I had no idea how unpopular the idea would be to Sum Zero readers. This was an idea that returned almost 50% in less than three months and received an offer to be purchased in the timeframe predicted. If this was an academic exercise, the thesis would garner an A if just evaluated on the outcome. On Sum Zero the idea got a one-star rating from the community out of a possible five – or a virtual F. Eventually the rating rose to a three stars. The idea was also the “most discussed” idea on the site for a week. I learned the hard way that “most discussed” really means that a lot of people engage in a combination of constructive criticism and attack of the idea and the author has to address their concerns. For me the whole episode was a helpful reminder that our investments will often not resonate with the “crowd.” The easy thing to do was to pass on Diamond Resorts and just purchase a popular blue chip company. In the case of Diamond Resorts, passing would have been a mistake.
I realize that, as an investor in Greenhaven Road, you by definition are an independent thinker and willing to step outside of the herd and invest in an emerging manager instead of an index or the largest Fidelity funds. In the case of Greenhaven Road, only time will tell if this was the right decision, but I wanted to thank you for your support and reiterate that I continue to unequivocally believe that being small is a great asset in the investment management world. It gives us flexibility, and a broader opportunity set to consider than big funds. And because asset gathering is not our breadwinner, we have to be laser focused on generating returns. As a smaller emerging manager, just like Diamond Resorts, we may not be popular, but we intend to be highly profitable.
TOP 5 POSITIONS
Careful readers will notice that none of the investments in the top five are new investments. These are all companies that have been discussed in previous letters. As such I will keep this section brief:
Diamond Resorts: The company received an all-cash buyout offer from Apollo Group right before the end of the quarter. There is still a small chance of an “overbid” from a strategic buyer such as Wyndham. On a dayto-day basis, the shares are a proxy for cash, trading within a very narrow range. As a shareholder we have the option to exercise “appraisal rights”. This means that we have a right to have a judge determine if the price paid by Apollo is fair. Several funds were successful in obtaining a higher payout in the Dell private transaction by exercising their appraisal rights. We may pursue this strategy. The deadline to decide is August 10.
Fortress Investment Group: The thesis remains the same: the market is undervaluing the quality of the management fees and ignoring the cash and investments on the balance sheet. This year the company tendered for shares and paid a “top off” dividend of more than 4%. The largest shareholders are the employees. The setup remains constructive on this sub-$5 stock; with more than $3.50 in cash, investments, and embedded incentive fees, there is significant downside protection. There is also a stable base of $70B in fee-paying assets. There have been headwinds in the price performance of permanent capital vehicles, which have made raising additional capital a challenge. This investment continues to appreciate materially.
Halogen Software: There have been no major developments since the last quarterly letter. I have heard anecdotally of both customer wins and losses. There remain multiple ways to “win” here, with the most likely being the sale to a payroll company. Insider ownership remains high at more than 40%, the valuation on an Enterprise to Revenue basis is less than 2, which implies a business in decline. The company is experiencing double-digit growth and has a new CEO with reasonable and promising customer retention and growth strategies. Time will tell with this unloved Canadian technology company, but the risk/reward remains compelling.
Radisys: We have owned Radisys since the first quarter of 2015. It began as a smaller position as there was uncertainty as to the future of the company. The company operates in the telecommunications space. As you may remember, there was a declining hardware business masking the growth of a high-margin software company. The shares have appreciated in price more than 100% from our initial purchases as the hardware sales are no longer declining, the software continues to grow, and the company has launched new hardware offerings that incorporate the software. This small company has secured Verizon as a customer, which is both a tremendous reference account as well as material from a revenue perspective. Interestingly, based on hiring activity, Verizon is likely not the final large customer. Management, which has historically been conservative in discussing the company’s prospects, has shifted to worrying about execution and meeting demand. The quarterly results will be “lumpy” for Radisys, but there is still an opportunity for substantial share appreciation as their software-based products gain traction. Radisys would be a logical acquisition for Cisco and a number of larger telecom hardware manufacturers.
Interactive Brokers: This remains a business with a very long runway for growth, healthy margins, and high insider ownership. You can find more than 20 pages of detail on the company on our website at www.greenhavenroad.com. The “Investor Letters” section has a long presentation I did for the Manual of Ideas Wide Moat Conference discussing our thesis. While not the least expensive company we own, the quality of the management, the growth runway, and the value proposition to customers are heavily weighted in our favor.
With our long bias, there was very little activity on the short side. We