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