Forage Capital letter to investors for the fourth quarter ended December 31, 2016.
“Prosperity knits a man to the World. He feels that he is ‘finding a place in it’, while really it is finding its place in him.” – The Screwtape Letters, C. S. Lewis
For the quarter ending December 31, 2016, Forage Capital (“the Fund”) returned +4.1%, net of all fees and expenses compared to +3.8% for the S&P 500 Total Return Index. The two largest contributors to performance this quarter were ODFL and MRC; the two largest detractors were OAK and SELF. From inception on July 14, 2016 to year-end, the Fund returned +3.4%, net compared to +4.8% for the S&P 500 TR Index. Around 54% of the fund’s assets were in cash at year-end. The other 46% was unevenly allocated across 11 stocks with a median market cap of $9bn. Lofty valuations and the absence of meaningful, sustained sell-offs within the universe of businesses I find investable, have confounded my efforts to put more capital to work during these first 6 months of the fund’s life. Considering our significant cash allocation, should the broader averages continue their quiescent ascent, the fund’s performance is highly unlikely to keep pace.
It appears I goofed in purchasing Global Self Storage (SELF) last quarter. I was enticed by the prospect of a responsibly capitalized REIT rolling up and applying easy operating aid to a fragmented landscape of mismanaged self-storage properties in 2nd tier markets that seemed relatively insulated from excess capacity, and was further encouraged by persistent open market stock purchases by Mark Winmill (the CEO) and Board Members. But then, in the Holiday Spirit of giving, on the day before Thanksgiving the Company stealthily announced an agreement to purchase, at an egregiously inflated valuation, a self-storage entity in which Mark had a substantial personal ownership stake. Investments in small cap companies like SELF (~$35mn market cap) are primarily jockey bets and I’ve learned through expensive mistakes that the slightest whiff of value-thwarting self-dealing is usually reason enough to punt. I sold all our shares at an 11% loss.
Something I’ve also learned in perusing the quarterly updates of other fund managers is that it’s helpful to occasionally probe investing tenets and frameworks, and so, wary of further amplifying the crusading screech that value investors have long pitch-perfected, I’ll start with some pedantry commonly applied to so-called “compounders.”
This trinity illustrates the path to wealth everlasting: purchase, at a sane price, a company whose unique capabilities allow it to earn a return on capital that exceeds that capital’s cost against an opportunity set vast enough to consume meaningful reinvestment. The box labeled “moat” is the only one with three outbound arrows because absent a sustainable advantage that repels determined competitors, today’s profitability is ephemeral and tomorrow’s growth is destructive. And without understanding an enterprise’s excess returnenabling edge, we can’t confidently ascribe value, so it follows that price-to-value assessments are moot. That sounds droolingly obvious when articulated, I know. But in practice I’ve found that, rather than consider these three factors in balanced unison, many investors subordinate the foundational pillar of moat, casually corralling it as addendum to an alternative angle of attack….
Isolated faith in huge, dynamic markets provokes our basest instinct to blindly extrapolate yesterday’s growth rates under misguided enterprise value-to-potential market size symmetry intuitions with little consideration for why, besides some tenebrous sense that what it does tangents some buzz word nourished trend, the company is uniquely positioned to sustainably capture value. On the flip side, well-intentioned TAM estimates, tightly circumscribed by our limited imaginations, often underestimate the extent to which an enterprise with a capably managed moat can profitably carve innovative niches, redefine use cases, and bisect orthogonal markets: early in its corporate life, Google believed its primary revenue source of licensing its searc engine to online portals could be supplemented by an advertising sideshow that might constitute 10%-15% of its revenue at some point; Dwight & Church’s baking soda (Arm & Hammer) was first marketed as a baking ingredient before it blessed laundry detergent, deodorant, toothpaste, and other consumables; that brick & mortar bookstores once represented Amazon’s primary competitive threat seems quaint in retrospect.
Whether assessing value-accretive market share gains in an established market or potential surplus capture in an embryonic adjacency, we’re usually better off starting from the inside and working our way out (understanding the moat that enables profitable participation in an expansive market), rather than the other way around (holding a high conviction view on an industry trend and buying stocks that “play” on that trend). It’s the difference between, say, owning Netflix because you think its flywheel of [subscriber growth/engagement, recommendation engine relevancy, and intelligently bid/created content] offers an insuperable competitive advantage over alternative entertainment providers, and doing so primarily because you’re confident that streaming video will continue taking viewership share from linear TV (we don’t own NFLX). But given that a stock cares not why you own it, do the reasons matter?
Here’s a fictitious, half-way credible stock pitch I whipped up:
“Company X is a small, branded snacks company based out of California with a long but unremarkable history. Unremarkable, that is, until now. Its newly branded additive-free energy bars are capitalizing on the erumpent appeal of healthy organic snacks, which are rapidly stealing share within the perennially stodgy, low growth convenience goods category. Following two years of 18% compounded growth, revenue during the most recent year catapulted 80% higher, but even so, the Company’s total sales make up just 1.5% of a $16bn organic foods market that I expect will grow by low-to-mid teens percent for the foreseeable future. Although the stock price has quintupled over the last year, a 5% market share in five years equates to 7x today’s revenue and, assuming the company holds its margins and the stock holds its current low-30s multiple, a 7-bagger in the stock.”
You’ve likely heard many versions of this cheesy pitch, whose extrapolative allure anesthetizes the pressing discomfort of not knowing why this enterprise, in particular, is well positioned to compete in what seems a crowded, barbarously competitive landscape with few entry barriers. To me, it looks like a “pass.”
But so, Company A is actually Monster Beverage, the addressable market is alternative beverages, and all the facts of that pitch were true when I passed on the stock in 2005 (back when it was called Hansen Natural), grimacing from the sidelines as it zig-zagged a route from ~$2/share to its current price of $45.
Passing on this stock was clearly wrong. But was it unreasonable? To me, Monster was a middling juice company that hit pay dirt capitalizing on a feverish but likely transient fad in a congested field of undifferentiated competitors, including one dominant energy drink brand and two traditional soft drink incumbents with the marketing heft and privileged retail shelf space to capture whatever surplus materialized. This narrative held more sway with me than another, more hopeful one about a talented management team