Hazelton Capital Partners letter for the fourth quarter ended December 31, 2016. But first check out our exclusive interview with PM on some of the hedge fund’s favorite small caps.
Hazelton Capital Partners, LLC (the “Fund”) gained 7.0% from October 1, 2016 through December 31, 2016, gained 23.1% year-to-date, and has returned 116.8% since its inception in August 2009. By comparison, the S&P 500 gained 3.8% in the same quarter, increased 12.0% year-to-date and has returned 141.6% since the Fund’s inception.
Hazelton Capital Partners – The Year in Review — Position Updates
Hazelton Capital Partners ended the 4th quarter with a portfolio of 18 equity positions and a cash level equivalent to 20% of assets under management. The Fund’s top five portfolio holdings, which are equal to slightly over 37% of the Fund’s net assets, are: Western Digital (WDC), Micron Technology (MU), Apple Inc (AAPL), CUI Global (CUI) and USA Technologies (USAT).
Except for pruning some positions and selling some upside calls over the past quarter, Hazelton Capital Partners’ investing activities have been fairly quiet with no new companies added to the portfolio. Even with the Fund’s cash position expanding from 10 to 20%, 2016 remained a strong year for the Fund.
At the end of 2016, Hazelton Capital Partners top two holding were Western Digital and Micron. Both of these positions focus on the digital storage industry. WDC is the leading manufacturer of Hard Disk Drives (HDD) with a 45% global market share, and recently acquired SanDisk and its 18% global market share in NAND flash storage. MU is the 3rd and 4th largest global manufacturer of DRAM memory and NAND flash storage, respectively.
The digital storage industry is at another inflection point. Until recently, HDD and NAND were seen as competing technologies to store data. When compared to HDD, NAND has a much smaller footprint, is mobile, energy efficient, and produces input/output speeds that are nearly 15x faster. However, all of these benefits come at a price that is still 10x more expensive per gigabyte than HDD and is only expected to decline to 6x over the next 5 years. Businesses are understanding that the value of data comes not only from storage but real time analytics, and they are recognizing that digital storage is a tradeoff between performance and capacity.
In 2015, it was estimated that 8 zettabytes (zb = ~8 billion terabytes) of data was produced globally and is expected to grow to 40 zb by 2020, as more consumer and industrial devices are being designed to capture data. By contrast, in 2015, only 0.65 zb of storage was shipped (0.56 zb of HDD and 0.09 zb of NAND) and that number is predicted to grow to 3 zb by 2020. Not all data is worth storing, but try telling that to teenagers and Millennials who commonly document every aspect of their lives with “selfies” and videos. Combined with overall growth in video creation, artificial intelligence, machine learning, and the internet of things (IoT) devices, one can quickly see how demand for storage will continue to outpace supply. But more importantly, not all data is of equal significance; being able to retrieve the data from an email dated six months ago is less critical than the current data generated from the sensor of an autonomous vehicle navigating a city street. Companies like Google that provide cloud storage and analytics integrate a two tier system for digital storage. Data that is readily needed for download or analytics will be stored on NAND, and data that is recalled less frequently is shifted to HDD. The decision of where to store data is left up to algorithms that are constantly transferring data from one storage format to another.
Investing in Western Digital and Micron carries the risk of an unforeseen, rapid technology disruption to the digital storage industry. However, this is unlikely due to the significant barriers to entry, both in terms of capital needed and intellectual property. The most recent technology pivot is the transition from 2D to 3D NAND. Global producers have invested tens of billions on R&D and retooling production, and this does not include the years of design and OEM vetting required before industry acceptance. Even though 3D NAND has been in production for the past 18 months, profitability is only expected by the end of 2017. WDC and MU are well positioned to take advantage of the robust digital storage demand, as each company begins to leverage its R&D and intellectual property, lower expenses, and improve profitability.
FMC Corp (FMC) – Closed +70% Gain
FMC is a diversified chemical company that operates in three business segments: Agricultural Solutions, Health and Nutrition, and Lithium. Agricultural Solutions produces insecticides, herbicides and fungicides to enhance agricultural crop output and is responsible for nearly 70% of the revenue and 62% of the company’s profit. Crop protection is a very specialized business requiring different chemical formulas based on the crop, the region, and the yearly change in strains of insects, weeds, and disease. With 70% of global sales concentrated within the top five agricultural chemical companies, crop protection is a very sticky business with significant barriers to entry.
At the end of 2014 and well into 2015, FMC continuously lowered its revenue and margin guidance as a combination of reduced agricultural demand, high levels of unused inventory and a Latin American currency crisis negatively impacted its earnings. In the agriculture industry, manufactures, like FMC, provide its product to farmers before the planting season and receive payment after the harvest when the farmers are flush with cash. Because of a combination of lower yields and demand, farmers were unable to readily pay for their products and FMC’s account receivables began to balloon in both size and percentage of revenue. Lower agricultural demand also led to reduced planting acreage adding to the growing industry oversupply. To make matters worse, Latin American, which generates 40% of FMC’s Agricultural revenue, was experiencing a currency crisis highlighted by the Brazilian Real. The money that FMC was able to collect in Latin America was losing its value on a daily basis.
Beginning in the first quarter of 2015, shares of FMC plunged as the company began to miss its already lowered earnings guidance. In the second half of 2015, Hazelton Capital Partners began researching FMC, and by the third quarter, we initiated a position. We were not attempting to pick the bottom in the market and given the initial size of our investment, we fully expected FMC’s share price to continue lower. Our research indicated that FMC’s business and products were sound, and even though a number of macro events were negatively impacting its revenues and profitability, FMC maintained a competitive edge in a very concentrated market. At the beginning of 2016, things began to improve for FMC Corp; the company was able to meet its lowered earnings expectations and did not have to lower future guidance.
Towards the end of the 4th quarter of 2016, Hazelton Capital Partners sold out of its FMC position. While we felt that the company and its fundamentals were improving with additional upside opportunity, there remained a large headwind impacting FMC and the