Graham & Doddsville Winter 2017 newsletter for the month of February 2017.
Michael Blitzer and Guy Shanon are the Managing Partners of Kingstown Capital, a value-oriented investment partnership that focuses on special situation securities across the capital structure. The firm was founded in 2006 with strategic backing from Gotham Capital and currently manages $1.8B. Michael and Guy both hold MBAs from Columbia Business School where they participated in the Value Investing Program and have taught Applied Value Investing as adjunct faculty. Michael currently serves on the Executive Advisory Board of the Heibrunn Center.
Graham & Doddsville
Graham & Doddsville (G&D): How did you both meet and how did the fund get started?
Michael Blitzer (MB): Guy and I have known each other for a very long time. We both went to CBS. I was ’04, Guy was ’99. We didn’t know each other while we were at Columbia, but at that point AVI [Applied Value Investing] was a very small network.
Guy Shanon (GS): So everyone knew each other from different years.
Michael Blitzer: Guy’s class had six people. They were the only six people at Columbia who were interested in value investing – it was 1999. There was no AVI. The program really grew from there.
Guy Shanon: Our initial investors and employees came from that network of students and professors.
Graham & Doddsville: We last spoke with you in 2010. How has the fund changed since then and what have you both learned?
Guy Shanon: The fund has grown but the strategy and portfolio structure are exactly the same. We still run a long-biased and concentrated portfolio of special situation securities across the capital structure.
Most of these securities are in the $1B to $10B enterprise value range for both equities and debt, though credit securities can be smaller. Being bigger also gives us research resources and access we just didn’t have when smaller, and the structure of the industry is making it harder for very small funds every year.
Graham & Doddsville: Why have you focused on that particular size?
Guy Shanon: I think one of the things we learned is that it is not so easy to make money with super small caps. You see a lot of questionable management teams and very low quality businesses which have not become bigger for what are usually good reasons. Then of course you have all of the extreme technical aspects, like if liquidity dries up that makes it even harder. Yes, there are sometimes great opportunities, and we look at small caps all the time, but they aren’t giving it away by any means, and focusing exclusively can be a tough way to make money over long periods of time.
We don’t think of ourselves as a big fund, and we think we can make the best risk-adjusted returns in the size range we currently target. The current portfolio runs the gamut from $300mm in market cap to $50B, so the range is wide and we look at everything. But the sweet spot tends to be this middle range which are small enough to still experience the technical factors that often lead to security mispricings but large enough to have quality of business and management. This size also tends to have a larger pipeline of the special situation categories we track like spin-offs and distressed debt.
Michael Blitzer: Also, there’s a big, timely debate right now about active versus passive investing. Passive has come into a lot of popularity. When we started twelve years ago, we maintained the premise that the markets are very efficient. Our strategy is to be exclusively focused on very small pockets of inefficiency within what is, generally, a very efficient market. We have to have the flexibility to go after companies that are smaller than $10B or $20B
Guy Shanon: And don’t have twenty sell-side analysts covering them.
Graham & Doddsville: As the number of special-situation funds grew, how has this impacted Kingstown? Have you been able to maintain an advantage?
Michael Blitzer: The longer we do this, duration of capital and time horizon has actually become more and more of a competitive edge. We’ve always defined the strategy as kind of having a medium-term time horizon, generally one to three years. These securities tend to have larger mispricings. A typical example is a situation that has a known or likely catalyst but unknown timing— you know it will happen sometime in the next three years, but it could be tomorrow or it could be years from now. Given the structure of the hedge fund industry and the structure of capital, this sort of patience becomes harder and harder over time unless you align yourself with long-term capital. So we’re clearly shorter-term focused than a private equity firm. But there are very few investors in the public markets right now who can take a one to two to three-year time horizon. Most can hardly take a month or a week. To take advantage of most of the mispricing, particularly in the special situation space, you have to have that kind of runway. Also there is a lot of capital coming out of event-driven strategies, which overlap somewhat with what we do, this is very good for us.
Guy Shanon: In the past twelve years since we started, time horizons have become a lot shorter. As students at Columbia and with the value-oriented internships you’ve had, you might not fully appreciate the low tolerance for volatility. If you go to some of these large multi-strat funds, time and volatility are very relevant because they’re running massive amounts of capital. In fact, they’ve attracted so many assets because they manage volatility so tightly. If you went to work there as analysts and you drew down a couple of percent in a month, you get stopped out. But then what do you do with that cash? You have to find another trade tomorrow – is that better than staying with the business you owned the day before? It just feeds the volatility. I think the fact that we only focus on very specific special situation categories also makes us unique. We don’t do risk-arb for example. We are just looking at certain areas where we know there are chronic mispricings. A lot of fire directed into a small area. That is what we do. And we have been doing it for a while and it works, and we get better at it every year.
Michael Blitzer: In addition to size and duration of time horizon, it’s also been concentration. We run a fairly concentrated and flexible mandate where we look across industry, geography, and capital structure. We think it is also a big advantage that we can evaluate the risk-reward across these different areas and pick our spots very precisely. Then obviously we combine all of this with what we like to think is a fairly deep research process. But you can only do that level of research if you’re concentrated. When you group it together, these things differentiated the firm initially and have been consistent through the life of the business.
Graham & Doddsville: How did you develop and cultivate an investor base that allows