Hazelton Capital Partners commentary for the second quarter ended June 30, 2017.
- Q2/H1 Hedge Fund Letters – Letters, Conferences, Calls, And More
- After Blaming Fake News For Trading Problems, “Oil God” Andy Hall Shuts The Door
- Finding Reinvestment Moats
Hazelton Capital Partners, LLC (the “Fund”) gained 2.0% from April 1, 2017 through June 30, 2017, gained 8.1% year-to-date and has returned 99.1% since its inception in August 2009. By comparison, the S&P 500 gained 3.1% in the same quarter, increased 9.34% year-to-date and has returned 175% since the Fund’s inception.
The Quarter in Review – Position Updates
Hazelton Capital Partners ended the 2nd quarter with a portfolio of 17 equity positions and a cash level equivalent to nearly 24% of assets under management. The top five portfolio holdings, which are equal to over 41% of the Fund’s net assets, are: Western Digital (WDC), Micron Technology (MU), Apple Inc (AAPL), USA Technologies (USAT) and Renewable Energy Group (REGI). Throughout the quarter, the Fund pruned its portfolio, selling its Enernoc (ENOC) position, scaling back on Softbank (SFTBY), and redeploying some of the capital back into current holdings. No new positions were added to the portfolio in the 2nd quarter.
Providing guidance or meaningful commentary on the current market is a bit like forecasting the weather in Palm Desert, California during August. Each day is very similar to the previous one until one day it isn’t. Moreover, with the VIX trading at 10-year lows and the indexes hitting new highs, it appears that the equity markets have become complacent to any rising geopolitical issues impacting the world: North Korean aggression, rising tensions with Russia, and Trump still believing that his presidency is a reality TV show complete with daily tweets and firings.
“Everybody wants happiness, nobody wants pain, but you can’t have a rainbow without a little rain.” - Unknown
With US equity markets hitting new highs, many market pundits are calling for caution - advising investors to move into cash and/or hedge their current positions. A market decline is not a bad thing. In fact, as long as a company’s fundamentals have not changed, Hazelton Capital Partners often takes advantage of market sell-offs as an opportunity to enter into or add to a current holding. It is important to remember that a market decline does not mean that every position will decline or decline in tandem with the market. Hazelton Capital Partners positions itself for a possible decline in the market the same way it prepares for a potential market rally by pruning back positions, selling out of companies whose investing thesis has failed or has been achieved, and redeploying the capital into new or existing positions. The first line of defense against a downturn in the market are the positions in the portfolio and the level at which those positions were purchased. Cash levels in the portfolio are an indication of market opportunities, not its future direction.
When focusing on a long-term investing strategy, one must understand that the path to financial success is littered with potholes, twists, and turns. The journey is not a continuous smooth trajectory higher. Sometimes, share prices need to go lower, allowing for capital to flow from weak to strong hands, before it can regain its momentum higher.
Besides running a concentrated portfolio, another major component of Hazelton Capital Partners’ portfolio management is to maintain a long-term investment outlook. A good deal of thought went into determining what constitutes a “long-term” investment horizon, especially in today’s short-term focused environment. A 5-year time horizon was chosen, in part, because it reflects a classic business cycle: 1-1.5 years of contraction, 1 year of recovery and roughly 3 years of expansion. Early into an investment, it is difficult to differentiate between an investment thesis that was “too early” or one that was “just plain wrong.”
Maintaining a 5-year investment horizon not only provides adequate time for an investment thesis to develop but after 2 years, it should become clear to an investor whether one’s investment thesis is accurate or unsound. The Fund recognizes that not every position will be held for at least 5 years; however, having a long-term outlook encourages investing patience and ensures that the expected investment return is commensurate with a long-term holding period. Currently, the average holding period for our top five positions is 3.5 years.
Western Digital Update
Over the last few months, Western Digital and Toshiba Corp have been embroiled in a legal dispute over their joint venture (JV) that manufactures NAND flash. The battle began soon after Toshiba recorded huge cost overruns and losses from the nuclear power division it purchased from Westinghouse. In order to cover those losses and underpin its balance sheet, Toshiba has been forced to sell its prized NAND Flash business that is jointly owned with Western Digital. According to Western Digital, the terms of their joint venture require Western Digital’s approval before Toshiba can sell its stake. Even though Western Digital is also one of the bidders for Toshiba’s portion of the JV, Toshiba has ignored Western Digital’s claim and has chosen a consortium that includes Bain Capital, and rival NAND manufacturer SK Hynix as its lead bidder. In May, Western Digital began arbitration proceedings over a potential sale, stalling the transaction.
With all this uncertainty, why continue to own Western Digital?
Western Digital has been a centerpiece of the portfolio for 7.5 years and a top 5 holding for the past 4 years. Over that period of time, uncertainty has consistently hung over this company like the Sword of Damocles. At the time of our initial investment in 2009, Western Digital was a hard disk drive (HDD) manufacturer with a 30% market share. The major reason why the company’s stock was so cheaply priced was because the market believed Western Digital would follow the same path as Kodak and Motorola, pioneers and innovators of their industry, who failed to transition to the new burgeoning mobile world. NAND flash storage is the technology used in all mobile devices and is a more advanced technology than HDD: It is faster, lighter, has a smaller footprint, and uses less energy - perfect for mobility. In late 2015, to remedy its dependence on HDD, Western Digital announced the purchase of SanDisk (a leading manufacturer of NAND and JV partner with Toshiba).
The digital storage industry has historically been plagued with technology obsolescence, fierce competition, and quick, repetitive business cycles. These factors still exist, but their impact is muted as the industry has matured and consolidated. With the speed of technology innovation slowing, and the cost to retool becoming more expensive, the duration of a digital storage business cycle has expanded. As many in the industry have become “rational” about their investments, the peak to trough of the cycle has also become less dramatic.
Western Digital is currently trading around 7x earnings and below that for earnings projected out to 2018 - Not quite the levels when the Fund initially invested in the company, but cheap nonetheless. The company’s current free cash flow run rate is $3 billion and it expects to add another $300 million from ongoing integration of both HGST and SanDisk by year end. Hazelton Capital Partners