Barry Pasikov year-end letter to Hazelton Capital Partners.
Hazelton Capital Partners, LLC (the “Fund”) gained 12.1% from October 1, 2013 through December 31, 2013, increased 48.6% year-to-date, and has returned 88.7% since its inception in August 2009. By comparison, the S&P 500 gained 10.5% in the same quarter, increased 32.4% year-to-date and has returned 96.8% since the Fund’s inception.
Hazelton Capital: The Funds Performance – The Year in Review
Hazelton Capital Partners ended the 4th quarter with a portfolio of 18 positions, a cash level of 22% of assets under management, and averaged just over 25% in cash throughout the year. As of year end, The Fund’s top five portfolio holdings were: Western Digital (WDC), DreamWorks Animation (DWA), Xerox Corp (XRX), Northern Tier Energy LP (NTI) and Marvel Tech Group (MRVL). These top five holdings represent 35% of the Fund’s assets and accounted for over 50% of the years profits. Beginning in the 3rd and into the 4th quarter of 2013, Hazelton Capital Partners added five new positions to the portfolio. Northern Tier Energy, an oil refiner, was the biggest investment of the five. More capital was invested in the 4th quarter of 2013 than any other quarter during the year. It just so happens that more positions were sold in the 4th quarter than any other quarter of the year, as well. The purchases and sales were executed independent of one another.
Sears Hometown and Outlet Stores (SHOS) – Closed Position -15% Loss
Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) was spun off from Sears Holdings Corp (NASDAQ:SHLD) in October of 2012. The stores, primarily franchised or dealer operated, focus on selling home appliances, hardware, and lawn and garden equipment. Operating with of a much smaller footprint than its competitors, SHOS has the flexibility to open stores in large mall settings, community shopping centers, strip malls, as well as urban store fronts. Since most home appliances (Washer/Dryers, refrigerators, ovens, etc.) need to be delivered and installed, Sears Hometown and Outlet Stores is able to take advantage of the growing “showrooming” trend by only maintaining floor models. By ordering its appliance directly from Sears (SHLD), Sears Hometown and Outlet Stores is able to utilize Sears’ (SHLD) purchasing power (SHLD is one of the largest buyer of appliances in the US), as well as its delivery and installation infrastructure. Moreover, with Sears Hometown and Outlet Stores ability to leverage off of the “Sears” brand and marketing power, Hazelton Capital Partners felt that SHOS had an additional competitive edge to compete successfully against other appliance retailers, such as The Home Depot, Inc. (NYSE:HD), Lowe’s Companies, Inc. (NYSE:LOW) and Best Buy Co., Inc. (NYSE:BBY). Additionally, Hazelton Capital Partners believed a strengthening housing market would only add a tailwind to what has been a very challenging appliance retail market over the past couple of years. Recently, SHOS has been strategically opening new stores in close proximity to a Sears’ (SHLD) store that was in the process of being closed down in order to capture a customer base that might have otherwise been lost. The combination of Sears Hometown and Outlet stores competitive advantages, together with its favorable financials, led Hazelton Capital Partners to believe that SHOS would be a profitable investment.
Hazelton Capital Partners failed to fully understand that many of Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) expected competitive advantages from its close association with Sears (SHLD) were actually eroding. Sears (SHLD) originally began as a mail order catalog, but expanded its business and developed into a department store. Over time, Sears found its footing as a discount retailer and, until 1989, was the largest retailer in America. Today, Sears has been surpassed by companies, such as Wal-Mart Stores, Inc. (NYSE:WMT), Target Corporation (NYSE:TGT), Best Buy Co., Inc. (NYSE:BBY) and The Home Depot, Inc. (NYSE:HD), as it continues to spend little to no money on expanding or even maintaining its brand. Its stores are antiquated and run down, reflecting the community it serves. Customer service is non-existent and its merchandise is outdated. These factors have all had a negative impact on the company’s brand and strength within the retail market.
Initially, Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) appeared to be a smaller more maneuverable retail vessel that was tethered to Sears Holdings Corp (NASDAQ:SHLD)’s Titanic purchasing power, delivery infrastructure, marketing and brand prowess. But after further evaluation, it became clear that Sears (SHLD) brand erosion was negatively impacting Sears Hometown and Outlet Stores, as well. The question that Hazelton Capital Partners cannot fully answer is whether Sears’ (SHLD) purchasing power and delivery infrastructure will or has been negatively impacted. Realizing that Sears Hometown and Outlet Stores retailing strength and future is tethered to Sears (SHLD) did not provide Hazelton Capital Partners any solace, even as many smart investors consider Sears (SHLD) to be “unsinkable.” Hazelton Capital Partners decided to exit the position at a loss.
Northern Tier Energy – Current Holding
The United States oil refining industry is highly fragmented with approximately 140 refineries and a throughput of almost 18 million barrels per day (bpd). It is also highly concentrated with the top five refiners representing nearly 50% of the US total refining capability. Oil refiners generate profits by purchasing crude oil, processing it into petroleum products, such as gasoline, diesel fuel, jet fuel, heating oil and asphalt, and then selling those products into the retail or wholesale market. The difference between the price at which a refiner can purchase its crude oil, refine it and then sell the petroleum products is referred to as the company’s “crack spread.” The crack spread is directly correlated to a company’s profitability; the greater the crack spread, the greater the company’s profitability. Hazelton Capital Partners has generally shied away from the refining industry simply because there are too many factors beyond a company’s control (price of oil, cost of refining, the economy, and changes in consumer sentiment) that can negatively impact its margins. Add into the mix a large number of players, and you have the makings of an industry that will be driven by irrational behavior and little control over its destiny. But Northern Tier Energy is unique in its ability to maintain a strong profit margin by sourcing cheap crude oil and the niche market it services. Additionally, NTI’s corporate structure also plays a role in its competitive edge.
Northern Tier Energy is located in St. Paul, Minnesota and has a refining throughput of approximately 92,500 bpd. In refining, as in real estate, there are three things that matter: Location; location; location. St. Paul’s close proximity to North Dakota provides NTI the competitive advantage of sourcing its light sweet crude oil from the Bakken Shale, a growing source of domestic oil. At nearly 1 million bpd, the Bakken Shale represents over 10% of the US domestic oil production and has doubled its output since January of 2012. This rapid production growth is causing Bakken oil to sell at a discount to the West Texas Intermediate (WTI) benchmark, as the Bakken lacks the transportation infrastructure (rail and pipelines) to easily transport its oil to refiners. These factors benefit Northern Tier Energy, providing the company with the cheapest source of light sweet crude in the United States. Location also plays a role in the market that Northern Tier Energy serves. The majority of the company’s gasoline, diesel, and other distillates are sold in the retail and wholesale markets of Minnesota. Because of the way the United States refining capabilities have been divided, there are months (mostly summer) where Minnesota’s gasoline demand cannot be satisfied by the regional refineries and additional product must be trucked into the market, adding to the wholesale price of gasoline. NTI benefits from the higher wholesale gasoline price while its own transportation costs are significantly lower.
Structured as a Master Limited Partnership (MLP), Northern Tier Energy is able to avoid paying corporate taxes. A MLP is a publicly traded partnership; essentially a “pass through” entity that distributes a majority of its earnings directly to its limited partners (unit holders). This distribution is often looked upon as a dividend, but in NTI’s case, it is taxed as ordinary income to the unit holder. Many investors are attracted to MLPs because they offer a high “dividend yield.” Hazelton Capital Partners likes the fact that NTI is structured as a MLP for two reasons: First, there is no compelling rationale for NTI to build up a cash reserve beyond its limited yearly or its more significant five year turnaround maintenance needs. Unless sentiment changes dramatically, the chance of building a new refinery in the United States is very remote, and acquiring an existing refinery would most certainly mean diluting NTI’s competitive edge and its profitability. Second, since there are no good options to grow or reinvest in the business, distributing the company’s earnings greatly reduces the chance of management doing something idiotic with its cash balances.
Hazelton Capital Partners had originally researched NTI in February of 2013 and found it to be a compelling investment, except that at $27.00/unit, it did not provide a large enough margin of safety (downside protection). In early summer of 2013, negative sentiment began developing around Northern Tier Energy’s crack spread. Additionally, NTI began their scheduled five year turnaround maintenance in the 2nd half of 2013, which meant that its earnings, and therefore its “dividend,” would be lower for the 2nd half of 2013. Both of these issues were short-term and cyclical in nature, having little impact on the company in the long-run. By the middle of September 2013, as the price of the stock declined to $19.00/unit, Hazelton Capital Partners invested in Northern Tier Energy, making it the fourth largest position in the portfolio.
Hazelton Capital Partners’ Investing Process
Hazelton Capital Partners’ strong performance for 2013 was a direct result of the Fund’s emphasis on portfolio management. Together, with research, portfolio management forms the foundation on which Hazelton Capital Partners’ investing process is built. Research identifies unique, undervalued portfolio prospects, while portfolio management decides whether the prospect “fits” within the portfolio and, if so, how much capital to allocate. Since the portfolio is restricted to 20 positions, each investment needs to meet a number of criteria. These criteria concentrate on the investment’s balance sheet, the correlation between investments, whether an investment provides sufficient downside protection, and a conservative valuation of the upside opportunity. Any new investment will need to not only meet these benchmarks but provide a greater upside potential than a current holding. Replacing investments within the portfolio does not happen routinely; but when it does, it upgrades both the quality and upside potential of the portfolio.
When determining how much capital to allocate to a position, Hazelton Capital Partners calculates three price levels: The price at which the Fund will initiate a position, the price at which the Fund will continue to add to the position, and finally, the selling price. The size of a starting position is at least 3% of the Fund’s total assets. This number is not arbitrarily chosen. A 3% position represents an outlay meaningful enough to impact the portfolio, while providing the flexibility to continue to build the investment if the price of the stock were to continue to decline. Hazelton Capital Partners purposely concentrates a disproportionate amount of its capital to its most undervalued investments. Historically, the Fund’s top five positions have ranged between 30% and 45% of total assets. This “top heavy” structure reflects the Fund’s strong commitment to getting the best value and performance for its money. Hazelton Capital Partners’ cash levels are not a premonition of future events, but a by-product of the investing process; the more investment opportunities, the lower the cash levels.
During the year, two of the Fund’s top five portfolio positions, Telular Corporation (NASDAQ:WRLS) and Michael Baker Corp (NYSEMKT:BKR), were taken private, accounting for 700 basis points (7%) of the year’s overall return. When the Fund invests in a company, the exit strategy is never dependent on the company being sold. The investment is made due to a favorable balance sheet, cash flow generation, downside protection and the strong belief that the market is mispricing or undervaluing the company’s true economic earnings potential. A buy-out is just one of the ways that the company’s market capitalization can be revalued. Since its inception nearly 4.5 years ago, five of the Hazelton Capital Partners’ positions have been taken private or purchased by another company. Of those five positions, four were a top five holding within the Fund.
Inigo Montoya: You know, Fezzik, you finally did something right.
Fezzik: Don’t worry, I won’t let it go to my head.
–The Princess Bride
Hazelton Capital Partners is approaching 2014 with cautious optimism, not from a macro or economic perspective but with the anticipation that the Fund will continue to find new investing opportunities to deploy more of its capital. Hazelton Capital Partners has developed a maxim that helps guide the investing process: Confidence is needed to be successful, but overconfidence is what destroys successful careers. One must not let past successes cloud future investing decisions. It is crucial to shed past biases and approach every investment, even current portfolio holdings, as if looking upon them for the first time. Each new year provides a great opportunity to refine the investing process, to learn from past mistakes and focus on gaining new insights. Last year was a strong year for Hazelton Capital Partners – “Don’t worry, I won’t let it go to my head.”
Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest along-side me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners assets in the same manner in which I manage my own capital. The best source of introduction to potential investors in the Fund has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me.
From my years of experience in business and investing, I have come to learn that trust is earned, not bestowed. It takes years of hard work to earn someone’s trust, but only a few seconds to destroy it. I do not take your trust in me lightly and pledge to continue to go beyond what is required to meet your expectations. The goal of Hazelton Capital Partners is to repay your trust with returns that will outperform the market. Please do not hesitate to call me at (312) 970-9202 or email me firstname.lastname@example.org with any of your questions or concerns.