Meson Capital partnership letter for the second quarter ended June 30, 2015.
Our net performance for Q2 was 14.1%, vs. indices (in order of relevancy for comparison) of: 2.5% Barclay Hedge Fund Index, 0.1% Russell 2000 and 0.2% S&P 500. Our YTD performance is 0.7% vs 3.4% Barclay Hedge Fund Index, 4.1% Russell 2000 and 0.2% S&P 500. Our portfolio averaged approximately 15% net long on a dollar basis for the quarter and 60% net short on a beta adjusted basis relative to the market. This is due to our shorts being high beta, speculative low-quality stocks. Given the breadth of available short opportunities, we continue to think it wise to hedge and position ourselves for a profitable outcome when an inevitable market correction finally arrives. Having purchasing power when others do not during market dislocations is the best source of returns in the long run.
The most meaningful event of the quarter was our transition at InfuSystem, our largest holding. After three years serving as Chairman of the board, the first two years of which were in an Executive role, I passed the baton to Gregg Lehman, whom I recruited last year. I continue to serve as the largest shareholder on the board and believe that the business is doing extremely well. InfuSystem has been a major success for us as well as shareholders during our involvement and is now on a solid growth trajectory with capable management.
Where we can generate the most unique value investing in and actively directing companies is during business transition periods. For InfuSystem that meant first turning the ship away from imminent bankruptcy three years ago and building a foundation to invest and build for growth – a three step process. There are different types of leaders who shine brightest during ‘wartime’ or ‘peacetime’, rarely both. We are most definitely the type that thrives on navigating those apparently uncertain times that requires intense focus to reduce risk and generate a profitable outcome.
InfuSystem is now the second activist investment where we have delivered a 3X return to our investors and public shareholders. Our first was HearUSA where we participated from the equity committee and sold the company to the largest supplier in under a year. Both began as turnarounds, giving us a great deal of insight into the chaos during leadership transitions and how to navigate through that. One insight gained is that it is only a sale or growth that gets credit from the public market to raise the stock price – the initial turnaround phase can be a thankless job but is a necessary first step.
This recent transition to a less active role at InfuSystem gives us the bandwidth to pursue our next big investment and we have already begun ramping up efforts on this. I believe this new activist project has the most upside potential with the fewest risk exposures of anything that I have worked on previously and can produce a 5-7X return in three years. Unlike InfuSystem which began as a turnaround situation and we could only focus on investing for growth after two years of ‘clean up’, this situation requires no mess to be sorted while enjoying a similarly low initial valuation. I look forward to keeping you updated on this at the appropriate time in the future when we are able to be more public.
Meson Capital - Test of Will: Geeknet gets Acquired
We run many different kinds of screens to search our universe of over 5,000 small and microcap stocks in the US. Some search for clues about high quality management while others try to identify factors that would lead other investors to misunderstand that situation. In the case of Geeknet, it was a company that remained after its parent business was divested – a complex and obfuscating corporate transaction. Two years ago we found an interesting clue to the savvy of management: as they were to be delisted from the Russell 2000 index, management commenced a tender offer to buy out the 6% of the shares to be mindlessly sold by the index funds at a bargain price of $14/share.
The company had a new CEO in place and as a newly independently run concern seemed like it would be more able to harness management focus on scaling the business that had been steadily growing for years. The business is a designer and online retailer of uniquely geeky toys and apparel – think Urban Outfitters or Spencer’s meets the Big Bang Theory. A bargain purchase price with quality and focused management looked to be a good opportunity.
The stock did well for the first two quarters for us as they headed into what seemed to be a solid holiday season. Then it hit an air pocket. The stock gapped down sharply after reporting 2013 holiday revenue and especially profits that were disappointing and consumers were upset over shipping delays. The company had been investing in rebuilding their platform to scale to a much larger company and had to make a step-change in its infrastructure. It proved too much for the holiday crunch and the wheels came off.
There are almost always tests of will as a long term investor – a stock (or investment manager for that matter) that you have a 2-3 year thesis about will have some period where it declines 25% or maybe even 50% for more volatile small companies. This may be from less than perfect business execution or maybe for no reason at all. There is always a decision point presented: buy/sell/hold at the newly lower price? If research indicates there was no fundamental reason for the decline then buying more is probably a good idea – but what if things are a bit, say 20%, worse than you expected but the stock overreacts down 50%? This is where intellectual honesty is most key and admitting when and how you’re wrong is imperative. To highlight a current mistake - Hooper Holmes is in this investigation category for us right now, the stock has declined sharply on poorer results than expected that we are currently digging deeper into.
Our general rule is that any 20% decline merits a meaningful research review to revisit the initial thesis and a fresh look. Especially for small companies, generally management quality and their intellectual honesty will be our deciding factor. If a company underperforms expectations and management is full of excuses – there is probably a good chance that you should admit you were wrong and just sell. On the other hand, if management is candid about their mistakes then they’re likely already half way to fixing the situation: in the short term the market rarely discriminates this subtlety and if anything gets it backwards. Based on my turnaround experience, I’ve developed a saying that “having problems is often correlated with not admitting those problems.”
In the case of Geeknet, management was extremely candid about their missteps and over the next year we were presented with an opportunity to add to our position as the stock drifted down so low as to be at cash liquidation value! While our initial thesis and estimate of value had to be adjusted downward somewhat, the price – value gap widened even more and management’s intellectual honesty (and our confirmatory due diligence) gave us comfort in the long term prospects. The company was just recently acquired at a 40% premium to our initial purchase price two years ago but our profit was closer to 60% thanks to Mr. Market giving us an opportunity to lower our basis after overreacting to the short term.
Meson Capital - A Radical Idea for Activist Investors
Earlier this year the WSJ published an article with the above title to be provocative amidst the constant activist stories demanding dividends, stock buybacks, spinouts, cost cuts or outright company sales. According to Factset, 84% of activist holdings are for less than two years. Instead – what might happen if there were “adversarial long-term investors” that demanded more investment into a certain area? Factset has over 20 tags such as “initiate dividend” but doesn’t even track “increase investment” as a category because it’s so rare.
This “business building” activism is actually what we have been cultivating as a style for some time now and oddly enough we drifted into it out of necessity as much as from tastefulness. We have a great deal of admiration for ValueAct Capital who have been practitioners of this style at larger companies, notably Valeant Pharmaceuticals. A key problem with the “sell the company” form of activism is that there is rarely a plan B if it fails – and it often does, as we first learned with InfuSystem after a regulatory change (since resolved) chilled potential buyers that were eager to acquire during our proxy contest three years ago. The “dividend/buyback/spinout” strategy is also extremely challenging for the microcap companies that we traffic in. Firstly there are rarely multiple divisions to be broken up at sub $200mm companies and secondly, since Sarbanes-Oxley there is a meaningful ~$2mm fixed cost burden to be publicly traded and shrinking the capital base proportionately increases this burden.
The final reason the business building strategy is rare is because it’s harder! It’s a lot easier to attack problems than to have a vision for growth and investment for a bigger future, entrepreneurs are rare and challenging to hire. We have always been looking for ways to have a differentiated competitive edge and in today’s environment – many of the easy/overcapitalized potential activist targets have been agitated enough already. We will continue to bring a more entrepreneurial business building approach that we have spent years developing and recently have begun a step change to increase our capacity partnering with experienced operators. Notably at smaller companies – a more intellectually honest and aggressive management team does not need to fight the substantial inertia present in larger targets and so can generate more impressive returns.
From an investment perspective – whether we are the ones doing the heavy lifting or someone else – we see a recurring pattern. When a management team is investing heavily in the business that causes earnings to be depressed, the stock will languish. However, once the investments prove their worth in the form of increased net income per share – the stock will rapidly show up on the “P/E” screens most investors follow and can jump rapidly. There is nuance to understanding the accounting as some businesses expense their growth in the form of increased headcount or R&D and others can capitalize it (especially retailers) which can generate excellent short opportunities as the EPS growth is actually value destructive. We can leverage our experience as business builders by identifying value creating investments that depress earnings in the short term and get in one step ahead of all the value-screeners looking for already rising net income and paying up for that.
Overall I have been satisfied with the business performance of both our long and short positions and am confident the stock prices will reflect this over the next year or two. I am eager for a less frothy market environment where our defensive business-focused positioning can separate us from the crowd.
Meson Capital - Positioned for a Challenging Market Environment: 99th Percentile Market Valuations
We continue to see data indicating the market is at or near all-time high valuations (Goldman indicating 99th percentile now) which means low return expectations for the average investor going forward 5-10 years. We have spent the last 6 years building a cumulative toolkit and reputation to be anything but average, with occasional demonstrations of capability along the way. While the opportunity set for passive investors has shrunk with the rising market, our ability to actively create business value while protecting ourselves with our short book gives us plenty to work on. After achieving a 3X return in HearUSA and InfuSystem, I’m confident our newest activist project that we are currently ramping up on will be our best to date.
I continue to have virtually all of my net worth invested alongside investors in the Partnership and recently added to my investment in the fund.
Please email me at email@example.com or call at 607-279-5382 if you have any questions or are interested in investing with us or co-investing in our upcoming new activist idea. As always, thank you for reading.
Meson Capital Partners LLC