Gate City Capital Management letter to investors for the third quarter ended September 30, 2015.
“Everyone has a plan until they get punched in the mouth.”
– Mike Tyson
Dear Investors and Friends,
While not always the most eloquent speaker, Iron Mike provides a vivid description highlighting the notion that events do not always go as planned. Investors attempt to reduce the damage that ensues when plans go awry through a process known as risk management. Risk management techniques such as conducting statistical analysis on historical returns, stress-testing the portfolio under various economic scenarios, and constructing elaborate hedging strategies can often be too smart for their own good. At Gate City Capital Management we take a simpler approach. We define risk as the possibility that an investment loses money, and our risk management process focuses entirely on the risk of losing money at the position level. When evaluating whether to allocate capital to any investment opportunity, we adhere to a phrase I learned in my own amateur boxing career at Notre Dame, namely “don’t get hit.” All trainees for the annual Bengal Bouts boxing tournament were required to shout this phrase in unison when our coaches would ask, “What is the number one rule of boxing?” These regimented chants instilled in me the importance of a good defense, or in value investing terms, a margin of safety. The words also have a certain resemblance to Warren Buffett’s two rules for investing, “Rule number 1: Never lose money. Rule number 2: Never forget rule number 1.”
At Gate City Capital Management, we avoid investing in companies where there is a risk of a permanent loss of capital. We search for companies with simple business models, clean balance sheets, and owned real assets and build our level of conviction through management interviews and plant tours. Despite these precautions, there are times when the stock prices of our portfolio companies decline in value. Although we look to be long-term investors in each of our portfolio companies, our decision on when to sell is quite simple and can be applied to almost any type of asset. We sell a company when the reason we bought it no longer exists. We formalize this process by preparing a write-up highlighting the key reasons for making the investment before allocating any capital. This preparation provides us with a plan of action should the stock price of one of our portfolio companies fall. If the price decline occurs with no change in our investment thesis, we have the conviction to maintain or even increase our position. However, if an event occurs that fundamentally alters our investment thesis, we will look to exit the position. In this way, we avoid the tendency some investors have of justifying the ownership of a poor-performing position by modifying their investment thesis midstream. We feel our two-step risk management process helps us avoid committing capital to companies that do not provide a substantial margin of safety while also providing a simple back-up plan should one of our investments not perform as expected. In this way, we look to avoid making poor, emotional decisions that often occur when fear and greed influence punch-drunk investors.
Gate City Capital – Returns:
Gate City Capital Partners generated a net return of -0.2% in the third quarter of 2015, compared to -6.4% for the S&P 500, -11.9% for the Russell 2000, and -13.8% for the Russell Microcap Index. Year-to-date, Gate City Capital Partners generated a net return of +9.0%, compared to -5.3% for the S&P 500, -7.7% for the Russell 2000, and ?8.6% for the Russell Microcap Index. Although the Fund delivered a slightly negative net return to investors during the quarter, we were pleased to largely preserve the purchasing power of our investors’ capital during a volatile period in the market.
Gate City Capital – Economic Commentary:
Economic news during the quarter was dominated by the Federal Reserve and their decision to keep the Federal funds rate unchanged at the September meeting. In making its decision, the Fed again cited low inflation but also raised concerns on market volatility and global economic growth. The market initially reacted negatively to the announcement as the potential timing of a liftoff from 0% interest rates became increasingly uncertain, but investors gained comfort from later Fed commentary suggesting a rate hike could be delayed for some time. We continue to be troubled by the Fed’s growing focus on placating the global financial markets when setting monetary policy. The Fed essentially provides interest rate guidance to the market through the use of dot plots, extensive commentary, and countless public appearances. As the late Yogi Berra said, “It’s tough to make predictions, especially about the future.” In a global economy with an infinite number of economic, financial, and political variables, it is impossible to predict what the appropriate level of interest rates will be one month from now, not to mention two or three years in the future. The Fed’s poor track record in prior forecasts makes this all the more evident. We feel that the Federal Reserve should set the Federal funds rate during each meeting at the rate they feel best promotes long-term economic growth for the United States of America and maintain as much flexibility as possible for setting policy at future meetings. Similar to a public company that may be motivated to make poor long-term decisions in order to achieve short-term guidance, the Fed risks further reducing its independence in order to fulfill implicit promises it has made to the market. With interest rates already at 0%, the Fed has few levers to pull aside from additional quantitative easing should the U.S. economy enter a recession. In the event that prior rounds of quantitative easing and monetary stimulus result in inflation, the Fed will find it extremely challenging to raise rates and risk negatively impacting the prices of financial assets in a world already awash in low interest debt.
Investors also became increasingly concerned about China’s slowing growth and the potential ramifications for the global economy. Over time, investors grew too comfortable that China’s multi-decade streak of economic growth and unending demand for raw materials could continue unabated. Doubts regarding the sustainability of Chinese growth have led to a risk-off mentality where investors look to reduce exposure to companies and countries dependent on Chinese demand. The Chinese government’s reputation for secrecy increases the level of uncertainty for investors, with many investors referring to the Chinese economy as a black box. We have no special insight, but believe it can be helpful to identify what we do know about the country. Despite numerous reforms, China continues to be a planned, state-controlled economy. Some market participants take comfort in this, believing the Chinese government can create economic growth simply by flipping a switch. However, planned economies that ignore Adam Smith’s invisible hand often result in a misallocation of resources as capital is deployed not to the area of highest return but to projects mandated by the state. Encouraging the Chinese government to correct prior misallocations of resources by pursuing additional investments likely only compounds the problem. China does have some precedent here, with an example being a policy to promote steel