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 TysonSeth Klarman Describes His Approach In Rare Harvard Interview
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
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 production during the Great Leap Forward of the late 1950’s. This policy resulted in mass deforestation, food shortages, and the production of poorquality steel as peasants were encouraged to meet production goals by manufacturing steel in backyard stoves. We suspect that Chinese growth targets will continue to be met, but also expect to see increases in debt, the construction of unnecessary projects, and continued manipulation of economic data. As a result, we continue to avoid companies that are dependent on China for their sales and profits.
Gate City Capital – Financial Market Commentary:
U.S. equity markets fell sharply in the third quarter, as weakness in the Chinese economy and uncertainty from the Fed led investors to reduce their exposure to equities. Small cap stocks underperformed, as investors looked to reduce risk from their portfolios. From a sector perspective, utilities outperformed as lower interest rates and the sector’s reputation for steady cash flows attracted investors. Energy and materials were the worst performing sectors, hurt by falling commodity prices. The healthcare sector also underperformed as investors became increasingly concerned with extended biotech valuations and politicians expressed displeasure at rising drug prices. International stocks fell sharply, with Chinese weakness spilling over to other emerging economies and commodityexporting countries such as Australia, Brazil, and Canada. Commodity prices dropped on the previously noted concerns on the Chinese economy. U.S. Treasury prices rose during the quarter, as slowing global growth and a Fed on hold contributed to a flight to safety.
During the quarter, several prominent investors spoke to the potential dangers on the growing popularity of exchange traded funds (“ETFs”). We thought it would be a good time to highlight our thoughts both on investing in ETFs and as an extension to passive investing and index funds. ETFs are exchange-traded securities generally designed to replicate the performance of a financial market index, helping investors gain exposure to certain asset classes while also providing diversification, low fees, and intra-day liquidity. Recently, the liquidity of certain fixed-income ETFs has recently been called into question. We share this concern, as ultimately an index can only be as liquid as the individual securities that comprise it and many of the underlying bonds and loans included in ETFs have light trading volume. The collapse in the price and liquidity of certain securitized products (which were created by combining pools of illiquid assets) during the financial crisis provides further evidence of this concept.
While liquidity risk is certainly something investors should be aware of, we also wanted to raise an additional academic critique regarding ETFs and passive index fund investing in general. Before doing so, we find it important to note that active fund managers have historically underperformed passive index funds over extended periods of time. That being said, we would note that most stock market indices (including the S&P 500, Russell 2000, and Russell Microcap) are market-weighted indices where each company’s weight in the index is generally proportional to the relative size of the company as measured by its market capitalization. Thus, the biggest companies also have the largest weights in the index. This approach is consistent with modern portfolio theory and extends beyond stocks to all global assets including bonds, commodities, and real estate. The issue we have is that this approach assumes all assets are correctly priced at all times. If for whatever reason, one security or asset class is overvalued, it will also command an outsized allocation within the index. Should more investors rotate money into the index, the problem is compounded as new money is invested in assets which are already overvalued. This process resembles some momentum-based investment strategies popular with many technical investors (where winning positions are added to and losing positions are exited) but is a process generally shunned by contrarian-minded, value investors. Should the overvalued security or asset class decline in value, the investor is left with larger losses than would otherwise be the case given the prior outsized allocation within the index. This scenario played out during the tech bubble crash in 2000 and the financial crisis in 2008 (tech comprised 34% of the S&P 500 in 2000 and financials comprised 22% of the S&P 500 in 2007) as active managers outperformed index funds during both periods. We are concerned that the massive asset rotation to ETFs and index funds could compound this problem in the future, especially when a period of unprecedented monetary policy risks the formation of bubbles across several asset classes. While active management does have numerous drawbacks including trading costs, higher management fees, and the fallibility of human portfolio managers, we believe that our consistent investment process focused on deep value companies with clean balance sheets and significant margins of safety should outperform formula-based index funds over the long-term.
Gate City Capital – Portfolio Commentary:
The Fund ended the second quarter with 15 positions and 6% of the portfolio invested in cash. The largest position was 17% of the portfolio and the top five positions made up 54%. The Fund added one new position and exited three during the quarter. Scott’s Liquid Gold (SLGD) was the largest contributor to performance, rising 43% during the period. As highlighted in our Q2 2015 letter, we added to our position in Scott’s following a sharp sell-off in the stock price at the end of Q2 and beginning of Q3. This had a positive impact on the Fund’s performance. Similarly, during the recent market downturn we added to several core positions when share prices declined without an underlying change in the business fundamentals. In both instances, we followed the decision-making process described in this letter’s introduction.
Our portfolio continues to consist entirely of deep-value microcap companies that we believe provide investors with both attractive upside potential and a considerable margin of safety. Our portfolio is representative of our investment process, as our average portfolio company has a price/book ratio of 1.1x and an Enterprise Value/EBITDA ratio of 4.5x. These metrics compare favorably to the S&P 500, which has a price/book ratio of 2.7x, and an Enterprise Value/EBITDA ratio of 11.4x. We continue to invest in companies with clean balance sheets, with 11 of our 15 portfolio companies having more cash than debt on their books. Our portfolio is diversified by sector, with 27% of the portfolio in industrials, 19% in real estate, 17% in consumer products, 13% in gaming, 7% in telecom and technology, 5% in distribution, 6% in retail, and 6% in cash. The average portfolio company has a market capitalization of $49 million and an enterprise value of $32 million.
At Gate City Capital Management, we look to build constructive relationships with the management teams of our portfolio companies through in-person meetings and facility tours. One additional way we differentiate ourselves from other investors is through our attendance of annual meetings. In today’s digital world, it is easy to vote proxies electronically and avoid the hassle of attending meetings in person. We take an alternative approach and view the annual meeting as an ideal time to meet and interact with the entire management team including the CEO, CFO, and the board of directors. Additionally, management teams tend to appreciate the interest we show in being a long-term owner of a company. In this quarter’s position commentary, we highlight Barnwell Industries, a company where we were the only outside investor in attendance at this year’s annual meeting. Our interaction with the management team during the annual meeting led to an invitation to tour Barnwell’s Hawaiian real estate assets. We accepted their offer, and in May of this year traveled to Hawaii to see the properties first-hand. The visit provided as with a greater appreciation for the value of the Company’s real estate and gave us with the conviction to make Barnwell a sizeable position in our portfolio.
Gate City Capital – Position Commentary:
Barnwell Industries, Inc. (“Barnwell”, “BRN”, or the “Company”) owns luxury real estate interests in Hawaii, engages in oil and gas production in Canada, and operates a water well drilling business in Hawaii. The Barnwell Drilling Company was incorporated in 1956 by founders R.S. Barnwell Sr. and Morton Kinzler. The Company initially drilled oil wells in East Texas and Northern Louisiana but refocused drilling efforts to Canada during the 1960’s. Barnwell’s expertise in drilling wells led the Company to expand into geothermal exploration in Hawaii in the 1970’s. Following the default of a Hawaiian customer for unpaid drilling services, Barnwell came into possession of a significant amount of land near Kona on the island of Hawaii. The Company moved its headquarters to Honolulu in 1980 and is now known as Barnwell Industries, Inc. Barnwell has 37 full-time employees.
Barnwell’s land ownership interests are located north of Kona on the Big Island of Hawaii, approximately 6 miles from the Kona International Airport. The area, known as Kaupulehu, features several luxury accommodations including the Four Seasons Resort Hualalai, the Kona Village Resort, Kukio Resorts, and two premier golf courses. Barnwell has ownership interests on 870 acres of land in Kaupulehu, known as Lot 4A. These 870 acres are divided into two increments. Increment I consists of 110 acres of land developed for 80 single-family lots. Increment II consists of 760 acres of land zoned for single and multi-family residential housing, a golf course, and a small commercial area. Maps of the area and development plans are provided below.
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