Value Investing

Meson Capital 2015 Annual Partnership Letter

Meson Capital annual partnership letter for the year ended December 31, 2015.

Dear Partner,

Our net performance for Q4 was 4.9% vs. indices (in order of relevancy for comparison) of: 1.9% HFRI Equity Index, 3.2% Russell 2000 and 6.5% S&P 500. For the year ended 2015, our net performance was 4.0% vs (0.8)% HFRI Equity Index, (4.4)% Russell 2000 and 1.4% S&P 500. Our portfolio averaged approximately 20% net long relative to the market.

Meson Capital

Our returns have been uncorrelated with other equity hedge funds (-8% correlation) and the S&P 500 (-11% correlation). In contrast the HFRI Equity Index has been 86% correlated with the S&P 500 over the last 2 years. The drivers of our returns are from specific business performance rather than the mood of the overall market. We also invest in original, less crowded investment ideas.

Although I believe that our long term performance potential is much higher than our return in 2015, I am satisfied with the outcome given the circumstances throughout the year. We faced a number of inauspicious outcomes on some of our larger investments during the year but were still able to preserve our purchasing power with a number of small wins and our short book. Some of these outcomes are just a matter of timing.

The recent market turbulence is setting us up for an excellent 2016 and onwards. We have a unique edge with our activist capabilities to create value at companies for the benefit of all shareholders.

Meson Capital

Meson Capital – Market Perspective

As of this writing the S&P 500 is officially in “correction” mode but the magnitude is still minor, leaving overall valuations highly elevated relative to historic levels. The modest decline in the indices in 2015 masked the fact that the average stock did much worse, the equal-weighted Russell 2000 declined over 10% and the median microcap (<$250mm cap) suffered a nearly 25% decline in 2015. Over time, smaller companies tend to outperform larger companies but this is clearly not true every year. A number of highly prominent value-focused hedge fund managers also suffered some of the worst losses (-15% or more) in their careers last year.

The structure of the market behavior resembles the 2000 tech bubble in a number of ways – the markets are being led higher by the largest companies (Google, Microsoft, Facebook, Amazon) while the capital is sucked out of the majority of other smaller companies. This creates an unfriendly environment for traditional value investors as many of these larger growth / tech focused companies are reinvesting all of their cash flow into growth – Amazon being the prime example. Unlike a conventional business that has a large amount of capital plant, many modern tech businesses expense their growth in R&D and engineering. There is no large factory to build and depreciate over 30 years for Uber, Airbnb, Amazon, Netflix, Apple, etc.

The pace of change in the world is accelerating and every year it becomes possible to disrupt larger and larger industries using information technology that requires very little tangible capital. The power of an idea and human capital has never been more economically powerful in history and yet it does not show up on the balance sheet at all. Warren Buffett has written about how Coca Cola’s brand has incredible value and yet doesn’t appear on the books. The value of a technology-enabled business culture can dwarf the value of a brand name.

This does not mean that the future of investing is solely about investing in unprofitable companies that can grow rapidly. What this accelerating pace of change does imply for investing is: 1) the predictability of future cash flows for most businesses is much less certain than may have been the case in the past and 2) the ability of a company to adapt to a changing environment becomes a much more important capability and is much harder to analyze. A culture of adaptability is virtually impossible to analyze through the financial statements but is instead a function of the culture and the people at the organization – this is where our experience building and running operating businesses is an edge.

Our goal as activist investors is to have the best of both worlds by buying stakes in statistically cheap businesses and then doing the heavy lifting to transform the culture towards its potential that is only possible by embracing modern tools.

Meson Capital – Inauspicious Outcomes & Mistakes

We invest with a thesis on a business-like time scale, typically 1-3+ years. In any given year, an undesirable outcome in the stock price is mere noise but over 1-3 years the fundamental qualities of a business can change quite a bit. Sometimes new information impairs the original thesis and we have to be intellectually honest and re-evaluate things. We get smarter from these mistakes and treasure the lessons. In any case, I will always be forthright with the sometimes unpleasant facts. In 2015, our headwinds included:

  • Our largest position InfuSystem declined 5% despite posting record revenues and profits
  • Our largest short position in a firearms manufacturer was one of the best performing stocks in the market, rocketing up over 100%
  • SIGA Technologies lost its appeal at the supreme court in an 11-year long lawsuit and now will have to recapitalize the company
  • We lost a small amount of capital in a proxy contest against a Canadian company in January
  • Two Chinese company shorts nearly doubled after receiving dubious take-private offers despite the Chinese stock market collapsing this summer
  • We paid nearly 7% of our capital to borrow shares to short-sell low quality small companies (this is not a mistake but the cost of doing business in a zero interest rate environment – our average short declined -32% in 2015)

I believe the first three of these points will work out very well over time and are mere short-term noise – the latter three cost us some money. Despite these unfortunate events, we completed the year
substantially ahead of the indices – onwards and upwards!

Meson Capital – Small (and some more modest) Wins

We had a number of smaller wins that more than compensated for these challenges – and most importantly maintained our purchasing power for the opportunities that the market is now creating amidst recent sharp declines.

On the short side:

Odyssey Marine is now over two years into a saga of a long – short story, coming soon to a theater near you! The stock declined 70% in 2015 and they avoided bankruptcy filings on two occasions. First in March they gave majority control of the company to a Mexican mining outfit in exchange for a high priced loan and the prospect for more capital if they receive environmental approval to mine phosphate in an ecologically sensitive area in Baja. Then they pulled a second rabbit out of a hat in December, selling virtually their entire shipwreck business to Monaco Financial a rare coin dealer in exchange for a small loan and the prospect of contract work. Shortly after this their ship was seized in Cyprus for potentially salvaging archeological items that should have been left alone – the case is ongoing between Cyprus and Lebanon. The environmental approval or denial should be known by March so we may finally witness the closing chapters soon.

Unilife too managed to avoid bankruptcy in December by giving up effective control of their business after the stock declined 85% in 2015. After revenue didn’t materialize, the company decided to put itself up for sale. There appeared to be no takers as they announced a licensing deal where we estimate proceeds will not be sufficient to repay the growing debt load. The creditors did insist the CEO cut his salary dramatically so it sounds like the party is over after 10+ years of telling a great story to investors.

Cadiz is the last of the three “rabbit out of the hat” to avoid bankruptcy shorts we had which only declined 45% during the year. After being denied access to the railway tracks to take water out of the Cadiz valley and with cash running out they sold most of their business – an unprofitable farm in the area. The creditors picked up the loan at 10 cents on the dollar so are in more of an effort minimization mode rather than profit maximization and don’t seem interested in seizing the assets. An equity raise seems likely on the horizon.

Keyw – the only company we can recall that named the Company after its allocated stock ticker, is a busted roll-up of defense contractors now chasing the dream of entering the cybersecurity arena. Caught between a rock and a hard place with the stock highly overvalued relative to the staid contracting business, they continue to plow all their cash flow into the so far unsuccessful cyber business with the objective of being aggressively acquired by the robot-controlled cybersecurity ETF. The stock declined 42% in 2015 and it seems implausible they would be able to repay the large amount of debt they now have.

Freshpet – the CEO was a regular guest on CNBC’s Cramer while demonstrating the quality of the product by eating their luxury dog food. The stock was a painful short during a promotional spree but as we say – gravity always wins – and the stock declined by 65% after missing estimates.

Corus Entertainment – the Canadian company declined 60% in USD currency after laws changed to unbundle the bloated cable packages in the face of cord cutting. Without mandatory purchasing of “Little House on the Prairie” and other Canadian heritage classics their profits suffered, particularly in light of their large debt load.

A basket of retailers with sharply negative same store sales comparables declined 50-80%: operating leverage working in reverse. Failing to adapt to a changing world is a difficult thing to recover from after sales decline double digits.

On the long side:

Geeknet – discussed in our last letter was a test of mettle and was acquired for a 150% premium (!) after the stock had tested our patience over the prior year and a half but remained too cheap to sell. Our patience was rewarded and we are impressed how well they were able to negotiate the sale.

Capital Southwest – brought in new management to break up the mixed-breed investment holding + operating company after the founder passed away. An early filing indicated a highly shareholder-aligned compensation structure for the new executives and hinted at imminent action. This was one of the few interesting special situations for us through the year with a solid foundation of value.

Heska – vet product stock doubled through the year as investments that previously had been depressing net income started to become visible with increasing revenue. We were taken aback at the rapidity of the rise but the market got smart quickly on what was happening on this one. This fit our archetype of “private equity style”: investing alongside the company that focuses on the long term business strategy despite consequences for short term profits.

Meson Capital – Our Strategy: Operational Activism

In my opinion, the era of being able to achieve sustainable above-market returns by outsmarting inefficient markets is coming toward its end. It has always been incredibly difficult to achieve superior returns to the market and there are still some small pockets of inefficiency but by and large, if all you bring to the capital markets is the ability to shift paper, it is a zero-sum game with incredible competition.

Instead what is needed is a more entrepreneurial approach that actually creates tangible operating value in the companies we invest in. We partner with world-class operators, consultants, and entrepreneurs to transform staid old companies into the modern world of technology-enabled businesses. Unlikely most private equity, we don’t have to take on debt or pay a 30%+ control premium for the luxury of access, as we create value for all shareholders.

We will continue to invest in a concentrated portfolio of companies with the following characteristics:

  • A solid revenue or asset base compared to purchase price
  • Net income is well below potential: this is why it’s unpopular with the market and cheap
  • Meaningful steps taken to improve their culture, strategy, capital structure, or operations
  • These steps often entail senior management changes, possibly driven by activists including us

We will drive change at 2-5 companies at any given time, typically with a 3 year duration for each activist transformation period. Often we will raise special purpose vehicles (SPV)’s alongside our main fund for these activist projects so we can purchase a larger block of the company to have more influence and better execute our strategy. We will also take 10-20 smaller positions in “farm-team” companies as we continue to develop competence in their business and industry.

To complement this and in order to generate alpha and hedge market risk, we sell short companies:

  • Without a meaningful revenue or asset base or with low barriers to entry
  • With structural business model challenges, weak cultures, or frauds
  • Who are either losing money or temporarily over-earning because of short term conditions
  • Where overall business conditions have already or are about to revert downward

The end result is a portfolio that has near zero correlation with the broader market. Returns are premised on our and our operating partners’ ability to improve the operations at companies that are purchased at a bargain valuation. These companies are often in the bottom quartile among their peers on operating performance metrics.

Meson Capital – Positioned for a Challenging Market Environment by Creating Operational Value

Even as of this writing with the recent market volatility and declines, we continue to see data indicating the market is at or near all-time high valuations which means low return expectations for the average investor going forward 5-10 years. Warren Buffett’s favorite Market Cap / GDP ratio stands at 107% as of this letter (down 8% YTD) which implies a <2% market return going forward and is still slightly higher than the level achieved in 2007 prior to the Great Recession. 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 in our newest activist projects.

I continue to have virtually all of my net worth invested alongside investors in the Partnership.

Please email me at rmorris@mesoncapital.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.

Sincerely,

President

Meson Capital Partners LLC