Hazelton Capital Partners letter to partners for the fourth quarter ended December 31, 2015.
To: Hazelton Capital Partners, LLC
From: Barry Pasikov, Managing Member
Date: February 18, 2016
Re: 4th Quarter 2015 Letter to Investors
Hazelton Capital Partners, LLC (the “Fund”) declined 1.2% from October 1, 2015 through December 31, 2015, declined 12.4% year-to-date, and has returned 75.3% since its inception in August 2009. By comparison, the S&P 500 gained 7.0% in the same quarter, increased 1.4% year-to-date and has returned 127.3% since the Fund’s inception.
The Year in Review – Stop the Ride; I Want to Get Off!!
Hazelton Capital Partners ended the 4th quarter with a portfolio of 19 equity positions and a cash level equivalent to 7% of assets under management. The Fund’s top five portfolio holdings, which are equal to 39% of the Fund’s net assets, are: Western Digital (WDC), DreamWorks Animation (DWA), Apple Inc (AAPL), Abercrombie and Fitch (ANF) and CUI Global (CUI).
Beginning in mid-August, investors have been treated to a market roller coaster ride, complete with stomach turning plunges, heart pounding recoveries, and a series of quick directional turns that have left many market participants not only nauseated but unnerved. Many investors have questioned why the market has turned so turbulent so quickly. The truth is that investors have unknowingly been on this ride for much longer than they are aware. Every roller coaster journey begins in much the same way: An upward and steady climb to the apex, and then as the riders slowly crest over the top, they pick up speed on the way down leading to the simultaneous feelings of exhilaration, unease, and apprehension. The main difference between a roller coaster ride and the current equity market is that a roller coaster ride lasts, on average, for 2-3 minutes, whereas the recent market swoon appears to be unending. Investors have once again been reminded of a fundamental fact about assets: Prices can go down as well as up. While emotionally taxing, market sell-offs are a necessary ingredient to maintain a healthy and robust capital market.
Capitalism is an economic system that is based on the principles of competition, private property, profit motivation, private enterprise and consumer sovereignty. These principles allow for supply and demand to set a market-clearing price for goods and service, assets, and wages. But the foundation on which the pillars of capitalism are built is failure. The main precepts of capitalism are that assets flow from weak to strong hands. Businesses may go bankrupt, their assets sold and employees let go, but from these ashes come new opportunities to re-deploy capital and utilize those assets in a profit generating venture. Of course, it does not happen overnight, and it is not without discomfort. But as we have learned so often throughout history, trying to arrest the inherent movement of nature will often lead to larger and more disruptive events in the future.
Until recently, the United States National Park Service (NPS) aggressively fought to extinguish all forest fires. The actions of the NPS, even though well intended, over time lead to an overgrowth of trees, grasslands, and brush, that when ignited, accelerated the scale, scope, and damage of future forest fires. Fire is one of the tools that nature uses to return its habitat into balance and promote future and sustainable growth. Similarly, the arbitrary actions of the global Central banks to stave off a recession and artificially promote growth through quantitative easing, may have been well intended, but produced a global economy which remains bottlenecked, its growth anemic and its asset prices distorted. Adding to this market instability, OPEC (Saudi Arabia), which behaves like a central bank for oil producing countries, has purposely been driving down the price of oil by oversupplying the global market by an estimated 2.5 million barrels/day. Representing over 15% of the world’s oil production, Saudi Arabia’s primary motivation to keep production elevated is to eliminate growing competition from countries like Russia and US whose production costs are significantly higher. Given the unpredictable actions of governments and governing bodies, it is no wonder why many people have come to question whether capitalism is dead or at the very least sleeping.
By all measures, markets have become more volatile over the past few months, but are they more risky? There two types of risk an investor incurs after making an investment: Business risk and market risk. Business risk is specifically associated with a particular company, its business model, management, or the industry in which it operates. These risks can negatively impact the value of a company. Market risk is systemic risk. It is the risk that the overall downturn in the market will drag down the share price of a company’s stock. There are a number of ways an investor can reduce the business risk within a portfolio, but the ideal way is to avoid these traps altogether. There is no substitute for having an in-depth understanding of a company’s fundamentals, its management and the industry in which it operates. The best way to achieve this knowledge is through extensive and ongoing research. But even armed with insight into a company’s internal workings, there is very little an investor can do, in the short-run, to shelter their investments when market pessimism reaches a gale force intensity.
How Hazelton Capital Partners Has Been Reacting to the Recent Volatility
As the current market turmoil is casting a long shadow upon the future outlook for the economy, it becomes increasingly difficult to foresee a time when markets will calm themselves, let alone improve from its current levels. It is commonplace for investing strategies to call for an increase in cash when market fundamentals become unhinged. Hazelton Capital Partners is a big proponent of having cash on hand to invest, especially during extreme downturns in the market. However, moving into cash during uncertainty may reduce the emotional torture investors have had to endure for the past few months, but it is only the first part of an investing process. The second part is having the mental strength to re-deploy that cash. The current market environment has given investors plenty to worry about, but long-term investing opportunities are born from extreme negativity and grow from uncertainty. In recent months, Hazelton Capital Partners has transitioned out of a handful of legacy positions and reinvested that capital and more intoan equal number of new positions with greater upside potential. The Fund’s cash is at its lowest level since the fund started back in 2009, and if we had more cash on hand, we would continue to deploy it. It is important to remember that Hazelton Capital Partners’ cash levels are a by-product of investing opportunities and not a macro outlook.
Hazelton Capital Partners remains concerned with the recent market volatility, but as we have also learned from past experience, measure twice and cut once. To avoid investing paralysis, The Fund’s current portfolio positions and potential new additions are continuously reviewed with a singular focus of validating our investment thesis, as we search for acts of omissions, overconfidence and a margin of safety level that is commensurate with market volatility. We have made mistakes over the past year, but no more or less than we have in the past. However, in the past, our portfolio of hand selected companies helped compensate for our oversight. Today, having an equity portfolio, regardless of its makeup, has become a liability. Given today’s current market environment, there are easily one hundred and one reasons why not to make an investment, but Hazelton Capital Partners is focused on the primary reason for making an investment: An opportunity to purchase shares of a cash generating company with a robust balance sheet and earnings power that is trading meaningfully below its future intrinsic value. This has always been and will remain our chief motivation for allocating capital, whether we are on a steady glide path higher or have crested over the apex.
CUI Global (CUI) – Current Holding
CUI Global is a manufacturing and service company with two very distinct revenue segments. The majority of its revenues and earnings is currently derived from designing and selling power supplies, transformers, converters and connector for original equipment manufactures (OEMs); a slow growing but steady business with predictable margins. To augment the power supply business, CUI made two acquisitions focused on the natural gas industry: Exclusive license and eventual ownership of GasPT2 technology in 2009 and in 2013, Orbital Gas Systems, and its VE Probe. GasPT2 is a technology that is able to measure the physical properties of gas sample and infer its composition in nearly real time. When combined with Orbital’s VE Probe, which can safely and quickly draw natural gas out of pipelines, the two create a gas chromatograph (GC), an instrument used to measure the methane content (energy content) of natural gas. Up until recently, a GC was used primarily in a lab setting, but with the increase in natural gas production from traditional and shale deposits, natural gas has become the main energy source for many countries, especially in Europe.
Snam Rete operates Italy and Europe’s largest natural gas transmission and distribution pipeline with over 20,000 miles of pipeline. The company receives natural gas mostly from Russia, Iran, Qatar and Iraq, distributing within Italy, as well as transporting the gas into other countries like France, Germany and the Netherlands. The methane content of natural gas from Russia is significantly lower than the gas coming in from Iran or Iraq. Because all the gas received by Snam Rete is mixed together, they currently have no way of determining the methane levels they are delivering, and as such, are required by their regulator to only charge at the lowest level received. To solve this problem, Snam Rete has decided to install GCs throughout its pipeline to accurately measure and bill its customers for their energy consumption. After 3 years of delays, CUI and a competitor received a RFQ (request for quote) from Snam Rete in September, 2015 for the all-in cost (the unit, installation and yearly maintenance costs) for delivery of over 3,300 units which turned out to be ten times the original plan.
On February 10, 2016, CUI Global announced they had received the entire first purchase order for 400 units through the beginning of October 2016. The company believes that they have a very good chance to receive the entire purchase order for all 3300 units over the next three years. Winning this project would be a huge boost not only to CUI’s revenue and profits, but to its reputation within the gas industry. Historically, utilities are slow to adopt new technology. But once they do, the entire industry tends to move as a collective over time. Snam Rete is seen as the “first adopter” within the European gas industry and carries the “good housekeeping” seal of approval, which should open the door to future sales to other countries.
Hazelton Capital Partners has owned CUI global for nearly two years. Our initial investment was a much smaller holding, and the position was reduced even further after the share price nearly doubled in less than 6 months, as the market anticipated a pending deal with Snam Rete. Today, CUI is a much stronger company and well positioned to win a large portion, if not the entire order. Additionally, CUI has made some significant inroads into other product segments including its IRIS system which allows pipeline companies to remotely monitor and operate sections of their pipeline via computer and its mercury detection unit that is based around its VE Probe. If one were to value CUI Global solely on its power supply business and pipeline service revenue, adjusting for expenses associated with its natural gas products, its earnings power would value the company around $6.00/share. Even with a modest revenue outcome from the Snam Rete’s RFQ win, CUI’s value could increase meaningfully.
CUI Global is the type of company that Hazelton Capital Partners likes to invest in. It operates is a niche segment of large industry, flying below most investors’ radar. We feel the downside is identifiable and limited while the upside could be very significant with a number of positive events beyond the Snam Rete deal.
Western Digital (WDC) – Current Holding
If there is one stock that symbolizes the market’s roller coaster ride, its Western Digital (WDC). We began purchasing shares of WDC in December of 2010 and over time, through steady appreciation, it grew into the largest portfolio holding. In January of 2015, Hazelton Capital Partners sold just shy of 1/3 of our shares as the company began to approach its intrinsic value. Over the next 12 months, Western Digital shares began to decline as the cyclical demand for digital storage began to wane. In October, in rapid session, WDC’s management announced a $3.8 billion investment by Unispendor, MOFCOM (China’s Ministry of Commerce) approval of the integration of HGST with Western Digital (Part of the legacy 2012 merger between Hitachi and Western Digital) and acquisition of SanDisk for $19 billion. In short order, WDC created a large cloud of uncertainty over the business and, in turn, the market drove down the stock price over 50% for the year. Uncertainty has not abated as questions remain if the US will allow Unisplendor, a Chinese company, to purchase a large stake in Western Digital. Without the influx of cash from Unisplendor, increased ambiguity will surround the acquisition of SanDisk as WDC will need to leverage its balance sheet and borrow over $18 billion dollars.
Western Digital’s downturn represented over 1/3 of the portfolio overall decline in 2015. Hazelton Capital Partners still believes that WDC is a well-managed company that has a long-term, sustainable competitive edge. Acquiring SanDisk will not only help the company quickly expand its growing SSD (solid-state drive) business but provide WDC with a steady source of NAND flash chips, something Western Digital has been sorely lacking. Management has already outlined that the merger between SanDisk will provide meaningful cost saving that will grow to over $1 billion per year by 2020. That is on top of the approximate $500 million the company will achieve from the final approval for integration by MOFCOM. In the past, Western Digital has been a cash generating machine and we believe, with the acquisition of SanDisk, it will become an even stronger cash generator. In the short-run we believe that some of the company’s value has been impaired but remain confident WDC will be able to both repair and grow its intrinsic value.
Cisco – Closed Position
In October, Hazelton Capital Partners closed out its position in Cisco Systems (CSCO). The position was held for just shy of 3 years and generated a total return of approximately 81%, which includes stock appreciation, dividends and option premiums.
Cisco designs, manufactures and sells networking equipment used to connect devices to the internet worldwide. With a 70% market share in switching, 50% market share in routing, and with internet traffic increasing, CSCO has become the de facto provider of equipment to businesses and governments alike. Over the past 10 years, even during the financial crisis, the company has been able to steadily grow its margins and increase its revenues from $28 billion to $49 billion. Over the same period of time, Cisco’s balance sheet saw significant growth as well, with its book value growing from just shy of $30 billion to just under $60 billion with a net cash position making up $40 of the $60 billion.
Gone are the days when Cisco used to be a high-flying internet stock complete with a 120 P/E multiple. Currently, CSCO sports a much more mundane multiple of 12x earnings (when accounting for excess cash balance) even though it has demonstrated consistent and sustainable growth. Hazelton Capital Partners exited its CSCO position in October at around $29/share even though we believe the value of Cisco’s business is currently worth between $31-$33/share. Starting in August and well into September, Hazelton Capital Partners began finding current and new investments whose upside far outpaced our expectations for Cisco and we removed CSCO from the portfolio to make room for new opportunities.
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.
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.
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