Graham & Doddsville newsletter for the month of November 2016.
Welcome to Graham & Doddsville
We are pleased to bring you the 28th edition of Graham & Doddsville. This student-led investment publication of Columbia Business School (CBS) is cosponsored by the Heilbrunn Center for Graham & Dodd Investing and the Columbia Student Investment Management Association (CSIMA).
Since our Spring 2016 issue, the Heilbrunn Center hosted the seventh annual “From Graham to Buffett and Beyond” Omaha Dinner. This event is held on the eve of the Berkshire Hathaway shareholder meeting and features a panel of renowned speakers. Additionally, Professor Bruce Greenwald was honored with a Lifetime Achievement Award.
In this issue, we were fortunate to speak with four investors from three firms who provide a range of perspectives and investment approaches. Despite differing strategies and processes, all see unique benefits from deep research and having an extended time horizon for investments.
Alex Seaver and Brad Kent of Stadium Capital Management discuss their concentrated, value-oriented approach to small-cap investing. The two partners detail their transition from private equity investing to the public markets in order to find more attractive opportunities. The team discusses the evolution of Stadium’s strategy, the methodical research and valuation process, as well as the
firm’s reluctant, but ultimately successful activist campaigns.
Neal Nathani of Totem Point Management shares his perspective on utilizing industry trends and rigorous research to find value and growth investment opportunities. Neal discusses what he learned in evaluating business quality from witnessing the dot-com bubble and in building complementary teams from watching Wayne Gretzky. Neal also shares an investment idea, Analog Devices (ADI), a semiconductor company that is at reduced cyclical risk and is not commoditized.
Chris Weldon ’12 of Stamina Capital discusses the launch of his fund, the evolution of his investment strategy, and the transition in skills and temperament needed to go from an analyst to a portfolio manager. Chris shares his experience investing in compounders, identifying quality transitions, and how Stamina will benefit from both by utilizing an extended investment horizon.
Lastly, we continue to bring you pitches from current students at CBS. CSIMA’s Investment Ideas Club provides CBS students the opportunity to practice crafting and delivering investment pitches. In this issue, we feature ideas from a Women’s Investment Ideas Club event, the 2016 Pershing Square Challenge, and the 2016 Ross Investment Competition. Jocelyn Doman ’17, Maria Muller ’17, William Hinman ’17, Mark Shohet ’17, Kenneth Chan ’18, Anton Korytsko ’18, and Alexander Teixiera ’18 share their ideas for Live Nation Entertainment (LYV), Skyworks Solutions (SWKS), and AMERCO (UHAL).
As always, we thank our interviewees for contributing their time and insights not only to us, but to the investment community as a whole, and we thank you for reading.
- G&Dsville Editors
Stadium Capital Management
Alex began his career at Goldman, Sachs & Co in New York in 1982 in Corporate Finance and Mergers & Acquisitions. Alex subsequently spent 10 years in the private equity and venture capital industry in the Bay Area at Hambrecht & Quist and InterWest Partners. In 1997, Alex co-founded Stadium Capital Management, LLC, where he is a Managing Partner. In 2005 Alex also co-founded Coliseum Capital Management, LLC, where he is remains an owner as well as a member of the firm’s Advisory Committee. Alex is also an investor and/or board member in a variety of earlier-stage private companies, primarily through Gold Bench Capital, LLC, which Alex also co-founded.
Alex graduated from Harvard College cum laude in Economics in 1982, and The Stanford University Graduate School of Business in 1986, where he continues to be a guest lecturer in Investments/Finance as well as in Corporate Governance. Alex is married to Christine Noyer Seaver, also Stanford GSB ’86. Alex and Christine lived in Palo Alto, CA from 1984 until 2001 when they moved back east to Connecticut with their four children.
Mr. Kent is a Managing Member and co-Founder of Stadium Capital Management, LLC. Mr. Kent serves on the Advisory Committee of Coliseum Capital Management, LLC, an investment firm based in Stamford, CT that focuses on special situation and distressed investments in smaller capitalization companies.
Prior to forming Stadium Capital, Mr. Kent was a general partner of InterWest Partners where he focused on non-technology acquisitions, recapitalizations, and late-stage venture capital investments. From 1989 to 1992, Mr. Kent was a Project Manager for William Wilson & Associates, a commercial real estate firm where he was responsible for developing, financing and leasing office development projects. From 1987 to 1989, Mr. Kent was a member of the Morgan Stanley Merchant Banking Group.
Mr. Kent earned a B.A., with distinction, in Economics and a M.S. in Industrial Engineering from Stanford University in 1987 and a M.B.A. from Harvard Business School, with high distinction (Baker Scholar), in 1993.
Graham & Doddsville (G&D): Could you tell us more about your background and how the two of you started working and investing together?
Alex Seaver (AS): When I graduated from undergrad at Harvard in 1982, I went to work in M&A and Corporate Finance at Goldman Sachs, a program that was still a novelty. There were six of us in the program and there were two or three the year before. The program grew exponentially when they realized that slave labor was a valuable resource. It turned out to be a great win-win for everybody. We were knuckleheads out of college, quickly learning the lingo and working on interesting deals. Back then, Goldman was a very small firm; it was a partnership and had a very collegial atmosphere. I had an opportunity to stay there beyond the analyst program to be a “lifer.” As much as I loved the people I worked with there, it wasn’t what I wanted to do, so I applied to business school and decided to attend Stanford.
I attended Stanford GSB in the mid-1980s, so it was a very interesting time for venture capital and technology out there. In spite of what was probably a natural orientation to value investing, I was enamored with the venture capital industry, but I didn’t know how to break into it. As a finance guy in the land of electrical engineers, I thought I had absolutely no qualifications and, at least back then, it felt as though you really did need an engineering background. I made a decision to try to back into venture capital a different way and at the time there were several, very successful, Silicon-Valley-focused merchant banks, with both investment banking and principal investing operations, such as Hambrecht & Quist, Robertson Stevens, and Alex Brown. These merchant banks catered to the emerging growth companies of Silicon Valley, but they also took advantage of the proximity and relationships to deploy capital. H&Q in particular had a pretty big venture operation, with over $500mm of capital. Back then that was a lot of money, especially in venture capital. I went to Hambrecht & Quist and made a deal to spend some time in investment banking, because I had some training at Goldman Sachs, before ultimately moving into the venture investing business there. I also made the best decision of my life in 1986 and married my classmate and love of my life for thirty years, Christine. I’m not sure how I convinced Christine to marry me, but somehow she fell for it. First piece of advice: marry up.
Less than a year later, a pure investing/venture firm, InterWest, recruited me. InterWest was interesting because it invested in areas outside of what I thought venture funds liked. The firm not only made more traditional venture investments but had a major focus in non-tech companies. There weren’t many firms like that, who invested in various phases of development, from venture investments in technology companies to LBOs of mature non-tech companies.
Brad Kent (BK): I am from Oregon originally and I was a member of Stanford’s class of 1986. Stanford had a program to study for an undergraduate and graduate degree at the same time, so I was an economics undergraduate and industrial engineering masters student and I finished both degrees a year later in 1987. I actually started in the investment business as a junior at Stanford, working part-time for one of the pioneers of venture investing, Melchor Venture Management in Los Altos, reviewing business plans for them.
When I graduated with my Masters in 1987 and all the consulting firms and investment banks came to recruit, I knew my number one priority was to be an investor.
Morgan Stanley hired me for its merchant banking group, which consisted of an LBO fund and a venture fund. I thought I was going to work on the venture fund, but I ended up working on LBO investments. Morgan Stanley had just raised what I think was the largest private equity fund at the time, $1.5 billion, which sounds quaint now. I worked on a number of LBO transactions, ranging from $200 million to $3 billion in enterprise value.
I did not intend to go back to business school. I knew I wanted to continue investing, although I didn’t care much which asset class. I liked the investment mindset and conducting investment research. But I wanted to go back to the west coast with Melissa, who would become my wife. A partner at Morgan Stanley introduced me to a guy named Howard Wolf. His real estate firm mostly built suburban office buildings in the Bay Area. It sounded pretty interesting to me. Real estate is obviously a very different asset class, but it is a similar investment analysis to a private equity deal. The cash flow generating asset is a property rather than a company, but the analysis is similar. Howard hired me to be a project manager, which was one of the best jobs ever because you do all the same investment work that we do here, but you also get to touch elements of the business with a more creative side. The architect and the broker salesforce reported to me. I got to do the investment work, which we find familiar here, but I also got to work closely with other functions. It was great fun.
In 1991, two things happened. One, the real estate market was terrible so we were not building new office buildings, appropriately. If you are a project manager for a development firm and you are not building, you either find something else to do or you are unemployed. I transitioned to an asset management role, which was fine but not as much fun. Two, my wife decided that she wanted to go to business school. I already had a master’s degree and didn’t feel a need to seek another one. But if my Melissa was going off to Harvard Business School, I wanted to be there to protect my turf! So we both headed off to HBS in 1991.
I had no interest in changing careers, but my wife got a summer internship for Apple and I needed to work in the Bay Area, so I joined McKinsey. It was a fine experience, but I knew I wanted to be an investor so I started looking for interesting opportunities while I was there.
AS: I joined InterWest in 1987 and in 1991 we needed more resources on the team. I interviewed a number of candidates and in the summer of 1992, a very good friend of mine, who is now the president of the Stanford Alumni Association, Howard Wolf, introduced me to Brad. When Howard heard what we were looking for, he said, “Hey, I’ve got your guy.”
Brad and I met in August of 1992, in the middle of his two years at Harvard Business School. Brad came to work with me and we’ve been business partners for almost twenty five years.
BK: I started working remotely for InterWest during my second year at HBS and as a result I did not have to recruit.
AS: Brad was working 20 to 30 hours a week for us but still managed to be a Baker Scholar. The second piece of advice I can give anyone is to hire people who are smarter than you are.
Graham & Doddsville: How did the two of you transition from private equity investing to the launch of Stadium Capital?
AS: At Stanford Business School, I took a class with Professor Jack McDonald, where I was also a Case Writer for him. He’s a legend at Stanford. He is now in his 49th year as a professor in Investments & Finance. I’ve been fortunate to guest lecture in his class for the better part of thirty years. He’s also on our advisory committee at Stadium Capital. Most Stanford MBAs who end up in the investing world take his class. It is so popular that they have to use two classrooms, one live and one next door with a video stream.
Part of the attraction is the quality of guest lecturers, present company excluded. In 1985, we had a guest lecture from someone well known in the investment world, but who was otherwise relatively unknown then, a guy named Warren Buffett. I was very affected by his talk but also Jack McDonald’s entire course. He is an evangelist for Buffett-style investing and the spectrum of value investing going back to Graham and Dodd. In spite of my desire to give venture capital a shot, this mentality and approach was always in the back of my mind.
Around the time that Brad joined InterWest, we were traveling the country looking at companies that, had they been publicly traded, would have been called microcaps, somewhere between $50 million and $500 million in enterprise value. Of course the first thing we would do in evaluating private investments was look at comparable companies in the public market. We began to notice, in the mid-1990s to late-1990s, a pattern of public companies trading at much lower valuations than their peers in the private market. We weren’t sure why that was the case. Not all companies were trading at discounts, but it happened often enough that it got our attention. As we like to say, nobody fools the two of us more than 100 times in a row.
BK: This is different than when we were working separately in private equity, when I was at Morgan Stanley and Alex was at InterWest. In those days, public companies typically traded at higher valuations than the private deals we did. Part of the appeal of private equity, of course, was that you could buy a company at a lower price than the public comps, leverage it, and then make the assumption that it would approach the public valuations later. That was the normal operating procedure. By the mid-1990s, that wasn’t the case at all. Money flowed into the private equity business, as you would predict, and almost everything became an auction. In an auction, you’d pay 6x, 7x, 8x EBITDA and we would see public comparable companies traded at 3x or 4x. We started asking ourselves, “Why are we doing this? Why are we paying 8x when we can buy a company just like it for 4x? Is controlling the company worth that premium?”
AS: During this time, we started to talk to some of these smaller public companies because, naturally, they might be attractive take-private candidates in our private equity business. What we discovered was that many of the management teams were nervous about exploring a sale, largely because they feared that the process could deviate and eventually result in a strategic sale in which management loses their jobs. At the same time, if we approached them as pure public market investors, we were welcomed with open arms and a red carpet.
Brad and I were essentially agnostic investors by mentality. If a great, publicly traded business with durable, defensible, and high free cash flow was simply a public market investment opportunity, then so be it. It might not be a private deal opportunity, but it might be a great investment.
We also began to explore why this valuation discrepancy existed. As Brad mentioned, on the private equity side, a lot more people had entered the fray. The market was more competitive and the marginal price setter in private opportunities tended to be an array of very smart private equity firms. These firms were not only competing with each other free-form, they were being choreographed by the bankers to compete with each other. By the end of a process, sophisticated, well-tuned investors were the marginal price setters. The smartest, most sophisticated investors were setting the price, with leverage as a booster.
On the public side, Brad and I discovered a few critical elements that captured our attention. First and foremost, the way that public equities were traded was changing pretty dramatically. In 1997, the order handing rules were changed from trading one-eighth increments to one-sixteenths. It was also generally acknowledged that this was a step towards fractional, or decimal trading and another massive reduction in trading spreads. This change represented an enormous loss in profitability for the brokerage community.
In what the world calls “microcap” – which ironically would have equated to fat, beefy private equity deal sizes for us in our old business – the public companies were generally considered to be detritus. Given the lower float and liquidity in microcaps, these companies didn’t get much love from the buy-side and sell-side to begin with. Disappearing trading spreads were the nail in the coffin.
The buy-side institutions were dropping coverage of massive swaths of microcaps. At the same time, the sell-side research, which had not been especially good to begin with for these companies, more or less vaporized. The opportunity for us, of course, was that these companies were still public. In stark contrast to our former private equity world, the marginal price-setter in the microcap public market tended to be the least informed and in many cases least sophisticated buyer, with an increasingly myopic, impatient investment horizon and radically different set of short-term incentives.
Microcap portfolios at places like Fidelity had two to three hundred positions, which in our view makes it nearly impossible to cover individual companies in any depth. We also discovered that portfolio churn was 100% or more, annually. What we observed was a universe of relatively thinly traded public companies, turned over massively by institutions, and little company-specific knowledge given the constraints of portfolios of this size.
When we made calls to buy-side owners to learn more about their views on these companies, it would often take several migrations to find the appropriate portfolio manager. Often the PM was relatively junior, relegated to microcaps as a way to train them so they couldn’t do too much damage. The PMs would earnestly try to answer our questions but even if they owned 10% to 15% of these companies, there typically wasn’t an individual investment hypothesis. You could often hear the papers rattling in the background as they tried to figure out what the company did.
As an example of the odd behavior in this market cap segment, we would often talk to sell-side analysts with sell ratings for companies we thought were actually attractive. We thought they might know something we didn’t. Instead, the head-scratching answer we often got was, “No, no, no. This is a great business. I would own it all day in my personal portfolio. Unfortunately, I have to issue a sell rating because I don’t see a near-term catalyst in the next three to six months.”
The lightbulbs were going off for us because the Holy Grail for an investor, from our point of view, is to find a less liquid market where there is inefficient short-term pricing behavior. One of our fundamental core beliefs is that markets can be inefficient in the short run but efficient in the long run. The more time we studied the public market, the more we discovered dynamics that tended to create short-term deviations from intrinsic value — there were time horizon issues, there were liquidity issues, there were compensation issues, there were portfolio construction issues. All of this created a situation where buy- and sell-side participants in the microcap segment made decisions that frequently did not seem rational to us. We believed that focusing on this less-well covered, less-liquid market, combined with a longer-term horizon offered a great opportunity for us.
See the full PDF below.