Graham & Doddsville Winter 2017 newsletter for the month of February 2017.
Michael Blitzer and Guy Shanon are the Managing Partners of Kingstown Capital, a value-oriented investment partnership that focuses on special situation securities across the capital structure. The firm was founded in 2006 with strategic backing from Gotham Capital and currently manages $1.8B. Michael and Guy both hold MBAs from Columbia Business School where they participated in the Value Investing Program and have taught Applied Value Investing as adjunct faculty. Michael currently serves on the Executive Advisory Board of the Heibrunn Center.
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Graham & Doddsville
Graham & Doddsville (G&D): How did you both meet and how did the fund get started?
Michael Blitzer (MB): Guy and I have known each other for a very long time. We both went to CBS. I was ’04, Guy was ’99. We didn’t know each other while we were at Columbia, but at that point AVI [Applied Value Investing] was a very small network.
Guy Shanon (GS): So everyone knew each other from different years.
Michael Blitzer: Guy’s class had six people. They were the only six people at Columbia who were interested in value investing – it was 1999. There was no AVI. The program really grew from there.
Guy Shanon: Our initial investors and employees came from that network of students and professors.
Graham & Doddsville: We last spoke with you in 2010. How has the fund changed since then and what have you both learned?
Guy Shanon: The fund has grown but the strategy and portfolio structure are exactly the same. We still run a long-biased and concentrated portfolio of special situation securities across the capital structure.
Most of these securities are in the $1B to $10B enterprise value range for both equities and debt, though credit securities can be smaller. Being bigger also gives us research resources and access we just didn’t have when smaller, and the structure of the industry is making it harder for very small funds every year.
Graham & Doddsville: Why have you focused on that particular size?
Guy Shanon: I think one of the things we learned is that it is not so easy to make money with super small caps. You see a lot of questionable management teams and very low quality businesses which have not become bigger for what are usually good reasons. Then of course you have all of the extreme technical aspects, like if liquidity dries up that makes it even harder. Yes, there are sometimes great opportunities, and we look at small caps all the time, but they aren’t giving it away by any means, and focusing exclusively can be a tough way to make money over long periods of time.
We don’t think of ourselves as a big fund, and we think we can make the best risk-adjusted returns in the size range we currently target. The current portfolio runs the gamut from $300mm in market cap to $50B, so the range is wide and we look at everything. But the sweet spot tends to be this middle range which are small enough to still experience the technical factors that often lead to security mispricings but large enough to have quality of business and management. This size also tends to have a larger pipeline of the special situation categories we track like spin-offs and distressed debt.
Michael Blitzer: Also, there’s a big, timely debate right now about active versus passive investing. Passive has come into a lot of popularity. When we started twelve years ago, we maintained the premise that the markets are very efficient. Our strategy is to be exclusively focused on very small pockets of inefficiency within what is, generally, a very efficient market. We have to have the flexibility to go after companies that are smaller than $10B or $20B
Guy Shanon: And don’t have twenty sell-side analysts covering them.
Graham & Doddsville: As the number of special-situation funds grew, how has this impacted Kingstown? Have you been able to maintain an advantage?
Michael Blitzer: The longer we do this, duration of capital and time horizon has actually become more and more of a competitive edge. We’ve always defined the strategy as kind of having a medium-term time horizon, generally one to three years. These securities tend to have larger mispricings. A typical example is a situation that has a known or likely catalyst but unknown timing— you know it will happen sometime in the next three years, but it could be tomorrow or it could be years from now. Given the structure of the hedge fund industry and the structure of capital, this sort of patience becomes harder and harder over time unless you align yourself with long-term capital. So we’re clearly shorter-term focused than a private equity firm. But there are very few investors in the public markets right now who can take a one to two to three-year time horizon. Most can hardly take a month or a week. To take advantage of most of the mispricing, particularly in the special situation space, you have to have that kind of runway. Also there is a lot of capital coming out of event-driven strategies, which overlap somewhat with what we do, this is very good for us.
Guy Shanon: In the past twelve years since we started, time horizons have become a lot shorter. As students at Columbia and with the value-oriented internships you’ve had, you might not fully appreciate the low tolerance for volatility. If you go to some of these large multi-strat funds, time and volatility are very relevant because they’re running massive amounts of capital. In fact, they’ve attracted so many assets because they manage volatility so tightly. If you went to work there as analysts and you drew down a couple of percent in a month, you get stopped out. But then what do you do with that cash? You have to find another trade tomorrow – is that better than staying with the business you owned the day before? It just feeds the volatility. I think the fact that we only focus on very specific special situation categories also makes us unique. We don’t do risk-arb for example. We are just looking at certain areas where we know there are chronic mispricings. A lot of fire directed into a small area. That is what we do. And we have been doing it for a while and it works, and we get better at it every year.
Michael Blitzer: In addition to size and duration of time horizon, it’s also been concentration. We run a fairly concentrated and flexible mandate where we look across industry, geography, and capital structure. We think it is also a big advantage that we can evaluate the risk-reward across these different areas and pick our spots very precisely. Then obviously we combine all of this with what we like to think is a fairly deep research process. But you can only do that level of research if you’re concentrated. When you group it together, these things differentiated the firm initially and have been consistent through the life of the business.
Graham & Doddsville: How did you develop and cultivate an investor base that allows for your strategy?
Guy Shanon: From the start, we’ve been very conscious of the importance of having the right partners. I think it mostly came from some humility. We understood that it is very hard to beat the market and you need help from your structure and partners. You have to match the duration of your capital with your investments. Going back ten years, we’ve turned down money from people that didn’t share this approach. We’ve never had a formal IR effort. You end up with a certain type of partner by way of hiring a professional marketing person. We have personal relationships with all of our partners. We spend a lot of time talking to them about how they think about investing. Not surprisingly, most of our partners have a value bias in their portfolios. But investment philosophy aside, a direct relationship with partners creates more transparency for them and keeps the alignment of interests very close; sometimes having a marketing person between us inserts another agenda into the mix. We think our approach is best for our partners’ returns over the long run.
Michael Blitzer: It’s just taken time and a lot of energy invested in getting to know our partners and how they think about investing. We’ve gone through periods where, for many years, we didn’t talk to anyone about new capital. We also learned by watching what didn’t work for other funds. But ultimately this has led to a small group of partners who have stuck with us over time. And with less time spent on marketing and investor relations, there is invariably more time spent on investing and the portfolio.
Graham & Doddsville: Going back to volatility, how do you think about risk in your investments and how do you exit positions that are going against you?
Michael Blitzer: We mostly define risk as permanent impairment, which I think is very different than most people who view it in terms of volatility. We take the approach that risk and volatility are very different. A lot of the returns that we’ve made have been either averaging down or buying things that were down. On a short-term basis, it’s very challenging to time tops and bottoms. I think a lot of people have failed doing that. One of the approaches of having a longer-term strategy and longer-term capital is that you can withstand those periods of volatility and take a view over a number of years.
Having said that, being very patient and permanent impairment often become the same thing eventually. We take the approach here that we are re-underwriting every single position every single day. If the facts change, we have to be intellectually honest and reevaluate that, otherwise you are just hoping. It’s a combination of research and portfolio management.
Guy Shanon: It’s easier said than done, but when something is going against you, you have to fight off the urge to ignore bad news. As Mike said, be brutally honest with yourself whether or not what you thought was going to happen actually did happen or is happening.
Over the years, a lot of our former students have asked us about starting funds and how we would evaluate somebody who is starting a new fund. I think there are three parts. There’s being a good analyst, and then there’s being a good portfolio manager, which is actually a pretty different skill set. Then there’s the third part, which is temperament. The big intangible. There are a lot of people who have one of the three or two of the three, but it’s very hard to have three of the three because it’s a mixture of a bunch of personality traits that are not often on the same gene. But you need all three.
Part of temperament is being able to be self-critical. Many people in this industry have been very successful all their lives. They have always been at the top 10% of everything they have done. All of a sudden, a position is going against you and you have to really break it down and be honest with yourself. Or you have to take a view that is vastly different from what the “smart” people are saying, what your smart friends who are making money this year are saying. A lot of people have never done that before. You have to be very critical and skeptical all the time, but also know when not to be. And how you go about that has a big impact on performance over time.
Michael Blitzer: You have to put up walls and blinders to eliminate behavioral biases when these things happen. Of course, when something goes against you in a meaningful way, the market is usually not that wrong. At the very least, it’s down for a reason. Stepping back and understanding what that reason is. I think the only way to do that is through a constant re-underwriting process and a diligent research process.
Graham & Doddsville: Do you have any formalized systems or processes in place to eliminate these biases when making tough decisions, like a “pre-mortem”?
Guy Shanon: Thinking, Fast and Slow is a great book. We’ve both read it. I read it over and over and I’m still learning, it’s not exactly beach reading. But we don’t have any formal framework. Anyone who says that they do, that’s more of a marketing gimmick. We’re very aware of the behavioral stuff, it’s important. It is possible that managing our own behavior effectively is the single most important thing we do as investors in public markets at the end of the day.
Michael Blitzer: Also the analysts here know that they’re not going to do well unless they start with the risks and the downside. Before we figure out how much we can make in an idea, we have to discuss what all the possible risks are that may or may not happen. I am not sure if I would call that a “pre-mortem.”
Guy Shanon: Pre-Mortem? We see that term a lot, it’s part of a checklist that people interviewing for jobs have decided they need to have in anything they write, it has become part of hedge fund analyst culture, like it’s some kind of innovation. But really it’s common sense—if you are going to put a substantial amount of your net worth at risk, wouldn’t you think through how it could go terribly wrong, and what the first signs of that would be? The answer is yes, and it’s probably a good idea to write it down.
Michael Blitzer: It’s also a little naïve. When most people have lost money, us included, it is often not from any of the twenty possible risks you listed in advance. When the bad outcome happens, you’d be shocked how often it was related to something that wasn’t on your original list.
For us, this is why it all comes back to valuation. Being a good investor requires you not only to be wrong in ways you didn’t anticipate and still not lose a lot of money. I think the only way to do that is to buy things very, very cheaply. For most investments that haven’t worked, we have been very wrong on a number of things and still not taken a large impairment.
Guy Shanon: I think that’s called “margin of safety.” The closest thing we have to a formalized process is our emphasis on written memos. For any position of a decent size, we write very detailed memos. We date them and we update them, so that six months or eighteen months later we can go back and see what we thought was going to happen. From a psychological standpoint, you can play all kinds of games if your investment ideas are all in your head, which is bad for performance.
Michael Blitzer: It also makes you refine your thinking. By writing something down you are forced to focus your thoughts in a way that verbally you cannot.
Guy Shanon: Yes many times I have had this experience: I decide I like something, then I write down the bull and bear cases for it, go back to it a few times over several days, adding things, and then I think, you know what, I don’t like this so much anymore. Writing things down brings more precision to your thinking and helps in the process of weighting factors. Often we all have very similar information, but the rub is, how do you weight it differently in a decision to get better outcomes, that is the Kahneman stuff too. You should get better at that every year and as you live through more things. But then again, you don’t want to be over-influenced by an unusually good or bad experience, because outcomes are more like the mean than the exception—again, Kahneman.
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