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For the quarter our performance was -7.4% vs. indices of 2.1% HFRI Hedge Fund Equity Index, 2.5% Russell 2000 and 3.1% S&P 500. Shorts broke even net of borrow fees while longs detracted 7.4% for the quarter. Although we do not normally provide intra-month updates, the recent public announcement of our largest position, Sevcon, being acquired at a 61% premium has made July an unusually successful month. As of this writing, we expect to be up approximately 20% Net YTD, well ahead of indices while maintaining a market neutral defensive positioning. We will provide up to date numbers when our administrator has completed the July close.
In our last two letters we describe our unique approach to long term fundamental investing using our machine learning, data-driven system we call Meson Gravity. In particular, we excel at short-selling where we have benefitted from a historical accuracy rate of roughly 80%. Short selling won’t make you rich in markets that do nothing but rise but we have still been profitable shorting on an absolute return basis since we positioned ourselves market neutral starting 2014. We hope for the best and certainly don’t pray for disaster but we are prepared to look unusually intelligent when a declining market finally arrives. Our penchant for short selling comes not from a place of cynicism but rather from a deep respect for how brutally competitive and hard business truly is, having built and run numerous private and public companies ourselves.
The ‘Buffett-metric’ US market cap to GDP stands at 135%, eclipsed only in history for 3 months at the 2000 bubble peak where it reached 145% briefly. The volatility index (VIX, aka the “fear index”) also reached an all-time low recently at 8.8% - the long term average is over 20%. Retail investor margin debt also has reached new highs. We wish long only investors, particularly those with margin debt, the best of wishes at their seemingly never-ending party that we have declined to attend. We have instead been busy working hard on investments that seem to us inevitable regardless of short term market gyrations: using data patterns to predict poorly performing businesses; improving efficiency of industrial equipment at lower cost; electrification and improving operations at decades old stalwart companies.
Portfolio Update - Machine Learning System Drives Diversified Positions
Our Gravity platform began to drive a portion of our diversified longs and shorts starting June 1 and we will have completely made the transition by mid-August. Our long portfolio consists primarily of our concentrated active positions where we have an ability to influence the future of the company in a positive way. Currently about 70% of our long exposure is in concentrated names like this. As we have built relationships with more private equity firms over time we will tend to be focused on opportunities where we can buy a meaningful toehold position and then work to acquire the company with a partner. We have two examples of this in the works at the moment in positions we have not publicly disclosed yet and I look forward to discussing them as they progress and we accumulate stock. This strategy is what we laid out as our goal as far back as 2013 when we made our first acquisition offer for InfuSystem but is very resource intensive and we have not had the resources or capital to execute on it consistently until recently.
Secondly, the opportunity set in the market leads me to conclude (perhaps 10% in jest) that all small caps are either activist opportunities or shorts. High quality management of good small cap companies realize they can personally make more money by going private so there has been a creaming effect over the last decade or so. The number of small caps that have become large companies is staggeringly small – either because they fall along the way or are taken private / acquired before they become large.
This skewed opportunity set is something we are well equipped to handle given our hands on approach where the undervalued small caps are ‘fixer uppers’. Our data-driven Gravity platform also recognizes this state of the world. This is unsurprising in that the system is designed to capture our fundamental investment approach and then implement it in a consistent systematic way, allowing us to reduce risk for our diversified positions.
The highest probability longs in our diversified portion of our portfolio are high quality larger companies that have a blend of good and consistent margins, ability to grow via acquisition (but not too much), and being moderately capital intensive (with some exceptions). Unlike ‘factor’ investors we are not looking for extreme top/bottom percentile values on any particular metrics – indeed these ‘red’ flags often indicate that the numbers are faulty rather than a true observation of interest. A recent academic paper for example showed that the lowest P/E stocks are not in fact the cheapest but are the most probable to restate “E” downwards! We aim for robust predictability in our approach, not extremes – 10 subtle yellow flags are better than 1 big red flag everyone else can obviously see. Example stocks in the portfolio include General Mills, Cisco, Church & Dwight, Paychex, and Comcast. Keep in mind these are <1% positions but the important idea to take away is that the best passive/diversified longs in this environment are boring, consistent, defensive businesses.
The short book by contrast is where we shine and the interesting opportunities are in this environment – regardless if the market continues its rise or not. Generally speaking they are companies that lose money, dilute their shareholders, are heavy on SG&A and low or declining revenue growth. You may recognize that these characteristics, while normally unappealing, describe some biotech homeruns. We do not currently short biotech or other similar industries where GAAP financials are essentially totally irrelevant to predicting success or failure. We have other data sets that we are working to incorporate over time for these more unique and subtle situations such as the track records of the individuals involved with the company, patents filed, etc. Keeping in mind that we have 200 shorts: examples of our highest probability shorts include alpha-En (which claims to have revolutionary Li+ battery tech), Pershing Gold, Yangtze River Development (Chinese real estate), VirnetX Holdings, and a couple hydrogen fuel cell players. We are highly confident in the long term prospects for these businesses and thanks to our system we can reduce the risk of short squeezes to a bare minimum due to the diversification and consistency of our portfolio management. As we say, economic gravity wins in the long run.
Due to demand from certain investors that are unable to invest in any