Greenhaven Road Capital commentary for the second quarter ended June 30, 2017.

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Greenhaven Road

Dear Fellow Investors,

If we are going to try to “outperform” the market by having a concentrated portfolio with off-the-beaten-path companies and non-consensus ideas, we have to accept periods of under-performance. Sometimes we are early, and sometimes we are just wrong. We will have down months, quarters, and years. Fortunately, this quarter was not one of those down quarters and this year so far is not one of those down years. The fund returned approximately 10% gross during the second quarter, pushing year-to-date returns above 30% gross. Net returns vary depending on investor class, but are approximately 25% year-to-date. Our returns compare favorably to the S&P 500 and Russell 2000 indices, which were up 9% and 5%, respectively, over the same period. As I have said before, short-term returns are “noisy” and not meaningful. If I told you we had performed well over a 15-minute period or an hour, you would say, “who cares?” We are playing the long game here, not focused on one-, three-, or six-month periods. Our five-year and fund life returns are all in excess of the relevant benchmarks net of all fees and expenses.

ANOTHER FOUNDATIONAL VOICE

As I consider buying, selling, and holding investments, there are certain themes and core ideas that I use as touchstones. For example, when investing in microcaps with limited liquidity, I can hear Chuck Royce whispering, “It’s not the liquidity discount that matters – is the company going to get there?” He means, effectively, that one must be very wary of the execution risk in illiquid companies because it can be a marriage and not a date if that limited liquidity disappears. This is why selection matters so much – you have to be happy with being a long-term owner. In addition to Chuck, I often think of my Stanford professor Jack McDonald, who brought in a speaker who had invested $25,000 in a private company. When the company went public, he had a 10 bagger, but he did not sell; he held and held and held and held, and eventually his investment was valued at more than $50M. This phenomenal return was only possible because he selected his company (Cisco) well AND viewed it as a very long-term investment in a company and management team he believed in. Despite a very large gain in the near-term, he remained focused on the longer-term business opportunity and let the magic of compounding work over more than a decade. Before I sell a stock that is up significantly, I ask “What would Professor McDonald think?” – code for the fundamentals of the opportunity ahead are far more important than the paper gain or loss realized to date.

Historically, when analyzing companies, I have heard the whispers of Marc Andreessen saying, “software is eating the world.” Looking around, I see evidence of software everywhere from my programmable TV remote to the braking system in my car. I am not typing on a typewriter and I don’t call a broker to place trade orders. This past quarter I read “Modern Monopolies: What It Takes to Dominate the 21st Century Economy” by Alex Moazed and Nicholas L. Johnson. The book argues that Marc Andreessen’s notion of software eating the world is directionally correct, but more accurately, platforms are eating the world. Andreessen is correct in that software will keep being applied to ever-expanding areas; however, the great companies will be platforms, not simple software. Single point software solutions are easily copied over time; the cost of development is relatively low and the barriers to entry are also low. Just look at the Apple App Store with more than 2,000,000 apps available. Moazed and Johnson argue that the great businesses of our time will be software-related, but they will be technology platforms like the App store and not the individual apps. The book delves into several different types of platforms and nuances between them, but for our purposes, “software is eating the world” is now “platforms are eating the world.” I have intuitively understood the advantages of network effects and the attractive economics of the incremental customer on platforms, which has led us to currently own four of them within our portfolio: Etsy, Interactive Brokers, Gaia, and TripAdvisor. The book is well worth reading as it provides precision and mental models to analyze platforms and think about their health and conditions for growth, and argues that many of the great businesses of this generation will be platforms. The book will be given out at Greenhaven’s annual meeting this year (details to follow via email).

TOP 5 POSITIONS

The top 5 positions in the portfolio are as follows:

Fiat Chrysler (FCA) – The thesis remains the same: if the turnaround continues to be successful, Fiat will earn in excess of $5 next year and have a net cash position. The company will benefit from margin expansion as their product mix shifts away from commodity sedans and increasingly towards luxury cars (Maserati and Alfa Romeo) and SUVs (Jeep). There are several ways to realize value, including selling off the parts business or spinning off the luxury brands, as they have already done with Ferrari. Ultimately, strong businesses with strong brands and reasonable balance sheets do not trade for 2X earnings for long. Either the company will fall far short of its 2018 plan and today’s prices will seem reasonable, or they will continue to execute and today’s prices will be deemed quite attractive.

EnviroStar (EVI) – Shares of EnviroStar have doubled in the six months that we have owned them. As discussed in our Q4 letter, this commercial laundry operation is growing through a “buy and build” strategy executed by CEO Henry Nahmad, who trained under his uncle, Albert Nahmad, who has grown another arguably “boring” business, air conditioning company Watsco (WSO), by more than 60X since he began the strategy. The math of such rollup/“ buy and build” strategies is very compelling. If you buy companies paying 4X EBITDA using stock that trades at 10X+ and cash generated, the returns can be astounding. For example, Pool Corp (POOL), also founded by Watsco alumni, compounded at more than 40% for a decade. There is a lot of execution risk in roll-ups, and time will tell if Henry Nahmad is up for the job, but he has committed significant personal and family capital to EnviroStar and thus far has made all the right moves, upgrading the CFO and completing two acquisitions to date.

ETSY (ETSY) – Etsy was discussed in great detail in our last letter. Share price appreciation has come faster than expected as an activist and two private equity funds have entered the picture. The CEO was replaced and layoffs have pared back the workforce by roughly 22%.

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