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An Interview With Alex Roepers
CAPITALIZE FOR KIDS: Can you walk us through how Atlantic Investment started and how the firm has been able to generate attractive risk-adjusted returns over a period that spans almost three decades?
Alex Roepers: I spent six years in the 1980’s working for two conglomerates in New York. One was Dover Corporation, a publicly traded industrial conglomerate and the other was Thyssen-Bornemisza Group, a European privately-held conglomerate. In both cases, I was involved in corporate development, mainly the buying and selling of companies.
I learned a few things while working for these companies: number one, the importance of due diligence and the analysis that comes with it; secondly, I learned to dislike paying premiums to gain full control – which you have to do if you’re an industrial buyer or private equity group. I also disliked the inability to trade positions and not have the liquidity to sell. So, I took my toolbox into the public market by starting Atlantic in 1988 and focusing on a well-defined universe of midsize industrial and consumer companies. Atlantic was started with a single purpose: to achieve a long-term record of superior capital appreciation using a concentrated value investing approach that was rooted in my experience with these two companies.
What gives an investment management firm like Atlantic the right to exist is the generation of superior capital appreciation over time. To get there, you need to concentrate capital. If you look like an index, you are unlikely to outperform in a significant way. Concentration of capital is a key ingredient needed to be able to provide superior outperformance.
But if you concentrate capital, you need some rules of the road because you have to be careful to avoid any significant losing positions. In venture capital, people expect that some investments are writeoffs. If you have ten investments, you can expect the majority to be failures while a few winners should not only make up for the failures but also provide the overall return. Even in the private equity space, you can expect to have some complete write-offs. If you’re in the public equity market on an unlevered basis and you put together a concentrated portfolio, which in our case is six stocks for our flagship U.S. fund, any write-off on one of those positions would be a disaster that can put an end to your fund or business.
How do you avoid losses in a concentrated public equity portfolio? We start with carefully defining our universe. Think of a pyramid of all public companies from small to largecap. The bottom part of the pyramid represents all firms with market caps below one billion, which we avoid as we seek adequate liquidity in order to be able to get in, to get out and to properly size positions during the holding period. The top of the pyramid represents companies with market caps of over $30 billion, which are not of interest to us either.
Our reason for excluding largecaps is that we are seeking to have multiple catalysts for unlocking value. Corporate action, activism, and takeovers are three ways to unlock value. For over $30 billion market caps, activism is less prevalent and/ or productive and takeovers are typically stock-for-stock deals that yield less upside than cash deals that are often seen in the mid-cap range where we invest.
With regard to unlocking value, we focus on the corporate action side, as an actively engaged shareholder to help management define and implement all the various ways we believe they can enhance shareholder value. This ranges from corporate development activities and uses of cash to improving operations, working capital management, corporate governance and the makeup of the portfolio – it’s a broad range. Regardless, these actions are usually both easier to implement and more meaningful at medium-sized companies.
Our target companies often generally need to improve their operations. When we get there, they are typically trading at a historically low valuation level and they need a sense of urgency to improve their results and valuation in order to get out of what we call the “vulnerability zone”, where they are potential takeover candidates, trading at just 6x EBITDA, 8x EBIT, or 10x forward earnings on lower-than-normal potential earnings.
At our initial CEO-level due diligence meeting, we discuss with top management the steps they intend to take to improve shareholder value. We will also follow up with our own recommendations for the initial actions the company should undertake to get the stock up 20% to 25% near term and out of the “vulnerability zone” and of course actions that create sustainable long term shareholder value over time for much more upside in the shares.
In our chosen mid-cap range, we seek to be a substantial minority shareholder, typically owning 2% up to 7% of the shares outstanding, which gives us the best of both worlds: credibility and access to top management as well as reasonable liquidity to trade and get out of the position.
If you look at any top 20 shareholder lists of publicly-traded companies in our universe, you will see that 2% ownership typically puts you in the top 10. Examining the top 20 shareholders a little closer reveals that we are in a world of passive investing, a world of widely diversified investors, including massive mutual fund complexes, ETFs, custodians and index funds. Typically 17-18 of the top 20 shareholders of almost any public company are these largely passive shareholders.
We feel being concentrated and a top 10 shareholder gives us a tremendous edge, because when we talk to management, they appreciate that this commitment separates us from just about any other large shareholder. Company boards and management teams don’t often get to talk to large shareholders that are as deeply knowledgeable about their company and industry as we are given our focus, concentration and almost three decades of investing in this space. Additionally, there are only a few investment firms that are as concentrated as we are. Fact is, virtually all professionally managed public equity portfolios hold more than 30 stocks. Most of the highly concentrated funds that make up the small minority are activists with varying styles along the typically used spectrum of “hard to soft” activism. We use a different spectrum, namely, “illiquid to liquid” activism. We see most activists as “illiquid activists” due to their overt public campaigns, waging proxy battles and obtaining board seats. If you think about the purpose of activism, which is to enhance or accelerate shareholder value creation, what really matters is that you will be able to capture the value created. We stay away from illiquidity for the simple reason that we want to be able to trade our positions and size them properly.
This active sizing of positions has generated nearly 20% of our gross returns, and almost 40% of our alpha, over almost three decades. We see active sizing, which is rarely discussed when analysing investment returns of public-equity investment managers, as the second most important alpha generating tool, behind superior concentrated stock picking.
If you are highly concentrated, you don’t just have six stocks and let each one of them be 15-16% of capital. You have one or two at 20%, two or three at 10% and one at 15%. Let’s say one of the top positions at 20% of capital runs up right after you establish a full position. We will start clipping it almost right away because we want to maintain it at 20% of capital initially. The moment it goes up say 30-40%, while not yet at target, the risk reward has become less compelling, so we may bring this position down from 20% to 15% or 12% of the portfolio. We are still solidly exposed to this name, but we have taken a lot of money off the table, clocking big gains and, in case this run happened in 3-4 months, a triple digit IRR on part of the position.
Most activists can’t actively size, because they’re illiquid as a result of their public activism, proxy battle and/or Board seat. So, we feel that Atlantic is quite unique in its positioning. We didn’t set out to do that, we set out to put up superior capital appreciation over time with a differentiated value investment approach within a specific investment universe.
CAPITALIZE FOR KIDS: Has your philosophy and strategy changed over time at all?
Alex Roepers: Since the inception in 1992 of the Cambrian Fund strategy, our flagship fund, almost 25 years ago, there have on balance been six positions at any given time. So, we have remained highly concentrated all along. Our cumulative net return over the past almost 25 years is almost 4,400% versus the S&P 500’s total cumulative return of 860%. Cambrian Fund is solid proof that stock-picking can outperform over time.
CAPITALIZE FOR KIDS: You should be very proud of that Alex – that’s remarkable.
Alex Roepers: Thank you. Compounding at a superior rate is our number one objective at Atlantic. I am nowhere near done and we plan on making this a much longer record.
CAPITALIZE FOR KIDS: How do you see the firm evolving? You know there’s obviously a lot of conversation right now on how hedge funds are incorporating big data and machine learning. Are you making use of any of that technology and if not, do you see your firm evolving in different ways?
Alex Roepers: We are not likely to use big data as we don’t see much use for it with our investment approach. We are industrial owner types performing extensive due diligence. We call ourselves “industrial tourists” as we conduct over 500 onsite company visits worldwide per year, seeing offices, plants, talking to managements and making judgments along the way. Other than our proprietary screening and signalling software and systems, which we have had for years and which allow us to focus on the areas and companies that are the most compelling, we do not computerize our stock selection or due diligence.
As far as evolving as a firm, we have grown, adapted and thus evolved over time but from an organizational and ownership structure we have essentially remained steady for most of our history. We have a long tenured research, trading, IR and finance team. Since the beginning of Atlantic in 1988, I have continuously been the CIO, spending most of my time on due diligence, doing company visits, and working closely with our research team of eleven senior analysts.
When we started in 1988, we only focused on U.S. equities. By 2003, the firm was at about $1.5 billion in AUM with strong marketability. As we felt the need to control our AUM in order to protect our ability to generate superior returns over time, which involved maintaining a high degree of concentration, our mid-cap focus and reasonable liquidity, we temporarily closed our U.S. flagship fund, Cambrian and the long/short fund AJR/Quest.
Cambrian Fund, the long-only six stock fund, and AJR/Quest are joined at the hip, as the long/short is long about fifteen names with the top six made up of the same stocks that make up Cambrian Fund. These top conviction positions make up 60-70% of AJR/Quest’s gross long exposure. In addition, we have another 9-10 other longs that add diversification on the long side. AJR/Quest has a typical gross short exposure range of 30% to 50% and 90% to 100% gross long so we are typically running a 30-60% net exposure. That fund has averaged about 11% net for almost 25 years, outperforming the S&P 500 total return despite having half the equity market exposure. Cambrian’s net CAGR over that period is almost 17% net.
I am giving you since inception numbers because for us it is all about the long term. There are clearly growth and value investment cycles. We have just come off a 10-year growth and large-cap investing cycle. Early last year, we made the call that as of February 2016 a value investment cycle had finally started. We believe it will take time before it becomes more obvious to more people. Our paper “Rotation to Value”, the main subject of my speech at the Capitalize for Kids Investors Conference in October 2016, was published in Institutional Investor in September of last year, and we continue to see proof that the value cycle is alive and well.
That has only become clearer to us. Now we are a year and a few months into that new value cycle, and it’s still a market where people are flocking to ETFs. It is a strong sign if value managers like us are able to outperform the main market capitalization-weighted indexes that are still getting major inflows on the growth side and the large cap side. The moment that inflows stop to these indexes and shifts to value, you are likely to see another four or five years of outperformance by active value managers over large cap and growth ETFs and funds.
Read the full article here by Capitalize For Kids.