Madera Technology Partners commentary for the third quarter ended September 30, 2018; titled, “Something Old, Something New.”
It is invigorating to see the amount of profound value that innovation is generating. I remember walking between meetings in San Francisco in summer of 2008, and just taking a mental step back to put everything into perspective, to encapsulate how powerful in terms of economic cycles these technology-driven changes would become. I phoned back to headquarters and was told how wrong I was. We are thrilled to be a part of it.
Madera ONE, our global streaming video strategy, returned -4.4% in 3Q and is +89% YTD
Madera UNO, our next generation machine-to-machine network strategy, returned +2.2% in 3Q and is +13.8% YTD
Madera NEXT, our low net exposure disruptive entertainment and next generation network technology strategy, returned -0.8% in 3Q and is +23.5% YTD
Madera Technology Master Fund, our low net exposure fund, returned -0.2% in 3Q and is +5.0% YTD
For comparison, the HFRX Global Hedge Fund Index returned -0.4% in 3Q and is down 1.2% YTD
While our job is to find innovation, part of our job for you is to also identify the growing mountain of alternate facts and to separate the wheat from the chaff.
One great thing about technology disruption is the amount of value that can be created in enjoyment, productivity, utility, and wealth. An offsetting factor of change, however, is displacement and disintermediation of legacy companies and products with a vastly inferior value proposition. These negative disruptive consequences are especially pronounced in the later stages of an economic cycle as hardship forces behavioral changes. It takes time for once successful companies to fall. When we look closely at the winners and losers resulting from technology disruption, it is clear to us that investors need to be thinking about shorts to protect their portfolio and monetize structural change.
Market volatility and short-term correlations present great opportunity in companies with strong idiosyncratic drivers tied to secular growth. We are seeing really great value in our next generation communications technology thesis (5G, IoT, machine-to-machine networks). Progress is being made as operational milestones are achieved. If you have capital that you would like to put to work, to buy the dip in something tied to long-term structural change, we advocate putting it to work here as we get the opportunity to invest at the inception of the next communications platform.
Our new big short
We love finding technology driven opportunity in industries that are decidedly not traditional tech and consider this to be a great tool in our toolbox. We have done this well on the long side with Home Depot and Walmart to mention two previous examples.
Our latest short position, which has been three years in the making and now represents a significant portion of our portfolio, is a manufacturing company. We have done an extreme amount of non-traditional work to uncover the opportunity and craft our very out-of-consensus view. The likely path forward for this company is a Chapter 7 bankruptcy liquidation.
We have done some old tech things like quite literally getting our boots dirty, standing in dusty fields across the country counting widgets. We have done some new tech things like utilizing aerial imagery from drones, planes, and satellites, feeding proprietary supply chain data from unstructured sources into JSTARS, and harnessing natural language processing to build our view of dynamic social sentiment. What is crazy to us is that we have not seen one other investment manager out here with us collecting information. It is this esoteric, maybe call it grass-roots research, in conjunction with our financial models, that really builds our conviction and provides our differentiated view here.
The company is producing 100% of the total demand capacity of the market. The margin on these units produced is negative. They lose money with every widget. The market is saturated and mature with a diverse set of scale competitors that have positive unit economics and adjacent business lines. To appease existing shareholders and to attract new capital, the company continues to pour more investment to further expand production. Meanwhile, at the same time as production (i.e., supply) is increasing, demand is collapsing. As you may suspect, the company has begun cutting price to clear out inventory. The trick is this inventory is also pledged as collateral to asset backed credit lines. And herein lies the Catch 22. The company needs the units sold to show revenue growth, but at the same time needs to show the unit in inventory to borrow against it. Since the company cannot turn off the machine for fear of disappointing investors, Accounts Payable continue to climb and suppliers go unpaid. Our forensic analysis of the accounting shows some of the worst metrics we have ever seen, with better positioned companies historically electing for bankruptcy protection. When we pull together our field work, data intelligence, financial modeling, and basic Economics 101, what sticks out is the incredible divergence in expectations versus other investors. There is an unbelievable amount of equity, debt, and human capital tied up in a structurally money losing venture that is deteriorating.
As we would expect in a stock with high expectations based on a lot of factually incorrect information, there are nuances to each segment of the capital structure that we can exploit. Our cross-asset approach to this opportunity has identified several attractive risk-adjusted ways to meaningfully enhance the return outside of our initial equity position.
We do not like mentioning shorts by name because a cornerstone of our process is lending our experience and expertise to provide the best strategic advice to the management teams and boards of our portfolio companies. We want all the hard-working employees at this company to succeed, and we would love to offer our help to the management team and board. However, we believe the management team is fraudulent, and our work leads us to seriously question the integrity of the company’s accounting. Customers are purchasing defective products, some resulting in injury. The best solution now is to rip the bandage off and re-distribute the skills of these employees to companies that can create value.
The longer this structurally failed company operates and the more bad capital that is thrown its way merely to kick the can down the road, the more value that will be destroyed and people harmed. This may not pay out immediately. We are patient. We have done so much work and have a lot of real-time data to give us confidence. When it does pay out, this will provide some nice short alpha.