Uncovering Alpha In Microcaps And Special Situations: Q&A With Peter Rabover, Artko Capital by Khai Nguyen, LinkedIn Pulse
Peter Rabover is the principal and portfolio manager of Artko Capital LP. His focus and expertise lies in value investing, small caps, special situations and M&A. Prior to founding Artko Capital, he was a Senior Analyst for a large San Francisco mid cap value fund and a Santa Cruz large cap value fund, as well as stints in the Peace Corps as an Economic Development Volunteer and various private equity/M&A consulting roles.
Peter holds a B.S. in Finance from Duquesne University and an MBA from University of Virginia’s Darden Graduate School of Business. He has also attained the Chartered Financial Analyst designation. He splits his time between San Diego and San Francisco, California.
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Khai Nguyen: I’m here today with Peter Rabover, Portfolio Manager at Artko Capital. Peter, welcome.
Peter Rabover: It’s great to speak with you.
KN: Peter, can you begin by telling us your background and how you got started in the world of investing?
Peter Rabover: My family and I grew up in Russia and moved to the United States in 1991. I remember having to do all the stereotypical things that Americans got to see on television in the 1980s: bread lines, communal living, etc. My mom took me to stand in that famous Moscow McDonald’s line when it opened in 1989. That really stood out as my first real “capitalist” interaction, which I loved. Since then, I’ve always been interested in how things worked economically, even if I didn’t really understand it.Sometime during my undergraduate years, things clicked for me when a professor gave me Peter Lynch’s “One Up On Wall Street” and Warren Buffett’s essays and I really fell in love with value investing.
After college I did corporate finance and M&A work for US Steel and a two-year stint in the Peace Corps in Kazakhstan as Economic Development Volunteer and where I finished my CFA program and got to launch one of the first microfinance lending funds in Kazakhstan. When I came back, I was ready to jump into my investment management career with Hahn Capital Management, a great mid cap value shop in San Francisco, with close to $2 billion under management. The firm gave me the opportunity to really immerse myself in the field. John Schaeffer, the Director of Research, was a great mentor. I spent five years there as a generalist, leading up to and during the 2008 financial crisis, which really broadened my experience as an analyst and as a value investor. I learned the importance of not only having a mindset focused on capital preservation, but also of an event driven philosophy, concentrated on value creating catalysts, to not fall into the dreaded value trap. I appreciated the opportunity of owning a portion of the portfolio in my 20s and had the ability to incorporate some of my own investment ideas in the portfolio, and of course to learn from my mistakes.
After completing business school at the Darden School at University of Virginia, I worked for another fantastic value shop, Scharf Investments in Santa Cruz, California with close to $5 billion of assets under management. Scharf Investments has a strong focus on investing in quality companies and a valuation mean-reversion philosophy which they have used successfully for many years. During that time, I also really got into endurance sports, including triathlons and trail ultra-marathons which provided ample time to sort out my thoughts, investment philosophy and theses on the trail.
KN: That’s quite impressive and fascinating, particularly the ultra-marathons. Any parallels between that and investing that you’ve found through your experience?
Peter Rabover: I’ve found that ultra-running (running long distance trail races of 30 to 100+ miles) has a direct correlation/parallel to value investing with respect to the mental mindset needed for success. Both require a long term vision to achieve big goals,knowing that that you’ll be running for 30+ hours or expect to be in an investment for three to fiveyears, while ignoring short term pains with the constant ups and downs, and maintaining focus on finishing the race or waiting for the investment thesis to develop. Another parallel that I like just as no trail or run is the same, whether it’s running in the mountains at night or running in the desert in the blazing heat during the day, no investment is the same either. The key is to prepare well, understand the conditions and adjust on the fly when things aren’t going as you expect. And of course experience counts for a lot and knowing yourself and how to react to conditions and events around you to not repeat the same mistakes over and over again.
KN: How would you describe your investment philosophy or style?
Peter Rabover: I am definitely not afraid to paint myself in the value corner, with a rather large focus on buying high-quality companies with a very large margin of safety. I like to have low downside risk, which I characterize as permanent impairment of invested capital, and not as price volatility. I am cognizant that I am human and humans make mistakes. My goal is to make sure when mistakes do happen, they are few and far between and the losses on those mistakes are minimal. The way I control for that risk is by being very patient on the buy-in price and investing in quality companies with consistent earnings or cash flows, strong balance sheets, great management, high returns on capital and strong competitive advantages and moats.
On the other side of the equation, I probably shifted from Buffett 1.0 of getting excited to buy super cheap assets and just sitting on them for years waiting for Mr. Market to catch up, to more of a Buffett 2.0 in whichnot only do I want a great price but also a great company. However, since I don’t own these companies like Warren Buffett can and don’t have complete control, I want visible upsides or likely events to create those upsides to be present in my investments. Those events or value creators can take many forms, from market-specificlike a rebound from cyclical lows, to company-specific like recapitalizations, special dividends, division sales and spinoffs, expansions in ROICs, among many others.
KN: Can you talk about Artko Capital and the fund’s investment strategy?
Peter Rabover: The fund strategy is what I would call Enhanced Value in which the vast majority of the portfolio is invested in 10 to 12 high-quality companies with a significant margin of safety, and I’m looking for a 100-200 percent upside in the next three to five years. The Enhanced portion of the portfolio is invested in more special situation securitiesfor which I see the upside as significantly higher but the probability of loss of capital is also increased. These investments will be smaller than the core value portfolio in the 2 to 4 percent range on average and with a short one-to-two-year holding period. These are more “off-the-beaten-path” investments, where Artko Capital might well be the only institutional investor with no competition, with low liquidity/size such as warrants, converts, preferreds, and an occasional short. In general, I’m looking to size my positions in which in an extreme scenario, my overall portfolio drawdown is not more than 10 to 15 percent with more than 100 percent of upside.
KN: What made you decide to focus on small caps and why is it advantageous?
Peter Rabover: With the proliferation of index funds and ETFs and a growing number of large hedge funds, it’s becoming increasingly difficult to add value to clients after performance fees by concentrating on large and midcap companies where it is not only very difficult to gain an edge but also we have seen disastrous crowding in certain names over the last few years. Small and micro caps certainly have their reputation for being volatile,but there are many high-quality companies with solid fundamentals selling at half the valuations of their large-cap peers.Small caps tend to be uncovered by sell-side and large funds that can’t make them a big part of their portfolio,due to liquidity and market cap limits,so it’s an area of the market in which fundamental research and due diligence can trulyadd value for our partners, both from focusing on limiting downside risk and seeing large significant upsides. By having a hard cap on our AUM at $50 million of new money, we can continue to deliver a value-added product for our partners over the long term without sizing ourselves out of our strategy and process.
KN: When looking at investment ideas, what specific attributes do you look at and what are their merits?
Peter Rabover: One of the most important aspects of value investing and in creating a bigger margin of safety for yourself is to make sure that investments are not only bought at great relative prices but also target high quality companies. Much like a margin of safety, the definition of what constitutes a high-quality company is quite nebulous, but I’ll try to define what we look for in our investments to make sure that our downside is limited and our upside outperforms over the longterm.
High Returns on Invested Capital (ROIC) – In 1984, Charlie Munger was quoted as saying, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years, you’re not going to make much different than a 6-percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses. If you can find a fairly priced great company and buy it and sit, that tends to work out very, very well indeed.” I believe that finding and buying those better businesses that have consistent high returns on capital is one of the key competitive advantages we can offer our partners. While not always, a high ROIC goes hand-in-hand with a company with high competitive moats that allow the company to continue to earn outsized returns. Our research process focuses not only on high returns but also on making sure they are sustainable for the long term, which includes analyzing the reinvestment opportunities, as well as current and emergent competitive threats.
Quality Earnings and Consistent Cash Flow – Over the long term, companies that can deliver consistent growth and low volatility in their earnings tend to not only perform well in the down markets but also command higher relative valuations in the up markets. Quality-earnings companies tend to also have a consistent cash flow conversion rate in that they do not resort to accounting gimmicks such as pension accruals, “Big Bath” writeoffs, aggressive acquisition accounting or revenue recognition tricks. Having seen spectacular collapses by Enron, Tyco and WorldCom in my lifetime, I am particularly sensitive to having clean earnings and positive cash flow from our investments. One of the advantages of investing in the small cap space is that unlike large multi-nationals, there are a lot fewer “levers” to pull to “make” the quarterly numbers, and, as a result, their accounting is a closer representation of reality.
Clean Balance Sheets – One of my favorite life memories is having a finance professor in the late 1990s describe debt and leverage as a “Mac & Cheese effect”. We all love mac &cheese, especially as college students. Maybe one bowl a week. Maybe two or even three. But gorging yourself consistently on mac &cheese is likely to result in health issues and make you extremely nauseous. The same goes for debt. A little bit of debt in your capital structure is pretty healthy and gives you room to grow opportunistically. However, a whole lot of debt can lead to a lot of health issues really quickly. Of course, a clean balance sheet is not limited to just debt. Hidden liabilities such as lawsuits, environmental or counterparty commitments have destroyed their fair share of companies. Avoiding unnecessary financial leverage risk is an important aspect of running a high-quality value portfolio.
Incentivized Management – One of the hardest things in investment management is getting comfortable with the things you don’t know or can’t control. Some people are never able to really get comfortable with “not knowing.” I’ll be the first to admit my discomfort with the notion. However, Itend to avoid sending panicked emails to CEOs of our portfolio holdings late at night. One of the ways I try to control this risk is through making sure our managements and boards are highly incentivized to create value, either via significant ownership or with compensation structured toward creating value. Though rare, our favorite executive compensation agreements are based on growth in ROIC or growth in Free Cash Flow as growth in those metrics is what drives value creation for investors.
Simplicity of Business Model – It’s no secret that complexity breeds risk. A finance company packaging derivatives on obscure assets is a lot likelier to have black holes in its business model than a grocery retailer. As a general rule, if you’re unable to explain what a company does in under a few minutes, it’s probably not a worthwhile investment. Warren Buffett is famous for having a rule of taking notes on annual reports on the back of the printed report. If the notes go over a page, then he usually passed on the investment. He passed on Lehman Brothers in just a few hours of reading its annual report. I’m of the same opinion. I like our core investments to be simple and explainable.
In a world of thousands of small and micro-cap illiquid investments, there aren’t many that are likely to meet a majority of these criteria. However, having an investment process geared toward finding high-quality companies for our core value portfolio, combined with our margin of safety philosophy, makes me feel comfortable that over the long term, our focus on high returns with an emphasis on capital preservation will do well by our partners.
KN: Can you go over some of the companies you are currently looking at and what makes those investment ideas compelling?
Peter Rabover: In our core value portfolio, in which we take concentrated 6 to 10 percent positions in high-quality companies with a high margin of safety, our favorite names today areGaiam, Inc(GAIA),Viad Corp (VVI) and Demand Media (DMD) with Kodak (KODK-WT) Warrants a key position in our Enhanced Portfolio.
GAIA was a two-legged thesis and one of them just materialized. The company consisted of two parts, the brand business, yoga equipment and apparel — which the market surprisingly gave it very little credit foreven though it was carried in major national retailers, like Target — and the Yoga TV streaming app business with revenues growing at 50 to 80 percent a year. While the company was planning to spin off the TV business, it decided to go in a different direction: to sell the brand business and to focus on the TV. The company announced a transaction to sell the brand and a small travel business for $180 million or $7.20 per share (at the time the stock price was around $6.50) and making a tender offer for approximately47 percent of the outstanding shares at $7.75 in June 2016. The stock is currently trading at ~$7.75 and after the tender offer, some taxes and transaction costs, it should have approximately $5.25 per share in cash and a building they own in Colorado that’s worth approximately $1.75per share. That should leave you with about $0.75 per share or $10 million for a TV business thatyou are essentially getting for free. So what are you getting for that $10 million? Right now, the company has 167,000 subscribers paying $10 a month ($120 per year)so a revenue run rate of $20 million. The natural rate of growth in this business is about 30 to 40 percent at which point the company would breakeven, but if you want to grow at more, you have to spend. GAIA hasguided for 50percent growth for the rest of 2016 and 80 percent for the next three years so that should put it at 450,000 subscribers/$54 million in revenues in the next 18 months or 800,000 subscribers/$100 million in revenues by 2018. What do you pay for something like that? It’s a fantastic asset in a high-growth field that’s on all major platforms (Amazon, Apple TV, Roku, Chromecast) and has a nice global component to it. Two ways to look at it: you can compare it to the Netflix’s of the world at 2x to 4x EV/Revenues or you can imagine that with 800,000 subscribers, it would be a valuable asset in the hands of a media company looking to grow. In other words, we expect this asset to be worth anywhere from $7.00 to $15.00 per share in the next year or two, and today, you’re getting it for approximately $0.75 per share. Also of note is that the company is led by JirkaRysavy who has a long history of creating value for his shareholders from founding and selling Corporate Express and Crystal Market/Wild Oats, to the most recent transaction of the brand business. After the tender offer, he’ll own close to half of the company, and we’re confident our investment is led by an experienced and well incentivized manager.
Or next favorite name is VVI. The company has a long history of being a giant conglomerate in the 1980s and 1990s that owned companies like Dial, Moneygram and Greyhound. Over the years, the company has shed the disparate businesses, led by a strong board and a management compensation plan tied to ROIC. What’s left today are two excellent businesses: Events & Marketing (E&M) and Travel & Recreation (T&R). E&M is the market leader in a global oligopoly of putting on major live events like Penton Exhibition, European Society of Cardiology Congress or Microsoft and Mary Kay corporate events. The company has been growing same-show revenues well ahead of the industry at high single digits and has bolstered its portfolio with excellent high-margin acquisitions in audio/video and travel management services. The quirk with this segment is that it has a lot of events on biannual rotations, creating an appearance of lumpy and occasionally negative growth revenuesthatI think scares off a lot of investors. The other business is an excellent operator of lodge, attraction and tour assets around North America’s national parks like Banff, Jasper, Denali and Glacier. The attraction assets like the Glacier Skywalk in Jasper National Park or the Banff Gondola are high-margin/ROIC assets thatare very synergetic with the hospitality assets. Together these two segments are growing EBITDA at 40 percent in 2016 (18 percenttwo-year CAGR when considering show rotation) while trading below 6x EBITDA and at 12 percent recurring Free Cash Flow yield with below 1.0x EBITDA in Net Debt, which we feel creates a strong margin of safety for the investor. We believe the businesses are worth more apart, especially with the option to spin off the lodging assets into a REIT, at close to $65 per share or more than 100 percent from today’s levels and over the long term, closer to $90-$100 per share. The management has indicated they would like for the T&R segment to get bigger before they consider spinning it off, but with two excellent recent acquisitions of tour and lodging assets in Alaska that increase EBITDA by 30 percent and pushing close to $50 million next year, we believe we are getting increasingly close to this goal. We’re looking forward to the June 2016 Analyst Day to hear more progress on this value creator.
Our newest core portfolio position in Demand Media (DMD) offers a rare strong margin-of-safety/high-upside opportunity in tech, a sector in which companies can easily lose 30 to 40 percent in a session, a risk that we as value investors do not have the stomach nor mandate to take on. In this particular case, with 70 percent of the $110 million market cap in cash and the $40 million Enterprise Value of the company trading at less than 0.4x EV/Revenues, with more than $100 million in NOLs, we felt our downside was limited. On the upside, this company has two segments: Market Places and Content & Media led by a strong management team, including the CEO Sean Moriarty who recently led the sale of Ticketmaster for more than $1 billion. We really like this business for the Market Places segment that has Society6 and Saatchi Art, two companies that connect artists to consumers to sell art and custom artist-designed clothing/gifts. These two profitable businesses have been growing its $52 million revenue base at a high 40-to-50-percent clip, on par with its two competitors RedBubble and Etsy, both of which trade at more than 2.5x+ forward revenues. This would put the valuation for the Market Places business close to $160 million, or more than 4x today’s Enterprise Value. In other words, you’re getting the high-quality Market Places business at a 75 percent discount, and getting the Content & Media business for free. The C&M business is comprised of three internet content properties:Livestrong, eHow and StudioD, generating approximately $65 million in annual revenue. The new management team has taken the tough decision to completely revamp these business from a high-volume, low-quality content farm business to a higher-quality, more mobile- and video-oriented content business that is more targeted to social media traffic, which shrank the revenue base close to 70 percent. Additionally, Demand Media just sold the Cracked.com content property for 4.0x revenues to E W Scripps, showing that they are certainly willing to sell these segments at the right price. While we’re not very excited about these businesses and are worried about their potential to drain cash, we do believe they should be worth something, at least at 1.0x-2.0x revenues, resulting in a 200-percent upside to $15.00 per share from today’s price levels.
Our strongest conviction position has been in the post-bankruptcy warrants of Eastman Kodak. After a few painful years of restructuring, the $500 million market cap company is left with a profitable collection of commercial printing and software operating assets, a 16 million square foot industrial park in Rochester, $2 billion in net operating losses (NOLs) and a large patent portfolio. Together, these assets are worth 2x to 3x the current price of the stock, and we believe the management team is serious about monetizing them in the near future beginning with the sale of the very popular PROSPER ink jet system that we believe will fetch $200 to $300 million with multiple bids currently outstanding. By using the proceeds to pay down the high cost debt, which we believe is the biggest hindrance to the stock price improving, the year-end 2016 Kodak will be generating a growing $100 to $120 million in Free Cash Flow with net cash on the balance sheet and options to monetize another $200 to $500 million in non-core operating assets. The out of the money warrants have a September 2018 expiration date, giving us more than two years for the management to execute on this strategy and to provide us with close to a 1-10 risk reward ratio on our position.
KN: What are you most worried about?
Peter Rabover: I think one of the biggest things we’ve witnessed in the last decade and a half or so is how quickly technology can displace industries thathad considerable barriers to entry and competitive advantages for generations. From Amazon displacing traditional retail, Uber displacing taxi service and car rental companies, Netflix shaking up cable and traditional media, the fracking revolution making OPEC irrelevant and so on. Traditionally stable, high recurring cash flow industries like home security or hotels are finding their entire business models upended in a span of a few years. Since a big part of my research is spent on finding companies with high ROICs, I try to look at all the possibilities, as far-fetched as they are,for howtechnology can displace them. I am closely monitoring the evolution of energy storage as I think even continuing on the curve of high decline in energy storage costs can shake up our entire energy infrastructure in a short of amount of time including E&Ps, midstreams, E&Cs constructing gas-fired turbines and transmission capex.
KN: Who are the target investors for your fund?
Peter Rabover: I know it’s a quaint notion but given that I am looking to stay small, I am really looking for long-term partners, not short-term investors. We’re looking for entrepreneurial, high-net-worth individuals and family offices as our target market. To that end, short-term hedge fund investors like fund of funds or those that track the investment performances of their managers via quantitative statistics probably would not be a good fit for us. I’d hate to cut off a big chunk of a potential investment market, but the reality is our investment strategy and fund liquidity constraints require patience and commitment from our investors.
We work extensively with our potential investment partners to ensure that they have a complete understanding of the strategy, and, unlike large funds, we keep them up to date with clear, detailed letters in addition to always being available via phone or email. The back office infrastructure and service provider set-up is done by the industry standards that our clients are used to seeing from their other alternative managers.
KN: How would investors best utilize the strategy within their portfolios?
Peter Rabover: We’re all for ETFs and index funds, and I think those cost-efficient investments should definitely be a large part of most investors’ portfolios. We usually recommend that investors consider an investment in Artko Capital LP as part of the alternative investment allocation, closer to venture capital and private equity given our liquidity constraints, low correlation with the broad stock market performance and a more performance-fee-oriented partnership structure. In the end, we want to be complementary, not competitive with the low-cost alternatives offered and to provide a unique investment alternative for our partners.
KN: Peter, thanks for the taking the time today with us to share your insights.
Peter Rabover, CFA
Artko Capital LP