Greenwood Investors letter to investors for the second quarter ended June 30, 2017.
Dear GreenWood Investor:
We’ve had a satisfactory first half of the year, but while results have been decent, we are not resting. In fact, we’ve never been busier. We are working hard to minimize opportunity costs and at the same time, take advantage of the buoyant market conditions. We continue to find numerous highly compelling ideas to reallocate capital towards. With the portfolio actions taken in the quarter, we’ve maintained a very robust risk-adjusted return profile. At quarter-end, our ratio of reward-to-risk stood at 38.3x, which is marginally better than the 38.2x at the beginning of this year. This was no small feat for us to achieve, but as we discussed in the fourth quarter letter of last year, this is our purpose. We continue to deliver a very actionable and timely portfolio. That is what we’re focused on, not short-term results.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
As we’re getting closer to our ten-year anniversary for the original composite, we believe it is far more useful to look at the long-term compounded results our investments have achieved. We believe highly satisfactory results can only be achieved through a concentrated portfolio of “best ideas,” which inherently produces lumpy results. Yet over the long-term, we believe we can generate results that beat the market by a long shot. We’re not investing in mega-cap fairly-priced multinationals. We go where there is extreme pessimism, controversy, low competition and structural inefficiencies. When our investments work, we typically measure performance in multiples, not percentage points. Of course, the timing of these results is the least reliable factor. But our roadmap we discussed in our third quarter letter last year has proved very helpful in improving our near-term performance.
Investing returns can be broken up into two very simple drivers. On a shorter-term basis, solid returns are primarily determined by one’s views differing greatly from that of the market’s. If the divergent view happens to be right, shortterm performance can be quite good. But over the long term, the qualitative factors of the investments will be the long-term drivers of our performance. These include their management styles, competitive advantages, the industry’s lifecycle, and conscious capitalist ways of treating stakeholders, among others. We look for a convergence of these high-quality performance drivers coupled with greatly divergent viewpoints about the near-term. We believe this is the best combination for the short, medium and long-term.
Last year our portfolio of companies had been showing great progress throughout the year, while the stock performance lagged the greater market. This was largely thanks to global investors’ views towards the European Union. Most strategists started to price-in a very high probability of the union coming to an imminent collapse. As this view has increasingly become almost laughable, markets have started to adjust to a more nuanced reality. Accordingly, the underlying performance of our holdings has started to become harder for traders to ignore.
In a similarly controversial call, we received plenty of pushback when we initiated our position of Whole Foods Market (WFM) last quarter. Yet the near-term performance of this key position has been highly satisfactory given the company’s take-out by Amazon in the quarter. Clearly the peak short interest and peak bearishness among sell-side analysts was a misread of the actual quality and fundamentals of the business.
We’ve used this roadmap to guide our efforts for over a year now, and this evolution has paid off handsomely. The greater the contrarian viewpoint, the greater the potential for the market to have misjudged reality by a wide margin. While the market has adjusted expectations closer to reality in the case of Whole Foods, it has been ignoring improving fundamentals at two other highly controversial companies – TripAdvisor (TRIP) and Ocado (OCDO LN). We initiated positions in both during the quarter, and are prepared to double each position on any near-term choppiness. We also took advantage of a significant adjustment in market expectations to New York REIT’s (NYRT) liquidating assumptions. We believe there’s very minimal downside in this short liquidation, with nice upside optionality.
We were keen to make TripAdvisor a sizable core position. The company is a powerful influencer of demand in the gigantic $1.3 trillion travel bookings industry. In fact, numerous third party surveys suggest that TripAdvisor influences half of the demand in the industry, with this share growing at an accelerating pace. Yet, like other highly successful demand-focused companies, the company has innovated first on user-experience and only later focused on monetization. Accordingly, it is monetizing only a quarter of one percent of the business it generates. Yet, every month that goes by, the company is introducing new features and functionality aimed at closing this gigantic monetization gap. All of TRIP’s competitors are focused on the supply-side of the business. While both sides are important for a functioning market, only one company can adequately capture the demand. We believe influencing demand is more powerful than controlling supply, yet market valuations would suggest the opposite, with TRIP trading at the cheapest valuation in the industry. Recent results have shown that not only is the TRIP ecosystem growing quite rapidly, but engagement is accelerating. Revenue per hotel shopper has turned back to growth and the company is making solid progress in monetizing the >7 million places that are being actively reviewed on its website by over 3.5 billion annual users.
Wall Street’s view of the company couldn’t be any further from reality, with heightened short interest at 17% of the float, and sell-side sentiment reaching a fresh peak in pessimism. This peak pessimism is happening at a five-year low in the stock at the exact time the revenue and profitability are turning back to growth. While TripAdvisor’s setup reminds us exactly of the one Whole Foods faced in the first quarter, we sincerely hope the most obvious acquirer (Priceline) doesn’t make an approach soon. We believe we’re getting a very high quality company at a valueinvestor’s price point. This gives it a very attractive short, medium and long-term roadmap. Unsurprisingly, it’s already our third largest position and will become our largest with any incremental weakness.
TripAdvisor is a perfect example of what we seek to find in global markets today. Our global approach is a prerequisite to finding the rare company that we buy at a decent or even bargain price, and eventually end up owning as a long-term, high-quality asset. This ideal candidate is also perfectly exemplified in FCA, which we exited during the quarter. We bought FCA for less than a tenth of its replacement value, it roughly tripled, and we have ended up owning a long-term compounding position in Ferrari (RACE), in which our cost basis is zero. EXOR (EXO IM) is another related company that we seek to hold forever. In a similar vein, we believe TripAdvisor is a very small redwood seed that could potentially grow for a very long time. And it could get quite large.
We are still rooting for Fiat-Chrysler through our meaningful ownership of EXOR. Now that GM has finally awoken to the very lackluster auto environment in the US, it is perhaps only one to two quarters away from realizing that the same can be said, if not worse, for the Chinese auto market. This is its last source of profitability. We would not be surprised if GM was keenly at the negotiating table with FCA before the end of the year considering a darkening global automotive outlook. We would gladly hold GM – FCA through a recession as the combined company will likely be the last man standing, profitably delivering cars to the next AT&T or Verizon of the auto space. Perhaps FCA’s board can talk some sense into GM about its investment in car sharing endeavors. As Lyft and Uber have both proved, we believe these are low return businesses at best and deeply negative-returning assets at worst. We would far rather be the most efficient manufacturer in the industry rather than bet the farm on trying to become the next Android or iOS. Unfortunately for the OEMs, the next Android is once again likely going to be Google.
Because autos are inherently cyclical, they are almost never buy-and-hold positions. As the US cycle started getting extended in 2016, we significantly increased our holding in EXOR with the goal of holding FCA through only this higher-quality company over the long-term. Now that FCA has rallied significantly, and the market is ignoring largely negative incremental data points for the industry, we thought the timing was right to execute a portfolio decision that had been many quarters in the making.
While the story of the first half of this year was largely one of the market catching up to reality, in two instances, the market ignored significant deterioration of fundamentals as was the case with FCA. We also took the opportunity to exit our position in Leonardo. The government has poorly chosen the new chief of the company, and as a result, it has been losing key talent in management. We still love the underlying quality of Leonardo’s businesses, but monetizing shares at a seven-year high while the risk-reward and performance drivers of the business were deteriorating was an obvious choice for us to make in light of the terrific opportunities in TripAdvisor and Ocado.
We purchased a starter 4% position in shares of Ocado. We had been studying the company for a year, and had used its unit-economics to build our thesis in Whole Foods. On the morning of the announced buyout of Whole Foods, the market rapidly sold off shares of the UK-based online grocery seller. We were standing buy, ready to take advantage. We believe Amazon’s transformational acquisition of our holding in Whole Foods significantly increases the strategic value for Ocado’s technology as well as improves the likelihood of a sizable partnership for the company. While the 6% cash-flow yield is slightly more expensive than TRIP’s, shares are trading below their long-term valuation averages. Food inflation has resumed in the UK after a prolonged period of deflation, and Ocado is poised to take more share in the secular growing segment of online grocery delivery. It remains the only highly-profitable grocery distributor at its scale and its technology is a perfect fit for any struggling grocery store looking for a lifeline in the brave new world of Amazon-Whole Foods. Ocado is the most highly-shorted stock in Europe, and it is hard to find a more hated company in global markets today.
Ocado and TripAdvisor are just two of the many companies on which we’ve been conducting deep due diligence. As investors that are signed up for our research alerts well know by now, we’ve been living at trade shows, airports and train stations in an effort to deliver on our purpose. The results so far this year have been good, but we want them to be great. As we are approaching our ten-year anniversary of the original composite, our goal is to ensure the next ten years are better than the first ten. Because of all the significant improvements and the streamlining of our framework, we believe the odds are favorable for an increase in long-term performance regardless of the economic outlook.
We are also highly focused on innovating the investor experience. Third parties have already validated our industryleading investor satisfaction, but we are not resting. We are increasing the frequency and depth of our research reports, while complimenting them with an increasing frequency of videos. Investors can now save time from a busy schedule and watch and learn about well over half of our portfolio.
As Adam Smith said, capital is merely stored-up labor that has been saved for use at a future date. As TripAdvisor’s highly engaged ecosystem shows us, people don’t want to out-source their hard-earned vacation. So why should they outsource the highly enjoyable process of investing their stored-up labor, that is capital? Because like so many legacy industries, less engagement was actually an improvement in the user experience. We are seeking to make the engagement with the capital allocation process fun and interesting again.
Does it not give you, the investor, satisfaction that your capital is positively changing the world? Whole Foods is improving animal welfare standards and bringing greater nutrition awareness to the country, while Bolloré is developing ports, roads, rail, solar stations and even fiber in Africa. Ocado is saving its customers multiple hours a week by delivering their groceries, and Telecom Italia is delivering broadband speed to a famously impatient country. MEI Pharma is seeking to save hundreds of thousands of lives that could be claimed by cancer. TripAdvisor is helping 3.5 billion people learn and grow through experiencing new cultures, and Flybe and Rolls Royce are getting them there for ever-cheaper prices, while burning less fuel. Piaggio, the original disrupter, invented the cheapest form of personal mobility, and Ferrari builds the fastest and prettiest cars in the world. We are partially enabling all of this progress, and we’re making money doing it. What could be better? We are working on our first co-investment opportunity where we will seek to add long-term value to our next major European target.
We are excited to continue innovating in the coming quarters, while keeping our focus on continuously delivering a timely and actionable portfolio. As always, we invite you to imagineer with us. I continue to be humbled by your trust in us and our framework, and will never stop working to improve results and our investor experience.
Steven Wood, CFA
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