Originally published on Tuesday, July 29, 2014.
Here at First Crown we've been fortunate enough to interview Ryan J. Morris, president of Meson Capital. Based in San Francisco, Meson is an entrepreneurial activist hedge fund that invests in proven businesses undergoing inflection points that they identify or cause. For more information on Meson, please visit their website. Enjoy!
What has been your best trade in terms of an annualized return, and what was that story like?
Though I am far better known as a long-focused investor, our biggest short: Odyssey Marine (NASDAQ:OMEX) has to be up there - the stock was $3.00 when we shorted it Oct 31, 2013, predicting it would be $0 within 12 months (or be forced to do a dilutive equity raise). Now, ten months later, the stock is around $1.30 (-66%) vs. the overall market being up roughly 10% in that time. We've added to it all the way down so if it files for bankruptcy in the next month or two as we are predicting, it could exceed a 100% IRR.
The story has been fairly well-publicized in the business media after we published a detailed investigative report at www.omextruth.com highlighting that the company was worth $0 to shareholders. I am much more interested in improving and building businesses like InfuSystem (NYSEMKT:INFU) but the current highly-valued market conditions make me very happy that I have built expertise on the short side over the years. We can focus completely on business fundamentals and ignore the macro by being net-neutral exposed.
In Kathryn F. Staley's "The Art of Short Selling" she mentions how some short sellers like to stay quiet on their positions. What do you believe are some of the pros and cons on being a vocal short seller?
The economy is like a garden, tended to by the forces of the free market: roses need to be watered, weeds need to be pulled. Free market forces work when "what you see is what you get." When the free market mechanisms break down because of promotional false promises or other misleading statements, a lot of harm can get done as money is diverted from useful projects for the economy into ones that may only benefit insiders.
The pros of being vocal are pretty clear: if you contribute new information or analysis to the market, you can potentially influence the outcome and capture a much higher IRR if you are correct. For example, Bill Ackman with his MBIA (NYSE:MBI) short: their AAA rating created a chain of value destructive events by allowing subprime "AAA-backed" CDOs to hide the fact that their holders (banks, AIG) were terribly undercapitalized given the real risk. Similarly, a company raising money from investors with zero chance of producing a return should be required to state that in its press releases. Otherwise you have the two-headed destruction of investors losing their money and wasting their valuable time sitting on the edge of their seat waiting for the "lottery numbers" to be called.
As with activism on the long-side, the costs are significant but manageable and amortize with experience. One must be very careful with what they say and only make critical statements that can be supported by hard facts (our OMEX report had over 150 footnoted references) and appropriately qualified opinion. In general, companies will only sue as a bully tactic if they think they can suppress criticism (that is likely accurate), but states have continued to erect SLAPP laws to prevent this kind of behavior. The other cost for being a vocal short is that there are only so many shares to borrow so you can risk a short squeeze or increase in borrow costs if your research is more popular than it is accurate or impactful.
All those things taken together and given that economic gravity will tend to win out over the long run means that I would only ever want to be a vocal short on a particularly nefarious situation where I believed I could really cause a transformative impact.
What are some of the most common GAAP discrepancies that the market generally doesn't understand?
GAAP, like democracy, is the worst system except for all the others… The biggest one I have seen up close is for financial companies (especially for non-banks) where GAAP requires consolidation of debt based on control even if a controlled entity is "bankruptcy-remote" (i.e. the parent isn't really on the hook for the debts of the child). This was one of the highest IRR investments I ever made back in 2009: aircraft leasing companies have SPVs that own aircraft and use securitized debt to finance them. The stocks (AER, AYR are still independent) dropped down to the level of their holding company cash so even if all their aircraft were written off to $0 the stocks were net-net's. In reality, new aircraft are highly secure assets as the old less fuel efficient planes become worthless first. Those stocks increased 5X in less than a year which was a major contributor to our incredible performance in 2009.
Other things to look out for: Percentage-Of-Completion accounting or any kind of accounting where you can book revenues before actually receiving the cash (typically more interesting as shorts). Deferred revenue is becoming more important to understand now for subscription businesses as cloud computing businesses have this model. Operating lease accounting and understanding that hidden liability is also often misunderstood. Retailers are the worst for this - the GAAP financials can make a retailer look modestly or unlevered but when you include the operating leases and the inherent operating leverage in the business retailers can decline VERY fast when they do - see Aeropostale now vs 2 years ago for a good example of this.
What are some of the key components that make the perfect storm for an activist investor, which may not be evident or explicit from public filings?
I feel like I have been very lucky to see more 'perfect storms' before my 30th birthday last week than most investors see in their entire career! I have never had any problem with pain tolerance or dedication but there are some things in business where, like a storm, some factors are just too distant from your sphere of influence. The worst of these that I have seen that I will never repeat is when a small company has a commercial contract with a large company and the investment thesis revolves around that contract being enforced. Note financial contracts are very different and typically very clear-cut to enforce but commercial contracts related to specific performance are always much more vague than you would expect as an outsider.
Let me put it this way: 1) When a CEO, who is bad enough to be fired by an activist, negotiates a big commercial contract against a big company with a whole legal team - there are going to be weaknesses and 2) Even IF a contract is solid, enforcing it against a major vendor or customer would take years through the courts and the small company might be dead by then. Of course, these kinds of agreements are never filed in whole publicly (they will at least have redactions) which makes it that much harder as an outsider.
For example, there was a certain regional airline that had a cost-plus operating contract with a major airline. They operated as promised until a dispute broke out between management teams and the major realized that they could make it physically impossible for the regional to operate on time by scheduling flights over top of each other and with connections that left before the other landed, etc. As I said, specific performance is always a messier proposition than a financial: $X wired on Y date - this led to late performance penalties that the regional was powerless to avoid!
Interestingly, I have encountered this storm on three occasions - at HearUSA (my first activist situation back in 2010), Pinnacle Airlines (OTC:PNCLQ), and Lucas Energy (LEI). At HearUSA, we tripled our money because we were able to create a bidding war for the asset after their main supplier Siemens (OTCPK:SIEGY) forced them into bankruptcy. I am always proud that I only have to learn hard lessons ONCE but in this case I got to learn it NET once as it worked out well the first time so it took two times getting banged over the head to unlearn from the first success at HearUSA. It's always important not to learn the wrong lessons and we are all most susceptible to doing so after early success.
With a computer and engineering background why value investing? Why didn't you go try to start a tech startup, surely that would have been more lucrative?
Interesting question - especially since I now find myself living in SF. My answer all comes down to understanding risk and competitive edge. I think in general you see the biggest innovations where two disciplines intersect and I'm hoping to contribute to that at my unique background being both an activist investor and a software engineer. There is no question that if your goal was to make $1 billion as fast as possible, starting a technology company is the way to go - the media is filled with stories of WhatsApp and Instagram and other companies that created huge fortunes in a couple short years. The problem is that you don't see the thousands of other companies in those markets with similar features that ended up being worthless and their (often equally smart and hardworking) founders have battle-scars and investor losses to show for their efforts: that's capitalism. The key problem for a new startup is that if the market for a new product or service is obvious and measurable then you are too late: a bigger competitor will already be there (there will never be another Facebook (NASDAQ:FB) or Google (NASDAQ:GOOG) …); so you have to always take a certain amount of existential risk that a market will even exist for your new company.
I actually started a software company right after graduating called VideoNote and we were profitable in our first year because we had no chance of turning it into a huge exit in a year. We picked up customers one at a time while keeping our expenses really low. Now, profitable by the end of the first year does not mean profitable from day 1 like buying a dividend paying ETF or something - we had no revenue and LOTS of stress for the first 8 months while we built the product and attempted to find revenue. That was one of the most valuable experiences of my career and I'd never trade that experience of building something from scratch with all the associated pain for an MBA degree.
You could paint a career risk/reward spectrum where on one end traditional money managers tweak an index of large caps, over / underweight a little bit here or there and on the other end: starting one company from scratch. I realized that I had really unique set of experiences being familiar with both ends of the spectrum so decided to take some of the best of both worlds. The other darker part of the answer is that I've always believed that over time, low-value added jobs will be replaced with automation and I think you're already seeing that with index funds in the financial industry… The entrepreneurial activist approach that I have tried to develop at companies like InfuSystem is where we can take something that is already proven but wasn't being run well or strategically. You're not going to get a 1000X return like starting Dropbox but you could still make 3-10X but more importantly, you've very unlikely to lose money when you chose your opportunities carefully (which comes from good judgment, learned by experience, earned from bad judgment!). Recently, we spent the last couple years codifying all of the investment lessons and screens that we could automate to build a really unique software platform so we can search through companies and allocate expensive human research effort dramatically more effectively.
Could you give us an update on InfuSystem?
InfuSystem has firmly entered the fun part of an activist project for me where decisions now revolve around growth and strategy. We have the right entrepreneurial CEO, Eric Steen, firmly in place and continually increasing the quality of the management team and the business. The big risk to the business that unexpectedly landed on us literally the week I took the Chairman position in April 2012 was CMS competitive bidding. Just last week it was announced that infusion pumps are not being included in the next round which is great to see. Within the business it's truly remarkable what Eric has been able to do in a bit over a year - revenue is growing double digits and both revenues and profits are at record highs and just starting to build momentum. There is always a lag effect for financials as good numbers are just a consequence of the thousands of little things that come from smart people working hard together.
If tomorrow you had to go all in on one fund, other than Meson, who's would it be and why?
If I didn't have all my investable net worth in Meson, I'd say Joel Greenblatt's systematic Gotham fund ("Magic Formula" was the precursor to this). Over time I have come to believe that there are two fundamental ways to outperform over time.
1) As a true entrepreneur/business person where you bring real world experience to the table and the ability to help shape the future path of a company - activism fits in this category and creating real new economic value is always uncorrelated with overall market movements.
2) Systematically capturing fundamental investment factors that are mispriced for structural reasons: magic formula (cheap+good) would be one of many examples of these factors. Doing either of these strategies well requires significant upfront investment to build business experience in case 1) or software in case 2).
Most investors fall somewhere in between and I think are basically bouncing around on waves they aren't even aware exist (either internal business fundamental change that investor #1 would understand or higher level fundamental factors investor #2 is deliberately capturing). The quintessential example is a value investor who bought a particular housing stock in 2012 because it had a low Price/Book and the stock doubled - what lesson do you take from that? That low P/B stocks are great? Buying all low P/B stocks over time can outperform the market by a little bit and is a well-known and followed factor - why not buy all low P/B stocks if that's your true thesis? On closer inspection, the whole housing index doubled so that investor could have had the same return with way less risk by doing that, but it was a blind spot because they were just focused on a narrow piece of the puzzle. This is a very tough if not impossible business to separate signal from noise if you are only looking at the end result (returns) - investors need to really look deep to the true fundamentals within a company, its people, and its broader industry.
What's on your ipod/iphone?
I just use Pandora since I don't have enough time to download songs anymore - recent stations: Eminem, Lana Del Rey, Beethoven, Benny Benassi, Modest Mouse
Anything else you'd like to add?
I would just leave by saying that I started out in this business by reading the works of all the famous investors, Buffett, Graham, Klarman, Greenblatt, etc. Those investors are brilliant and have been so generous to share what they know but the world is different now: sophisticated hedge funds have so much capital that they will arbitrage any inefficiency that can be modeled easily and the markets are at all-time high valuations ever (for the median stock, the mean was higher in 2000 briefly carried by large caps). What does that all mean? The easy money has been made and the only way to outperform now is to have a truly defensible competitive advantage that is hard to replicate. That's always the question investors should ask themselves going into any situation just as they would if they were starting an operating business. If you don't have a good answer then you're almost certainly on the other side of someone else's edge.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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