The New York hedge fund, Greenhaven Road, ran by Scott Miller has had success with being a small fund, and staying small. The fund embodies what we do with Underrated Small-Cap Stocks, looking for off-the-beaten-path value stocks.
In the first quarter, the fund was down 3%, underperforming the gain on the Russell 2000 of 2%. This type of performance comes as the Greenhaven runs a fund that's not meant to mirror the market, with none of its top 5 holdings in the S&P 500. Still, over the last three- and five-years, it has managed to handily beat its benchmarks. Here are two of the most interesting ideas we found in the Greenhaven Road portfolio this quarter.
Greenhaven Road's most interesting top 5 holding
Halogen Software (OTC:HGENF) - This is a Canadian-based software company, trading on a Canadian exchange, selling talent management software to mid-sized companies, primarily in the U.S. This is a simple math story: Halogen's share price is denominated in Canadian dollars; with today's exchange rates, a Canadian dollar equates to around 80 U.S. cents. Other than share price, every other number for Halogen - including cash on the balance sheet and revenues - is valued in U.S. dollars.
When converting the currency properly (not clear that everyone does this basic math correctly), Halogen has just about the lowest enterprise value (market cap less cash)/revenue of any company we know of that is not facing some sort of terminal decline. Specifically, at $7 (NYSEARCA:CAD) - where Greenhaven bought a lot of additional shares - the company had an EV of less than $85M USD and revenue (growing 10%+) of $65M, so it was effectively at an EV/Rev of 1.3X when SAAS companies will typically trade anywhere from 2X-8X depending on growth rates, margins and the competitive landscape.
The valuation is not demanding. The largest problems with Halogen are that customer acquisition costs have risen and growth has slowed. By Greenhaven estimates, Halogen is paying approximately $55K to acquire each new customer, but the company was only being valued at less than $40K per existing customer when using the public market enterprise value/# of customers.
The argument to management was that it is cheaper to buy back stock than go and acquire new customers. The company has since put in place a large buyback for 1.2 million shares (5% of the outstanding shares), and fortunately, given the large cash balance, Halogen can buy back shares and still acquire new customers.
The new CEO is outstanding and has embraced a partnership model to acquire customers more efficiently. I think he is making very sound decisions and look forward to the progress the business makes. The combination of a low multiple and improved marketing efficiency could be a powerful catalyst for future returns. The HR software space is undergoing consolidation as companies go from offering piecemeal solutions, such as payroll, benefits management, or talent management, to offering a complete suite of solutions.
Given the current valuation, the corporate overhead that could be stripped out by an acquirer, and the lowered customer acquisition costs if folded into a larger company with an existing customer base to sell into, the economics for an acquirer would make sense even at twice today's share price.
Greenhaven Road's most interesting new stock
In the past quarter, Greenhaven Road made three new investments. This is the most they have ever made in a single quarter and is partly a reflection of the market's volatility and growth in available funds.
The most interesting new buy is RMR Group (NASDAQ:RMR) - Asset managers can be wonderful businesses that benefit from recurring revenue and operating leverage. The biggest risk with an asset manager is that when assets decline, the operating leverage works in reverse. In other words, if assets decline by 50%, often earnings will decline by more than 50% because there is a base level of fixed costs. Asset managers that are unlikely to lose their assets should be highly prized and trade at a premium. RMR Group is an unusual situation with many ingredients for meaningful appreciation. Let's start with what they do.
In the company's words, "RMR is an alternative asset management company with $21.0 billion of assets under management, including more than 1,300 real estate properties. The RMR business primarily consists of providing management services to: Four publicly traded REITs, three real estate operating companies, and one real estate securities closed end fund. RMR has over 400 professionals in its corporate headquarters in Newton, MA and 25 offices throughout the U.S." I love asset managers and I had never heard of RMR Group before reading about the company in David Brown's "Value Investor Insight" January interview, since the company did not exist in its present form before December 2015.
Let's turn back the clock just a little bit to 2007… Scott Miller was working in an operating business and having a lot of success investing in a personal account. He had decided that he wanted to work at a hedge fund to better monetize his skills and learn from others. Because of the laws of supply and demand, this is easier said than done. There are a lot of people who want to work in potentially high-paying places, and there are just not that many hedge funds that are hiring. After months of looking, a college roommate (and current investor in Greenhaven Road) got him in for an interview with a fund in which he was invested. I knew it was essentially a courtesy interview, but it was a foot in the door, and the only door that was opening even a little bit. As part of the interview process, the portfolio manager asked him to analyze TravelCenters of America. This company is a truck stop operator recently spun off from a REIT. I spent an enormous amount of time visiting truck stops, learning the ins and outs of the truck stop business, and looking at TravelCenters of America from top to bottom, which was about as sexy as it sounds. I then began looking past the numbers and started to think about the motivations of the different parties, concluding that TA was burdened with leases that were very favorable to the parent company. It was as if the REIT wanted as much of the economics as possible to flow back to the parent company at the expense of the newly public company.
If Scott had to invest in TravelCenters, they were more interested in the parent company than the spinoff. He also learned the fund he was interviewing with was a top 5 holder of TravelCenters of America, and it was one of their largest positions. It did not take a genius to figure out the portfolio manager liked the company. The portfolio manager did not agree with his analysis, and he did not get the job. The stock later went from $30 to $2, and the leases were renegotiated. The reason for bringing up this anecdote is that the holders of those leases, the people who structured the deal, are the same people who created RMR Group - the Portnoys. These are smart people with shrewd deal-making skills.
RMR Group came public in a highly unusual manner. In 2014, the Portnoys lost a REIT management contract they had with Commonwealth REIT to two activist investors. There were multiple lawsuits and a lot of mud was slung. If there is a "story" on the Portnoys, it is that they managed the REIT for their benefit, not that of the REIT shareholders. The incentives were such that the larger the REIT was, the more the Portnoys made. Their incentives were to grow the REIT larger and larger, managing more and more properties.
They were taking home $50M+ management fees annually while the REIT was dramatically underperforming its peers. To simplify, the narrative is Portnoys = greedy at the shareholders' expense. Remember, they may be greedy, which is legal last time I checked, but they are also clever. They were managing four more REITs and they were rightfully concerned about losing the contracts for these as well.
So the Portnoys and their legal team came up with a way to not only protect their REIT management contracts, but also to effectively make the management contracts permanent. RMR Group engaged in an "Up-C" transaction where the owners of the REITs were given shares in RMR in conjunction with their agreeing to new management contracts. This was effectively a tax efficient IPO of RMR Group that placed the shares with the owners of the managed REITs. When shares were distributed on December 14, an investor who owned $1,000 worth of REIT shares received approximately $10 worth of RMR stock - an immaterial amount. The Portnoys gave up ownership in half of their company but got shares in the managed REITs, ironclad management contracts on the REITs, and a tax asset that increases in value if the share price rises.
Let's look at these one at a time. The shares in the REIT are straightforward and align the Portnoys and the REIT holders. The contracts have a 20-year duration that renews every year, so they are effectively perpetual contracts. The fees to break a contract are onerous, as you would expect when shrewd negotiators are putting together contracts they never want cancelled. The contracts pay both management and incentive fees, and like the truck stop contracts from years ago, are favorable to the Portnoys/RMR Group at every turn. Lastly, the tax asset created by the Up-C transaction is such that it increases in value as the shares of RMR Group increase in value.
The Portnoys should care about RMR share price because they own half of the company and because it increases the value of their tax asset. In the Portnoy universe of the REITs they manage through RMR and the operating companies, RMR Group is the crown jewel; it is how they get paid, and we get to sit alongside the Portnoys.
This is a wonderful business with incredible contracts and a history of growth and aligned interests between the Portnoys and RMR holders. In essence, our investment came down to basic math and three numbers. The first is the length of the contracts - 20 years self-renewing is virtually unheard of. The second was the valuation of approximately 4X EBITDA for a high-quality money management business with strong contracts.
Lastly, the ratio of approximately $1 of RMR stock for every $100 of REIT stock owned creates conditions for indiscriminate sellers. More complicated math is required to understand the true tax benefits that accrue to the Portnoys because of RMR share price increases, but their 50% ownership combined with the tax benefits portend well for our investment. Greenhaven believes that the conventional wisdom that Portnoy = greedy is now actually Portnoy = greedy for RMR shareholders. Given their history of entrepreneurship and creating value over time, investors should have the opportunity to make money alongside them.