By VW Staff
For the 4th fiscal and 2nd calendar quarter of 2016, a partnership interest in Artko Capital LP returned 5.7% net of fees. At the same time, an investment in the most comparable market index alternatives Vanguard Russell 2000 ETF (NASDAQ:VTWO), iShares Micro-Cap ETF (NYSEARCA:IWC), and the Vanguard S&P 500 ETF (NYSEARCA:VOO) gained 3.8% 4.0%, and 2.4%, respectively. For the last 12 months of our fiscal 2016, an interest in Artko Capital LP returned 12.9% net of fees, while investments in the most comparable aforementioned market index alternatives were down -6.7%, -12.0%, and up +3.9%, respectively. Our gross, quarterly, and cumulative results, as well as those for the comparable indexes, are available in the table below. We are happy about our first full-year performance, and will focus the letter on discussing how we got there.
Artko Capital On Catalyst-Driven Investing
A big part of our investment process is not only identifying undervalued quality securities, but also figuring out the events that will lead them to appreciate in price within our target holding period. Buying something just because its undervalued is unlikely to result in high long-term returns, and generally, we look for catalysts that will get us there. However, we would not call this particular strategy "event-driven," as we consider soft catalysts (e.g., continued high ROICs and growth) just as value-creating as hard catalysts (e.g., special dividends or spin-offs).
One of the most difficult aspects of this particular strategy is getting comfortable with "not knowing." Can we predict with 100% certainty whether a company is going to keep paying special dividends or divest a business to unlock enterprise value? Of course not. We have to be able to act with less-than-perfect information. But just as a good chef knows that combining certain ingredients, cooking them under a specific heat and using proper cookware will result in a quality meal, our job involves researching the specific company or industry ingredients, ensuring that external economic or regulatory environments are the proper "temperature" for those ingredients to create value.
The most important ingredient in forecasting catalysts is making sure that the people who are in charge of making economic value-creating decisions are properly incentivized to make them. Sometimes answering the most basic questions, such as "What is management's motivation to make this event happen?" or "Is this person going to get stinking rich if he/she does what we think needs to happen?" can shed some excellent light on figuring out the likelihood of certain events. Unlike in large caps, where management usually has already accumulated significant wealth, and is likely more concerned with ego and reputation than earning an extra few million, we find that most management teams of small-cap companies are still very much in the wealth accumulation stage and are hungry to grow it.
Other ingredients we consider are the balance sheet, historical actions by the company and management team, and industry dynamics. The balance sheet is perhaps the second most important ingredient in catalyst-driven investing. Does the balance sheet have hidden assets that can be monetized or spun off? Does it have the capacity to undertake value-creating events? Does it make sense to have the current capital structure? Thinking through the answers to these questions helps us to narrow down our potential investment candidates and likelihoods of catalysts happening.
Finally, we tend to look for answers to questions like "Has this company, board, or management team done this sort of transaction before?" or "Are there industry events or dynamics that make a catalyst likely?" via our due diligence process. In the end, there are no "sure thing" events in investment management, and investing involves high degrees of uncertainty, but we've found when buying uncertainty at a high margin of safety with the research process focused on ascertaining the likelihoods of value-creating events tends to work very well over the long term.
We had a good first year, and out of the 15 securities in our fully invested portfolio, a significant portion of the positive performance in the down small-cap markets came from 7 securities that had realized some sort of catalyst or event. We'd like to review what happened in our portfolio over the last 12 months below:
- USA Technologies (NASDAQ:USAT) - This was a 7% position for us that has appreciated over 48% from our initial buying levels and close to 30% from our dollar cost average price this fiscal year as we continued to add to the position as our confidence in the thesis increased. The company began to convert on its significant growth opportunity of increasing its vending machine connections by 32% to add to its installed base, and ending the 1st quarter of 2016 with over 400,000 connections. With the increasing value of transactions, as well as transactions per connection, USAT was able to grow its recurring revenue base by over 34% for the 9 months of its fiscal 2016. More importantly, by converting the financing for its transaction equipment from internal capital to external capital, the company has begun to show consistent free cash flow generation, which we expect to increase exponentially going forward. We're encouraged that our thesis is panning out, and still consider this a strong conviction idea within our portfolio. Longer term, we believe this company would be a better fit within a larger financial transaction processing company, and still expect over a 100% upside from today's levels in the intermediate future.
- US Geothermal (NYSEMKT:HTM) - HTM was a 10% position in the portfolio for us this year and it has appreciated over 55% from our buy-in levels and 40% from our dollar cost average price, on the back of a number of transactions and announcements. We expected the company to continue to convert the 200 megawatt (MW) project pipeline to grow its current 40 MW geothermal base. Some of the key announcements this year included:
- A purchase of 35 MW of capital equipment for $1.5 million, or a 95% discount, saving the company $28 million on future capital expenditures.
- Operational progress on a 28 MW project in Geysers, CA, by attaining the necessary permit and connection agreements. The company is currently looking to sign a Power Purchase Agreement (PPA) prior to starting construction. We believe an expected near-term announcement of a PPA should be received well by the markets.
- A $5.1 million buyout of Goldman Sachs's (NYSE:GS) minority interest of the Raft River, ID, plant. The buyout enabled US Geothermal to announce an immediate $3 million expenditure project to increase the plant output from 9 MW to 13 MW by 3Q 2016, and increase its annual free cash flow by another $1.5 million, or approximately 25% over last year.
- A project to increase the output of its Neal Hot Springs, OR, plant by 3 MW by building a cooling tower. The company is currently testing well flow in the area to provide water for the tower, and we expect it to move on this project in the near future.
- Obtaining financial capacity to borrow up to $50 million from Prudential Capital Group, removing a major overhang with respect to the uncertainty surrounding the company's ability to finance the growth of its pipeline and fear of an equity dilution.
By themselves, these were not major events; however, taken together, they show a management team committed to capitalizing on the tremendous growth opportunity ahead, which should provide another 100-200% upside from today's price and for the company to generate over $20 million in highly recurring free cash flow from last year's ~$6 million figure.
- Gaiam, Inc. (NASDAQ:GAIA) - GAIA was also a 10% position in the portfolio for us this year, and it has appreciated approximately 20% due to its announced transaction in the 2nd calendar quarter of 2016. While we were patiently waiting for the announced spin-off of the streaming yoga TV business to materialize this year, GAIA decided to go in a different direction by selling the brand and travel businesses for $180 million, or $7.20 per share. While we always valued those businesses between $150 million and $200 million, we were pleasantly surprised by the deal. However, we're more excited about what the company is going to look like post-transaction. In July 2016, management completed a tender offer of $7.75 per share for approximately 40% of the outstanding shares, which left the company with over $7.00 per share in cash and real estate, and only 75 cents for the streaming yoga TV business which we estimate to be worth between $7.50 to $15 per share in the next few years. The business has a 7,000+ title library with close to 170,000 global subscribers, expected to grow 80% a year for the next few years. This will drain some of the cash from the balance sheet, but we think investing in a highly recurring cash flow customer base with very low content creation costs makes tremendous economic sense, and a longer-term subscriber base of close to 1 million should be very attractive to a bigger media company.
- Village Super Market (NASDAQ:VLGEA) - VLGEA was a 7% position in the portfolio from our initial September 2015 buy, and including a generous 4% dividend yield has returned close to 20% from our initial buying and dollar cost average prices. While no significant events have materialized, including a special dividend anticipated by us, the company continued to report positive same-store sales and strong free cash flows, while fighting higher wage headwinds and competitive pressures. Our original thesis was that a company that earns a consistent 10-12% Return On Invested Capital (ROIC) due to its strategic ownership of a large co-op should appreciate to at least 7X-8X EBITDA multiples of its average performing peers as the market appreciates the company's returns and cash flow generating ability. VLGEA has closed the gap with its peers somewhat, and now trades at 5X forward EBITDA multiple and a 10% free cash flow yield with a rare unlevered balance sheet. We anticipate the daily stock sales by the blind trust of one of the original founders, which sometimes account for as much as 20% of the daily volume, to stop by 4Q 2016, giving an additional boost to the stock price.
The Enhanced portion of the portfolio has had a number of significant value-creating events throughout the year as well:
- Kodak $14.93 September 2018 Warrants - We were very excited about the performance in our Kodak warrants this past year. We originally allocated approximately 4.5% of portfolio capital to these securities, and continuously added to the position as the price went from $3 to below $2 early in 2016 to keep at the same proportion level. In 1Q16, the company announced the intention to sell its PROSPER ink jet commercial printing system, and began to take steps to refinance its high-cost capital structure. The market soon began to appreciate the true value of the underlying assets and their cash flow-generating ability, with the stock appreciating over 45% in 2Q16. At the same time, our warrant position has appreciated over 100% from its lows and is now close to 9% of the portfolio. We expect imminent announcements from management on the PROSPER sale and refinancing, and will likely begin to pare down our position to control our exposure if the price continues to move up.
- Full House Resorts (NYSEMKT:FLL) - Our 2% position in Full House did not disappoint this year, as it returned over 30%. Our investment in this company was mostly an investment in one of the most respected managers in the gaming industry, Dan Lee. Over the course of the last year, Lee has successfully turned around the underwhelming operations of four casino properties in Nevada, Indiana, and Mississippi, improving 1Q16 revenues and EBITDA by 11% and 79%, respectively. In June 2016, Full House closed the acquisition of Billy Broncos Casino in Colorado Springs for an advantageous 5X EBITDA price, and was able to refinance its onerous debt burden creating significant breathing room for management to continue to create value. We're excited to continue to watch what Lee can do with this $36 million market cap company.
- MMA Capital Management (NASDAQ:MMAC) - Our original 3% position in MMAC has returned over 45% this past year on the back of the company completing a number of value-unlocking transactions that helped to grow its book value 46%. MMAC bought back over 12% of shares outstanding in the last year, and over 25% over the last 2 years - significantly below its accounting and economic book value, creating substantial accretion to the shareholders. Other book value growth was driven by a net increase in the fair value of the bond portfolio and by net income generated during 2015 and 2016 from net gains on assets, derivatives and extinguishment of liabilities from the company's balance sheet. Finally, the company signed a lucrative deal to manage the $211 million tax credit portfolio for Bank of America (NYSE:BAC), where it gets to collect substantial asset management fees without taking on significant capital risk. Going forward, we anticipate MMAC to grow its book value by at least 100% by continuing to monetize the hidden assets on its balance sheet, including its interest in a Savannah, GA, real estate venture; its put option to buy back Morrison Grove Asset Management in 2019; growing the solar lending joint venture, and buying back more shares below the company's economic value.
Our other investments in CSW Industrials, Graham Holdings, and Viad contributed modestly to our performance with returns ranging from 1% to 6% without major significant events. Our investment in National Research Corporation has returned over 11% in the form of regular and special dividends, while the price has stayed relatively flat. On the downside, our investments in the warrants of AIG and Del Taco were down approximately 7%, and we've taken advantage of the lower prices by adding to our original 3% positions.
Other Portfolio Updates - Core Portfolio Sales
To revisit our sales process: on the upside, we sell when we believe that our investments are now trading at fair value (or beyond) and where we see opportunities to deploy that capital elsewhere. More importantly, to the downside, we will always take the loss when it is clear that thesis is irreparably broken, as was the case this past quarter.
- Babcock & Wilcox Enterprises (NYSE:BW) - We sold our 4.5% position in Babcock & Wilcox Enterprises toward the end of 2Q16. As a reminder, it was a business spun off from the Babcock & Wilcox Company in mid-2015. At the time, it had all the elements that we look for: depressed price due to shareholder base dislocation, large net cash position, and properly incentivized management. Additionally, a growing non-coal backlog offered good visibility and intention to diversify away from its high-margin coal plant aftermarket service business - which, at the time, accounted for close to 50% of the business and presented a good investment opportunity. While the initial results and price reaction were encouraging, we were on the sidelines about adding more to the position due to our concerns regarding the secular nature of the coal market decline. On June 28, 2016, the company pre-announced a number of actions, including a restructuring of the coal power segment due to what it now sees as a 15-20% decline in the next 12-24 months for its parts and services business and a large charge for a mistake it made on a Waste-To-Energy project in Europe.
This raised a number of red flags for us, mostly the inability of management to forecast or see its markets - which, just a few weeks ago, they expected to be flat. Our experience told us that realistically it is unlikely to be the last guidance down or a restructuring announcement. Even though the stock dropped over 15% from our buy-in levels, we felt the thesis was broken and our margin of safety was no longer there, as we saw more potential for permanent capital impairment. We decided to take our loss and exit the position. In the end, our investment in Babcock & Wilcox detracted approximately 80 basis points from the overall portfolio performance as our largest single position loss in fiscal 2016.
In an exercise of identifying mistakes that we would not like to repeat to avoid similar losses, we found a couple that we hope will make us better investors in the future. First, while we were skeptical of the end-market stability based on our research, we fell for the reassurances of management that it was likely to be flat. We should have been more skeptical and weighted the industry trends more. As Warren Buffett once said, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." Second, we will be more mindful in committing large amounts of capital to positions that have exposure to industries in secular decline despite the potential upside. It is much harder to assess a true margin of safety in these situations, and while we got out with a ~15% loss, it could have been worse.
Core Portfolio Additions
- Demand Media (DMD) - Our newest core portfolio position in Demand Media offers a rare strong-margin-of-safety/high-upside opportunity in tech, a sector in which companies can easily lose 30-40% 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% of the $100 million market cap in cash and the $30 million Enterprise Value (EV) of the company trading at less than 0.3X EV/Revenues, with more than $100 million in Net Operating Losses (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 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% rate, on par with its two competitors RedBubble and Etsy (NASDAQ: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 of the whole company. In other words, you're getting the high-quality Market Places business at a 75% discount, and getting the Content & Media business for free. The C&M business is composed of three internet content properties - Livestrong, eHow, and StudioD - generating approximately $65 million in annual revenues. The new management team has taken the tough decision to completely revamp this segment 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 resulted in the revenue base shrinking by over 70 percent. Additionally, Demand Media just sold the Cracked.com content property for 4.0X revenues to E.W. Scripps (NYSE:SSP), showing that the company is certainly willing to sell these segments at the right price. While we're not very excited about this segment and are worried about its potential to continue to drain cash, we do believe it should be worth something, at least at 1.0X-1.5X revenues, resulting in a 200% upside to $15 per share from today's price levels. Since our initial entry, management has made more tough decisions in shrinking the StudioD workforce to control expenses and initiating a small $5 million share buyback in 2016.
Market Outlook and Commentary
We started our first year in July 2015 with one European drama - the Greek fiscal crisis, or Grexit - and ended it in June 2016 with another - the British voting to leave the European Union, or Brexit. In between, we had economic growth scares and a collapse of oil to $26 per barrel in winter of 2015. Throughout all that, the resilient U.S. economy has managed to continue to grow at an over 2% clip and lower the unemployment rate to levels not seen since the late 2000s. As we enter the second half of 2016, we are starting to see the beginnings of certain structural weaknesses, led by a buildup in inventories, lower job creation, and signs of late stages of the credit cycle, combined with the uncertainty over the Brexit and U.S. November 2016 elections. However, unless we see an exogenous system shock on the scale of Lehman or 9/11 - the events that tipped the world into the last two recessions - we are not expecting a near-term contraction. We see tailwinds in housing, good job creation, and strong consumer demand to continue to carry the US GDP growth in positive territory, but our outlook is tempered more to a slower, 1-2% growth.
Over the last year, the small- and micro-cap markets are down ~5% and 10% from their highs, while the S&P 500 (NYSEARCA:SPY) price level is modestly up. Corporate earnings for the last 12 months have been battered by the energy sector, down 77%, and a somewhat stronger dollar; however, we expect for earnings growth to return to high single digits by 2017, if global economic growth continues at our expected pace of approximately 2%. The earnings yield - the inverse of the price-to-earnings ratio - has remained steady at 5.9%, though still below its historical average of 6.8%. However, over the last year, the 10-year Treasury rate has dropped by 1% to below 1.5%, or almost negative in real terms, widening the real spread over the equity yield to over 6.4%, significantly above the historical average of ~4%. With $11 trillion worth of global bond assets offering a negative rate of return, and an expectation for global central banks to continue to run an incredibly loose monetary policy, we expect the U.S. stock markets to continue to trade at higher than historical multiples and lower earning yields for the foreseeable future, due to dearth of better investment alternatives for investors. However, with more pressure on earnings from slower growth, we anticipate market volatility to pick up as investors become more sensitive to any hiccups that could potentially hinder earnings growth. We still see this as a stock pickers' market, and will continue to look for bargains; however, in the coming year, you should expect us to begin to hold more cash and to opportunistically engage in broad market hedges.
"It's easy to grin / When your ship comes in / And you've got the stock market beat. / But the man worthwhile, / Is the man who can smile, / When his shorts are too tight in the seat"
- Judge Smails, Caddyshack
Our partnership had a great first year, and we are satisfied with our results. Part of our success has been staying away from the underperforming and more volatile small-cap sectors in energy, pharmaceuticals, or technology, where we rarely feel we can have a competitive research advantage. However, there will likely be periods where those sectors will become "hot" again, and we may well underperform the market indexes. We hope to still be smiling during the periods when our "shorts are too tight."
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.