Dear Partners and Friends,
In the third quarter, the partnership returned +1.4%, net of all fees and expenses, bringing the year-to-date net return to +11.0% and the one-year trailing net return to +18.1%.1 Our intermediate and longer-term compounded average growth rates (CAGRs) have been solid as well.
If you missed it, we published a variety of materials over the summer to celebrate our firm’s 10th anniversary. You can find them on our website. As of the end of the third quarter, our firm’s assets under management (AUM) were approximately $47 million. Welcome, new partners.
Explore/Exploit: Going Rogue
Ants and bees are both members of the order Hymenoptera, whose members are typically eusocial, cooperative insects that live in large colonies that can be viewed as superorganisms. When an ant finds an attractive source of food, it leaves a pheromone trail on its way back to its nest that other ants can follow. Bees use a different strategy to alert their compatriots to good finds. They fly back to the hive and do what entomologists have dubbed a “waggle dance.”2 Through these elaborate dances, bees give their peers directions to a field of newly bloomed flowers (or maybe to a picnic table after a five-year-old’s birthday party).
But if every ant simply followed the strongest pheromone trail to the best food source, that food source would eventually run out, and the ant colony would be at a loss. And if every bee simply followed the directions imparted by the most dynamic waggle dance, a beehive would likewise exhaust this resource.
Fortunately, some ants and bees have a rogue streak. These intrepid individuals will deviate—veer off from the pheromone trail or shun the directions of the waggle dance—and seek fortune and glory on their own in search of new sources of nectar, honeydew, syrup, or sap.
Evolution through natural selection has fine-tuned this balance; most ants and bees follow the proverbial herd (or, in this case, swarm, hive, colony, or army) and target a known food source. But a smaller group will launch out on their own and seek novel sources of food.3
Rory Sutherland, Vice Chairman of advertising agency Ogilvy, discussed this in his fun, wide-ranging book, Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life:
There is a parallel in the behaviour of bees, which do not make the most of the system they have evolved to collect nectar and pollen. Although they have an efficient way of communicating about the direction of reliable food sources, the waggle dance, a significant proportion of the hive seems to ignore it altogether and journeys off at random. In the short term, the hive would be better off if all bees slavishly followed the waggle dance, and for a time this random behaviour baffled scientists, who wondered why 20 million years of bee evolution had not enforced a greater level of behavioural compliance. However, what they discovered was fascinating: without these rogue bees, the hive would get stuck in what complexity theorists call ‘a local maximum’; they would be so efficient at collecting food from known sources that, once these existing sources of food dried up, they wouldn’t know where to go next and the hive would starve to death. So the rogue bees are, in a sense, the hive’s research and development function, and their inefficiency pays off handsomely when they discover a fresh source of food. It is precisely because they do not concentrate exclusively on short-term efficiency that bees have survived so many million years.4
The manner in which ants and bees divide their resources is among a class of ideas that have been dubbed explore/exploit problems by zoologists, economists, and computer scientists.5 Questions related to these problems and their cousins—optimal stopping problems—range from the personal to scientific to corporate realms.
How much time should one spend exploring for new sources of food, information, or ideas before shifting to exploiting the current best source? Should one remain in the dating pool or pop the question and seek to settle down? Should a company continue to refine a product or launch it as it is? How much should be spent on R&D in search of new drug candidates vs. on marketing existing products? And as in the classic framing of one optimal stopping problem, how many potential secretaries6 should one interview before making one an offer of employment?
Of course, portfolio managers are faced with similar types of questions. We must determine how we allocate one finite resource—time—between exploring for new investment ideas (and new types of investment ideas) and monitoring, researching, and generally sticking with (exploiting) our existing strategies and positions. Should we follow the herd or veer off on our own? Just how patient should we be with what we have? We must also determine how to allocate another finite resource—our current capital base—amongst a plethora of potential investments. Leverage, cash balances, correlation, and position sizing all factor into the decisions.
While economists have come up with optimized algorithms for certain modeled scenarios—the Gittins index, for example, or the 37% rule for the secretary problem—the real world is messy and, as you may have suspected, as analytical as I may be, I do not believe in an algorithmic approach to research, position sizing, or portfolio management.
Wide Funnel, High Bar
Unlike bees, we investors can spend the majority of our time exploring for new investment ideas while simultaneously “exploiting” our existing positions. Sure, we must spend time monitoring and doing ongoing research on our holdings, but at least in a concentrated portfolio like ours, we are left with a lot of time to be on the hunt. I am frequently asked about my approach to sourcing new ideas. The top of our funnel is very broad. I do small amounts of reading, research, and valuation work on a large number of companies. But the real meat of our process comes in the middle of the proverbial funnel—the winnowing down of potential investments from a large list of possibilities to a small, concentrated portfolio of best ideas.
I have been investing for my entire career—over 20 years now—so there are many companies, sectors, management teams, and business models that I know well or am familiar with. In addition to following many of these on an ongoing basis, I study many new special situations and event-driven setups as they arise: mergers, spin-offs, reverse-Morris Trust transactions, tenders, rights offerings, and various other sources of corporate change (and thus potential for mis-valuation and catalysts). I am well versed in special situations research, which frequently involves studying proxies, S-1s, S-3s, 8-Ks, 10-Ks, 13Ds, Section 16 filings, PACER filings, and the rest of the alphabet soup of regulatory filings that apply.
There are elements to our top-of-the-funnel process that are systematic: The review of various classes of special situations, for example. But like rogue ants and bees, I allow for a large amount of room for serendipity and following my nose. We are not investing in the same types of investments as most funds.
While the top of our funnel is wide and allows for variation, the bar for a stock’s inclusion in the portfolio is always very high. When interviewing secretaries, it is unlikely that one will be a hundred times better than others; after getting a feel for the field, one can make a decision and offer a job. But in investing, a fantastic investment can indeed be orders of magnitude better than an average one, so it is worth having a certain amount of patience. On the flip side, our bar can’t be so high that nothing ever meets it. The perfect is the enemy of the good enough.
We therefore utilize the concept of a threshold approach: As I have previously discussed, we typically underwrite for an expected IRR of at least 25% (I have famed this as seeking “three-year doubles” or better) with limited risk of permanent capital loss on the downside. While it is easy to focus on the first half of this target (the threshold IRR), the second half (limited downside) is every bit as important. This is why you will tend to see less levered (or net cash) companies in our portfolio. You will also see quality, growth, modest valuations, and, frequently, catalysts.
A mid-20s IRR is a high bar, and to be clear, we don’t necessarily expect to generate fund-level returns at that rate. We strive to generate excellent risk-adjusted returns, but we’ll invariably get some stocks wrong along the way or some stocks will take longer than we think to achieve fair value. But by aiming high, we have achieved a ~20% annualized gross return (and therefore mid-to-high teens net return, depending on share class) since inception.7
Market Backdrop & Portfolio Update
Our top five positions as of the end of the quarter were Clarus Corp (CLAR), Correios de Portugal, S.A. (Euronext Lisbon: CTT)(OTCPK:CTTPY)(OTCPK:CTTOF), Horizon Kinetics Holding Corporation (OTCPK:HKHC), Turning Point Brands (TPB), and an undisclosed position.8 You will find none of these companies in broad market indices such as the S&P 500.
IPO and capital markets activity—including the return of SPACs—has picked up, and there are pockets of froth in the market. A major investment bank recently distributed a list of “meme” stocks; it was comprised of more than 60 companies. AI, quantum, nuclear, rare earth, and space-related stocks are attracting significant speculative capital, regardless of business model quality. As usual, we have no “fear of missing out” (FOMO) on these types of stocks. There is always something we are missing out on, and we are okay with that. There are enough attractively priced companies in the market outside of the bubble areas. We have demonstrated that we can generate solid returns while generally avoiding tech and other trendy sectors.
Meme stocks and momentum sectors aside, even many of the highest quality companies in the market do not appear to be inexpensive. Remember, investing is not simply about identifying the best companies. It is easy to note that (at least six of) the Magnificent Seven companies are dominant in their fields. The important question for those that own these stocks, though, is whether they are attractively priced.
Steve Mandel, who runs the hedge fund Lone Pine, has been quoted as saying, “I don’t need an analyst to tell me whether a 10x PE stock is cheap; I need one to tell me whether a 40x PE stock is cheap.” We can flip this framing: We don’t need analysts to tell us whether a 40x PE company is quality or growing or loved; we should ask whether a single digit PE stock is quality or growing or can one day be loved. When we find one of these (like APi Group (APG), Turning Point Brands (TPB), or Cadre Holdings (CDRE), among others in our portfolio), I get excited.
As I caution in most letters, our portfolio may behave quite differently than the broader market indices over the short term (especially during periods of bubbles and froth in the markets). Unfortunately, we are going through a period this month in which our fund is down while various market indices are up. Several of our core positions have pulled back not due to ascertainable fundamental reasons, but seemingly on account of motivated sellers (perhaps, in some cases, mutual fund tax loss sellers ahead of their fiscal year-ends).
I view this recent weakness as an opportunity. I believe our portfolio is attractive and that a number of our core positions have upcoming catalysts. With the appropriate long-term time horizon, I’m confident in our portfolio and approach.
I have been working hard on a new idea over the past few quarters, and this position is now in our top five. While I cannot yet discuss it publicly, I look forward to sharing more on this investment in my next letter.
Conclusion
Long-term clients, as well as those who joined in the last quarter: Thank you. I truly appreciate your trust and support. Your alignment and long-term orientation allow me to invest in the manner that I believe will maximize our risk-adjusted returns. I look forward to writing to you again in the new year. In the meantime, don’t hesitate to reach out if you would like to discuss any aspect of the partnership.
Sincerely,
Dan Roller
Original Post
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
