GreenWood Investors 2Q18 Letter: Mind The (Expectations) GapVW Staff
GreenWood Investors letter for the second quarter ended June 30, 2018; titled, “Mind The (Expectations) Gap.”
Our second quarter letter explores the primary driver of our recent performance: large gaps between trading consensus and reality. We have continued to refine this ranking framework, and we explain further in our short 3.5-page letter.
- We had another decent quarter (+11.7% in Traditional and +12.8% in Global Micro);
- Most recently, the expectations vs. reality roadmap ranking criteria has been the most important driver of returns and we’ve re-allocated capital towards those ideas where the market is increasingly missing the forest for the trees;
- We discuss the processes that drive insight and value creation and how we endeavor to be at the center of efforts to accelerate both for all of our stakeholders, including our co-investment.
Dear GreenWood Investor:
We had another decent quarter (+11.7% in Traditional and +12.8% in Global Micro), making our first half of the year somewhat attractive (+21.4% and 22.0% respectively), but not at all yet satisfactory to us. Thanks to the management teams that we’ve backed executing well, considerable fundamental value was built in the first half of the year by nearly all of our managers. In some cases, the market has reflected this progress, as in TripAdvisor (+7.1% of our 1H performance), Ocado (+6.6%), MEI Pharma (+6.3%), and to a lesser extent Rolls-Royce (+1.8%), EXOR (+1.5%) and Ferrari (+0.6%). In others, it has simply ignored it, as was the case with Flybe (+1.5%), or even punished it, as was the case for Bolloré (-1.3%), Telecom Italia (-0.2%), and Front Yard Residential (-0.5%).
That’s great for us, as we prefer pessimism and a sanguine market reception to fundamental increases in value. Past short-term performance is of small importance to us. What is far more important is that we fulfill our purpose (discussed in the Q4 2016 Letter) and continue to hone the portfolio into a very timely and actionable set of opportunities. We have reallocated capital to ensure our portfolio’s risk-reward ratio remains above 40x in early July, historically a very high level that has in the past translated into future solid returns.
As we welcome a considerable number of new GreenWood Investors into our collaborative community, having a very actionable and timely portfolio is particularly relevant. Some market volatility has returned this year, and we are hopeful new opportunities will provide us an ability to continuously hone our portfolio into a very actionable group of securities. Our pipeline is full and we remain capacity-constrained in our deep and thorough research efforts. As the performance drivers both from this year and from years past remind us, opportunity costs in capital deployment can be quite large. A small number of companies will be driving our outperformance at any given time, and while the timing is unpredictable, analyzing our very comprehensive flow of ideas is not. We need to increase our capacity as the unresearched pipeline continues to expand faster than we can properly investigate. We hope to have news before the end of this year, but are taking our time to ensure a perfect fit and a sustainable business that lives on low management fees, which as we’ve always said, will decline as our assets scale. Thankfully, our ranking system is helping to ensure we are not missing the most timely or actionable pipeline candidates, as always. The framework was born of a need to dedicate scarce resources to only the most attractive opportunities while also helping with capital reallocation, though these are always human decisions and not formulaic.
We have made very important progress with our coinvestment, the Builder’s Fund, which is more than 20% of our Global Micro Fund’s portfolio. We are very much looking forward to seeing our efforts to help the company build value start to materialize in the second half of the year. Your author has been criss-crossing strongly-rebounding Mediterranean countries building consensus for these long-term value-enhancing actions. We believe we have now secured a consensus among all relevant stakeholders and look to accelerate the value creation process not through coercion but through the merit of our ideas. We don’t believe the statutory methods of influence will be needed, but are prepared to use them if they are required, and we have many available to us given the level of support we have. Our offshore Builders fund is now closed, and we will likely close the domestic fund in the coming weeks. We will not tolerate cash dilution in the fund as the stock performs well.
The market could not be more naive to the considerable progress being made at both our coinvestment, but also Telecom Italia, Bolloré, Flybe, and Piaggio while even still underestimating the significant positive developments at MEI Pharma and EXOR’s companies. While most of our peers would prefer quick rates of return, we do not invest for the ephemeral Internal Rate of Return (IRR), which often yields a lower total return. Yet, in order to optimize for both short term performance and long-term returns, we introduced our expectations vs. reality roadmap into our ranking criteria in the third quarter of 2016. As always, we continue to also optimize our portfolio and pipeline for risk-reward ratios and our assessment of the company’s quality.
When your author was recently asked to weigh in on the value vs. quality debate, he was left wondering, why would investors only choose one and not the other? Of course we can optimize for both, and the fact that most firms still don’t ensures that we have substantial opportunities in the very wide gap between deep value and supreme quality. Our three-pronged optimization process has helped a “value” investor like us perform well in a period that hasn’t been kind to other “value” investors.
While optimizing for both value and quality has given us considerable advantages, most recently, the roadmap ranking criteria has been the most important driver of returns. We have continued to upgrade this ranking criteria to better prioritize opportunities where sell-side and buy-side analysts are completely missing the forest for the trees. To the extent this process iteration continues to improve our results, eventually our peers will catch on. Like Amazon claims, our competitive advantage lies not in a patent, but in being ahead of our peers. Our framework is significantly better today than when we first implemented it in 2012. As we add opportunities to the pipeline and continue to iterate based on learning from mistakes and successes, our outperformance has reflected these improvements. Trust that we are still not yet satisfied and are seeking to accelerate our virtuous circle discussed in last year’s fourth quarter letter.
Our network of partners is far more expansive today than even six months ago. Our engagement with our community is growing, with events hosted in New York, Paris and London during the quarter. Through our investors, we have entrepreneurs, business leaders and investors with “skin in the game,” giving us continuous feedback and intelligence from every continent. While some of these investors are consultants, their input and our engagement with our coinvestment is considerably higher-quality than that of consulting firms, because we have significant skin in the game and prefer to hold our investments for longer than a couple years. We are the antidote to a myopic Wall Street that has driven 78% of CEOs to forgo long-term investments that would worsen near-term earnings. In studying the most pronounced value creators over time, it is apparent that each builder had to create or do something significantly different from the competition.
With nearly all companies focused on self-defeating short-term profit maximization in the modern era, doing things differently has rarely been easier. Most of what we have proposed at our coinvestment is not novel, and all of it has been done before by other firms. We were surprised these conversations hadn’t happened in a meaningful way sooner. As mentioned earlier, we look forward to these proposals being adopted in the near-term as we believe the quality of our ideas has been self-evident to board members, management, and fellow shareholders.
It is our intent that by providing research to these industry stakeholders and our investors, we will help them accelerate their own ability to create value in their fields. In Gary Klein’s great Seeing What Others Don’t, he outlines how connecting random dots from different fields has driven over three quarters of major breakthroughs and insights. Charles Darwin’s insight of evolution was sparked by reading an essay by Thomas Malthus which posited that populations grow until they exceed the food supply, after which they start competing with each other. Darwin realized that competitive advantages matter in nature, just as in investing, but that maintaining a competitive advantage required constant evolution. Rare are the species, like the alligator, or companies that can maintain competitive advantages for long periods of time without evolving. Klein profiled numerous other major insights that were derived by using theories from alternative fields applied with fresh eyes to an entirely different situation. We continue to be positively surprised by the input from our partners derived from their diverse views on our research.
This is a symbiotic process as opposed to a more “transactional” approach that Wall Street has long taken. It is therefore more durable, honest and candid. Interests are aligned, and an understanding of the opportunity set has led to counter-cyclical subscriptions in the past. But our growth has been intentionally slower than having a marketing department and attracting “hot money.” Your author’s Italian nonna (grandmother) always advised that the most durable roots of a plant take the longest to grow. We apply this lesson quite frequently in both our investments and our own business building.
Furthermore, unlike many other funds and banks that use the exact same “expert network,” which results in one or two “experts” guiding the entire consensus on a particular company, a diversity of views and opinions ensures a higher quality of information. This is akin to a high quality news organization (a lamentable dying breed these days) that seeks at least three separate sources of validation for breaking news. While it is always more time consumptive and difficult, it helps reduce error. In a concentrated portfolio such as ours, reducing errors is one of the most important drivers of outsized performance. It should also come as no surprise that we often think of ourselves more as investigative journalists, rather than stock analysts, as it better characterizes our daily efforts.
Even with these rigorous efforts to reduce error, we are humans and we will always make mistakes. In some ways, look forward to them. For with every mistake, our process will improve which should help us generate better future performance. That’s the most important thing for us as we are always trying to make our next results better than our long-term record. We will not always be successful, as concentrated managers always hit dry spells, sometimes long ones, of underperformance. Yet we used lessons from our underperformance a few years ago to significantly upgrade our process in an attempt to make these dry spells less likely.
The insight framework described by Klein also underlines the importance of specializing in multiple different fields, while having exposure to numerous others. We have always sought to balance the dichotomy of being a specialist in our invested industries, while also maintaining a generalist and global approach. We are willing to look at anything. Given these two opposing forces pull one’s attention in opposite directions, we have let our ranking framework dictate which areas are most fertile for us to begin our specialization process through deep research. However, even within a day of our prior assumptions being proven incorrect and a particular opportunity no longer being as attractive as previously thought, we routinely start fresh on a completely new company or industry.
As mentioned before, the most important driver of our recent outperformance has been our expectations vs. reality roadmap. This has notably been in companies where consensus views are overly pessimistic, while the underlying fundamentals continued to positively compound. The public negative view (for a long) is particularly important. While many institutional investors talk about the inherent problems that size brings in reducing the opportunity set, we find it odd that no one mentions the fact that large and respected funds have a community of followers that very quickly transform sentiment on stocks to overt bullishness. Funds that we greatly respect have recently shut, not because the reduced opportunity set, which we continue to find to be very robust, but because the amount of investors following these funds often transforms consensus opinions on a company without meaningfully improving the performance of the security. It’s always the information that the market is naive to that generates the short-term outperformance.
Take for instance, Telecom Italia, where international funds followed an activist fund, and though it temporarily pushed the stock higher, the company now trades at an even deeper 65% discount to the breakup value on the eve of the breakup, which we highlighted here. Unfortunately for our experience, buy-side consensus was very bullish and there were few shorts in the company. This has led to the stock being a languid performer for us, and we are hopeful recent political drama in Italy has completely washed out the clown car investors that chased the activist fund into the name. Speaking of Italy, it will probably come as no surprise to our investors, we view the political drama slightly favorably and nearly diametrically opposed to the “establishment” view that has increasingly been out of touch with reality all over the world. It’s a rare day when our views oppose consensus macroeconomic views, but we are always mindful of these just as we are when our views contrast to consensus on an individual investment. The major difference is that we back up our views on individual companies with very thorough investigation and the variables are few enough such that we can have higher degrees of conviction on the moving parts. We will stick with our bottoms-up method, yet the political drama in Italy has negatively skewed consensus on nearly all Italian stocks. This pessimism is not warranted in many companies, so we think the most recent months of Italian equity underperformance is a gift.
Having just returned from London’s Farnborough Air Show, these past few days, we have heard train conductors routinely warn passengers to “mind the gap.” As this year’s primary driver of performance has been wide gaps between perception and reality, we take the advice to heart. Through capital re-allocation within our portfolio to those areas that are at the top of our trifecta framework of risk-reward, quality, and expectations gap, we hope to build on the progress made so far this year. The recent decision to limit research to only investors with skin in the game will help ensure the deck remains stacked heavily in our favor and the trading consensus in our companies continues to hold a wide divergence with reality. We trust our management teams to continue to compound value at their respective companies, and eventually, the market will catch up to this reality. The faster our management teams perform, the wider this gap will be. This, in turn, will drive more solid outperformance and more reallocation.
With Mifid II having been implemented earlier this year, less efficient European markets have even less information transparency, which will only improve our opportunity set while at the same time, placing an even larger premium on high quality analysis. With the evaporation of human trading desks at brokers and investment banks, as well as the significant truncation of sell-side analysts happening in Europe, there are black holes being left in the old crossroads of information on Wall Street. We spy an opportunity here, and are working on multiple projects to significantly expand the amount of thoughtful research we can post publicly without affecting consensus on our investments. GreenWood was actually named such because we fell in love with the OED definition of greenwood being, “A wood or forest in leaf (regarded as the typical scene of medieval outlaw life).” Friends that were publicists begged us not to advertise anything with the word “outlaw,” in it. But the essence is carrying through to the organization we are growing.
We aim to be a very different organization, far off the beaten path, and not even a fund, but a community. We hope that all constituents are better off by engaging with us, not just because our performance should outperform over the long-term, but because we’re constantly challenging the status quo and engaging all stakeholders to improve. And we warmly welcome nudges from our investors to continuously improve and adapt our own thinking to alternate information.
Thank you for joining us in this effort to build a better business model, that works for all stakeholders as opposed to a few. We look forward to the months ahead with cautious optimism. And we look forward to hearing from you, or seeing you at an upcoming event or lunch!
Steven Wood, CFA