Troy Marchand's Foundry Capital Group 3Q15 Letter: Special SituationsVW Staff
Below is the first ever letter from Troy Marchand of Foundry Capital Group. They launched a micro-small cap special situations fund June 2, 2015. This is their 3Q 2015 Letter to investors. It starts out by going over their investment philosophy and then gives their top 5 holdings.
Foundry Capital – Tenets of their Investment Philosophy:
- Long Term Value Oriented
- Concentrated Portfolio
- Look for Catalysts
- Will use Activism
- Prefer Nano, Micro or Small cap stocks as they are most inefficient
- Volatility is NOT risk
Foundry Capital – Top 5 Holdings:
VISI, INAP, TSYS, RST, IPAS
We thought our readers would be interested and we were given permission to post – Read below for their full letter:
Troy Marchand's Foundry Capital Group letter to partners for the third quarter ended September 30, 2015.
Being our first quarterly letter, we would like to thank each of you for entrusting your assets with Foundry Capital Group. We are truly humbled and honored.
Before we dive into the portfolio, we want to discuss some key tenets of our investment philosophy:
- We are long term, value-oriented investors. Our time horizon is two to three years, and therefore our investment results should be viewed in similar time frames. While we apply a disciplined investment process, the timing of value realization events are often out of our control, so judging the portfolio on any time frame less than three years is not the proper way to think about our results. We are not market-timers or macro-forecasters; we study companies one-by-one to find the very best risk rewards while attempting to be market agnostic; i.e. each stock trades on its own merits, rather than relying on economic factors to move the stock up or down.
- We use the term “Value Investor” to insinuate we buy stocks selling at a discount to intrinsic value, which means we are looking for stocks that for some reason are not getting respect from Wall Street, and thus are trading substantially below the ultimate value of the company, as estimated by us. Undervalued stocks come in many shapes and sizes, such as micro-cap companies, where few investors are looking; illiquid stocks, that most investors avoid; or a variety of other reasons that lead stocks to trade at low valuations. We are seeking to make investments in companies where we believe our downside is very limited. A term we did not coin, but believe represents how we think about our risk-reward in stocks we own is: “Heads we win, tails we don’t lose much”.
- Concentration is crucial to our strategy, which means investing more capital into fewer stocks. We would rather own 15-20 high-quality ideas than over-diversify our portfolio. Concentration allows us to pass on a lot of “pretty good ideas” in order to only invest in “great ideas”. We firmly believe that over-diversifying the portfolio would hinder potential returns rather than protect downside risk once we own more than ten stocks. Concentration can cause more volatility over short periods, but over time that volatility should be to the upside if we are correct more times than we are wrong. Concentration allows us to focus our efforts on fully understanding each company in our portfolio.
- We invest in stocks with catalysts on the horizon, which is often driven by significant change at a company. One catalyst we focus on is investing alongside activist investors. They are often seeking some change in a business in order to unlock hidden value for the benefit of all shareholders. We believe investing alongside a select few activist investors can offer long-term returns above and beyond the market over full business cycles. Our discussions with an activist investor are often an integral part of our own due diligence and research, so that we can truly understand the levers that can be pulled to unlock value. We also have discussions with company management teams and boards of directors, along with writing letters demanding change and support for activist investors. If you would like to see any of our communications with boards of directors, please let us know and we would be happy to provide them to you as we are representing you through this investment. As we see opportunities and needs arise, we will more directly drive change through leading activist campaigns.
- Our belief is micro- and small-cap stocks offer the best risk-reward in the public stock market due to the inefficiencies they exhibit. Large investment firms often times cannot invest in micro-cap stocks, thus fewer investors are looking at the same stocks we are, causing stocks to fall under the radar. Wall Street research does not typically cover micro-cap stocks due to their size, volume and liquidity; which helps to create more inefficiency as less information is available to investors. Some micro-cap stocks can be very illiquid, but we are comfortable being patient to enter a position if we believe unlocking long term value is likely and the position offers a compelling risk reward. This illiquidity and lack of information can cause wild swings in stock prices, many times on no news or retail investors not using limit orders to enter or exit trades, which causes volatility on a daily basis. Over longer periods the volatility should occur to the upside if our thesis is correct.
- Volatility and unrealized losses are not the definition of risk, as risk in a particular stock cannot be calculated by a formula. Risk is the permanent impairment of capital, meaning a fundamental change has occurred, and the stock is no longer worth its estimated value. We attempt to limit risk by investing with a large margin of safety in each investment. The process of figuring out the margin of safety and intrinsic values of each investment is a lot more art than science. There is no set way to view risk or downside in each business. In some cases it may be the assets on the balance sheet: a building, a collection of patents, a strong brand name, a valuable piece of land; in other cases it may be a business segment with a highly defensible position, competitive advantages that produce high cash flows with locked in contracts, high replacement costs or barriers to entry.
“In investing, what is comfortable is rarely profitable” — Robert Arnott
September, from a performance standpoint, will be a month to forget, and while we are not happy with our results, we must all remember that one month is not the correct time horizon to measure performance. For the month of September, the Fund declined by 8.28%, bringing the inception return to date to -13.35%. For the quarter, the fund outperformed the Russell Microcap Index and the Russell 2000 Index, declining 9.71%, but we are not satisfied with the results. However, these results are not outside the range of possibilities given that we manage the portfolio in a focused manner. An unfortunate, but inescapable, trade-off associated with our methodology is that in exchange for returns that should be attractive over a several year time frame, there will be interim periods where our results experience significant volatility. Unfortunately, we cannot provide precise descriptions of “interim” or “significant” nor do we know in advance when our results will suffer. Stock prices are unpredictable in the short run, but over the long run, are ultimately determined by cash flows. We still believe our portfolio offers tremendous value, and some catalysts will begin to play out over the coming months.
Internap (INAP) is the main culprit of the Fund’s decline. INAP, at purchase, was the Fund’s largest holding and after announcing on September 1, they were exploring strategic alternatives, the stock rose 13% on the day; on a day the overall market was down roughly 3%. On September 24, INAP pre-released estimated earnings for the 3rd Quarter and lowered full-year guidance slightly, which caused a 20% sell-off on the day, followed by a 10% loss the subsequent day. Moves of this magnitude cause us to reevaluate the situation and determine if the fundamentals have changed, in this particular case we determined that the story and fundamentals were still intact. Now trading at roughly $6 a share, from our purchase price of $9.45, we still believe the company is worth low double digits in a sale, which we believe will occur by year-end. We have not sold a single share in this bout of volatility.
Several things have been odd with the whole INAP situation, since we have owned (purchased first lot June 2). The story begins with RDG Capital, led by former Icahn President, Russell Glass sending a 10-page public letter to the company. He described the current industry M&A environment as “white hot” for consolidation and viewed the takeout price to be $16-19 per share, using comparable computations from peers and recent acquisitions within the industry. Shortly after the letter from RDG, the company fired the CEO and replaced him with an interim CEO, who happened to be the Chairman of the Board. He has previously sold companies as CEO, so we believe he was hired to sell the company. Generally when a new CEO is put in place half way through a quarter, he is quick to lower forward guidance and estimates if there is even a remote chance he won’t be able to achieve the previously laid out guidance by prior management. Typically new CEO’s get a “pass” on their first earnings call, so it makes sense they lowball forward estimates as much as possible if they are not 100% convinced they will achieve guidance laid out by the former CEO. The new CEO did not lower guidance on his first earnings call. The previous CEO of INAP was well-regarded by investors and the industry, so speculation is that he did not agree with selling the company, thus he departed. The next interesting point is why would a company pre-release earnings, which are lower than Wall Street estimates, and lower guidance five days before the end of the quarter, with the next earnings call over a month away? Unless, the company is already involved in a sale process, where INAP thought the sale price would be lower than investors are anticipating. One reason could be management is resetting expectations lower to avoid lawsuits and investor outrage at taking a “low ball” price in a sale. These comments are purely speculation on our part, but we believe the company is currently speaking with potential buyers, such as Zayo Group, to purchase the entire company for $10-13 a share. To further increase our confidence in the price of INAP’s assets, we got some validation in the process of writing this letter as Windstream (WIN) sold their data center assets for 14x EBITDA. Roughly 75% of INAP’s EBITDA is generated from its data centers, and if you were to apply the same valuation, INAP would be worth $13 a share. Even if you were to apply a lesser valuation to its other segment (representing 25%), you would still get a valuation above $10 per share (54% higher than current price and still an overall gain from the Fund’s cost basis).
We purchased two new securities in September, Widepoint (WYY) and Garnero Group Acquisition Corp – Rights (GGACR). WYY was trading over $2 a share when a Cyber Security ETF (Symbol: HACK), which owned 11% of the shares outstanding of WYY, started selling shares without regard for price, caused by the ETF fell 36% during the flash crash on September 1, due to investor liquidations. Eventually the ETF drove the stock price down so much it triggered an outright sale event (i.e. the ETF cannot own a stock under $100 million market cap), which further pressured the stock. Eventually the stock hit $0.80, when a deep value investor, Nokomis Capital, bought the remaining shares from the ETF (Nokomis was already the largest shareholder of WYY). We like to invest in securities where someone else is forced selling without regard to price. We believe the current business with government contracts in hand is worth roughly $1.40, and longer term should be sold in 2016 for over $2 a share. WYY management reiterated its full year 2015 guidance of $75-80 million in revenue, which is a 50% increase year-over-year. On June 29, 2015, WYY reported a partnership with Samsung; this is just one major partner they are working with on a new product for mobile phone security. Garnero Group is a Special Purpose Acquisition Company (SPAC), otherwise known as a blank check company. The Fund purchased a small position in the Rights of Garnero Group, which gives us the right to own 1/10th of a common share, upon consummation of a merger with Grupo Columbo. Shareholders will vote for the proposed merger in mid-December. We purchased the Rights in the mid $0.20 with the common trading near $10 (which is the amount of cash held in escrow for shareholders of the common stock). So, in theory the Rights should be worth $1 upon consummation of the proposed merger, which we think has a very high probability of closing. Once the deal closes, the stock could trade lower than $10, but it would have to trade under $3 a share before we started to lose money on the trade. We have spoken with the management of the SPAC and Grupo Columbo, and feel comfortable with the proposed merger. We will discuss other holdings in future letters.
We appreciate the trust you have placed in us with overseeing your investment and will continue to manage your capital with diligence. We remain, as always, extremely grateful for the opportunity to manage a portion of your wealth. It is a responsibility that we take very seriously, and we will always endeavor to be a worthy steward of your capital. If you know of others who could benefit from Foundry’s services, we would be grateful for an introduction. As always, please do not hesitate to reach out with questions or comments concerning portfolio holdings, or value investing ideas in general. We always enjoy corresponding with clients.
On a housekeeping note, we have transferred assets to Interactive Brokers, from Jefferies to lower transaction costs substantially. We also have come across two compelling opportunities, which require control positions. We are in the process of raising an additional $10-15 million for stock in a Co-Investment vehicle (SPV) in order to group with other like-minded investors to launch a full activist campaign and gain control. We think both opportunities offer substantial upside. Please let us know if you would be interested in participating or know of anyone that may like to participate.
Foundry Capital Group
Troy Marchand's Foundry Capital Group 3Q15 Commentary
Troy Marchand's Foundry Capital Group commentary for the third quarter ended September 30, 2015.
The Fund was down 0.82% for the month of October. Nothing of substance occurred in either direction in the portfolio. Internap (INAP) had a bit of bounce, along with TeleCommunication Systems (TSYS), while iPass (IPAS) sold off during the month on low volume. The overall market had a solid October, but our portfolio is very event dependent. Our returns will be driven by catalysts playing out, not market movements. Our portfolio is market agnostic, which means we will typically not track market movements up or down. It was a quiet month on the news front for our holdings, but we expect a couple catalysts to play out by year end.
We purchased one new security in October, Omega Protein (OME). Omega delivers healthy products throughout the world to improve the nutritional integrity of foods, dietary supplements, and animal feeds. Wynnefield Capital sent a letter to Omega Protein’s Board of Directors on August 11th. The letter called out the CEO and Board for making a poor acquisition to enter the human nutrition market, along with the following comments:
“It's time for the Board to immediately hire an investment banker and run the process to unlock the value in Omega that's staring the entire Board in the face. You will see that this is the right way to proceed rather than engaging in a shootout with Wynnefield that the Board will most surely lose at considerable expense to shareholders. As the record shows, Wynnefield is tenacious, and has repeatedly been successful, when we are confident, as in this instance, we are right.” – Nelson Obus
Management and the board did in fact hire an investment bank, but regardless of the outcome, we think Omega is trading very cheaply based on our estimates for future earnings. We believe OME can earn over $2 a share in Earnings Per Share (EPS) in the next 12 months, and at our average cost of $18, would mean the stock is trading at just 9x forward earnings. We are not finding growing businesses trading at this sort of cheap valuation in the market. We think $2 in EPS is very conservative and place a huge amount of value on the animal nutrition business.