Half Moon Capital Partners 2Q16 Commentary: Short Papa Murphy’sVW Staff
Half Moon Capital Partners commentary for the second quarter ended June 30, 2016.
Half Moon Capital Partners, LP (the “Partnership”) returned 0.6% net of fees in the second quarter of 2016, bringing the year-to-date performance to 4.6%. This compares favorably with the S&P 500, Russell 2000 and HFRI Hedge Fund indices that recorded returns of 3.8%, 2.2% and -0.4%, respectively.
The end of June marked the five year milestone for the Partnership. As we look back on the performance over this period, we thought it would be helpful to highlight some of the outcomes which we are proud of and just as importantly, areas where we believe we improved.
We pride ourselves on being independent and uncovering original investment ideas that are supported by very deep research. Our differentiated process has proven to result in a low relationship to the market but also to other investment funds (0.31 correlation to the HFRI). Our approach has also demonstrated it preserves capital effectively in times of duress—during the S&P 500’s largest monthly drawdowns over the last five years, the Partnership has held its ground well (as the table on the next page illustrates).
Since inception, our longs have consistently outperformed the broader market, generating a cumulative 129% gross return–nearly twice that of the market. This has been a result of repeated successes and avoidance of losses—20 core long investments have returned over 50% while only two have resulted in greater than a 25% capital loss from our basis. Our high success rate on the long side has led us to progressively increase the size of our highest conviction positions over the last three years. Another area of improvement has been around rebalancing procedures. Had we more rapidly deployed capital inflows in 2013, our performance would have been meaningfully better. We learned from that experience and believe we are now more effective at rebalancing the portfolio.
On the short side, the most noteworthy refinement to our process has been related to timing and position sizing. Specifically, increasing a position’s size as an anticipated event approaches and reducing the size in between catalysts. Over the last five years, our short book has generated a cumulative 17% gross return relative to the inverse of the market at -77%. We are proud of the alpha we have generated and believe our ability to source original and unique short opportunities will protect us well in times of turmoil and result in an attractive return over the cycle.
Half Moon Capital Partners – Portfolio Update
At the end of the second quarter, the portfolio was comprised of 44% long positions, 23% shorts and 33% cash, equating to a gross exposure of 67%, 21% net long. Although our gross exposure is nearly as low as it has ever been, we are confident it will generate an attractive return. As always, this overall exposure is predicated primarily on the number of attractive and appropriate opportunities we can find and secondarily on our view of the investment climate. We will remain ever-focused on uncovering new investments and will never bend our underwriting standards in order to simply increase our exposure.
Long positions recorded a gross increase of approximately 0.5% in the quarter. Two positions appreciated greater than 20% and no single long declined greater than 20% in the quarter. Murphy USA (MUSA) rose 20.7% driven by strong financial performance and a favorable outlook for RIN prices. Earlier this year we established a position in RMR Group (RMR). The investment was previously referenced as the “real estate management company” in our last letter. RMR appreciated 23.8% in the quarter; below is an overview of the rationale supporting this investment.
RMR Group is an asset management company providing management services to four publicly traded REITs (HPT, SNH, SIR and GOV), three real estate operating companies and one mutual fund. The company trades at a substantial and unwarranted discount principally due to technical trading factors, limited marketing and timing of its December 2015 spinoff/ IPO listing. Lack of sell-side coverage and the controversial controlling Portnoy family added to the disconnect. Given managements’ history of acting in a less than friendly manner to shareholders, our diligence efforts were focused on evaluating the corporate structure and how we could lose. Our work led us to conclude that the Portnoy’s incentives were sufficiently aligned with those of the other shareholders. Incidentally, I personally led several IPOs for the RMR companies over a decade ago when I was an investment banking analyst—providing additional insights into the modus operandi of these operators. Despite the stock’s appreciation to date, we still believe that it offers an attractive upside. Given the quality of its cash flows (20- year management contracts from a relatively diversified asset base), we value RMR at a 5% FCF yield or 12x EV/ EBITDA (excluding potential inventive fees) which equates to $40 per share versus its trading price of $31 at June 30.
At the end of the quarter, the Partnership held eight core long positions. This reflects the sale of two positions. The first, Tower International (TOWR), was sold in May when it failed to monetize its European operations, obscuring the outcome path to value realization for the stock. We also discovered that one of its customers, Volvo, decided to in-source some of its parts manufacturing in Belgium. TOWR produces parts for the Volvo V40/S60/XC60 at its Belgium facility. Volvo represents 7% of total TOWR revenue. This would imply a potential EBITDA loss of $15-20M. The plant appears to be quite highly automated, so the margin on this business may be higher. TOWR may well be able to replace this capacity before it rolls-off but we found this additional risk concerning enough to exit our position. The investment resulted in a weighted average return of -12.6% from our basis last year.
Early in the quarter, we exited one of our longest-standing and most profitable investments (generating a 148% weighted-average return from basis), JB Sanfilippo (JBSS). As readers may recall, this is a company we have discussed multiple times in our letters. During most of 2015, it was in fact our largest position. The unique insights into wholesale nut prices were one of the factors that gave us the conviction to make it our largest position. It was also what provided us with the signal to sell. Tree nut prices are not something that are quoted on a commodity exchange nor readily published. Through contacts we developed with various growers and industry trade associations over the years, however, we were able to anticipate price changes.
When we first invested in JBSS in 2012, it was undergoing a restructuring that upgraded management, closed uneconomical facilities, consolidated and centralized operation and increased its investment in branded products. These initiatives were effectively completed in 2014. While management has continued to execute and gain share, the majority of its subsequent financial performance has been driven by rising commodity input prices, particularly almonds and walnuts. From 2010 to 2015 the price for these two nuts increased over 300%.
The unabated rise in commodity nut prices that benefited JBSS over the last several years on the way up is now going against it as prices have recently reverted much lower. Earlier this year when checking with growers regarding the crops coming to harvest, we discovered prices were down a staggering 50% year-over-year. This led us to not only exit our long position, but reverse our exposure and short the stock. Our JBSS short position generated an 18.1% return for us in the quarter as the reality of its prospects weighed on the stock. Please reach out if you would like to see our write-up supporting the position or discuss further.
Short positions recorded a gross return of 3.5% in the quarter. This largest contributor to the performance in our short book was Papa Murphy’s (FRSH) which generated a 38.1% return. At times, FRSH was a painful and frustrating position to have in place as relentless stock promotion and short-term revenue growth seemed to mask the company’s worsening problems and the incremental signs of impairment in the model. Going into the year, this was one of our highest conviction shorts. As we detailed in our Q4’15 letter, we believed new challenges associated with its SMS text marketing practices would have a negative impact on sales growth. Our prognosis turned out to be correct and our patience has been rewarded. The financial consequences of temporarily inflating revenue by buying struggling locations and undertaking unsustainable promotional campaigns are coming back to haunt FRSH. The company is now in a financially precarious position, a position that we do not believe will improve soon.
At the end of the quarter, the Partnership held seven core short positions. This reflects the reduction in size of two holdings, the previously discussed addition of JBSS as a short and the covering of Badger Meter (BMI). Although the thesis outlined in our Q4’15 letter supporting BMI as a short remained intact, we elected to cover the position following the announcement that it was pursuing a sale process. This resulted in a 10.4% loss on the position in the quarter. No doubt a frustrating outcome, but we believe the right decision from the standpoint of risk management.
It has been a very enjoyable first five years managing the Partnership. We remain as committed and focused as ever. We greatly appreciate your support and look forward to many more years of investing to come.