April 29, 2020
Investing in small/micro cap companies and special situations within a concentrated portfolio
Artko Capital 1Q 2020 Partner Letter
For the first calendar quarter of 2020, an average partnership interest in Artko Capital LP was down 37.4% net of fees. At the same time, investments in the most comparable market indexes—Russell 2000, Russell Microcap, and the S&P 500—were down 30.6%, 32.0%, and 19.6% respectively. Our detailed results and related footnotes are available in the table at the end of this letter. Our results this quarter came from broad portfolio declines from Recro Pharma, Spartan Motors, Viad, Altria and US Ecology warrants while a near doubling in our Sharps Compliance holding contributed to improving the overall performance.
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Peter Rabover
Portfolio Manager
Artko Capital LP
April
2
9
, 20
20
Dear Partner,
For the
first
calendar quarter of 20
20
, a
n average
partnership inter
est in Artko Capital LP
was down
37
.
4
%
net of fees. At the same time, investment
s
in the most comparable market indexes
—
Russell 2000, Russell
Microcap, and the S&P 500
—
w
ere
down
3
0
.
6
%,
32
.
0
%, and
19.6
% respective
ly.
Our
detailed
results
and
related footnotes
are available in the table at the end of this letter.
Our results this qua
rter came from
broad portfolio
declines
from
Re
c
ro Pharma
, Spartan Motors
,
Viad
, Altria
and
US Ecology
warrants
while
a near doubling in our
Sharps Compliance
holding
contributed to
improving the
overall performance.
2Q19
3Q19
4Q19
1Q20
1 year
3 year
Inception
7/1/2015
Inception
Annualized
Artko LP Net
15.7%
7.9%
17.4%
-37.4%
-8.5%
-1.9%
26.4%
5.1%
Russell 2000 Index
2.1%
-2.4%
9.9%
-30.6%
-24.0%
-4.6%
-1.7%
-0.4%
Russell MicroCap Index
0.9%
-5.5%
13.5%
-32.0%
-26.4%
-6.6%
-11.8%
-2.6%
S&P 500 Index
4.3%
1.7%
9.1%
-19.6%
-7.0%
5.1%
38.1%
7.0%
On
the Great Uncertainty
W
e usually have a pretty straight forward partner letter format
with a focus on individual
companies
up
front and a small discussion on the markets and the economy in the back
which
,
in a way
,
is a
good look
into
the weights we assign in our thinking to the topic
s. However,
given the precipitous events of the last
few months
,
we thought it would be impo
rtant to share our thoughts on the markets and the economy in
the beginning
of the letter
this quarter
,
with the focus on portfolio discussion toward the end.
One of the main purposes of
secondary
equity markets is to help facilitate the exchange of shares in
companies listed on the stock exchanges at prices that are in (very loose) theory
are
equivalent to the
companies’
long
-
term
economic
values. Reams of white papers have been written on the effi
ciency of the
markets
in processing information
instantaneously
and
in
pricing
company
values, as well as serving as
the underpinnings of modern economic theories. It sounds nice
and
comforting and occasionally
,
for
certain periods
,
in stocks of larger cap
italization companies
,
it actually works. Until it doesn’t.
But for the
most part, if you want to be an investor in
,
say
,
Facebook stock
and you think the current price in the
stock market
does not
reflect your estimate of the Facebook
company value and the potential returns,
you can buy
or sell
thousands and millions of shares in under a
few seconds
, at prices that are within a
few basis points of the last trading price.
The liquidity and the theoretical efficiency of the
secondary
stoc
k
markets, as well as the prestige, is why a lot of companies choose
the US exchanges as their primary
market
.
On the other hand,
the smallest, most illiquid pockets of the public stock market
s
are rife with
inefficiencies and
,
for the most part
,
the price
s
in the near term
are driven by liquidity needs of the few
dozen shareholders in each company
versus the company’s underlying long term values
.
This
is part of
the opportunity set in the space and accepting volatility and significant intermediate term dis
connects
between prices and long
-
term values is part of the implicit risk reward offer that the
microcap
and
nanocap
segment
s
offer.
This past quarter has not been an exception to the past behavior in panic and liquidity driven selling in
microcaps. On Ma
rch 18
th
, 2020, the Russell Microcap Index reached an index level of 348.5
, or almost
50% below its August 2018 high and 44% below its levels at the beginning of the year. While the index has
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close to 1,500 holdings with an average market cap of $550mm (to
our portfolio average of a $1
2
0mm)
we were
also
not immune to the panic selling
as
prices for a
couple of our large
Core Portfolio
positions
were down
significantly
on sales of just a few thousand shares as no buyers were to be found. We would
be lying to you if we said
this was not a scary and unpleasant gut check moment as this selling went far
beyond the normal volatility to be expected in the space
but given our conviction in the long term values
of our companies we held firm on holding on to our portfolio
companies
.
One of the hardest psychological exercises
we have
had to practice in our career is the ability to distinguish
between the stock price of a company and the
long
-
term
value of the company.
Making long term
investment decisions into illiquid
public
co
mpanies
where you
cannot
just blow out of certain positions
on a moment’s notice sharpens your initial process focus on the fundamentals and the ability of these
companies to withstand economic shocks.
We are currently in a very serious economic shoc
k. Frankly it is
too early (as of late April 2020) to assess how big of a damage impact the shutting down of the global
economic engine, the US economy, will have. Close to
27
mm people or
almost
20% of the employed labor
force
are
currently out of work. Th
e US GDP in the
2
nd
and 3
rd
quarters is likely to be down
over
30%. And
that
is
only if the public policy makers decide the current Covid
-
19 situation is
politically
safe enough for
the United States
economy
to be re
-
opened again
soon
, which may take even
longer.
The domestic
oil
market may never recover
to levels of the last 15 years
.
While many are forecasting a “V shaped” recovery
we are less sanguine about the situation and think it
is more
likely that the economy
take
s
a couple of
years, maybe all the
way through
late
2021
,
to show signs of health, confidence and healthy growth
in
employment and GDP
.
During that time
,
we expect
the
markets
in all capitalizations
to remain highly
manic and volatile with more drawdowns and rallies along the way.
That
is
the bad news. There are, however, many reasons, as an investor to be positive.
The GDP numbers
will likely look scary on the Great Depression levels, but it is i
mportant to recognize we are not a 1920’s
heavy manufacturing based economy and while a lack of centralized economic control may seem
counterintuitively chaotic, the United States’ economic system’s lack of rigidity
,
relative to
its global
counterparts
,
is
the economy’s
biggest asset in helping it to recover quickly. It may seem that the current
economic uncertainty is incredibly daunting
.
H
owever, the economy and the country have faced
challenges of similar magnitudes in the recent past with the attacks
of 9/11 and Dot Com crash in 2001
,
the Financial Crisis and Great Recession in 2008
-
2009,
and
with those experiences
,
still fresh enough to
draw favorable conclusions in our economy’s ability to bounce back from significant challenges. In fact,
having
learned the lessons on not acting quickly or big enough in 2008, the Federal Reserve’s and federal
government responses, while rife with continued long term moral hazard and macroeconomic
consequences
have
,
for now
,
staved off the fear of the cascading e
ffect collapse of the financial system
that underpins the economy. There is a slight advantage to
company management
, as the CEO of one of
our holdings put it, to at least knowing
you are
in a recession and acting according
ly instead of potentially
overinvesting at the top of the cycle.
We are cautiously optimistic on the long
-
term recovery of our economy and a
recovery of
microcap
markets. However, we would be remiss if we did not share our concerns about what a post
-
Covid economy
could look like. In the 1
st
quarter of 2017 GMO’s Jeremy Grantham posited a thought on the persistence
of abnormal corporate operating margins. Grantham
puts the cause down to three factors: Increased
monopoly power, increased political power and increased brand power.
The general pattern described so far is entirely compatible with increased monopoly power for US
corporations. Put this way, if they had ma
terially more monopoly power, we would expect to see
exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight
reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations;
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and fewer new
entrants into the corporate world and a declining number of increasingly large
corporations. And because these factors affect the US more than other developed countries, US
margins should be higher than theirs. It is a global system and we out
-
brand them f
or one thing.
W
e can see that the pattern continued to persist in the three years since Mr. Grantham wrote those
words. The higher regulatory barriers have
continued to lower net new business formations and
allowed
the big to get bigger.
Unfortunately,
w
e believe the current recession will only exacerbate this trend
resulting in a significantly higher concentration of corporate power in the hands of the few players within
more industries
as the smaller players fail or become unable to compete
. One need on
ly look no further
than what happened in April 2020
with
the Payroll Protection Program where well
-
connected and
highly
-
lawyered companies were able to get
payroll
loans
1
(which a lot of them did not need) within the firs
t
days of the program
while
the smaller businesses it was intended for did not even get a chance to apply
before the program’s funds ran out.
We have
written to you in the past about the continued underperformance of the microcap and smaller
capitalizatio
n indexes relative to their large counterparts. As you can see by the tables on pag
e 1
and the
one below
,
the microcap index has underperformed the S&P 500 by almost 50% (38.5% vs
-
10%) and
when measured
against
the
performance of the
top 50 stocks in the
stock market
that number widens to
65%
!
2
We
still
consider this gap to be unsustainable and do expect it to at least narrow at some point. However,
we believe the aforementioned fundamental factors as well as a significantly larger Quantitative Easing
1
Two of our
Core Portfolio
holdings, Flotek and Sharps Compliance
,
have also received
multimillion
-
dollar
loans
from Payroll Protection Program
2
We’ve launched our partnership 4.75 years ago and consider the 5
-
year number to be
easier to us
e and digest
,
rounded u
p
for the purposes of this discussion
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program from the Federal Reserve
,
whose predecessor p
rograms have been at least partially responsible
for the current gap,
may allow for th
e
disparity
to persist and even widen further
.
Additionally
,
there is a
longer term worry that
this trend will widen the wealth in
equality gap to the point of societal
dissatisfaction
leading to more extreme political
outcomes for
the private sector
.
Finally, and mostly
anecdotally, but
we have
observed the last decade
becoming more irrational with respect to
asset
pricing
from a $270mm valuation for a $699 juice presser
company whose product
could have been squeezed by
hand; a $9b valuation for a fake blood test device company to a $130b plus valuation for an electric car
manufacturer with no history or potential fo
r sustainable profitability and that is under multiple Securities
& Exchange Commission (SEC) investigations. The phenomenon of easy, cheap money available to people
with charisma and the right connections that
,
in the past
,
have resulted in unrealistic va
luations and
spectacular
scams, is likely to continue resulting in even more bewildering asset pricing
, making our job
as fundamentals
-
based investors even more difficult.
More difficult, but not impossible
. Which brings us full circle to our initial poi
nt of the disconnect between
liquidity
and uncertainty
driven
microcap
stock pricing and the
long
-
term
economic values of our holdings.
The aforementioned gut check moment
was a lot less scarier knowing that
,
despite the economic turmoil
and black swan lik
e volatility
,
our portfolio holdings were unlikely to face permanent capital impairment
and would likely emerge from the recession in stronger positions
and signi
ficant
ly higher values
tha
n when
they entered it.
So what g
ives
us the confidence to continue holding our positions
an
d
even adding to
some
over the last few months?
•
High quality balance sheets:
We have talked a lot about our preference for clean, high quality
balance sheets as a pre
-
requisite for our initial Core Portfolio investments.
Our Core Portfolio
which represent
s over 90% of our assets today has a weighted average/median
net
cash balance
of
4
.5%/
6
.5% of our average holdings’ $120mm market cap.
With only one of our companies,
Viad
,
at an increased but unlikely risk of default
,
we consider our partnership’s consoli
dated
balance sheet to remain a source of strength and stability
over the next year as the economic
realities begin to take their toll on
the more leveraged competitors and small and microcap
companies in general. On the margin, based on numerous managemen
t conversations, we expect
that balance sheet strength and economic turmoil will result in opportunistic acquisitions for
some of our holdings, including but not limited to HireQuest, Acorn Energy and Flotek.
•
Incentivized management: Nothing sharpens mana
gerial focus than the potential for losses in the
millions of dollars in wealth, especially when compared to the alternative prospect of “just losing
a job.” While our partnership has the liquidity characteristics of a private equity fund we do not
have co
ntrolling positions in our holdings.
Through late
-
April 2020, our average/median insider
ownership was
over 20% of outstanding shares, with an average/median Value
-
at
-
Risk for our
management teams over close to $30mm. In other words,
we believe our managem
ent teams
have significant incentive to focus not only on capital preservation today but on the wealth
creating opportunities in the future.
On a more important confidence building signal, out of our
10 Core Portfolio positions, the management teams of 4 o
f them used the March 2020 sell off to
add to their existing holdings.
•
Growth and valuation:
Probably the thing that gives us the most confidence
,
however
,
is our
expectation of at least two thirds of our Core Portfolio to have positive revenue and earnin
gs
growth this year
despite a severe recessionary scenario. Companies like Gaia, Research Solutions,
Spartan Motors, Sharps Compliance and Recro Pharma are among our portfolio holdings that are
actually expected to benefit from current events in the near t
erm. Our more cyclically oriented
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HireQuest and Viad investments should come out of the recession with stronger competitive
positions and market shares as some smaller, worse capitalized competitors are unable to operate
as going concerns. It is still impo
ssible to tell what 2020, or even 2021 is going to look like but
thinking through the individual company earnings potential, we currently see our portfolio trading
at less than 3.5x EBITDA/Operating Cash Flows in a normalized economic scenario, which given
the aforementioned focus on balance sheets and incentivized management allows
us
to continue
to focus on the longer term
upside potential of our holdings.
W
e have
purposefully included the
valuation segment toward to the end of the Great Uncertainty
discussion as it is the most
nebulous, but felt it was important to include, given the significant disconnect between current
pricing and long term values.
In general, while there are significant reasons to be worried about the economy, what the post
lock down
recovery is going to look like
,
and the distorting effects of fiscal and monetary policies on long term market
performance, for reasons mentioned above
,
we are pretty excited about the opportunities in our portfolio
and on our watch list that li
e ahead.
We expect the
in
coming economic
and corporate
earnings
data to
result in signific
ant
volatility
but
also
decreased uncertainty a
nd
allow us to pi
ck through some great
oppor
tunities in the next year
.
The performance will likely be lumpy, as it always has been given the
portfolio concentration
,
and will be significantly more event rather than market performance driven, but
we are confident
in the
significant
long term re
turn
opportuniti
es
that our portfolio and our
targe
t market
segment
s
p
rovided by last quarter
’
s sell off.
Pa
rtnership Updates
We welcomed
two
new partner
s
to the partnership th
is quarter
,
bringing our total to
4
4
at
the end of
March
.
We have
successfully completed our fifth audit, which, along with the partnership financial
statements, you should have received last week. Additionally, tha
nks to your timely votes, we have a new
PPM effective March 2020
and we are proceeding on pace with our Colorado fund registration and exiting
California. We should have finalized updates for you in the next few quarters. Despite the current
economic chal
lenges
,
we
are excited about the continued growth in partners and assets under
management and
,
as always
,
are thankful for your business
.
Next Fund Opening
Ou
r n
ext
partnership openings will be
May
1
, 20
20
, and
June
1
, 20
20
. Please reach out for updated
offering documents and presentations at
info@artkocapital.com
or 415.531.269
9.
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Appendix
A
: Performance Statistics Table
Artko LP Gross
Artko LP Net
Russell 2000
Index
Russell MicroCap
Index
S&P 500 Index
YTD
-37.3%
-37.4%
-30.6%
-32.0%
-19.6%
1 Year
-2.9%
-8.5%
-26.4%
-24.0%
-7.0%
3 Year
1.7%
-1.9%
-4.7%
-6.6%
5.1%
Inception 7/1/2015
54.6%
26.4%
-1.7%
-11.8%
38.2%
Inception Annualized
9.6%
5.1%
-0.4%
-2.6%
7.0%
Monthly Average
1.0%
0.6%
0.1%
0.0%
0.7%
Monthly St Deviation
6.4%
6.0%
5.6%
5.9%
4.0%
Correlation w Net
-
1.00
0.86
0.84
0.79
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Legal
Disclosure
The Partnership’s performance is based on operations during a period of general market growth and
extraordinary market volatility during part of the period, and is not necessarily indicative of results the
Partnership may achieve in the future.
In addition, the results are based on the periods as a whole, but
results for individual months or quarters within each period have been more favorable or less favorable
than the average, as the case may be. The foregoing data have been prepared by the Ge
neral Partner and
have not been compiled, reviewed or audited by an independent accountant and non
-
year end results
are subject to adjustment.
The results portrayed are for an investor since inception in the Partnership and the results reflect the
reinvestment of dividends and other earnings and the deduction of costs, the management fees charged
to the Partnership and a pro forma reduction of th
e General Partner’s special profit allocation, if
applicable. The General Partner believes that the comparison of Partnership performance to any single
market index is inappropriate. The Partnership’s portfolio may contain options and other derivative
secu
rities, fixed income investments, may include short sales of securities and margin trading and is not
as diversified as the indices, shown. The Standard & Poor's 500 Index contains 500 industrial,
transportation, utility and financial companies and is gene
rally representative of the large capitalization
US stock market. The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000
Index and is generally representative of the small capitalization U.S. stock market. The Russell Microc
ap
Index is comprised of the smallest 1,000 securities in the Russell 2000 Index plus the next 1,000 securities
(traded on national exchanges). The Russell Microcap is generally representative of the microcap segment
of the U.S. stock market. All of the in
dices are unmanaged, market weighted and reflect the reinvestment
of dividends. Due to the differences among the Partnership’s portfolio and the performance of the equity
market indices shown above, however, the General Partner cautions potential investors
that no such
index is directly comparable to the investment strategy of the Partnership.
While the General Partner believes that to date the Partnership has been managed with an investment
philosophy and methodology similar to that described in the Partn
ership’s Offering Circular and to that
which will be used to manage the Partnership in the future, future investments will be made under
different economic conditions and in different securities. Further, the performance discussed herein does
not reflect t
he General Partner’s performance in all different economic cycles. It should not be assumed
that investors will experience returns in the future, if any, comparable to those discussed above. The
information given above is historic and should not be taken a
s any indication of future performance. It
should not be assumed that recommendations made in the future will be profitable, or will equal, the
performance of the securities discussed in this material. Upon request, the General Partner will provide
to you
a list of all the recommendations made by it within the past year.
This document is not intended as and does not constitute an offer to sell any securities to any person or
a solicitation of any person of any offer to purchase any securities. Such an offe
r or solicitation can only
be made by the confidential Offering Circular of the Partnership. This information omits most of the
information material to a decision whether to invest in the Partnership. No person should rely on any
information in this docume
nt, but should rely exclusively on the Offering Circular in considering whether
to invest in the Partnership.
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