Meson Capital Partners LLC Q3 2016 Letter
Last month a great activist investor, whom we greatly admired, Ralph Whitworth passed away at the age of 60 after a battle with cancer. Whitworth co-founded of Relational Investors and most recently was the Chairman of HP, helping navigate it through leadership turnover and challenges. We include a tribute and essay on some of the ways great directors like Whitworth can help companies achieve their potential.
1
October
2
9
, 201
6
201
6
Q
3
Partnership Letter
Dear Partner,
Our net performance for Q
3
was
9.8
%, vs. indices (in order of re
levancy for comparison) of:
4.6
% HF
RI
Hedge Fund Equity Index,
9.0
% Russell 2000 and
3.8
% S&P 500. Our portfolio
was
market neutral
on a
beta adjusted basis for the
quarter
;
our longs
added 13.4
%
to returns while shorts
detracted
3.6
%.
Our
market neutral portfolio helps us focus on our business
’s
operations and ignore the headline driven
,
frothy stock
market. “
The les
s prudence with which others conduct their affairs, the greater the
prudence with which we should conduct our own affairs
.
”
–
Warren Buffett
This
quarter saw markets reach back to all
-
time highs with the “Buffett indicator” of total market cap /
GDP in the US standing at 121% now. This has only been
exceeded
only
once
in
history
–
for
approximately 9 months
at the peak of the 1999
-
2000 bubble and ensures low future returns for the
market as a whole. We are not predicting a crash but feel very comfortable with our short book
,
which
consists of companies that should do poorly
in any economic environment over time. Our longs are
businesses that are significantly undervalued and are set to benefit from macroeconomic and
technological tailwinds. Our longs also have excellent governance by virtue of our presence as a large
shareh
older on the board directly or through proxy.
Confusing market environments like this call for a
renewing
focus
on first principles
–
going down to the
“physics” of what drives the stock market. Last Q’s letter we visited why there may be no reason to
expect
interest rates to revert to their historical mean due to fundamental demographic and technology
changes that are unprecedented in human history. Our strategy is carefully designed to be on the right
side of these mega trends while protecting
our capital i
n a wide range of different scenarios.
First principle #1
–
humans and machines are good at different things. Business is still a highly social
activity and ultimately no matter how mu
ch data on
e brings into a board
room, decisions are still made
on a soc
ial, in
-
person capacity. No quant fund will ch
ange out the board of a company,
install great
management and improve a company’s strategy with all the political and social hurdles along the way.
In contrast
,
a
machine can ingest, analyze and interpret a vastly wide
r and deeper array of data than a
human ever could.
Meson Net
HFRI Equity
Russell 2000
S&P 500
Q3
2016
9.8
%
4.6
%
9.0
%
3.8
%
YTD 2016
6.1
%
4.2
%
11.5
%
7.8
%
2015
4.0%
(1.0)
%
(
4.4
)
%
1.4
%
2014
4.7%
1.8%
4.9
%
13.
7
%
Since Jan 1, 2014
15.5
%
5.0
%
11.1
%
24.6
%
2
First principle #2
–
due to potential margin calls, large short positions are too risky. A key success factor
for portfolio management on the short side is being able to endure “pain”
–
we have quantifie
d this in
some original research
that
we performed over the summer
;
which we will publish shortly. That caps
the size of individual short positions and means that to get the appropriate exposures, more short
positions are required. This means more data
is requ
ired
but we
as humans have only limited time and
neurons
–
this
is where machines can help
augment our
strengths in pattern re
cognition
.
First principle #3
–
exponential price/performance drivers in technology exist.
Ever since I was very
young and reading Warren Buffett’s letters and Ray Kurzweil’s books, I h
ave been fascinated by
exponential trends.
Technology entrepreneurs have been familiar with Moore’s law for decades
–
the
doubling every ~18 mos of the price/performance of computers. Today these self
-
compounding
technology trends are spilling over into
fields that are not traditionally technology
-
driven. Witness
Amazon’s decimation of the retail industry thanks to its computing and robotics in hyper
-
efficient
warehouses. The pace of change is only accelerating and transforming one industry after anothe
r
–
software is “eating the world” as Marc Andreessen said 5 years ago in a WSJ op ed.
Combining
t
h
e
s
e
principles
,
we conclude
we
want to do things that the machines cannot on the long
side where we can take concentrated bets. On the short side we
can use the machines to help us
identify the
~
2% lowest quality companies in the universe that are unlikely to benefit from or even
survive the accelerating change in the market. We have been working lately to apply an increasing level
of data science / ma
chine learning to this area and will have more to disclose soon. This effort on the
short side won’t knock the cover off the ball but it will give us the comfort to be concentrated for our
entrepreneurial activist efforts on the long side. If the market
ever takes a dive again we will be one of
the few funds with purchasing power
–
which was an enjoyable position to be in back in 2009.
We still consider ourselves “value” investors but as Charlie Munger says “all intelligent investing is value
investing”. O
ne
narrati
ve we
d
isagree
with
conventional
value investors is that
one
can’t make money
shorting because the market goes up over time. This is indeed true but the deeper dynamic is creative
destruction
, and
the pace is
accelerating
with
the average life of an S&P 500 com
pany down from 30
years to 10
since WWII
.
F
or every Am
azon success story for example,
100 retailers go bust. For every
Shake Shack there are 30 bankrupt ‘concepts’. The data shows
that
more stocks actually decline than
rise over time
–
even more
so in environments like today where overall valuations are so stre
tched.
The second area of disagreement is how easily incumbent companies can clone the products of upstarts
–
especially when it comes to exponential
technology
change
s
.
This is nowhere more apparent today
than in the automobile market where numerous
conv
entional
value investors are long the big
automakers GM, Fiat, BMW, etc
.
as they trade statistically cheaply. I will save the full details for another
essay but I will make the bold statement that because of 1) the limited transferability of engineering
fr
om internal combustion drives to electric drives and 2) improvements in robotic manufacturing
techniques
–
GM and BMW are FAR more likely to go bankrupt before Tesla does. For some historical
context, the transition from steam to diesel trains in 1920
-
194
0 is fascinating
(
https://fusionmx.babson.edu/entrep/fer/Babson2002/II/II_P4/II_P4.htm
)
–
spoiler alert: none of the
steam engine manufacturers survived the transition...
3
A
Tribute to Ralph Whitworth and Gentleman Activism
The term
activist investor
is by no means a uniform
character
–
there are as many tactical and
personality differences as with the label
entrepreneur
. While we work
to build our own unique
approach, there
are certain figures whom I
greatly
admi
re
and
who
have shaped my thinking. The
investing world lost one of those figures in Ralph Whitworth who tragically passed away last month at
age 60, succumbing to cancer. Whitworth founded Relational Investors with
David Batchelder in 1996
,
whom I had the pleasure to meet
earlier
this year. Whitworth was able to drive leadership changes at
large cap, highly politicized companies including IBM, Home Depot, Waste Management, and in his final
act
–
Hewlett
Packard as
Chairman of the Board.
H
eadlines about highly public activist
campaigns
over the last couple years have, in my view, led to a
great number of
pretenders
entering the activist
arena.
Hedge Fund Research (HFR)
lists
only 71 out of
8,000 funds
as
activist
bu
t o
f those perhaps
only
a dozen have leaders that go to the lengths of going
in
to a board leadership role with
chairman responsibility
as Whitworth
did
. Leading through tumultuous
change and chaos is dramatically more challenging than simply highlighting
the failures of management.
Business is hard
–
there are rarely, if ever, simple linear A
B solutions at underperforming comp
anies.
T
here are
nuance
d reasons
why a state exists
that need to be appreciated
for a viable path for
change to
be implemented
.
Whitworth took the time to understand the situation, never raising his voice in the
boardroom and listening to those he may have disagreed with.
Waste Management had successfully acquired hundreds of companies to rationalize municipal garbage
disposal ma
rkets. As with virtually all roll ups
–
there was a bump in the road and in 1999 the company
found itself in an insider trading and accounting scandal. Whitworth stepped up and into the unenviable
role of Chairman during the crisis and helped lead the co
mpany through.
I
n late 2011 after the $10bb
Autonomy acquisition debacle and the third CEO in as many years
–
Whitworth joined the board of HP
and
stepped up to the Chairman role. He managed to navigate the brains and egos of Silicon Valley to
help HP ge
t out of its tailspin and back on track.
“We’re thought of as the quiet activist, although some
of our projects have become contentious,” said Whitworth in a 2013 interview with the Union
-
Tribune.
“We’ve found that it is more effective if we can convince
the management of our case. Then they can go
do the work and get the credit.”
While I sadly never had a chance to work with Whitworth, I hope I can honor his work by perpetuating
his ideals and leadership style.
Thoughts on Board Member Ideals and
Responsibilities
One way that activist investors like Relational have been successful at creating shareholder value is by
reconstituting boards of directors.
What makes a ‘good’ board member is a complex and nuanced topic.
I like to think in terms of
reasoning up
from first principles
.
4
In America
-
the board and officers have a legal fiduciary duty to represent shareholders/owners and to
maximize the value for those stockholders. Other countries have dual or triple mandates su
ch as to
maximize value to the employees or the local community
–
I do not consider those topics here nor do I
personally think those are appropriate mandates. Those are admirable goals but better achieved via
regulation rather than clouding a clear singl
e optimization variable
,
but that is a topic for another paper.
What does it mean to “maximize shareholder value” and represent shareholders? Even though the
mandate is singular for directors and officers, this is
not simple.
Management and
directors are distin
ct
group with
management in charge of execution and
directors in charge of oversight
“
nose in finger
s
out
”
. Backseat driving
rarely helps either part
y
but having a navigator in the pas
senger seat wins
rall
y
ra
ces
in
unpredictabl
e
and b
umpy
terrain
.
W
hat
about
the timeframe
to maximize value
?
N
ext quarter? For the next 100 years as some Japanese
companies argue for? Personally I think the right time frame is 3
-
5 years to aim to maximize expected
value creation (i.e. in a risk
-
adjusted way). Why 3
-
5 years? This
timeframe
strikes
a
balance of
measura
bility and foresight.
C
ompanies that look out further will tend to avoid proper accountability
and those that are shorter are subject to strategic blunders.
There are rare exceptions of compani
es that can have coherent strategy and action beyond 5 years
–
Berkshire or Amazon
being notable example
s
but even there, they rarely plan anything specific further
than a few years out. Even for an individual
–
I would pose the question “What would you d
o if you had
3 years to live?” and then consider how that answer is truly different than how you would answer if you
had 50 years to live...
Director & Officer
G
oal
: Maximize shareholder value over the next 3
-
5 years.
Ok, with this more specific timeframe
–
how would this be best achieved? Officers develop and execute
the strategy and are responsible for the action.
This
difficulty
is
compounded
for smaller companies
with
fewer resources to cus
hion errors as well as companies in more dynamic
markets. I
n those cases,
the risk of misstep
or delay
are
much higher
and
dire
ctors need
to be m
ore intimate
in real
-
time
with
what the signposts of
f
ail
ure and success truly look like.
The ch
allenge increases further
in
‘
intan
gible
’
or information driven
businesses
(software,
tech, biotech
, etc
.
)
where GAAP accounting measures
do
not represent reality adequately.
Directors aren’t tasked with action but rather
policy
–
in a sort of Maslow’s Hierarchy order:
1) “Governance”
–
i.e. to ensure resources are being dedicated to the benefit of shareholders (i.e. avoid
agency costs: from outright theft at the extreme to wasteful or suboptimal spending)
2) To hold the CEO accountable to his strategic plan and incenti
vize appropriately. If necessary, change
the CEO.
3) Provide support to the CEO
& management
on an ongoing basis to augment strategic planning and
bring
resources
to the table
5
In my experience having served on half a dozen boards, most boards are adequate
at the basic
governance function and there is very little outright theft or blatant waste at companies. The
differences
between good stewardship and po
or oversight
are more subtle.
F
or example holding a CEO
accountable to their plan but based on metrics that are not truly correlated to maximizing
shareholder
value over 3
-
5 years (e.g. annual EBITDA). Or the board agrees to a strategic plan that does not correctly
diagnose the dynamics of a market and flawed objectives are targeted.
Going through this list of policies
–
let’s dig deeper to reason
what characteristics of directors make an
ideal board.
1)
Governance
Like basic physi
cal needs in Maslow’s Hierarchy
–
to prevent and see the signs of outright bad or
unethical behavior is the lowest bar for anyone qualified to be a director. Most even modes
tly
experienced business people should be able to ‘know it when they see it’. Some more complex issues
may be accounting that
fails to
apply GAAP
or illegal activities further down the hierarchy. A board
needs at least one
strong voiced
person who has
sophistication with accounting and controls to catch
issues like this early before they grow to consume the company (like Enron). If one person sounds the
alarm about blatantly bad behavior this should be enough to prevent further corrosion.
2)
Holding the C
EO accountable and incentivizing appropriately
Incentives are a powerful thing and history has shown that management will frequently behave in a way
that maximizes their own incentives. This is partly for understandably selfish reasons
–
we are a
capitali
stic society
–
but also because the world is complex. When there are a multitude of variables and
changing circumstances, the incentive structure can provide clear and solid direction to move towards
for management.
The issue arises when incentives and th
e ultimate goal (shareholder value creation over 3
-
5 years) are
not necessarily obvious to link. Very few businesses have smooth, straight
-
line, incremental paths each
quarter or year. There are multi
-
year investment cycles and risks that must be taken.
Also
–
to
paraphrase Warren Buffett
–
a duck floating down a river may think he’s a fast swimmer but he ought to
focus on position relative to other ducks. What an executive can control and the outcome are not
directly linked.
To correctly hold a CEO acc
ountable and incentivize properly
, it requires a director to 1) be objective
enough to ask tough questions (which is largely a function of how important the board fees are vs a
director’s other activities); 2) understand the business well enough
to separat
e out what is in the CEO’s
control and what is subject to external influence and; 3) to understand the company’s market dynamics
to evaluate those external influences. For this level of responsibility, the director need not be able to
craft a strategy but
he needs to understand it as this is the only way to craft aligned incentives.
If the CEO consistently is unable to perform then directors need to be able to step up their involvement
and make a change. Apathy is always the number one enemy in my experie
nce
–
directors rarely act
decisively enough in the area of management accountability. The board must make expectations clear
6
and if they are not met then change will be required at the CEO level. The risk of making changes
increases rapidly as a busines
s deteriorates due to lack of performance.
3)
Supporting the CEO with strategic development and bringing resources
The “self actualization” of our board hierarchy
–
this is where a board goes from merely preventing
damage or agency costs and can help positiv
ely create value for the shareholders. The board gets
involved in crafting corporate activity with long term consequences. If management has spent a great
deal of effort building up to a board
-
approval
-
required initiative and the board votes against it,
the
process has failed. The board should be a constant sounding board to iterate and improve the strategic
options for the company. The company should always be in a position where it is constantly whittling
down potential options to focus on a small num
ber of key initiatives, if this is not the case then the raw
material at the board and management level are lacking.
The two key areas that board members can create value are A) having the strategic foresight to “look
around corners” and anticipate future
issues so management can take preparatory action sooner and B)
bringing resources to the table to increase the number of strategic options available.
I.
Strategic Foresight
The value in strategic foresight is ultimately to change management behavior to take e
arly action to
either A) increase opportunity or B) reduce risk.
Foresight that increases opportunity would mean investing early into an area that may not provide an
immediate cash return but positions the company well in the future. In order to contribut
e in this way,
a director would need to have some experience or knowledge in an analogous market dynamic to that
facing the Company at the current time. Understanding the change dynamic in a market and
competitive landscape is the most important input
-
a
n incorrect diagnosis leads to compounding errors.
Risk reduction is a bit easier for board members than increasing opportunity as it requires less specific
knowledge of the market. Being able to evaluate potential partners or vendors at the board level i
s
important here. Seeing internal dynamics where a re
-
organization would need to take place also is
important and would require executive or board experience. Being able to identify weaknesses in the
CEO’s direct reports and divisions in advance is valua
ble as recruiting has significant lead time
requirements.
II.
Bringing Resources
Strategic foresight is an intellectual exercise
–
bringing resources is action that leverages the experience,
network, and reputation that should be expected of someone in as high
level position as the board of a
public company. A key phone call can open a door for a CEO that he otherwise may have spent months
trying to break into at a potential strategic partner, customer, regulator, executive recruit or vendor.
Especially at th
e C
-
level and board level, relationships are a key enabler so relevant industry connections
can be very valuable in this respect. To a far lesser degree than in commercial matters, the resume of
7
experience and reputation can help for fundraising by its ha
lo effect (and conversely
–
a negative
reputation can taint it just as strongly). This is also true for recruiting key executives.
This category also requires board members to be engaged and willing to cultivate their network and
connect with relevant peo
ple for the benefit of the company. Board members need to believe in the
strategy and be willing to make the calls.
Overall Board Function
Above are the ideal qualities for individual directors. Also important is how the board functions as a
group. I
have been in some situations where the collective intelligence is far lower than each individual
and
in
others
where it is clearly additive. It falls on the Chairman to set the right tone and dynamic.
Diversity of thought is extremely important
–
any idea tha
t has the potential for resources to be
dedicated to it should be thoughtfully debated vs its alternatives in proportion to the potential
cost/benefit to the company. Having the ideas and facts dominate the discussion where all feel safe to
contribute is
key. There is much more risk in awkward silence than overly vigorous debate in my
experience.
Directors should be educated on the facts before meetings so the time together can be spent on
debating the merits of ideas and trade
-
offs,
not
on basic educatio
n which it is director’s responsibility to
do on their own time. Meetings should have clear agendas and goals. Speculation on potentially
knowable matters about the business or marketplace should be avoided if there is a way to postpone
debate and gather
more facts to properly inform discussion. The goal of any discussion should be to A)
identify potential future opportunities or issues B) distill decisions to the key trade
-
offs embedded in
them and C) identify areas of further fact
-
finding.
Driving Ope
rating Improvements to Ignore
a Challenging Market
Environment
The
data
continues to indicate
the market is at or near all
-
time high valuations
,
which
translates to
low
return expectations for the average investor going forward 5
-
10 years
.
The supply/demand balance of
financial capital is not favorable to those that can merely move paper around
.
A
more proactive
approach
to generating value
is required.
As the
IMF warns
of slowing global growth, our approach of
focusing on investing in the right people at smaller companies can charge forward regardless of macro
issues.
I was proud last quar
ter to be elected Executive Chairman at Sevcon. I first joined the board in
December 2013 after the nomination by Mario Gabelli. This is the third time I have held this role at a
public company. The company is leading
the
charge in an area that I have b
een passionate about since
childhood and
it is a tremendously exciting time for both the company and the world at large to start
moving towards sustainable transportation.
8
I continue to have virtually all of my
investable
net worth
committed
alongside
inve
stors
in the
Partner
ship
and am excited to be growing the firm
.
Please email me at
rmorris@mesoncapital.com
or
call at
415
-
322
-
0486
if you have any questi
ons
or are interested in investing
.
As always, thank
you for
reading.
Sincerely,
President
Meson Capital
Partners
,
LLC
9
Disclosure:
The information contained in this document is confidential and is being provided for information
purposes only to a limited number of financially sophisticated persons
who have expressed an interest
in the matters described herein.
This is not an offering or the solicitation of an offer to purchase an interest in Meson Capital
,
LP (the
“Fund”) or any affiliate thereof. Any such offer or solicitation will only be made to
qualified investors by
means of a confidential private placement memorandum and only in those jurisdictions where
permitted by law.
The views, opinions, and assumptions expressed in this presentation are as of the date printed on the
first page, are subjec
t to change without notice, may not come to pass and do not represent a
recommendation or offer of any particular security, strategy or investment.
An investment in the fund is speculative and involves a high degree of risk. Opportunities for
withdrawal, r
edemption and transferability of interests are restricted, so investors may not have access
to capital when it is needed. There is no secondary market for the interests and none are expected to
develop. The fees and expenses charged in connection with this
investment may be higher than the fees
and expenses of other investment alternatives and may offset profits. No assurance can be given that
the investment objective will be achieved or that an investor will receive a return of all or part of his or
her in
vestment. Investment results may vary substantially over any given time period.
Results are compared to the performance of the S&P 500 Index for informational purposes only. The
Fund’s investment program does not mirror the S&P 500 Index and the volatilit
y of the Fund’s
investment program may be materially different. The performance figures include the reinvestment of
any dividends and other earnings, unless otherwise noted. Past performance is not necessarily indicative
of future results. The holdings ide
ntified in this letter do not represent all of the securities purchased or
sold in the Fund.
Performance results for individual investors will be different from the perfo
rmance results of Meson
Capital,
LP depending on their timing of capital contributions
and withdrawals. Meson Capital Partners,
LLC or affiliated entities (“Meson”) is not responsible for any liabilities resulting from errors contained in
this communication. Meson will not notify you of any errors that it identifies at a later date.
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