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The Joy Of Footnotes

The Mezzanine by Nicholas Baker is a stream of consciousness novel that follows the protaganist’s thoughts during  lunch-hour activities, including the purchase of new shoelaces. Since the novel is basically just the running dialogue of the a person’s thoughts, it includes deep observations of a lot of everyday items. After reading the novel, I came away appreciating the design of everyday objects much more. The book manages to be simultaneously, deep, absurd, and hilarious.

I originally picked up The Mezzanine, after Matt Levine mentioned it during a Reddit AMA as a literary inspiration for his use of footnotes, supplementing his legal experience. The novel’s protaganist indeed praises the “luxuriant incidentalism of footnotes” in certain classic works. Those that appreciate footnotes:

“…know that the outer surface of truth is not smooth, welling and gathering from paragraph to shapely paragraph, but is encrusted with a rough protective bark of citations, quotation marks, italica, and foreign languages, a whole variorum crust of “ibid’s” and “compare’s” and “see’s” that are the shield for the pure flow of argument as it lives for a moment in on mind.”

Great scholarly works can use footnotes as “reassurances that the pursuit of truth doesn’t have clear outer boundaries: it doesn’t end with the book; restatement and self-disagreement and the enveloping sea of referenced authorities all continue.”

“Footnotes are the finer-suckered surfaces that allow tentacular paragraphs to hold fast to the wider reality of the library.

Additionally, the book indirectly considers a lot of Epistemological questions. The protagonist wonders what influences his thoughts:

“Will the time ever come when I am not so completely dependent on thoughts I first had in childhood to furnish my comparisons and analogies and sense of the parallel rhythms of microhistory? Will I reach a point where there will be a good chance, I mean a more than fifty-fifty chance, that any random idea popping back into the foreground of my consciousness will be an idea that first came to me when I was an adult, rather than one I had repeatedly as a child?”

Perfectionism Vs. Getting Things Done

“Perfect is the enemy of good.”

“Better done than perfect.”

Neither of these quotes apply to surgery, or dismantling bombs.  Fortunately, this blog does not involve surgery, or dismantling bombs.

Getting details right is important.   In bankruptcy cases, the word “and” can have $450 million consequences.   A single misplaced space can derail an entire python script. One must be cautious before putting money and reputation at risk. Nonetheless, that is not an excuse for not taking action, and starting the first draft.

According to Byron Wien: “If you want to be successful and live a long, stimulating life, keep yourself at risk intellectually all the time.” This blog should keep me intellectually at risk.

To quote Seneca:

“We should hunt out the helpful pieces of teaching, and the spirited and noble-minded sayings which are capable of immediate practical application—not far-fetched or archaic expressions or extravagant metaphors and figures of speech—and learn them so well that words become works.” 

As Ryan Holiday said in The Daily Stoic: “Education- reading and meditation on the wisdom of great minds is not to be done for its own sake. It has a purpose.”

I have over a dozen partially written drafts of posts, which I intend to release over the next couple weeks.

The Hard Thing About Finding Easy Things

 In the The Art of War, Sun Tzu wrote that those who excel in warfare do so because they seek out battles that are easy to win. Similarly, Warren Buffett wrote that he likes to look for one foot hurdles to step over, rather than trying to jump over seven  hurdles.  Of course actually finding  easy battles, and one foot hurdles is itself quite challenging.   If it was easy market forces would ensure that it quickly becomes hard. With so much brain and computer power dedicated to financial markets, there are few areas of opportunity left worth exploiting.     However,  by developing a behavioral and structural edge,  one can act on the rare opportunities, and  perform better than those that theoretically have an analytical and informational edge.

How can one develop a behavioral edge? Cultivating the right habits in order to be physically and mentally healthy goes a long way.  Considering carefully what media to read is important to avoid being overwhelmed by noise. Finding time to think requires excellent resource management. It requires discipline to be willing to work on a name for months, only to pass on it, or to wait for months or even years for the right business to become cheap enough.  Some might not enjoy spending hours reading about obscure nanocaps or corporate transactions, while ignoring popular stocks in the news.  Some people seem naturally more willing to be contrarian, but I doubt anyone finds it easy all the time, especially during drawdowns.  Being fearful when others are greedy, and greedy when others are fearful is harder than it sounds.  Checking oneself for cognitive biases before any major financial decision is important.  This is not an easy process, since cognitive biases have biological roots.  I like to take a “red cell” approach, and try to understand potential short arguments for any stock I own.      The connection between action and consequence is usually delayed in markets.     It requires a lot of discipline, double checking and introspection to  make your way through the vicissitudes of investing.

The cultivation of a structural edge is also nuanced.  If you have developed a behavioral edge, then you can probably manage your personal finances in a way that allows your personal accounts to be invested for the long term. This requires maintaining excess liquidity at most times.  If you manage money for other people, you have to be really careful who you take on as a client. If a client has a shorter time horizon than you, or are likely to need to pull money suddenly, the impact can be devastating.  This is a difficult tradeoff, especially for small funds, since more AUM means more fees right away. With the right clients a capital markets disruption is a major opportunity, with the wrong clients it is a disaster.  Whether in a personal account or a fund, simply having a long time horizon  and a liquidity cushion can be a major source of long term alpha.

If one chooses to look at what other’s don’t  one may actually end up with an analytical and informational edge in areas with less competition. I like to invest in things that are uninvestable for most investors with better resources, whether due to “headline” risk, illiquidity, or other institutional constraints.   For example liquidations, delistings, and anything nanocap  are fertile grounds  for bargains. There are also interesting opportunities in distressed debt, and bankruptcies.  I also  like to look for situations where statistical services(Bloomberg, YCharts, Yahoo Finance, etc) are likely to have misleading or incomplete data, and companies that don’t  fit in a comfortable category.   Sometimes consolidated financials can be deceptive because of accounting rules, especially if a company has made acquisitions, holds real estate and/or holds a portfolio of securities.  I also always make sure to adjust for material events that occurred after the 10-Q or 10-K date in determining a valuation.   Judging by occasional market behavior I don’t think everyone does this.  In any case there is always a gap between accounting reality and economic reality.   The financial statements are just a starting point.

An ideal long term holding is a business that has a major competitive advantage and can easily earn a high return on capital over the long term, even if management screws up.   These businesses are hard to find, and they’re sometimes hidden in a group of weak businesses that screened poorly, or attached to an old business that didn’t work.    Thrift conversions are ignored by many, and easy to understand.  Although the upside for thrift conversions is rarely large, the risk/reward tradeoff is phenomenal.  Key information is often found on the OCC and FDIC websites, rather than in Edgar.   Most OTC securities are ignored by sophisticated and large investors(plus the messiness of sorting through hundreds means  you aren’t competing as much against computers). Sometimes I can get an informational edge by actually bothering to go to the company’s website and/or  buying a token share and calling the company to ask for financials, which one has a legal right to access as a shareholder.

Whatever the investment, I’m only interested in buying if a lot can go wrong before I lose, and just a little going right provides a nice gain.  Finding the right security is hard, but it should be easy to win once its in the portfolio.   “Sifting through the debris of financial wreckage, out-of-favor securities and asset classes in which there is limited competition”,  as Seth Klarman has called it does requires intense discipline and dedication, but provides ample rewards.

The extraordinary delusions and madness of crowds also serves up huge bargains from time to time, but the analysis is much harder.      In all transactions, one must ask,  why is someone willing to take the other side?   I suspect there is more benefit to carefully analyzing my own psychology than to trying to outsmart others.  I’d rather buy from a “non-economic” seller, when possible.   Funds with industry or market cap mandates sell spinoffs indiscriminately.  Funds that manage to an index dump companies kicked out indiscriminately.  Delistings and liquidations are also sometimes forbidden by investment mandates regardless of the actual condition of the business or quality of the assets. I like to look at the portfolios of large concentrated funds that are facing massive redemption or shutting down, or from investors otherwise desperate for liquidity(oops did I say that out loud?).   Sometimes people sell securities for reasons that make sense from the perspective of their job security, but are actually unrelated to the merits of the security being sold.   Of course it takes a lot of searching to find where the right sellers are.

Charlie Munger told Howard Marks: “its not supposed to be easy, anyone who thinks its easy is stupid.”  Indeed, finding easy things is hard.

Annals of Questionable Corporate Governance

The BDC Activist has some excellent coverage  of the in-progress management changes and controversy at Business Development Corporation of America(BDCA), a non-traded BDC managed by affiliates of AR Global.  The external manager plans on getting acquired by Benefit Street, pending the vote of shareholders at BDCA.   The BDC Activist points out similarities between this situation and recent events at Fifth Street, KCAP, Full Circle, and TICC Capital.  The actions of independent directors have a significant impact on shareholder’s returns.   Here are a few of the key points:

  • Prospect Capital and NexPoint both offered to acquire the manager, and offered BDCA shareholders arguably  lower fees and overall better deals, but BDCA turned them down.  BDCA was especially virulent in its opposition to Nexpoint
  • Nonetheless, the board of BDCA unanimously recommends that investors vote yes on the transaction.
  • Board members recently increased their compensation significantly.
  • The BDC Activist also points out that independent directors of BDCA have zero ownership of the stock in this $2.5 billion asset company!

It doesn’t appear that the management contract was shopped very well.  Is Benefit Street really the best option that’s available?Probably not.  There are a lot of asset managers out there with economies of scale that would love to have another $2.5 billion in AUM.

Here is the full piece on BDCA by BDC Activist

Here is the  preliminary proxy

AR Global and its affiliates have a reputation aggressive capital raising , but their stewardship of investor assets has been abysmal.  They have a history of questionable corporate governance.  The “independent” directors often serve on boards of multiple affiliated REITs and/or BDCs, and have been approving of abusive management all along.

Affiliates of BDCA management previously  committed proxy fraud and consequently paid a $3 million fine.

As part of an attempted rollup of several non-traded REITS, with the goal of locking in 20 year + management contract, investors were asked to vote on proposals that would have removed investor protections.

The proxy for ARC Hospitality in particular looked like the ballot in a banana republic democracy.  Like the others, it  asked investors to give up basic rights.  But it had a twist.  The explanation for proposal 3 contained this:

“If this amendment to the Charter is not approved, the Relief Period under the March Advisory Amendment would be terminated and could cause the Company to be unable to meet its capital requirements, including payments due on our outstanding indebtedness, which could have a material adverse effect on the Company.”

The external advisor, which had previously caused the company to lose deposits on properties due to sloppy planning and management, had temporarily been receiving its fee in shares, since the REIT was so overextended it couldn’t afford to pay in cash.  The Proxy stated that if the proposed changes were not approved, it would demand payment in cash, potentially bankrupting the company.  They backed down partially on this requirement, but ultimately shareholders ended up approving most of the proposals at ARC Hospitality and the other affiliated REITs.  With few exceptions the independent directors at these REITs approved of all of the changes.

 

The BDC that is also a REIT

BDCS qualify as BDCs under the tax code.  BDCs by tradition also happen to usually be RICs under the tax code.   REITs qualify as REITs under the tax code.  RICs and REITs have  very similar requirements in terms of distributing income, and nearly identical benefits in terms of avoiding corporate level taxation.  However, investment limitations are different.

BDC is an SEC construct. REIT is an IRS construct. These categories are not mutually exclusive.  Mackenzie Realty Capital is a BDC that is also a REIT under the tax code.

From the 10-K:

MacKenzie Realty Capital, Inc. (“MRC,” “we” or “us“) is an externally managed non-diversified company that has elected to be treated as a business development company (“BDC“) under the Investment Company Act of 1940 (the “1940 Act“). Our investment objective is to generate both current income and capital appreciation through investments in real estate companies (as defined below). We are advised by MCM Advisers, LP (“the Adviser” or “MCM Advisers“). MacKenzie Capital Management, LP (“MacKenzie“) provides us with non-investment management services and administrative services necessary for us to operate. MRC was formed with the intention of qualifying to be taxed as a real estate investment trust (“REIT”) as defined under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). We qualified to be taxed as a REIT beginning with the tax year ended December 31, 2014, and made our REIT election in our 2014 tax return.

Anyways, Mackenzie Capital’s group of funds  are fascinating on many levels.  Mackenzie Sponsors/advises non-traded funds that specialize in exploiting inefficiencies in the market for illiquid retail programs.  Basically they buy non-traded retail programs at steep discounts via tender offers and  then either hold them through liquidation, or sell them at a higher price on auction sites.  They will sometimes puts out deep discount tender offers right after a non-traded program suspends its stock repurchase program.  The suspension of the share repurchase program generally indicates either the fund is in trouble, or it is pursuing strategic alternatives.  It doesn’t take long for a literate person to figure out which.    Mackenzie trades with and provides liquidity to uninformed unsophisticated counterparties that have extreme desire for liquidity (in most cases they buy from retail investors who actually bought fully loaded shares during the offering)

Mackenzie’s funds appear to follow the “no bad assets, just bad prices” school of investing.    An illiquid non-traded REIT, BDC or LP that is managed by a parasitic external advisor deserves a NAV discount.  Yet, in most cases they are worth more than zero.     Mackenzie in the illiquid space is sort of like the Bulldog Investors /Special Opportunities Fund is in the traded space, except on steroids without the activism. There are a few other groups that follow a similar strategy, such as CMG Investments, although mainly via personal account or LP structures.

Remember when Third Avenue’s distressed debt fund had a liquidity mismatch problem and had to suspend redemptions? Mackenzie’s funds bid on the shares at a 61% discount to  NAV.  The offer letter reminds me of a vulture eating a vulture .

 

Liquidity Services

Liquidity Services Inc.(LQDT) has a high ROIC business model and an underexploited balance sheet. Several areas of the business are growing rapidly and have massive potential markets, but these positive factors have been obscured by headline risk surrounding contract renegotiations and a goodwill write down related to a since disposed of acquisition. LQDT is selling at a steep discount to a reasonable private market value.

LQDT has an approximately $200 million market cap and an $95 million enterprise value, once the large cash holding is subtracted out. On a per share basis LQDT has ranged from $4.42-$10.61 over the past year, and its recent price around $6.70 is nearly 90% below the all time high in 2012.

Salvage Business

LQDT is in the “reverse supply chain” business, operating multiple on line auction marketplaces for surplus and salvage assets. LQDT generates a revenue by retaining a portion of proceeds from sales of surplus managed for sellers. About 60% of merchandise volume is sold using a consignment model slightly over 30% on a purchase model(entailing inventory risk), and profit sharing is the remaining. The salvage business is highly fragmented both by geography and product type, with few competitors offering integrated solutions. LQDT runs multiple website offering over 500 product categories across major industry verticals including consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts, hardware, energy equipment, capital assets, transit equipment, etc. etc.

Disposal of surplus is not a core function or a core cost of most businesses. Consequently customers care primarily about ease and convenience, and are less likely to be overly price sensitive, although a well established platform that is able to generate higher returns on surplus is at an advantage. Liquidity Services on line platform and large buyer base provide competitive advantage in serving corporate and government customers . LQDT’s base of registered buyers and a transactions completions have grown steadily,between 2006 and 2015. Global Merchandise Volume(GMV) has risen at a rate of approximately 19% per year since 2006. Network effects are significant competitive advantage.

The competitive advantage is also demonstrated by the high ROIC the business has typically earned. ROIC excluding goodwill has been above 20% in 8 of the last 10 years. In many years Return on capital is off the charts high when you consider the company has historically maintained a cash balance well in excess of what is necessary to operate the capital light business(to be fair they do have operating leases though).

There are several growth areas into which LQDT could reinvest capital. LQDT still has negligible international exposure, although its Asia/Pacific revenue doubled in 2015. Its expansion overseas is driven by demand from existing US customers with overseas operations. Additionally, the state/local government business (GovDeals) has grown steadily since it was acquired in Revenue for GovDeals is up 13.1% y/y and GMV was up 12.3% in the first half of fiscal 2016, due to both new customers and increased volume from existing customers. GovDeals has signed up barely 10% US municipalities, but is over 10x the size of its next largest competitor. Additionally, GovDeals is generally commission only revenue, rather than consignment revenue.

LQDT reported an increase in registered buyers/sellers in the energy industry, although volume has not yet increased drastically since prices of equipment have not yet settled. This area will eventually provide an amusing and temporary boost in volume, although is relatively small compared to the state/local government and international opportunities.

Headline Risks

LQDT is a meta-dumpster dive. Headline risk is present due to customer concentration and a previous botched acquisition.

LQDT management has continuously worked to diversify away from dependence on the DOD , and DOD contracts as a percent of revenue have declined from over 90% in 2004 20 40% in 2015 as other industry verticals have grown. LQDT declined to bid on the DOD rolling stock contract due to unprofitability. LQDT still has non-rolling stock asset and scrap liquidation contracts with the DOD but they were renegotiated at less profitable rates.. The compliance issues of dealing with the DOD provide some imperfect entry barriers.

LQDT recognized a goodwill impairment of $147 million in 2015 due to the sale of Jacob’s Trading, which it drastically overpayed for several years earlier.(this was basically a major contract with Wal-Mart). Nonetheless given the multiple other bolt-on acquisitions it is hard to argue that management is bad at allocating capital.

Is it losing network effectsWhile GMV is down significantly due to the Jacob’s sale, completed transactions and total auction participants for the first 6 months of 2016 were flat compared to the prior year. There is not evidence that buyers have abandoned the platform. Meanwhile, the GovDeal business continues to grow at a double digit annualized pace, regardless the Jacob’s Trading or DOD issues.

LQDT is in the midst of executing what it calls the “Liquidity One” transformation which will attempt to more fully integrate the multiple auction websites, and increase international presence. The silly corporate jargon name can be forgiven given the compelling logic of the changes.

Overall the headline risks appear well mitigated by the low valuation and significant growth in other areas of the business.

Valuation

Given the unpredictably of the future, I have embedded several layers of conservative assumptions in valution. EBITDA as a % of GMV has historically ranged from 5.7%-11.2%. The average from 2006-2014 was 7.9%. My valuation assumes it will be 5.0%. Additionally, I take the highest level of CAPEX of 2014 to be the long run maintenance CAPEX. The base case assumes no growth. The upside case is still well below management’s growth expectations. EV/EBITDA multiples of 8-12 for a growing high ROIC business seem reasonably conservative. For what its worth, EV/EBITDA for LQDT ranged between 13 and 28 from 2006-2014, although it was growing at a faster rate during that time period.

Back of the envelope:

600,000 GMV and an 8x EV/EBITDA multiple = 43% upside

800,000 GMV and 12X EV/EBITDA multiple = 140% upside.

I expect GMV and EBITDA as a % of GMV to normalize starting 2018, once the “Liquidity One” plan is implemented(some parts of the plan are being implemented this summer). Under a wide range of conservative assumptions investors have significant upside.

Also notable: Genco, which generated $1.6 billion in annual revenue operating a similar business to LQDT was acquired by FedEx for $1.4 billion. Unfortunately I didn’t locate profitability data on Genco, but its unlikely its long term profitability record would be much better than LQDT. Applying the equivalent EV/sales multiple to LQDT’s trough annual revenue of $300 million results in a price of $262.5 million, nearly 3 times the current $95 million enterprise value of LQDT.