Askeladden Capital Q3 2019 Investor Letter - "Earn It"
YTD through 9/30/2019, Askeladden Capital Partners LP returned in excess of ~ +41% gross and ~ +32% net, compared to ~ +17% for our benchmark, the S&P 1000 Total Return.
The Q3 2019 letter discusses how we intend to earn our keep as we rapidly scale towards our long-stated target of closing to new capital at $50MM FPAUM.
Earn It
:
2019
-
10
-
28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
1
Dear
Partners
,
Askeladden Capital Partners LP returned in excess of ~ +41% gross YTD through 2019
-
09
-
30. This
compares
favorably t
o S&P 1000 To
tal Return performance of ~+17%. Since
inception in early 2016, we
have cumulatively returned ~ +186% gross, compared to benchmark performance of ~ +59%. On an
annualized basis, that’s ~ +32
.3% and ~ +13.3
% respectively.
More details are provided in
the performance
table on the next page.
I’m
here to talk about why none of that matters
going forward.
As of the end of Q3 2019, Askeladden’s total
-
strategy FPAUM (across the fund and SMAs) was roughly
~$13 million. This is up from ~$9 million
this summer
, and up from ~$3 million a year ago.
Abse
nt a
su
bstantial market drawdown, it is
likely that when I write you again in several months, our capital base will
be
meaningfully
larger than it is today. We continue to add new clients and receive additional capital from
existing clients, in larger and
larger chunks. I
now
believe it is likely that Askeladden will reach $50 million in
committed capital and close to new investors within the next two years
–
if not sooner.
An obvious consequence of our rapid capital raising is that the majority of o
ur ca
pital base in 2020 and 2021
will not have significantly benefited from our strong returns since
inception
–
or even our returns so far this
year
. Returns since inception, and the process that drove them, certainly played a role in attracting that
capital
base
. They do not, however
, tangibly benefit new clients, or new capital added by existing clients.
It is thus mathematically possible for us to look back, at some future point in time, and have strong
-
to
-
exceptional time
-
weighted returns
–
and yet be in
a position where the majority of our clients earned
mediocre returns on the majority of their capital invested with Askeladden. This is, in fact, perhaps the
bas
e
rate
for many funds: money
-
weighted returns lagging time
-
weighted returns, as various factors (complacency?
restricted opportunity sets?
fragmented fo
cus?)
contribute to star managers losing their shine over time.
Such an outcome would not be acceptable to us in any way, shape, or form.
To some extent, of course, we
have
structural problem solving
mitigants in place.
From the beginning, I had a strong sense of
intentionality in how I built Askeladden
–
I
wanted it to be different. I invite comparisons to the benchmark
and explicitly aim to beat it
–
not in any given quarter or year, of course
–
and
thus
we charge performance
allocations
only
on outperformance versus the higher of zero or the index, over a three
-
year period.
Rather than believing ourselves to be a mas
ters of the universe capable of earning alpha with any clients and
any
amount of
capital, we’ve cultivated a
client base that is
aligned with our
classic value investing
philosophy,
and frequently reiterated our intentions to close to new capital at $50 mi
llion in fee
-
paying AUM, to preserve
our runway for investing in idiosyncratic small and micro
-
cap opportunities.
R
ather than believing that we can successfully do everything, we continue to focus on doing one thing, and
doing it well
–
identifying
value
i
nvestment opportunities in
companies of good to great quality that
trade for
attractive valuations in absolute terms, allowing us to benefit from a combination of strong cash flow,
reasonable growth, and positive multiple rerating over time.
This is a gr
eat place to start, but in the absence of motivation and
focus
, it wouldn’t be enough.
To this end,
o
ne of my favorite commercials of all time
i
is a joint Coca
-
Cola and Wal
-
Mart spot titled “
Earn It
.” Please
take a minute to watch it; I hope the story resonates with you as much as it does with me.
I’ve never expected anything to be handed to me; I’ve always expected to earn my keep. The balance of this
letter is thus dedicated to h
ow we intend to continue to “earn it” for all of our clients
–
current and future.
We love our portfolio today and are
strongly
optimistic about the outlook over the next several years, but
we’re also aware that far
-
future returns are often earned from wo
rk we do today
–
so westward on we go.
Earn It
:
2019
-
10
-
28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
2
Performance Table
Westward On:
Where We Go From Here
It’s important to understand that the world is
probabilistic
in nature; we can’t fully control most of the
important outcomes in our life
–
luck
, or as some people prefer to call it, randomness, will inevitably play a
role.
As
I’ve reiterated time and time again, I believe that we have benefited from significant luck since
inception, and that we will not benefit from such luck over all time periods.
The existence of luck
is, nonetheless, a poor excuse for succumbing
to the sire
n song of nihilism. In
substantially all areas of life, we have the ability to do at least something about our circumstances. Indeed,
agency
, the idea of free will or “belief behavior matters,”
is an empirically
-
demonstrated
caus
al
factor in
success, however you choose to dimensionalize it.
T
he balance of this letter will provide
commentary
via
inversion
–
identifying thr
ee of the
critical,
80/20
type
risks
that could lead to our performance suffering in t
he future, and outlining
how we intend to mitigate
those risks
.
Some of the material below may have been covered before or elsewhere, but it represents our
latest thinking as we approach the fourth anniversary of Askeladden’s inception.
It is of course n
ot an
exhaustive overview of every aspect of our process and thinking, but hopefully it at least level
-
sets, for
everyone, how we approach the important task of allocating your capital effectively.
We have tried to focus
on the
evolution
of our thinking:
what’s different, rather than what’s the same.
Earn It
:
2019
-
10
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28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
3
“
W
e can't choose where we come from
,
but we can choose where we go from there.
I know it
's not all the answers
. B
ut it’s enough to start putting the
pieces together.
”
–
Charlie Kelmeckis, “
The Perks of
Being A Wallflower”
Risk
factor
: not having enough good ideas.
Mitigating factors
: the watchlist.
Since inception, the investing environment has, on the whole, been
exceptionally
conducive to our process, as
demonstrated by our strong returns, as well
as our
“reloaded” portfolio
. Despite the market being at or close
to all
-
time highs, not only is our portfolio
fully invested, but we have more attractive ideas than we have
room for
,
such that we are able to pick and choose the highest
-
quality, highest
-
return opportunities.
Our current
portfolio
-
wide prospective return
is around ~27%,
despite strong gains so fa
r in October
–
substantially a
bove our underwriting threshold. I
t is at
this
attractive level without us taking excessive risk on
any dimension
we can identify
.
For example: w
e do not have any position larger than 16% of AUM. We do not have
much expos
ure to the
price of any specific commodity
. Over 40% of our portfolio derives a substantial portion of revenue and
profitability from recurring,
multi
-
year
contractual revenue streams
from creditworthy customers
, such
that
even in a strong
recessionary en
vironment, revenues would be highly visible
/
predictable
.
We take very little
leverage risk:
40% of our portfolio has either
de minimis
debt o
r net cash, and of the remaining 60%
with
some debt
, only a
small portion
has
more than 2x net debt to EBITDA
(our threshold for starting to
worry
.)
We do not believe that any single geopolitical event
–
such as a meaningful currency devaluation, enactment
of a particular regulation, or so on
–
would have an overwhelmingly negative effect on our portfolio as a
w
hole. We have run portfolios in the past that are
much
riskier than today’s; we would certainly be willing to
do so again, but it is our hope that our watchlist will, over time, allow us to continue to optimize our
risk/reward by providing an ever
-
growing
set of potential investment candidates, giving us full and clear
insight into actual, rather than hypothetical,
opportunity costs
of capital.
We have described
our
watchlist process e
xtensively in
previous letters
, and
thus will not review
it
here.
What
we will discuss: a
midst a very strong year, one disappointment that stands out is that we have not grown the
number of names on the watchlist very much in 2019; it remains stuck around 140.
There are several contributing
factors. One is churn due to M&A, which is always a factor in small
-
cap land
but seems to be particularly elevated over the recent past
–
off the top of my head, watchlist companies
acquired since mid
-
2018 include KMG, TY
PE, MAMS, PNTR, NCI, DFRG, and JM
BA; there are more, but
you get the idea
. Similarly, as our quality standards have grown more stringent, o
ther companies, particularly
some of the lower
-
quality ones, have either been removed from our watchlist as they no longer fit our
process
(DTEA)
, or
have succumbed
to excessive leverage
(KONA, WIN).
At the same time as these factors have seemed to accelerate the number of companies churning off the
watchlist, the greater monitoring burden associated with our more diversified portfolio has
also reduc
ed the
time available for us to conduct new research. Finally, an unusually volatile year has allowed us to take
advantage of harvesting capital from existing positions, and redeploying it
–
for the most part
–
into posi
tions
already on our watchlist. T
h
e associated diligence
for both updates and existing portfolio positions
has often
been quite extensive.
Earn It
:
2019
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10
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28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
4
On the one hand, obviously our process is working just fine with the current watchlist. Returns since
inception, and returns over the next year or two
, will largely be the result of a watchlist the same size (or
smaller) than the one we have today
, and unless something goes terribly wrong, we think we’ll be pretty
pleased with our cumulative performance over the first 5
–
6 years
.
If we (for simplicit
y) assume the watchlist
stays at
~150 names in the near future, then at any given time, we
can build a 15
-
stock portfolio from the lowest valuation quintile of the watchlist, with
another
15 stocks to
spare (that might not be interesting at the time, for w
hatever reason.)
Th
e current watchlist, with churn
being
replaced by new companies, would be perfectly good
-
enough
to execute
our investment process.
But we’re not satisfied with good
-
enough
: notwithstanding our year
-
to
-
date performance and our robust
future performance expectations, we’re disappointed in our slower
-
than
-
expected progress in building the
watchlist
. We view the watchlist as the equivalent of shots on goal or red zone possessions
–
the more you
have, the better your chance of running up
the score. Considering that we have a select handful of
opportunities that are substantially more attractive than any others in our coverage universe, who’s to say
there aren’t more like that out there, that we should know about and be looking at?
It’s cl
ear, at this point, that
reaching
300 stocks on the watchlist (our original target) is
unachievable
over the
medium term, and perhaps ever.
ii
200, however, continues to seem like an attainable goal over the next few
years.
Meanwhile, we have some tangible
steps we are taking to improve the efficiency of our research.
1)
Quality over quantity.
There have been times, in the past, where we have grown the watchlist much
more quickly than we have today. But KPIs are only useful to the extent that they align with
useful
real
-
world outcomes, and doing research for research’s sake
just to boost the watchlist number isn’t
helpful if it doesn’t lead to having more actually
-
useful investment opportunities.
In some cases in the past, we went after research projects t
hat were easy, for the sake of completing
research projects, even if those projects were on the cusp of our quality thresholds at the time. With
our quality threshold having steadily risen, we now choose to focus our energy more on companies
that we actua
lly have a higher chance of investing in.
Although we’ve added fewer companies to
the watchlist over the past year than we’d like
, we feel
very good about the ones that we
have
added;
several have in fact entered our portfolio. W
e now are
much quicker
to immediately take a pass on businesses with characteristics we don’t like (such as
excess leverage, marginal business quality, or poor management.)
2)
Selectively broadening our circle of competence.
As a result of our efforts over the past few years,
we
are comfortable today in many more areas than we were at inception, or during our first few
years. As one example, our work on Franklin Covey (FC)
–
not only on the company itself, but on a
plethora of its publicly traded, subscription
-
business peers
–
h
as made us much more comfortable
with evaluating subscription businesses, which are often very high
-
quality and sometimes deeply
misunderstood.
This understanding has manifested itself in a new position, tied for largest exposure
in the portfolio, that be
ars strong similarities to where Franklin Covey was this t
ime last year.
Similarly
, we
initially
had an exclusively U.S. focus, as we believed that we were ill
-
positioned to
understand
culture / consumer / governance differences
that might make internati
onal markets
different than our home market. We have since reconsidered to some extent.
There doesn’t appear
to be much rational basis for being distrustful of governance or accounting in non
-
U.S. first
-
world
markets
. In fact, European small
-
caps often
have much clearer and more comprehensive disclosures.
Earn It
:
2019
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10
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28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
5
Similarly, i
n certain situations,
cultural
differences between countries are more cosmetic than real
, at
least for investing purposes
. For example, enterprise software and the associated consulting se
rvices
serve the same purpose in Italy, Norway, and Israel as they do in the U.S.; the value proposition, use
case, and purchase analysis are e
ssentially identical. D
own jackets wear the same in New Zealand as
they do in New York, and tollbooths work the
same in Austria as they do in Addison
, TX
.
iii
While
there are still risks like currency exposure that we have to consider, we do think that many
international companies merit our research and attention; we’ve been pleased with positive initial
results here,
although our sample size is too small to be meaningful yet.
More to come on this.
3)
Reinvesting in research capabilities.
As we scale, we necessarily lose certain advantages, such as being
able to nimbly establish large allocations at a moment’s notice w
ithout moving the market. However,
a compensating factor
–
up to a certain point
–
is that going forward, we will have the ability to
invest additional funds into extending our research capabilities. Certain tools or resources
, such as
access to data or
other people’s time,
could enhance or accelerate our research process,
and we have
been starting to evaluate some options. We are still early in this process, and will report back when
we have something tangible to discuss.
We believe that our eventual a
t
-
scale asset base is the sweet
spot between being small enough to invest in small/micro
-
caps, yet having enough resources to
maximize the productivity of our research process.
To be clear, we are very firm in our desire to continue as a one
-
man investmen
t team; for reasons
discussed thoroughly in
previous letters and pitchbooks
, I have no intention of hiring an analyst.
This does not mean that we cannot benefit from others’ expertise
through a variety of formats
(subscriptions, contrac
t consulting, etc), and we intend to explore these possibilities fully.
4)
Reinvesting in non
-
research capabilities.
In addition to being Askeladden’s portfolio manager, I am
also
the CCO
and the COO
. I
w
rite and file my own Form ADV update and place most of the
trades.
I am al
so my own tax preparer for my personal taxes.
With all apologies to the Texas State Securities Board and the IRS, these are non
-
value
-
added
activities for me to be spending my time
on
–
compliance, trading, and taxes/accounting are
undoubtedly extremely critical functions
that any business needs to provide full attention to
, but they
are not my specialty. I’m good at research, and my time is best spent on th
at. There are competent
,
qualified professionals who
–
for a price
–
can handle a
reas that are not my specialty,
in a manner
that will not only result in higher
-
quality work, but will also keep my time focused on research.
Risk
factor
: mistakes of analysis or judgment.
Mitigat
ing factors
: margin of safety,
finding the sweet spot between concentration and
diversification,
avoidance of leverage,
focus on quality factors,
differentiation between knowable and
unknowable factors.
Assuming that we have sufficient opportunities to ev
aluate and act upon, the next critical risk that we face is
whether or not our judgments on these opportunities are appropriate. We were recently asked
by a
prospective OCIO client
if we think that ou
r outperformance over time will be driven by the magnit
ude of
our winners, or the frequency of our winners
–
i.e. are we running a VC
-
style portfolio where a few big
winners drive overall performance, or are we running a bank
-
style loan book where we want to earn good
returns very consistently on the overwhelm
ing majority of our investments.
Our answer is definitively the latter. We have discussed before
(
Q1 2019
)
why, for a variety of reasons, we
prefer to try to identify consistent sources of positive carry, thereby benefiting from the gravitational pull of
Earn It
:
2019
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10
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28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
6
cash flow and growth (and multiple rerating) over time, rather than trying to look for a few home runs. Th
ere
are people who can execute the VC
strategy well
–
I’ve known some
–
but I’m simply not one of them.
I’m
not looking for hundred
-
baggers; that’s a bad
base ra
te
.
I’m looking for
two
-
baggers over three year
horizons
. The watchlist is designed to consistently surface such opportunities.
There are the standard, fairly trivial answers to this issue, and we’ll get to them momentari
ly. One I’d like to
highlight as
different, however
, is differentiating between what questions are knowable and unknowable.
To frame the issue, let’s return to the issue of
luck
we discussed earlier. We do, strongly, believe in
agen
cy
–
making the right decisions consistently will result in better
-
than
-
average pay
offs, given enough iterations.
However,
luck
can inter
act with outcomes in funny ways, thanks to phenomena like
complexity
and
social
proof
.
Why is it that Even Spiegel is a billionaire? Why is it that some artists produce one
-
hit wonders from
nowhere
–
then never compose anything else that catches people’s attention?
Luck, obviously.
Michael Mauboussin has some of the answers in
“
The Success Equation
”
(
TSE review + notes
). An important
takeaway for investment purposes is that certain phenomena in the world are subject to unpredictable
development. Here are a few real
-
world examples: sometimes new
technology adoption is far more rapid
than anyone expected
–
think about how Uber, AirBnB, and the iPhone went from nonexistent to ubiquitous
over the course of a decade. In other situations, technologies that many people t
hought would become
ubiquitous f
ail to have any discernible impact over similar time periods.
The implication is that not all assumptions are the same; modeling high growth in one situation might be very
different from modeling high growth in a different situation. As a novice analyst,
I failed to appreciate such
nuances, and often made category errors, assuming that you could take the same approach to al
l companies in
a certain bucket
–
i.e. all high growth is uncertain, or all businesses that look the same behave the same.
A tangibl
e research takeaway is that
if a phenomenon
is fundamentally unknowable
/ unpredictable
,
more
research isn’t going to help. For example, although primary research is generally not part of our process, we
do have friends who use primary research extensivel
y. While they usually do a great job and find ways to
extract value from it, we have seen some specific instances where they had a high level of confidence in a
specific outcome, only for reality to be very different. This wasn’t because they didn’t do t
heir work; rather,
it’s because they were trying to make accurate predictions about phenomena that are, fundamentally, very
hard to predict
–
because
the same set of initial circumstances can result in vastly different outcomes.
Better understanding nuance
s like these has allowed us to calibrate our investment process. In certain
circumstances (such as levered companies), we have become far more conservative,
and less willing to
underwrite certain outcomes with
any
confidence
whatsoever
. In other circumst
ances (such as recurring
-
revenue businesses), we have become far
less
conservative, and far more willing to underwrite certain
outcomes with
a high degree of
confidence. We have become more aggressive in underwriting
knowable
factors
–
which we can unders
tand better through thorough research
–
and become far more conservative in
underwriting
unknowable
factors
–
which we generally believe cannot be elucidated by research to a degree
helpful for the investing process.
When we aren’t sure if something is kn
owable or unknowable, we like to
default to “unknowable” for conservatism
–
overconfidence
is killer in our business.
Nuance
s like these are what drive outperformance. On its face, value investing is easy: buy good businesses
at good prices. But the day
-
in, day
-
out process of actually executing on that objective requires mak
ing
nuanced distinctions on the exact nature of margin of safety.
Moving on, other changes to our portfolio management process include a somewhat less concentrated
approach. While we still believe that as a one
-
man shop, it doesn’t really make sense to
have more than 15
-
20
positions, we also believe that running a 6
-
7
stock portfolio is an unnecessarily difficult, risky, and stressful
Earn It
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2019
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28
Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
7
way to make a living. Moreover, now that we have a fuller sample size, we’ve been able to observe that while
our bigger
positions have generally done better, the spread is not so meaningful that it justifies the risks
associated with having
, say,
a third of our portfolio in a single position.
While not everything has been smooth sailing (of course), we generally have rece
ived acceptable
-
to
-
exceptional outcomes on the majority of our investments
–
so we now prefer to not take positions in excess
of 20% of capital, and to instead give ourselves more shots on goal for our pro
cess to profit in any
period.
Another evolution th
at we will discuss in the next section is a refining of our preference on taking cyclicality
vs. leverage risk. One more for this section: our increasing focus on higher
-
quality companies, measured by
metrics such as gross margins, Net Promoter Scores or
other measures of customer value proposition,
growth prospects, recurringness of revenue, and so on.
While we cannot speak for all investors everywhere, we now have clear and compelling data that our process
works best for companies on the high
er end of
the quality spectrum. Although we’ve had good outcomes in
both categories (higher
-
quality and lower
-
quality companies), all of the process mistakes we regret occurred in
the lower
-
quality bucket.
As such, a
ll other things (such as returns potential) equal
, we now somewhat prefer higher
-
quality, higher
-
valuation companies to lower
-
quality, lower
-
valuation companies. Of course, we’re still sticking to our roots:
our entry prices still usually equate to high single to even sometimes double digit “owner earni
ngs” yields.
Compounder bros, we are not.
Risk factor: external “macro” challenges.
Mitigating factors: avoidance of leverage,
caution around cyclicality,
avoidance of single
-
factor
Russian Roulette
, focus on secular realities
, focus on customer /
stakeholder v
alue proposition
,
and
focus on
“fairness.”
Most readers are likely aware that we do not have any in
-
house market view; we do not attempt to time the
market (or the economy) by tactically allocating our portfolio in light of prevailing and expe
cted future
unemployment conditions, interest rates, or market valuations
. We aim to run an “all
-
weather” investment
portfolio that focuses on secular rather than cyclical factors. We believe that A) most people cannot
successfully time the market or the
economy, and that B) even if some people can do so effectively, we
cannot
–
it would introduce more noise than signa
l into our process, as we have
discussed extensively.
This does not mean, however, that we have our heads in the sand about macro risks. Q
uite the converse. I
am completely aware that, like many investors who came of age after the 2008 financial crisis, my experiences
are not reflective of a full market cycle. Several of my mentors were fortunate (or unfortunate) enough to
experience not o
nly 2008
-
2009, but also the ‘90s tech bubble and subsequent crash, in real time.
This taught
them lessons that we, by proxy, can internalize into our process.
We have intentionally cultivated
relationships with such mentors to help us access more well
-
ro
unded perspectives.
One of our takeaways is that leverage doesn’t matter until it’s the only thing that matters.
We’ve seen many
investing write
-
ups over the past few years proclaim a company with 3
–
4x net debt to EBITDA to have a
reasonable or even “st
rong” or “safe” balance sheet. Such investors are clearly from a different planet from
us; anything above 2x gets our eyebrows raised, and anything above 3x is a big red flag.
Although credit conditions have been very favorable over the past decade, we’
ve had the opportunity to
observe, up close and personal, what it can look like when that ceases to be true
–
there are pockets, such as
energy, where
“extend and pretend” reached its limit.
If you run into the wrong environment, 3x leverage
can quickly t
urn to 4
-
5x, which can quickly turn into dilution or worse.
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2019
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Askeladden Capital
Q3
2019 Letter
samir@askeladdencapital.com
8
When Askeladden launched, our approach was equally cautious around cyclicality (and/or discretionary
demand) and leverage: we viewed both of them as things that bothered us, but both were on equ
al footing.
Although we remain equally cautious on cyclicality, we are far more concerned about leverage now than we
once were (and we were pretty cautious to begin with.)
The simple reason for this is
path
-
dependency
.
As we’ve studied more companies over time, what we’ve
realized is that the two risk factors play out very diffe
rently for operating businesses.
For example, we’ve researched a number of companies with some cyclical/discretionary component to
demand, that went through setbacks. Some of these were companies that saw some decline in demand in
2008
-
2009 due to reduced
consumer and business confidence; others of these were companies that saw
specific industry down
-
cycles (rail, energy, etc) that led to more severe reductions in demand.
There are obviously different circumstances
–
sometimes demand goes away and doesn’t
come back
–
but,
for illustrative purposes, let’s restrict our discussion to durable sources of demand that may be deferred, but
don’t go away. As merely one example, people will always want to eat, buy clothes, and entertain themselves.
They may trade d
own or defer some such experiences during recessions, but over the long term, we can be
confident that this demand will be reasonably consistent.
In such cases, industry slowdowns can actually be a long
-
term
boon
to well
-
capitalized companies. Marginal or
levered competitors may defer investment
or go out of business entirely; well
-
capitalized and well
-
run
companies can take advantage of this void by investing in new products and locations, by poaching customers
from competitors who are underinvesting, etc
. Good companies will, too, suffer from the slowdown in
demand, but they often emerge stronger
–
and at the very least, the slowdown does not typically strike them a
terminal blow.
In other words, macro challenges are annoying, but not fatal.
Leverage is
different, because it introduces path
-
dependency. Demand may come back, but if it comes back
after your debt is due, it’s game over. We’ve actually seen many cases where leverage didn’t
outright
kill a
company, but sort of killed it in slow motion.
Fo
r example, in several different industries, we’ve seen software leaders acquired by PE and then run for
cash. In the process, they underinvested in R&D, leaving open a doorway for smaller competitors to take
share. Then they end up in a catch
-
22 situatio
n
–
they can’t increase R&D because the cash flow is needed
for debt service, but they can’t maintain their cash flows, let alone generate organic growth, without
remaining competitive on their feature set.
Value destruction is likely either way, whether
it’s a slow burn or a
quick blow
-
up.
So while we don’t want our
entire
portfolio to be exposed to businesses with the potential for cyclical declines
or deferrals of demand, and we thus keep track of this exposure top
-
down to make sure we’re not setting
ou
rselves up for the worst, we’re also more comfortable with this risk than with leverage risk.
Another mitigating facto
r, partially referenced a few paragraphs ago, is a focus on secular trends that, in the
long term, are more important than near
-
term fluct
uations. We believe that many investors incorrectly
emphasize the cyclical, when they should be emphasizing the secular. For example, for most high
-
quality
software/technology companies we’ve studied, 2008
-
2009 is an irrelevant blip in a long and disting
uished
history of growth. Moreover, there are two separate software/technology companies in our portfolio that
have a decade
-
long track record of strong growth despite a high level of expo
sure to basket
-
case economies
(one of which is Italy, to give you a
sense of the headwinds they’re fighting)
. This is not to say that they
would prosper equally in all environments; obviously they will do better when their customers do better. But
it is a universal truth that we will use more technology tomorrow than we
do today; over any meaningful
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9
investment horizon, that truth is far more important to the progress of specific companies we track than
more temporary factors like the state of the economy, or which political party is in power.
Speaking of political partie
s, regulatory / political risk has been an increasing focus for many investors over
the past year, as tweets have turned into tariffs in the current Trump administration, and hard
-
line pro
-
regulatory
(Medicare for All)
and pro
-
labor
($15 minimum wage)
stan
ces have been bandied about in the
Democratic debates.
Discretion being the better part of valor, I deleted a more comprehensive discussion of how we’re
approaching some of these issues, as my experience with
ideology
has taught me that I’d make some portion
of my client base unhappy no matter what I said. Suffice to say that
ideas p
roposed by both political parties
would positively and negatively impact different portfolio companies in different ways.
We generally tend to focus on situations in which these risks are manageable and marginal rather than total;
we avoid healthcare, fo
r example, given the fact that it seems profit streams can be legislated out of existence
at a moment’s notice. We are not experts on how to price this sort of binary risk, so we avoid it. There are
other binary risks
–
like tax rates
–
that are somewhat
easier to price (at least in the sense that you can very
easily keep track of what companies would be worth under a different tax regime.)
Although we don’t intentionally optimize around this sort of variable, through the diversification that comes
with
having a broad opportunity set, we feel like we’d be relatively well
-
insulated from any specific regulatory
decision like increasing corporate tax rates, or restricting the domestic energy industry. We think about
factors like these and try to avoid play
ing Russian Roulette
–
i.e., we don’t like playing games that can kill us.
So, for example, the potential for fracking regulations is merely one reason (another being oil prices!) that we
keep a close eye on our direct and indirect energy exposure.
iv
We n
ever want a single uncontrollable external
factor to wreck our returns.
One unique angle we will point out, with regards to avoiding politically
-
oriented macro risks
,
is
fairness
/
stakeholder value.
Much has been made of the recent shift in corporate focus from “shareholder capitalism”
to “
stakeholder capitalism,” backed by top CEOs as well
-
respected and profit
-
oriented as Jamie Dimon (not
exactly Public Hippie Number One). Although this is not an approach that I would always have agreed with,
it is one I’ve increasingly come around to over
time: I’m generally very skeptical of investing in companies
that I believe are exploitative
–
regardless of who it is they’re exploiting.
The most frequent angle in which we conduct such analysis is customer value proposition. We categorically
do not in
vest in companies such as tobacco companies (which kill their customers), or companies such as
timeshares and Herbalife
-
style MLMs (that, in our opinion and that of many others,
charge their customers
far more than the value provided in return.) Even abse
nt our general avoidance of healthcare, we would not,
similarly, have wanted to invest in a Valeant or Turing
-
like company that was
raising the prices of critical lif
e
-
saving drugs by orders of magnitude
for no tangible reason other than to enrich shareholders and executives.
Setting aside our moral compass, we believe that there is a compelling mental
-
models based rationale for
avoiding such companies:
fairness
.
Fairness, as Richard Thaler explains compellingly in
Misbehaving
(
M
review + notes
), is among the enduring human behavioral traits long ignored by economists
(and MBAs).
v
People generally have a strong intuitive sense of what is “fair” and what is “not fair,”
and even if something is
reasonable/rational, it is unlikely to be sustainable if it doesn’t pass the fairness test
–
because people
generally revolt when they fee
l they’re being treated unfairly
and getting the short end of the stick
(this is what
Charlie Munger calls “deprival superreaction syndrome.”)
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Such revolt can take many forms. Customers who don’t feel like they’re getting a good deal may defect to a
comp
etitor, or
–
worse for the business
–
may seek regulatory remedy if they feel they are being treated
particularly unfairly. Conversely, of course, businesses with extremely strong customer value propositions
and happy, high net promoter score customers ar
e unlikely to face lots of regulatory backlash, or, for that
matter, disruption. In any event, serving rather than exploiting customers is better for business.
Of course, fairness doesn’t just apply to people who a company serve, but also those who work there. While,
as Office Space demonstrates to great effect, every workplace is probably going to suck in some ways, there is
a line between usual job frustration
s and employee exploitation.
Even as a born
-
and
-
bred Texan
capitalist, I find it difficult to read about
unpredictable scheduling
and think
that the
re’s anything “fair” about it: it is one thing for a business to pay someone an agreed
-
upon hourly wage
for their time, and quite another for a business to hold
all
of someone’s time hostage but only compensate
them for a small fraction of that time. I th
ink that setting ideology aside, most rational people
can agree that
we would find such behavior
fundamentally unfair
, were we on the receiving end of it
. And behavior that is
near
-
universally perceived as
fundamentally unfair eventually tends to get puni
shed by the authorities.
Many of the companies we invest in, by the nature of what they do, require high
-
dollar specialized talent and
have appropriately
-
designed incentive schemes and positive corporate cultures to make sure that people
participate in the
value they create. Other companies, however, do employ a higher proportion of low
-
wage
employees, and
–
by and large
–
we have found that although we do not explicitly optimize for this factor,
most of our companies tend not to be at the bottom of the ba
rrel when it comes to employee compensation
and work environment.
This may be because of the “1 Great Employee = 3 Good Employees” philosophy espoused by Kip Tindell
in his memoir,
“
Uncontainable
”
(
UCT review + notes
), about the history of The Container Sto
re. Again,
setting aside warm
-
fuzzies, paying employees more can be good business, i.e. profit
-
accretive, if it results in
better talent and better motivation.
As a result, even though
–
again
–
we don’t explicitly optimize for companies that would not be
subject to
additional regulatory oversight, we feel that our portfolio is
generally
not overly
-
exposed to negative impacts
from increased regulations. This isn’t to say that certain policies implemented by certain candidates wouldn’t
have a negative impa
ct. It is to say, however, that our investment process is, on the whole, designed to
deliver performance
regardless of such factors;
we don’t want to be like those companies that would have reported
good results,
except for the weather.
Fo
r
example, ove
r the last several years, many of the companies on our watchlist and in our portfolio have
been negatively impacted by tariffs. Undoubtedly, our performance would have been higher
–
as would that
of the market
–
had the administration not taken such a har
d
-
line stance on tariffs.
Of course, on the
converse, our returns
–
as well as those of the market
–
have received a one
-
time boost from the cut in
corporate tax rates, which could perhaps be reversed in the future. Such an event would undoubtedly harm
o
ur returns, but it should not be used as an excuse. The whole point of margin of safety and value investing
is to deliver strong returns over multi
-
year time horizons
despite
such circumstances. We can’t control our
mark to market over any short
-
term tim
e period, but we’re highly confident that given enough time, our
positive
-
carry focus will shine through.
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:
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-
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11
Conclusions
The next time I write to you, Askeladden Capital will be four years old. In many ways, building a business
has been different than I’
d ever imagined.
But in the most important way, it’s been exactly the same: I can’t think of anything else I’d rather be doing
with my life. Running this business uniquely enables me to live my best life, which is one of the primary
motivators for making
sure I do my best to leave it all on the field.
We’ve come a long way, but there’s even
farther to go, and lots of work still left to do.
A sincere thank you to each Askeladden client for entrusting us
with your hard
-
earned capital.
Westward on,
Samir
i
Puppy Love is actually my favorite commercial of all time. Obviously. But it’s excluded for our purposes here because,
c’mon. Puppies are basically cheating.
ii
An obvious mathematical problem is that at some size of watchlist, churn from M&A will matc
h or exceed our ability
to continue to add new names. Using some dumb fake numbers, let’s say that on top of portfolio monitoring and
updates on high
-
priority investment candidates already on the watchlist, we can add two to three new ideas per month
on a
gross basis
–
2.5 on average, or 30 per year. However, churn is a function of watchlist size
–
it is reasonable to
assume that M&A and other sources will eat up some percentage of the total watchlist every year. If this number is, say,
5
–
7%, then as t
he watchlist grows, our net adds will not only drop in
absolute
terms, but will also drop even more
meaningfully in
percentage
terms.
For example, at a current watchlist of ~140 names, perhaps we could assume we will lose 7
-
10 per year to M&
A. A
reasonable net add number is, perhaps, 20
–
23, or ~15% growth in the size of the watchlist.
However, at such time as our watchlist were to grow to ~250 names, churn would then account for 13
–
17 losses. Net
adds would therefore be perhaps only
15 per year
–
or a far more paltry 6% adds.
The takeaway here is that the bigger the watchlist gets, the harder it is to grow; when I was starting from zero, there were
very few stocks to update on, and very modest churn given the small size of the list,
so it was easy to grow the list
rapidly. As the list gets bigger, there is more maintenance and more churn, which makes it harder to grow. This is the
basis on which I am placing more emphasis on quality
–
if net adds are increasingly precious, then we
shouldn’t give
ourselves latitude to put “meh” ones on the list simply for the sake of having them on the list.
iii
As J.K. Rowling once said, I’m dropping anvil
-
sized hints here...
iv
There are, of course, nuances here
–
midstream/downstream vs. upstream, g
lobal vs. U.S., ongoing/recurring
operational demand vs. short
-
cycle demand levered to fracking completions, etc etc. You get the point, though.
v
Thaler, I believe, clarifies or strongly implies that chief among the groups of people who don’t understand
fairness are
MBAs and MBA students.
“Gouge, baby, gouge!”
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12
Appendix
–
Important Disclaimers
P
lease note that
YTD figures are
estimates based on our brokerage statements
–
they do not factor in
nuances of the accounting for performance allocations that
is perform
ed by our fund administrator
–
hence
our use of the tilde “~” to represent that results are estimated.
Gross returns
from
inception through
12/31/2018 are audited. YTD 2019 returns are unaudited; however, results that we report are rounded down
from official statements provided to clients by our fund administrator.
SMA clients should also note that the returns discussed in this letter are only for Askeladden Capital Partners
LP, and individual SMA account performance may vary due to tracking err
or, account parameter restrictions
(such as international trading permissions), and other such factors.
Fees are also reported for an investor
paying the standard fee structure; investors paying a different fee structure (such as non
–
qualified clients to
whom we cannot legally charge a performance fee) will obviously have different results, whether they are
SM
A clients or LPs of the fund.
As such, please consult your own account statements to determine your
individual account performance.
Moreover, please
also note that investors in Askeladden Capital Partners pay a variety of fee structures
–
including my own capital, which pays no fees, and non
–
qualified clients on whose accounts I cannot legally
charge performance fees.
This means that Partnership
–
wide
audited returns reflect a variety of fee structures,
and this fee structure on average (factoring in, for example, my account not paying any fees at all) results in
partnership
–
wide fees being materially lower than the stated fee structure.
Therefore
, I b
elieve it would be misleading to report the Partnership’s actual audited net returns in the table
above, as they would materially overstate the returns that would have been achieved by a client paying the
standard fee structure.
As such, instead, in these
letters, I report fees for a hypothetical investor paying our
standard fee structure. Cumulative net results in the table above are thus materially lower than actual audited
net results, but, in my estimation, substantially more useful for analytical pur
poses.
Investors with any
questions are welcome to review our audited financials for 2016
–
2018.
Past performance is not a predictor of future results. We do not expect our future returns to approximate our
historical returns. Amounts may differ due to r
ounding.
Net returns are calculated assuming a hypothetical
investor paid the standard fee structure of a 1.5% annual management fee and 30% of the outperformance, if
any, vs. the S&P 1000 Total Return index,
which was chosen because it had, at the time o
f inception,
historically outperformed the Russell 2000 and most accurately represents our typical investment universe of
small and mid
–
capitalization U.S. equities (i.e., those with a market cap of $10 billion or less). We may invest
outside this universe
(for example, in U.S. large caps or international small caps.)
This is not an offering of securities or solicitation thereof; any offering of securities would only be made to
accredited investors via a Private Placement Memorandum under Rule 506(c) of Re
gulation D, and any
prospective partners who did not have a pre
–
existing relationship with Askeladden as of 1/18/2017 would be
required to verify their accredited status with relevant documentation. This requirement does not apply to
separately managed acc
ounts. Any documents prepared prior to 2017
–
01
–
18 were not intended for public
distribution and should be read accordingly. Askeladden Capital Partners, and SMAs that mirror its strategy,
should be considered high
–
risk investments suitable for only a small
portion of an investor's overall portfolio,
as they involve the risk of loss, including total loss. Specific risk factors
are enumerated in our Form ADV.
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