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Eric Khrom of Khrom Capital 2013 Q1 Letter

Eric Khrom of Khrom Capital 2013 Q1 Letter

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Published by allaboutvalue
2013 Q1 Letter by value investor Eric Khrom of Khrom Capital.
2013 Q1 Letter by value investor Eric Khrom of Khrom Capital.

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Categories:Types, Business/Law
Published by: allaboutvalue on Jun 17, 2013
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Khrom Capital Management LLCwww.khromcapital.com
757 Third Avenue, 20th FLNew York, NY 10017T: 212.376.5337info@khromcapital.com
May 14, 2013Dear Limited Partners:In the first quarter ending March 31
, 2013, our Partnership returned 23.0% net of fees and expenses.On average, we held 41% of our assets in cash throughout this period.
S&P 500 K.I.F., gross K.I.F., net
2008 (31.1%) (32.6%) (32.6%)2009 26.5% 91.9% 82.9%2010 15.1% 23.8% 18.6%2011 2.1% 22.8% 18.0%2012 16.0% 46.8% 36.4%2013 YTD 10.6% 30.4% 23.0%
Annualized Return Since Inception 5.5% 29.8% 23.3% 
Please refer to the disclosure at the end of this letter.
Investor vs. Trader
 We ended the quarter with 64% of the fund’s assets in cash–a historical high for us. This balance may soon shift. We are investigating new opportunities, which we cannot yet disclose. Hence, this letter willbe short, as we adhere to Benjamin Franklin’s advice: “Either write something worth reading, or dosomething worth writing.” Though this quarter we have chosen the act of doing instead of writing, we still wish to remind Partnersof our investment philosophy and how it differs from that of most market participants. Funds thatinvest in equities can be divided into two groups: traders and investors. Traders focus on the cashsomeone will eventually pay for an asset; investors focus on the cash that the asset will eventually 
Khrom Capital Management LLCwww.khromcapital.com
payout. The investing frameworks within which the two groups operate–even if they have the sameIRR hurdle–lead to vastly different underwriting processes. Take as a simple example a business called ABC Co., which sells for $100 a share and produces $10 inannual earnings (let’s ignore any potential growth or decline in those earnings.) An investor with a 20%IRR hurdle would conclude he could not pay more than $50 a share for this business ($10 / 20% =$50). In other words, the investor looks to achieve his IRR target by relying on what the asset itself 
can  produce 
. A trader, however, may look at ABC Co.–while also having 
the same 
20% IRR hurdle–and justify purchasing the shares. The typical trader argument would be that this business is worth more than the10x earnings it sells for– 
to someone else 
. This valuation would typically be justified by either using peermultiples, private transaction comps, value to a strategic acquirer, or simply a multiple re-rating by themarket when it “smartens up.” In other words, the trader looks to achieve his IRR target by relying on what the asset
sell for 
. Though there is nothing inherently wrong with trading, such a strategy risks lowering the underwriting standards of a capital allocator. This temptation to lower valuation standards becomes especially acute when there is a dearth of great investment ideas. That is because even during times when asset pricesare high, a relative value approach can always be used to justify still higher prices. On the other hand,an investor with an objective value approach–a sole focus on the total cash that an asset can produce– has only one way to justify a valuation that meets his IRR hurdle. Consequently, during frothy markets,a trader is susceptible to finding rationalizations for activity, while an investor is likely to be forced tohold cash. Trading, as opposed to investing, also comes with greater risk of ignorance. Since a trader expects toeventually flip the asset on to another buyer, he will rarely ask the same questions as the investor whoacknowledges he may hold the asset forever. The essential question in a trader’s repertoire is, “What will my return be when I sell it for X multiple?” The investor instead asks, “What will my return be if Ihold the asset till the end of its life?” That fundamentally different question leads to a drastically different research approach. The due diligence hurdle for an investor is higher, which leads to greaterconviction and a more concentrated portfolio than that of a trader. Additionally, trading decreases the odds of finding an investment in which one has an edge. A traderopens the floodgates of information overflow–using a relative value approach, every asset for saleseems like an opportunity. An investor, however, substantially narrows the pipeline of opportunitiesthat warrant his attention–using an objective value approach, he knows there are few assets whoselifetime cash flows he can confidently predict. When an investor looks at an asset, he pictures the size of the cash pile it could generate throughout itslife. When a trader looks at an asset, he pictures the size of the bid it could receive at a future auction.
Khrom Capital Management LLCwww.khromcapital.com
 We find it hard enough to predict the future cash flow of an asset. The last thing we want is to add theextra variable of determining what someone else should pay for these cash flows; the fewer variables wehave to underwrite the better. Our aim is not just to maximize profits, but to do so while consistently taking as little risk as possible. Therefore, we try to rely on only two things to meet our IRR hurdle: theperformance of the asset over its life and the price we paid for it.
 Welcome Aboard
  We are excited to announce the addition of James Basili as Senior Advisor to Khrom Capital. Jim hasbeen in the investment management business since 1999, and is currently the founder and Managing Partner of Blacktree Capital Management. Prior to Blacktree, Jim was a Principal at GeocapitalPartners, a leading venture capital firm, and then co-founding Partner at Kinderhook Partners, aninvestment partnership focused on public equities.Over the past few years, we have had the pleasure of co-investing with Jim and Blacktree on numerousoccasions, to great success. Jim’s informal advice and involvement as we have worked together hasbeen invaluable, and after looking for ways to cooperate more formally, we are delighted to be able tomake our association official through the position of Senior Advisor. As Senior Advisor, Jim will have a hybrid of two roles at Khrom Capital: that of a board member andthat of a consulting general partner. In his role as a board member, Jim will provide advice and counselon strategic issues, and another layer of risk management. As a consulting partner, he will be availableto contribute to the due diligence process on potential investments, and to the monitoring of existing positions. Think of the first role as providing us with another set of eyes, and the second as providing another set of hands. Jim will invest his personal capital in the Partnership, aligning his interests withthose of the Partnership's other investors.Should you ever wish to chat with Jim, feel free to reach out to him at jbasili@khromcapital.com.* * * As always, virtually 100% of my net worth is invested in the Partnership as I aim to compound my  wealth alongside yours. I look forward to writing to you again after the second quarter.Sincerely,Eric E. Khrom
 Managing Partner Khrom Capital Management, LLC 

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