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2014 Q1 Meson Capital Letter

2014 Q1 Meson Capital Letter

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Published by CanadianValue
2014 Q1 Meson Capital Letter
2014 Q1 Meson Capital Letter

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Published by: CanadianValue on May 02, 2014
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05/06/2014

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1 May 1, 2014 2014 Q1 Partnership Letter
Dear Partner,
Our net performance for Q1 was -0.2% vs. indices of: 1.5% Barclay Hedge Fund Index, 1.1% Russell 2000 and 1.8% S&P 500. Aron and I have been ramping up our new partnership together this quarter and it has been something of a transition quarter to get our processes all in place. We recruited a fantastic new board member at InfuSystem in Gregg Lehman and I announced I would be stepping back from my Executive duties and changing my role to non-Executive Chairman. The company has transitioned well past the activist chapter and is now solidly both feet into growth mode under Eric
Steen’s capable leadership.
We also welcomed a number of new investors to the fund including several of the smartest fund managers I know. We intend to tap them as resources as we build our investment process and business.
A Unique Environment
Today’s market poses
a challenging environment, one that we are uniquely equipped to handle given our idea sourcing and research software platform that we built over the last year. Overall valuations
during the 2000 “Great Bubble” were higher than today but they were concentrated
in large-cap stocks. Today, there are no large asset classes unaffected by the supply/demand balance favoring cheap capital and low returns: all asset classes are expensive. An interesting recent quantitative study showed that the median stock (which is less affected by say the largest 100 out of 10,000 stocks being wildly overvalued as in 2000) is at an all-time high valuation
 –
 
EVER
. To make stock picking even more difficult, dispersion is at an all-time low
 –
 meaning the range of EV/EBITDA multiples is narrower than ever. These two combined means that there is virtually nothing that is
obviously 
 cheap in the market. We have been aware of this trend for some time and started solving it starting in 2010. First using an entrepreneurial approach to activism and building value within underperforming companies. Then, after this experience gave the necessary depth, we began to systematize (
checklist + automation
) these insights and built a software platform to source ideas and optimize allocation of our most scarce resource: time.
I actually don’t believe the current environment is cyclical
 but rather is the result of structural changes.
“Value investing
has become hugely popular and simple stock data is widely accessible. This is the reason why
obviously 
 cheap stocks are bid up and dispersion is at all-time lows. If the reason for an investor buying a stock is solely based on its valuation multiple, newly popular
“smart beta” funds will
express this thesis in a much more refined and accurate way across many similar stocks with less risk
 –
 those investors are librarians in an age of Google.
 
2 So, as with all evolutionary progress, the key problem is understanding how to get one step ahead of the current environment. If the multiples of earnings are all clustering around th
e mean and “discovering”
low multiples has been completely commoditized, then the differentiator moves deeper: what causes the earnings to change in a nonobvious (e.g. not just a stable growth rate) way and how do you find those causes? This requires a depth of business understanding that purely statistical methods are too rudimentary to achieve. As an insider of half a dozen public companies since 2010, we are a lot more familiar with the subtle differentiating elements: InfuSystem has now increased its EBITDA by roughly 50% from when we became involved late 2011 and the stock has tripled. There was no stock screen that could distill the events in the boardroom that led to Eric Steen being hired as CEO vs some other candidate that may have resulted in a totally different outcome. However, there are subtle clues around the situation that it would have been an interesting place to look and
the stock didn’t increase until well after the actions
had taken place that were responsible for the increased earnings.
Another Healthcare Transformation Story
Hooper Holmes is a 100 year old company that provides life and wellness insurance services. Your parents or grandparents might have gone to an old HH brick and mortar location on Main Street to get their health checkup (height, weight, cholesterol, blood pressure) before their life policy became effective. Warren Buffett says that if management finds itself in a chronically leaky boat, you're better off finding a new vessel than to keep bailing. It took Hooper over a decade of losses but management finally threw in the towel and sold the structurally declining brick and mortar business August 2013. The "New Hooper" is now focused on the health & wellness market, an area with big tailwinds thanks to new ObamaCare incentives for employers to keep their workforce healthy and out of the healthcare system. The first step to improving health is measuring it, but with big companies that have dozens or hundreds of locations and thousands of employees, coordinating annual check-ups including blood draws is not easy. This is where Hooper comes in - their national network of thousands of nurses, a captive lab, and coordination know-how makes it easy for big companies to offer wellness programs to their employees. The stock doesn't look cheap on trailing metrics - which show losses - otherwise you wouldn't be able to buy it at today's discount prices. That said, we look for tangible indications today that value will be apparent to all tomorrow (or 1-3 years from now more specifically) and the stock will increase accordingly. 1) EV/Sales of approximately 0.8X ($19mm EV / $23mm revs) vs. numerous historical transaction comps at 2X EV/Sales
 
3 2) 25% historical annual revenue growth CAGR for the remaining segment (with only 2 sales people and nominal management attention as it had been a secondary business historically) 3) A new CEO and now focused management project wellness revenue will grow 25-40% CAGR over the next 4-6 years 4) New CEO Henry Dubois as a Change of Control provision in his employment contract of 2X comp (at the high end of market) and 2mm options at $0.50/share which align his interests with an ultimate buyout In short, Hooper Holmes has transitioned from a failing turnaround into a focused company growing the top line at 25%+ per year and trades for less than 1/3 of its ultimate buy-out multiple. We acquired our position shortly after the main asset sale and the dominoes causing fundamental business change had already begun falling.
Two Economists Walk down the Street…
 
An update on our garden weeding efforts. Odyssey Marine announced they received a contract to salvage the SS Central America, one of the most valuable shipwrecks in history. The ship sank in 1857 and was untouched until 1987 when a highly charismatic Tommy Thompson raised $20 million from investors in Columbus, Ohio to salvage the documented gold. Tommy raised the money and after numerous trips, he successfully salvaged the vast majority of the documented gold: estimated at
$50mm worth, which is incidentally roughly equal to OMEX’s cumulative revenue from non
-related-parties since inception. Then, like any good pirate, Tommy disappeared with all the gold, leaving investors without a dime. He has been a fugitive of the law and his whereabouts are unknown. The investment vehicle he used to raise the $20mm has been essentially in bankruptcy with no assets for over a decade. To rephrase a story about two economists walking down the street with differing views of the efficiency
of markets… If you are walking down the street and see a year old lottery ticket, the odds of that ticket being a winner is NOT 1 in a million (or whatever the lottery’s statistical odds are). It is 1 in a million
TIMES the odds that a winning lottery ticket has been left unclaimed on a street where everyone can see it for a year (call that also one in a million odds as it would have been highly publicized that there was in fact an unclaimed winning ticket somewhere out there) = 1 in a Trillion odds. Under the contract that it received after a competitive process, OMEX bears 100% of the cost to salvage any remaining gold from the SS Central America and receives 45% of the recovery after its costs. Nobody we spoke with related to the original case believed there could still be economically salvageable treasure and if there were, presumably Tommy, with $50mm of untraceable currency (gold), a ship, and knowledge of the vessel would have found it, but we shall see soon! We continue to believe that OMEX will have to raise highly-dilutive equity or run out of cash and declare bankruptcy by this summer and are short the stock.

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