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At the horse track a handicapper must judge many variables, including, crucially, the jockey. As investors we too must be able to accurately judge the capability, character and judgment of the management teams and boards of directors in which we entrust our capital.
Dear Fellow Partners, The third quarter headlines were again dominated by the actions of central banks and worries of a slowing world economy. While we acknowledge the significance of these issues on asset values, we believe it is difficult—if not impossible—to predict how those items will play out, as well as how other investors will respond to them. We think our time is best spent trying to find investments that can be profitable under a variety of scenarios, instead of trying to figure out what central banks will do or if another recession is at hand. As Confucius said, “To know that we know what we know, and that we do not know what we do not know, that is true knowledge.” We continue to focus on the things we think we can understand and in which we can more accurately assess the odds, though we remain mindful of the macro-level risks that will affect many businesses. Debt levels and the asset price manipulations of various governments have reached heights never before seen; of this we are well aware. Our goal is to successfully guide the fund through the economic storms that are likely created by the normalization of debt levels and the eventual unwinding of central bank actions. Jockey Rating Those familiar with horse handicapping may immediately grasp the allusion in this section’s title, but those less familiar with the track may require further explanation. When handicapping a horse race it is important to understand how fast a horse has run historically. That however is a difficult task, given that horses race on different tracks at different times and for different distances. The Ben Graham of the horse racing world is probably Andrew Beyer, whose books, including Beyer on Speed and Picking Winners, brought about a revolution in horse handicapping with the popularization of what he called speed figures. These speed figures allowed one to compare the speeds of horses, adjusted for race distances and track conditions. One component of the speed figure is the speed rating, which relates to the distance-adjusted speed. While Beyer never went on to develop a “Jockey Rating” (though he certainly recognizes jockey capability as one of the many factors that are crucial to successful handicapping), that theoretical idea is the topic at hand. One of your managers has a particular fondness for the track. (Rest assured it is a healthy fondness, as he recognizes his inherent limitations and keeps the activity to a small diversion!) Each year he and his wife take a summer trip to Saratoga in upstate New York, one of the top tracks in the country. During this year’s trip, his wife got to experience the agony of not having a jockey rating. In one particular race, she seemed to have a sure winner with not more than a furlong to go in the race. Unfortunately, the jockey, who wasn’t completely in the clear, let up noticeably on her horse as they approached the finish. Surely enough, the trailing horse came from behind and rallied for a dramatic victory. Despite recouping her bet with the second-place finish, she failed to win a nice sum on the winning horse. It was ultimately a poorly ridden race. Unfortunately, companies can be poorly ridden as well; and it pays, in both capital and frustration, to avoid these situations. We bring up the topic because there are three investments that we’ve made over the last two years whose results have been disappointing and whose “Jockey Ratings” were either poorly judged or inappropriately overlooked. We will refrain from specifics for the time being because these companies remain in our portfolio and subject to our efforts. However, generally speaking, the recent issues with boards and managements in our portfolio relate to suboptimal incentive alignment, poor oversight (by appropriate boards or shareholder constituents) and poor strategic focus. Over the years we’ve come to conclude that the management dynamic is especially crucial in the world of small and microcap investing. We enjoy fishing in this ocean of small companies for reasons we’ve discussed before and about which we’ve written a whitepaper, with the main reason being that this universe includes more inefficiencies and thus more chances for mispricing. But we have to recognize that poor or mediocre management teams, of which there are many in the small and micro-cap space, do little to improve the odds of our success as investors, regardless of the price paid. Given that poor or mediocre management teams can significantly impair good small businesses, just imagine what they can do to average businesses. In addition, the competitive advantages that are often built up over many decades in larger businesses are
generally not present in these smaller companies. Thus, decisions from the people at the top can have a significantly larger influence on the direction and outcome of a small business when compared to its larger peers. While we’ve certainly spent time thinking about management over the years, our recent travails have stressed some old lessons and also taught us some new ones when it comes to looking at management teams. In developing a mental model of a jockey rating, it is necessary to evaluate managements and boards of directors regarding their: Compensation levels Employment agreement features Ownership incentives Past management performance Attitude toward cost controls Strategic thought process Actions compared to words Luck versus skill Board structure Benchmarks and metrics Disclosure policies Other business dealings Personal life choices Capital allocation skills Related-party concerns
We want capable and appropriately incentivized management teams overseen by competent and engaged boards of directors that oversee the business for its owners—the shareholders—instead of those that seem to treat the business as their own personal checkbook, where a passion for making money off of shareholders seems to take precedence over making money for shareholders. While there are likely few management teams and boards of directors that would deserve a top “Jockey Rating” after a realistic assessment of these factors, the idea behind such a mental model is to avoid otherwise intriguing investment ideas where the “Jockey Rating” is inadequate and the likely investment outcome is similarly inadequate. High Returns with High Arctic? As we mentioned in our prior letter, we’ve been spending some time analyzing oilfield services companies. During the quarter we invested in one such company called High Arctic Energy Services Inc. (TSX: HWO). The company is an oilfield services, drilling, and equipment rental business headquartered in Red Deer, Alberta, Canada. While based in western Canada, the company has significant operations in Papua New Guinea (PNG). Despite several unique characteristics, we believe an investment in High Arctic could provide significant potential upside with important downside protection in its asset base. As we completed our investment, High Arctic was trading at the following metrics:
As Stated * Share Price Market Cap Net Cash Enterprise Value Dividend Yield TTM P/E P/TBV EV/EBITDA $1.75 $80.00 $12.80 $67.20 7.00% 2.94 x 0.99 x 1.87 x Fully Diluted * $1.75 $88.31 $12.80 $75.51 7.00% 3.25 x 1.10 x 2.10 x
* All financial values are in millions of Canadian dollars, except for share price which is simply in Canadian dollars. The share price is not our average cost, but the share price when we stopped buying shares.
While there are certainly appropriate concerns about the company’s exposure to PNG and a large customer in PNG; as well as its historical reliance on the natural gas business in Canada, we believe each of those worries is overstated and is more than priced into the stock. Interestingly, our take is that the company’s exposure to PNG is actually a net benefit which diversifies the company away from a more price-sensitive North American region, and provides a potential tailwind based on significant resource development occurring in PNG. The company has a couple of additional assets which also receive little notice by the market and which are not represented to the fullest degree on the company’s balance sheet. The first is the company’s tax loss carryforwards, which have only begun to be recognized on the balance sheet. Additionally, the company owns three highly specialized drilling rigs which were originally developed to drill for deep gas reserves but were written down considerably during the company’s recent restructuring. These rigs, thanks to the unfolding horizontal drilling revolution, may now very well have valuable applications in deep shale oil drilling. The company is already benefiting from the tax loss assets and is beginning to realize the potential of these underutilized rigs. High Arctic pays a dividend which exceeds a 7% yield at our cost. While there is clearly room for this payout to expand, the company is managing this against significant reinvestment opportunities both in PNG and elsewhere. High Arctic is also, in our opinion, intelligently repurchasing shares through a normal course issuer bid for which it received approval in late March of this year. Further, we are comforted by the fact that Cyrus Capital Partners is a large shareholder by virtue of High Arctic’s restructuring. While Cyrus has a representative on the board, as a distressed credit fund, it likely will seek a liquidity event at some point, which we believe could be a positive catalyst. If you would be interested in a more detailed write-up on the company, please feel free to reach out to us, as we’d be happy to send you one. While we’ve chosen to highlight High Arctic here, it is not the only oilfield services company we’ve been examining. We continue to be mindful of our exposure to a particular sector, especially one reliant on a commodity subject to significant swings, but we remain pleased with the opportunity set in this industry. Miscellaneous Chanticleer Advisors will soon be launching a new website. Once the new site is complete, current partners will receive a username and password from us, and all others will have to sign up and request an individual username and password in order to access the site. Our quarterly letters and much of the same information on our prior site will be able to be accessed on our new site. Additionally, investors will have access to their statements online. We look forward to introducing the site in the near future. Sincerely,
Mike Pruitt (704) 366-1535 email@example.com
Matthew Miller (704) 366-5078 firstname.lastname@example.org
Joe Koster (704) 366-0496 email@example.com