Chanticleer Investors II - Q4 2012 Letter Excerpt

The Search for Owner-Operators “There is a difference between a manager running a company that is not his own

and an owner-operated business in which the manager does not need to report numbers to anyone but himself, and for which he has a downside. Corporate managers have incentives without disincentives – something the general public doesn’t quite get, as they have the illusion that managers are properly “incentivized.” Somehow these managers have been given free options by innocent savers and investors. I am concerned here with managers of businesses that are not owner-operated.” –Nassim Nicholas Taleb, Antifragile: Things That Gain From Disorder Many of the mistakes we’ve made that have contributed to mediocre performance over the last couple of years have come as a result of not having been invested with management teams that: 1) Treat minority shareholders the way the management teams would like to be treated if their roles were reversed; or that 2) Have a track record demonstrating that they have the “capacity to suffer”—to use the words of Gardner Russo & Gardner’s Tom Russo—by forgoing short-term profits in order to do what is right to increase long-term intrinsic value. We believe that a primary reason these management teams lacked these qualities was because they weren’t owner-operators. They either didn’t own a lot of stock in the company; or the shares they did own weren’t significant enough when compared to their other compensation to truly align their interests with us as shareholders. In recent years this factor was probably most noticeable with the big banks, though we didn’t invest in any of them. Risky activities leading up to the financial crisis led to short-term reported profits, which led to large compensation and bonus packages for the management teams that were much more important to them than their stock ownership in those companies. The end result was short-term gains in reported earnings and extreme risk taking that eventually led to the destruction or near destruction of those companies, requiring significant government intervention in order to keep the entire financial system afloat. In contrast, Brown Brothers Harriman (BBH), a privately-held partnership that competes with the big banks on many levels, sailed through the 2008 crisis. Though they don’t disclose their profits, a 2011 article in The Economist did mention that 2008 was BBH’s best year ever. Maybe the “skin in the game” that comes with the partnership structure had something to do with it? In Antifragile, Taleb places fragility into three categories: the fragile, the robust (or resilient), and the antifragile. The fragile is harmed by shocks and randomness, the robust stays the same, and the antifragile gets better. Taleb places owner-operated businesses in the robust category, with a special mention of smaller companies when he writes, “There seems to be a survival advantage to small or medium-sized owner-operated or family-owned companies.” In the past, we have always given great consideration to the management teams of the companies in which we look to invest. We study their track records, look at their incentives, and try to get a thorough understanding of how they view capital allocation. But it is also just one factor, albeit an important one, among many others. Almost any stock or other asset is a good purchase if the price is low enough. The job for us as portfolio managers is to manage the balance between the quality and prospects of the business and management team, and the price at which Mr. Market is offering us a chance to purchase shares. A mistake we think we’ve made in some of our previous investments is not giving enough weight to the question of management team quality when considering how big a margin of safety we require in an investment before purchasing shares. A company trading for six times earnings might not be nearly as good of a deal as one trading at ten or twelve times earnings, for example, if the latter is run by owner-operators who consistently do the right things to increase the value of the business over a long period of time and treat minority shareholders and themselves as equivalent owners of the business. “Cash combined with courage in a time of crisis is priceless.” -Warren Buffett, Chairman, Berkshire Hathaway Investing with owner-operators that understand capital allocation also has the potential to be a cure, or at least a form of relief, for what Fairholme Capital Management’s Bruce Berkowitz refers to as “premature accumulation.” It is hard, if not impossible, to time the bottom of a stock price when purchasing shares. And it is hard, if not impossible, to predict how

important macroeconomic risks—which we are worried about today—will play out in the future and exactly how they will affect the businesses in which we invest. But by finding and investing with management teams that are on our side and are conservative with their balance sheets, we can even gain a little bit of antifragility with our investments when volatility erupts, as long as we are taking a long-term investment horizon so that we may reap the rewards when the smoke has time to clear. We can gain this antifragility by partnering with management teams that increase the intrinsic value per share of the businesses they run when things get volatile, disrupted, or especially when chaos and crisis ensue. They can do this in two primary ways: 1) Gaining market share at the expense of weaker competitors and/or buying those weaker competitors at bargain prices; and 2) Repurchasing their own shares at bargain prices. The value added on a per-share basis by performing actions such as these can be enormous. The keys are to find management teams that understand this; are conservative and patient when deciding what to buy and when to act; and maintain a balance sheet that allows them the flexibility to act, and the courage to jump on an opportunity when it presents itself. If you are involved in the management of a public company and you can buy back your stock in the open market for half of what it is worth, conservatively calculated, then you are in essence earning 100% on the capital you use for those buybacks. While the wisdom of repurchases such as this may seem obvious, we again turn to Warren Buffett for further elaboration and to drive home the point, especially for any of the management teams in our portfolio that may read this letter. As Mr. Buffett wrote in his 1984 letter to shareholders: “The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons—one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended. The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer. ...The key word is “demonstrated”. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth—and, after a while, neither will the market.” Miscellaneous As a reminder, starting January 1st, 2012, the fund became responsible for accounting, audit and tax preparation costs up to 0.50% of net assets per year, on a quarterly basis. Chanticleer Advisors, as previously noted, continues to subsidize the portion of the costs above 0.50% resulting in an acceptable expense ratio paid by fund investors. We are pleased that Michael J. Liccar & Co. will continue to provide our third-party administration services in 2013, and prepare our tax documents. Our 2012 audit will again be conducted by Joseph Decosimo and Company, PLLC. We expect to have K-1’s out toward the end of March and hope to have our annual report ready in early April following the completion of our audit.


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