We apply a private equity
mindset to the public markets
The Opportunities Fund applies a private equity
mindset to public company investing
We invest in a concentrated portfolio of carefully-selected businesses, run by management teams we know and trust, and usually with the intent to hold for several years. Occasionally, in the public markets, there are opportunities to buy fractional ownership in businesses at prices below what a rational seller would part with for the entire company. The Fund targets a 10-15% IRR over time and seeks to preserve capital by avoiding companies that trade at expensive valuations, have significant leverage and/or operate in industries subject to rapid change.
We maintain a disciplined approach by classifying
each investment according to our “Playbook”
Investors are often asked to describe their investment strategy. To our knowledge, it has never been answered with the explanation that the investor likes to overpay for shrinking, low-quality businesses run by subpar management teams (although this is quite often what happens).
Instead of conventional classification, we describe our investment strategy using the analogy of a sport’s Playbook. A team with only one play can often be stopped, but a championship team will have perfected a few plays to ensure success regardless of game conditions and the opposition’s tactics.
In our Opportunities Fund, we classify each investment according to four plays:
Risk is the chance
of permanently losing money
In The Intelligent Investor, Ben Graham, a legendary investor, teaches that you can benefit as an investor by imagining that you are equal partners in a business with a man named Mr. Market. You have an odd arrangement with your partner: every day he will name a price and you can make one of three choices:
Mr. Market is also an unusual person. He is very emotional – swinging between optimism and pessimism – and he does not mind being ignored. Sometimes his price seems reasonable but often he lets his optimism or fears get the better of him and names either an unreasonably high or low price. Given these conditions, if you are an independent thinker with sound business judgment, you can take advantage of Mr. Market, buying from him at low prices when he is pessimistic and selling to him at high prices when he is optimistic. In fact, the more volatile his emotions, the more often you can take advantage of him. However, if you allow his mood to influence your own, you are destined for financial ruin.
Four-time Indianapolis 500 winner Rick Mears once said of car racing, “To finish first, you must first finish.” The same is true of investing. Compound interest is a powerful force but can be derailed by negative numbers. Consider the following: If you lose 50% in one year you must now make 100% to restore your initial capital, which, assuming average returns, will take you 10 years. But if you lose 70% you need to make 233% and 17.6 years of average returns to recoup losses. By the time you get back to the starting line, you will have been lapped by the market and probably never catch up. This is why we define risk as a permanent loss of capital.
Like the engineer who anticipates the unexpected and builds in an extra margin of safety, we perform an exceptionally careful analysis before making an investment. By recognizing the inevitability of unexpected events such as economic crises, natural disasters, political events and new technologies, we build a margin of safety into our investment decisions.
Blockbuster was once the industry leader in home video rental. Technology has enabled cable operators to offer video-on-demand, Netflix has introduced both video streaming and a mail-order service and Redbox has introduced video rental kiosks. In short, technology advanced and Blockbuster filed for bankruptcy in September 2010. Blockbuster’s market value exceeded $5 billion in early 2002 and shareholders lost everything within a decade.
Cisco Systems was a global leader in networking equipment for more than a decade prior to March 2000. Revenue had doubled and its earnings had tripled. However, in March 2000, the stock traded for almost 200 times earnings and despite a great decade of results, by mid-2011, the stock had declined 80%.
Las Vegas Sands is a large casino owner/operator in both Vegas and Macau. The stock peaked at $139 in late 2007 when the company had $7.5 billion of debt against only $360 million of operating profit. When the financial crisis arrived, Las Vegas Sands’ solvency was questioned and the stock plunged below $2, a 98% decline. Despite a 20-fold increase to $40, by mid-2011 the stock remained over 70% below its peak.
Bear Stearns peaked above $140 in 2007 but was forced by regulators to sell itself to J.P. Morgan for just $10 in March 2008, a 92% decline. Bear’s shareholders did not get to participate in an industry rebound because of the forced sale. Similarly, the government forced massive dilution of Citigroup’s equity in exchange for a bailout. Before stock splits, Citigroup peaked in early 2007 above $545 and by mid-2011 traded at just $38, a 93% decline.
The Bre-X story is well known in Canada. The company’s market value once exceeded $4 billion but quickly unraveled when the fraud was uncovered in early 1997 before the company eventually filed for bankruptcy and investors lost everything. In mineral discoveries by little known companies, it pays to be cautious. The record book is full of disappointments.
The goal of the partnership is to earn 5-7% annualized net returns, over a reasonable timeframe, while controlling volatility and minimizing the risk of permanent loss. We define a reasonable timeframe as five years, which translates into a cumulative return in the range of 30-40%. We think our goal of achieving stable, 5-7% net returns compares favorably to our two principal benchmarks – the iShares Canadian Investment Grade Corporate Bond Index ETF and the iShares US High Yield Bond Index (C$-hedged) ETF. These two benchmarks reflect well-known and accessible fixed income alternatives which can be regarded as our Limited Partners’ fixed income opportunity cost.
In the Flexible Fixed Income Fund, we believe that there are multiple mental frameworks that can produce attractive risk-adjusted returns. We have created an ‘Investment Playbook’ framework which articulates specific models of thinking used to evaluate fixed income investments. Our process is centered on evaluating individual investment opportunities using appropriate models of thinking demanded by the circumstance. Proper evaluation should enable us to identify investments that have low chance of permanent loss which also offer attractive absolute returns. Dogmatic adherence to a single mental framework is not a value maximizing strategy. Instead, we restrict ourselves to investing in businesses and capital structures that we can understand and where we can clearly formulate a thesis for attractive returns.
A critical part of our goal is to minimize the risk of permanent loss (what we consider to be true investment risk) and control volatility. We would posit that “permanent loss” also be considered “permanent loss of purchasing power,” a concept that takes into account the impact of inflation on capital. At current rates of inflation, one dollar today needs to grow by about 2% on an after-tax basis to avoid loss of purchasing power. From this perspective, it can be understood that long term allocations to cash effectively ensures permanent loss. Even at today’s low rates of inflation, a 5-year holding period would result in an approximate 10% impairment on cash relative to the future cost of living. Our view is that higher yielding fixed income investments are one of the few conservative means of minimizing loss of purchasing power while maintaining a liquid investment profile.
The Dark Horse LP is an investment limited partnership intended for high net worth, institutional and accredited investors. “Dark Horse” is an old handicapping term referring to a horse that is overlooked, unappreciated and mistakenly cast off as another long shot. The true Dark Horse sports long odds while possessing many of the skills and attributes of the favorite. It is the best value in the race. It is the type of wager that those who “know their stuff” and do their research seek.
The Dark Horse is the underdog that should not be such and is exactly the sort of investment that we seek for our partners.
We aim to avoid liquidity, concentration and market risk by adhering to strict risk controls and discovering esoteric company specific opportunities to exploit with long & short positions.