Selection Equities Fund commentary for the fourth quarter ended December 31, 2018, discussing their new potions in Under Armour and Rubicon Project.
We are happy to report robust absolute and relative performance for Selection Equities Fund, LP (CEF or the Fund) for the yr, up +15.9% and +12.1% on a gross and internet basis, respectively. Our annual performance compares fairly properly in a troublesome interval for the markets which saw the Russell 2000, the S&P 500 and our main Blended Benchmark finish within the pink at -11.zero%, -Four.Four% and -9.Four%. The fourth quarter particularly was a tough one for equities buyers, because the Russell 2000 led the best way down on -20.2% efficiency with the S&P 500 following at -13.5%. Our stocks were not resistant to the sell-off because the Fund posted a internet decline of -12.9%. Regardless of the down leads to This fall – an rare however vital condition of our funding strategy – we are quite happy with the outcomes for the yr, and maybe even more importantly as I will talk about under, the way it positions us as we head into 2019. Our complete internet compounded return since turning into an unbiased agency two years in the past now stands at $1.36 for each $1.00 invested, versus the $1.06 return derived from our Blended Benchmark.
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This fall hedge fund letters, conference, scoops and so forth
As is customary in our yr end letters, we’ll supply some commentary available on the market’s performance and look at the drivers of return on an annual foundation. We’ll then provide an update on CEF efficiency for the quarter before providing a couple of words on our typical portfolio development and how we measure success in differing market circumstances. We’ve got two new positions to debate and observe their full write-ups are in the appendices which comprise four pages of this nine page letter. Lastly, we shut with some thoughts on the outlook for the yr upcoming and what it means for our portfolio.
For equities buyers of almost all stripes, 2018 ended as a yr to overlook. The yr started nicely enough. Enthusiasm was robust as members cheered the current passing of the Tax Cuts and Jobs Act. Business confidence and earnings progress, partially driven by the arithmetic effects of the lowered tax price, was surging. A February wobble followed an unusually robust start to the yr, however buyers largely appeared previous the decline given the robust financial backdrop. As summer time arrived, issues surfaced and the tailwinds that had largely grow to be priced in, gave option to rising headwinds and new deterrents to progress. While newspapers had little hassle finding fodder for headlines, the primary problems with tightening monetary coverage, an emerging trade warfare with China and rapidly declining oil costs disrupted the serene image of synchronized international progress that had beforehand emerged, and buyers soon started to reprice markets for the lower progress trajectory.
Markets started their decline because the calendar turned to This fall and finally entered a “bear” market, given the S&P 500’s decline of larger than 20% off its highs in August. As is usually the case in these selloffs, small caps led the best way down when it comes to order and magnitude of decline. Probably exacerbating the quarter’s decline was the fact that much of the downdraft occurred in the sometimes quiet month of December. Absent a few of the regular market members, lower liquidity, yr finish positioning and tax motivations created a buying and selling setting that produced the most important decline for the markets within the month of December since 1931, finally leaving most equities buyers with losses on the yr. Wanting nearer at small cap efficiency, we see an astounding 89% of these securities finished in the purple for the quarter – a better proportion of declining shares than even This fall of 2008 and the fourth worst proportion within the index’s 40-year historical past. (For a full accounting of the quarter that was for small caps, I discovered this piece from Royce Funds fascinating.)
Apparently, solely two of the 4 durations of comparable decline are related to financial weak spot. As we take a look at the drivers of returns on an annual basis by reviewing our yr finish template, it appears we’ll possible add another episode to the listing because it was clearly not weak earnings progress that triggered the decline. In reality, it was more probably the reverse, as the Fed used the robust economic progress as grounds to institute four fee hikes somewhat than the three initially envisioned at the yr’s start. The upper rates, themselves suggestive of decrease multiples (albeit moderately so) seem to have additionally spurred on a change in temper which precipitated an enormous shrink in PE multiples. While maybe a gross oversimplification, it seems one might characterize 2018’s market efficiency as the yr that: what fiscal coverage giveth, monetary coverage taketh.
Like the markets, most of our shares declined within the quarter. Any shares we owned in measurement impacted the portfolio accordingly whereas mild hedging activity produced good points of somewhat more than 1%. No position detracted greater than 2.5% for the quarter, although our holdings in YELP, BXC, UA, DEST, and DS each detracted ~2% from gross portfolio performance. Despite their worth declines, the companies are performing as expected on a elementary basis.
The lone potential exception to this categorization is YELP. It seems the corporate’s transition to non-term contracts shouldn’t be going as seamlessly as initially anticipated. Though a number of parts of the conversion have confirmed disruptive, the most important factor that has slowed close to time period top-line progress possible stems from a change in the company’s compensation model for its gross sales drive. It appears reps did not regulate to the model with the convenience originally anticipated, and lots of selected to go away more shortly than the company had anticipated. With fewer reps onboarding paying advertising accounts than focused, revenue progress slowed. Although the transition has been bumpier than anticipated, the corporate’s robust stability sheet and healthy base of consumer evaluations remain. Additionally it is encouraging to see the corporate just lately completed an impressive stock buyback and has initiated a new one to capitalize on the decrease share worth. Although the transition has not been a clean one, the long-term case stays.
DEST – Our position in Destination Maternity presents our newest example of the so-called environment friendly markets at work and further highlights the vagaries inherent in investing within the small cap area. The company reported 3Q outcomes early in December. Although totally on monitor, a number of parts revealed through the report weren’t precisely spot on with expectations, and shares have been severely punished. Stock got here in slightly larger than anticipated and sales progress within the eCom channel, previously a real brilliant spot for the corporate, slowed. Though administration reiterated their outlook for FY2019, for FY2018 they lowered their gross sales steerage by 100 basis points and lowered the high finish of EBITDA steerage. All in all, the unanticipated parts and slight shift from expectations was merely not an amazing search for a staff that had just unveiled their huge strategic plan just 5 weeks prior.
However does decreasing the top end of EBITDA steerage of $17M by $1M actually mean that the corporate is value half what it was? Mr. Market stated yes. Although skeptical of this re-rating, I in fact began double checking our work. Every week later I had the great pleasure of assembly with the workforce on the company headquarters in Moorestown, NJ. Upon additional examination and as highlighted by administration on the decision, most of the “issues” from the 3Q report had affordable and explainable causes. For example, the $7M of excess stock was from a prior management staff and is believed to be monetizable without meaningful reductions. And the eCom progress, whereas slower than earlier than, got here at considerably larger margins and double-digit gross revenue greenback progress.
Extra importantly, the long-term imaginative and prescient – to turn out to be a leaner, extra efficient company with excessive returns on capital that dominates a singular specialty retail area of interest – remains fairly achievable. Like most things in the actual world, I do not anticipate the benefits of those efforts to return neatly or in a precisely linear or flawless trend. However I do anticipate them to return. With a view that the group is gifted and their plan to develop money flows at 20% or better for the subsequent few years is achievable, we seen the valuation of lower than 4x EBITDA as engaging and unlikely to persist for long. We took the market’s response as an overreaction and used it as a chance so as to add to the place.
New Positions – Under Armour (UA) and Rubicon Project (RUBI) are our latest positions. Though they differ by measurement and business and appear to have nothing in widespread on the floor, both fit our investment framework for high quality and potential return. Considerably like Chipotle (CMG), Under Armour is our newest smallish, giant cap and one other robust model’s story of progress interrupted. The thesis rests on the case the corporate can carry out higher than it has just lately and is presently underearning relative to normalized margins. Rubicon Project is the other platform firm alluded to final quarter and is probably much more fascinating as I consider it gives a chance to make multiples on our funding over a multi-year time horizon. Both write-ups are included within the appendix.
A Phrase On CEF Portfolio Development – If we are going to outperform the “stock market”, an understanding of the standard conduct of the shares out there is beneficial. As This fall of 2018 has simply demonstrated, the dichotomy of performance between the “market” and the shares inside the market could be quite large, especially when things go haywire as they seem to each two or three years or so. Think about that whereas the S&P 500 was down -13.Four%, small caps fared worse and underperformed their bigger friends by a reasonably vital 7%. Perhaps extra apparently, when wanting closer on the small cap index itself, we see that while the “market” was down -20.2% for the quarter, 1 / 4 of the stocks inside it have been down over -33% and the “average” stock, or median decline, from its 52-week high was -37%.
This may increasingly look like dangerous information for small cap buyers. To the contrary, it is truly good news. And additionally it is a main cause our portfolio is structured the best way it’s. As far as stocks go, I view the small cap pond as unequivocally the most effective one to fish in. There are extra shares. There’s more volatility. They provide higher info inefficacies. Put merely, the area just gives a higher probability of finding outstanding danger/reward conditions that can help us generate engaging funding outcomes. But it isn’t all excellent news. When the air goes out of the balloon every now and then because it all the time does, they incessantly endure the worst.
Because of this – along side the fact that I have all of my investable belongings invested in the fund – I are not looking for a portfolio that’s all the time totally comprised of small cap stocks. As an alternative I want a portfolio of equities with stability that’s equally as capable of outperforming in a down market as it’s in an up market. Though no one can reliably predict when both will come, that does not mean we can’t put together for each. When one considers the maths behind the compounding of capital, it is straightforward to embrace the notion that the path to capital creation runs first via capital preservation. Accordingly, our strategy is one which seeks to stability the risks of the occasional drawdowns that necessarily accompany equities while enabling us to participate in the upside that comes along with the creation of these invaluable enterprises. As positive as danger and return are two sides of the identical coin, if we’re capable of mitigate losses during these sell-offs, we’ve the opportunity to profit doubly: initially from this minimization of lack of capital, and then subsequently, from the selective buy of some securities from a extremely engaging pool of newly created bargains.
For these reasons because it pertains to our long-biased, concentrated investing strategy, I view any outperformance in a down market as a hit. Although our portfolio declined through the quarter, we successfully minimized a meaningful lack of capital. Maybe extra importantly, we did so while simultaneously enhancing our potential returns by means of the buying and selling of present and new holdings from a highly engaging opportunity set. Whereas giving back positive aspects or experiencing paper losses isn’t a joyous occasion in the moment, it’s an infrequent but mandatory situation of our funding strategy.
Though I’m fairly glad with our outcomes for the very temporary period that was this past quarter, I’m much more happy with our outcomes for the larger and extra essential picture that’s this past yr. To see why, let us examine our outcomes to the indices – our principally free funding various. Whereas small cap index buyers can now buy an earnings stream that’s still anticipated to grow at some double-digit price within the close to term, they’ve to take action from a capital base that has depreciated by a larger amount, effectively negating the alternatives unearthed in the current market turmoil. However, in our lucky circumstance, we are including a couple of particular and extremely targeted earnings streams, most of which have fallen farther, which might be growing quicker, that we get to purchase from a capital base that has appreciated. So, while I am delighted with our up efficiency in a down yr, I am much more enthusiastic about how this outcome coupled with our activities in a sloppy trading surroundings place us for a horny compounding outcome next yr.
The word of the moment seems to be uncertainty. Little readability has surfaced in our ongoing commerce struggle with China, current market circumstances have been choppy and the dysfunction coming from Washington seems to be even more dysfunctional than typical. Earnings progress has decelerated because the arithmetic results of the tax minimize fade, and lots of view the path ahead as much less clear than it was a number of months in the past. The market’s trailing PE multiples have just lately trended to near the lows of the last 5 years suggesting a believable argument might be made some of this slower progress has already been discounted. In fact, the trailing numbers inform us nothing of what progress is to return, but our base case suggests continued however slower earnings progress for our home financial system. Whatever the trajectory of earnings progress, I anticipate the placid circumstances of 2017 will come to be remembered because the anomaly they have been, and the more elevated volatility might be here to remain. For the lively manager, these durations have typically introduced great alternatives, even if it was not all the time clear that was the case in the mean time.
Our eclectic portfolio, composed of 10 – 15 companies with their own idiosyncratic risks and company-specific stories, seems set to perform nicely in this surroundings. Although our holdings will assuredly be influenced by the market course within the brief term, within the medium to long run, our performance shall be pushed by the enterprise outcomes of those particular corporations and the unfolding of the catalysts that lay in entrance of them. Contemplate DEST, whose prospects might be decided much more by administration’s means to execute on their plan fairly than a average transfer in the broader inventory market. And we are at present including another one that matches this invoice. Whereas many would possible lump these into the event driven/particular state of affairs bucket, I merely think of them as undervalued alternatives that fit our funding framework. Whereas not all our positions fit this catalyst-driven framework, our portfolio provides a pleasant stability consisting of many who do and position us nicely to carry out in most any market surroundings.
As I wrote in a quick Christmas Eve missive to our buyers after considering the worth to value discrepancy of our portfolio, I consider these winter months will prove to have been a really engaging time to add to our portfolio. While I’m happy with our monitor document since inception and our trajectory in our first two years as an unbiased company, I proceed to consider that on both an absolute and relative basis, one of the best continues to be but to return.
In closing, whereas I do know our strategy won’t yield outperformance each quarter, I proceed to consider it is going to be nicely value our while over the lengthy haul. Maybe more importantly, given nearly all of our investable belongings are invested alongside yours, we might never ask buyers to assume dangers we ourselves won’t.
Thank you in your continued help as we work to grow our capital together. As all the time, we are joyful to discuss our investment outlook with you at your convenience. Please reach out any time.
Mitchell Scott, CFA
Appendix 1: UA and RUBI
UA – Heading into 2015, Under Armour’s success story was almost unparalleled in sports activities and model constructing historical past. Constructed largely from founder Kevin Plank’s blood and sweat on the again of his crafty and savvy advertising strikes, the corporate was the fastest model to realize $5B in gross sales in trendy history. Based in 1996 by the then 24-year-old entrepreneur out of his grandmother’s basement, the company did a whopping $17,000 in gross sales of the moisture-wicking undershirts the company has now develop into famous for in that first yr of business. 10 years later, the corporate had $281M in sales and was newly public. Life as a public company was good and the brand came out of the gate scorching, posting sales progress in excess of 20% for an astounding 26 quarters straight. (A lot of that origin story is informed here in a current interview with David Rubenstein.)
In 2015, emboldened by its success up to now, the corporate unveiled a three-year plan to “Get Big Fast.” The plan was predicated on shifting the model into the large three sports brand hierarchy aspect by aspect Nike and Adidas and capturing the benefits that went together with it. They focused massive sales progress spurred on by an enormous advertising push to help new product launches. The large plans carried huge spending and a rising value construction that matched. Unfortunately for the company, their timing couldn’t have been much worse, as the company went for progress headlong proper into what has now turn into referred to as the retail apocalypse. Amazon’s impression, beforehand a nagging aggressive difficulty to retailers, abruptly turned acute. Retailers began closing stores. Some like Under Armour’s second largest buyer, Sports activities Authority, who had been struggling regularly, abruptly went bankrupt. Sales progress went from +20% into the pink for one quarter. Inventory accrued in the channel. Gross margins fell ~400 bps and the corporate deleveraged on their expanded value structure with EBITDA margins getting minimize in half to 7%. Over a troublesome two-year interval, shares obtained reduce into lower than a third of their prior value.
As they say in investing circles, the model hit the wall. In fact, this was not their meant end result, but the occasion shouldn’t be without precedent. Nike hit the wall in 1982. Whereas it was a unique era, many parallels exist. Both brands have been 21 years previous. Nike sales progress slowed from 25% to low single digits. Inventory collected in the channel. Gross margins fell by some 500 basis factors and the company similarly deleveraged on its value structure with EBITDA margins falling from 18% to 6%. Over a troublesome two-year period, shares received reduce into lower than a 3rd of their prior value. And then they bottomed to create what turned out to be one of many nice shopping for opportunities of a lifetime. Shares have been up five-fold over the subsequent 5 years and by no means appeared again.
Our thesis right here is just not built on the notion Under Armour is the subsequent Nike. Our thesis is constructed on the notion the corporate needs to perform higher. And whereas it appears a given most public corporations all need to do higher, it isn’t a given everyone can. That’s the reason a valued model is important to thesis. Although the brand remains robust, the corporate’s momentum, an underappreciated concept in enterprise, has at present waned. Because of the current underperformance and bloated stock, a few of the company’s advertising efforts have been curtailed. With fewer earnings dollars to spend, many new product initiatives have been also delayed. Accordingly, for much of the last two years, the company has been targeted on slicing costs and has usually been in retrenchment mode.
At their current analyst day, it was clear the corporate has a serious give attention to turning into a leaner and higher returning enterprise. They spoke to more targeted advertising initiatives, quicker new product improvement and improved measurement of return on advertising spend. Now compensated totally on EBIT greenback progress, the company is incentivized to emerge a leaner, larger returning and more adaptive model. Will the company’s new products reply to advertising as they’ve prior to now? Only time will inform. However it appears Kevin Plank’s means to create one thing from nothing is unquestionably an indication he can again create sustained success from an organization that now finds itself among the elite brands in sports. While valuation seems to be expensive on current multiples, it also seems to suggest market individuals recommend little or no probability the company will ever regain its prior working margin success. Whereas a Nike-like run from right here is clearly far from assured, it’s maybe not as farfetched as a first glance may recommend.
Rubicon Project – In small cap land, it’s typically stated it’s more essential to guess on the suitable jockey than the best horse. (I discovered an interview on this topic with MicroCap Club Founder Ian Cassell fascinating.) The considering goes that the smaller the company, fewer bureaucratic layers provide a CEO with more authority and duty for strategic course and profitable execution of corporate goals. Larger touches with company leaders and staff present a robust leader more opportunity to affect company tradition and depart an outsized mark on firm efficiency. While I have found this to be usually true in my experience, that doesn’t imply we aren’t on the lookout for thoroughbreds too. So, what a few state of affairs where we are betting on a jockey who is betting on his chosen horse? I consider we have now that here with Rubicon Project.
The Rubicon Project is an unbiased ad change platform that focuses on automating the process of shopping for and selling digital advertisements. As a supply aspect change, the company’s principal focus is on matching the advert stock of its content publishing clients with brands and advertisers who are on the lookout for digital actual property for their advertisements. Given the hundreds of miniature auctions that happen to match a purchaser and vendor to create an impression (i.e. a efficiently matched advert), the corporate depends on algorithms to match the perfect bids with the appropriate content material all in a method that places advertisements shortly, so the content is displayed directly. As we speak ~$1B of ad spend goes by way of the company’s platform which processes trillions of impressions per 30 days. For its position in sourcing and matching promoting demand, the corporate retains a small proportion of the ad value flowing via its platform as a charge, often known as its take price.
The global programmatic ad market is giant, estimated at ~$34B as we speak. Whereas Fb, Google and Amazon are the most important players (who importantly additionally have already got their own ad inventory), the rest of the business is sort of fragmented and growing strongly. Cellular is the large driver of progress at this time, however other makes use of like programmatic audio for corporations like Spotify and related television purposes recommend the business is more likely to proceed to develop at a mid-teens price within the coming years. As one of many largest remaining standalone unbiased advert trade platforms, Rubicon is presently very properly positioned to seize a lot of this business progress. Nevertheless it was not all the time this manner.
In early 2017 when company founder and CEO Frank Addante began trying to transfer to the boardroom and install a brand new CEO, the company was dealing with various challenges. Rubicon was late to answer the business’s move to header-bidding, an open public sale format that was a change from the extra insulated waterfall ad matching structure that had allowed the corporate to thrive on its close-knit publishing relationships. With advertisements effectively bypassing the Rubicon platform, the corporate’s place in the value chain soon came underneath query. It was dropping share, advertisements going by way of the platform have been declining and take charges have been shrinking. In Might 2017, well-regarded advert tech business veteran Michael Barrett joined the company as CEO in the midst of this shift within the business. With robust credentials, together with two 9 determine exits and a stint as Yahoo’s Chief Income Officer, we view his business expertise and contacts and understanding of the aggressive landscape as a serious plus.
So, we discovered one among Barrett’s first strikes after becoming a member of the corporate to be quite shocking. A number of months into his tenure, he effectively minimize the company in half by deciding to take their demand aspect take charges right down to zero%. Not was Rubicon a two-sided change charging fees to both events within the transaction; as an alternative it turned a one-sided change targeted primarily on sourcing the perfect demand potential for its content-providing clients. By eliminating the buyside payment, the corporate’s position within the bid matching course of is now more clearly understood as solely that of an aggregator of buying demand for its publishing clients. In an business that has had its justifiable share of shady players who have used the opaque nature of the marketplace as a conduit to overcharge, gouge and even in some instances, defraud its clients, the company has eradicated any appearances of self-dealing that the two-sided platforms typically face. The eradicated purchaser fees have additionally decreased the entire value of transacting on the Rubicon platform, which has enabled it to draw a higher entry to inventory. By shifting to a clear, environment friendly and low-cost mannequin, the company has positioned its platform to thrive as a one-sided marketplace targeted on high volume and low value per transaction.
These strategic moves seem aptly timed as another development in the business, Provide Path Optimization (SPO), has spurred many advertisers to shrink the variety of platforms they’re using to find ad inventory. Buying groups similar to promoting businesses and demand aspect platforms are concluding more meaningful relationships with fewer exchanges are preferable to the inverse and result in a better quality expertise of putting advertisements and an improved potential to measure ROI. These developments and the competitive dynamics sometimes associated with scaled exchanges with powerful community effects recommend that advert platforms which at present quantity within the lots of will probably consolidate down to 5 or ten in the coming years. It’s possible some might exit because of the synergistic nature of an acquisition by a participant with its personal present inventory as we lately noticed with AT&T’s buy of AppNexus. The transaction is imagined to have occurred at ~8x a number of of sales, a degree which speaks to the synergistic nature of opening up a content material provider’s stock to a broader pool of consumers, in addition to the conflicts of curiosity probably concerned when an change platform just isn’t really unbiased.
Rubicon’s move to chop its demand aspect purchaser fees – one of many final within the category of brief term pain for long term achieve – has positioned the corporate quite properly to emerge as one of the few consolidating exchanges of scale. But few buyers seem to have observed as consolidated financials proceed to paint the portrait of a enterprise in transition. As the company continues to be lapping robust comparisons from the prior yr because of the change in business mannequin, 3Q 2018 consolidated financials show the corporate posted an 18% decline in sales. But for individuals wanting slightly nearer, indicators of a wholesome and rising business are there. The take price has been growing modestly whereas advert spend going by way of the platform is rising 24%. Secular progress drivers like streaming video which are related to greater spend per advert at the moment are coming into view with gross sales on this vertical rising at a 70% price. With the company having fun with high incremental margins and anticipating gross sales progress within the ~20% range, it probably won’t take lengthy for the financials to present a unique image. With half of its market cap in cash, shares at lower than 1x EV/gross sales look engaging and supply a sensible path to incomes multiples on our funding over the approaching years.
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