We enjoyed broad-based performance in the fourth quarter as all holdings were positive contributors. The leading gainers, in order of largest impact to smallest, were Progyny (PGNY), Allegiant Travel (ALGT), Floor & Decor (FND), Ensign Group (ENSG), and Avalara (AVLR). In general, those companies whose stock had lagged earlier in the year rebounded the most in Q4. We discuss why we expect this to continue in our 2021 Outlook below.
Q4 Portfolio Adjustments:
We liked our position entering the quarter and believe it continues to serve us well. Accordingly, we did not make any major changes to the portfolio. On the margin, we added to what had been our relative underperformers (in terms of stock price, as opposed to in relation to how the business was performing compared to our expectations) while trimming the strongest stock performers slightly. This activity is consistent with our goal of having every dollar “work as hard as possible” for all of us. We added to Armstrong World Industries (AWI), Progyny, Grand Canyon Education (LOPE), and Allegiant Travel, while we pared Avalara, Floor & Decor, and, to a lesser extent, Goosehead Insurance (GSHD).
2020 Attribution:
Not surprisingly, those companies who were able to grow through the pandemic and even see their growth rate accelerate as a result were our largest gainers in 2020, with Goosehead Insurance and Avalara leading the way. Their business execution and performance were outstanding, as we believe both companies will shortly report 2020 revenues in excess of their pre-pandemic expectations. Also contributing significantly were Ensign Group, Progyny and Floor & Decor despite each being disrupted to some degree and duration by COVID.
The largest impact of COVID on our portfolio came from our only meaningful detractor to 2020 performance, Spirit Airlines (SAVE). Perhaps we moved more slowly than we should have to sell the position because Spirit was performing admirably until the outbreak. Moreover, history has shown again and again – and including in 2020 – that our companies with their resilient business models, structural competitive advantages and superior balance sheet strength and liquidity generally take advantage of volatility and accelerate their share gains during downturns. COVID, however, was no garden variety downturn. Different rules apply to a six standard deviation collapse compared to a “mere” three standard deviation setback. We could have anticipated the possible outcome more quickly than we did. It was a lesson we shall not forget.
The good news is that each of the gainers listed above contributed appreciably more by the end of the year than Spirit had cost. Interestingly, at year’s end, even the bludgeoned airline industry demonstrated the advantage of our model. For the year, the airline index ETF (JETS) was down 28%. However, our core holding Allegiant Travel managed to finish the year up 9% as the advantages of their vastly differentiated model, ultra-low-cost structure, and financial strength became manifest and as its medium- and long-term outlook and earnings power brightened markedly. Moreover, with our ability to be nimble and act in a contrarian way, we actually generated a 34% return over the year on our average capital invested in Allegiant. That result may be the most surprising positive outcome in a year full of them.
2021 Outlook:
While we view short-term predictions generally as a fool’s errand, we can unequivocally express our confidence in the near-term outlook of our portfolio companies as we look to 2021. In particular, we like the prospects of those companies that had to face considerable adversity in 2020. Progyny essentially lost an entire selling season while the inexorable march toward adoption of their services not only continued unabated but will accelerate in our opinion under a Biden administration. Allegiant Travel will be the poster child of pent-up demand as even a curmudgeonly hater of crowds like me will pay money to get on a plane and take kids to Disney World when the pandemic is done. Despite an incredible operating performance in 2020 that led to record profits, as an operator of skilled nursing facilities (SNFs), Ensign Group will enjoy a reduction in a huge amount of extraordinary costs and will benefit as an acquirer of underperforming facilities from all the small operators crying uncle under the enormous weight of the operating environment, the dynamic and intensifying regulatory burden, and the required investments in facilities and systems required to remain relevant to clients and to those referring patients to SNFs. The same scenario applies to other portfolio companies. We believe that even those like Avalara and Goosehead Insurance whose growth accelerated in 2020 will not face a slowdown in 2021 but are simply reaching escape velocity and still have the vast majority of their journey ahead of them and will gobble share and market opportunities at an ever-increasing pace. And as relates to Avalara specifically, we are willing to bet that states will aggressively pick up the pace with corporate indirect tax enforcement as they seek to plug holes in their budgets and flex their new-found jurisdiction over, and ability to collect, sales tax on ecommerce inside their state. Non-compliance will be broadly seen as what it already is – an irresponsible and asymmetric gamble where penalties can be staggering compared to the cost of compliance. Companies will run to Avalara to help them manage this important but enormously complicated process.
Owls Nest Partners Update:
We could not accomplish our goal of being our clients’ best-performing investment over any full economic or investment cycle without vision, execution, and discipline on the operational side of our business to match that on the investment side. Just as 2020 was a year of progress and growth with our investment program, so it was on the operational side of Owls Nest Partners. Our vision operationally is clear – to ensure that our clients get any information they might possibly need in an accurate and timely manner, that our research team is never distracted from the overarching mission stated above, and that all Owls Nest Partners stakeholders have total confidence in the best-in-class institutional-grade rigor of our operations. In our pursuit of total operational excellence, we made a number of important investments highlighted below. And to ensure both operational and investment discipline we reiterate below our schedule of closing to new capital, even as that moment begins to draw near.
In late 2019 we underwent a full gap analysis run by Constellation Advisers, a leading outsourced operations, middle office, and CFO firm that also conducts due diligence for many leading allocators. As that relationship seasoned and as our respect for them grew, we decided to go even one step further, and in January 2020 we hired Constellation as our outsourced middle office to perform daily cash and position reconciliations and shadow accounting. In 2021 we are expanding the relationship to include outsourced CFO work and portfolio valuation analysis for our separate account clients.
In 2020, we also retained Vigilant Compliance, the largest outsourced compliance office and consultancy in the country by AUM. In 2018 they guided us through our initial registration, and they have now taken on the role of full-time outsourced compliance consultant. David has retained the Chief Compliance Officer title and will continue to do so for the foreseeable future. We believe that it is important for this title to remain in-house, as it places an extra level of accountability on us that may be lacking in fully outsourced situations. That said, Vigilant is, well, truly vigilant in ensuring our day-to-day processes meet not just the letter of the SEC’s regulations, but the spirit.
Our IT infrastructure has been frequently upgraded since our first day. This is an area of any firm that can always be improved and has our constant attention. But in the end, there is nothing like a global pandemic to test out your infrastructure. On March 12th following the stay-at-home order issued by the Governor of Pennsylvania, our entire team shifted to remote work on little notice, and not a beat was skipped. With remote desktop protocols established within our virtual private network, cloud and web-based applications, and video communications already set up, we carried on as if we were all commuting to Chadds Ford each morning. We used the pandemic to test our disaster recovery and business continuity plans, which were successfully carried out with only minor adjustments necessary thereafter.bas
From a client communications perspective, we implemented Dynamo, a customer relationship management tool specially tailored to our industry. Dynamo makes client reporting less manual and hence enhances both the promptness and consistent accuracy of our reporting. Over time, Dynamo will facilitate our having a secure and internally controlled client portal to ease access to current and historical reporting for our clients and the advisers they authorize.
And while this may seem like burying the lede, we logically saved the best and most recent update for last. On November 2nd Michelle Krayer joined our firm as the Director of Operations. Michelle had previously spent ten years at Endowment Capital Group in a similar role and most recently spent six years at Wilmington Trust as a Wealth Client Administrator. She will absorb responsibility for all day-to-day operational functions and contribute to the oversight of our outsourced partners and reports directly to David. We are thrilled to have Michelle join the Owls Nest Partners team and mission as we know she will make us more effective and more efficient. Michelle is smart, engaging and a joy to work with, but the most relevant aspect to her character as affects your investment is that Michelle obsesses over details like no one any of us have ever met.
One of the advantages of investing in Owls Nest Partners is that this is not, as they say, our first rodeo. We are aware of – and for better or worse have experienced firsthand – the potholes and landmines that proliferate along the path toward building a great firm that lives up to its promises to its clients/partners as well as its employees/team members. We have a wonderful, fun, and rewarding business, and we intend to keep it that way.
Discipline around capacity and growth is the goose that repeatedly lays the golden egg. With our appreciation of this fact, we will close to new capital once our assets under management reach $250M. To be clear, this is not imposed due to any concern on our ability to invest more than that amount of capital. Instead, we view this as a reasonable point in our growth to pause and make sure that everyone internal and external and especially clients, is happy with all aspects of their relationship with Owls Nest Partners and furthermore, that all operational policies, procedures, vendors etc. are prepared for the next leg of growth.
There are many factors that contribute to what we view as the capacity of our strategy, including deal-breaking organizational considerations. The job is great fun in part because there is no political decision making and there are no employees who are not 100% dedicated to our shared mission. Our only employee challenge – agreeing to a location of a holiday party – did not even surface this year.
For those who want an answer to the capacity question grounded in math and monetary motivations, such an answer can be intuited from the following facts: 1) Your portfolio manager has a track record approaching 15 years in duration of outperforming that benchmark (gross) by more than 15% per year, and 2) due in part to its commitment to capacity constraint as well as the prospect of continued performance, Owls Nest Partners earns an incentive fee equal to 25% of the outperformance relevant to the benchmark’s total return. There is no need to get too precise with the math. The moral is clear: Never accept a dollar to manage at any management fee if that dollar must be invested in a way that would detract from the performance necessary to make real money and thrill clients! In addition, all employees including the PM have at least 50% of their liquid net worth in the Fund, so we all fixate on performance, not AUM. The capacity exercise is more art than science and includes other tactical considerations such as advantageous liquidity. Despite the many arguments others have used to defend scaling their businesses (most of which are flawed and even fatuous, self-delusional and entirely selfserving), we view ours as a strategy that is optimally one of $750M total AUM, and we will close to new clients before that at $500M, so that existing clients still have the capacity to add capital as they grow.
Why We Do What We Do
Flowing from what was written above, this seems like a good moment to reiterate WHY we do what we do. We started Owls Nest Partners for three primary reasons. First, it is great fun working for a small number of clients each of whom you know directly, with a small number of colleagues each of which is committed to a culture of working together toward a common goal, and owning a small number of companies each of which is run by ethical, experienced and committed management teams doing great things tackling meaningful problems and in their own way making America a greater country.
Second, in our own small way, we want to change the investment world. We want to change it from a business dominated by firms that optimize their structures around how best to maximize their own short and mediumterm profitability, to one that optimizes around long-term, sustainable performance for the client and trusts that the manager will do just fine (by Chadds Ford, PA standards at least where keeping up with the Joneses can be done with a Subaru) if he does his job well. Maybe it is because we have run money previously for universities and foundations. Maybe it is because we have a direct relationship with each client. But when we launched the firm and had to settle on a fee structure, we refused to ask ourselves the question – what will the market bear? Or said slightly differently, “How much can we charge and how big can we be for a long enough time before it ends badly so as to make us the most possible money?”
Keynes once wrote a simple sentence that strikes me as profoundly important even though it is generally lost among his greater works and was being applied in his immediate argument to tariffs and the economic causes of the ominous goings on in Russia, Italy and Germany. In “National Self-Sufficiency” (June 1933), he wrote “experience is accumulating that remoteness between ownership and operation is an evil in the relations among men, likely or certain in the long run to set up strains and enmities which will bring to nought the financial calculation.” Our faith in the importance of intentional alignment of interests drove our view of what constitutes the ideal client relationship and fair fee structure, and even directly informs the type of companies we own. We don’t want caretaker managements who stack their boards with sycophants and charge accommodating compensation consultants with the task of creating a generous pay package maximizing to the edge of tolerance the extraction from “remote” owners of the business. We will not settle for being remote owners. We need to know that management hears us and is in it with us. Similarly, we think those with capital to invest – individuals, family offices, endowments, foundations – should not have to settle for having “remote” relations with the manager of their capital. That too will end badly, as Keynes predicts. But by being true to our commitment to being disciplined around growth, we know we can keep our business special and hopefully inspire those with capital to throw off relationships with remote managers and instead insist that their managers fully commit to putting their clients’ long-term performance first and foremost among their objectives.
Oh, and yeah, the third reason we do this is that when it comes to our own money, we are not content to just own “the market” or to tie it up in illiquid stuff that is ultimately dependent on the liquid markets anyway, or in stuff dependent on leverage working as beautifully as it has since 1981, an extremely anomalous moment and period that bears no resemblance to today. We would much rather own a handful of great companies we know well and in whose long-term performance we have great confidence, and then have the benefit of liquidity, nimbleness, and lack of leverage to be able to take full advantage of any volatility along the way.
Investment Program:
For the benefit of any first-time readers, the hallmark of the Owls Nest Partners approach is the purchase of industry leading growth companies when a temporary headwind has recoiled the fundamental growth drivers and compressed its multiple. This typically happens as hot money “renters” exit and drive the price down. There is no such thing as a free lunch: we can only receive our requisite value if we accept that our companies will appear “catalyst-less” and uninteresting for some time. We believe we are wildly overcompensated for this modest level of patience, especially since it is in these moments that a company can invest in its own business with the highest returns. There is wonderful optionality associated with a well-run, shareholder friendly, cashladen company that is able to aggressively put money to work during a temporary headwind.
It is our belief (and experience) that our future outperformance will not be driven by any economic or market forecasting prowess but instead by ten unique investments, each playing out over time. We perceive these investments to have modest downside due to high quality and low expectations, and very significant upside as growth and margin expansion return in spades. We seek reasonable ballast and diversification within the portfolio as a result of our natural conservatism (strengthened by our co-investment alongside clients) and our predisposition to avoid crowded trades and instead invest in temporarily out of favor areas.
Closing Thoughts:
We hope you and your family remain safe and well.
More than ever, we thank you for your support and for choosing to have your money working alongside ours.
Gratefully,
Philip, David & the Owls Nest Partners team
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