Performance:
Holdings as of 6/30/2022:
We ended Q2 2022 approximately 98.7% invested. We ended the quarter with the following holdings (in order of position size, largest to smallest):
Median Total Debt/Market Cap: 6.8%
Median Market Cap: $3,530 million
Active Share vs. Russell 2000: 99.6%
1Past performance is not indicative of future results. Performance presented from inception through September 2020 is for a representative account of the Owls Nest Partners Concentrated Long Only SMA strategy (the “Strategy”). As of October 2020, performance is for a composite of accounts managed in accordance with the Strategy (the “Composite”). Please see the Disclosures at the end of this document for further information with regards to performance.
Quarterly Attribution:
The witch’s brew of high inflation, rapidly rising interest rates, an impending recession of unknown size, and even a war in Europe fueled a rout in the stock market. 2022 was the worst start to a year since 1970 for the S&P 500 and the worst start ever for the NASDAQ Composite. We were not spared. In fact, since our companies generally are growth-oriented, smaller, and less-liquid, we have felt the full brunt of the bear.
While changes in stock prices, in aggregate, do a reasonable job of reflecting changes in near-term fundamental prospects and macroeconomic outlook, they are often, as we believe they are now, indiscriminately applied and often dislocated from the change in long-term value. Inflation and a stalled economy will absolutely affect all companies, including ours, over the next twelve months, and that is reflected in the stock prices and reduced assumptions. What is not appreciated, in our view, is that the economic malaise will only help accelerate the long-term market share gains of our companies which drives their ultimate value.
At least one savvy investor agrees with our assessment and is betting billions that we are right about the disconnect between current prices and long-term value manifested in our portfolio companies. During the quarter, portfolio company Datto, Inc. was acquired at a substantial premium by Kaseya, a private competitor sponsored by Insight Partners. The deal was announced in the first quarter and closed in late June. We will discuss Datto and our thoughts about private equity as a catalyst for value realization more below.
Aside from Datto, the share prices of all other holdings were down during the quarter, led by Progyny (PGNY), Goosehead Insurance (GSHD) and Avalara (AVLR). This sounds odd, but we believe Progyny’s stock price decline had practically nothing to do with Progyny whose fundamental momentum and outlook is as strong as ever. Instead, the problem is that it has no direct peers and is lumped in by sell-side analysts with an eclectic menagerie of health care “tech enablers” most of which are recent IPOs, quickly running through cash reserves and no clear track to eventual profitability or even survival, in some cases. Progyny, by contrast, is highly profitable, self-funding its rapid growth and loaded with cash. As we’ve experienced and discussed before, this “baby with the bathwater” phenomenon can only last so long, and the cream in a reasonable time frame rises to the top. Avalara’s price reflects fears around the slowdown in e-commerce, and Goosehead’s primarily reflects concerns related to the slowdown in housing transactions which serve as an important source of leads for new client acquisition for Goosehead.
Avalara and Goosehead, however, are prime examples of the uniqueness and resilience embedded in the Owls Nest approach. Avalara helps companies of all sizes automate compliance, calculation and remittance of sales tax and other indirect taxes. Sales tax is not going away. Tax codes are not getting less complex. With increasing transparency because of technology, taxing jurisdictions (there are more than 12,000 of them in the United States) are getting more capable of full enforcement. And frankly, while e-commerce is slowing down after a meteoric pandemic boost, it still continues its climb. But what appears to be not fully appreciated is that ecommerce marketplaces are still a small percent of Avalara’s business, and even within that portion of their business Avalara’s revenue model isn’t tied to the value of e-commerce. The number of transactions has to decline very significantly to affect the subscription cost, and client companies still have to calculate tax, handle exemptions, and file sales tax returns irrespective of the volume or profitability of business in those jurisdictions.
While many things are dynamic and uncertain today, two things are constant and assured. American home and car owners will insure those assets, and increasingly they will do so through Goosehead Insurance agents. It is true that all other things being equal, Goosehead’s new business levels will be reduced by a real estate slowdown since referrals from that ecosystem are a great source of inexpensive leads. Recall that a long time ago, Goosehead realized that realtors and mortgage lenders love working with an insurance agency that represents 140 different carriers and has 400 licensed agents in a call center as it ensures that no transactions get held up due to insurance problems. Leading with that value proposition allows Goosehead to grow efficiently with essentially-free referrals to active insurance buyers from real estate players trying to help their own business. Compare that to buying Super Bowl ads that no one will remember, that communicate nothing of any substance, and that are watched almost entirely by people not actively shopping for insurance. But this is not to say that this is the only way Goosehead agents get new business. They can, for example, use the time to get referrals from existing clients or circle back to prior prospects. And the present spike in inflation which caused the mortgage rate increase and housing slowdown can actually turn out to be a powerful tailwind in two ways. First, insurance prices are soaring reflecting higher asset values and claims costs, and as prices go up so do the commissions Goosehead earns. Second, most people only give thought to insurance when they are buying a new house and/or when they get a big price increase. With these price increases there will be a ton of “reshops”, and Goosehead sits pretty with the best model offering the best value, the greatest choice, and by far the strongest growth in the industry. And with barely 0.5% of the industry, there is a lot of share to gain.
The theme here is that we are not speculators wagering on some sort of short-term trend. Experience has shown us again and again that trend hopping is almost impossible for anyone to consistently execute well since it requires getting the trend right to begin with, assessing correctly the extent to which the trend is already embedded in prices, and getting the timing of both entry and exit right. It’s musical chairs, it’s a loser’s game, and it’s a path to permanent capital loss which is the real enemy of capital preservation and growth. The proven path to winning is true investing in durable and differentiated businesses. We intentionally did not use the word “quality” in the prior sentence, and we discuss our thoughts on the elements of “quality” more completely below. As a preview, simply being big and well known is generally not something we think guarantees durability and differentiation and instead often leads to crushing complacency.
Portfolio Adjustments:
Re-underwriting the portfolio is always job #1. After all, the only way to lose money is with the companies you already own. Missed opportunities are a shame and perhaps an opportunity to learn how to get better. Losing money, on the other hand, has to be avoided. This belief is why we work so hard to stay on top of our companies. Including their industries and competition, and why every company, no matter how fervently we felt about it yesterday, is for sale today if the fact pattern changes.
All of this, however, is not to say we aren’t constantly looking for new ideas. In fact, due to the market carnage, 2022 has been a year of huge effort on the new idea front. The data from our research management system in which we post our internal research efforts tell the story. During the first half of the year, we reviewed 717 different companies updating our price target and revisit dates. 77 of those were new companies.
Experience, however, has taught us to be patient and wait for that “fat pitch” down the middle. You cannot rush the process, and you can’t compromise on “quality”. Finding the company with the right characteristics, at the right price, at the right time, that actually improves the portfolio is no small feat. All that effort was not wasted. We continue to work on some interesting near-term prospects, and there are many others where the stars may align in the future. But for now, no new name was as good as what we already own. Given the outstanding value and the fundamental strength of the current portfolio, we opted to redistribute the Datto proceeds throughout the existing portfolio. We will add a name when it can make the portfolio better from a value, growth and/or risk management perspective.
Consistent with the comments in the section above and our tendency to take advantage of weakness to add to positions, the largest increases were in our Avalara and Goosehead positions. Due to its relative strength, Ensign was the only position we lightened up on, and Repay was the position we added to the least due to its having been increased meaningfully last quarter.
Datto, Inc. and How will Private Equity put its $5 Trillion of Purchasing Power to Work?
While you have to be patient to be successful in this industry, results sometimes come sooner than expected. Such was the case with Datto, which was acquired less than a year from when we initiated our position. The timing surprised us, but the outcome did not. The merger of the two companies makes a great deal of sense, and we thought it very possible at some point one would acquire the other.
Datto has years of accelerating growth and margin expansion ahead of it. Its new products are extremely well positioned, and its leadership position is unchallenged. While we think the company got a very fair multiple in the sale, we had hoped for at least another three or four years of compounding before we sold the position or the company sold itself to fully realize the accreted value. So, in some regards the timing of the acquisition is very disappointing. However, with such great reinvestment opportunities in the current portfolio, we are confident in the ability to compound the capital from here at the same rate or better than Datto could have. One final comment. We congratulate the Datto board on doing the right thing for employees, customers and shareholders. The new company is incredibly strong and will come up with even better solutions for customers. And with a lot of skin in the game, management and the board also did the right thing for shareholders. Nothing trumps alignment of interests.
We are not experts in private equity strategy and tactics, but we suspect that Datto will not be the last time we cross paths with private equity. When David Swensen started moving the Yale endowment toward privates in 1985, private equity was a backwater inhabited by a small club. According to Thomson Reuters, the total U.S. private equity capital raise that year was $6.73B. After the 1990 recession it was still less at $6.14B. Preqin estimates that the total number of remotely substantial private equity firms was perhaps 100 in 1985. How quaint. No wonder there were so many opportunities to source uniquely. By contrast McKinsey estimates the 2021 U.S. private equity raise at more than $600B, and the global raise close to $1.2T. The number of firms has swelled to nearly 10,000 with more added each year since the financial crisis than existed in 1991. And now they are sitting on $2.5T (that’s $2,500,000,000,000) of dry powder to put to work. With leverage, you get in the area of $5T of buying power. One thing is certain: They aren’t just going to return the money to investors.
With private company seller’s expectations still high and the public stock market crushed and relatively defenseless, it would appear that the public markets are an incredibly target-rich environment. I suspect the prime targets would ideally have real cash generation and unlevered balance sheets to start (since they will want to load on some debt), would have durable and resilient franchises because of the debt load and the necessary holding period, and would have meaningful growth opportunities so that at the time of the exit an exciting narrative can be spun that will lead to a higher multiple. We wouldn’t be surprised if they started flashing their wallets now at one or more of our companies. Frankly, they’d be stupid not to. While we would no doubt groan with disappointment if any of our companies were taken out with anything less than a spectacular premium, from recent levels any takeout would logically offer a great return.
What “Quality” Means to Owls Nest Partners
Quality. It sounds great, but it is a term so vague and overused, it is meaningless, which is why we try to avoid using it. Who doesn’t want it? I guess diversified funds must at least internally acknowledge they have names that aren’t “quality” as part of the cost of being very diversified. And I guess the term “non-quality” doesn’t exist. We just call those “value stocks” for the most part.
Whenever the stock market has a tailspin, commentators quit talking about growth and talk about “quality”. So, what does quality mean to Owls Nest, and why? Perhaps because of the benefit of a long lens to observe history, we reject standard understandings of quality having to do with sheer size, historical reputation, or historical stock performance. IBM was the ultimate blue chip “widows and orphans” stock when I entered the industry. This summer, IBM’s stock is trading where it did in the summer of 1999. However, that unfortunate outcome is positively brilliant compared to some fellow blue chips of the time including Xerox which is down ~90% since then, or GM or Eastman Kodak whose equity was essentially wiped out in bankruptcy. If you find market history boring and pop culture is more your thing, you might refer to Woodie Allen’s comedy Sleeper (1973) in which the lead character, Miles Monroe, wakes up after being asleep for 200 years. One of his first comments after he understands how much time has passed is “You know, I bought Polaroid at seven. It’s probably up millions by now.” Not exactly. Polaroid, which graced the cover of Life Magazine shortly before the movie’s release with the story titled “The Genius and his Magic Camera”, endured a gut-wrenching 80% drop over the next few years and ultimately went bankrupt. Amazingly, Eastman Kodak and Polaroid weren’t the only members of the famous and beloved “Nifty Fifty” stocks of that period to go bankrupt. So did Sears, JC Penney, Kresge/Kmart, and, just recently, Revlon.
As with most things, we consider “quality” not from a stock market perspective – looking at earnings consistency, stock beta, dividend yield or what have you. Those rear-facing attributes got you all-in on GE in 2000. Ugh. Instead, we judge quality based on factors from the real economy. In a nutshell, we determine quality based on whether a company offers a durable, expandable, and highly differentiated value proposition to its customers and the resilience of its business model which, together with a cash-laden balance sheet, ensures the ability to sustain and expand those advantages through any downturn and self-fund subsequent accelerated growth.
The quality threshold is by far the toughest one to cross to earn a spot in our portfolio. It is also the most important since it provides the ultimate downside protection and the ability to go on offense when others must play defense. The “moats” that we look for to drive and verify this differentiated offering generally fall in the following buckets: the ability to lock out competitors through network effects, exclusive distribution, patents or regulation; the ability to lock in customers through high switching costs; category primacy through brand and trust; product/service differentiation through clearly superior technology, support, or other features; and cost leadership as the lowest cost producer. We saved cost leadership for last because it is the most important and ultimately most durable and defendable.
These “moats” are assiduously studied in business school, but there is nothing new here. In fact, perhaps the greatest example of the power of low-cost leadership combined with the ability to go on offense when others are forced to play defense is almost 150 years old. Andrew Carnegie was notoriously ruthless on costs and had a wide cost advantage. When rampant speculation in railroad stocks abruptly ended amidst a liquidity squeeze, many railroads and scores of banks including Jay Cooke’s banking empire went bankrupt and the Panic of 1873 ensued. This depression lasted until 1879, and Carnegie took full advantage and undertook his most ambitious expansion ever. Not too many years later, he was the richest man on Earth.
For what it is worth, our quick and dirty measure of the moat’s strength is the degree to which competition is structurally incapable of catching up. Using the metaphor of the formerly new and great car that is on the shoulder of the road broken down and requiring a lift, we classify these competitors as “jacked-up”. By way of example, huge captive insurers like Allstate and State Farm are burdened with a hopelessly obsolete and inefficient distribution model and have no way of matching Goosehead’s pricing advantage and will lose share to Goosehead for decades to come. Small independent flooring and tile companies make up the majority of Floor and Decor’s industry, but these small players are saddled with an expensive and extended supply chain due to the industry’s four step distribution process which means they will never be able to compete price-wise or availability-wise with Floor & Decor who sources directly from manufacturers and now has all the benefits of scale and financial capacity. This last example hits particularly close to home as I grew up in the family’s hardware/lumber stores. We were the largest supplier in our county until some guys from Atlanta, Home Depot, showed up when I was in high school. Our jacked-upness was soon exposed, and no matter the fight the business is no longer and all that market share went to Home Depot.
To keep this letter tolerably short, we will not recap all the details of all the moats that are protecting the quality of our businesses and which will allow them to step on the throats of weak competitors during turbulent times. Hopefully, detailed discussions of the names in prior letters accomplishes that. But please be assured that your companies indeed have durable, expandable and differentiated value propositions which will protect and grow your money.
And it is our unwillingness to compromise on this criterion that forces us to work so hard for new ideas. But that’s OK. After all, this effort and disciplined process around verifying quality is a moat around our own business. Scaled and diversified money managers who’ve taken any money from short-term oriented clients cannot possibly justify the work and patience required to build out the full industry mosaic on a small, less-liquid business like we can and do, especially when that company typically is something of an oddball lacking any direct peers and when that company is going through some sort of headwind and the focus of the work is necessarily long-term in nature. In our vernacular, their pursuit of AUM growth and limited tracking error has made them…well…jacked-up.
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.
Final Thoughts:
For more than a decade, I had the privilege of serving on the Investment Committee of the Delaware Community Foundation. As was common then, the portfolio and process were consultant-driven, and the stable of managers was made up of well-known, large shops. I will never forget the meeting at the depths of the Global Financial Crisis in early 2009, when the growth manager – who had gotten absolutely crushed, especially with his bet on the “China Super Cycle” – explained that they believed that the world had changed and that it was prudent at that moment to get much more defensive. The stock he particularly touted was Clorox, a company of indisputable stability but one which had no reason to be in the portfolio of a dedicated growth manager given its sub 2% revenue growth rate, especially at a time when growth was monstrously depressed. I was flabbergasted. This was antithetical to everything in the firm’s DNA, and certainly not what we had been sold. I had always been taught that the surest way to lose money is to change your style, switching from what you’ve always done to whatever style is presently working. They had no good answers why they had suddenly put some massive macro overlay on top of the individual stock strategy, and they had no good answers as to why then was the time to get defensive. The horse had long ago left the barn. I had wanted to fire them for a while because of this drift, and after that meeting everyone agreed and the deed was done. And it was a good thing, since the firm hugely underperformed its peers and its replacement. Why had this prominent shop changed its stripes? Ultimately, I learned that the issue was that they had scaled and taken money from large clients who didn’t really understand the strategy and who insisted on dampened volatility.
I relay the story above because it showcases by comparison perhaps the largest and most important moat in our own business – you, our roster of clients that are truly long-term oriented and who understand what it is to invest as opposed to speculate and to be owners of some great businesses. We have experienced a pandemic and a nasty bear market with incredible partner support and without a single redemption. Only with this firm foundation, can we fully exploit the opportunities available in turbulent times and help our clients fully leverage their greatest advantage in investing – their ability to act with a longer-term horizon.
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 & the Owls Nest Partners team
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
Disclosures