Ever met a hedge fund manager that gives back fees if future years are bad?
Me neither, until I met this manager.
I first heard of this manager in a September 2005 interview she had with the excellent investment newsletter called Value Investor Insight.
She gave the interview shortly after leaving Legg Mason where she worked with the legendary Bill Miller for more than 10 years.
The interview was full of valuable insights that made me a better investor.
“Perfect investments have three layers of return. The first layer is the short-term return to what I’d call static intrinsic value.
The second one is when the business, strategy and management turn out to be what you think them are and there’s real value creation.
The third layer, if you’re really lucky, is when the market gets so excited that it discounts more and more of the future into the present. The big homeruns are usually there.
I always try to find at least two layers of potential, but it’s also important to recognize when you put something in your portfolio whether it’s a one-layer or a two-layer name. You’re going to make a two-layer name a bigger position.”
“I’ve learned that you have to have a lot of different risk-reward profiles in your portfolio.
You’ll have some things you think can go up 25% but you don’t think can go down very much.
You’ll have things that can go up 50%, but might go down 30%.
Others can go up ten times, but may go down 75%.
I try to manage to the proper mix of all those.
You just can’t have a portfolio where you say everything is priced to have 20% upside with little downside.
What’s going to happen is that you’re going to be wrong about two of them and they go down 50% and you’re screwed because nothing else has enough upside to make it up.
Our portfolios are managed to be reasonably loss averse, but that doesn’t mean every position in the portfolio has to be that way.”
After a short detour at Matador Capital Management she in November 2006 started her own hedge fund called Lane Five Capital Management.
I am of course talking about Lisa Rapuano.
At Lane Five she really made headlines in the hedge fund world when, instead of the normal 20% yearly performance fee, she structured her fund so that she receives a 40% performance fee but only calculated after three years (triennial).
With this fee structure Lisa addressed the most common criticism of hedge funds that they only participate in the upside in good years but not on the downside. In other words, there are no negative performance fees.
Since reading that interview I've been following Lisa’s investments and learning from her.
About a year ago I asked her if she would be willing to do an interview and share some investment insights with you.
It took more than a year to get done but finally Lisa scraped together enough time for the interview below.
I hope you find it as valuable as I did (emphasis mine).
Apart from the November 2006 fee structure for your new fund of 20% performance fee that is calculated triennially instead of once a year and the November 2007 Value Investors Congress presentation you have been very quiet.
What have you been up to?
Lisa Rapuano First let me give you an update on that experiment in fees.
As you mention, I launched my fund with an innovative fee structure - wait three years and then charge only on the positive returns over the market. I also was lucky enough to have a set of long-term Limited Partners who were willing to commit to a three-year lock up.
The lock-up and delayed fees worked together.
We finished our first triennial period at the end of 2009. We were not good enough to earn any performance fee at all, since it has to be both positive and ahead of the market.
Additionally, given the changes in the marketplace we simply did not think a three-year lock-up was a tenable proposition under any circumstances. So, in changing to a one-year lockup, we had to abandon our three-year fee structure as well.
Our new terms remain incredibly client-friendly, fair and well matched to our process: 20% of positive returns over the S&P 1500 on an annual basis with a traditional high water mark.
I think, however, that it was an experiment worth trying. It communicated a "money where our mouth is" commitment to long-term investments.
What I was extraordinarily surprised by however, was how little this matters to many potential investors. There is an institutional imperative that has evolved in hedge funds that is very similar to that which has evolved in long-only funds.
Being different, no matter how right it may be, doesn't help.
Having had to change the terms, we remain true long-term investors. We will not get a performance fee unless we truly earn it and clients will not pay for the beta inherent in a long-biased, non-volatility constrained portfolio.
I am convinced more than ever that managing for the short-term increases errors, increases risks and promote poor analytical judgment. Since we manage a portfolio of all public, relatively liquid stocks, we think we can stay true to concentrated, long term value investing while providing clients more reasonable liquidity terms.
Outside of the fee changes, Lane Five and I have simply pursuing our passion for uncovering value in good long-term businesses.
I've not been intentionally quiet; I've just been working on building my portfolio and business with single-minded focus.
Can you talk about your investment approach and how it has developed over the past few years?
Lisa Rapuano Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.
So, our approach in some ways hasn't changed in many, many years: find deeply undervalued companies, investigate and analyse them with great rigor to understand long-term business value, and create a portfolio that balances risk and reward appropriately to outperform long-term.
The core of the process is to understand the nature of a business in order to assess its ability to generate free cash flow over its life span. This involves a great deal of good old-fashioned securities analysis in order to understand the key variables of the business, how margins progress, how pricing works, how much capital has historically been required to grow, things like that.
We're then at a point where we simply understand the business and the company's past and can start the much more difficult process of looking ahead. We focus on what the company might look like in three to five years, since we believe the shorter term outlook is nearly always reasonably discounted into the stock price.
When you're looking at a three to five year time horizon, you ask different questions. You think more about strategy, pricing, competitive position, capital decisions, incremental profitability and business models than you do about what might be driving this quarter or next's variability in performance.
You focus more on long-term demand drivers and the company's customer relationships, culture and management ability. We spend a lot of time analysing the past in order to gets hints as to this future, and we spend time talking to the company, its competitors and customers about the long-term view.
Over time, we think this gives us some competitive advantage in that we develop a certain amount of credibility with managements as we ask the right questions and demonstrate that we truly do care about the long-term and we do the work to really understand and care about the business.
Once we have a base of knowledge, we'll do a variety of ten-year forecasts. We focus very much on figuring out our most likely outcry - what we believe is most likely to happen, and we'll forecast those variables and value the business using DCF, P/E, EV/EBITDA and other multiples based approaches.
We'll think about the economics of this particular business and think about where it should be valued based on our experience and on how other businesses are valued.
We'll drill down aggressively into what we think the key variables of whether that value will be determined. If we've figured out, for example that a return of operating profit margins to historical levels is the KEY determinant of value for a particular company, we will spend an inordinate amount of time on just that one issue.
We also look at a variety of other outcomes, even if they seem improbable to us, and value the business under those scenarios as well. This gives us a "Probability Weighted Value" that we use to think about the expected return of this business. It also gives us a framework to think about how we could lose money and how it might be better than we expect, which is valuable information in determining position size.
On the question of how this process has evolved, as I mention above in many ways the process is stable over many years.
But, one of our Core Values at Lane Five is to Adapt and Evolve Actively. The tools change and people get smarter and information flows more quickly. To maintain a competitive advantage we have to evolve ahead of the market.
The adoption of a probability based framework was an adaptation we added in the early 2000's, for example. Another example is that after 2008 we found that our general tendency to "look through" short term setbacks in order to remain focused on long-term value sometimes caused us to lose sight of true business deterioration, so we now balance some near term multiples based analysis with our long-term probability based framework.
Additionally, the framework of theoretical finance is constantly getting more sophisticated and we adapt our thinking aggressively to stay current. We spend much more time on behavioural economics, for example, making sure we understand why a security would be mispriced, not just that it is mispriced according to our financial analysis.
How is your fund structured in terms of long positions, short positions and leverage?
Lisa Rapuano We are a long-biased fund. We tend to run about 70-100% net long, with a maximum of 100% gross long. Since we run a very concentrated long-term fund on the long side, we believe that going over 100% gross long isn't prudent.
On the short side, we only short for alpha - we do not use shorts to control exposure explicitly or to hedge or control monthly volatility. Our shorts tend to be relatively long-term as well, not as long as the long side of the fund, but clearly not focused on information-based trading. We're looking for bad or declining businesses, saturated markets, changing business models, over-hyped products and other models that are not fully discounted.
This model has been chosen very specifically to suit the skills of me and my team. We think being able to short makes us better analysts, it keeps us more honest.
We also like the flexibility to hold a lot of cash or be a bit more short when we think there are no great values lying around.
However, we think eliminating the pressure to stay low-exposure (and to therefore often put on very poor shorts) is a good match for our style of holding deeply undervalued companies for many years.
How do you typically find ideas and what is your selection process before an idea gets added to the portfolio?
Lisa Rapuano We're very eclectic in our search and discovery process.
We don't have the traditional "funnel" that everyone else seems to put in their marketing materials: you know, the one with the pretty picture where everyone starts with a universe and culls it down with their allegedly rigorous process that magically gives them the 175 perfect stocks for their portfolio.
We actually think the funnel is silly and that people probably don't actually use a funnel to find their stocks.
Though it is eclectic, our multi-pronged approach to discovery has some common, systematic elements.
We look at screens of stocks making New Lows or correcting dramatically in short periods of time, we monitor previously under-performing sectors or groups, we identify very broad thematic, secular drivers that might be under-recognized, we look for insider buying, especially of distressed situations, we look for complex, opaque or "too-hard" companies that other investors may sell off because they're too much work, and we just generally keep our ears and eyes open to new ideas.
As I mentioned above, there has to be a reason something is mispriced.
In the case of New Lows and large price moves and underperforming sectors, it's relatively easy to identify the reason - investors are sick of looking at them, they've lost credibility and in general there is simply a selling capitulation that drives the price way below the real value.
In the "too hard" category there may be a lack of natural buyers, and in some very long-tailed secular themes it often takes years for investors to realize the true implications of change.
Once something gets on an interest list, we put it through a very preliminary process to determine if it warrants our time and energy.
We do not own many stocks, and anything we buy has to improve the overall portfolio and/or be better than something else we already own. Many of the things we initially flag as interesting never makes it past this process.
Some things recycle multiple times as potentially interesting before we finally decide to really put it through our overall research process.
Once an idea has been fully vetted and we have an idea of the business value and variability around that, it can be assessed for a portfolio position.
I go into portfolio construction in a bit, but the short answer here is it has to be better than something we already own, or improve the overall risk profile of the portfolio to make it in.
What are some of the mistakes you have made and what did you learn from it?
Lisa Rapuano I make a lot of mistakes, it is part of this business. If you're not making mistakes then you're not trying hard enough!
There are some mistakes that are endemic to the process. You can try to improve on them, but they will never go away.
Value investors like I am are usually a bit too early, both on the buy and the sell side. It's just part of our process - we're looking for unrecognized value, and we'll be buying long before any catalyst is evident (and thus discounted.)
In this particular case, we try to mitigate the impact of being early on the buy side, just be recognizing who may still be selling, trying to think through how short term news might be perceived, and controlling our position size so that as the stock continues to fall we can confidently buy more.
On the sell side, we learned long ago that holding on to terrific businesses a bit longer than our original value might have indicated is usually a good idea. That being said, there are not that many truly terrific businesses, so most should be sold as they approach value.
The rare company that is increasing value, expanding markets and allocating capital rationally, though, often has much more value creation in it than we have discretely forecast.
Then there are the mistakes where you just misjudged the situation in your analysis.
For me, this has almost always been when I thought something was low probability but then it happened.
We owned ABX Air, an airfreight company that ran all of the US operations for DHL. After exhaustive analysis, we thought the only way we could lose money was if DHL pulled out of the US altogether. We analysed Deutsche Post extensively and thought that the U.S, while losing money, was so strategically important to DHL that the chances they would pull out were slim to none. Well, one day we woke up and DHL was closing its US operations. This is a pure judgment error.
How do you fix something like that?
We knew it was a risk and it was a risk we were willing to take. Again, sometimes these things just happen. You can look back, and if your process was solid and you made a good decision given the information at the time, it does little good to quibble with the outcome. So, we analyse these types of mistakes, but it not a focus on what happened, but simply to make sure we did all the work we could have been expected to do, our judgments were based on sound analysis, and well, sometimes your just wrong.
There are other mistakes, however, that you can try to eliminate, or at least not repeat.
For me, my worst ones have been when I strayed from either my core values or my process. So, when we've done something as a "trade" (it just seemed too easy,) and not subjected it to the rigors of the process it usually doesn't work out. (Lesson = don't do that!)
The very worst example of that was when we got caught in the Volkswagen short in 2008. Luckily, we got out before the "real" short squeeze that drove it to 500, but we still managed to lose a lot of money in a short period of time.
The lesson here was really that if it's seems too easy it probably is. It was a crowded trade, which we never know, since we sit here in Baltimore, Maryland and know nothing about what all the fast money is doing in New York, and the complexity of the Porsche transaction was simply glossed over.
Another big mistake we made was also in European cars - the Renault stub. We did a lot of work on this one - we knew Renault very well, we were long Renault and short Nissan and Volvo, thus creating Renault, Inc. for free. How simple! How brilliant! And we got an incredible amount of positive feedback on this lovely idea!
Well, that alone should have been a huge red flag. No one EVER likes what I am buying - I always get groans all around. I usually have what I call The Retrospect Effect at work in my portfolio. If it works out, well then, of course because it was so cheap. If it doesn't work out well, then, of course because EVERYONE KNEW it was bad!
Additionally, with Renault this was not a good business! We don't usually buy bad businesses, at least not ones this bad. So the margin for error was much lower than it is with our normal cash rich, solid balance sheet, great competitive advantage companies that are more the norm for us.
This is what I mean when I say we strayed from our process. The Renault mistake was thus compromising our process to reach for value, and overconfidence inspired from external feedback. We then compounded it by not managing the risk associated with the large gross exposure required to maintain a stub position.
There were enough lessons in that one mistake to fill up a whole chapter in my investment diary.
What are your ideas concerning portfolio composition and the value of individual holdings in relation to the portfolio?
Lisa Rapuano I think that most investors spend way too much time talking about stocks and way too little talking about portfolio construction, so I am glad you asked this question.
I believe that one should run a relatively concentrated portfolio, be completely ignorant of the index weightings, hold cash if there is nothing great to buy and diversify with a keen eye toward what actually will drive both the risk cases for an investment and the high return cases.
We run between 20-40 positions on the long side, and we're not afraid to let a winner run to 10-15% of the portfolio.
A new position has to be compelling enough to put at least 3% of the fund in it or it's not worth dabbling in.
The actual position sizing we choose will be based on:
(i) the return profile of the name relative to other things in the portfolio as well as on an absolute basis,
(ii) our confidence level in the business model
(Notice I did not say in the valuation....this is partly as a result of the "lessons" from 2008. A truly great business will bail you out from mistakes. Ideally you are buying it very cheap so that would be a very large position. A cheap business that is not a great business will NOT bail you out if you make mistakes in evaluating the opportunity.
So, two companies that appear to have identical percentage undervaluation will merit different position sizes in the portfolio based on the "goodness" of the business model and the competitive position.)
A word on concentration. You can take it too far.
I know there are managers out there who get enthralled with the Kelly Formula and start putting out 25% or 50% positions because this one is REALLY is the best.
That just defies common sense. Anyone can be wrong, and any outcome can happen, even if it seems low probability. Keeping a minimum 20 name portfolio with about 5% as a normal position keeps you from making those kinds of mistakes.
We don't worry at all about over and under weighting sectors versus an index. The pressures in our business to look just like an index and yet outperform it are silly and irrational, so we simply choose to cast aside those notions. Just because an index is 20% in one sector doesn't mean that it is the right weighting.
To maintain diversification, then, instead of looking at sector weightings we spend a great deal of time thinking through the drivers of risk and return. All companies have elements of cyclicality, secular trends and execution as drivers of both risk and return. The key is parsing those elements and thinking through how they might relate to other risks and return drivers in your portfolio.
For example, we bought Abercrombie & Fitch in 2009, despite all the negative issues around U.S. specialty retail, escalating cotton prices and Chinese labour inflation. We figured out that its true value drivers were closing US stores, which they could control, and incredible incremental returns from opening international flagship stores. At the low valuation we were then paying, we thought we could absorb the cyclical and secular risks of the company given the return drivers were largely things the company could control.
What companies do you find interesting at the moment and why?
Lisa Rapuano Our largest position is a basket of for-profit education companies.
We own DeVry (NYSE:DV), American Public Education (NASDAQ:APEI), Bridgepoint Education (NYSE:BPI), Corinthian Colleges (COCO), ITT Education (NYSE:ESI), and Apollo Group (NASDAQ:APOL).
All the positions together are about 17% of fund.
I will focus on Corinthian Colleges () here, because it is one of the most hated names in any space.
For profit education is a contentious business model, which has polarized politicians and investors alike. Some investors are so morally against this business model that they consider the entire space to be un-investable.
Others who are willing to dabble in the industry consider Corinthian specifically to be un-investable because it is “low quality” product, its financially unreliable student profile and the handful of potential regulatory issues.
Frankly, that’s a lot of hurdles to get over, so some may just be waiting until we get more clarity on those issues before even thinking about doing work on the company – it’s in the “too hard” bucket.
Thus far, the shorts have been right, at least from a stock price perspective, so this is a highly contrarian call.
With the stock at less than $2, the market is pretty much saying that the company is destined for Chapter 11. However, if it does not go to zero (which I do not think it will for reasons I will outline below) it will be an incredible investment over the next two years.
First, let’s look at its current valuation, then let’s go through why people think it is a zero, and why I think this is wrong.
This is a complicated story, so I'll simplify as best I can.
At $2, the market cap of COCO is $170 million. At June 30, there was $330 in debt and cap leases and $107 in cash for a total EV of $393 million. On a TTM basis it trades at 1.9x EV/EBITDA, 0.21x EV/Sales and 1.1x EPS excluding goodwill write-downs and severance charges.
Obviously, no one thinks the trailing twelve months is relevant. Looking forward, then, if one believed the low end of the guidance of the company for FY (June) 2012 it would be trading at about 5.8x EPS, 3.2x EV/EBITDA and 0.24x sales.
The market price indicates no one thinks this estimate is achievable, nor do they think it represents the trough, fundamentally.
The bear story on Corinthian used to be the Cohort Default Rates, which in 2008 and 2009 were over 20%. The company has addressed that issue and 2010 CDR’s are going to be down to 9-10% with none of its schools at risk.
Then the bear story shifted to Gainful Employment, the new regulatory regime that the Department of Education put in place to great fanfare last year.
None of Corinthian’s programs are at risk of losing funding under the new rules.
Then the bear case shifted to counter-cyclicality and enrolment declines. We are currently seeing enrolment declines, but we believe they are largely self-induced as explained below.
Now, with the stock below $2, the bear case has shifted once again.
The biggest are of concern appears to be the balance sheet. I have heard from more than one source that this company is “in the hands of the banks.” Indeed, it is a credible sounding story: Bank of America leads the syndicate on its revolver, which expires in October, 2012.
Additionally, there are several covenants in the revolver that could be breached including fixed charge coverage and financial responsibility (an arcane measure the Department of Education requires).
Given that the company generated NEGATIVE $100 million in free cash last fiscal year, there is no way it can lower its debt enough to give the banks comfort, so even IF they meet the $0.30-0.35 they are guiding to (a number the bears do not believe, but more on that later) because it is back-end loaded and the covenants are on a TTM basis, it will possibly hit the FC covenants in the fourth quarter of 2011 (fiscal Q2).
Additionally, we all know BAC is in trouble and who wants to extend terms in this market?
The banks will intervene and the company is toast.
While just writing that is scary for an owner, I actually believe it will pay off almost the entire revolver by June, 2012, and that given the progress they will show on paying down debt and the nature of this business model, the banks are highly likely to work with the company even if the single covenant is breached in December, 2011.
To understand how the debt will be paid off, first we have to assess the credibility of the low end of guidance at $0.30.
The company is talking about enrolment starts turning up in the second half of the year and $60 million in cost savings from cost cuts and severance executed in F2011, allowing it to earn $0.30 despite negative operating leverage from lower student counts.
We have identified an ADDITIONAL $55 million ($0.40/share after tax) in cost savings that are likely to start to come through in F2012, and be fully realized in F2013.
These include some additional headcount reductions (in admissions counsellors), significant savings from financial aid systems enhancements, the lack of repeated costs from training required last year in the face of regulatory scrutiny, and other non-repeated costs from 2011.
The company has since announced that they are letting go of 325 employees and that they have identified $60 million in cost savings that will begin to benefit it in FY 2012, so our $55 million is slightly conservative.
These cost savings gives us a great deal of comfort that the $0.30 is truly going to be a trough number and will likely either be higher in 2012 or will set the stage for substantial recovery in 2013.
On the revenue side, sceptics are fearful of continued enrolment softness that they seem to believe is due to structural lack of demand. We believe these enrolment fears are overblown. This year’s decline is the result of a combination of factors:
- Enrolments were up over 28% last year and 24% the year prior, creating very difficult comparisons,
- The company stopped admitting Ability to Benefit students (those without a High School degree who can be shown to benefit from the vocational training) which had grown to over 15% of students,
- The company consciously dampened the admissions efforts over concerns of the regulatory overhang,
- There were no new program introductions
- The company raised price to insure compliance 90/10
- The admission staff changes in 2011 and into FY 2012 led to lower productivity
All of these things will their anniversary in the second half of FY 2012.
Ability to Benefit students are being admitted in small numbers to selected schools, some new programs are being introduced, and enrolment counsellors are getting more comfortable with the new regulatory environment.
To be very clear, we do NOT think there is a lack of demand. The value proposition to students is intact, and is misunderstood.
Keep in mind that last year, Corinthian PLACED over 40,000 graduates into good jobs in healthcare and trades (or at least better jobs than the low-level service jobs they had previously).
Moving from $8 an hour to $20 is a big deal.
There is a fundamental misunderstanding about the role Corinthian plays in the education of students. These are students who need training to get skilled work. Vocational training is vitally important to the future of our workforce.
From there, we need to look at cash flow.
Earnings of $0.30 translate to about $100 million in CFFO before working capital.
Working capital swings can be significant. In the fourth quarter of 2010, the company delayed receipt of $87 million in Title 4 funds, which were subsequently received, so already there in an $87 million inflow to CFFO. Additionally, the third-party financing for students eliminates another draw down on receivables.
The company says it will generate $225 million in CFFO in 2012. Capital expenditures in 2012 will be significantly curtailed, with only two school openings and no repeat of the big IT initiatives to drive quality in 2011, at $45-50 million.
So, according to the company, it will have $175 million in free cash flow. We are not as aggressive, using only the net income plus D&A and less the $87 million reversal I receivables, so let’s use “only” $137 million for our purposes. If all is used to pay down debt that puts them at $86 million in net debt at year end.
If it generates guided free cash, it would be at under $50 million. None of this includes the extra $55 million to $60 million in savings we highlighted earlier.
In addition to generating free cash from operations, there are sellable assets at COCO.
The Heald acquisition came with real estate that could be sold and leased back for probably around $75 million. Heald itself could be sold if necessary as could the automotive campuses WyoTech. While the sale-leaseback is highly likely according to the company, the other assets will likely be retained.
After selling the real estate and generating the free cash, the company will have close to or zero debt.
This is not a case of financial distress.
So, looking out to June 2012, we’d have a company with no debt, generating trailing twelve month trough earnings of $0.30 and normalized trailing twelve month trough free cash flow of about $55 million, ($100 million less $45 in capex, no benefit from working capital.)
If the stock were still at $2, it would be 6.7x trailing earnings and 2.15x free cash flow. If we think the cost savings we identified work into 2013 numbers with zero growth, it would earn $0.72 and $172 million in free cash flow, so would be 2.7x forward earnings and 0.98x free cash flow.
Of course there are risks at Corinthian, but at the valuation we’re now seeing we think it is an extremely compelling investment.
Lisa thanks for your time and insights.