To: McIntire Investment Institute (“MII”) Interested Parties
From: Aditya Bindra, McIntire Investment Institute President
Subject: McIntire Investment Institute Spring 2017 Semester
Date: Sunday, April 2, 2017
MII has defined Q1 2017 to be the period from December 14, 2016, to March 31, 2017. We, the current management team, were instated on December 14, 2016. We quickly took to trimming and reweighting the portfolio to reflect our market views and new portfolio management strategies. As a result, the portfolio was changed materially prior to 2017. Consequently, we have included the period from December 14, 2016, to January 1, 2017, as part of Q1 2017. We will return to traditional quarters in the following letters. Seeing that the portfolio is run passively for a majority of the summer break (many managers have compliance restrictions from their various summer employers), this letter will be discussing the Q1 performance, which roughly represents the performance over most of the Spring 2017 semester. The following investor letter will recap the performance and club updates over all of 2017.
Over Q1 2017, MII’s portfolio grew from $685,649.10 to $740,511.12 — a cumulative return of 8.00%. By comparison, the S&P 500 index returned 4.61%. This represents an outperformance of 3.39%.
Clearly, during late January to mid-February, our portfolio grew rapidly. Much of this was driven by our longs on Tucows and Nvidia and shorts of Grubhub and Ruby Tuesday. As was to be expected, this outperformance was not everlasting. The S&P 500 index quickly sought to make up the difference throughout the remainder of the quarter. Figure 2 shows this performance attribution relative to the S&P 500 index more clearly.
With the end of Q1 2017, MII returned 16.46% and the S&P 500 index returned 16.93% over the past twelve months.
Long vs. Short Exposure
Over Q1 2017, MII maintained an average net exposure of 70% (100% long, -30% short, 30% cash). This broadly reflected our willingness to ride a bullish market and our conviction in numerous investment ideas. As we downsized and exited some of our short positions and our long positions grew in market value, our net exposure reached 76.13%. On April 15, 2017, MII’s 24 associate teams will be submitting their investment ideas to management. Given especially high market valuations, our opinion that we are at the top of a credit cycle, and rising interest rates, we expect that the risk to reward profiles of the incoming long investment ideas to be markedly less attractive than that of the short investment ideas. As such, we expect our net exposure to decrease materially over the upcoming quarter(s).
Further analysis of the individual performances of our long and short portfolio reveal some interesting observations. Over Q1 2017, MII’s long portfolio contributed 5.70% and its short portfolio contributed 2.23% (note that these contributions do not sum to MII’s quarterly return of 8.00% due to our 30% average cash exposure). Despite the long portfolio’s larger contribution, the average long position grew only 2.67% while the average short position fell 4.93%. Granted, the short portfolio had at most nine positions and the long portfolio had 23. It only took a few outsized winners in the short portfolio to push the average short position return higher than that of the long portfolio. Nonetheless, this disparity is noteworthy, especially during a bull market.
Though we do not put too much stock in an analysis over such a short time horizon, we think this difference to be the result of MII’s ability to identify misperceptions of unsustainable business models in collapsing and/or increasingly competitive industries. Our shorts on Ruby Tuesday, Grubhub, and Vitamin Shoppe are great examples of this.
Winners and Losers
Our performance this quarter was largely the result of a few outsized winners. We kept a tight lease on losing positions, especially positions that we considered as “legacy” (i.e., positions that have remained in our portfolio through several management cycles and whose original theses are outdated or no longer reflect the views of current management). Doing so allowed us to capture any remaining upside in such positions and exit them before they moved away from us. The five biggest winners contributed 7.00% while the five biggest losers contributed -2.64%.
The following will provide specific commentary on several noteworthy winners and losers.
Tucows ($TCX–L): +41.63%
Tucows has two separate business segments — network access services and domain services. The domain service business employs a fairly simplistic business model: generate cash from domain registration fees charged to domain resellers and from the sale of retail Internet domain names and email services. Conspicuously, the number of resellers and domains offered are key drivers of this business segment’s growth. As such, when Tucows announced on January 20, 2017, that it was acquiring eNom from Rightside, the stock jumped 18.71%. This $83.5M acquisition provided Tucows 14.5M domains, nearly doubling its 2016 count of 14.8M domains. This acquisition added 28,000 active resellers as well. Tucows now is the second largest domain registrar in the world. Since the announcement of this acquisition, Tucows has gone up over 40%.
More importantly, we still hold a high level of conviction in this position. Much of our theses have to do with the opportunity that lies in Tucows’ network access services segment. This segment is operated wholly through Tucows’ subsidiary, Ting. For one, with an emphasis on smaller towns, we feel that Ting Internet will disrupt the traditional, broadband internet market. Ting can provide faster speeds — twenty times that of broadband internet — in smaller locales at competitive prices. Secondly, by leveraging the networks of Sprint and T-Mobile, Ting, a MVNO (Mobile Virtual Network Operator), has been able to sell a low cost, no frills phone service that has shown tremendous growth potential. In 2016 Ting Mobile’s net revenues increased 22%. Consequently, at this time we have no inclination to downsize our position.
Grubhub ($GRUB–S): -14.26%
In our view, Grubhub, with little to no economic moat, is attempting to keep up with a market that has grown to be extremely competitive. Both large players (e.g., Amazon Restaurants and UberEATS) and local competitors have caused for significant industry headwinds. In fact, these large players arguably offer a better service that is far more cost-effective. Grubhub’s margins will undoubtedly shrink as a result of the company’s inability to continue charging industry-high commission rates.
It should be noted that for online delivery, a core driver is an expansive network of participating restaurants. Grubhub, the first-mover in this space, has the largest market share. As a result, it has been able to command high commission rates from its participating restaurants (13.5%, on average). Over 2017 and into 1H 2018, we expect Grubhub’s first-mover effect to dissipate. Amazon and Uber have both repeatedly demonstrated their desire and ability to undercut current market leaders by taking very narrow margins over the short-term.
Moreover, as part of the MII Point72 Stock Pitch Competition (more on this later), the winning team (Christopher DeSouza, Colin Suvak, Andrew Parkerson, and James Parkerson) conducted analysis on more than a million anonymized Grubhub credit card transactions. This research revealed that for zip codes where Grubhub competes with both Amazon Restaurants and UberEATS, Grubhub has experienced significant compression to top-line growth. While both Amazon Restaurants and UberEATS are still in early stages, we only expect them to put more pressure on Grubhub’s margins.
Grubhub’s Q4 2016 earnings report began to show early signs of these theses. Although revenue increased by 37.50%, EBITDA slightly missed consensus estimates. The stock moved -4.16% that day and -17.49% since. We have already built a relatively large short position and intend to hold as our convictions continue to play out.
Ruby Tuesday ($RT–S): -21.44%
Our initial short of Ruby Tuesday was built on three thesis points:
- Ruby Tuesday’s attempt to improve profitability by remodeling its restaurants and beginning a “Fresh Start” initiative is a fundamentally flawed and expensive strategy.
- Management has changed hands several times over in the near history. Each management team has been less successful than the previous. This instability will lead to further declining profits.
- Fast-casual dining is threatening Ruby Tuesday. Management has failed to either fully acknowledge or combat this increased competition.
Nearly a year after initiating this position, we see that these theses are nearly played out. Ruby Tuesdays’ Q2 2017 earnings report was the catalyst that finally drove the stock down. In regards to thesis #1, Ruby Tuesday announced that it was closing 95 stores in connection with its Fresh Start initiative. Despite this, Ruby Tuesday went on to mention “fresh” 24 times in this earnings report press release. Management has indicated its intention to continue with this initiative, despite repeatedly poor results. Being short, we hope they continue down this path. Theses #2 and #3 were realized in several metrics — same-restaurants sales declined 4.1%, restaurant level margin declined 410 basis points to 11.50%, and total revenue fell 17.7% to $214.7M.
This earnings report caused the stock to fall 24.65%. As the stock continued to decline in the days to come, we grew concerned that the position’s risk to reward profile was deteriorating. Further analysis — LBO valuation, looking at potential buyers, and examining future catalysts — confirmed our intuition. As such, we decided to realize much of our remaining profit (we had already downsized significantly in February 2017). Since we think they will miss on earnings again, we left a -1% exposure.
The day we downsized our position, Ruby Tuesday published a press release that it had retained UBS in its active search for a buyer. The stock quickly rose 14.90% in pre-market on this announcement. As our downsizing order was at market open, we realized less profit than we had intended to the night before. Ultimately, this was a nominal amount in respect to the initial position we had taken.
The market has been pushing the speculative buyout premium higher since this announcement. Ruby Tuesday has been hovering around a 40% premium to the pre-press release price. We think Ruby Tuesday will miss next earnings on April 6, 2017. This earnings miss, though very unlikely to return the stock to its pre-press release price, should increase our remaining unrealized profit. We will likely exit what remains of our position shortly after.
Daktronics ($DAKT–L): -7.62%
Daktronics is a supplier of electronic scoreboards, large electronic display systems, and digital messaging solutions. The company has five operating segments: commercial, live events, high school park and recreation, transportation, and international. This position, which we consider to be a legacy position, was initially pitched as a long due to its diversification of products and customers, monopolistic positioning, and high growth opportunities.
Unfortunately, while Daktronics has been able to maintain its monopolistic positioning and diverse portfolio of both products and customers, it has begun to show signs of financial stress due to the lack of growth opportunities. Revenues are shrinking, margins are deteriorating, and cash dividends per share have halved. We attribute much of this to be weak demand in Daktronics’ live events and commercial segments. Daktronics, in its Q2 2016 earnings report, claimed that weakness in live events is the result it delaying “production during the quarter to take advantage of new designs with enhanced reliability features and expected lower production costs.” We were not comfortable with this assertion. We feared that the weakness in live events was truly the result of decreased demand. Our fears were realized as gross margins continued to shrink over the following quarters. The jury is still out for the decreased revenues for Daktronics’ commercial segment. This segment has been known to be particularly lumpy due to a more concentrated portfolio of larger sales. Given the current market conditions, we feel that this is likely also the result of lesser demand.
Currently we have an unrealized loss of 17.47%. Given our lack of conviction in our theses, we have initiated a stop loss at an unrealized loss of 20%. As we intend to exit this position shortly, we will update our stop loss if Daktronics rallies.
TASR ($TASR–L): -6.98%
Taser sells conducted electrical weapons (CEW) — e.g., tasers and stun guns — and Axon products, which namely include body cameras and Evidence.com. Our initial theses were as follows:
- Taser has a commanding control of the CEW (99%) and body camera market (75%) due to its brand credibility and superior product line.
- Recent social, political, and legal pressures have increased the demand for non-lethal weapons by police departments and citizens alike. Taser is poised to capitalize on this trend.
- Axon is Taser’s attempt to offer a full-service integrated system for law enforcement agencies. These departments can use Taser weapons and Axon body cameras, centralize digital management of these products through Evidence.com, and provide attorneys and agencies access to a simplified digital evidence workflow. This business has great growth opportunities and attractive margins (81% gross margins for FY 2016).
While Taser traded sideways for most of Q1 2017, its Q4 2016 earnings report pushed the stock downwards slightly. While revenues beat consensus estimates by 15% (Axon +154% year over year, Taser +25% year over year), gross margins declined by roughly 500 basis points. This ultimately caused profits to only rise by 33% year over year. Taser, a growth stock that did not grow earnings at or above consensus, declined as a result.
We are not discouraged by this earnings report. Although the amount Taser spent on operating expenses was higher than expected, the expenditures reflected the company’s desire to position for the long-term. These expenditures on dash cameras, research and development, and artificial intelligence are unlikely to generate revenues today, but demonstrate the company’s desire to shift its business model. Taser, having already captured much of the CEW market, needs to shift more resources into high growth areas. The initial success of Taser’s Axon segment has pushed the company to pursue an end-to-end SaaS platform for police departments. Such an offering will aid policemen in their use of body cameras “in the field, at the station, and in the courts.” Moreover, this SaaS business benefits from higher margins and a stable stream of recurring revenues (subscription model). We think the market is overlooking the opportunity that exists in Taser’s strategic transition away from hardware to SaaS.
As value investors, we are comfortable with the short-term fluctuations and will continue to hold this position.
At the end of the previous fall semester, all returning members were requested to complete an end-of-semester survey. This survey provided us valuable insight into how we could provide MII members with the best experience possible. Though we have not by any measure achieved all we set out to do, we believe we have made measured improvements to MII. The following outlines our notable changes and events over Q1 2017.
Associate Teams Investment Pitches
For the past several semesters, all associate teams have been required to put together a long/short investment memo each semester. The thinking had been that the best way to pick up great investment skills is to complete a rigorous investment memo from beginning to end. By having associates lead their respective analysts through this process, the hope was that the necessary skills were taught by managers during general body meetings and reinforced by associates during the course of developing an investment idea.
While this approach had its fair share of successes, we identified several addressable downsides. Notably, this had put increased reliance on our associates. In this model, associates are the middlemen between managers and analysts. While we have great faith in all of our associates, we, as managers, needed to be more involved in ensuring that the necessary skills are thoroughly taught and instilled in all MII members. Additionally, this approach had left associate teams with little direction. Teams were tasked with completing an investment pitch and left to their own devices. While management had continued to teach the necessary skills during general body meetings, the lack of structure had made it increasingly difficult for associates to reinforce these teachings. On top of this, this approach had not been designed for management to be able to provide feedback easily. Feedback only coming at the end of the semester was not timely and provided less help than needed.
We decided to combat these deficiencies by revamping the associate investment pitch process. While associate teams are still required to develop investment pitches over the course of the semester, they now have an assigned manager mentor and more concrete deadlines for each step. The manager mentor is responsible for ensuring each of his associate teams are reaching assignment deadlines and and providing help at any step. This help could range from discussing potential investment ideas with an associate team or working through an entire DCF valuation. Effectively, managers are now required to take a much more hands-on role in each of his assigned associate teams. Additionally, by establishing deadlines for nine steps in the investment process, we are also able to provide more frequent feedback and teach each step more thoroughly. We have defined the nine steps as follows:
- Idea Generation
- Company Description and Industry Analysis
- Business Model
- Thesis Points and Market Perceptions
- Market Misperceptions
- VAR and Exhibits
- Risks, Signposts, and Investment Timeline
- Consolidation and Submission
Though the final associate team pitches are not due until April 15, 2017, we are much more confident that this new process will be fruitful. We hope that these changes will trickle into our portfolio returns as we enter some of these investment ideas in the months to come.
The use of alternative data by professional investors has increased in the past several years. Alternative data has become a cottage industry. There are myriad technology start-ups processing and distributing vast amounts of unstructured and hard-to-find data that can be used to create an investing edge. Larger hedge funds have begun to internalize data analytics and now look to hire talented data scientists, statisticians, and computer scientists to create internal software that will help the fund outperform.
The goal of the Data Focus Group was to encourage MII members with an appropriate background to exercise their interests in a structured environment. Data analytics provide opportunities for investment hedging (e.g., against seasonal risk) and assisting in generating unique investment theses that would be difficult, if not impossible, without data.
The Data Focus Group is an auxiliary addition to MII. There are no membership requirements, but an interest in data science and a background in computer science is encouraged. The group meets one to three times a month separate from general body meetings. While the group is still in early stages, we hope that we can continue scaling it to a point that it is ingrained as a core pillar of MII.
MII Point72 Internal Stock Pitch Competition
In February 2017, MII hosted an internal stock pitch competition with Point72 Asset Management. Eight teams of three to four MII members competed against one another in a preliminary round. Finalists were then selected by non-competing managers. The four finalist teams presented their respective pitches to a board of Point72 judges. The 2nd-year students on the finalist teams were consequently offered an opportunity to interview for Point72’s Sophomore Summit, a one-day externship program for highly-qualified candidates interested in investing and the Point72 Academy.
Point72, along with many of the other top long/short funds, has increasingly become more data-driven in its investment process. As such, this stock pitch competition additionally included a data component that MII normally does not have access to. Point72 provided MII with roughly one million anonymized transactions for Esty, GrubHub, and Macy's, respectively. These transactions included information regarding user IDs, order dates, order totals, description of purchases, and so on. Though all investment research was driven by a fundamental, bottoms-up process, each team developed creative techniques to glean information from the data to supplement their theses. As mentioned earlier, the winning team identified that Grubhub had been suffering far more than the market had perceived in areas where it directly competed with Amazon Restaurants and UberEATS.
We were very pleased with this inaugural event. We hope that it becomes an annual partnership with Point72 Asset Management in the years to come.
Q1 2017 has been a great quarter — both in terms of portfolio performance and in club-related activities. We are proud to reflect on what we have been able to accomplish over this time. That being said, there is still much to do. We are hungry to continue pushing MII to new heights.
If you have questions or concerns with any of the above, please feel free to contact me.
McIntire Investment Institute President
The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.