Rowan Road Capital letter for the third quarter ended September 30, 2018.
Third quarter was uneventful (flat) when it comes to market worth motion for our fund’s portfolio. As of September 30, Rowan Road Capital fund was up 26% in 2018 (earlier than charges) versus 10.6% achieve for the S&P 500. When it comes to portfolio positions, nevertheless, our fund has seen fairly a little bit of exercise.
Get Our Activist Investing Case Research!
Get the whole 10-part collection on our in-depth research on activist investing in PDF. Reserve it to your desktop, learn it in your pill, or print it out to learn anyplace! Enroll under!
Q3 hedge fund letters, convention, scoops and so on
Our guideline #9 outlined in the Appendix of this letter, which we extremely encourage all of you to learn, is “Do a lot of reading and thinking and not a lot of acting.” In that we’re type of polar opposites to many buyers on Wall Road which are inclined to do a number of appearing and not an entire lot of considering. We strongly consider that exercise is the enemy of returns, and we’re fairly snug doing nothing till there’s something to do. Nicely, that “something to do” time got here in September and continued properly into October. Volatility has elevated dramatically in October as considerations about tariffs, commerce warfare and rising rates of interest took over buyers’ minds.
Over the previous 12-18 months we now have been doing loads of studying and considering on a handful of corporations. We have now been learning their enterprise fashions, their administration groups, their company cultures, taking a look at their rivals, analyzing their financials, and considering fairly extensively about their future prospects. Nevertheless, all of that behind-the-scenes work has not translated to any portfolio motion. Why? As a result of we didn’t assume that Mr. Market had provided us a beautiful worth for these companies that might guarantee each a margin of security (our precept #5) and double-digit long-term, anticipated returns that we demand from our investments. We now have been affected person and disciplined and over the previous two months, Mr. Market has lastly given us a chance to personal companies that we had dreamed of proudly owning at costs that current us with some very engaging anticipated charges of return. The truth is, our calculated IRRs for the subsequent 5 years (Inner Price of Return) for these investments are in extra of 20% every year.
We may be very affected person, however when the alternative presents itself, we are likely to take daring motion based mostly on our convictions. That is precisely what we did in the third quarter of this yr. We took this chance to exit a lot of legacy positions that had labored out nicely for the fund (will go over them one after the other later on this letter) and constructed up sizable positions in corporations that we consider are considerably higher companies, with far more engaging future prospects and progress charges. We’re nonetheless in the midst of accumulating shares in these shares for our fund as the volatility persists in the markets, and we can be discussing these positions in our future letters.
So what did we promote and why?
Rowan Road Capital: Chipotle (CMG) – Exploiting the market’s fear and greed
We’re sure all of you’re conscious of this restaurant chain and lots of you could have tasted their burritos. Once we first began the fund in 2015, there was a Chipotle restaurant throughout the road from the workplace. I might go there for lunch a few times every week. I favored it as a result of it was low cost, tasted excellent, and I might eat fairly wholesome meals there. I might get brown rice, beans, grilled hen and salsa and it might be a pleasant meal. I keep in mind I checked on the market cap of CMG once I was standing in line for my burrito and it was near $20 billion (very expensive with lofty expectations). Two years later, I had lunch at Chipotle in South Lake Union in Seattle. Nonetheless the similar worth and nonetheless simply as tasty, however the market cap was now round $9 billion. I assumed, now this seems much more fascinating! The inventory was hammered resulting from considerations about quite a few studies on e.Coli and Norovirus outbreaks over a interval of 12-16 months, and ultimately, in November of 2017, the valuations of Chipotle inventory acquired to very unreasonable ranges. At the moment, we felt that it had reached a most level of pessimism and the odds have been closely on our aspect to make a double-digit price of return on CMG inventory over the subsequent 5 years.
Our rationale was easy. The elemental rules upon which Chipotle was constructed and skilled super success — discovering higher components, getting ready them utilizing basic methods in entrance of the buyer, and serving them in an interactive format with nice groups devoted to offering wonderful eating expertise – have been nonetheless very a lot intact. We thought the points impacting the firm have been momentary and could possibly be solved with a targeted administration and focused PR efforts.
Simply six months after we began shopping for shares in CMG, the inventory had rebounded 80%, as they employed a brand new CEO (Brian Niccol) who had a really profitable monitor report at Taco Bell. Similar retailer gross sales and margins began rebounding and Mr. Market had shortly shifted from most pessimism to extreme optimism. The danger/reward had shifted dramatically in a really brief time period, and we determined to promote our place as we thought the market priced-in a few years of return in just some months’ interval. We reinvested the proceeds in a greater alternative with far more engaging anticipated returns.
Tractor Provide (TSCO) – Boring enterprise, thrilling returns
Our funding strategy right here was just like our funding in CMG. Tractor Provide is the largest operator of rural way of life retail shops in the US. The corporate is concentrated on supplying the wants of leisure farmers and ranchers and others who take pleasure in the rural way of life. It’s a boring enterprise, however one which enjoys some robust economics and aggressive benefits.
In the summer time of 2017, TSCO inventory received hammered on considerations about deteriorating similar retailer gross sales that have been impacted by weak power and agricultural markets, non-normal climate patterns and deflationary considerations. We began shopping for the inventory as our in depth analysis on the firm offered us with confidence on their favorable long run prospects. Then, in September of 2017, the firm issued a enterprise replace and revised their outlook downward. The inventory took a heavy 17% nosedive that day as Wall Road couldn’t look past simply a few quarters and fear took over. We took benefit of this chance so as to add to our shares at what we thought was a really engaging worth. The place we differed right here was our mindset of a 100% proprietor of the enterprise, targeted on the prospects of the enterprise for the subsequent Three, 5, 10 years (it’s superb what benefit you possibly can have simply by wanting previous the subsequent couple of quarters).
Only one yr following our preliminary buy of TSCO inventory, market sentiment had utterly rotated. The destructive influence from the power and agricultural market began dissipating, similar retailer gross sales began rebounding, and deflation turned much less of a priority. The inventory rebounded 70% in simply 12 months. We nonetheless like the firm and its administration group, however decided to promote our shares as we would have liked the money to spend money on far more engaging alternatives at the time.
Gilead Sciences (GILD)
Gilead Sciences is a research-based biopharmaceutical firm that discovers, develops and commercializes medicines in areas of unmet medical want. The corporate is well-known for its dominant HIV franchise. It additionally has a strong portfolio of merchandise and pipeline of medicine for remedies of liver illnesses, inflammatory and respiratory illnesses and cardiovascular circumstances.
This funding has not labored out as nicely for us as the earlier two, however we nonetheless made cash on it. We first began shopping for the inventory in GILD again in the fall of 2016 as Wall Road has been rising more and more involved about the firm turning into a sufferer of its personal success. The corporate had made a really profitable acquisition of Pharmasset in 2011, which resulted in the FDA approving the drug beneath the identify Sovaldi as remedy for the hepatitis C virus lower than two yr later. By 2015, this hepatitis C (HCV) franchise had grown to $19 billion in revenues on prime of $11 billion in revenues from the HIV franchise. It was an unimaginable success story with out a lot competitors and the inventory had risen by about 450% by the finish of 2015 reflecting this success. There was one “problem” for the long run prospects of the enterprise – their hepatitis C drug utterly cured most sufferers in simply eight weeks of remedy. The molecule that was so nice for his or her sufferers ultimately took down their HCV revenues to round $5 billion…and though their revenues from a really profitable and rising HIV enterprise had elevated to over $14 billion by finish of 2017, it was not sufficient to exchange the misplaced revenues.
Our guess in 2016 was based mostly on the premise of a really strong firm tradition with a long-term monitor report of success in treating sufferers with unmet medical wants. Our rationale was that the HIV franchise was going to proceed to develop and be extraordinarily worthwhile for the firm, whereas HCV enterprise would decline however proceed to churn out wholesome money move to fund future acquisitions. At the time of our buy, the inventory valuation was very low cost (or so we thought) buying and selling at 17% free money circulate yield. As well as, that they had $32 billion in money on the stability sheet, which provided us a big margin of security. Two years later, their revenues from the dwindling HCV franchise continued declining, and that they had not been capable of substitute the misplaced revenues (though they did make a profitable, in our opinion, acquisition of Kite Phrama). Our current choice to promote was resulting from our rising concern on the deteriorating long-term prospects of the firm and its tradition. An awesome variety of firm administration personnel and its Chief Scientist have left the agency over the previous 12 months, and the CEO who has been with the firm for over 25 years introduced his choice to retire. This place not met our funding standards and we determined to promote and reinvest the proceeds in additional engaging alternatives with considerably higher danger/reward state of affairs. In the finish, we nonetheless netted a small revenue on this funding.
“This Halloween, it’s not a Hollywood monster that’s bringing the fright to investors: It’s a whole cast of scary characters, including trade tensions, tech disappointments, rising interest rates, and wild swings in China’s markets. Combined, they helped push the benchmark S&P 500 into the red for the year. Globally, stocks extended their month-long slide.” — Barrons journal
Our view on all the macroeconomic worries which are “spooking” the markets is the similar because it all the time has been. We expect it is worthwhile to repeat what we wrote in our Q1 2018 letter:
We do not know what the market goes to do over the subsequent quarter or the subsequent yr, and we make no try and make such predictions. There’s nothing in our document that means that we will add any worth by making these predictions and making an attempt to time the market (in distinction to an inordinate quantity of power and assets that’s spent on these actions on Wall Road). We stay targeted on what we do nicely — figuring out top quality, well-run companies which might be more likely to compound our capital at double-digit charges of return over the long term, and we attempt to purchase these opportunistically when Mr. Market gives us a pretty worth. This strategy has proved to achieve success for us all through our funding careers, and we’ll proceed to give attention to that as a result of we expect it’s logical, repeatable, easy and simple.
On that word, we’re at present discovering some very engaging funding alternatives with the current market downturn. Our present portfolio boasts substantial upside potential over the subsequent Three-5 years with greatest anticipated returns that we have now seen since we began the fund in 2015. When you’ve got further capital sitting on the sidelines that you simply want to put to work, this might be an opportune time to take action, as we’re aiming to opportunistically add to our present concepts whereas they nonetheless current good worth.
Thanks on your confidence and belief in our funding self-discipline. We’ll proceed to take a position with a very long time horizon like it’s our personal cash – as a result of it’s. We respect the alternative to develop your loved ones capital alongside ours. As all the time, ought to you’ve got any questions or feedback, we might be very glad to listen to from you.
Alex Kopelevich, CFA
Joe Maas, CFA
This text first appeared on ValueWalk Premium