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Downside Protection

Below are notes from a new book, along with thoughts on Howard Hughes Corp’s big move and the “rabbit” finally revealed at Interactive Brokers…


I just finished a new book by Nitin Sacheti titled Downside Protection: Process and Tenets for Short Selling in All Market Environments. Sacheti is the founder and portfolio manager of Papyrus Capital, a long/short equity fund.


If you like reading case studies, you’ll like this book – even if you never a short a stock ever. You’ll learn some potential pitfalls in different business models. You’ll sharpen your ability to detect weaknesses and vulnerabilities in the names you look at.


I like this book for several reasons. One is that the case studies Sacheti chose to write about are not well known. You won’t read about Enron or Valeant here. And you won’t read ancient history either. (No ZZZZ Best).


Instead you’ll read about Invensense, Globalstar, Fusion-IO and others. I find reading about these “smaller” ideas much more satisfying. They lack the pizzazz of the frauds and headline busts. But as Sacheti points out, big blow-ups like Enron or Valeant are rare, hard to find and take years to unravel. Sacheti focuses on “the singles, doubles and triples that occur regularly and create a high batting average for an entire portfolio rather than a single home-run.”


One of them is United Foods. I liked this story. In particular, I like how he sourced the idea. One of Sacheti’s key ways of finding short ideas is to “follow the actions of the Industry Leader/100LB gorilla.” Watching what they do can help identify businesses that are about to get quashed.


So, when Amazon acquired Whole Foods in mid-2017, he found that a “significant portion of their cost of goods sold line (i.e., supplier relationships) was concentrated with United Foods.” He knew Amazon’s focus on costs. And naturally, he started to think about how Amazon might deal with that line item.


It’s such a seemingly simple deduction. And yet, it seemed to go unnoticed by the market at the time. (An investment bank initiated with a $40 target in mid-2017… the stock would hit single digits within 18 months).


Meanwhile, Sacheti talked to industry insiders and reached the conclusion that Whole Foods was likely to shift away from United Foods. Amazon’s own distribution centers would handle that business.


Another of Sacheti’s tenets is to follow the insiders. Insiders at United Foods were selling “significant amounts of stock in late 2017 and early 2018.”


It all lined up and the short worked out very well. Sacheti concludes:


“I included this chapter in the book to illustrate that shorting does not have to involve understanding an extremely esoteric tech product to gain an edge. Simply following Porter’s Five Forces in situations where large changes happen to a big customer allows us to identify the right ponds in which to fish.”


The book is an easy read. The chapters are short. The United Foods story unfolds over 7 pages. But I found some valuable insights in that case study. It reminded me why I don’t like companies with large customer concentrations. (Kontoor Brands recently intrigued me, but after reading that one-third of its sales came from WalMart, I stopped working on it. Might be a mistake on my part, but that’s a risk I have a hard time getting over.)


I also like that Sacheti included a chapter on stocks he decided not to short. These include Viasat, Twilio, Hugo Boss, Ubiquity Networks and several others. Again, these are short vignettes, but have interesting takeaways. (Re: Hugo Boss, Sacheti writes “stay away from shorts with products customers love…”)


There are also bits of wisdom and interesting nuggets sprinkled throughout. For example, in a discussion about following insiders:


“While we hope that every manager aligns incentives with shareholders as well as the Warren Buffetts of the world, the truth is that the vast majority do not run companies as sound as Berkshire and do not own as much stock as BRK’s founders. They run businesses that cater to the quarter and the short-term. They cultivate corporate cultures that value politicking in a quest to get as rich as possible, as quickly as possible, without regard to long-term shareholder value. InsiderScore… did an analysis in 2012 that looked at 10b5-1 selling plans… which showed a -3.1% return over a 6-month period on companies where clustered insiders selling occurred on market caps above $200m.”


If you geek out on this stuff like I do, you’ll enjoy the book!


*** Notes on Stocks


(Disclosure: Woodlock House is long both of the stocks mentioned below. Of course, we can sell at any time and we don’t have to tell you, don’t rely on anything I write, etc. See our disclaimers.)


July fireworks came a week early for Woodlock House. Shares of Howard Hughes Corp. (HHC) soared 41% in one day (June 27) on news that the company would “explore strategic alternatives” – including the possible sale of the entire company.


Now what happens? We wait and see what the company comes up with. We value Howard Hughes at ~$170. A Jeffries analyst came out with a valuation of $165. I’ve seen valuations higher. (One came across my desk yesterday from a large, well known money manager that had NAV at just over $200 per share). The CEO’s big personal investment in warrants only breaks even at $150. Seems hard to believe Howard Hughes sells for less than that.


Of course, they could do a partial sale (which I think more likely). Perhaps they sell the Seaport, for example, or part of it. There are a lot of possibilities. In any event, given the (still) large gap between the share price and NAV, we’re hanging on. We bought more the day before the pop. (Lucky!) And our average cost dropped a smidge to about $102.


Interactive Brokers (IBKR) finally unveiled “the rabbit.” It’s a peer-to-peer exchange where people can buy, sell and trade bets on sporting events. The press release is here:


https://www.businesswire.com/news/home/20190701005765/en/


They’re hoping people take part in the promotion and then become IB clients.

I admit to being a bit underwhelmed by the idea. Not sure what I was expecting, but it wasn’t this. Maybe it works. Sports betting is big business, of course. And now that it’s legalized in a bunch of places, maybe it will get even bigger. I have a lot of questions about it though. Like, what will the value of these customers be to IB? I don’t know. There is a lot to think about. Second quarter results come out July 16. I’m sure “the rabbit” will be a topic of conversation on the call.


In any event, it doesn’t change my view on IB overall. I’m a fan of the platform. I’ve had only good experiences with it. I like the business. And I like the stock. The valuation hasn’t changed much since I wrote about it in April:


https://www.woodlockhousefamilycapital.com/post/ibkr-annual-meeting-notes


As earnings season rolls in, I’ll post more thoughts on stocks I’ve mentioned here.


Thanks for reading. And Happy July 4th! Send me mail:

info [at] woodlockhousefamilycapital.com.


***

Published July 3, 2019

See our disclaimers


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