Choice Equities Fund commentary for the third quarter ended September 2020, highlighting multiple multi-baggers from each of their themes of Digital Advertising Beneficiaries and Small Cap Value Stocks.
Q3 2020 hedge fund letters, conferences and more
Dear Investor:
I hope this letter finds you well. I am pleased to report a second consecutive quarter of strong performance. Our portfolio finished up +35.0% on a net of fees basis for the quarter, producing net gains of +43.3% for the year thus far. This compares to the S&P 500 which finished up +8.9% for the quarter and 4.9% for the year-to-date, while the Russell 2000 again lagged finishing +4.9% for the quarter but still with a loss of -8.7% year-to-date.
Executive Summary
In this letter, we discuss the major drivers of our performance, highlighting multiple multi-baggers from each of our two basket themes that we previously described as Digital Advertising Beneficiaries and Small Cap Value Stocks. We then discuss new portfolio addition Select Interior Concepts. Finally, we provide a few thoughts on the outlook, and provide a brief update on our view of a K shaped recovery.
Quarterly Commentary
The COVID-19 pandemic continues. Despite incremental progress in our understanding of the virus, a return to normalcy and life as we once knew it remains elusive. Fortunately, citizens across the globe continue to demonstrate the resilience and resourcefulness for which humans are known, as significant progress in learning how to accomplish the necessities of daily life has enabled many critical parts of our economy to resume some semblance of proper functioning.
Markets seem to have adopted this view and resumed their climb higher, with most indices now posting moderate gains for the year. However, despite what the movement of the headline indices may suggest, performance of the stocks within the market remains quite lopsided, and our K shape recovery description continues to be apt. The shift to a digital economy that was already underway has been accelerated, producing both winners and losers, as manifested by the highly divergent earnings and stock price trajectories of many companies within the market.
This volatile dichotomy has provided fertile grounds for stock picking, and I’m pleased to report our activity has enabled us to take advantage of these conditions. Positions initiated this spring were meaningful contributors to performance, and we were active again this quarter, with new holdings making positive contributions as well. In total, share prices of four positions more than doubled within the quarter as our themes of Digital Advertising Beneficiaries and Small Cap Value stocks both produced meaningful contributions to returns. Digital Turbine (APPS), new position Select Interior Concepts, Inc. (SIC), Pinterest (PINS) and reinitiated holdings in Bluelinx Holdings, Inc. (BXC) and At Home, Inc. (HOME) all contributed in roughly equal amounts to returns in the quarter. Celsius Holdings Inc. (CELH) shares also again performed well as the beverage brand seems to have benefited from increased discovery from investors and a commensurate rerating of the share’s multiple with our position since turning into a fourbagger.
Position Commentary
Digital Advertising Beneficiaries
Digital Turbine, recent addition Pinterest and existing holding Magnite, Inc. (MGNI), are beneficiaries of increasing digital advertising spend as ad dollars continue to shift to digital channels. However, as advertising spend is generally considered quite cyclical, the stocks of these secular growth companies were hit hard this spring when cyclical weakness presented itself. But recent reports have supported our theses that these weak conditions were temporary, and the depressed purchase prices and rebounding business fundamentals have generated wonderful results, with APPS since turning into a seven bagger and PINS more than doubling since our purchases.
APPS – Digital Turbine shares continued to benefit from increased investor discovery as it becomes increasingly clear the former microcap company is quite well-positioned in the world of digital advertising. As a platform that enables Android users to seamlessly download apps to their devices and also enables better tracking and measurement of advertising effectiveness, the global increase in time spent on mobile devices has been a boon for the company. The recent integration of Mobile Posse which has brought T-Mobile users and greater scale to the platform has also been a positive as the envisioned cross selling synergies are beginning to emerge. The company appears poised to continue to benefit from steady tailwinds from increasing smart phone usage and higher spend on digital advertising.
PINS – An improving outlook for digital advertising has also renewed interest in Pinterest. Equally importantly, the company appears poised to take the next steps in its natural evolution to improve on monetization efforts of its valued user base. Unlike other platforms who primarily connect people with each other, many of the things people seek Pinterest for – namely ideas and inspiration – are actually products themselves. Accordingly, the company is rolling out new features that make it easier for their users to find and buy these products. And they are rolling out other new products to continue to improve user engagement as functions like Story Pins enable users to follow multiple pages of step by step instructions for things like tutorials or various DIY projects. With a still yawning gap in the important average revenue per user (ARPU) metric versus the likes of more mature peers like Facebook, continued improvement in this area could drive meaningful profitable revenue growth for years to come.
MGNI – Magnite shares have mostly treaded water of late and seem to have been treated as a bit of an afterthought. Perhaps prospective investors have been turned off by the name change from The Rubicon Project. Maybe there is some angst over the coming implementation of various privacy initiatives and their effect on the digital advertising ecosystem. Or it could be that the post-merger consolidated financials and short but steep drop in digital ad spend which drove EBITDA briefly negative for 2Q 2020 mean the company does not screen as particularly attractive at the moment.
However, the merger with Telaria, Inc. looks like a good one. With it, MGNI gets a leading position in the Connected TV market, the fastest growing segment of the digital advertising space, as management integrates a company with well-regarded functionalities and an industry leading customer list. Together, the company now becomes the leading supply side platform (SSP) and the only player of real scale in each of the CTV, audio, mobile and desktop formats. As publishers continue to consolidate their relationships with advertising partners down to just a handful of platforms (i.e. supply path optimization), Magnite’s offering as a true independent and objective omnichannel player positions the company as one of just a few likely winners. Though this share gain opportunity has been coming into focus for a while now, it is nice to see that their customers agree, as Disney and Hulu recently reiterated they were using Magnite for exactly these reasons.
As a share-gainer in an industry likely to grow at low double-digit growth rates or better, the company looks set to generate impressive growth in revenues and cash flows. Though trailing-twelve-month financials may not convey the message for now, the merger looks like the latest in a series of sound, strategic maneuvers by Magnite CEO Michael Barrett. For a company with an impressive management team, a good balance sheet and a bit of scarcity value as the only public SSP, valuation of just ~3x next year’s likely revenues seems quite compelling.
Small Cap Value Stocks
Our decision to invest in a basket of small cap value stocks this spring continues to pay dividends. After small cap value stocks experienced one of their worst quarters on record, I’m pleased to say we were able to find a few babies in the proverbial bath water. Our basket includes Citi Trends Inc. (CTRN), Travel Centers of America Corp. (TA), Bluelinx Holdings and At Home Inc., all of which have doubled or more since our purchases. Hooker Furniture, Inc. (HOFT), Carrol’s Restaurant (TAST) and United Xpress, Inc. (USX) have also been meaningful contributors, as has recent addition SIC. All of these investments typify what we seek from these types of positions, namely: good businesses, cheap stocks and improving outlooks. As a case in point, the improvement in outlooks were recently underscored at both CTRN and HOFT by recent management decisions to resume returning cash to shareholders through share repurchases and dividend payments, respectively.
SIC – Select Interior Concepts, Inc. is a company I have had my eye on for a while now. As an investor with an affinity for building products distributors and the sometimes-eye-popping long-term shareholder returns these companies have a knack for producing, I have been intrigued with its potential for some time. Much like we found a few years ago in our comparison of a young SiteOne Landscape Supply, Inc. (SITE) to industry paradigms Pool Corporation (POOL) and Watsco, Inc. (WSO) (see here for the case study), SIC stands to benefit from the same type of industry structure that has enabled these companies that have staid mid-single digit organic sales growth profiles to produce some of the most impressive total shareholder return records around. Accordingly, this was one of the companies I spent a great deal of time with at the Las Vegas builder show eight months ago.
By way of introduction, the company consists of two segments that primarily fulfill product needs of residential builders. Each has a market leading position in businesses where local scale and geographic presence matters. Residential Design Services (RDS) provides an outsourced interior design and installation service to its homebuilder partners. Its primary value add is to assist prospective homebuyers in navigating the cumbersome process of managing the selection and installation of the many various flooring, countertops and cabinet products that go into a new home. The company procures and installs the products thereby simplifying a process that often has a number of subcontractors coming and going at various and somewhat unpredictable times. The Architectural Surfaces Group segment (ASG) is the largest distributor of natural and engineered stone slabs in the country. These products are sourced across the globe and typically sold directly to builders, countertop fabricators and kitchen and bath dealers who finish the installation from there. Due to the outright bulk of the products and desire of homeowners to see their slabs given the heterogenous nature of stone patterns, these products can be difficult to source and showcase in adequate supply for smaller operators.
With ASG as the number one player and RDS as a clear-cut number two, both segments have market leading positions but also big white space opportunities remaining where they do not have a presence geographically. Both businesses are also beneficiaries from growing economies of scale as advantages in purchasing and distribution create savings they can then pass along to their customers, which enables them to then attract more customers, thereby perpetuating the distributors’ virtuous cycle. As we have seen in other building products rollup stories, if the acquirer does deals responsibly at sensible multiples, acquisitions can be a productive use of capital as the company is essentially just buying smaller versions of itself. And by spending within their annual cash flow generation, they can typically add 5% to 10% a year to topline growth. Altogether, these dynamics create an opportunity for the company to embark on a multi-year market consolidation opportunity via accretive acquisitions that can be quite rewarding.
Despite these promising characteristics, it has been little more than bumps and bruises for SIC since coming public via the unorthodox route of a direct listing in 2018. Some of these troubles seem attributable to plain misfortune, though there have been some missed opportunities and operational missteps along the way too. Clearly, timing has been inauspicious from the start. The company came public right as housing was entering a mini recession in 2018. SIC’s geographic mix, which at one point saw 80% of RDS sales coming from California, was ill-suited for the times considering that state’s housing market was going deeply negative as it digested the negative impact of SALT taxes there. Microtrends within the housing market would go against the company as well, with builders leaning into production of smaller homes and buyers doing less upfitting. Despite the softness, corporate SGA would remain stubbornly high. Then there was a distracting activist campaign, subsequently abandoned. Shareholder turnover would follow. And then a pandemic. Finally shares would bottom this summer after the company fell out of the Russell 2000. So, for much of the company’s public life, company fundamentals would underperform national housing market metrics and frustrate shareholders.
But things appear to be changing for the better. Starting at the top, changes at the board level have led to a change in leadership as Bill Varner, a seasoned building products CEO has joined the team. He has impressive experience within the industry, most notably taking United Subcontractors (an interiors installation provider) from -$20M of EBITDA to $50M of EBITDA in just six years. Another positive sign is that he is bringing some of his lieutenants with him, all of whom have been incentivized with equity heavy compensation packages. Recently the company identified $20M of costs they can take out of the business. The California housing market, which RDS has diversified away to ~50% of its segment mix, is now performing strongly, as are most other regions currently. Their digitally enabled Momentum Design product is small but gaining traction and leading to new customer wins. And though it seems unlikely to expect the company to immediately return to the acquisition market, it seems more likely than not this will become a meaningful driver of results in the medium term.
Perhaps comparisons to more mature players WSO, POOL or SITE which all trade north of 20x 2020E EBITDA may be a bit optimistic or premature. So maybe comparisons to younger building products distributors like Installed Building Products, Inc (IBP) and TopBuild Corp. (BLD) who trade around 14x to 15x 2020E EBITDA and likewise lean a bit more cyclical make for a better comparison. Even so, all of the necessary preconditions for success appear present. SIC has a proven management team, a strong market position and a long runway for growth in businesses that can benefit from accretive acquisitions. So, as we look out over a multi-year horizon, it is not unreasonable to see a big opportunity here. But with SIC currently trading around ~6x 2020E EBITDA, we certainly are not paying for that outlook.
2020 Outlook
By many measures today’s market is as lopsided as ever. Many intra-market relationships like the performance of growth stocks versus value stocks or the Russell 2000 versus Nasdaq now rest at decade-plus level disparities. Such dichotomies seem quite strange. But so is wearing a mask everywhere. So, in many ways, this weird market might just be an accurate reflection of our weird economy. And of course, there is an election looming on the horizon. Regardless, this bifurcated market continues to look quite attractive for stock picking, a condition I expect will remain true no matter who wins the election.
Conclusion
In closing, while I know our approach will not yield outperformance each and every quarter, I continue to believe it will be well worth our while over the long haul. Perhaps more importantly, given the overwhelming majority of our investable assets are invested alongside yours, we would never ask investors to assume risks we ourselves will not.
Thank you for your continued support as we work to grow our capital together. As always, we are happy to discuss our investment outlook with you at your convenience. Please reach out any time.
Best regards,
Mitchell Scott, CFA
Portfolio Manager
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