Idea Brunch with Aaron Sallen of Merion Road Capital Management
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Aaron Sallen!
Aaron is currently the chief investment officer of Merion Road Capital Management, a long/short equity fund he founded in July 2016. Before launching Merion Road, Aaron worked as an analyst at Napier Park Global Capital, a multi-billion-dollar hedge fund, and worked in a private equity role at Macquarie Capital. Aaron is also active @aaronjsallen on Twitter.
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Aaron, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch Merion Road?
Thanks for having me Edwin. I’ve had a fairly traditional path in the investment management world. Coming out of undergrad I did a brief stint in investment banking and then moved to Macquarie where I worked in a principal investing role, acquiring assets and companies on behalf of the bank’s infrastructure funds and proprietary balance sheet. While I enjoyed this experience, I eventually realized that I would be better off in the public markets.
After a pit stop in Chicago, where I got my MBA, I moved back to NY and joined a small team managing a long/short event-driven book at Napier Park. Our strategy was to manage a tightly-hedged portfolio that captured mis-pricings around various events like spin-offs, restructurings, post-merger entities, activism, and merger arbitrage. It just so happens that the event-driven strategy was very popular during the time that I was there and I noticed a lot of capital flowing into the space. There were a few instances where an event de-jour would fall through and the company in question would trade well below fundamental value as all the event guys rushed to the exit.
Noticing this I had two ideas. The first would be to have a strategy focused on scooping up busted events. I quickly realized that the universe of those is simply too small to build a dedicated portfolio. The second idea was to have an event strategy focused on small-cap names where larger event funds couldn’t invest. The way that I viewed it was that there would be limited overlap between small-cap investors and event specialists. In mid-2016 I decided to test my theory and put together a small-cap event portfolio. This portfolio became Merion Road.
What differentiates you from the numerous other equity investors with a small-cap bent? Why do you think you’ve been able to meaningfully outperform since your launch ~6 years ago?
A lot of the performance to date has to do with my strategy set out on day 1. There are not a lot of small-cap investors who are solely focused on special situations. The ability for me to leverage my years of experience in the event world, from both a private and public perspective, has been instrumental.
For instance, on the merger arbitrage side of things I have been able to identify some low-risk situations with attractive returns due to the size and complexity of the deal. One of the first positions I put on was the Primo Water (PRMW) acquisition of Glacier Water (GWSV). This checked all of the boxes. GWSV was OTC listed, small, and illiquid. Importantly, the merger consideration consisted of cash, stock to be held in escrow, and non-traded warrants, making it complex to properly hedge. I was able to acquire GWSV and get a 5% gross return after hedging costs, or ~20% IRR based on when the capital was released. This excluded the value of the warrants which I viewed as icing on the cake.
With the benefit of hindsight, however, I can also say that there are a bunch of other factors that have aided me on my journey.
First and foremost would be a keen sense of risk management that I learned at Napier. This impacts how I hedge the portfolio, which is not always as straightforward as it sounds (while I have a target range for portfolio beta, correlations go to one during periods of market distress and I cannot rely on historic figures alone). Limits around position sizing and industry concentration have also helped me avoid any large blow-ups. And at a position level, understanding the inherent risks in the business and how I can be wrong is central to my underwriting process. Factors impacting this obviously include things like balance sheet strength, earnings predictability and sensitivity to economic factors, and absolute valuation. Excluding 2 positions liquidated during winter 2020, the most I have lost on a single name is 4.4% of NAV.
I also have a pretty good sense of who I am as an investor and my predispositions. I know that I skew more conservative and am skeptical of groupthink. Recognizing this tendency, I can force myself to view every idea with an open mind. Nine times out of ten a successful investment will be because I drew the right inferences and focused on the key variables, not because I identified a small piece of information that everyone else missed. I think I am a good analyst, but I think I am a better portfolio manager.
You have a pretty diverse portfolio – ranging from a used auto dealership (NYSE: CRMT) to a microcap bank in Alabama (OTC: UBAB). How are you able to come up with off-the-beaten-path ideas in an industry with so much groupthink?
Sourcing new ideas is the hardest part of the job. There are about 2,000 stocks in my investible universe ($25mm-$1bn of market cap) and it’s a one man shop over here. I have all sorts of tools to help me identify names, but at the end of the day it comes down to being efficient with my time – quickly dismissing companies I would never invest in and directing my efforts to the most interesting opportunities. One trick that has been helpful has been keeping a list of companies that I have looked at in the past, whether I invested in them or not, with notes on my thought process at the time. I routinely go back and revisit names to see if they are any more interesting from a valuation perspective or if there is a new catalyst.
An example of this would be Tuesday Morning (now OTC: TUEMQ), an off-price retailer which had entered bankruptcy in early 2020. Though the valuation was attractive with tangible book value many multiples above the share price and positive near-term operating performance, the company lacked an equity committee. I passed based on the conclusion that the risk of common shareholders getting left behind was too great, but kept the name on my watch list. When it was announced that the judge would grant an equity committee later that year, I was able to quickly build a position. Though I missed the first 100-200% move in the name, I still captured a nice move in the stock as it re-rated higher.
It's interesting that you mention United Bancorp of Alabama (OTC: UBAB — $139 million). UBAB is a community bank that received a large investment in the form of low-cost perpetual preferred equity as part of the Treasury’s ECIP program. I actually sourced this idea from a Twitter thread that made the rounds in the Fin-Twit community. So, in a sense, this is an instance of me fighting my contrarian nature and succumbing to groupthink. It actually took a few months for me to dot my I’s and cross my T’s as I considered all the ways that ECIP could not be as beneficial as it initially seemed or how owning a tiny community bank could prove unattractive. While I decided that the ECIP idea was worth putting on, true to my nature, I avoided the most popular of the group and invested in UBAB. Though UBAB was less well covered than the rest, it boasted some of the best operating metrics like organic deposit growth rates, rate spreads, loss ratios, efficiency ratios, and return on assets. The valuation was equally as attractive and my assessment of management was positive.
Is meeting with management a meaningful part of your investment process? If so, are there any operators you admire?
Talking with management is absolutely a critical part of my process. You can think about it from two perspectives. First, there are a lot of “cheap” small-cap names out there. But they are cheap for a reason – typically being that management is not shareholder friendly. Avoiding these situations is incredibly important to maximize returns. While sometimes you can just rely on history (a zebra doesn’t change its stripes), a conversation can go a long way to better understanding how minority shareholders will be treated. This is particularly true when a new management team takes over.
Second, small-cap companies tend to be lower quality than the larger, more established players. Good operators can create a lot of value and bad ones can destroy it. By digging into any sort of operational or strategic initiatives, I can gain greater confidence on a company’s earnings trajectory.
I think the team over at Rocky Brands (NASDAQ: RCKY — $169 million) is really good. When they stepped in at the end of 2016, RCKY was a struggling work boot manufacturer with declining sales and zero profitability. They quickly went to work consolidating distribution centers, rationalizing SKUs, and divesting a non-core division. Within short order, EBIT reached high-single digits and the team turned to growing the business. Most notable is their Lehigh Outfitters segment, which is essentially a high-growth, capital-light, B2B distribution company for work boots. The interesting thing is that anyone could have called them back in 2016/2017 and heard about the steps they were taking to improve the business. But given their size, it kind of floated under the radar until numbers improved.