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Idea Brunch with Bill Martin of Raging Capital Ventures
Bill Martin shares Ingredients for a Winning Investment, Research Process, Activist Campaigns, and Interesting Ideas
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Welcome to Sunday’s Idea Brunch, a weekly interview with underfollowed investors and emerging managers. We are very excited to launch our inaugural issue with Bill Martin of Raging Capital Ventures!
Bill is currently a private investor and a serial entrepreneur who co-founded Raging Bull, InsiderScore, and Princeton Ventures (now Princeton Equity Group). He was previously the founder and Chief Investment Officer of Raging Capital Management, a long/short hedge fund that was well known for its activist work, private investments, and short selling. Raging Capital compounded at 15%+ net over 15-years and grew to nearly $1 billion in AUM at its peak.
Bill, you are unique in that you’ve both started successful companies as an entrepreneur and backed many as an investor. What are the necessary ingredients for a winning investment?
Great question, although I wish starting and backing winners were as easy as following a recipe!
A few key ingredients do come to mind, though, including:
- Betting on Entrepreneurial Owners. Albeit not a pre-requisite for all great investments, I can’t overstate the importance of having a corporate culture of entrepreneurial ownership. This occurs when management and employees have real skin-in-the-game and are also empowered to build and innovate. It is this creativity, invention, and attention-to-detail that builds great companies. Hired caretakers can go through the motions, but it is not the same. Partnering with great founders and CEOs who have this mindset can change your investment life. Just as notably, it is much harder to short these types of operators!
- Is Business Getting Harder or Easier? A simple but important part of my framework is evaluating the factors that are creating tailwinds or headwinds for a company. For example, I ask questions like "Is TAM growing or shrinking; where is the company in its product cycle; what are the relevant competitive dynamics; is cost of capital rising or falling, etc." You can use this mindset to think about both longs and shorts over various timeframes. Obviously, it is better to go long when a stock is cheap and things are getting easier, or to short when a stock is expensive and things are getting harder.
- Protect your downside. The best laid plans can and do go awry. Markets go up and down; not even Jay Powell can permanently suspend that cyclical reality. Limiting downside through margin of safety and avoiding zeros is necessary for investment survival, even if it is not sexy during bull markets. Although it is inherently riskier, I try to approach venture investing like this as well, as I don’t have the luxury to regularly “swing and miss” like some bigtime VCs.
- Staying Power through Conviction. A winning investment requires grit, persistence and patience. It is not easy to wait for the right pitch or the right price, nor is it easy to sit tight as the business evolves over time in the face of both opportunities and challenges. You need to “own” your ideas from the inside-out in order to have the proper conviction to know when to buy and sell and to successfully navigate the inevitable ups and downs.
What are two or three interesting ideas on your radar now?
Liberty Sirius (LSXMA): LSXMA trades at an approximately -25% discount to the value of its stakes in Sirius XM (SIRI) and LiveNation (LVY). I believe that discount will narrow as LSXMA is poised to imminently control 80% of SIRI, which will allow it to tax efficiently dividend cash flows from SIRI to LSXMA. This should enable LSXMA to turbo-charge its buyback; ultimately the two entities will likely collapse into one, fully eliminating the discount. Importantly, since it is largely excluded from the indexes, SIRI itself is an inexpensive stock, trading at north of a 7% free cash flow yield and growing nicely. Thus, via LSXMA, you’re effectively buying SIRI at a dirt cheap 10% free cash flow yield!
Five Point Holdings (FPH): A large California land developer that was spun out of Lennar (LEN) in 2017 via an IPO at $14 per share, FPH has been ignored by investors due to its past long development cycles and lumpy cash flows. Now, with the stock around $8, FPH is finally at an inflection point as its 15,000-acre Valencia project in Los Angeles County (which took 20 years to permit and develop!) is finally selling homes. Additionally, FPH’s Great Park community is now mature and cash flowing, while there are signs that the company’s Candlestick Park project may finally start to move forward. Importantly, the balance sheet is rock solid. Recent management changes, plus plans for an investor day, should also help to catalyze the stock.
Exterran (EXTN): In the speculative camp, EXTN has multi-bagger potential as its markets recover from the energy bust and it transitions to a more capital-light business model. Specifically, EXTN could secure an “offtake” partnership with an infrastructure investor with a low cost-of-capital who desires the company’s water solution deals for ESG reasons. This would enable EXTN to convert a portion of its business to more of an origination and servicing model, freeing up cash flow and accelerating de-leveraging. Sam Zell owns 25% of the company and has strong influence on the board; he also bought more stock in Q2 at around these levels.
What are some of the first things you do when researching a company? What does that first hour of research look like for you? Do you do anything that few others do?
My goal when researching a new company is to quickly understand the core business model, key financial metrics, and major fundamental drivers. I typically start with a review of high-level conference presentations and the 10-K. I will also review quarterly conference calls with a focus on the Q&A section – specifically, what kinds of questions are analysts focused on? I try to nail down the 2 or 3 key variables affecting the business and determine whether I have any edge in understanding those variables.
I also like to try to put myself in the shoes of the owner or manager of the business – would I want to own all of the business if I could, would I put 100% of my net worth in the company, what would I do if I were CEO, etc.? If I start getting excited by the answers to those questions, it is worth spending more time on the idea.
I’m usually valuation sensitive – using back-of-the-envelope math, does a business seem fairly valued or is there some kind of dislocation (either too high or too low). I usually spend more time on the apparent dislocations. If the valuation seems appropriate, I typically set the company aside for now unless I think digging in can help inform my thinking elsewhere. In emerging and fast-moving sectors, I often find it valuable to keep tabs on many of the players as future dislocations will often appear on short notice.
As much as I enjoy the intellectual process of learning about a new company or sector, I also take pleasure in quickly nixing an idea from further consideration. There are many fish in the sea and only so many hours; I try to stay focused on the best investment and learning opportunities.
In terms of differentiation, I try to lean on my network of entrepreneurs and operators to source and diligence ideas and/or to uncover unique and valuable nuggets of information. As a fellow entrepreneur with a range of relevant experience, I often can open certain doors that other investment analysts cannot.
You have had a lot of experience with shorting biotech and biopharma companies. What are some common red flags you look for when evaluating companies in this space and if you were running the SEC are there any regulatory changes you would make to help protect investors from this volatile industry?
Raging Capital’s biotech short basket was a reliable source of material alpha (and often absolute returns) for the firm for many years. My former partner Brian Bellinger, who now runs Monimus Capital, was an integral part of our efforts here. Ironically, no one on my team, including myself or Brian, had a deep science or health background. We also flew in the face of conventional thinking among hedge funds that shorting biotech is too risky given their binary nature.
What was our approach and why did it work? To start, in recent years, literally many hundreds of biotech companies have gone public. Most of these upstarts only have one or a handful of molecules under development, making the odds of market success very low. Statistically, only around 10% of drugs (oncology is less than 5%) that enter Phase 1 trials ultimately ever get approved by the FDA. The number is even lower when you exclude “sequel” drugs as well as drugs made by Big Pharma, who generally have higher success rates because they are quicker to winnow the losers from their deeper pipelines.
Along with betting against those long odds, we would also actively screen out the “good actors” with solid technology pedigrees, well-regarded management teams, leading VC backers and underwriters, and the like. These are the set of companies that are most likely to be binary winners.
With the remaining set of potential short targets, we would laser in on the worst actors: executives and boards with shoddy pasts, weak audit firms, low quality underwriters like Roth or H.C. Wainwright, questionable technology, etc. With this resulting collection of biotech dregs, we would then construct a very diverse portfolio with a focus on limited position sizing in order to further manage risk. This was a very successful strategy over time.
I do think the SEC should pay more attention to selective and misleading disclosures, particularly around clinical trial construction (where the “goal line” is often moved) and data read-outs. Beyond that, I think biotech markets would be much healthier if the Federal Reserve would respect market economics and allow for actual interest rates.
You have run a number of successful small cap activist campaigns -- Salary.com, Vitesse Semiconductor, and Immersion to name a few. What are some of the common problems you see at small cap companies and what should individual investors do to spot or avoid them?
The world of small caps is full of undervalued companies. Unfortunately, most of these companies are “cheap” for a reason. That is, management and board governance are often very weak with entrenched interests and no urgency to unlock value. This is where small cap activists can be very helpful.
The typical small cap board member often 1) owns little of the company’s equity (= no skin-in-the-game), 2) is retired and enjoys the steady income that board comp provides, and 3) has become friends with the CEO (or already was one!) and the rest of the board. While not a bad actor per se, this typical director is basically just mailing it in. They’re rarely interested in rocking the boat in terms of shaking up management, reforming operations, or selling the business.
An activist can sometimes change the trajectory of a board even with just one or two representatives, as they can lead by example and their presence can often be enough to spur other directors to do the right thing. Unfortunately, the sitting CEO, who is usually the chief beneficiary of the gravy train, will sometimes seek to create mischief and undermine these efforts, usually with the help of board allies. This can make change much more difficult to accomplish and/or stretch out the time required.
The recent growth in passive investing combined with new diversity and other social agenda mandates only makes the job of activists more difficult, as it is now common for many of the top 5 or 10 holders of a small cap stock to be holders like Vanguard, State Street, and Blackrock. These passive investors rarely seek to rock the boat and usually seek to “split the baby” in proxy contests.
I am peripherally involved with two current small cap activist projects that highlight some of the prevalent opportunities and issues:
- Comtech (CMTL): Outerbridge is leading a proxy fight against an entrenched 85-year-old CEO and a close-knit board that until recently had an average age of around 75 years. The business and stock have performed poorly for years, even though the company’s municipal 911 database business is a gem (with numerous potential buyers), and the satellite business finally has growth tailwinds. Despite a compelling message, Outerbridge’s biggest challenge is going to be convincing the passive holders of 30%+ of CMTL to support the necessary wholesale change.
- QAD Software (QADA): Nantahala is leading a legal effort against the take-private acquisition of QADA by private equity firm Thoma Bravo. Nantahala argues that QADA ran a limited sales process due to the desire of the company’s controlling shareholder, Pamela Lopker, to roll her equity in a deal, thus limiting the range of possible buyers. Nantahala also uncovered that Lopker, along with the co-chair of the special committee in charge of evaluating strategic alternatives, bought a private jet together during the sales process!! Ironically, if QADA’s board had just reformed the company’s governance on its own, the stock would probably be trading at similar levels to Thoma Bravo’s takeout price. The court should throw the book at QADA.
Finally, individual investors rarely pay attention to the board or read the proxy. That’s a mistake. They should understand how much equity each director owns (excluding options), how long they’ve been on the board, and how many other boards they serve on (and which ones). With work, you can scope out the (more common) “career” board members from the (rare) “entrepreneurial owners.” The proxy also contains a trove of great data on management and board comp and incentives.
Wall Street typically focuses a lot on modeling and financial statements. You have been in the trenches founding companies, growing companies, selling companies, serving on the boards of companies, going activist on companies, and now making venture investments in companies. Has being in the trenches changed your view on investing and do you see common themes Wall Street misses by focusing on numbers too much?
Absolutely. Once you’ve run a business and dealt with payroll, product deadlines, customer issues, et al, you quickly realize that not everything runs in nice quarterly increments – specifically for smaller, less mature companies. Having this experience provides a valuable edge and is one that most investment analysts lack. See John Train’s classic article, “How Mr. Womack Made A Killing”, for a fun example of this in action.
At Raging Capital, rather than referring to consensus estimates, we often focused on whether the lumpy results of some of our small cap and venture investments were “directionally correct” or not. In one case, one of our venture investments literally missed probably 75% of its quarterly budgets over five years, yet it still grew into a large successful business that sold for $1 billion!
Also, regarding small cap investing, I think many investors do not understand the importance of product cycle cadence. One-hit companies will often spend years investing in their next generation product(s), typically while growth slows and at the expense of margins, only to then see growth re-accelerate and margins expand once the product comes to market. Understanding this cycle can be very profitable.
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