Idea Brunch with Derek Brown of Dardanelles Capital
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Derek Brown!
Derek is currently the portfolio manager of Dardanelles Capital, a Boston-based long/short equity fund he founded in October 2022. Before launching Dardanelles, Derek worked as an analyst at Graham Partners, was a managing director at Fox Point Capital, worked in financial reporting at Lululemon during its IPO process, and was an associate at PE firm Advent International.
Derek, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch Dardanelles Capital?
Thanks for having me, Edwin! I grew up in Raleigh, North Carolina, far away from Wall Street. My mom was a teacher, and my dad was an accountant. My first exposure to business was working for my dad during summers in high school and college on audits throughout eastern North Carolina. I became fascinated with how companies worked, and what made one business better than another. I was often surprised at what I learned. I was a kid but still learned a ton about the importance of a financial model even though I had no idea what it was called at the time. Those early memories of learning from my dad how to reconcile inventory and tie out the financial statements proved to be important and tangible building blocks obviously for the path I have chosen.
I attended Davidson College and after college I spent two years as an investment banking analyst in Charlotte. After my stint in banking, I moved to Boston to join Advent International, a private equity firm. On my first day, a Managing Director asked me about “RONTA” (i.e., return on net tangible assets). I looked at him like he had three heads. I had a lot to learn, but that kicked off a journey over the subsequent 20 years and it helped shape my approach to identifying the companies that we invest in today.
After two years as an associate at Advent, the partners asked me to move to Vancouver to join the finance department at lululemon athletica and help prepare the company for an IPO on the Nasdaq. My accounting background was useful in assisting the company in compiling three years of historical financial statements from a hodge podge of computer systems and boxes of physical files! That said, I had no idea how fortunate I was at the time – being given an inside view of one of the great consumer businesses of the last 25 years. Shortly after the IPO in July 2007, I left for business school.
After graduating business school, I joined Fox Point Capital, a long/short hedge fund based in New York. For the subsequent 13 years, until starting Dardanelles Capital in 2022, I worked for two different fundamental equity hedge funds – Fox Point Capital and Graham Partners. They were great roles for me and a lot of fun. I was able to incorporate my forensic accounting skills, hunt for quality businesses, and love of consumer-centric businesses while at the same time developing an appreciation for the real-time and relentless scoreboard of the public markets – expectations, timing, analyst upgrades/downgrades, breaking news, and everything.
I have an entrepreneurial streak and always thought I would run my own fund. After eight successful years with Hal Berry – a friend and mentor – at Graham Partners, I knew the time was right to take the leap. Most assets in the market were being managed by passive strategies or short-term pod shops. Additionally, the hedge fund model that existed in the 2000s had morphed as the successful funds from that era had grown to much larger asset management firms that were not as nimble as they once were. Finally, the prior decade plus with zero or low interest rates that had provided a powerful backdrop for many long-biased investment management strategies was changing fast. The dynamic of weaker businesses being buoyed by cheap money was a real headwind to the fundamental long/short model that benefits from stronger businesses outperforming weaker businesses. With the zero-interest rate period coming to an end and the opportunity set much more conducive for a longer duration long/short strategy, I felt like the time was right to start my own firm.
There are a lot of long/short equity funds out there. What are some of the ways Dardanelles differentiates itself from the crowd?
The Dardanelles investment strategy is a throw-back to the hedge funds of the 1990s and 2000s. I came into the hedge fund business in the Tiger building at 101 Park Street and got to participate in some of Julian Robertson’s Monday idea lunches. Those early lessons – buying the best businesses in the world and shorting the worst – permeate our strategy, but we’ve also refined our approach to adapt to today’s market environment.
We focus on high-quality consumer-centric businesses that are in the middle of important, and often misunderstood, inflection points. I have focused on consumer-facing businesses for most of my career. We keep it simple. Our core criteria for a long investment are a business with 1) competitive advantages; 2) secular growth tailwinds; 3) management that understands the competitive advantage and allocates capital efficiently; and 4) an attractively priced stock due to a misunderstanding or an underappreciated upcoming fundamental inflection point. We approach each investment with an owner-operator mindset but seek opportunistic entry points to skew the risk/reward proposition and allow us to underwrite more attractive IRRs.
Our short portfolio contains businesses with structural challenges or deteriorating fundamentals not fully appreciated by other investors, which we anticipate will become apparent within the next twelve months. We apply a mosaic approach to our short investment process that incorporates detailed financial statement analysis; interviews of partners, suppliers, and competitors; competitive analysis; and analysis of management turnover and stock sales. Most of our short positions are in consumer-centric businesses, but short selling tends to be more of a horizontal endeavor where experience leads to pattern recognition. There is more in common with Valeant and Silvergate – two of the biggest winners on the short side during my career – than the industry classifications would suggest.
We’re also mindful that the market is larger than we are and look to optimize our approach by isolating idiosyncratic risks and minimizing market and factor tilts across the portfolio. Being long the 20 best businesses in the world and short the 40 worst businesses was a strategy that worked in the past but can lead to concentrated periods of excessive volatility in the market today. Our portfolio looks a bit different and has a healthy mix of compounders and emerging growth businesses – large and small – on the long side. And on the short side, we target secular decliners, overhyped businesses, and companies with existential risks. We’re not hunting for pure growth or value. We don’t think that way. But it is important, today more than ever, to understand what you own and the portfolio risks it presents.
You had the opportunity to work on the LULU IPO. Amazing. How has your past work experience influenced your investment process?
I was fortunate. Working closely with senior management teams so early in my career gave me an appreciation for the human element of businesses. Businesses are the sum of many small decisions made by individuals, who all have their own motivations and desires. We spend a lot of time thinking about governance and culture, which may not be as large a part of our investment process if not for my early work experiences.
Additionally, our investment process is rooted in the real world. In addition to a focus on the human aspect of a business, we recognize that businesses are much more than growth rates and margins that can easily be toggled in a spreadsheet. Building a great company is hard. When things get tough, we want to know why. When they come easy, we want to know if it’s sustainable. We emphasize the first principles of value creation – competitive advantages and secular growth drivers – in addition to governance and culture in our investment process as the ultimate drivers of the financial model. Starting from first principles, allows us to arrive at conclusions that can be different from many that begin their process in Excel or are only focused on what will drive the stock performance the day after an earnings report.
Two years into running the fund how has it been going? What have been some of the positive surprises or unexpected challenges so far?
First off, I love it. I’m incredibly proud of what we have built in two years, but it hasn’t been easy. The rewards from investing and success in an entrepreneurial venture do not come in smooth doses, which can magnify the ups-and-downs. Additionally, while I was prepared to wear many hats – CEO, chief marketer, head of human resources, etc. – in addition to analyst and PM, nobody could have prepared me for the demands on my time. I couldn’t have made it through the market and business volatility or the time crunch without an amazing team – both partners and employees – that are supportive, competent, and willing to bet on our firm’s future. This has been a welcome positive surprise.
When I launched Dardanelles, I had a hypothesis that I could scale up my investment strategy and process from the role of an analyst responsible for a handful of ideas to a full portfolio. This has largely gone according to plan, but as expected we’ve had challenging periods of time. I can think of two in particular – one for longs and one for shorts – that have allowed us to refine and tweak our strategy around the edges.
The first period took place in July 2023 when some of the most speculative pockets of the market rallied significantly, negatively impacting our short portfolio. We quickly learned that we had too much exposure to high short interest, volatile short positions that had high correlation to each other. As individual positions, these types of investments have been wonderful contributors for us over our careers, but we needed to tweak our strategy for the full portfolio. We are still focused on identifying the best possible shorts in the market but have stricter portfolio parameters around overall exposure to high short-interest stocks and have complemented the short portfolio with more “melting ice cube” businesses that have a different factor-profile.
The second period took place this spring. We found ourselves in too many complex investment theses that struggled when the U.S. consumer environment began to slowdown. There can be a gravitational pull to invest in “off-the-run” or “artisanal” alpha ideas to differentiate, but a simple, well-researched thesis is much more likely to succeed than the sum-of-the-parts that is never going to be unlocked or the turnaround that should succeed if only management “understood” what they needed to do. We have since enhanced our focus on our core criteria – competitively advantaged business with secular tailwinds and competent management teams at attractive prices.