Idea Brunch with Matt Sweeney of Laughing Water Capital
Matt Sweeney on the path less traveled, special situations, and his top idea
Welcome to Sunday’s Idea Brunch, your weekly interview series with underfollowed investors and emerging managers. We are very excited to interview Matt Sweeney!
Matt is currently the managing partner and portfolio manager of Laughing Water Capital, a long-biased fund he launched in January 2016. Before launching Laughing Water Capital, Matt was a contributing author at Boyar Value Group and a director at Cantor Fitzgerald. Since its inception 6 years ago, Laughing Water Capital has compounded at 29% annualized, net of fees, compared to 15.5% for the Russell 2000.
Matt, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background, why you started Laughing Water Capital, and what has contributed to your strong performance?
I was very much a late-bloomer when it comes to investing. I didn’t grow up around the stock market, and I managed to graduate college as a history major having never taken a single accounting class, finance class, or business class. Despite this lack of formal education, my first real job after college was at Cantor Fitzgerald, a mid-tier brokerage and investment bank, working in the middle office of the institutional equities trading desk. If it had been normal times I would have been severely under-qualified, but this was days after 9/11 when Cantor lost more than 650 people. Within a few months, I had moved to the trading floor as an equity salesperson, where I was forced to learn in real-time.
The experience on the trading floor and as a salesperson was an excellent way to learn what NOT to do if the goal is to beat the market. This was a commission-generating role. The best customers owned 300 stocks and churned their portfolios all the time. The job was very much inducing people to trade by pointing out companies that “missed” earnings, or when a sell-side analyst changed their opinion on a stock. The trading floor was fun and loud and exciting, but after a year or two I figured out how insane it all was. Here I was at 24 years old, with zero ability to analyze a business, calling up portfolio managers who managed billions of dollars and telling them they should buy or sell based on a one penny earnings miss or beat… and they would listen to me! I secretly knew that I had no idea what I was talking about, so why were these people listening to me?
Thankfully I got pointed in the right direction by a trader at The Royce Funds, which is a small-cap value fund. I was told that if I was smart enough to realize that running around screaming buy! Sell! Etc. every time the wind blew in a different direction was crazy, then I was smart enough to start reading Ben Graham, Warren Buffett, Joel Greenblatt, and some of the other modern masters of investing. I took the advice and dove into the investing classics with both feet, and pretty much immediately was hooked.
From there it was the better part of a decade of going home after work and spending time on weekends learning accounting, reading 10Ks, studying businesses, reading past investment pitches by great investors, going through the CFA program, studying behavioral economics, and writing up ideas and sending them to anyone who would critique them in order to help me learn and improve as an investor. Slowly but surely my own style developed and my confidence grew to the point that I was ready to launch Laughing Water Capital in early 2016.
Over the preceding decade or so I had met and read about many investors who crushed the market in no small part by putting the odds of success strongly in their favor, and I was determined to do the same with LWC. This meant deliberately choosing to stay small, ignoring the indexes, having a super high hurdle rate for inclusion in the portfolio, and being sure to only accept limited partners that fully understand the difference between the value of a business and the price that business may be afforded by the stock market. I view these attributes as sustainable competitive advantages that are very obvious, yet unattainable for most investors. However, they are foundational to LWC and have contributed greatly to our past performance.
In your great interview with The Acquirers Podcast you said, “In the best case we can find an underappreciated compounder at a special situation price.” Can you expand on this? What are some of the common themes that cause high-quality companies to trade cheap?
I am broadly of the view that most of the time the market is efficient. More often than not stocks are priced appropriately. However, there are certain fact patterns that are fairly reliable in terms of indicating that a security may be mispriced. The bible of this sort of special situation value investing is of course You Can Be A Stock Market Genius by Joel Greenblatt. Greenblatt lays out what to look for in the classic special situation setups, with spin-offs being the most well-known. Without going through the mechanics of spin-offs or other setups here, the idea is that there is some set of conditions that easily explain WHY the stock might be cheap. I am of the view that if you don’t have a strong answer to the question, “why am I so lucky to find this incredible opportunity” then you are likely the patsy at the poker table. Answering this question is a big part of my process, and if the answer has anything to do with valuation, you are likely playing with fire. It amazes me how many pitches are out there that essentially boil down to, “it is trading at 16x earnings, and it should be trading at 20x” or something similar.
In my view, multiple expansion is not a thesis. Multiple expansion can only ever be a cherry on top of either 1) some fundamental improvement to the earnings power of the business, or the perception of the earnings power of the business or 2) a cessation in forced selling by some other shareholder that is dealing with some sort of structural constraint that forces them to act irrationally.
If you can come up with a reason why the earnings power of the business is misunderstood by the market, or if you can identify why a seller is acting irrationally, then you have a great place to start. From there, for me it is then about focusing on situations with the least amount of variables in between where the business is today, and the future state where the earnings power of the business has fundamentally improved.
There is nothing wrong at all with growth as a means to improve earnings power, but in my view, there are a lot of variables involved. You have to have the right product, at the right price, meeting the right need, with the right cost structure, and the right operating leverage. Even if you get all of that right, you are still entirely dependent on the behavior of your customers, who themselves are dealing with their own set of variables. A lot can go wrong with all of these variables, and typically if there is a perception of future growth, you are paying a high price, which means the cost of failure is high.
LWC is diversified across what I call the value spectrum, meaning that we do have some investments that are more tied to a thesis of underappreciated growth potential, but there is a heavier weighting to investments that come down to one or two key variables. In the best cases, these variables will be entirely in the hands of properly incentivized individuals who can drive earnings power by simply flicking a switch.
The example I always use to illustrate this idea is what I call “good co / bad co,” where there will be one business that has two segments that are in different parts of their life cycle or are of differing quality. If one segment earns $1 a share, and the other segment loses $0.50 a share, on a consolidated basis the business earns $0.50 per share, and the market will likely put some multiple on that consolidated earnings power.
In a world where according to JP Morgan 80% of investors are relying on quantitative metrics to drive their investment decision making, it is only a small minority of investors that will take the time to look under the hood and appreciate that to an intelligent business person a stock such as this should be valued more on the earnings power of the $1 a share segment rather than on the consolidated earnings power. Putting a multiple on the consolidated number effectively capitalizes the value of the bad co as a negative value indefinitely. But that’s not how it works in the real world if you have a management team that is properly incentivized.
For example, if we were talking about a business that is still 20% owned by the founding CEO, and the founding CEO has been open that he is experimenting with a new business line (the bad co) that will likely lose money for a period of time, it is very likely that this bad co will not be a drag on the Company forever. At some point, the bad co will either reach maturity and become a net contributor to consolidated earnings power, or it will be shut down, in which case the earnings power of the good co can shine through unobstructed. In both cases the earnings power of the entity will effectively double based on this one variable, assuming that the good co has a reasonable competitive position. When this happens, not only will the consolidated earnings power effectively double, but the company will now be an easier to understand pure-play, and the market loves simplicity, which will likely contribute to multiple expansion.
“Good co / bad co” is perhaps the cleanest way to think about these types of situations, but I always keep my eyes open for other similar permutations where there is an easily understandable reason why the company might be mispriced, and a path toward increased earnings power that relies more on a single variable tied to human behavior rather than dozens of variables tied to the behavior of complex organizations like competitors and customers.
In the best cases, the good co. will have high returns on capital and a long runway for continued reinvestment in the business, so that this good co. can remain in the portfolio as a compounder for many years to come.
You have a pretty diverse portfolio – ranging from a microcap sweetener company to a U.K. homebuilder. How are you able to come up with off-the-beaten-path ideas in an industry with so much groupthink?
The key here is structural. As mentioned previously, LWC is specifically designed to ignore the broader indexes, except considering them as useful reference points over multi-year periods. There is a ton of evidence to suggest that the best managers over longer periods of time frequently underperform the markets over shorter periods of time. This is because, with the exception of the last few years where what has been most popular has performed the best, to outperform in the long run, investors have historically been best served by buying what is out of favor rather than what is most popular. If you are intentionally buying what is unpopular, it is not very likely that your portfolio will win a short-term popularity contest. There is a ton of academic evidence to support this view, and while at only 6 years LWC’s track record is arguably not yet relevant in this context to date we have only beaten the market about 50% of the time when measured on a quarterly basis.
Despite all of this evidence, most professional investors are forced into a short-term game by limited partners that may pull their money during a period of underperformance. LWC is specifically looking for the eclectic and the anomalous, which is a real luxury. We are not beholden to the indexes, so we are free to range far and wide in pursuit of truly anomalous opportunities that are not at all related to the indexes.
What is an interesting idea on your radar right now?
The world is in an uncertain place right now. Of course, I would say there is always some uncertainty, but between inflation, interest rates, supply chain problems, and war in Europe, I would argue that investors would be well served by being a bit more cautious than usual. At the same time, I have no ability to time the market, and I don’t believe anyone else does either, so cowering in fear is not a good option. Despite all the uncertainty, it is still totally possible that the fearful headlines of the day will quickly fade, and the world will enter into a “roaring 20s” type period. The range of potential outcomes is very wide at the moment.
While I am hopeful that the roaring 20s are just around the corner, “hope” is not an investment strategy, and I am leaning more toward businesses and stocks that can thrive in difficult periods, yet still do well in upside scenarios. They are perhaps less likely to be “homerun investments” but they have a very high on-base percentage looking out over the intermediate-term regardless of what else happens in the world. An example would be Countryside Partnerships (London: CSP — GBP1.44 billion), which is a UK-based homebuilder.