Idea Brunch with Sean Westropp of Deep Sail Capital
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Sean Westropp!
Sean is currently the chief investment officer of Deep Sail Capital, a long/short equity fund launched to outside investors in July 2022. Deep Sail focuses on microcaps, special situations, and quality growth on the long side and potential frauds, pump and dumps, and fads on the short side. Sean is also active @DeepSailCapital on Twitter.
Editor’s Note: Sunday’s Idea Brunch is looking for more talented untraditional investors to interview. If you know of someone magical, please email email@example.com or hit reply!
Sean, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch Deep Sail Capital?
Thanks for having me on Edwin! I have a diverse background with both investing and corporate experience. I have spent most of my life, since my teenage years, as an investor in public markets. Over the course of the years, I have tried many investment strategies, including technical trading, options strategies, forex, crypto, angel investing, value investing, and growth investing.
I decided to launch Deep Sail Capital in 2021 after running a predecessor incubator fund for several years. Deep Sail Capital Partners LP utilizes a long-short equity strategy with a natural bias towards net long. Our strategy is best described as a “growth at a reasonable price” (GARP) strategy within a portfolio of 15–25 longs and 20–40 shorts. Our long portfolio is broken into three areas of focus: quality, microcaps, and special situations. Our approach combines rigorous fundamental analysis with deep analysis of business models, industry dynamics, and management effectiveness, which allows us to identify undervalued companies poised for significant growth.
In your fund launch letter, you wrote that Deep Sail will “try to fish in the right ponds.” What are the “right ponds” for you and your fund?
At Deep Sail Capital, we use two separate criteria to determine what “the right pond” is for us to fish in. The first set of criteria is our industry focus. I have selected industries that have historically high returns on capital invested, stable growth trajectories, high barriers to entry, and little commodity exposure. These include industries like software, payments, e-commerce, gaming, medical devices, financial services, tobacco and spirits, luxury apparel, and serial acquirers.
The second set of filter criteria we use for companies that fall within our industry focus is our Four Pillars of an Exceptional Investment. These pillars are how we evaluate all the investments, both on the long and short sides. The four pillars are: 1) a high-quality business model; 2) outstanding management; 3) substantial long-term growth prospects; and 4) reasonable valuation.
By limiting the fund’s investable universe to our focus industries and further overlaying our four pillars of exceptional investment, I believe we will end up with a group of stellar businesses with reasonable valuations. This positions our long portfolio with an above-average chance to outperform over the long term.
Deep Sail Capital has a robust short book of 20 to 40 names and has had a lot of success shorting frauds and fads over the last year. What is your approach to managing your short book? And what are some of the common red flags you look for in short ideas?
The fund’s short-book strategy and tactics have evolved over the years, largely driven by my own mistakes and successes. The short portfolio provides both a source of alpha and a way to increase leverage on our long portfolio while keeping our beta largely hedged. Our short portfolio generally has between 20 and 40 short positions at a time, and our maximum exposure to a single short position is 3% of NAV. We do this mainly to avoid single short positions blowing up on us and causing significant negative impacts on our performance. By keeping individual short exposure small, we can hold short positions through painful short-term volatility or short squeezes.
In all our short positions, valuation is a key component. Our short positions must have valuations that we believe are at least 100% higher than what we believe to be the fair value of the company. In many cases, the valuations of our short positions are many times more overvalued than what we believe is fair value. However, we do not view valuation alone when evaluating a short position. We use a set of short criteria that all short positions must meet. An example of this criteria is that we will not short anything that has a short-borrow rate above 30%.
On top of our valuation and our short criteria, we look specifically for short positions that have company-specific catalysts approaching. Other red flags we look for in short positions include highly promotional management, companies that chase fads, serial equity dilutors, companies that pay for promotional research, and companies that continually underdeliver.
There are plenty of good places to look for shorts. I will highlight a few here that I feel are great starting places.
IPO Hangovers. IPOs are designed to inflate the valuations of companies; that’s literally the job of IPO investment banks. IPOs are structured in such a way that the float is generally constrained right after the IPO and then slowly eased. Low-float IPOs are especially good at manipulating the float (see $GPRO, $SHAK, $TLRY, and $ARM). According to my historical analysis and experience, the best time to short an IPO is approximately 2 to 2.5 months prior to the IPO lockup date, which is usually 6 months after the IPO date, but check the filings for confirmation. Examples right now include CAVA Group (NYSE: CAVA — $3.76 billion) and Mobileye (NASDAQ: MBLY — $27.8 billion).
Industry Bubbles. Industry bubbles are when an entire industry gets "hot" and inflated, usually on the back of retail excitement for a "new industry." Examples of this are the cannabis bubble, the EV bubble, the metaverse bubble, or what seems to be the current AI bubble. The best way to short these types of industry bubbles is usually using a basket approach, in which you select 4 to 6 individual stocks in the bubble to short. Examples right now are eVOTL companies like Archer Aviation (NYSE: ACHR — $1.31 billion), Joby Aviation (NYSE: JOBY — $4.32 billion), and Eve Air Mobility (NYSE: EVEX — $2.15 billion).
Pump and dumps. These are usually obvious and can even be identified by watching disclosures around paid promotions. Pump and dump schemes typically involve management needing capital to further invest in the business, so they embark on a promotional campaign to artificially inflate stock prices (all of which is legal if properly disclosed). These are generally small-cap stocks in which the float is already tight, so any buying may drive up the price a lot. Once the price is up, management will generally drop a share offering or some type of funding raise on the market to take advantage of the higher share price. This will then end the promotional campaign and dilute shareholders, which will drop the share price. Some companies are so good at this that they do it every few years. An example right now is Innodata (NASDAQ: INOD — $194 million).
Growth Deceleration. It is incredibly hard for a high-growth company (+30% revenue growth per year) to grow over a long period of time. There are very few companies or business models that I have found that are able to do that. It’s even harder for hypergrowth companies (+50% revenue growth per year) to not slow significantly at some point. Being able to determine the point at which growth slows and thus the stock re-rates can be an excellent short-term strategy. An example right now is Duolingo (NASDAQ: DUOL — $6.65 billion).
You have a pretty diverse portfolio – ranging from a microcap construction supply company (AEP.V) to a large Argentine e-commerce company (MELI). How are you able to come up with off-the-beaten-path ideas in an industry with so much groupthink?
At Deep Sail Capital, our long portfolio is broken into three buckets: quality, microcaps, and special situations. This strategy, plus our small size, allows us to venture into parts of the market where many other investors might not be comfortable. When it comes to our search process, we use a mix of screeners, my investor network, Twitter, and thematic-driven ideas.
We use screeners to help us screen for our industry focus and the four pillars of an exceptional investment that I discussed earlier. Through screens, we focus on the fundamentals of the business and then evaluation and valuation later. We are not looking for the cheapest equity within our investment universe. We are looking for the best, highest-quality businesses at a reasonable valuation.
My investor network has grown over the years through interacting with fund managers or private investors that I respect. I do my best to share my best ideas with them, and they do the same with me. Anyone is welcome to share ideas with me or ask my opinion on an investment idea on Twitter @deepsailcapital or via email at firstname.lastname@example.org.
What are two or three interesting ideas on your radar now?
I’ve got three contrarian ideas to share!
1/ Inmode (NASDAQ: INMD — $1.72 billion) is an Israel-based medical device company that sells minimally invasive RF technologies to offer a comprehensive line of products across several categories for plastic surgery, gynecology, dermatology, otolaryngology, and ophthalmology.