Idea Brunch with Yaron Naymark of 1 Main Capital

Yaron Naymark Shares His Experience Launching a Fund, Research Process, and Two New 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 second issue with Yaron Naymark, CIO and Founder of 1 Main Capital!

1 Main Capital is a long-biased investment partnership that invests primarily in high-quality, attractively valued, growing businesses. Prior to founding 1 Main Capital, Yaron accumulated more than a decade of investing experience at multi-billion-dollar value-oriented public and private equity firms. Since its February 2018 inception, 1 Main Capital is up 180% net of fees compared to 69% for the S&P 500.

Yaron, how has your experience been launching a small hedge fund, and what has contributed to your strong initial performance?

Launching a fund has been a lot of fun. Being subscale has of course led to some challenges, but I found them to be manageable based on life circumstances (decent savings, low burn rate, long time horizon).

On the other hand, launching with no institutional capital really let me build my firm and strategy in a way that suits my personality best. When funds market to big LPs, they typically get asked lots of questions that may put the manager in a box: What market cap do you invest in, what sectors, what gross / net do you run, how big is a max position? For me, launching at my size allowed me to experiment in an unconstrained way to find what worked best for me, because by prioritizing returns over marketing I believe I will end up with a more marketable product.

Having never run a portfolio on my own before launch, experimentation was important for me. Of course, I learned a lot from people I worked for and with at prior funds. I incorporated a lot of those learnings into my philosophy. I was also confident I was a good stock picker. I just had to tinker with the process to find what worked best for me. At my size, I was able to start with lower gross / net exposures on day-1 and increase both over time as I saw how the portfolio (and I) behaved in periods of market volatility. I was also able to tweak the list of investment characteristics that were non-negotiable for me in my core holdings.

Now, when I talk to larger potential investors about the strategy, I can tell them this is what I have done, and I am confident in knowing that it performs. I have not put myself in a box that I can’t get myself out of. I believe that the advantages that come with starting on a clean canvas will be enduring, while the challenges of starting at a small scale are already beginning to subside (as we continue to grow). So, I am excited to see what the next 5 years look like for 1 Main.

You seem to have a knack for finding off-the-beaten-path companies before they become popular like RCI Hospitality (RICK) in 2018. How do you come up with original ideas in an industry with a lot of groupthink?

To be honest, my process doesn’t lead me to search for off-the-beaten-path companies. I am just genuinely curious and intrigued by studying businesses and management teams so am willing to look at anything (including names that are off-the-beaten-path). Whenever someone mentions a new product or service they love, my mind starts to think about what the market opportunity looks like, what the capital and margin profile of the business looks like, what it would be worth if it was public, etc.

This natural curiosity makes it equally likely for me to study a business no one has heard of or a mega-cap that everyone knows and has an opinion on. I genuinely don’t care how well-followed a company is or isn’t. I just want to understand it from my perspective and there is really no substitute for doing your own work because as the saying goes, “you can borrow someone’s ideas but you can’t borrow their conviction.” For me, this is my life’s work – I’m not looking for any shortcuts. This approach of building my own conviction also makes me a lot more confident to hold these positions through ups and downs.

The only requirements for something to make it into the portfolio as a core position, are that it meets certain quality and return thresholds. Basically, we are looking for 25%+ IRRs in predictable, well-run, well-capitalized businesses that are leaders in growing and rational end-markets and that are reasonably valued on earnings or free cash flow 3-5 years out.

In the case of RICK, we were buying our shares at a mid-single-digit free cash flow multiple, with the expectation that the business would be able to compound FCF per share at a 20% CAGR over time. In the case of KKR, we were buying our shares at a high-single to low double-digit multiple of owners earning with similar expectations for per-share earnings growth. In both cases, the businesses were well-capitalized, well-run, and open-ended growth strategies with attractive returns on incremental capital. Whenever we come across opportunities with those characteristics, I get excited and can’t wait to study the business. Importantly, despite us earning nice returns on these holdings so far, we are still very excited about the future, and both remain large positions for 1 Main Capital today.

What is an interesting idea on your radar now?

I like Mastech Digital (NYSE: MHH — $199 million), which is an IT staffing company that was spun out of iGATE in 2008. After selling iGATE to Capgemini for $4 billion in 2015, MHH’s founders, who together own ~60% of the company, turned their attention to growing MHH. They hired a new CEO, Vivek Gupta, in 2016 who is executing on a playbook to transform the company into a higher growth, higher margin IT consulting business. The company has tripled adj EPS since Vivek took over, and I think will triple it again in the next 3-5 years while hopefully benefiting from multiple expansion.

The staffing business segment, which makes up a majority of MHH’s profits today, “rents” consultants to companies like Accenture on the wholesale side and Verizon on the retail side of the business to help them fill their temporary IT needs. A typical consultant is billed out at $77 per hour, generating around $150k of annual revenue for MHH at approximately 20% gross margins. Occasionally, clients choose to hire a consultant on a full-time basis, at which point they pay MHH a permanent placement fee at 100% gross margins, though this makes up less than 1% of total revenues. This business grows well in excess of GDP with minimal capital requirements.

The Data & Analytics segment (D&A) was established in 2017 when MHH acquired InfoTrellis for $36 million. In this segment, MHH takes on specific projects for its customers to help solve specific and defined business problems using data & analytics tools that it helps them build. A typical project here is $500k to $15 million, with a duration of a few months to a few years, and, since there is much more value add provided by MHH, gross margins are around 50%, or 2.5x the levels of staffing margins. Revenue growth and margins in this segment are a function of investment, but at steady state the operating margins here should be mid-20s, or 3-4x the levels of staffing. Currently, the business is aggressively investing to expand its capabilities and sales team, so margins are temporarily depressed. 

While each of these segments should grow nicely organically over time due to growing global IT spend, with MHH we have the added benefit of investing alongside a management team that has a proven ability to reinvest earnings at very attractive returns. In fact, MHH has deployed over $50 million into M&A to build the D&A segment since 2017, at an effective purchase multiple of 5x normalized EBIT.  To do this, the company leverages its expansive network and industry experience of its leadership to find potential targets and then bids for them using a shared-risk approach to purchase price by using earn-outs and contingent consideration — which is something we did a lot in my Private Equity days but something you don’t see many public companies doing, especially small caps. MHH can then cross-sell its other capabilities into the acquired customer base, leading to revenue synergies which it does not pay for. In short, management thinks and acts like owners. They integrate these assets well, and they will likely repeat this M&A playbook for the next handful of years to create a lot of value for shareholders. As I said earlier, I think they can triple adj EPS to mid $3s in the coming years and that is without ever leveraging up the company in any meaningful way. For the right target, I think they would take leverage up and grow earnings even faster.

That sounds interesting. Are there any other names you are excited about at the moment?

Yes, I am really excited about Malibu Boats (NASDAQ: MBUU — $1.48 billion), which is a leading manufacturer of ski/wake boats as well as recreational boats. Ski and wake is an incredibly attractive subsegment of the overall boating market. It has been taking share from other segments of the boating market for a long time, as people seek to lead more active lifestyles (skiing, wakeboarding, wake surfing, etc.). On top of that, three players control pretty much the entire market, due to years and years of R&D to ensure the perfect type of wake, as well as brand awareness driven by professional skiers and wakeboarders. These competitors behave very rationally. The result is what I like to call secular-cyclical growth. Of course, overall boating demand is cyclical, but within these cycles, ski/wake is secularly taking share at very attractive unit economics.

Specifically, MBUU has averaged over 30% ROEs since coming public. Better yet, the company converts a very high percentage of its earnings into FCF and has shown an impressive ability to reinvest those earnings into tangential offerings and M&A in other secularly growing parts of the boating market.

Malibu is well-capitalized to withstand any economic volatility and be able to play offense when others are playing defense. On top of that, the company has a highly variable cost structure, allowing it to protect margins during downturns. On its Q4’19 call, management said that volumes would have to drop 80 to 90% before the company’s margins approached breakeven (instead of positive) territory. The company’s public peer, MasterCraft has delivered a similar message as well.

However, despite its ability to withstand economic volatility, MBUU is benefitting from the strongest demand management has ever experienced. During the pandemic, boating demand skyrocketed to the point where manufacturers like MBUU are still unable to fill all their orders. On its most recent earnings call, the company mentioned that channel inventory would not be back to normal levels until fiscal 2023.

Naturally in such a strong demand environment, investors are worried that we are at “peak” boating demand while at the same time also fretting about near-term supply chain challenges. People also worry that higher rates will dampen boating demand — something I agree with for many segments of boating but not ski/wake which are sold to high-net-worth individuals less reliant on low rates to make the math work.

In total, I think investors are missing the big picture: the market is giving us an opportunity to buy an exceptionally strong brand with attractive returns on capital, a strong management team and secular growth for a single-digit unlevered earnings multiple. Earnings and FCF visibility in the coming years are very high, meaning that before we even know what happens to boating demand in 2024 and beyond the company will have generated a very substantial portion of its enterprise value in cash. For these reasons, I really like the risk-reward for MBUU at 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?

Before I start to research any new idea, it must first make its way through a mental filter that I have developed over many years. It is important to quickly say no to ideas that aren’t a fit so that time isn’t wasted on those and is instead diverted towards maintenance diligence on existing holdings and diligence on new ideas. For example, I avoid businesses in hyper-competitive industries, shrinking end markets, and businesses with a high degree of financial leverage — so I can quickly say no to those as they come across my radar.

Once past the initial filter, my process usually begins with reading a recent 10-K or S-1. In other situations, I open the most recent investor presentation and event transcript. From there, my curiosity can take me anywhere: Reddit message boards, sell-side research, conversations with customers or former employees. Throughout my research, I try to better understand not only the business I am looking at, but its peers and competitors as well and whether I think management is high-quality. Finally, I put pen to paper to try to model what I think the business can look like in a financial sense over the coming years, before speaking with the company to help refine my thoughts further. Of course, investing is just as much art as science and so no two investments have the same exact process for research, but of course there are similarities in the things I look for and pattern recognition helps increase the velocity of sifting through ideas.

As for whether I do anything truly unique — the honest answer is no. I am hungry and competitive and am a very good business and management team analyst. I have a level-headed temperament that is helpful in making good decisions in periods of emotional duress. I am clearly not the only one who has those traits. That said, while my process isn’t unique per se, it is impossible for someone to copy or replicate my exact process because each investor sees the world through their own filter and experiences which are unique to that individual. Importantly, I am confident my process works for me in generating attractive returns without taking excessive risk and is repeatable over time and through various market cycles. That confidence is what makes me comfortable keeping pretty much my entire net worth invested alongside my LPs and looking forward to seeing what my 10- and 20-year track record look like when we get to those chapters in the book.

You have had some experience investing in small-cap deSPACs. What makes some SPACs attractive to you and has your view towards SPAC investing changed with some of the recent SPAC collapses?

Anyone who has studied SPACs for enough time should understand their pitfalls. As one of those students, I have been generally skeptical of this recent SPAC-attack. Specifically, SPACs that are bringing targets with limited operating history public using aggressive forward projections are, as a group, likely to perform very poorly in the coming years. That said, I was not immune to a de-SPAC-collapse of my own. I recently owned warrants of a de-SPAC that brought a PE-backed physical therapy provider public. In this situation, the target had a long operating history of stability, reinvestment and debt service, so in my view, it was more analyzable than one with limited operating history. Immediately after the deal closed, management disclosed material changes to the business and significantly took down the forward projections that it put out pre-close. These problems have put the company in an over-leverage situation which will make it challenging to dig its way out of the hole. When the facts change, I change my mind, so I exited the position on the day the issues were disclosed for a decent loss. My view on SPACs remains unchanged – I am a skeptic in general but am always open to finding the exception. I am also process (rather than outcomes) oriented and so will continue to look for situations that I think could generate attractive returns for my LPs and will not be deterred by a single bad result.

Yaron, thank you for the great interview! What is the best way for readers to follow or connect with you?

I am pretty responsive if you reach out to me on Twitter (@1MainCapital) or email (yaron@1maincapital.com).

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This newsletter is not investment advice and is for informational purposes only. You can reach the publisher by email at edwin@585research.com. This article is for premium subscribers of Sunday’s Idea Brunch newsletter. If this article was forwarded to you, please consider becoming a premium subscriber to receive interviews like this one every Sunday. Learn more here.