Exclusive with Fund Manager Chris Karlin (Aquitania Capital)

(Chris Karlin is a longstanding member of the SumZero Community)

Chris Karlin is the Managing Partner of Aquitania Capital Management. Aquitania seeks to maximize risk-adjusted returns by identifying and capitalizing on securities trading at values meaningfully divergent from their respective fair values by integrating an intensive fundamental research discipline, a private equity valuation methodology and an event-oriented perspective. Aquitania invests opportunistically across the capital structure and across geographies. Prior to founding Aquitania, Mr. Karlin worked at several investment firms including Farallon and First Pacific Advisors. He has been quoted in the Wall Street Journal and Bloomberg and is a SumZero contributor. He can be reached at chris@aquitaniacapital.com.

SumZero:As bond yields continue to fall and the earnings yield on stocks continues to rise, how willing are you to shoulder equity risk?

Chris Karlin: I am an absolute – as opposed to relative – value investor. My investment process is simply to assess the risks assumed in owning a given security and to determine if the expected return from the price converging from market to intrinsic value adequately compensates for assuming such risks.

As bond prices rise, and their respective yields continue to fall, the expected return often fails to compensate for the assumed risk. In contrast, as equity prices fall, and their earnings (or more specifically free cash flow) yields rise, they are more likely to offer adequate compensation for the risks assumed and are consequently attractive for purchase.

SumZero: What active steps are you taking to mitigate risk right now?

Chris Karlin: At Aquitania, risk is managed not through a quantitative model, but rather by thoroughly understanding the companies that we own. This is accomplished through an extensive due diligence process to understand each business and the ecosystem in which it operates.

The time to mitigate risk is not in times of crisis, as the price for mitigating risk then is dear. Rather, the time to mitigate risk is during times of complacency when the price for mitigating risk is cheap. This is done by trimming or exiting positions where the reward-to-risk has compressed due to price appreciation, adding to short positions at rich valuations and purchasing cheap put options. Ideally, times of crisis and market dislocations are to be used to take advantage of asset mispricing caused by others trying to mitigate risk and deploy capital. My goal is to manage the portfolio in a manner such that we can be a provider of liquidity in times of crisis – at a dear price to our counterparties.

SumZero: What are you doing, if anything, to capitalize on recent volatility in the market?

Chris Karlin: Most market participants equate volatility to risk. I do not. In my opinion, risk is the probability of a permanent impairment of capital. Risk can only be assessed by understanding the intrinsic value of the securities we own. Most investors are uneconomic trend followers that buy gainers and sell losers. Consequently, volatility creates opportunity, not risk as I can exploit the uneconomic selling of others as I look to deploy capital.

SumZero: What sectors are you avoiding now?

Chris Karlin: I am sector agnostic, but I have seen no value in long-term treasuries for some time now as I do not believe that the expected return adequately compensates for the assumed risk.

SumZero: Where are you finding the most compelling opportunities in the market?

Chris Karlin: I focus on identifying asset mispricing situations which leads me to consider both the unintentionally overlooked and the actively avoided. There are a decent number of both in the United States, particularly in the last month.

But the most compelling opportunities right now in my opinion are in Japan and Korea. I am finding plenty of companies in those markets with solid balance sheets, a track record of profitability and high free cash flow yields that are priced well below liquidation value. While the catalysts are not usually evident, these are situations with highly asymmetric reward-to-risk profiles. I may not know how large or when my return will come, but I am highly confident that I will not lose much in these positions.

SumZero: Do you feel that the latest technology craze is fundamentally sound/sustainable?

Chris Karlin: One of the best lessons I’ve learned as an investor is that you do not have to make a lot of decisions to be successful. Warren Buffett calls it waiting for the fat pitch. I have learned over the last 20 years that my investment edge is derived through intensively researching complex situations where such effort can give me an informational advantage over my counterparties.

Similarly, I’ve learned that it is an unnecessary distraction to spend too much time thinking about questions for which my answer will not impact my investments. Frankly, I’m not really sure even which technology craze is the latest! I’m no luddite, and I’m an extensive user of technology in my professional and personal life, but beyond noticing that it is has been a relatively easy financing market for startups and growth companies – which tends to be mean reverting – I have no insight or opinion on this.

SumZero: At a $60 billion valuation, what is your sentiment on shares of Facebook (Nasdaq: FB)?

Chris Karlin: I focus on the unintentionally overlooked and the actively avoided. Facebook is certainly not the former, although some who were disappointed that they did not receive riskless profits in the IPO may now be avoiding the stock. I think the underwriters did an exceptional job of maximizing value to the selling shareholders by capitalizing on the hype and demand in the marketplace. Typically, the IPO process is managed to put a small number of shares into the public float such that demand will far outstrip supply causing the price to rise. The money left on the table by the issuer can be viewed as a marketing expense and they retain the ability to issue additional shares at the prevailing market price. Facebook issued over 400 million shares in the IPO at a rich valuation. Investors who expected that demand would outstrip that supply and result in a large price gain just seems naïve. People continually make uneconomic decisions and Aquitania is designed to identify and capitalize on these mistakes, although I had no position in Facebook.

I am by no means an expert in Facebook. I think they have built a tremendous platform, but I think monetizing that platform will prove to be challenging because doing so will require them to exploit their users personal data and I think that is a very delicate path to follow between maximizing profitability and alienating your user base. Google does this more effectively, because most users don’t feel as exposed using Google as they do with Facebook.

Backing into valuation, if my goal is to earn a 15% IRR over the next 5 years, Facebook has to grow to a market cap of $120b from $60b today. To support such a valuation, revenues would likely have to grow to around $30b from $4b today, roughly a 50% CAGR with resulting EBITDA of $12-$14b vs. $2b today. Is this possible? Perhaps. They seem like a very smart group of people and should be commended for what they have built so far. But it is certainly not the fat pitch that I’m looking for.

SumZero: How has the Europe financial crises impacted your portfolio?

Chris Karlin: My portfolio is long-biased, so I have experienced some declines on the long equity side that have not been fully offset by my shorts. However, I had built up a large cash position over the last few months which not only tempered my losses, but also provided a liquidity pool to deploy into existing and new positions at what I believe are attractive prices.

SumZero: What is the most valuable piece of investment advice that you have ever received?

Chris Karlin: I’ve been extraordinarily fortunate in that I’ve worked with some outstanding investors and have had a chance to meet a good number of investors that I hold in high regard. My office is filled with their quotes to both remind and inspire me of the philosophical tenets of value investing. Essentially, value investing is behavioral, and the most valuable insights to me focus on that aspect as opposed to the mechanics of investing. I firmly believe that anyone can learn to practice the mechanics of value investing, but what separates the outstanding investor from the average is how they behave in both times of crisis and prosperity – and this is driven by behavioral characteristics that I believe are more innate than learned. The single best piece of investment advice that I believe captures this essence of value investing was articulated by Warren Buffett when he said “Be fearful when others are greedy and greedy when others are fearful.” And that is the founding principal on which I run Aquitania.

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