Top-Ranked Deep Value Manager's Latest Small-Cap Idea

John Rolfe, the founder and managing member of Argand Capital Advisors, has been one of SumZero's most prodigious and best performing members. Over the last decade, he has submitted 50 ideas to SumZero, generating an annualized average total return of 39.32% and an annualized median return of 32.05%. Prior to launching Argand in 2001, Rolfe served as a principal at Fir Tree Partners. He holds an MBA from Wharton, and degrees from the University of Florida and Virginia Tech.

Rolfe's fund is based in Stowe, VT., where he routinely skies before the market open. SumZero sat down with Rolfe to discuss Argand Capital Advisors, portfolio management, and his most recent idea on Martinrea International ($MRE:CN).

Kevin Harris, SumZero: What is the story behind the launch of Argand Capital Advisors?  What led you to strike off on your own?

John Rolfe, Managing Member and Founder of Argand Capital: I launched Argand Capital Advisors with a partner, Michael Marone, in 2001. The two of us had met while we were both working in DLJ’s investment bank in the mid-1990s. We both left DLJ around the same time. I went to Fir Tree Partners, which at that point was a $100mm fund focused primarily on global activist equity investing. Michael went to Emerald Partners, a value-oriented fund that had been started by two folks from Mutual Shares. We each spent 3-4 years at those respective firms, at which point we decided that we wanted to try it on our own. We were both coming out of relatively small firms, so had a lot of exposure to not only the investing side of the business, but also the marketing and operations. We felt that we stood a pretty good chance of making a go of it on our own. We were relatively young, and didn’t have a big fixed cost base, so decided that the time was right. We started with about $1.5mm of friends and family money, a couple of computers, and a couple of phones. We co-managed both the portfolio and the business through 2008, at which point Michael decided to go in-house at a larger firm. I continued on a sole-managed basis after that.

Harris: What advice do you have for investment professionals who may want to launch their own funds?  What is the best advice you received on launching Argand, and what would you advise your past self to do differently?

Rolfe: Unfortunately, the price of entry has gone up dramatically to the extent you want to attract institutional money. Expectations changed drastically post-Madoff. Institutions now require an administrator, and often want to see operations support (a CFO) and possibly analytical support (an analyst). So, the burn rate for the business right out of the gate is much higher than 20 years ago. It’s much harder now to bootstrap the business and cover all the functions with just one or two people. The exception is if you are comfortable running a friends-and-family fund, and have the ability to circle money solely from high net worth investors, as opposed to institutions. The best advice we got on launch was not to screw up the returns in our first year. If you do that, the chances of long-term success drop dramatically, because you’ll have a terrible time getting any traction raising assets. If we had to do thing differently, we would have focused more resources on marketing in the early days. We naively supposed that if we posted good returns, money would naturally follow, but it doesn’t always work out that way. In many cases, it makes sense to give away a piece of the economics to an external marketer in order to get access to institutional and/or high net worth money that otherwise wouldn’t give you the time of day. At the end of the day, it’s better to own 70% of something than 100% of nothing.

Harris: During your time on SumZero, you’ve topped our All-Time, Long, Deep Value, and Consumer Rankings.  Your ideas have an average total return of 39.38%, a return vs. benchmark of 17.28%, and an annualized median return of 31.82%.  To what do you ascribe your outperformance? What is your advice for other investment professionals?

Rolfe: I would say that a common theme among many of my ideas is that they generate substantial cash flow. Stock prices may meander, and market value may disconnect from intrinsic value for extended periods of time, but as long as the business has strong underlying cash flows, it will have the wherewithal to weather these periods, and should have a decent measure of downside protection. This increases your overall optionality, because it naturally gives you a longer time period for the market to ultimately properly value the business. There is no single “right” way to invest. There are many approaches that work. However, I would say that with respect to advice for other investment professionals it is important to have a clearly defined sense of what you look for, and how you want to invest. You need a firm internal compass that will let you sift through ideas quickly and zero in on the ones that make sense to dig in on vis-à-vis your investing style. If you don’t have this internal compass, you’ll spend a lot of time spinning your wheels on ideas that have a sexy sounding pitch/story, but at the end of the day will never make it into your portfolio.

Harris: Your most recent SumZero idea is on Martinrea International Inc. ($MRE:CN), an auto supplier which you had previously written up in Feb ‘17, and closed in Jan.‘18 for a 90% return.  Could you walk us through your thesis?

Rolfe: Martinrea is a Canadian-domiciled tier one automotive supplier that trades on 2019 numbers at roughly 3.5x EBITDA and 5x EPS. They have two primary businesses, metal forming and fluid handling systems. In the metal forming business, they are a major player in aluminum, which has great tailwinds as auto OEMs look to lightweight their vehicles to make them more fuel efficient. Although the company has 44 facilities spread across 4 continents, it is highly focused on North America, which accounts for roughly 80% of revenues. Martinrea was founded by Executive Chairman Rob Wildeboer and two colleagues from Magna in 2001. For the first ten years of its existence, management was very active buying distressed assets to assemble the current portfolio of capabilities. However, over the past five years they have pivoted to integrating and optimizing the existing footprint, which has helped drive operating margins from 3.8% (in 2014) to 6.4% (in 2017) in a relatively flat production volume environment. Margins are expected to continue expanding going forward, with a medium-term target of 8%. The improved operating performance has driven reduction in leverage, and improvements in both ROIC and ROE. New business wins have been accelerating in recent quarters, and there have been meaningful open market purchases of stock by members of senior management. In addition, the Company recently announced its first-ever normal course issuer bid. I find the management team to be thoughtful, accessible, and disciplined with respect to capital allocation.

Harris: How susceptible is Martinrea to the continued ratcheting up of trade tension between the US and Canada, particularly related to steel and aluminum?

Rolfe: The risk with respect to steel and aluminum tariffs is manageable. 95% of the steel in Martinrea’s auto business is on resale contracts, meaning that price is a pass-through to customers. Aluminum components are not on resale, but contract pricing is reset every 1-3 months, so risk to Martinrea is limited. Moreover, Martinrea’s North American plant footprint is well diversified across Canada, U.S., and Mexico, so it has a fair amount of flexibility when it comes to rebalancing manufacturing in order to address potential tariff issues. The company is exposed, though, to the risk of a broader trade war between the U.S. and Canada. I discuss this in greater detail below.

Harris: What do you perceive to be the biggest risk to your thesis?  What could go the most wrong?

Rolfe: The biggest risk at this point is that Canada and the U.S. cannot reach an agreement on NAFTA 2.0, the U.S. imposes 20-25% tariffs on vehicles produced in Canada, and the associated cost increases to U.S. consumers crater the auto market. I don’t consider this a likely outcome, as it is in both countries’ interest to get a deal done and, moreover, the auto industry (on both sides of the border) is too important (both symbolically and in actuality) to use as a sacrificial lamb. However, “logic” doesn’t always seem to come into play when it comes to the current occupant of the White House, so this outcome cannot be completely ruled out.

Harris: What is the most contrarian call that you’ve made during your investment career?  How did it turn out?

Rolfe: For that I have to go back to the financial crisis of 2008-09. For those who weren’t trading back then, it’s difficult to convey just how terrifying it was. You could be losing 3%, 4%, 5% of your equity value in the portfolio on any given day, and it was persistent from October 2008 through early March of 2009. There was real doubt as to whether the global financial system, as we knew it, was going to survive. There came a time after repeatedly being bludgeoned when I decided that if the system was going to fail, I would have bigger issues on my hands than portfolio performance. So, I took the other side of the bet, i.e. that a solution would be cobbled together and the pillars of the system wouldn’t ultimately crumble. I increased my overall exposure pretty materially, with a focus on those names I was familiar with that had been exceptionally brutalized. As we know, the system was saved. The repositioning led to an annual portfolio performance in 2009 for Argand that was orders of magnitude better than anything it has posted either before or since.

Harris: How concentrated do you run your portfolio?  What are your high-level thoughts regarding portfolio concentration?

Rolfe: Not particularly concentrated. A large position for me is 5%. An average position is closer to 3%. I understand the benefits of pushing high conviction bets; however, you also have to build a portfolio that you can live with day-to-day from an emotional standpoint. I don’t deal particularly well with downside volatility, so prefer to keep position sizing somewhat modest.

Harris: Would you describe yourself as a value investor?  What do you think is most misunderstood about the discipline of value investing today?  

Rolfe: Yes, absolutely. I think a lot of folks bifurcate the world into value and growth, but this doesn’t make sense to me. I define value investing as buying an asset at a discount to intrinsic value. Just because a business is growing quickly doesn’t mean you can’t buy it at a discount to intrinsic value. Assessments of that intrinsic value may have much greater variability for the faster growing business, but you may still be able to purchase it at a discount. I think you’ve seen a lot of folks who would traditionally consider themselves value investors buy into higher growth, higher multiple names over the last few years under the assumption that there are new paradigms emerging that will permit these businesses to maintain their rapid growth. To me, a more appropriate continuum would be value vs. momentum, where momentum (trend following) is agnostic to underlying value and just assumes that near-term trends will continue for some period of time. All that said, I remain firmly in the old school, low-multiple, downside asset protection school of value investing. I feel like it gives me greater margin of safety than the growthier type names.

Harris: What role do online research tools like SumZero play in your research process?  

Rolfe: I use them extensively. The writeups are a great source of idea flow. I try to at least read the elevator pitch for every new idea that gets posted. If that catches my attention, I’ll take a quick look at headline multiples, and if they seem reasonable I’ll go ahead and read the full writeup. The comment sections are also a good resource, since they often help quickly zero in on issues that others are aware of.

Harris: Where else do you see value in the market today?  Where else is Argand focusing?

Rolfe: The persistency of the bull market has made it reasonably difficult to find exciting new names. I’ve been doing a fair amount of work on the semiconductor capital equipment space (LRCX, AMAT, MKSI, etc.). The market has taken the entire sector to the woodshed, under the assumption that the coming couple of quarters represent the beginning of a longer-term downtrend, as opposed to a near-term trough. I think that there is a compelling argument to be made that the large, and increasing, role of semiconductors in virtually every area of our life has indeed made the industry less cyclical than it was historically (when it was tied primarily to the PC cycle). In addition, to-date, the capex volatility that is driving weakness for the next two quarters seems to be related entirely to timing shift on the capex spend, as opposed to cancellations.