SumZero plays host to several thousand buyside funds that each have a unique strategy and perspective on the market. From time to time we enjoy highlighting selected funds and engaging them in dialogue for the benefit of all investors. Today we are pleased to present a Q&A with the heads of Two Fish Management, a $385mm Indianapolis-based asset manager.
Founded in December 2007, Two Fish Management, LLC is an options focused investment management firm that aims to provide excess risk-adjusted investment returns over conventional benchmarks through a variety of unique strategies for individuals, independent financial advisors, broker/dealers and institutions. Two Fish Management is managed by two, long-time SumZero members, Mike Morris and JR Sauder.
Mike Morris Bio:
Mike founded Two Fish Management in December 2007, directing fundamental research and security selection for the firm. Prior to forming Two Fish, Mike served as the Director of Investment Research for KSM Capital Advisors. He started his career as a consultant with Tucker Alan focused on S.E.C. accounting fraud investigations and damages valuations. Mike received his B.S. in Finance and Accounting, magna cum laude from Indiana University’s Kelley School of Business. While at Indiana, Mike was a Collegiate Rugby All-American.
JR Sauder Bio:
JR founded Two Fish Management in December 2007. His primary role at Two Fish is managing the trade desk and reviewing securities from a technical perspective. Prior to forming Two Fish, JR worked as a business valuation analyst for Katz, Sapper & Miller in Indianapolis and was the financial manager at Odyssey Ventures in San Francisco. He holds an undergraduate degree in economics from Princeton University and while in school, played football for four years.
Nicholas Kapur, SumZero: Let’s get it started with a look at one of your firm’s largest positions, Sears Holdings (SHLD:US), Eddie Lampert’s long-term turnaround play. This is a stock that has pulverized investors’ ability to be patient as the world waits for the thesis to materialize. What do you see now that others don’t see (or are no longer willing to believe)?
Mike Morris, Two Fish Management: We are typically attracted to sum-of-the parts situations where a potential restructuring of an asset base can provide shareholder value significantly greater than the going concern valuation. SHLD fits this profile for us where the downside / bear case is well articulated from a going concern perspective, but an asset view of the company offers positive optionality.
There are reasonable valuation estimates of SHLD’s top 500 properties at values per square foot ranging from $50-$150 per square foot, depending on the location, state of distress, etc. However, the top locations provide asymmetry in terms of redevelopment potential. In our view, Lampert has made the logical decision to not re-invest cash flow into a deteriorating retail concept and explore higher and better uses for the asset base. We also believe the market underestimates the strategic value of some Sears Holding’s mall locations to Simon Property Group (SPG:US) and the potential for a REIT conversion over time.
Nicholas Kapur, SumZero: What key criteria are you looking at to determine whether your thesis is gaining traction?
Mike Morris, Two Fish Management: We will continue to monitor sales of properties, leases and business lines to see how they compare to the imbedded valuation in the market.
Nicholas Kapur, SumZero: eBay (EBAY:US) is another big position for you. What’s your stance on the current war between Carl Icahn and eBay management?
JR Sauder, Two Fish Management: We love it. In our opinion, Carl Icahn is right and PayPal should be spun out to highlight its value. We invested in eBay primarily for PayPal and its potential as a standalone business; which we believe is enormous. Although we could foresee a situation where PayPal is spun out and is bought by Apple (AAPL:US), Google (GOOG:US), or Amazon (AMZN:US) relatively quickly, the bigger issue that Icahn raises is poor corporate governance. The Skype transaction and existing Board member’s conflicts of interest are legitimate concerns.
Mike Morris, Two Fish Management: Most corporate boards are focused on the stability and growth of the “enterprise” as opposed to the return on equity. Perpetuating the “enterprise” is great for highly paid executives and board members, but not necessarily for shareholders.
Nicholas Kapur, SumZero: You’ve published an exhaustive analysis of Barrick Gold (ABX:US) on SumZero several months back, and I believe you’re quite bullish on the stock today. What’s the foundation of your thesis there?
Mike Morris, Two Fish Management: We find Barrick’s domestic assets to be materially mispriced relative to Goldcorp (GG:US), providing a margin of safety even at lower gold prices. This is a company that generated $1 billion of operating cash flow in Q4 2013. If they continue to reign in their capital expenditures on value destroying growth projects like Pascua Lama, this company can generate significant free cash flow over the next few years even at current gold prices.
Nicholas Kapur, SumZero: What is your outlook on the price of gold, by the way?
JR Sauder, Two Fish Management: I’d say we are agnostic right now on gold. That sounds like I don’t want to answer your question, but our thesis on the gold miners and Barrick, in particular, has little to do with the price of gold. If I had to pick a direction, our belief is that real interest rates will stay flat or decline which should provide support for gold prices over the next year and longer, but in the short run I have no idea.
Nicholas Kapur, SumZero: Your fund was recently short Lululemon (LULU:US). What’s your current outlook on the company given the attempted turnaround at the top end?
Mike Morris, Two Fish Management: We covered the majority of our short position at $49 in late January. Our short was almost entirely based on valuation and increasing competitive pressure from Athleta and others. There are better short opportunities now in retail – valuations are extreme in certain areas – Under Armour (UA:US) is a good current example trading at 38x trailing EBITDA.
Nicholas Kapur, SumZero: Care to expand on that?
Mike Morris, Two Fish Management: Under Amour is an incredible success story from a business growth perspective, but has only generated $120 million of operating cash flow over the last 12 months, which is supporting an $11 billion enterprise value or 92x operating cash flow. This is a highly competitive space (e.g. Nike (NKE:US) and Adidas (ADS:GR)) whose alternative products could depress merchandise margins over time. In addition to valuation concerns, we have observed some aggressive accounting by the company including booking a “bargain purchase” gain from a large real estate purchase in their “operating” income in 2011. From a capital allocation perspective, we question why the company would borrow $100 million to help finance its Map My Fitness acquisition in late 2013 when its stock provides more attractive acquisition currency. More broadly, the market is valuing consumer discretionary stocks as if they are fast growing consumer staples. The reality is that demand for these types of products is cyclical and levered to general economic conditions.
Nicholas Kapur, SumZero: Are we in a bubble right now?
JR Sauder, Two Fish Management: Probably, but people think you are crazy if you answer yes to that question because “this time is different.” After reading Michael Lewis’ The Big Short, I would say the crazier people think you are for saying it is a bubble, the closer it is to popping. There is some uncomfortable data that has come out recently.
First, margin debt is back at all-time highs. Second, Chinese exports were down 18% in February year over year. As Jeremy Grantham mentioned in his last GMO letter, we can go higher. I think he said we needed to go up another 30% to officially be in a bubble based on their models. His larger point of the good news seems to be priced in we are in agreement with.
Nicholas Kapur, SumZero: What’s your most compelling short right now?
Mike Morris, Two Fish Management: Deutsche Bank (DB:US) remains our most compelling short, primarily from a portfolio perspective. Metaphorically, DB is a proxy for the global financial / credit system and provides significant downside optionality to global credit strains. This global bank carries stated leverage of 29x equity, 6 years after Lehman!!! We believe DB will have to de-lever over time, pressuring returns on equity.
Nicholas Kapur, SumZero: Name one Fortune 500 CEO that should be replaced. Why?
Mike Morris, Two Fish Management: Peabody Energy ’s (BTU:US) management team is on the list for leveraging up the balance sheet at the top of the cycle in 2011 to buy Macarthur Coal. We see these “pro-cyclical” deals repeated over and over with natural resource companies. Cliffs and Barrick are other examples.
J.R. Sauder, Two Fish Management: Speaking of Barrick, they are in the news again for a proposed merger with Newmont. While we believe the combined company would have North American mines (specifically in Nevada) throwing off significant cash flow. However, our confidence in ABX's current board and management team to cut costs and reduce bureaucracy is close to zero.
Mike Morris, Two Fish Management: Case in point, they are now reversing course and discussing a spin of their Australian-Pacific mines with Newmont’s Asian assets. We and many other analysts recommended a spin-off of these assets, yet they recently completed sales of some of these mines at cyclically low valuations. We would love to know the cost of the McKinsey study that John Thornton (new Chairman) ordered in December 2013 (per Bloomberg) – hopefully not as much as his signing bonus – especially since they are coming to the same conclusions we outlined in our August 2013 white paper.
Nicholas Kapur, SumZero: Forget stock price. What’s the most impressive large-cap company out there today on an all-around level, i.e. quality of product, management, performance, etc.?
Mike Morris, Two Fish Management: Liberty Media (LMCA/B:US) has been extremely impressive in terms of its wealth creation for shareholders. From 2006-2013, the stock provided a 36% annualized return to shareholders, including all spin-offs. The company has frequently repurchased shares well below net asset value, which enhanced returns. We appreciate Liberty’s focus on avoiding corporate taxes by spinning off assets rather than selling them to other companies or financial buyers. We also like their willingness to use their balance sheet / debt markets to acquire stable high cash flow margin businesses like satellite radio and cable.
Nicholas Kapur, SumZero: Let’s talk about your fund a bit. What’s makes the Two Fish process unique?
Mike Morris, Two Fish Management: We focus on “unique” securities that are uncorrelated with the market and other securities in the portfolio due to the catalyst itself or an attribute of the business (e.g., gold stocks).
JR Sauder, Two Fish Management: We rarely buy underlying stock in a company to initiate a position unless we think some sort of catalyst (a buyout, a spin-off, etc.) is imminent. If we can’t identify a catalyst in the near term we will sell put options to initiate a position. Thus, we are creating our own catalyst by selecting the options expiration date. Currently we are selling short duration (30 days or less) options because of our view that the market is overvalued and we aren’t getting adequately compensated to add longer duration exposure. If the long end of the VIX curve increases, we are not opposed to locking in long dated options.
Nicholas Kapur, SumZero: What’s the genesis of the fund name, Two Fish?
JR Sauder, Two Fish Management: The name Two Fish comes from the Biblical account of Christ feeding the multitudes with two fish and five loaves. For us, it lets people know what is important to me and Mike and it is a great example of resourcefulness and stewardship; and the power of compounding!
Nicholas Kapur, SumZero: What are your favorite sources of news/information?
Mike Morris, Two Fish Management: Value Line, Barron’s, Value Investor Insight, Magic Formula
Nicholas Kapur, SumZero: What do you read on a regular basis?
JR Sauder, Two Fish Management: During the trading day, I am monitoring Twitter on a regular basis. It is a great source for current info. On the weekends, I read Barron’s and then all the articles or stories I wanted to read during the week, but didn’t get to.
Nicholas Kapur, SumZero: What is one work process you’ve incorporated into your routine that you’d endorse for others?
JR Sauder, Two Fish Management: An important routine is tracking your daily profit and losses. This seems obvious, but holding yourself accountable to your results on a daily basis is a good discipline. Not that you will make a bunch of adjustments if you lose money for a few days in a row, but if a few days turns into a few weeks, then we need to start discussing changes.
Nicholas Kapur, SumZero: What is the worst tendency you see in many investment managers that can easily be overcome?
Mike Morris, Two Fish Management: Letting theory drive decision making. Data and empiricism should drive decision making.
Nicholas Kapur, SumZero: What’s the most important thing a professional investor should know before he/she decides to get into the industry?
JR Sauder, Two Fish Management: Their business is not going to play out exactly how they sketched it out on the back or a napkin and their financials aren’t going to look exactly like the pro forma they put together. That’s all part of it. Be flexible and listen to what the marketplace is telling them.
Mike Morris, Two Fish Management: They need to understand that starting an investment firm / fund is an entrepreneurial venture. Your business plan is as critical as your investment performance or research quality.
Nicholas Kapur, SumZero: I personally believe that knowing when to sell is much harder than knowing when to buy. What is your ‘sell’ process like?
JR Sauder, Two Fish Management: We would agree with you; knowing when to sell is much tougher. This is actually one of the reasons we like to use options. We will let the market determine if we are going to stay in a position or if that position has expired worthless. When we do own common stock, there is typically a catalyst that we are expecting. As long as that thesis is intact, we will hold the position. If the catalyst happens or we have new information that tells us that it is unlikely to happen, we will exit.
Nicholas Kapur, SumZero: What book (financial or not) has had the most profound effect on the way in which you do your job?
Mike Morris, Two Fish Management: Education of a Speculator had a profound impact on me in terms of approaching the markets from a data-driven empirical perspective.
JR Sauder, Two Fish Management: Moneyball because it’s about thinking differently and finding value in what others undervalue.
Nicholas Kapur, SumZero: Name two fish that got away. What lessons did you learn?
Mike Morris, Two Fish Management: (1) Not loading up on Liberty Capital / Media in 2009 when the stock traded at a massive discount to a sum of the parts valuation. We were concerned that discretionary type assets would continue to suffer short-term, due to the macro environment and sold $20 strike puts instead of purchasing the underlying equity. This mistake made us look more closely at sum of the parts stories and minority interest discounts (e.g., VOD, NWSA, YHOO) as core underlying holdings.
(2) Positioning our Hedged High Yield strategy slightly net short (at the money dollar delta) at certain points from late 2011 to early 2012. The market drawdown from the U.S. credit rating downgrade in August 2011 was a good reminder of the mark-to-market volatility of a derivatives book. This experience resulted in an overly defensive stance on our net equity exposure through early 2012. Our reaction has been to manage the strategy as a “pure-alpha” market neutral approach rather than having a beta tilt.
Nicholas Kapur, SumZero: Who’s the most underrated investment figure that people should study more?
Mike Morris, Two Fish Management: Henry Singleton’s track record from Teledyne (TDY:US) is a model for how a CEO should be a long-term market maker in his own stock to enhance returns for shareholders. There is a great chapter dedicated to his life in the book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. During Singleton’s reign, Teledyne’s average P/E was over 25 when the company issued stock and was under 8 when he repurchased stock.
DISCLOSURE: As of April 15th, 2014 Two Fish Management LLC holds the following positions: longs SHLD, EBAY, AAPL, ABX, LMCA, NWSA, VOD and BTU shorts DB, UA, AMZN and LULU. Positions are subject to change.
IMPORTANT DISCLOSURE INFORMATION
Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Two Fish) will be profitable, equal any historical performance level(s), or prove successful. Opinions and positions are as of a specific date and are subject to change without notice. A copy of Two Fish's current written disclosure statement discussing its advisory services and fees is available upon request.