Mistakes… I’ve had a few
At Somar we strive daily for continuous improvement to make sure the portfolio at market close is more compelling and has more upside than the portfolio at the start of the day. We use several tools for this: talking with management, direct observation, data science, reading, observing other people’s mistakes and analyzing our own mistakes.
This month we will share what we learned from some of the mistakes we’ve made since inception. After reading this letter you may be surprised how we have been able to deliver returns despite so many mistakes. That speaks to the quality and upside of the opportunities we are finding. We have found more attractive opportunities in the last 3 months that at any time in the life of the fund. That is a topic for another letter…
Mistake number 1: Outrageous Valuation is not protection enough for a short
We had a short position in a consumer technology company. It had an early lead in a growth market but not a defensible moat in our opinion. Leading competitors were developing alternative approaches and our short was losing market share. We expected market share losses to continue in the foreseeable future. Channel checks with customers and competitors corroborated these findings.
At 20x forward revenue we felt we had a very attractive short opportunity. The market was assuming the company would grow to serve substantially all of the market at maturity. While possible, we felt that was an extremely unlikely scenario: there are many additional competitors entering the market with superior offers. In H1 2017 a larger, growth-challenged technology company acquired our short at 30 x forward revenues and we had a very unprofitable position on our hands.
Our detailed post-mortem taught us important lessons. First, while financial considerations tend to rule investment decisions in the markets, they are not absolute. A CEO and a board struggling with growth issues and an unattractive equity story may be willing to overpay for an acquisition in the hopes of changing the narrative and buying more time to attempt a turnaround. Irrational financial decisions are easier to make for management teams and boards with other people’s money. Second, growth disappointment stories can take longer to play out and open themselves to acquisition outcomes. Third, valuation is a weak provider of margin of safety in short investments.
Mistake number 2: Larger operations have a higher probability for hiccups
Last year we built a position in Chipotle Mexican Grill. Our analysis showed a compelling risk reward as
they recovered from the e-coli and norovirus outbreaks from 2015. Our thesis was:
- Chipotle will be able to fully recover its customers as it revamped their operations and team (incl.
hiring Jim Marsden a top Food Safety expert) to prevent additional episodes in the future
- Superior customer value proposition, serving fresh wholesome food at low prices
- Still a lot of opportunity to expand its operations in both the US (to more than five thousand
restaurants from currently about two thousand) and International markets (where basically there are
no restaurants today)
- Industry leading unit economics with store ROIC of about 70% prior to the incident and about 30%
at current volumes
- Our Data science project tracks daily visits to restaurants and showed customers slowly returning to
the store and accepting a 5% price increase
On July 2017, an additional Norovirus incident occurred at a Virginia store. This led to a strong sell-off in
the stock and put in question the company’s ability to recover lost customers. In Chipotle’s defense, it
appears that the incident was caused by an employee not following the company’s protocol and coming to
work sick. That said, it affected the customers’ confidence in the company and slowed the traffic recovery.
Somar lost money and our returns suffered from it.
We didn’t appreciate how difficult it is for an operation with more than 2,000 stores to operate a flawless
operation that prevents all employees from breaching the protocol. Given the national exposure of a big
chain like Chipotle that makes it a very slow and bumpy recovery of confidence and traffic. Ultimately, this
makes it unlikely that Chipotle can fully recover its previous peak traffic. Our investment thesis didn’t
appropriately account for this.
Mistake number 3: Investment thesis can be wrong
Last year we invested in TripAdvisor which, we believed, provided a very compelling risk/reward based on
the following investment thesis:
- TripAdvisor will increase the monetization of its industry-leading traffic by assisting hotel shoppers
book their hotels [Instant Book] instead of just charging Cost per Click to its advertisers
- TripAdvisor can defend and expand its industry leading traffic moat: largest amount of reviews
offers fresher and more relevant information which attracts more traffic and reviewers in a virtuous
- Online travel is a growth industry offering mid-teens growth. TripAdvisor will continue to take
market share and grow faster than the industry
TripAdvisor’s management had been very deliberate and slow in the roll-out of Instant Book. Through our
data science checks we picked up on an acceleration of the roll-out to substantially all of the bookable hotels,
coupled with agreement with the largest hotel chains and online travel agencies. When TripAdvisor reported
its earnings, their hotel shopper growth had decelerated to a yearly rate of only 3%, not only lagging the
online travel market pace of mid-teens but also the overall travel market of mid-single digits. This put in
question our investment thesis and we could think of no good explanation. We were left with the conclusion
that TripAdvisor’s consumer proposition was not as compelling as we had judged it to be.
In the after-market the shares were trading down about mid to high single digits and we took that
opportunity to substantially sell our position. This served us well, as the stock fell even more the following
days. We lost money but we took comfort in being clear minded about identifying a problem with the thesis
and being quick to react to it. That saved Somar investors further losses.
As you can gather from these three examples we analyze in-depth our mistakes and learn from them. This
makes us better investors year after year. We are deep believers in continuous learning and the growth
mindset so well explored by Carol Dweck in the book we gave you last Christmas.