Hedge Fund Manager Interview Series - Ori Eyal

In November, we announced we would be conducting interviews with emerging hedge fund managers (defined as less than $250M in AUM) as a regular feature on the blog. It gives me great pleasure to bring you the second edition of those interviews.

Ori Eyal is the portfolio manager for Emerging Value Capital Management, a global value fund based in NYC with investments around the world. In a recent speech to students at NYU, he remarked "Most of my investing knowledge comes from studying Mr. Warren Buffett and his value investing philosophy." Since 2008, he has materially outperformed the S&P 500 and a comparable world index. This is a fantastic interview and we hope you enjoy it!

In addition, if you or the fund you work for would like to be interviewed for upcoming editions of the emerging manager series, please send me an email (hunter [at] distressed-debt-investing.com)

Tell us a little bit about your background and the people that influenced your investment style?

While I started out as a Computer Scientist, I was always interested in finance and economics. Around the year 2000 I read “The Essays of Warren Buffett” and became a value investing addict. Studying the writings of top value investors including Warren Buffett, Joel Greenblatt, and Seth Klarman has helped lay the foundations for my investment framework. The basic tenets of value investing make intuitive sense to me: buying something for less than its worth, investing within your circle of competence, demanding a large margin of safety, and the power of compounding over time.

Ever since, I have been on a journey to learn from the masters of value investing and to develop my global value investing framework. I earned my MBA at the University of Chicago’s Booth School of Business in 2006. I worked for Deutsche Bank as an analyst at one of their global investing funds. I also interned for several hedge funds, including Deephaven and Aquamarine.

In 2008, after a decade of developing and practicing my global value investing framework, I finally felt ready to launch my own fund, Emerging Value Capital Management (EVCM). EVCM is a long-biased global value fund. At EVCM, I strive to integrate my global value investing framework with the best practices and ideas from the value investors I have studied. My life savings are invested in EVCM fund so I “eat my own cooking.”

What were some takeaways from your experience with notable value investor Guy Spier?

I was very fortunate to work for Guy Spier at Aquamarine Fund while studying for my MBA. Guy Spier is an extremely talented and thoughtful investor who looks at the world as one global integrated market. Using his deep insights into how the world operates, and his latticework of mental models, Guy has been able to successfully identify and invest in some of the world’s greatest businesses.

At one point, Guy and I traveled to Israel together and we went to visit and research about 15 undiscovered companies in Israel. In some cases I think we were the first international investors that had ever visited them. Watching Guy interact with the management teams of these companies was a key learning event for me. He has the ability to quickly develop rapport with everyone in the room and get to the main business issues that each company faces. By the time the meeting is over, Guy has a better understanding of the business than the company management team does. Working for Guy helped me develop my global value investing framework. He taught me how to analyze great businesses and how to approach and interact with company management teams. He has been a great mentor, role model, and friend over the years. When I launched EVCM fund, Guy Spier was my biggest supporter and my first investor.

Zeke Ashton of Centaur Capital has also been a great mentor, teacher and friend. After I launched Emerging Value Capital, Zeke was kind enough to invite me to his office and has helped me further develop and refine my investment approach. Closely studying the fantastic investing framework that Zeke has developed as well as many of his specific investments, has been a tremendous learning experience for me. Particularly helpful has been studying Zeke’s excellent risk management framework and his covered call methodology.

I have also learned a lot (and continue to learn) from my interactions with great investors including Monish Pabrai, Whitney Tilson, Glenn Tongue, Mathew Richey, and Rick Reiss.

How do you balance "embracing short term volatility" and raising capital for a fund?

I don’t like volatility any more than other investors. However, I do recognize that some volatility is inevitable when investing in stocks. In general, all of my fund investors are disciplined, value oriented investors with a long term (multi-year) time horizon. Smart investors focus on the investing strategy and the logic and research behind the fund holdings while ignoring short term volatility in results. EVCM fund investors have earned a excellent return to date. Those that added capital when the fund had an occasional down month ended up earning fantastic returns.

You dedicate a substantial amount of your time and resources investing globally? Is that a function of the lower number of opportunities in the United States or more of sense that overseas markets are less efficient?

Even today, most value investing takes place in the U.S. and is applied to U.S. stocks. Having an international background, I became convinced that value investing can and should be applied to global markets. Therefore, one of the main tenets of my investment strategy at Emerging Value Fund is global value investing. I invest in various countries based on where I find the best investment opportunities. When I invest outside the U.S., I look for investment opportunities that are so attractive that they more than compensate me for bearing additional geo-political and macroeconomic risks. Portfolio construction is a bottom-up process driven by where I find the best investment opportunities at any given time. I don’t have a target allocation for any specific country. Rather, I keep my “idea radar” open for opportunities around the world in both developed and emerging countries. I search the world for the best investment opportunities and use them to construct the portfolio.

My favorite international investing theme is the growth in the number and in the wealth of emerging market consumers. It is one of the most powerful secular investment themes of which I am aware. As the emerging markets population urbanizes, it rapidly embraces capitalism, creates wealth for itself, and increases its purchasing power. To profit from this trend I seek to invest in businesses that sell to emerging market consumers. Willi-Food (discussed below) is an example of a company that is well positioned to benefit from this long term trend.

There are a few key benefits that EVCM fund expects to gain from global investing. These are currency diversification, exposure to emerging markets consumers, a larger investment opportunity set (more stocks and bonds to choose from) and less efficient asset prices (more mispriced assets to invest in). The Euro, the U.S. Dollar, the British Pound, and the Japanese Yen all face severe problems, making it difficult to determine which developed market currency is “the worst.” In general, I think that emerging market and commodity based currencies are likely to appreciate over time versus developed market currencies. Global investing allows me to diversify EVCM fund’s exposures between developed market currencies and, when possible, to shift our exposure from developed to emerging market currencies. In the best of cases, I can find investments in emerging markets where I expect to make a strong return both from the asset itself and from the local currency appreciating over time.

One of your main investment types is dubbed "Great Business at a Good Price" - can you give us an example or two today that would meet this criteria?

When evaluating potential investment opportunities, it helps to have a detailed framework or mental models for thinking about investing. My model tries to categorize investment opportunities into 4 different types:

• Great business at a good price
• Cheap Growth
• Special situation
• Global Macro

Obviously, real world investment situations are complex and don’t always exactly fit these models.

A good example of a current EVCM fund investment is Carrefour, the French retailer. It is the second largest retailer in the world, with operations in France, Spain, China, and Brazil. It is a great business, with a long history of profitability, and dividends, a strong balance sheet, a wide economic moat, and a recession resistant business model. At the same time, it is also a special situation investment. New management was instituted in 2007 by Colony Capital and Bernard Arnault and they are working hard to increase efficiency and cut costs. Also, there is a good chance they will spin off Carrefour’s significant real-estate assets into a separately listed company. I see a potential 50%+ upside when either of these 2 initiatives work out.

Do you prefer special situation investing? Where are you seeing the most opportunities amongst your various investment strategies?

Special situation investing is an attractive strategy that can provide high returns that are less correlated to the general market movement. Special situation also tend to have catalysts which unlock value when they occur. Having catalysts helps prevent the situation where you invest in an undervalued company and it remains undervalued for a long time. So yes, I like special situation, but I also like my other investment categories (great business, cheap growth, and global macro).

If you had to pick one investment today, that you had to hold for 10 years, what would it be?

That is a difficult question. The world today is changing at an accelerating rate which leads to the rapid erosion of economic moats. If forced to choose, I would pick Nestle which I believe is the world’s greatest business. Nestle is the world's leading food manufacturer with operations in more than 70 countries and with products in coffee, bottled water, milk and dietetics, prepared dishes, pet food, chocolate & confectionery and pharmaceuticals. Its brands include: Nescafe, Nestea, Nespresso, Carnation, Coffee Mate, Hot Pockets, Lean Cuisine, Kit-Kat, Dreyer’s Ice Cream, Eddy’s Ice Cream, Gerber baby food, Purina, Dog Chow and Friskies dog food. In addition, Nestle itself is an umbrella brand signifying quality and great taste to consumers around the world.

Nestle has excellent long term growth opportunities in emerging markets as the rising middle class shifts its discretionary spending to Nestlé’s brands.

I think Nestle is a safe way to invest in the growth of both developed and emerging market consumers and I expect that it will be larger, more dominant and more profitable 10 years from now.

Favorite long / short today? Reasons?

G. Willi-Food International (Nasdaq: WILC) is one of Israel's largest food importers with a focus on the Kosher and Health-Food segments. WILC designs, imports, manufactures, markets and distributes more than 1,000 food products. Products are sourced from 200+ suppliers throughout the world to more than 2,000 customers in Israel including all the major Israeli food retailers, wholesalers, and the Israeli defense forces. Imported products include: canned vegetables, fruits, pickles, canned fish, bakery products, lemon juice, high-quality oils, dried fruit, nuts, pasta, halva, coffee creamer, snacks, dairy products, noodles, and more. The Company adds 40-60 new products to its offerings each year.

In many cases, Willi-Food works with global food manufacturers to re-engineer both the food contents and the production lines into a kosher end-product. This end product is then imported and distributed in Israel under the Willi-Food brand. All Willi-Food products are certified Kosher according to strict rabbinical authorities, which positions Willi-Food as a strong competitor in the lucrative kosher products market. Although most of the Company’s products are sold under its own brand, Willi-Food distributes a variety of items from world-leading manufacturers, such as Completa coffee whitener (Netherlands), Zanetti cheese (Italy), Breda butter (Netherlands), Nobleza Gaucha Yerba Mate tea (Argentina), Lurpak “spreadable” butter (Denmark) and Arla Foods dairy products (Denmark). In addition, Will-Food provides some products on a private label basis.

While 80% of revenue is from Israel, the company's activities extend beyond importing into the Israeli market. Willi-Food distributes its products in both the USA and Europe and is actively working on expanding its sales in these and other international markets. The kosher food market is estimated to be over $14B/ year in the USA alone. It is growing at 15% per year and is underserved with few branded kosher products. Among others, kosher products appeal to Jews, Muslims, and Health conscious consumers. Willi-Food is actively targeting this huge international market and any success here could dramatically increase the company’s revenues and profits.

WILC is owned and managed by the Williger brothers who co-founded the company. They are conservative managers that have done a good job at slowly and steadily growing shareholder value. Under their management, revenue has grown from $30M in 1999 to $120M in 2010 while net income has grown from $1.8M in 1999 to $8M in 2010. I visited the company in Israel and I was favorably impressed by what I saw.

WILC’s market cap is $88M. The company has about half its market cap in net cash and is looking to deploy this cash to acquire a US distributor. Net of cash, WILC trades at 5X 2010 earnings, a cheap price for a profitable, growing, recession resistant business with strong competitive advantages (brand, distribution, kosher know-how, global supplier network), a team of experienced and proven owner-managers, and with an attractive growth runway (global kosher food market).

What is the greatest piece of investment advice you like to adhere to in managing a portfolio on a day-to-day basis?

The key to long-term wealth creation is not earning high returns. Rather, it is earning good returns while avoiding (or minimizing) the blow-ups. The biggest mistake that investors make is not investing in a conservative enough manner. The world is a dangerous place for capital. Inflation, expropriation, revolution, currency devaluation, industry declines, wars, natural disasters, depressions, market meltdowns, black swans, theft, fraud, and taxes all pose a constant and lurking threat to growing (or even just maintaining) wealth over time. In any given year, the probability of disaster is small. But over many years and decades anything that can go wrong eventually will.

As long as we can stay in the game, the long-term power of compounding will work in our favor. A 10% real annual return will multiply our money over 117 times in 50 years. But having even one single year with catastrophic losses undoes years of great performance. Simply put, the key to amassing wealth over time is avoiding catastrophic losses and never having to start over from scratch. When things go wrong, we can avoid catastrophic losses only by investing conservatively and without leverage. Conservative investing is like insurance—it seems like a waste of money until something bad happens and then you are glad to have it.

I see funds that use leverage (either at the portfolio level or by investing in highly levered companies), and I see funds that are too concentrated. Over the long run, leverage and excessive concentration usually end badly.

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Hedge Fund Manager Interview Series - Harris Kupperman Part II

Yesterday, we brought you the first part of a two part series interviewing hedge fund manager Harris Kupperman. After the interview, for those interested, Harris runs a fantastic blog: http://adventuresincapitalism.com/ that I suggest you check out. Enjoy the second part of the interview!

Are there any other 5 year trends outside of precious metals ? What do you think is the next gold going forward?

I have some theories of my own going forward and I’m buying some stuff but I’d really rather not jump in there. The problem is that the world wide economy is looking weak. Some countries are good and some are mediocre but a lot of countries are in really bad shape and it is really hard to get too optimistic on global GDP overall. I don’t think we’ll see global GDP decline much but it could muddle along for a decade. So it’s really hard to find real growth industries because the world is just not growing.

I think it’s more exciting to look at the specific economies that are really growing. You have places in Latin America and Asia that are really growing fast. These are small economies that are not as inter connected with the global economy yet and the asset prices are cheap. As an investor in these countries you can pick up a tailwind of GDP growth of 5 or 10% yoy. They are small economies and people don’t talk about them much but I think it’s exciting and that is really where I focus my energy now.

I’m sure there are a lot of over looked companies there.

Exactly, but I think you need that macro tailwind. Which means you need an economy that is growing 10% a year because then you are going to have growth in the economy and even more growth at the company level. It is just going to be really hard to find industries or companies that can grow in a stagnant economy so if you can focus on the few economies that are growing I think you will do quite well. There will always be a few countries out there doing well but you really want to have that tailwind.

Even harder to find companies that have yet to be discovered.

Right. Which is why some of these smaller economies are so much more interesting. Because $1b+ hedge funds can’t go there. A lot of the companies are $50-100m market cap or even smaller. It’s a place for people like me to figure out, not the big guys. So the pricing is much better.

How do you get around the communication and accounting standards?

You need to just go in there and not think of it like a western investor. You should spend a month or 2-3 weeks there and just approach it with an open mind. You should read my post on Mongolia if you haven’t yet.

I read that and I thought it was great. I thought there was a particularly interesting point regarding the accounting where you said at a certain point you need to just take a leap of faith and invest even if you don’t know what the accounting is yet.

There is accounting. There are numbers. There is research to do. If you go in there and make investments you have to assume that you are going to have a few problems. However, if in aggregate you buy the companies cheap you are likely going to do all right as a whole. Another important point is that if you are in a country, like Mongolia, where they don’ t have investors showing up and they don’t talk to shareholders and things aren’t all cleaned up and pretty in the accounting there is a good chance that there is no incentive for people to over state things like there is here. Besides, their motive is to understate things for taxes, not to overstate so that their stock options go up in value.

That is an interesting commentary you rarely hear about emerging markets. What do you guys think of technical analysis? Do you use anything like this?

It’s really hard when you are a fund trying to buy millions of shares of a small company and it is hard for you to really have a view on the chart pattern of a $50m market cap company. If you go in there and buy a few million dollars of stock your buying alone could dramatically affect the price action and impact the chart.

What do you like and dislike about being a hedge fund manager?

Just don’t like the marketing but I love everything else. I have been able to meet and work with some great people. I have learned a lot and I have gotten to travel all over the world. It is really a great thing in my mind. I just really don’t like dealing with marketing but nearly everything else is great.

I have some of the best investors in the world and some of them I talk to routinely. The marketing thing is just pointless though. You go to NY and do 50 meetings and get 4 or 5 guys who seem interested and at the end of 3-4 weeks of effort you get one guy who writes a check. I’ve gotten to the point where the fund is closed to new investors and I just don’t want to market and deal with nonsense. Marketing and sales used to take a quarter of my time and now I spend none of my time on that and it is the greatest thing ever.

The best way to grow assets is to put up consistent returns?

You know, I don’t even want to grow the fund. The fund is closed. It is funny though, since I’ve closed the fund I’ve had more investors than ever offering to give me money than when it was open. I’ve turned away lots of money. It’s a strange thing.

Is this because you don’t want the fund to get bigger and lower your opportunity set?

I just don’t want to deal with investors really. I had a bad experience in 2008 with a lot of redemptions and I just don’t want to repeat that. You know, if you are a big fund with large caps you can deal with redemptions by just selling and moving on. If you are a small cap guy though and own 5% to 30% of a company it is really hard to get redemptions. You create your own worst monster because as you sell you keep pushing it lower which is bad for everyone.

What advice would you give to someone else starting a small fund?

Just focus on the track record and ignore raising capital. Hire the best people you possibly can also. Don’t try to save money because it always costs more in the long run.

What’s the most profitable investment you’ve ever made?

That is hard to say. I was really early on uranium. I was in it before $16 and it went up to $145. The little producers naturally went up much more in percentage terms, so that was pretty amazing.

What was the worst investment you ever had?

Oh man…. we saw piles of FNM, LEH and BSC puts expire worthless. 2008 was the hardest year for me though, we started out good but then when equities started falling we began buying too soon. Something we liked a lot would be down 40% and then we’d buy some and it would go down another 75%. Those weren’t necessarily bad investments but it was painful. Shorting in general is just very very hard and stressful though. Most of my worst investments have been on the short side.

Any other memorable trades worth mentioning?

Energold was an interesting one. We had a big position that we started building early in 2007. At the end of 2008 it went from $5 to .55 and was trading at less than cash despite no debt and being fcf positive. When it went down to 0.55 we were buying and now it is back to about $3. I couldn’t believe it could be that cheap when it happened. I mean, it was trading at $5 and we thought it was cheap then. It was one of those rare gifts in the investment world. We missed it the first time because we weren’t aggressive enough in chasing after it. We just didn’t realize how good it was. Then we got a second chance. We got to buy shares at a fraction of our cost basis. It was crazy.

How do you generate ideas?

Mostly I am just lucky to have many friends who are smarter than me! I am always talking to people in the industry and that gets me lots of interesting companies to look at. Just asking who is taking market share, who is most respected, this is a great way to generate investment ideas. I never look to Wall Street though, I don’t talk to wall street analysts and I only know like a dozen fund managers. The less I am influenced by Wall Street the better in my mind.

How do you decide when to sell an investment?

That is a tough question as I always sell to soon; if someone bought only the companies I sold they would be a rich rich man! Generally I try to decide what to hold based on the opportunity set in front of me. Sometimes an idea goes up dramatically or something happens that changed your thesis and that makes the decision easier but generally I sell something when I have a better idea I’d rather put the capital into.

What do you do when you’ve had many investments in a row move against you?

Ultimately we are fundamental investors and when a stock gets cut in half that is when you realize if you know the company well or not. If you like a company at x price then at 0.5x you should like it even more. So when things move against us we try to buy more. We also always keep some cash around to help us in these situations. In the past we have used margin as well, although I am a bit scared of it, if deemed necessary I will margin up to be a buyer.

What is the largest position you have ever taken as a % of capital?

We’ve had a few big investments go our way. I remember putting 25% into US global and watching it go from $5 to $75. If you really want to generate outsized returns you need to put your high confidence trades on in big size so you are there when the time is right. We don’t typically take a small position. That is a test of your knowledge and conviction of the idea. If an idea we have is not worth putting at least 5% or more of our capital on then we will pass on it. If you are really doing your homework and you are disciplined then you will not find many opportunities worth purchasing. There are just so few truly amazing companies; they are so rare, that when you find them cheap you need to buy a lot of them. We very rarely just jump into a 25% position though. It usually starts out smaller and so we typically buy some because we like the business and our research shows the company is good. Then we go talk to management and are impressed and so we buy some more. Then we see how the next quarter goes and it is even ahead of what we thought they’d do, so we’ll buy even more. So a 25% position grows into that size. We measure the 25% of capital based on cost also, so if something goes up a bunch we don’t necessarily trim it just because it is up a lot. I think that is a mistake because if you trimming your larger positions you are inherently selling the investments that are working out best for you.

So far we have not gotten a 25% investment wrong. We have gotten a few 10% of capital ideas wrong though. We really only find a 25% of capital idea every couple years and so we know when we have something that is valuable when we do. We probably find an idea worthy of 5% of capital a few times a year, an idea worth 10% of capital maybe once a year if we are lucky but a 25% of capital idea comes along very rarely.

Do you think it was easier to make money in the markets now or 30-40 years ago?

I think it is a bit harder now since you need to do better research. Screening software and tools are free and so powerful now that if you want to find amazing situations you need to look for situations that don’t show up in financials because once the situation becomes apparent in the financials and shows the earnings power of the company then there are already 100 people looking at it. There are always opportunities though. One way to deal with competition is you can go to other countries. You can find companies at 1/3 book value, trading at a 2 p/e with 20% dividend yield if you go to the right countries and know where to look.

What is the best investing book ever written?

I read mostly history and biographies now. I used to read finance and accounting in the past but now much less frequently. If I had to pick one though I’d say Marc Faber’s Tomorrow’s Gold is the best book ever for investing. That book really helps you understand big picture themes and it is very well written. You can make good money finding cheap companies and many investors do very well with this strategy. When you find a really cheap company you will generally double your money, which is not bad. However, to make 10x or more on your investment you need to find big picture themes as well. Once you get those big themes right, and then find companies that benefit from that with good management teams, that is how you get 5-10x+ returns on an idea.

What do you like to do in your free time?

I am lucky to do what I love so I have been able to blend my traveling and reading with my business. Most of my free time I spend reading and traveling. I will take a friend for a week or two and go see somewhere new and interesting. We will rent a car and drive around, meet with some companies and see some interesting stuff. I really like to travel, I am on the road at least a third of the time, and I enjoy reading so that is what I try to do as much as I can.

Do you think you’ll be investing professionally until you’re old or do you think you’ll hang up the hat and retire at some point?

I haven’t given it much thought. I am having a great time though and so I have no intent to retire anytime soon. Even if retired, I would probably continue to do this with my own money. Honestly, I am not sure what I would do if I retired but I really am having fun doing this.

Thank you for your time Harris

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Hedge Fund Manager Interview Series

Over the last two of three months, I have toyed with the idea of doing something like Value Investor Insight for emerging hedge fund managers. Over the years I have met some truly incredible investors running smaller funds that most have never heard of. These investors are not trying to build an empire but are instead content to manage smaller pools of capital without the head ache or managing a $1b fund. Some of these investors have absolutely incredible track records and are full of investing wisdom. Because of a number of major projects I have going on across the sites (one will be announced Monday), I thought it better to start the series right here on the blog for all to see. I will be working with Shaun Noll, founder and managing partner of Stirling Capital Management -who did today's interview- to bring you a series of interviews over the next few months.

With that said, if you are a hedge fund manager with less than $100M of assets and would like exposure, please reach out to me (hunter [at] distressed-debt-investing.com). Or if you have a recommendation for a manager you would like to see interviewed, I can do the hard work and try to convince them to come on the site. Value, event driven, distressed - we welcome all!

I have been following Harris Kupperman for a while now and I am always impressed with his ability to foresee long term macro shifts and put those themes to work with deep fundamental company research. In addition to this, Harris is 100% self taught and built an incredible track record with a fund he started straight out of college. He is one of the best investors I have met when it comes to finding “small companies that will become big companies” and so it gives me great pleasure to introduce Harris Kupperman of Praetorian Capital. This is part 1 of the interview. Part 2 will go up tomorrow.

Please tell us how you got started investing Harris:

I had always been interested in economics and the markets but I first began investing in college. I started managing some family money and by the end of college was up more than tenfold on my money when the world was in free fall. After that, family and friends asked me to run their own money and the easiest way to do that was to start a hedge fund. So senior year of college I started my hedge fund.

So you started your fund very young. That is impressive and unusual.

The hedge fund kind of started itself in some ways. People would come to me and ask me to run $25k or $50k for them and so that is how I started the fund. We’ve done very well since the fund began and so here I am today.

So did you have any investment experience prior?

No previous investment experience, I just read a lot of books. I still read constantly, I typically read at least 10 books a month. In college, I was going to school but wasn’t putting much effort into my classes because I was so focused on investing.

I am completely self-taught though. When I was learning, one thing I would do is look at big investments made by great investors in the past that were successful. Then I would see how that idea performed over time and I learned what worked and why. I learned a tremendous amount by reverse engineering their trades and I think that helped me a lot.

How much money did you start the fund with If you don’t mind disclosing?

I started the fund with $90k but at the end of the first 6 months we were at $1m and then by the end of the first year we were at a few million. The fund’s size just ramped from there. I really never went out and tried to raise capital until 2008. I wanted to put together a 5 year track record first since I thought that would speak for itself. After a few years we had a very good track record though, in the top 1% of all funds out there. So we were making money for people and then people would come to me and say, “My friends want to invest in the fund also, what can you do?” and that is how the fund grew. I didn’t go to New York and do a lot of interviews and actively try to raise money, I probably should have in retrospect but I didn’t. I wasn’t trying to start a business for the sake of starting a business, I was doing it for the intellectual pursuit of what makes money in the market.

Of course spending time on investing money is better than spending time on marketing.

Yeah, I always thought that if the track record was good the money would come to you. And that is not quite the case. If you’re a contrarian it means you’re buying when other people hate it. So then when you go pitch the fund to potential investors they ask what you are buying and you tell them “X is what I’m buying and I know you don’t like it but here is why it makes sense”. It’s tough to raise money that way because you know they are going to think you are crazy.

I guess that is one of the natural side effects of being contrarian.

Of course and I’m also not investing in big companies people have heard of. I am investing in tiny esoteric situations nobody knows about that have a lot of upside potential. While there is great potential in these areas it just makes for a difficult sales pitch to your average New York investor or institution.

What kind of investing were you focused on when you started? Sounds like long/short equity?

Basically our specialty, and I say “our” since I have a couple people working for me, but our specialty is finding little companies that will become big companies. We look for a secular or macro trend where we have the wind at our back, then we try to find the best couple companies in that industry. We get to know management well and then we get to REALLY know the industry, and when we feel comfortable we take a big position. We are not a highly diversified fund, at any given point we hold somewhere between 10 and 20 stocks and the top 5 positions are more than half our capital. There just aren’t that many good situations out there. When you get to know a company and really like it, you want to have a big position. It takes a tremendous amount of work for each idea and so you want to be there in size when we find something we like.

We have always focused on small companies though. I simply feel that is the best way to compound returns over the long term. If you look at the 500 largest publicly traded companies in the US, over the last 100 years you would have compounded at roughly 7%. If you look at the next 1500 companies you would have seen compounded returns of nearly 12% and if you look at even smaller companies it gets better. The compounded average returns of the next 1000 companies are nearly 20%. The crazy thing is that everybody knows this as it has been demonstrated in academic studies over and over and over again. The problem is that in small caps you are going to have a year every 3 to 5 years where the entire sector gets wiped out and is down 20% or more. If you are trying to run a money management business you may not survive that year as investors redeem from your fund and you have to sell into declining and less liquid stocks. What if your fund’s first year is that year where small caps decline dramatically? Your fund will likely never get a second chance and that will be the end right there. So everyone knows that small companies generate higher returns over time but it is a difficult strategy to implement for these reasons and so we choose to focus in this area. There just isn’t as much competition.

Do you use leverage?

We have but it is not really what we like to do. A small amount of leverage won’t kill you but if you take on too much it gets very dangerous and makes the fund more difficult to manage.

So you are long only? You don’t talk very much about shorting stock.

No, in the past we have been very short. A few years ago, we saw a lot of the problems coming that hit in 2008, so from early 2006 we were actually net short. This was quite frustrating though as our long book would be up over 100% a year and then we’d give back a good chunk of that on the short side. This was a very frustrating experience because you see crazy frauds keep going up when it is so clear they are a disaster. We ended up being broadly right but after that experience I decided I never really want to be on the short side again. It is very easy to look at a cheap stock and say this thing is going to go higher because the company is growing earnings very fast. It is much more difficult however to time when an over leveraged or fraudulent business is going to finally fall apart. There are so many great little businesses out there also that we have decided to primarily focus on buying these companies as opposed to shorting.

I think that is understandable and we have heard similar thinking from other very successful investors. Not to mention that psychologically it is much harder to manage that side of the book.

Exactly, and if you are good you don’t necessarily need to look for bad companies. Since we are in small caps which are relatively binary, when you get one of these right you’re going to make 5-10x your money. This is not the way shorting works though as you’re not going to make 5x returns on the short side. Maybe you’ll make 50% instead. As a result of this and everything else we don’t focus on the short side anymore. Of course we always have some stuff we are looking at on the short side and if we came across something amazingly bad we might put on a smaller position but we are pretty much long only at this point.

Do you ever put on any macro hedges? There have been a lot of the more famous investors talking about this lately. This would be the Seth Klarman or David Einhorn approach with a generally long only strategy but with a few cheap insurance policies for protection.

The thing about insurance is that you have to pay a premium for it. If you think about it you are going to compound better if you don’t go out there and pay up for protection because protection is generally priced for the guy who is selling it. The fund is friend and family money and my own money is a big piece of the fund so we can take a lot of volatility and don’t have to focus on smoothing out our returns. I just don’t see a reason to be hedging and over paying for insurance since we are looking out and trying to figure out what is going to happen over the next 5-10 years and not trying to generate low vol returns so I can market to someone else. I’ve seen way too many funds try to do that try and squeeze out 200bps a month, every single month, just so they can go try and raise $2b. That may be a great business strategy but it is not very intellectually satisfying so we don’t focus on that.

Sounds like you’re style has changed quite a bit over last 10 years then?

I wouldn’t say it’s changed a whole lot. We don’t short much anymore because we just decided we didn’t want to be on the short side anymore. Honestly, I don’t think there is much money to be made on the short side anyway these days. If I felt like there was a very pregnant opportunity I’d probably put more energy into it but I just don’t feel like there is much downside from here generally.

Why do you say that? I would say that is pretty contrarian in itself. Do you think the global situation is pretty stable?

I don’t know. It was so obvious before, just so blatantly obvious. You had to be a fool not to see it. I just don’t feel like the problems are as obvious anymore. Companies have decent balance sheets more or less. There are lots of problems lurking out there but there is not the systemic risk in the same way.

I think the primary risks now are government issues and governments misbehaving. They are over leveraged, over regulating and just acting idiotic. I think the real risks for the next decade are governmental and macro and not really companies that are frauds. Basically any company that was over leveraged or a fraud got taken out in 2008 and 2009 and so we haven’t had a chance for new over-leveraged industries to be built. So I just don’t think there is that much downside. Maybe the market could drop a third from here, and it wouldn’t really be shocking. Overall though, I just don’t feel like there is a chance for a whole-sale slaughter as there was before. Especially with governments printing so much money and holding up asset prices forever.

So then naturally you must be bullish on precious metals?

I find macro or secular themes with a strong tailwind to them and go find the best companies in the industry and so I think precious metals are an interesting place to be right now. I got involved originally in precious metals back when gold was at $330 back in 2003, we got really active in 2004 and you know we are still involved. It changes from time to time but it is a macro theme that will go on for a long time. The problem is you won’t find the bargains in this space you found 5 years ago.

That makes sense though with so many people digging in that space now.

Right. The thing about these trends is that you need to discover them early when nobody cares about them and then take your position early and we’ve done that really well in precious metals and in the whole commodity sector really. I think the better trend now is not necessarily buying gold. It could go higher, I don’t know much. It could double or triple from here but it won’t go up 10 fold like it could when you’re buying it at $330. I think the more interesting trend to get into is buying into the mining services sector. This is our biggest sector bet right now. It’s a bet that companies have used up their resources at a much higher rate than they have discovered new deposits industry wide across the globe. You have seen a lot of industries where they are depleting their resources faster than they are being replaced, whether it is nickel or oil or any of these things. The numbers aren’t always the same but in some industries like copper you have just seen that nobody is putting money back into it. You drill holes and it costs money and you have to put that against your income statement and executives don’t want to do that. So instead companies have been spending a lot more on making acquisitions to replace reserves. The problem is that there just aren’t that many valuable little resource companies any more since nobody has really found anything big. If you look at global expenditures on the hard rock exploration spending it probably needs to run at $15b to replace what has been mined. This year should come in at $8-9b and last year was half of that and the peak in 2008 was at $12 or 13b. So the industry as a whole is clearly not replacing what is mined. Then taking into account that global GDP is growing a few percent a year and global population is growing at a few percent a year, it is clear that you need to do more than replace reserves you actually have to grow worldwide reserves. Before the play was to buy the commodities and commodities companies themselves but I think it now is more exciting to invest in the arms merchants, the guys selling the picks and shovels.

For the first time in a long time the mining companies are making good money, they’ve paid down a lot of the debt they acquired in the last decade in their acquisition binges. I think now that they have cash flow they are going to start spending on exploration, partially just because there is nothing truly valuable left to acquire. You look at some of the prices paid by some of these guys in the last few months on acquisitions and it is amazing. Kinross over paid on Rubicon, Goldcorp overpaid last week on Andean. You look at some of these and you realize that they either have to vastly overpay or they take their chances drilling holes and at some point drilling some holes just looks more attractive. I think that is the trend I’d rather bet on than betting on the price of gold going much higher, although I think it will.

Stay tuned tomorrow for Part 2 of our Hedge Fund Manager Interview Series with Harris Kupperman of Praetorian Capital.

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