Exclusive Interview: Greenstone Value Opportunity Fund

A few months ago, I received in my inbox the 1Q 2010 letter for the Greenstone Value Opportunity Fund. Not only were their returns spectacular but also their largest position at the time was Tronox, a company we did a distressed debt research piece on earlier in the year. Needless to say, with their candor, their value investing mindset, and their ability to see the forest through the trees in a number of highly complicated situations, I was incredibly impressed. I reached out to founders Chris White and Tim Stobaugh, and asked them a number of questions in the interview below. I was split the interview into two parts, and will post the second part later in the week. Enjoy!

Of the prominent investors (Seth Klarman, WEB, Graham, etc) out there, who would you say your styles most mirror? And why?

We tend to think about other investors as being in a variety of different categories, and we try to glean from them opportunities or ideas in those areas where we think they are the strongest. Mark Faber or Jim Grant, for example, are not necessarily known for being very good stock pickers, but they make incredible calls time and time again from a broad macro perspective. Obviously a Seth Klaram has a go anywhere, anytime style, it’s just that he’s a large relevant investor with a superb track record; we like to think we mirror him in some ways from the perspective of liking tangible assets and free cash flow, but we realize any comparison at this point is more than a bit premature. Outside of David Einhorn, who we think is phenomenal, we actually think some of our own limited partners are the best investors we know. Michael Scholten of Clear Harbor Asset Management is the best ‘common sense’ value manager we know, and Brad Radoff of Fondren Capital has an amazing ability to get up to speed on an idea; he’s quicker than anyone we know, with a diverse style and breadth of knowledge that is truly impressive. In addition to these two, who are LP’s, we are proud of our limited partner base, and have a lot of talent there that can provide immeasurable advice. We try to take note of what Jerome Simon and Keith Cockrum of Lonestar Capital Management are up to. Julian Robertson has influenced our industry more than any investor, so we always try to keep tabs when he offers perspective on the news of the day (we might also point out that he’s the inaugural winner of the Friend of New Zealand Tall Poppy Award).

At the end of the day, we’re a young, small friends and family hedge fund, and we can definitely play in ideas where others face too much liquidity risk and/or don’t have the ability to put a relevant amount of AUM to work. But, we’re also not afraid to invest in large caps when we think their capitalizations represent the best risk/reward. We really just try to learn from everyone, and try not to put ourselves into a box; if asset values and FCF’s are telling us to go to a particular sector, then that’s what we do. In addition to continually learning from our mistakes, we let our deep value philosophy, with a focus on underlying free cash flows and tangible assets, and investment process dictate what we do.

You run a fairly concentrated book. Talk about your thinking behind diversification and running a fund.

We try to have about 80% of our long portfolio structured in what we consider our classic (deep) value investments. We try to run a concentrated book of between 15-30 investments because we want positions to be significant from a return standpoint to the portfolio; the game is hard enough that if we pick winners, we want them to be meaningful. These core positions are generally sized in the 3-6% range in terms of AUM. The other 20% of the long portfolio is comprised of special situations, where maybe the valuation doesn’t meet our hard and fast criteria, but they have the potential to provide outsized returns (i.e. 3-10X returns). These positions are generally sized in the 0.5-1.5% range in terms of AUM, but we consider it relevant to take a position because they can prove meaningful to the portfolio due to the implied leverage in investment. This level of concentration can go against us too, and we fully expect to have losing positions. While the portfolio might take a more significant hit when a core position declines relative to someone running a book of 100 names, we try to be brutal when deciding on whether to stay with a holding. Our bottom-up, rigorous due diligence process allows us to be highly familiar with the underlying issuers, especially the core names, so when positions move either way we feel we can make informed decisions regarding the portfolio.

We are definitely conscious about diversification and the hedging we need to employ in the portfolio. As an example, from an industry perspective we try not to have exposure of greater than 16-18% of AUM. While we have approached these levels several times in the past, primarily through appreciation, our disciplined approach required that we scale back these positions as they moved higher. We also sometimes look for “interesting” ways to hedge certain positions. For example, as our oil-related holdings started climbing last year, we thought a pullback was certainly possible. So, we hedged our exposure to oil with long positions in regional airlines like Republic Airways (RJET) and Hawaiian Holdings (HA), which were trading at valuations of less than 4X EBITDA and FCF. Not only did we pick up what we thought were great value investments, there was an obvious hedge if oil prices declined. We also put a huge premium on liquidity. Tim previously managed a fund that was comprised of highly illiquid investments, and he took some great lessons from that experience. Typically, 80% of our holdings are NYSE or NASDAQ listed companies and we could trade out of our positions in a day or two. This also gives us comfort when owning such a relatively concentrated portfolio.

In your opinion, what is the hardest aspect of running a hedge fund?

Time. Because we are a small fund, and there are just the two of us, there are many times when it does not seem there is enough time in the day. It’s not just about running a fund and generating returns, it’s about building a business, and all the things that go on outside of just pure investing. Whether it’s taking advantage of a 10-minute 8% correction window, returning a call to a limited partner, or just having enough hours in the day to keep everything in balance outside of running a hedge fund, there are personal sacrifices to be made. We work in close proximity on a trading desk environment where there are no fancy titles or big offices; there is little time for personal phone calls, and it’s about being productive when we’re in the office. We also try and think about every decision as if we were a much larger fund, whether that’s how we set up our offshore fund, who we chose as third party service providers, or how we communicate with our limited partners. All of this requires that Tim and I wear multiple hats every day, including fund manager, compliance officer, capital raiser, risk manager, and investor relations. The other hard part is ignoring all the ‘noise’ we hear every day on the likes of CNBC. It is hard sometimes to avoid all the noise and panic around you, and have the confidence to wade into the waters and take a position when the process tells us it is time. When we are pressed for time, our processes tends to bail us out. We have quantifiable metrics for some things, i.e. do we make a certain amount of phone calls every day, are we increasing our LP base every quarter, etc. With regard to investing, we definitely rely on our process to tell us when the valuations make sense. We think the other very important part is in communicating with your LP base. If you constantly communicate your ideas and philosophy, and reach out to them every month or two, then when the tough times occur they’re more likely to stick with you, because they understand the process better. Buffett used to quote something like he wanted LP’s to “measure us, as we measure ourselves.” We agree with this and think it’s more important than ever to have the right LP base.

Talk a little bit about your background. How did the two of you come together to launch Greenstone?

Tim has worked his entire career in the financial services industry. He spent over 11 years on the sell-side at a boutique investment bank helping raise capital for small and micro-cap public companies. During that time, he helped raise over $300 million in almost 50 different transactions. The great thing about being at a single-office boutique was the amazing breadth of experience he received while there. At some point during his tenure, he was an analyst, investment banker, institutional salesman, trader, compliance officer, and head bottle washer. More recently, prior to joining me to launch Greenstone, Tim was with a buy-side hedge fund with around $75 million in assets. Again here, the breadth of experience included all aspects of running a small fund: portfolio management, trading, CFO, investor relations, etc. In addition to the operational expertise that he brings to the table, he has essentially spent the last 15 years or so analyzing capital structures, negotiating deals with management, and investing and trading micro, small and medium-cap stocks. I was born and raised in New Zealand, and started investing as a 16 year old after reading my first Warren Buffett book. It was from that point on I knew I would be an investor in public markets. It was my dream to come to the United States, and work on Wall Street. Originally I thought Wall Street was the place to be, until I took a job offer in Dallas, and spent 7 years on the buy and sell side, investing and raising money for public companies. The story of how I actually got from New Zealand to Dallas is humorous to some. . When I arrived stateside I had a total of $400 on me, so I negotiated to buy a car and a mattress for $175. I still remember driving that Mazda 323 down the road with a mattress strapped to the roof and no air conditioning. I eventually sold that car two years later for more than $175. I still remember those lean times, and it keeps me motivated.

Our careers eventually overlapped for about 2 years at the small investment bank I mentioned earlier, and we became great friends. Not only did we become friends, but we spent a great deal of time, both during our tenure together and after Tim left to move over to the buy-side, discussing investment outlooks, philosophy, trading styles, etc. We came to realize that we shared two things in common: similar personalities and similar investment styles. We are both highly competitive, brutally honest people who are motivated to succeed. We know we can trust each other to do the right thing, and you may as well not go into business with someone if there isn’t 100% trust. There will be ups and downs, times of pressure, and you have to know that your partner is there completely there for you. It’s also about humility and intellectual honesty. As we constantly reevaluate our positions, say when a position moves against us, we ask ourselves: Are we early, or are we wrong? Is this conviction or pigheadedness? We are not afraid to say we made a mistake.

What has been one of your biggest investment mistakes of the past? Biggest investment success?

Blockbuster (BBI) is a story we spent a lot of time on, and felt very comfortable with regarding our knowledge base and the valuation. We traded the common equity and exited successfully, but we bought a position in the unsecured debt post refinancing of their senior facility. Late in 2009 we walked out of a meeting with senior management thinking we should sell the bonds, but we noticed an insatiable desire in the market for high yield, with investors chasing yield to unsustainable levels. We thought we could game the market and hold onto the bonds, selling the position before they announced their Q4 earnings in March 2010. Of course, the company pre-announced poor results, and the bonds declined 50% in a week. I think we learned that once you lose confidence in a position and determine you’re a seller, you need to get out and not try to game the market. We constantly kick ourselves for our losses, more often than not it seems on our shorts, or it’s a timing issue where we’re wrong for an unbearable amount of time. We truly believe you learn more from your mistakes than from your winners. They’re extremely painful, and it’s a feeling only people managing their own money, along with friends and family dollars, can truly relate to.

As far as investment successes, we think entering the Trust preferred securities of the major money center banks in late 2009/ early 2010 was a successful trade. Entering the auto bailout mess was another interesting time for us, with the Hayes Lemmerz (HAYZQ) bankruptcy, and Exide Technologies (XIDE) providing valuations that gave us comfort. Entering the airline sector in late 2009 when oil was increasing was hard to do, but the valuations told us we needed to be there. From a pure percentage return standpoint we have almost a 100 point gain on our Tronox Bonds, representing a return of close to 300%. This was definitely the first time we’ve earned over 100 points on a bond, and while it’s probably not our best investment ever, to earn 100 points on a bond is a rare event…for us anyway. The hard part about the bankruptcy process is being able to have enough information to take a position when no one else wants too. The timing of the return opportunity is critical. As with all our investing, and particularly with these we have mentioned, we try to first and foremost define the downside potential. For example, before taking a position in Tronox we did a tremendous amount of work on the environmental liabilities, talking to the EPA, lawyers, Superfund employees, doing analysis of past EPA and Superfund settlements versus the original claims, etc. After all these discussions we formed a probability analysis of what we thought the potential environmental liability would be (our work showed a 20-28% eventual loss). It was understanding the liabilities early on that provided the comfort for us to take a position. The other fundamental analysis on TiO2 recovery, industry processes/dynamics, inventories, pricing, etc was easier… the wildcard was the environmental liabilities. With the wildcard essentially defined and off the table, the process became easier for us to get comfortable with, and we even eventually took an equity position as well. Whether you are talking about the preferred securities of the money center banks during the financial crisis, the automotive suppliers during the bailout, the airlines during a recession, or a Tronox during bankruptcy, our best investments have been when the panic has been the highest, the blood in the streets has been excessive, and panic-selling has been the norm. These are events we look for to trust our process to find good buying opportunities.

When allocating capital, must discussion in the past few years has been on value investor’s transition to start taking a look at the larger/macro picture. If anything, how does the general economy and macro trends play into your investing style and how you run the fund?

That’s a very interesting question and it certainly involves more work than in living memory, but we try not to over think each and every position. We focus on tangible assets and free cash flow. Our limited partner investors don’t come to us to invest in Coca-Cola; they come to us to invest in deep value, distressed companies that very few people are looking at. So, something we have to remind ourselves is that by the time we’re interested from the multiples we look at, the issuer typically already has significant downside protection built into the valuation. But before taking a position we take into account the technicals of the market and the underlying company because black box trading has become so significant.

Having backgrounds in economics, we do tend to have broad-based themes when investing, in addition to simply monitoring the market for mispriced securities. For example, we think China and India are going to be among the largest drivers going forward due to their GDP growth potential and the fact they make up 40% of the world population. When you consider that the current per capita consumption of these countries is now at very low levels but growing, as well as the future industrialization of these countries and the development of a middle class, we tend to look at their import needs in terms of certain commodities (coal, oil, gas, iron ore), and the mode in which they will receive those commodities (tanker and dry bulk). We think China will be by far the bigger factor in the equation than ever before, and prices will ultimately move more on Chinese demand than in the US. Having said that, we would never try to trade commodities; instead, we would attempt to find issuers with significant commodity exposure at very attractive deep value multiples.

We also think the power shift from Wall Street to Washington is something to keep an eye on. We feel Washington is somewhat broken because of the influence of special interest groups, and the political process requires Washington to remain beholden to these entities. The scary part is that fiscal responsibility ultimately only comes about by being forced to take action. For example, New Zealand lived in fiscal denial for decades, and then in 1984 was forced to go cold turkey from a fiscal and monetary standpoint. It was a painful transitional of ten to fifteen years, but there were plenty of opportunities to pick up assets when no one else wanted them. If we don’t have some sort of fiscal responsibility from the Obama administration, the 2008/200909 credit crisis will be a small issue compared to the day that the US cannot print anymore money, or there is no buyer for US government debt. For these reasons, we’re partial to countries like Australia and Canada, who are commodity-rich, with stable monetary policy, friendly corporate tax policies, and in close proximity to Asian countries with insatiable desires for their primary products. So, I’d say we definitely more than ever take into account a certain amount of governmental control, future interpretations of the law, and general macroeconomic policy analysis. Whereas macro/political used to make up around 10-15% of your decision making, it’ probably double that today. The recent banning of existing drilling in the GOM by the Obama administration was pretty fascinating, and we think some interesting legal precedents could come out of that action.