CLAR - Maran Partners Fund Q3 2023 Letter

2023-11-03 07:40:00 ET

Summary

• Maran Capital is a value-driven, concentrated, long-term investment manager focusing on small-cap stocks and special situations because we believe these are the most inefficient corners of the market.
• Maran Partners Fund returned +3.4% in Q3 2023, bringing the year-to-date return to +9.7%.
• The portfolio manager believes that recent market declines have improved the opportunity set for investments.
• The fund's core holdings have strong characteristics, including aligned management teams, share buybacks, strong balance sheets, and low valuations.

Dear Partners and Friends,

In the third quarter of 2023, Maran Partners Fund returned +3.4%, net of all fees and expenses, bringing the fund’s year-to-date return to +9.7%, net. ^[1]

As a portfolio manager, I’m always supposed to like our portfolio. I get to shape it, so I should always be able to look at it and say, “This is the best I can do right now; it is as optimal as I can get it.” Of course, conditions are constantly changing, and sometimes the opportunity set is better than at other times. We have been cautiously positioned with a decent-sized cash buffer for most of the last year or so. But given recent market declines—and yes, against the backdrop of inflation, war, risk of impending recession—I believe the opportunity set has improved further. Existing positions I know well have gotten cheaper (indeed—extremely cheap) even while their fundamentals have improved, and I have found a few new positions at valuations that seem too good to be true.

These opportunities have not materialized in a vacuum. The Russell 2000 small-cap index has declined over 17% since the end of July. Some stocks have fallen significantly more. There has been much written recently about how cheap small-cap value is and its abysmal recent relative performance compared to larger-cap stocks.

Some of this commentary is compelling, but I’m also reticent to put too much weight on index-level analyses. There is lots of garbage in small-cap land, and we don’t own anything like an index worth of stocks. What I can opine on is the value and opportunity I see in our dozen or so core holdings and special situations.

I frequently underwrite for three-year doubles, and right now I think our entire portfolio meets this bar, or indeed a higher one. I think some of our stocks could triple or even increase four to five times in the next few years. Of course, as always, I don’t have a view as to what the market or our stocks might do in the near future. But looking out over a multiyear time horizon, I am as excited about our portfolio as I have been in quite some time.

Many of our core holdings continue to share a number of characteristics that I believe help tilt the odds in our favor:

• Aligned management teams / high inside ownership
• Actively buying back shares
• Strong balance sheets
• Secular tailwinds driving growth
• Catalysts / Value-unlocking transactions
• Low valuations on a variety of metrics, including large discounts to private market values

Framing Investments: How’s the View? What’s Implied?

I have touched on each of these frameworks before in past letters, but there are two mental models that I tend to use frequently in my analysis: Inside view vs. outside view and the price asks the question .

The first, inside view vs. outside view traces its roots to Thomas Bayes and his famous theorem, with further advancement by Kahneman and Tversky (who came up with the inside view and outside view terminology), and others. And the price asks the question is simply a reframing of the age-old mental model of reverse engineering as applied to valuation in investing.

I was recently having dinner with a friend of mine, and he told me that he thought he had just gotten over a bout of Dengue Fever. His symptoms were fever and a bad headache that lasted a few days. While I was sympathetic to his ailments, I’m not sure my first guess for their cause would have been Dengue. He had not traveled outside of the US, and Colorado sees perhaps 10-20 Dengue cases annually. With headache and fever as the primary symptoms, Dengue is far from one of the most likely diagnoses.

His inside view took him from a list of symptoms to a specific potential self-diagnosis. The outside view would have asked, if 10,000 people in Colorado had these same symptoms, how many of them would have Dengue? This framing quickly highlights the low likelihood of that malady and the much higher odds that it was something else. As the saying goes, “when you hear hoofbeats, think horses, not zebras.” In other words, don’t neglect to think about the base rate.

When you ask a CEO what his company’s margins will be in two or three years, he might tell you about the exciting growth plan the company has in place coupled with the cost savings measures it plans to take and come up with a nice forecast for future profitability. This is an example of utilizing the inside view to come up with a forecast. The contrasting outside view might be that the average company in this industry has margins of half of his forecasted level or that the company’s prior margins over the last decade or two averaged half of the forecasted level.

Michael Mauboussin summarizes these contrasting approaches to forecasting in his book Think Twice :

An inside view considers a problem by focusing on the specific task and by using information that is close at hand, and makes predictions based on that narrow and unique set of inputs. These inputs may include anecdotal evidence and fallacious perceptions. This is the approach that most people use in building models of the future and is indeed common for all forms of planning…

The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. ^[2]

The applications to investing span sectors (the base rates for certain types of drug trials, gold prospecting, and electric vehicle battery companies aren’t great), asset classes (SPACs), acquisitive companies (base rates on acquisitions are poor as a class, as Mauboussin points out) and general forecasting of company margins, growth rates, market penetration, and more.

The outside view helps us improve our forecasts by utilizing base rates. Reverse engineering, or t he price asks the question , helps us understand what expectations are embedded in a stock price, alleviating the need for explicit forecasts altogether.

I discussed this mental model a few years ago in my 3Q 2020 letter, where I summarized the concept as follows:

“As an alternative to attempting to value a company in the traditional manner utilizing a variety of inputs and forecasts, analysts can and should invert the process, and ask what expectations are embedded in a stock at its current price.”

In that letter, I compared the embedded expectations in a stock trading at eight times cash flow vs. one trading at “35x sales, 360x EBITDA, and 420x earnings.” The market’s embedded expectations of the former were dramatically lower than that of the latter. ^[3] By reverse engineering what assumptions the market holds to justify a given valuation, it can help shed light on how realistic those assumptions may be.

As I wrote at the time, “I prefer the prices of our stocks to ask easy questions, perhaps those even a kindergartener could answer.” We have numerous stocks where the prices are asking very easy questions right now.

Of course, these frameworks and models are just tools in our toolkit and provide additional perspectives through which to evaluate companies and investments. Sometimes “this time really is different” and the outside view could lead us astray. But used as a part of a comprehensive analysis, they can frequently be enlightening.

Portfolio Update

In addition to several new investments, we continue to own the same core handful of positions we have discussed in recent letters, although their weights have shifted based on relative risk-reward levels.

Clarus ( CLAR )

Clarus received an offer of $160 million for its bullet and ammunition segment from Clarus’ chairman, Warren Kanders. A situation like this obviously requires a thoughtful approach to managing the conflict of interest, but this transaction would lift the ESG overhang that accompanies businesses of this type and would bring Clarus to a net-cash position, highlighting the extremely cheap valuation of the remaining segments.

Clarus’ market cap is $210 million, and the company should have net debt of around $105 million at yearend, before contemplating the aforementioned transaction. Post-transaction, the company would have net cash of approximately $55 million (~25% of the market cap) and an enterprise value of $155 million.

The Outside View

Investors and analysts frequently extrapolate recent results, whether they be positive or negative. Just as our hypothetical CEO in the example above was too optimistic about his results given his inside view, the market can frequently get too negative about a company by utilizing an inside view approach. I believe that may be the case with Clarus today. This myopic approach seems to be leading the market to say that the consumer is weak and Clarus’ recent margins have compressed, and therefore that its margins will be low forever.

What are normalized margins for Clarus’ remaining businesses? The outside view would have us look at a large number of companies in similar industries and examine their average margins over time.

Through this lens, I think that it is not unreasonable to assume that Black Diamond can generate double digit EBITDA margins at midcycle profitability. While the company targets 15-20% margins long term (a level that may be informed by too much inside view optimism), in looking at a number of comparable companies, both private and public, we think 10% normalized margins are a reasonable statistical bet. Clarus’ brand, category leadership, and product lines, which includes many products that “save your life” (I don’t think anyone wants to save ten bucks by buying an off-brand climbing harness), give further weight to the fact that it should be able to earn this fairly pedestrian midcycle margin.

If in the next few years Black Diamond can generate this double-digit EBITDA margin on ~$225-250 million of sales, that segment would produce around $25 million of EBITDA. Similarly, Rhino Rack could potentially generate $18-20 million of segment EBITDA, as it approaches a 20% margin on ~$100 million of sales.

Less cash corporate expenses, Clarus would generate ~$40 million of EBITDA in this scenario. This implies the stock is trading for less than 4x normalized EBITDA (and under 0.5x sales). This seems far too low.

As with margins, so too with valuation. Rather than using an inside view to come up with a valuation, we can also turn to the outside view—in this case, over a decade’s worth of comparable transactions in the outdoor industry.

Since 2010, the average comparable transaction in the outdoor industry occurred at greater than 2x revenue. At this rate, Black Diamond Equipment would fetch more than $450 million and Rhino Rack, around $200 million. Together, along with the ~$55 million of net cash that the pro forma company should have, we’re looking at greater than $700 million of value. If Clarus’ remaining brands are just worth the industry average transaction valuation, it would be valued at $19/sh (more than three times the current stock price).

If Clarus’ brands are worth the lowest revenue multiple paid in the table below, CLAR would be valued at $14/sh (more than twice the current stock price).

The Price Asks the Question

What is implied by Clarus at a ~$155mm pro forma enterprise value?

There are many ways of answering this question. Using the average revenue multiple from the table above, Clarus’ current valuation implies that its sales (again, pro forma for the contemplated sale of the bullet and ammo segment) would be just $74mm (rather than the $300mm+ that they are). We can also look at what the overall valuation implies regarding the valuation of the segments. Here are a few possibilities:

I’ll be blunt. Each of these seems absurd. Any of them highlight the deeply discounted valuation. Take the first box, for example. Buy Black Diamond for well less than 1x revenue and get Rhino Rack and Max Trax (recent purchase price: >$200 million) for free.

We don’t use price targets here at Maran. I think they can be too rigid and can lead investors to fail to update their beliefs as often as they should. Instead, I tend to think about probability clouds with respect to intrinsic valuations. There are many possible future sets of growth rates, margin profiles, economic backdrops, and investor sentiment profiles that we could live through over the next few years. It is not a good use of time to specifically guess which path will unfold. But the key is that the starting point positions us so that the vast majority of these paths yield substantial upside.

We already saw that applying the average historical comparable valuation to Clarus’ recent results can yield a triple in the stock price. If Clarus grows Black Diamond revenue to $300 million and Rhino Rack revenue to $150 million over the next three-to-five years, upside is into the high $20s or low $30s.

And while no one wants to think about real upside scenarios during a time like this, let’s not forget that

Clarus’ medium-term targets for Black Diamond and Rhino Rack are revenues of $400 million and $200$300 million, respectively; if they achieve these targets, we could see valuations in the $40s and beyond. Any of these outcomes would be fantastic, but the key is that none of them are close to priced into the current stock price.

Clarus has a history of opportunistic share repurchases, including buying back 10% of the company below $6/sh in 2015-2016 and tendering for stock at $8 in 2018. If Clarus enters 2024 with 25% of its market cap in cash and a stock price anywhere close to where it is now, I wouldn’t be surprised to see it utilize this tool again.

Finally, recall we still have a few hidden lottery tickets in this investment. Clarus’ lawsuit against HAP Trading continues; a legal victory or settlement could prove meaningful relative to Clarus’ current valuation.

Vistry Group ( BVHMF , LSE: VTY)

Vistry reported its first half results and provided a strategy update during the quarter. Vistry announced that it will transform itself into a pure-play partnerships business, which is what the activist investors involved with the company were fighting for. Notably, approximately £1.3bn will be freed up and utilized to eliminate debt and for buybacks and dividends. The company is targeting £450mm of adjusted operating profit in 2023 with growth to £800mm in the medium term.

Remember, the market capitalization of Vistry is just £2.4bn and the enterprise value is approximately £2.7bn. If Vistry can buy back one quarter of its shares while doubling operating profit and eliminating its debt over the next three to five years, I think very good things will happen to the stock price. If Vistry trades at an £8bn market cap (10x operating profit of £800mm, a multiple that we hope will prove conservative given the quality of the business; comparable transactions have occurred at 11-13x operating profit) and reduces its share count to 260mm shares, the share price would be 3100p, over four times the price at which the stock currently trades.

Correios De Portugal, S.A. ( CTTPY , Euronext Lisbon: CTT)

CTT was victorious in its arbitration proceedings against the Portuguese government and was awarded approximately €25mm, or 6% of CTT’s market cap. This is a meaningful windfall, especially in light of CTT’s ongoing share buyback, which it continues to execute daily. Given my belief that the company’s enterprise value, after considering the value of its bank and excess real estate, is close to zero, share buybacks are extremely accretive. This windfall will only increase the amount of capital CTT can apply toward buying back its shares.

Beyond the Top 5

We recently invested in a few additional new positions, including a special situation that we think will have a catalyst in the next six months that could lead to upside of 50-100%. Downside seems limited in the meantime. I expect to share more detail about some of these positions over time.

Conclusion

There has been much attention placed on the fact that the Nasdaq ( NDX ), S&P 500, and Russell 2000 ( RTY ) are all in the middle of double-digit drawdowns from intra-year highs, and that the Russell is down by a third from its all-time high. Drawdowns are a normal part of equity investing. 10% drawdowns occur in approximately two thirds of all years. 25% drawdowns occur in almost one out of every four years.

We are set up to weather these storms and to take advantage of this normal, expected volatility. I touch on it in most letters, but I truly believe our structure (the vast majority of partners have made three- or five-year commitments) and our limited partners (aligned, patient, with strong understanding of the strategy) are crucial to our ability to outperform.

This means we can be on offense right now while other funds are selling in the face of fear or due to redemptions.

Thank you for your continued trust. Please don’t hesitate to reach out if you have any questions or if you would like to discuss the fund further.

Thanks,

Dan Roller

Original Post

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