(Ep.88) The Acquirers Podcast: Matthew Sweeney – Value Spectrum: Concentrated Small And Micro, Event-Driven Long-Short Value Investing

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In this episode of The Acquirers Podcast Tobias chats with Matthew Sweeney, Managing Partner at Laughing Water Capital. During the interview Matthew provided some great insights into:

  • The Value Spectrum
  • Focus On Economic Drivers Instead Of Forward Earnings
  • Validate Your Ideas With A Red Team
  • Finding Opportunities Using Keyword Search
  • Special Situation Investing
  • Invest With Owner Operators
  • Buying Compounders As They Come Out Of Special Situations
  • A Recession-Proof Defensive Portfolio Component
  • Shorting As An Asymmetric Trade
  • Laughing Water Partner Letters
  • The Origin Of Laughing Water

Check out:

Laughing Water Partner Letters

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Matthew Sweeney of Laughing Water Capital. He’s a small and micro event-driven value guy. Fascinating letters. I’m going to talk to him right after this.

[intro]

Tobias: Hi, Matt, how are you?

Matt: Doing very well. Thanks for having me on, Tobias. I really appreciate it.

Tobias: So, let’s talk a little bit first about Laughing Water. How do you characterize what you do there?

Matt: So, broadly speaking, I guess the way to think about it is a concentrated small-cap strategy. And concentrated for me means typically around 15 stocks. So, I wouldn’t say ultra-concentrated were like a five-stock portfolio or something like that, the reasonable degree of diversification, and in fact, mathematically, you could argue that it’s too diversified, but it’s the right fit for me. And it’s mostly small and micro-cap stocks. It’s unconstrained in terms of where the documents are, but I just happen to find most of my best opportunities at the lower end of the market cap range. So, that’s where I spend my time.

And I call it a value strategy. But, of course, value means different things to different people. I think about that as a spectrum where on one hand of the value spectrum, you might have, like undervalued asset plays. And on the other hand, you might have underappreciated growth. And there’s a whole range of possibilities of value between those two sides. And I try to diversify across that. So, there’s some names in the portfolio that are undervalued on an asset basis, and some that I think are underappreciated growth. The bulk of the names are kind of in the middle, where I wouldn’t argue that they’re the best businesses in the world, but they’re pretty good businesses. And they’re not the fastest growers in the world, but they typically have a growth element to them. But the reason why they’re really valuable is because of some sort of noneconomic event or social situation-type variable that allows us as buyers to buy them at a price below what a reasonable businessperson would pay for them over time.

Buying Compounders As They Come Out Of Special Situations

Tobias: Did you see Dan Loeb had a comment in one of his recent letters where he said, they’re trying to buy compounders, but they’re trying to get them as they come out of special situations? Is that sort of analogous to what you’re doing?

Matt: I actually had not seen that from Dan Loeb, but that’s exactly what it is. I say in the best case, we can find an underappreciated compounder at a special situation price. And that special situation can come from a variety of reasons. It’s not typically the classic Greenblatt’s pitch special situations where it’s a spinoff or something like that. I, of course, look at those things. But even just looking statistically, we could see that spinoffs are not as successful as they once were likely because so many people are looking at them. They tend to be much more idiosyncratic one-off opportunities that come up. And they’re sometimes attached to good businesses that if they’re managed differently or under a different management team, have the potential to turn into compounders. But at the moment, people are looking at them and just saying, “There’s a problem here. There’s something going on, that explains the cheap price.”

Tobias: Do you have any examples that illustrate what your strategy is?

Matt: Yeah, I don’t want to talk too much about names. But a good example of one that’s just totally idiosyncratic, I think is really interesting is this company, Whole Earth Brands, the ticker is FREE, F-R-E–E. And if you’ve been reading the newspaper at all, or at least the New York newspapers, seems like every day lately, Ron Perelman has been on the cover of the newspaper because he’s having a problem with his [unintelligible [00:03:51].

So, if you think about Ron Perelman two years ago, was the 47th richest person in the world. And this year, one week, he’s on the cover of The New York Post because he’s trying to sell his Hamptons estate for $180 million and the next week, he’s on the cover of The New York Post because he’s trying to sell his art collection for a couple hundred million dollars. He wound up selling his position in Scientific Games. I believe it was $1.5 billion. And another sale he made were two companies called Merisant and Mafco. And one of them is basically they do licorice extract. So, it’s a flavoring that goes into tobacco to flavor tobacco.

The other one does non-sugar sweeteners. So, you can think of like the little blue packets of Equal that people put in their coffee as well as a couple other ones that are popular European brands, and then they have some natural sweeteners like stevia-based sweeteners. Anyway, Ron Perelman also sold that. And if you just think about it from a high level, it’s a pretty decent business. No one’s going to wake up tomorrow and decide to change the sweetener they put in their coffee. It’s pretty dependable.

Where it gets interesting is that it was bought by a SPAC. The SPAC was called Act II Acquisition. SPACs, of course, have a terrible track record. So, a lot of people don’t even look at them at this point, although, because recently there’s been a couple home runs, so people have a renewed interest. But where it gets interesting is you can look at it and the SPAC deal is actually struck back in January. And the initial price was, I think, 575 million, if I remember correctly. And then when COVID hit, they actually wound up renegotiating the price lower on two different occasions where the final price was actually, I think it was 440 million. And what happened basically, is that Ron Perelman already had a debt problem. And then the Coronavirus came, his debt problem really got out of hand, and he would just fire, selling these assets because he needed capital so bad.

So, that alone is just an interesting setup. I mean, it’s not every day that a multibillionaire has to liquidate his portfolio and sell things at fire-sale prices. And then you could look at Ron Perelman’s track record and say, “You don’t get to be a multi-billionaire without a pretty good batting average. So, it’s just more validation that these might be pretty good businesses.

And then think about the way Ron Perelman runs his empire. And traditionally, what’s happened is he has his operating companies, and they kick up cash flow to parent company, the services debt stack. But what that means is that the company level, he’s not necessarily making all the investments he should be making in order to make the business as efficient as it could be. And I think that’s the case here.

For example, there’s two different businesses that seemed to fit well together. And they had two different accounting departments and two different IT departments, two different packaging procurement groups, but very low hanging fruit in terms of looking at this and saying, “Is there an opportunity here to widen margins? Because you think about what drives business value over time, I mean, today, most people argue it’s only revenue, but that’s not really true. It really should be earnings growth and cash flow and stuff like that.

But you could, of course, get to those things through growth. But you could also get to them through operational efficiency. And one of the things I think about a lot of times is, which is easier for the growth, maybe, I mean, there’s certainly some companies where growth is easy, but it’s a pretty low bar in my mind to decide to eliminate a duplicate accounting department. And that’s not rocket science. And that fits well with kind of my working assumption when I’m thinking about an investment because the base assumption is generally that I’m the dumbest person in the room.

And if you could find something to explain, no, you’re not actually the dumbest person in the room, the seller is the dumbest person in the room, for the most constraint, I certainly don’t want to imply Ron Perelman is dumb, but the seller is under some sort of constraint, where they’re forced to make a non-economic decision. That’s just a fantastic starting point for any kind of investment. And then layer on the opportunity for operational improvement, like I just said, the two accounting departments, and they have some room to improve their footprint in terms of their manufacturing capacity. And then, of course, consider the people involved. So, the SPAC Act II is– the second act of a guy named Irwin Simon, who previously founded Hain Celestial.

Fascinating story, he started the company literally in this garage after mortgaging his apartment to finance it. And then he turned it into $2.5 billion revenue business. Now, he’s not infallible by any means, you could look at his capital allocation track record and say that it wasn’t always the best, maybe he was overpaying for things and per-share value did not perfectly match business value growth.

But nonetheless, I mean, just making up a number, I would bet there’s less than 1000 people in the world that started a business and took 2.5 billion in revenue. So, at the very least, he’s not a normal person to be partnering with. So, you have someone like that with a fantastic track record of building a business, buying from someone like Ron Perelman who has a known problem on his hands, and you put it together. And that’s kind of a unique opportunity that the mechanical screeners can find. And it comes up rarely something like that. But if you’re fortunate enough to find something like that, it can really drive returns over time.

Tobias: So, the thesis was basically, Ron Perelman has been– He is a very good investor, famously took over Revlon in the 80s, sort of came to prominence in the 80s doing that, and there have been various books written about him. I’ve got some of them behind me right there. And for debt reasons, he’s had to sell down some of his holdings, including houses and art, and probably some of his smaller businesses, perhaps. And he’s been a little bit of an absentee landlord, using the cash flows to finance the debt rather than reinvesting in the business. And here, it’s transitioning to somebody who’s a focused, or a management team is going to be focused on the business. And they have a good track record in growing a business like this. It’s basically a bit on the new management team being able to take what should what should be a pretty good asset and take it to another level.

Matt: Yeah, I mean, high level. That’s correct. The actual management team is staying in place. It’s just now there’s a new board of directors and the chairman, so rather than Ron Perelman overseeing it or Irwin Simon is overseeing it, but the management team themselves is staying in place. And what’s interesting about that is now that they have it, they’re a public company, they have a different set of motivations. And they’ve actually been buying shares in the open market, which suggests that they are pretty happy with the way their incentives are aligned, which is always a good thing to say.

Invest With Owner Operators

Tobias: So, you mentioned in the brochure that you sent to me that one of the things you look for is owner-operator type managers. So, this certainly fits that bill. But why is an owner-operator style manager important?

Matt: Yeah, there’s a couple of reasons. I mean, one is just the obvious, which is incentives. I mean, when people have skin in the game, they tend to perform better. That’s not a secret, there’s plenty of evidence to suggest that. I think another thing that is interesting though, is in today’s world, where so much of the market is driven by index flows and ETF flows, owner-operator businesses are actually disadvantaged by the indexes, because indexes are market cap-weighted, but float-adjusted.

So, if you have two companies, and they’re exactly the same in the real world, if the CEO or whoever one of them owns a whole bunch of stock, you would say, that’s probably the better bet. But in index world, the index would actually buy less of that business. So, it’s just a way to skew yourself and give yourself an advantage versus the indexes, in addition to the obvious of just saying, people perform better when they have skin in the game.

And for me, especially with a concentrated portfolio, I want to be able to sleep at night. And a good way to sleep at night is to say, well, the guys that have all the skin in the game and the management team are probably not sleeping. They’re probably worrying all night about things that I don’t even know about because I’m an outside passive shareholder. It’s just nice to have them shoulder some of that burden.

Tobias: How did you get started as an investor? And how did you transition to the point where you are now?

Matt: Yeah, so I have a unique origin story. I feel in this business, you meet so many guys that started investing in stocks when they were 12 years old, and that was definitely not me. In fact, I graduated college without ever taken a single business class or a single accounting class or anything like that. I was a history major. And as a history major, or even before that in high school, every teacher I ever had told me that I should be a lawyer, specifically be a litigator. And I know you have a legal background.

Tobias: I don’t know if that’s a compliment.

Matt: [chuckles] Well, I understand. What it was, whether it’s a compliment or not, was that I was the guy that if I got something wrong on a test, or– a grade I thought should be better on a written paper or something like that, I would come back with my reasoning and argue say, “No, this is why it’s right. This is why I’m right. You think it’s this, but I think it’s this,” and there’s a difference in perception there. I think just having that analytical interest in trying to find the differences in the perceptions set me up for something like a litigator, potentially in arguing everything. So, as a history major, and then I went to– as I graduated, I actually intended to spend a year doing basically a gap year working as a paralegal at a law firm that was run by an alumni of my school. And that was the plan. But that plan got put on hold in 2001 because that was actually starting in September of 2001. And then 9/11 happened. And that kind of changed everything for me.

I grew up about a half-hour outside of New York City. There were, I believe, was 26 people from my hometown were killed on 9/11, including two guys that I went to high school with. And both of those guys worked at Cantor Fitzgerald, which was– I guess, for people who might not know they’re– I think the hardest thing, 656 people at Cantor were killed on 9/11, and they were basically more known as a bond brokerage, but they had an equity department as well. And through some connections I had people in town, and then my friends that work there and whatnot, somebody that survived, tracked me down and called me and just said, “Look, we need help, come you in and help us?” And I spoke with the people at the law firm. And they said, “Of course.” It was such a strange time in the world. And the law career would always be there. If I wanted to go back to law school, I could always do that. But at that moment, it felt the right thing to do to go in and help at Cantor Fitzgerald.

My first day was, I think it was, if I remember correctly, September 18. And I was in the Disaster Recovery Zone in Connecticut, where prior to 9/11, there were like maybe 20 people that work there. And when I started there, there were 80 people there and my– I mean, there’s nothing funny about it because of the circumstances. But I think a rare example where I could say my first job on Wall Street was actually building desks. And in my interview process, they were like, “Do you have any construction experience?” I said, “I actually do have construction experience.” They said, “Great,” start building desks because there’s going to be a lot more people showing up here. And that was how I got my foot in the door. After building desks, I was basically like a middle office role on the equity trading side, institutional equity trading. As you can imagine, when everyone in front of you is gone, you could climb the ladder pretty quickly. So, within a couple months, I was actually on the trading desk in a sales trading role.

Tobias: That you had built?

Matt: Yeah, exactly. A sales-driven role, mission-based role where you’re calling– the best customer to think of as somebody that owns 300 stocks, and billion under management, and they trade every day because it’s mission-based. Somebody like that, their training portfolio is great for missions. So, a big part of the job would be calling up a customer and say, “Oh, my God, XYZ missed earnings by a penny, you should sell.” Or, “Oh, my God, Goldman Sachs upgraded, you should buy.” And for me with absolutely no background at all in finance, or accounting or anything, I had no clue anything about the stock market, I was kind of amazed that as a 23-year-old kid who was still working as a bartender on weekends, I’d be calling up guys that were like, 50. And they managed $10 billion, or whatever. And they would listen to what I said and say, “Oh, this guy says we should sell it, we should sell it.” It was just totally bonkers.

I realized pretty quickly that that did not make sense, that world did not make sense. It took me a while to connect the dots though and figure out that the guys who were the opposite of that, the guys who were the worst customers on a commission basis actually made a lot of money on the investment side. So, basically, people that run portfolios, like I do now, where 10 or 15, or 20, stocks, whatever it might be, a reasonable amount of AUM, a small-cap focus, and low turnover, low trading, that sort of stuff, and just real business analysis. And I was clued into that by– it was actually a customer of my partners, who was a guy that worked at the Royce funds, which is a small-cap value shop, I’m sure you’re familiar with. And I was pining them one day, like how crazy I thought the whole thing was. And he basically said, “Wow,” I mean, he’s joking, I think. I hope he was joking. He said, “Wow, it sounds like you might actually have a brain in your head. So why don’t you use it and go read Ben Graham, go read Warren Buffett, go read Joel Greenblatt,” etc., etc., etc. And it blew my doors off.

I went home that night, and I started reading and I was probably up all night. And it’s cheesy to say, but it’s like Buffett says, it’s inoculation. You either get it right away, or you never get it. And for me, it was like something I never even knew existed. But all of a sudden, I found it. And it was like the perfect fit. So, I began too aggressively torpedo my career, because I realized I didn’t want to be just turning for a commission. I wanted to be an investor. And I would go in all day and sit there trying to do my job. But at night and weekends, I’d be reading 10-Ks and trying to learn, teach myself how to build models. And I eventually transition to more of a capital markets banking role to learn some of the technical skills like the modeling. And I went through the CFA program to learn the accounting and that sort of stuff. And then reinvented myself as in what I was calling an idea generator where my idea– my pitch was, I’m going to focus on these guys that only run small amounts of money. They don’t trade a lot, but they take big position. So, if I could get something in their book, they would do the trade with me, that would generate the commissions, etc.

The real idea, again, hopefully, one of these guys will hire me one day. But that would be how I made my jump from the sell-side to the buy-side. The problem though, is that these guys that put up the best numbers, if you only have 100 million, or whatever, it might be under management, it’s typically a one man or two men team. And the jump from a two-man team to a three-man team is a huge jump. So, I had a number of people saying, “Keep the ideas coming, keep the ideas coming in. At some point, we’ll find a way to work together.” And it just never really happened. Eventually, my boss at Cantor came to me and said, “Look, I walk around the room and I see most of the guys sitting here, throwing a football across the room and watching ESPN.” And you’re here reading 10-Ks and building Excel spreadsheets like, what is it that you’re really trying to do? Because your commissions are down by 70%.”

He basically said, “Look, would I be doing you a favor if I showed you the door?” And the answer was yes, because by that point, I’d become a partner of Cantor Fitzgerald. And if I had quit, I would have lost my partnership interest but because they showed me the door, I had a five-year runway to get paid out. That gave me the foundation to do my own thing which turned into Laughing Water Capital. I did a small stint with a by side asset manager and a research role. Spent some time there. I do actually feel like the research team there at Boyar Value Group was fantastic. I learned a lot from the research analyst, but I also had my own ambitions.

Over the years my interest in the game, interest in the art of investing. I did a lot of things like going to Berkshire meeting in Omaha going to VALUEx Vail in Colorado and a number of events where I met a bunch of guys who had started with small amounts of capital running concentrated portfolios. They put up good numbers and over time they were able to build a real business. And I’ve always thought about it, like Buffett has said, which is, you could be on a boat in the ocean surrounded by sharks. But if you have good returns, people are going to swim with you.

Tobias: [laughs]

Matt: [chuckles] I mean, there are a number of guys that I know who started small, and then made real businesses and eventually pushed me into it said, “Hey, why don’t you do it? Your returns are good. Your ideas are good. Why don’t you start your own business?” And I did that in 2016. And that was Laughing Water Capital. So, we’re coming up on our five-year anniversary. In February, it’ll be five years. And it’s been a fantastic journey.

Tobias: And so how did you find your initial backers? Were they folks that you had known through Cantor? Or through the Berkshire or VALUEx Vail? How did that come about?

Laughing Water Partner Letters

Matt: Yeah. I really just started with my money and money from my wife and small family money. I don’t really have a great friends and family circle, I never really raised money from friends and family. But what I always tried to do was write clearly about what I’m trying to do, my thought process behind my investments and my strategy and my beliefs about the way the world works in terms of realizing value. And I just put those letters out.

They started but sending them to a few people that indicated their interest, and then they start getting forwarded around, and then they wind up getting talked about on Twitter and other places like that. So, people just started to find me and say, “Hey, I like what you’re doing, would you take some money?” And I said, “Of course.” Subject to certain restrictions, like, for example, I have a very sticky capital base, and a very highly-screened capital base. So, everyone in my partnership is entirely fluent in the language of investing. And I’ve never once had to explain to someone like, “This is what a special situation is,” or, this is why a small manager acting alone and just trying to stand away from the herd can outperform. People understand what’s going on.

I think that’s super important because having a stable capital base is one of the keys. I mean, you’re running a concentrated portfolio, you’re running small caps, volatility is real. And in those times when it’s most volatile, is when the portfolio manager needs to be able to think most clearly and focus most [unintelligible [00:22:14] on what’s really going on. And if you have people calling you up saying, “What’s going on there? We should be panicking,” it makes it that much more difficult to focus on behaving the right way. So, I’ve totally insulated myself from that risk by only taking money from people that understand what we’re doing. And that comes actually with a long period. So, 95%, or maybe it’s 98% of the LPs at this point, have signed a multi-year lockup. And that gives me the capital base that I need to behave the way I want to behave, which will, over time hopefully continue to drive outsize performance.

The Value Spectrum

Tobias: Let’s take a step back and talk a little bit about your philosophy. So, we know that it’s a value-based philosophy. You’re currently focused in small and micro, and perhaps using special situations as the trigger to look into positions. But it doesn’t sound like you’re necessarily constrained to small and micro. And you’re not necessarily constrained to the special situations either. So, you’re just looking for along the value spectrum, something that is undervalued to simplify it as much as that.

Matt: Yeah, that’s from a high level, that’s a good way to think about it. One of the things I mentioned earlier, the value spectrum, I do think it’s notable that I diversify across that spectrum. So, there are some things in there that are definitely much more asset plays, cash-rich balance sheets on exciting businesses, that kind of stuff. Like Aimia, for example, fits in that bucket. That’s when I know you spoke with Chris Mittleman about a number of weeks ago. And that portion of the portfolio, if I’m being honest, has been a notable drag versus like the bulk of the portfolio, which is middle of the road businesses that are just under-appreciated and cheap for those special situation reasons. And, of course, there has been a drag versus the more growthy the edge of the portfolio.

I think it’s important to think about diversifying across that spectrum to be intellectually honest because we all know, there’s a number of, I guess, for lack of a better term famous value investors from 10 years ago, or 20 years ago, that have really struggled in recent years. I don’t want to say most of the, but a lot of the best performers, the golden age of value coming out of the tech crash and that sort of stuff. Those guys, a lot of them I’ve really struggled in today’s world. And it’s probably only a matter of time before the same can be said from the people that are extremely on the growth side now.

One of the things I think about some of the growth names and I’m not sure if any of these names or anything like that, but you see these stocks with 20 times or 30 times or 40 times revenue or something like that, and you need a really long DCF to justify that. And invariably, it seems like the thesis is that over time, they’ll get leverage on the sales and marketing line. And that might be true. But for most of these businesses, too, they’re really first movers. So, they have a huge first-mover advantage. There’s definitely a, I guess, generational shift underway in terms of cloud computing and stuff like that. So, their first-mover advantage, but eventually that first-mover advantage is naturally going to erode. And to me, it seems incongruous to claim that you’re going to get leverage on sales and marketing, just as new entrants are approaching the market.

So, you have to assume that at some point, margins are going to really widen out. And you have to assume that those margins are going to widen out by cutting sales and marketing, but how are you going to cut sales and marketing when for the first time you’re facing real competition? The pushback against that is like, “Oh, well, switching costs are really high.” And, again, that might be true. I mean, there’s certainly going to be some winners in the space. But I question how intellectually honest that is to claim that there’s going to be super high switching costs from a company that is a disruptor right now, because the switching costs are not too high for the incumbent– [crosstalk]

Tobias: Demonstrably so.

Matt: Yeah. So, there’s definitely going to be some winners and there’s definitely going to be some huge successes. But I think if you look at people where their whole portfolio is these fast-growing fast names and whatnot, I don’t necessarily believe that it’s intellectually honest to say that that’s a strategy and a process that’s going to endure for the long term because it seems like at some point, there’s going to be some very natural roadblocks to those businesses now.

So far, it’s worked really well. And I get shame on me for not being more invested in those stocks. And for lack of a better expression, I guess I’m picking the wrong dartboard. But for me, where I’ve put up returns that the prospective LP said to me earlier today, you’ve put up tech like returns, but I’ve been underweight tech, I feel pretty good about that because I think that that’s intellectually honest. And I think that this is my strategy, my approach is going to be timeless, because so much of it is based on taking advantage of the failings of human nature and market structure. So, it’s not every day that Ron Perelman has troubles with his debt stack, but it happens. And it happens fairly often, where you could take advantage of it. And that’s not tied to any of the macro factors that may be fueling a lot of the growth success right now, so it’s not tied to low-interest rates.

And there’s some risk that many of the sexy SAS stocks are really just interest rate players in the skies. And there’s some risk that people are really exhibiting recency bias when they assume that all these things are going to grow to the sky because you look at Google and Amazon and Salesforce and others that are truly dominant businesses. And people take that framework and apply it to the next company that just says SAS and their name.

Again, I’m not sure any of those names or anything like that, I’m just more cautious than most. And I think that, for me, and my partners, as I think about the next 30 years is, I want to have a strategy in a process that is repeatable, and repeatable, and repeatable and repeatable and not interest rate, timing in disguise or anything like that because I have no doubt that at some point, there will be the next group of investors that fit into the mold we see today of– I don’t want to use any names, but I’m sure we all know a number of the best value investors from the 2000s that have really struggled for the last 10 years.

At some point, we’re going to see some examples of the “best growth investors of the 2010s” or “2020s.” And they’re going to really struggle. And, for me, all I’m doing is trying to take advantage of human nature and market structure to find cheap securities. And that’s going to be timeless, I think.

A Recession-Proof Defensive Portfolio Component

Tobias: Are you explicitly thinking about diversifying across those different strategies as you’re building the portfolio? Or is that just something that you’re agnostic to what goes in and you take the opportunities when you find them?

Matt: I do explicitly think about it on the tails, but there’s always some portion of the portfolio. I shouldn’t say that on both tails. It’s always on the left tail, like the asset value tail, I explicitly always keep a portion of the portfolio in securities that I consider to be more defensive, whether that’s an asset value play or countercyclical or something.

But something that should do really well when a recession eventually comes. We seem to forget that recessions are real things. I think you’re Australian, so maybe you don’t have any real experience with recessions. But in the States, they used to happen before the Fed just started printing money all the time. So, I want to have some portion of the portfolio that is explicitly in there for defensive reasons. For example, a cash-heavy balance sheet, and a management team with a history of capital allocation. When there’s a recession, the cash on the balance sheet doesn’t actually change in value in terms of a dollar value, but in terms of purchasing power, it goes way up. And that’s really attractive. I definitely look for stuff like that or businesses that explicitly do better in weaker economic situations.

So, for example, for a long time I had a big investment in pawnshop companies. On the growth side, I don’t explicitly seek them out. But I’m certainly aware that if you can find a great business, and you can have that growth potential, and you could point to a sustainable competitive advantage, you could do really well. Interestingly, though, a lot of the ones that I would have in my growth bucket started as special situations picked.

Special Situation Investing

So, just very quickly to touch on one that I own is PAR Technologies, which is restaurant point of sale software. And the fantastic CEO, fantastic product, fantastic everything.

But where it was really interesting to me is that if you rewind a couple years ago, before the new CEO, the business was family-controlled, and you could look at a long term stock chart, and it was basically flat for like 25 years because the controlling family was not effectively allocating capital. In many cases, they were actually, I would argue, burning capital, like, for example, the founder’s son and daughter, I believe who was running a health club out of the corporate offices. That’s not very efficient.

No, that’s just not what you want to see from a management team. But then there was some outside pressure for some activists who came in and credit to the founding family, they did the right thing. And they brought in a new CEO who’s fantastic. And he’s a pure software guy. And they’ve stopped doing those things like the health club and whatnot. But there’s still a special situation angle, because the base business, the historic business they had is actually defense business, which they still own. And then there was a restaurant hardware business, which they still own and actually ties in very nicely with the restaurant software business.

But they’ve said at some point, and they’ve openly said that they’re going to divest that fence business at some point. And just looking at something like that, where I mean, the stock is rewriting considerably, it’s not cheap on traditional metric training. I do think it’s cheap, versus its growth, potential inverse the capital allocation ability of its CEO. But you also get this added bonus, because at some point they’re going to sell that defense business and while they do that, it’ll clean up the financials, and make it easier for people to look at it as a pure-play, make it easier for the quant models that scraped the world and dominate the market these days and make it easier for those models to see what’s going on.

Even though it’s a growthy business, and it’s not cheap on traditional metrics, it’s cheap, versus other growth names. And it’s certainly cheap when you start factoring in those kind of levers they have to pull to reveal the value to the world.

Shorting As An Asymmetric Trade

Tobias: When you think about shorting, how do you go about that?

Matt: So, definitely long-biased. I look at shorting primarily, it’s just a curiosity alongside the long process where I don’t typically set out looking for shorts. But, occasionally, in my travels, reading and studying businesses, you come across something where you say this is something that is worth shorting, or worth digging into longer on the short side. So, that’s part of it. And then I also maintain the flexibility, although, I extremely rare to use it.

But more exposure shorts, where it just taking down the gross of the buck, because the reality is, when things go wrong in small-cap world, well, everyone the stock market is, is when things go wrong, correlations go to one, and small-cap and micro-cap get hit harder than anything else. So, it is nice to have flexibility to use some index shorts or that sort of stuff to just protect against that.

There’s a very fine line, I think, between market timing and doing that effectively. And I think I’ve stayed on the right side of that line by– I’ve really only deployed that strategy in a meaningful way once, which was back then in March with COVID. And you could look at that intellectually and say it was not market timing, because if you were reading the headlines out of Asia and everything else, you could see that it was the real potential for a big problem was there. So, at the same time, you can look at risk-reward and getting short some of the retailers and stuff like that where they had supply chain risk.

China, even before people realized that the world would be in lockdown, and there was supply chain risk and something like that. And it was very lopsided trade to be short some of those retailers because if there were supply chain risks, then it could be in real trouble. But if there were not supply chain risks, I think it’ll be very unlikely that a group of retailers would all of a sudden rip higher and really squeeze you on the short just because retail is so hated in the obvious story surrounding Amazon and everything else.

It really just set up as a really asymmetric trade to be able to express through shorting some index products [unintelligible [00:34:29] retail products.

Tobias: How are you expressing the short? Are you actually shorting or are you buying puts? How are you doing?

Matt: Both, but I tend to avoid options. Very, very rare, a very small percentage of that might have been in options, and most of it is just in the shorting ETFs and that sort of stuff.

Finding Opportunities Using Keyword Search

Tobias: So, let’s talk a little bit about how you filter, validate, source ideas, what’s that process?

Matt: Yes, I think about it in a couple different ways. One thing I don’t do is any kind of mechanical screening that has valuation or something like that as an input. I’m very broadly of the view that if something looks cheap in today’s world that is not cheap because everyone has a screener and the mechanical ability to go through and find that. So, if it looks cheap, it most likely has been picked over. Now, there’s obvious exceptions. One that jumps to mind immediately is Apple, where a couple years ago, it was trading at P/E of 12, or 13, or something like that. So, there are obvious exceptions. But broadly speaking, I don’t do any kind of price-related mechanical screening.

My most effective technique beyond just reading broadly and staying curious is probably stuff like keyword search where you can identify certain events. So, I tend to look through anything like– for example, a tender offer, which is nothing about a tender offer by itself that’s exciting, but it is an indication that something might be about to change. And the basic thought is that markets are broadly efficient, most of the time, markets are efficient. So, if you’re going to be so lucky to find an inefficiency, your odds go up, if you’re searching for something where or the matrix is changing. Something in the matrix is changing. There’s an event or something happening, that might explain why the market has it wrong. So, there’s a couple different things over the years that I’ve just narrowed in on with keyword searches. And tender offer is a very simple one. A number that are much more complex and much more quirky keywords that tend to pop up in filings and stuff that will tell you things are going on. That’s a big one, a big part of it for me.

Focus On Economic Drivers Instead Of Forward Earnings

It’s really just continuing to sift through the world and find interesting things and be aware that situations pop up every now and again, that are really unusual, the Perelman example is a good one. And you just stay aware that those things are out there, and try to focus on what’s going to be important. And I think it’s interesting, actually against sticking with the Whole Earth Brands example.

I should quickly give credit to Dan Roller at Maran Capital, who I think is someone has spent some time on that, some credit for being associated with that idea. But if you look even on Value Investors Club where there’s a right up there, there’s people in the comment section that are debating, what will EBITDA be in two or three years? How successful will this cost rationalization plan be? What will EBITDA be? That sort of stuff is important, but I look at what Seth Klarman has said about needing to have the ability to make decisions with only 80% of the information because if you wait till you have all the information, the opportunity is probably gone.

So, you can look at it, we could quibble over whether EBITDA in 2021 is going to be 65 million, or 60 million or 70 million. We could quibble, but it doesn’t matter, because you could take the low end of that and haircut it and the stock would still be cheap versus comps. And the most interesting thing is we have a forced seller, you could look at it and say this is a guy that from the original sale price, which Perelman is known as a hard negotiator. The original sale price, we have to assume that he was under some pressure then, but the original sale price was 575 million. And then after everything that’s happened, this SPACing process, the COVID fact, everything else, the shares are available for like $250 million market cap. So, it’s less than half of where Perelman was originally selling it.

The odds are heavily in your favor at that point that even if execution is imperfect, as the story unfolds, as the stock is added to indexes, because it’s not on indexes yet. As Erwin Simon goes out and does this thing. Keep in mind, Erwin Simon, if he formerly ran a $2.5 billion revenue company, he’s intimately familiar with the way the sell-side works. And even though this is now only, I think the market cap right now is called 300 million, even though this is only a $300 million market cap, Erwin Simon has behind him a long track record of doing M&A. And the banks certainly know who he is, because they know he’s been a good customer to him in the past. Now, he could go out and say, “Hey, I am probably going to do some M&A here at some point, but how about some research coverage? All of a sudden, you could have some real banks shining a light on a stock that nobody else is looking at.

I think those sort of factors are more important than deciding if in 2021, EBITDA is going to be 65 million or 60 million. What’s really going to matter here, at least in the near term, is how those dynamics shake out. And how the fact that Ron Perelman was a forced seller kind of develops. Clearly as we go on through the process, we need to re-underwrite and change and check our assumptions. And always try to be updating for the current valuation and stuff like that to see if this has the potential to burn a long-term hold in the portfolio.

I mean, there are situations where this could be a stock that you own for 5 or 10 years. And it’s not crazy to think that if they get the right cost of capital, they could use this as an M&A platform. And it’s interesting to think actually the insiders, their shares from the SPAC are locked up until the stock hits $20 a share. And the stock right now is at eight. So, those are things that could justify a long term hold here. We’re not there yet though, it doesn’t matter.

The $65 million EBITDA on next year or the 60, or 55, or wherever it might be is less important right now. It’ll be more important a year from now. But right now, focusing on those things that are just outside of true economics, they’re just quirks in the world, are the kind of things that can drive performance.

Validate Your Ideas With A Red Team

Tobias: So, that’s some discussion there about how you’re validating the ideas. But are you doing channel checks, speaking to management teams? How do you validate the idea?

Matt: Yes, I definitely all of those sorts of things. It’s a bottom-up process, starting with reading the financial statements and the transcripts. I almost always speak with management teams, I don’t always, but I almost always do. I try to speak with former employees, that sort of stuff, competitors, read the filings on the competitors. I don’t really do any sell-side research. I don’t really use that. It just doesn’t really fit well in my process.

Basically, just turning over as much as I can trying to get to the thesis and then trying to destroy the thesis by questioning all the things that I’ve come up with through my first round. So, if you think of the initial round as financial statements, transcripts, management, and then you’ll be able to paint the thesis with that. And then you try and destroy that thesis by going to things like competitors and customers and former employees and say, “What is the truth from the outside versus what the truth is, as they project it through their financial statements?”

And then, the last part of it is something I call a red team, because I’m a one-man show, I don’t have a partner or anything like that, to help me realize the flaws in my thinking. But what I refer to as the Red Team is actually an idea that was put together by Scott Miller at Greenhaven Road, who you may be familiar with. If not, you should probably try and speak with him at some point. He is a fantastic investor and great human being. But he about a year or two ago brought together a number of like-minded investors to do an event with Annie Duke, who has written books about decision making. She’s a former professional poker player and the psychology because she almost had a PhD in psychology, she dropped out to play professional poker, but she’s an authority on decision making, I guess.

Basically, had an event, trying to explain how decision-making works, and how as investors, we can improve our process. And one of those things is being aware of your own biases. And the second thing is being aware that you can never fully defeat them. So, the red team idea is, if you take other people that have a similar but different skill set, and have them look at your ideas, but the idea that in advance, we’re going to make an agreement that nobody’s going to get their feelings hurt here.

The idea is that you would make me uncomfortable. And so, there’s a number of other investment managers I can rely on for that. And where I actually feel like I have a real advantage is that when I think of Laughing Water Capital, the largest cohort within the LP base is actually other professional investors. And that’s everything from former equity managers or current equity managers that used to have a small-cap strategy, but now they have too much money to invest in small caps. So, they invest with someone like me, while they also run their own portfolio, or private equity types, where a lot of times I hear from private equity investors that in their world, they’re always buying from the smartest person in the room. But in my world, I’m often able to buy from the dumbest person in the room.

The point is, just a network of people who are LPs, and their incentives are on returns just as mine are. So, they’re not afraid to tell me I’m stupid. And that’s really the goal. I don’t want anyone to tell me that my idea is great, or that my idea is “correct.” What I want is pushed back to help me understand what I’m missing, what I’m doing wrong, other things I need to think about, how the pieces needs to be adjusted over time, things in advance that would make me change my mind. All of these things are meant to defeat the demons that we all have, which control our behavioral response to decision making.

Tobias: What’s the source of that red team idea? Is that like a Bill Belichick? Does it come from Pats or something like that? I remember, maybe in the last year or two.

Matt: I’m not sure. As much as it’s painful, I’m a Jets fan, so I can’t really comment on Belichick or the Patriots. But, for me, the first time I had heard it, or at least got intimate with, it was this even with Annie Duke, so I thought I would credit her. It’s definitely possible it came from somewhere else.

The Origin Of Laughing Water

Tobias: Just for fun, we’re coming up on time here. What’s the source of the name Laughing Water? It’s great name.

Matt: Thank you. It’s the joke in the hedge fund world is that you name the fund after the street you grew up on or something like that, but I grew up on Homestead Avenue, and there’s already like 10 different Homestead funds, so I had to dig a little deeper. And my family has a small place on the North Fork of Long Island in a community called Laughing Water, and the right way to think about that is cornfields and a hammock and a book and just thinking and reflecting and letting the world come to you.

Tobias: Why is that place called Laughing Water? Is that something like you let the corn– put it in a steel for a little while and out comes Laughing Water?

Matt: Well, [laughs] it’s funny because there is a connection– Well, for this specific Laughing Water, it’s actually a Native American link, where Native Americans had lived there at one point, there’s a creek there. But in terms of also being an Irish American guy, the Laughing Water connection to whiskey and [unintelligible [00:45:35] actually means Laughing Water, which is always been a source of jokes, but it’s very much the Native American attachment from where I got it.

Tobias: That’s absolutely fascinating. Thanks very much for the time today, Matt. If folks want to get in contact with you, how they do go about doing then?

Matt: Yeah, the best thing to do would be to go to laughingwatercapital.com, specifically, the letters section, you could go there and review past investment letters and past investment pitches I’ve done, to just get an understanding of how I think. And there’s also a button there that will allow you to sign up for a distribution list. And then I’m not very active on Twitter, but I am on Twitter under, I believe is LaughingH@OCap. And that’s the best way to do it.

Tobias: That’s fantastic. Matthew Sweeney, Laughing Water Capital. Thank you very much.

Matt: Thanks very much, Toby. I appreciate it.

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