Interview with Guy Shanon and Michael Blitzer, Managing Partners of Kingstown Capital
About the fund & strategy:
- We run a long-biased and concentrated portfolio of special situation securities across the capital structure. Most of these securities in the $1B to $10B enterprise value range for both equities and debt, though credit securities can be smaller
- Learned that it is not so easy to make money with small caps – see a lot of questionable management teams and low quality businesses and have technical aspects like liquidity
- Don’t think of ourselves as a big fund and we think we can make the best risk-adjusted returns in the size range we currently target. This size also tends to have a larger pipeline of the special situation categories we track like spin-offs and distressed debt
Number of special situation funds grew – how has this impacted Kingstown?
- The longer we do this, duration of capital and time horizon has actually become more and more of a competitive edge
- Given the structure of the hedge fund industry and the structure of capital, patience becomes harder over time unless you align yourself with long-term capital. We’re clearly shorter-term focused than a private equity firm but there are very few investors in the public markets right now who can take a 1-3 year time horizon
- If you go to some of these large multi-strat funds, time and volatility are very relevant because they’re running massive amounts of capital. If you drew down a couple of percent in a month, you get stopped out. But then what do you do with that cash? You have to find another trade tomorrow and it just feeds that volatility
- We only focus on special situations and just look for certain areas where we know there are chronic mispricings; we run a concentrated and flexible mandate where we look across industry and capital structure. We run a fairly deep research process which is possible because we are concentrated
How do you think about volatility, risk, and exiting positions that are going against you?
- We define risk as permanent impairment and take a view that risk and volatility are very different
- We take the approach that we are re-underwriting every single position everyday – if the facts change, we have to be intellectually honest and reevaluate
- It’s easier said than done – when something goes against you, you have to fight off the urge to ignore bad news
- In terms of evaluating somebody who is starting a new fund, there are three parts: there is being a good analyst, and then there is being a good portfolio manager; then there is temperament; there are many that have one of the three of two of the three but it’s hard to have all three
- Part of the temperament is being able to be self-critical; many people in this industry have been successful all their lives – when a position is going against you, you have to really break it down and be honest with yourself
- You have to put up walls and blinders to eliminate behavioral biases
Screening and search process to actually putting capital to work?
- View has always been that markets are very efficient
- Look for places where there is chronic mispricing; keep the fund size small because the bigger you get, the fewer places you can look
- All we do is look at special situations – we look at every spin off, every bankruptcy and distressed credit, every rights offering, and every privatization
- Keep looking at these categories and you own the good ones, unlevered and at good valuations, and you can be a little patient, you have a good chance of outperforming
- We are unique in that we screen for situations first, not valuation – this is to avoid value traps
- Then we look at valuation on an absolute basis – if it’s cheap, then we start fundamental research (if it’s liquid equity, we’re not in a rush and we’ll have full blown research process; credit is different – we’ll own credit if we’re pretty sure and need to take advantage of liquidity)
Idea you want to share?
- Largest position now is Adient (ADNT); largest manufacturer of auto seating in the world and virtually every auto company is a customer; Johnson Controls (JCI) spun out of the company in October of last year; it struck our interest given the structure and nature of spinoff – much smaller subsidiary, different industry, underinvested business of the parent, and misunderstood
- Misunderstood because it was viewed as very low quality and cyclical business because it was auto parts; this bias along with forced selling as a result of no longer being part of S&P 500 pushed valuations to approximately 4-5x earnings late in 2016
- Many competitive barriers to entry in an industry dominated by two main players and business is more of a high-return just-in-time logistics provider and supplier than an old-line manufacturing company
- One of the biggest knocks against ADNT is the disruption and potential change in industry but ADNT is a beneficiary of the move towards autonomous vehicles; they have a position with every manufacturer; ADNT and Lear (LEA) control majority of the global market; as vehicles become more autonomous, big differentiator is going to be interior package and seating is the biggest component
- Unusual to get an above average business for a third to a quarter of S&P P/E multiple
- We think ADNT is going to generate $9 in earnings this year; lower margins relative to LEA relates to under-investment in the business while controlled by prior parent; higher margins would take them to $12-13 a share; stock got as low as $45 in November and is still only $60
- With respect to bear argument on auto cycle:
- Auto industry is cyclical in general; then there is the idea of a SAAR wall – we don’t think SAAR is going to plummet
- Regardless, ADNT can make a lot of money with SAAR sitting here it is right now or if it falls somewhat; ADNT also has international revenues
- Even if unit volume declines, they can increase content per car in some markets over the next few years; also making progress selling seats into non-car markets
- We aren’t saying numbers on SAAR can be bad for few quarters; this is a business that should grow sales over the next five years
- We have this moderately hedged due to Trump risk on Mexico and China
- Our short exposure is 0 to 25% – majority of hedging is where we think we can isolate industry risk
- We are short some auto part suppliers but still a very meaningful net exposure to ADNT
Managing between looking for things that you feel have bottomed out and incredibly difficult task of timing the market?
- We just don’t know and we just do our best; bottom line is we are not going to own something unless there’s some reason to think it’s really misunderstood or really overlooked
- You have to use valuation as an anchor – not to say that something trading at 5x earnings cannot go to 4x; things can always get cheaper but it’s binary – things are either cheap or they are not
Advice for people entering the industry?
- It’s a good idea to listen more; people view every interaction as a way to show how smart they are; instead of thinking about your next question or insightful observation, just listen
- For interviews, we meet hundreds of people who share investment ideas that sound the same. You get a unique insight because you have been thinking about this information differently or you found new information through primary research (you visited 25 stores, met some customers, filed a FOIA request, etc). Any monkey can generate EBITDA multiples and slap them on slides – more kids are going to undergraduate business schools than ever and thousands of people who know Excel and have taken Finance
- Unlike most other professions, there is no specific experience required; appreciate how much you don’t know and find a place where you can learn but also where you share a common investment philosophy; if you don’t have common philosophy and a real passion for investing, it’s not going to work; you can’t fake passion and fit
- Given the popularity of hedge funds over the past decade, a lot of people have come into the industry because it’s the next logical step or the way to become wealthy; it’s what investment banking was before that; it has attracted high performing individuals many of whom have never experienced a setback or disappointment; this business humbles people very quickly and how you deal with setbacks will determine success or failure; we focus on asking about these disappointments when we interview high performing candidates that go from Ivy League to bulge bracket Wall Street firms then to hedge funds
- No matter how old or experienced he or she is, you have to bring a notebook to every single meeting and you have to write everything down
Kingstown Capital Management is a value-oriented investment partnership that focuses on special situation securities across the capital structure. The firm was founded in 2006 with strategic backing from Gotham Capital and currently manages $1.8B.