Ryan Morris of Meson Capital has been showing up on my radar frequently over the last six months (often through SumZero). From what I have read, he seems very capable and his write-ups have struck a chord with me. There is something about his approach that makes me think of the old Buffett partnership letters. I can´t really pinpoint what it is that makes me make the connection, but I think it is really his general approach. Morris is focused and and he looks for opportunities in obscure situations, often derived from misconception. But most importantly, if he needs to, he will get active. It is my opinion that the ability to take on an activist role, can be highly valuable for an investor and I base this opinion on Warren Buffett´s Partnership letters.
In the Partnership letters, you can find two detailed accounts of Buffett´s approach to activism in the cases of Sanborn Map and Dumpster Mill. I really love those two accounts and I find myself reading those sections every now and then. The way I see it, one of Buffett´s competitive advantages was a “decision-tree” -approach. The process would be something like this:
(1) He recognizes mis-pricing in a security.
(2) He takes on a position, putting it in the “Generals”-category.
(3) If there is a correction, he can sell and monetize his profits.
(4) If the divergence increases or the price lingers, he can add to his position until he gets into a control position and can exercise his influence to extract the value out of the its assets.
The brilliance with this approach is that once you enter a position, the price movement does not really matter. Up or down, either way will give you options to work with. Buffett explains in his first half letter in 1964:
What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it. This doesn’t do much for our short-term performance, particularly relative to a rising market, but it is a comfortable and logical producer of longer-term profits. Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.
In order to do this the companies he invests in (1) must be small enough for him to be able to get to a control position and (2) the incentives and possible actions of other blocks of shareholders and the executive management must be clear.
Now consider this quote from Mr. Morris:
InfuSystem Holdings Inc (Nasdaq: INFU) is an interesting example of what I mean by no competition because of “structural factors” above. When I made it a large position in November, it was only about a $25M market cap and the shareholders were mostly hedge funds managing $100M+ and it was a sub 1% position for them.
The assets are great, but the performance has lagged due to the CEO and board of directors (who have granted themselves roughly 18% of the shares over the last 4 years while the stock has declined 75%). It made no economic sense for any of these holders to try to do something about this, as being an activist takes a significant dedication of time and effort so it wouldn’t make sense to triple a 1% position. Because I could make it a much larger position to my fund, it was proportionally worth it to “bang the brick wall down with my head” and do something about the situation. I’ve been so lucky to work with some great and supportive partners for this investment.
Pinnacle Airlines (Nasdaq: PNCL) has a similar structural issue where the board owns basically no stock and the other holders are large. In general, there is a nearly total competitive void in microcap companies that need a change of direction at the board level, which is another reason why I have been increasing my involvement in that and why I think there is a significant source of excess return there.
Now here is Buffett´s discussion on his investment in Sanborn Map:
The bulk of Sanborn’s business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities.
For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn’s profits would become too great and placed a number of prominent insurance men on Sanborn’s board of directors to act in a watch-dog capacity.
Prior to my entry on the Board, of the fourteen directors, nine were prominent men from the insurance industry who combined held 46 shares of stock out of 105,000 shares outstanding. Despite their top positions with very large companies which would suggest the financial wherewithal to make at least a modest commitment, the largest holding in this group was ten shares. In several cases, the insurance companies these men ran owned small blocks of stock but these were token investments in relation to the portfolios in which they were held.
The tenth director was the company attorney, who held ten shares. The eleventh was a banker with ten shares who recognized the problems of the company, actively pointed them out, and later added to his holdings. The next two directors were the top officers of Sanborn who owned about 300 shares combined. The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors. The final member of our cast was a son of a deceased president of Sanborn. The widow owned about 15,000 shares of stock.
The Sanborn story plays out with Buffett buying the widow´s shares and additional shares on the open market, he teams up with other disgruntled investors and they set up a plan to split the business (the mapping business and the securities portfolio). The board opposes, but a proxy fight scenario is unlikely as Buffett and co. are almost certain to win it, would that situation occur. In the end the SEC approves a plan to sort of spin-off the securities portfolio.
Now, consider Morris´ situation with Pinnacle. As with Sanborn situation, the incentives of the Board of Directors at Pinnacle aren´t necessarily in line with the common shareholder. The biggest client (Delta) is also the biggest claimant. In a chapter 11, whose interest is management and BoD going to look after? Here´s Mr. Morris on the subject:
To reduce risk, I have formed a 13D group with another large shareholder to get a voice for shareholders. Hopefully that voice is on the board that currently owns a mere 1% of the company, or if necessary through an equity committee should they decide to file chapter 11. As was the case with HearUSA, chapter 11 is not the same as equity being wiped out. Pinnacle is definitely more messy and less certain than the aircraft lessor situation in 2009 but I am also more sophisticated an investor and don’t make the position size as big. It definitely fits the criteria that I like where most everyone else is panic selling for reasons that look valid at first glance, but metaphorically once you do some real research you find yourself alone in the library and that the covers of the books are very different than the contents.
For the sake of argument, here are two other quotes from the SumZero interview:
I have evolved in a more activist direction over the last year and a half because the big risk factor that you can’t control just with research is that of the stewards between you and the assets of the company you own. If you have a great asset but a board of directors and CEO who don’t know how or don’t want the value of those assets to accrue to shareholders, then you have a problem as an investor. So I have been increasing my ability to use this tool when necessary to change the risk/reward profile of an investment. For smaller companies, which I really exclusively look at for competitive reasons, it is particularly important because the range of management quality is so wide. I got into this tack first by having some bad experiences with my positions and reacting and now people I know tend to contact me and ask for help. So if any readers out there have a cheap company that will stay cheap because the directors aren’t acting in the shareholder’s best interests, let me know and maybe I can help!
Another aspect of this passive-with-an –option-to-control approach is that the control situations are behaviorally different from the ‘Generals’. Here´s Buffett discussing control situations in a Partnership letter:
Of course, this section of our portfolio is not going to be worth more money merely because General Motors, U.S. Steel, etc., sell higher. In a raging bull market, operations in control situations will seem like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.
And Ryan Morris:
I am not actively short them, but I don’t understand why people are valuing so many cyclical stocks like Caterpillar (NYSE: CAT) as if they are not cyclical. I think the market has become more superficially focused than ever as evidenced by, for example, dividend stocks being the highest performing category last year. The current dividend on a stock is nearly meaningless but if the market just prices things that are immediately apparent then it explains this kind of behavior. It creates a good buying environment for my “bad perception/good reality” style of investing but it also means that things that appear ugly will get cheaper for a while.
Now, on to Dempster Mill. Here´s Buffett´s own recap of the investment:
This situation started as a general in 1956. At that time the stock was selling at $18 with about $72 in book value of which $50 per share was in current assets (Cash, receivables and inventory) less all liabilities. Dempster had earned good money in the past but was only breaking even currently.
The qualitative situation was on the negative side (a fairly tough industry and unimpressive management), but the figures were extremely attractive. Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years. Just why any particular one should do so is hard to say at the time of purchase, but the group expectancy is favorable, whether the impetus is from an improved industry situation, a takeover offer, a change in investor psychology, etc.
We continued to buy the stock in small quantities for five years. During most or this period I was a director and was becoming consistently less impressed with the earnings prospects under existing management. However, I also became more familiar with the assets and operations and my evaluation of the quantitative factors remained very favorable.
By mid-1961 we owned about 30% or Dempster (we had made several tender offers with poor results), but in August and September 1961 made, several large purchases at $30.25 per share, which coupled with a subsequent tender offer at the same price, brought our holding to over 70%. Our purchases over the previous five years had been in the $16-$25 range.
On assuming control, we elevated the executive vice president to president to see what he would do unfettered by the previous policies. The results were unsatisfactory and on April 23, 1962 we hired Harry Bottle as president.
As Buffett explains in his letters, once in control it’s not a mispricing problem anymore, but more of an asset conversion problem. Accordingly, now it all comes down to execution. In an earlier letter, Buffett had talked about the new CEO Harry Bottle (allegedly recommended by Charles Munger) :
There is one final point of real significance for Buffett Partnership, Ltd. We now have a relationship with an operating man which could be of great benefit in future control situations. Harry had never thought of running an implement company six days before he took over. He is mobile, hardworking and carries out policies once they are set. He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated.
Morris became active at Infusys Holdings after holding the position for four years. Here´s the first paragraph from the cover letter:
As stockholders of InfuSystem for as long as the past 4 years, we have been disappointed with the performance of the Company as the stock has lost almost half its value. This culminated with the write down of the entire goodwill balance in 2011. At the same time as the Company’s value has eroded, we believe the board of directors and current executive management have enriched themselves with excessive stock and cash grants. In summary, we believe that the current direction of the Company and the current board of directors are not in the best interests of stockholders.
And here are quotes from Morris, after he became the executive chairman of Infusystem Holdings:
“Our prime mandate is to create value for all shareholders,” says new Executive Chairman Morris. “Further, we believe that our personal economic fates should continue to be entirely tied to performance. Accordingly, new board members will be compensated solely in stock options. “
“We are pleased to have someone of Dilip Singh’s stature to serve as Interim CEO,” Mr. Dreyer said. “Dilip has nearly 40 years of operational, executive management and board experience with global Fortune 500 companies and a proven record of overseeing profitable growth in rapidly emerging sectors.”
Perhaps I am struck by a severe case of confirmation bias and undoubtedly, as these comparisons also demonstrate, these situations are not identical. But in both cases these two investors are focusing on investments in which they see themselves having a competitive advantage against their counter-parties.
I have no knowledge on Morris’ performance but I do like his style. It will be interesting to follow him in the future.
Meson Capital Partners
A thread on Ryan Morris on the Corner of Berkshire and Fairfax forum