Dear Partner,
In the first quarter of 2023, Woodbridge Capital Partners I, LP (the “Partnership”) returned 6.69% while the S&P 500 returned 7.50% (with dividends reinvested)1. Since its inception in April 2020, the Partnership has returned 118.2% compared to the S&P 500’s 61.8%.
In the first quarter of 2023, the inflation saga, which began with COVID, continued. In particular, the Fed continues to contend with the balancing act of combating stimulus-induced inflation while maintaining economic stability. The rate hikes appear to have been effective thus far. Inflation has eased from last year’s high of 9% to around 5% (as of the last twelve months through March),2 and, despite the quantitative tightening, the economy at present still looks to be holding up, with consumer spending above pre-pandemic levels, healthy consumer balance sheets, and low unemployment.
That isn’t to say that the rate hikes haven’t resulted in any casualties, the most notable of which has been Silicon Valley Bank (SVB). With a focus on venture capital clients, SVB’s deposits surged between 2020-2021. Most of those deposits ended up being invested in long-term, fixed-income securities at a time when rates were at historic lows. This exposed SVB to substantial interest rate risk. As rates rose, the fair value of their assets fell to the point that their equity was effectively negative. Concerns regarding SVB’s solvency spread like wildfire throughout the tight-knit venture capital community. As concern devolved into panic, withdrawals were made in lock-step, and a classic run on the bank ensued.
The collapse of SVB, as well as that of a few other regional banks and the emergency rescue of Credit Suisse by the Swiss government and UBS, has exacerbated existing anxieties and even stoked fears about systemic risks in banking. These fears, however, appear unjustified. Major banks remain well capitalized. In the case of SVB, their fate was primarily the result of a failure to properly manage interest rate risk, a large proportion of accounts that exceeded the $250,000 maximum FDIC protection, and an unusually correlated client base.
This quarter’s turbulence in the banking industry has caused the Fed to reevaluate their plan for monetary policy. They now expect that credit conditions in the market will tighten, reducing the need for higher rates to combat inflation. In March, the Fed published its Summary of Economic Projections, which showed that they expect to raise rates another 25 basis points and then hold there through at least the end of the year. But the market does not buy these projections. The market expects rates to be cut by the end of the year, probably because it forecasts an imminent recession that will compel the Fed to ease monetary policy whether inflation is resolved or not. Only time will tell which of their views, if either, is correct.
With all this talk of recessions and inflation, I’d like to reiterate that we invest in businesses, the values of which are the present value of future cash flows from now to infinity. Though current events do affect our businesses, whether or not they are good investments will almost certainly be determined by their fundamentals – not by what interest rates are in six months, or what GDP growth is next year. While Jesse and I spend much of our letters discussing the general state of markets, we do so only to provide you some context.
During the quarter, we increased the concentration of our portfolio by exiting two positions. The first of those exits was Advanced Emissions Solutions (ADES), a provider of pollutant control solutions in coal-fired power generation. We regret making this investment. Our original thesis for ADES was a relatively straightforward deep value investment. When we first purchased in the beginning of 2022, ADES had a cash balance equivalent to over 70% of their market cap, which we believed, and still believe, severely undervalued the remainder of their assets. Their enormous cash pile represented significant potential to shareholders, whether in the form of a special dividend, an accretive tender offer, or sale to an acquirer. Management seemed to be aware of this potential as they had already announced a “strategic alternatives review to maximize shareholder value.”
Unfortunately, that couldn’t have been further from the truth. Management announced that as a conclusion of their strategic review, ADES would engage in an equity-financed acquisition of Arq, a producer of coal waste remediation products, that would significantly dilute existing shareholders. Just one trading day after the initial announcement, the stock plummeted by around 40%. Although we were obviously disappointed with management’s decision, we decided to hold for two reasons. Firstly, the negative impact of the announcement was already reflected in the price following the drop. And secondly, given the clear disapproval of shareholders reflected in the stock price, we believed that there was a high probability that the acquisition would fall through when put to a shareholder vote.
As events would soon make apparent to us, our trust in management to act in accordance with their fiduciary duty to shareholders was misplaced. Management, realizing that the “proposed” acquisition was unlikely to be approved by shareholders, bypassed the vote by issuing convertible preferred shares in exchange for equity in Arq. Since the conversion of the preferred shares into common stock is contingent upon the approval of ADES’ shareholders, the new terms appear, at first glance, to keep the decision in the hands of shareholders. However, the preferred shares would accrue dividends with a coupon rate that would increase over time, effectively forcing the hand of shareholders.
In light of these developments, we sold our investment in ADES. While the fundamentals of the business remain attractive, we lost confidence in their capacity and intent to provide shareholder value. It is unclear why management pursued this path. Perhaps they are very confident that it is the right decision, but we do not share their confidence. Or perhaps they did not want to sell the Company (which would have benefited shareholders) simply because they were more interested in keeping their jobs. In terms of returns, this investment was one of our biggest mistakes. Cumulatively, it reduced our return by about 7% annualized during our holding period. We underestimated how much value can be destroyed by a management team whose incentives are not aligned with those of shareholders. We will not make the same mistake again.
The second of our exits was Geo Energy Group, an Indonesian coal mine owner. Unlike the case for ADES, our primary motivation for selling Geo was to concentrate our portfolio in our best ideas. Geo’s coal assets are undervalued under any reasonable outlook for coal prices; however, we believe the proceeds from our sale will be better employed elsewhere. We purchased at an average price of 0.43 SGD (Singaporean Dollars) per share, sold for 0.34 SGD per share, and received about 0.06 SGD per share in dividends. In other words, Geo was only down modestly while our other stocks got a lot cheaper. The fact that both of the companies we disposed of in the quarter were related to the coal industry is purely a coincidence and wasn’t the result of any particular view on energy commodities. At this point, we have no investments in the energy sector.
At the risk of sounding like a broken record, I’d like to continue to make clear that the investment opportunities currently available are some of the best we’ve seen, rivaling the 2020 market crash. For example, our largest holding is a company with a market cap of ~$9 billion. The company has excess cash of $3.4 billion and generated ~$3 billion of free cash flow in the last two years. If you were to buy 100% of the shares of this business at the current prevailing price, after four years you would have recouped all of your money, and still own the business! We are glad to see management taking advantage of their stock’s absurdly low valuation by doing exactly what we would if we were in their shoes: repurchase hand over fist. With over $600 million and $200 million in stock owned by the Chairman of the Board and CEO, respectively, management’s interests should be well aligned with those of shareholders.
While this is a very rough picture of just one of our investments, we hope it sheds light on why we are so optimistic about our portfolio. We remain confident that the Partnership will outperform the S&P 500 over the long term. If you ever have questions or concerns about your investment, please do not hesitate to reach out to us. As always, we remain committed to your investment success.
Thank you,
Kyosuke Mitsuishi & Jesse Flowers
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR
2https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm