Dear Partners,
This quarter marked our first six months of operation. Rowan Street Capital, LLC was initially funded in March 1, 2015 and through August 31, 2015 the fund has posted a positive gain of 1.4% before fund expenses. During the same time period the S&P 500 had declined by 7.7%.
Let me explain what the fund expenses are. These include our start-up costs, amortized over 5 years for accounting purposes, a fund administration fee, as well as tax and financial statement preparation fees. We should emphasize that our start-up costs and our operational costs are incredibly low by industry standards. By our estimates they are probably, at most, a third of the general operating costs of a comparable fund. We were able to achieve these low costs thanks to Joe Mass and his other company, Synergy Financial Management (SFM), which is a Registered Investment Advisor (RIA) based in Seattle, WA that is overseeing Rowan Street Capital, LLC for compliance purposes and provides us with various financial subscriptions necessary for our research. Although there are many synergies between our fund and Synergetic Finance, there are fund expenses that we must still pay for and even though they are relatively small, they do have an effect on our fund performance (net), since our fund is very new and still relatively small in size. As our fund grows, these expenses will be very immaterial and will not have much effect on our investment performance.
To that point we have also made significant progress increasing our assets under management (AUM) by 35% in the third quarter. Our goal is to at least double our AUM by the end of 2015 from where we stand today, and we have a number of prospective partners in the process of signing up with Rowan Street. It’s exciting to receive new capital from investors when the market experiences a correction, which gives us “plenty of ammunition for the hunting season”.
Our incarnation is that short term results (less than three years) have little meaning, particularly in reference to investment operation such as ours, where we construct and manage our portfolio of companies with a long term approach and have a mindset of a business owner. It’s important to note we expect our results, relative to S&P 500 and the general stock market to be better in declining markets, but we may have a difficult time keeping up with bubbling markets. We are very conservative with the capital that our partners have entrusted us with and always remember Warren Buffet’s famous two rules to investing. Rule #1: Don’t lose money; Rule #2: Don’t forget rule #1.
Rolls Royce Holding PLC (RYCEY)
Rolls Royce PLC is the latest addition to our portfolio. This name has an automatic association with the luxury car manufacturer; however Rolls Royce Holdings PLC has nothing to do with the car business, which was sold back in the 70s to allow the company to concentrate on jet engine manufacturing.
Rolls-Royce Holdings plc is a United Kingdom-based company that designs, develops, manufactures and services power systems for use in the air, on land and at sea. The Company operates through two divisions: Aerospace and Land & Sea. The Aerospace Division produces aero engines for large civil aircraft and corporate jets and provides defense aero engines and services. The Land & Sea Division comprises power systems, marine and nuclear businesses.
The main competitive advantage that Rolls Royce enjoys are the switching costs that result from the firm's gas turbine engines being well integrated in the wide-body aircraft platforms of Boeing and Airbus. Rolls-Royce's customers, the airline operators, are hesitant to switch to new engines as it is time-consuming and the change entails high investment costs and retraining of maintenance personnel. The engines have long economic lifetimes, and the support services aid customer loyalty. Long product cycles ensure that a platform win brings in revenue for multiple decades.
Rolls’ aero-engines division is where the real value can be found. Rolls shares a duopoly with General Electric in wide-body jet engines, and the barriers to entry for any newcomer would be formidable. In this business, Rolls earns a 20% return on invested capital. However, Rolls’ sales aren’t one-offs: the company sells its engines at cost, or at a loss, but signs lucrative maintenance contracts over the life of the power system. These maintenance contracts produce income for years after the initial sale. There are few other companies with such a lucrative business model.
Hidden Value
Rolls has made many mistakes over the past few years. These errors include a wasteful £1bn stock buyback, diversification into industries where the company has little experience and a slow transition to new product lines. But now the company is trying to draw a line under these mistakes and move on. Luckily, Rolls has world-leading reputation and multi-billion dollar order book already in place to support this turnaround. Specifically, at the end of the first half of this year, Rolls’ order book stood at £76.5bn, equal to more than six years worth of sales at current production rates. And with a new management team in place, along with a San Francisco-based activist $19B hedge fund — ValueAct led by Jeffrey Ubben, which has a reputation for unlocking value from struggling companies — Rolls’ restructuring should yield lofty returns for investors. Warren East, Rolls’ new CEO, has stated that the company’s restructuring plan will be announced sometime over the next 12 months. The program will be focused on cutting costs, improving cash flows and improving performance at Rolls’ key aero-engines division. We think that Rolls has plenty of room to maneuver, restructure and return to growth. The stock is down almost 50% from the highs in January of 2014, and down 25% just in the past 3 months. We believe that recent share does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses, and estimate that we can get roughly a 15% annual compounded return over the next 10 years from the stock based on today’s share price.
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Now I would like to go a little bit off-topic and talk about something that does not directly relate to our fund or any of our investments, but will definitely be of interest to many of you and especially familiar to those living in the Bay Area. In particular, I would like to share our thoughts on the crazy speculative mania that we are currently witnessing, which will no doubt eventually lead to permanent capital losses for its countless participants.
Silicon Valley Mania. A Déjà Vu?
It’s always amazing to see the speculation that can take place not only in the stock market, but in the private market. When private markets give you higher valuations than the public markets ignoring any illiquidity discounts, it just doesn't make any sense.
In the Valley, there is such term as a unicorn, which is a privately owned company that rounds of venture funding have valued – on paper, at least – at $1bn or more. About two to three years ago, these beasts were still relatively scarce, with only 39 or so roaming the country. Today, as The Guardian reports, “there are about 142 unicorns, with a collective value of some $506bn – and a lot of venture capitalists and big institutional investors with a lot riding on those valuations being sustained.” Please take a look at the chart below from Barron’s May article that shows the speed at which this mania has spread just over the past 2 years:
I have compiled a list of tech and social-media privately owned companies that are happy to stay private, having garnered huge valuations and enormous amounts of liquidity and arguably are becoming today’s version of the Nasdaq in 1999. Please notice the pace at which the valuations have increased since 2013 as well as the ratios of current valuation to the cumulative equity capital raised.
Eventually, there needs to be an exit strategy for venture capitalists and other investors that are flooding these companies with cash. Let’s take a look at how the most well-known newly public tech and social-media companies have done since they went public over the past few years. As you can see in the table below, with the exception of Facebook, LinkedIn and ServiceNow, all of these are deep in the red. It looks like the public markets have not greeted these with the same enthusiasm as the private markets have, which maybe a sign of what to expect from the majority of the private companies listed above.
There is a great book by John Keneth Goldbraith (renowned Harvard economist):
The book’s focus is "recurrent lapses into financial dementia" going back to the tulip bubble in 17th century. To summarize, human nature never changes and every bubble or, as I would refer to them, episodes of mass insanity go through exactly the same pattern over and over again, but we never learn from history. I thought I would share a little from his essay with you, which I find very applicable to today’s Silicon Valley mania:
“In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by an always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
Speculation building on itself provides its own momentum. This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall.
For built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape. Something, it matters little what – although it will always be much debated – triggers the ultimate reversal.”
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We’re confident that this time will be no different and this “mass insanity” will end just like all other speculations have in the past.
Thank you again for allowing us to manage money for you. It is a great pleasure for investment managers to work with patient, long-term oriented investors. As an emerging fund, we are always looking for new investors. We would greatly appreciate it if you could pass along our letters to those whom you believe would be interested in Rowan Street Capital’s approach toward capital management. We believe our process of investing with conviction in high-quality companies that have solid downside support offers a pathway to superior long term compounded returns. We thank you for joining us on the journey.
Sincerely,
Alex and Joe