Rhizome Partners Q4 2021 Investor Letter

Stock Market


Frustrated couple checking bills at home using laptop

EmirMemedovski/E+ via Getty Images

Rhizome Partners historic performance data

Dear Partners,

For the fourth quarter of 2021, Rhizome Partners generated a net gain of 6.7% versus an 11.0% gain for the Standard & Poor’s 500 Index and a 16.2% gain for the National Association of Real Estate Investment Trusts (NAREIT) Index. For the year, Rhizome Partners Class B returned 24.9% versus 28.7% for the S&P 500 and 41.3% for the NAREIT. Since inception, our portfolio has had 61% general market exposure, 27% cash/SPAC holdings, and 12% market-neutral investments.

For 2021, Clipper Realty and FRP Holdings contributed 7.5% and 4.5% gain, respectively, to the fund. Seven additional investments added 2.0-3.0% gains to the fund. Aspen Group and portfolio hedging resulted in 3.0% and 1.5% losses, respectively. Please see later sections for a detailed breakdown.

  1. S&P 500 returns include dividend reinvestments and are fully invested
  2. FTSE NAREIT All Equity REIT Total Return Starts on 3/31/2013 and includes dividend reinvestments and are fully invested
  3. Net return is net of expenses and incentive allocation for Class B. Individual partners may experience returns that are different than the Class B return.
  4. Rhizome Partners Class B Net Return is accomplished while holding 27% cash and SPACs while comparable indexes are fully invested. Class B Net Return also includes 12% of investments that are workouts/special situations/hedged. Total market exposure was only 61% since inception.

General Commentary

The year 2021 was an eventful one for active market participants. It included parabolic short squeezes of AMC and GameStop. Capital cycle theory worked for energy and commodities as every investor, including Rhizome, swore off investing in these two industries. The 2020 mania for special-purpose acquisition companies (SPACs) fizzled out. Covid-19 beneficiaries that traded at 10-100 times revenue sold off brutally toward the end of 2021. Investors who claimed their portfolio strategy was never sell have been unusually quiet. Experiencing a market euphoria can be intense and seemingly everlasting, like a teenager’s first crush. Speculation (driven by human greed) that leads to bubbles and mania is as old as time. But investments that are untethered from reality and trade on narratives and hype are like sand sculptures beside the ocean. They eventually tumble because the waves erode their foundations or they crumble from the top after baking in the sun. This too shall pass.

Describing our fund, I recently told another fund manager, “We mostly invest in rock pits, real estate, plastic packaging, chemical distribution, equipment rental, cable companies, and warehouses.” It dawned on me then why no one wants to talk to me at cocktail parties anymore. But we are really invested in NIMBYism, LIPOR + E, route density, scale advantages, high freight-to-weight ratios, pricing power, regulatory barriers, physical moats, skilled labor scarcities, oligopolies, and shrinking supplies. The companies in our portfolio have many of these traits. These seemingly boring enterprises have structural advantages that enable them to sustainably earn high returns on capital. More important, we believe these advantages will endure over time.

We are doubling down on the point we made in our Q2 2021 investor letter, comparing our investing style to professional football player Joe Thomas’s NFL career. Like Thomas, we strive for consistency, longevity, and productivity and we’re content to be short on flair and theatrics. We measure ourselves against our own scorecards and measure our investment outcomes against our own underwriting. Our job is to protect your capital, grow it, and beat inflation by a nice margin over the long term.

“Punch Card” Real Estate Return Updates

Since inception, our fund has invested in eight concentrated pure-play real estate positions with a minimum size of 10%. As of year-end 2021, we averaged a 39% internal rate of return (IRR) on these investments, with an average multiple on invested capital (MOIC) of 1.55 times. These investments have meaningfully driven our partners’ returns over the years. Many of the positions have individually contributed more than 10% gross return to the fund. We have never lost money in any real estate investments with a position size greater than 10%. Our worst investment, Laaco, Ltd, had a 4% IRR. We sold out of the investment and reallocated to Clipper Realty and FRP Holdings in late 2020. Laaco was sold to CubeSmart within a year for about 5 times our cost basis. Although we did not capture the upside, it’s comforting to know we were involved with a deep-value investment.

Ticker

Company Name

Start Date

End Date

IRR

Realized/ Current MOIC

Estimated Peak Position Size

Exited/Active

Mays

JW Mays

2013

2016

66%

1.97

17%

Fully Exited

CTRE

CareTrust

2014

2016

90%

1.41

11%

Fully Exited

FRPH

FRP Holdings

2015

2018

32%

1.73

26%

Fully Exited

LAACZ

Laaco

2017

2020

4%

1.06

16%

Fully Exited

INDT

INDUS Realty (Griffin)

2017

Active

24%

1.85

15%

Partially Exited

HHC

Howard Hughes Corp

2017

Active

10%

1.32

18%

Active

CLPR

Clipper Realty

2020

Active

58%

1.62

17%

Active

FRPH

FRP Holdings

2020

Active

28%

1.40

17%

Active

Average

39%

1.55

17%

  1. All companies are pure play real estate companies
  2. Minimum peak portfolio allocation of 10%
  3. Performance as of 12-31-2021
  4. Includes gains and losses from hedging using OTM puts

Please note that the MOIC multiples are depressed by existing positions where the discount to net asset value (NAV) has not fully closed yet. We expect the MOIC multiples to rise over time as the thesis plays out. We believe that the forward returns of most of the active investments are greater than 15% annualized. This should increase the MOIC multiple going forward. Our MOIC multiples have also been reduced as a result of our risk-management efforts. For example, FRP Holdings exceeded 30% of the portfolio when it appreciated from lows 30s to mid-40s during the period from late 2016 to the middle of 2017. We sold shares to reduce the position concentration, which had the unintended effect of reducing MOIC multiples. We encourage you to audit our track record. We’ve created detailed stand- alone investment presentations and provided deep-dive analysis of these positions in our investor letters.

We believe our unique results came from diligent underwriting and buying at large discounts to private market value. These companies are backed by good real estate assets experiencing positive trends. In addition to share-price appreciation, intrinsic value was validated by private transactions, such as CubeSmart buying Laacos and Blackstone buying FRP Holdings’ warehouse portfolio. JW Mays is the only company trading below our exit price, which is due to management quality. A sale of the company, however, could result in proceeds that are multiples of our exit price. This is in deep contrast to the recent meltdown of SPACs and some overly priced growth companies. The gains experienced by speculation were temporary.

We liken our investment process to “a private approach in public markets.” For example, we drove 3,000 miles to see all the assets owned by FRP Holdings, and we spent 30 days on the ground trying to understand the master-planned communities owned by Howard Hughes. We have physically toured Clipper Realty’s apartments and strolled around its neighborhoods. We’ve spoken multiple times with the management teams of all these companies. Our approach is distinctively “private market due diligence,” whereas most public market participants are content to rely solely on Securities and Exchange Commission (SEC) filings and Google Maps. We are merely doing what a private owner would do before buying a piece of private real estate. Our philosophy is simple, but the execution can be difficult and time consuming.

It is a statistical outlier that we do not have any losses over eight investments. We believe it’s a result of three key factors. First, we avoid structurally challenged real estate, such as B and C malls. Second, we avoid the mistake of making apples-to-orange comparisons. For example, Fifth Avenue in Midtown Manhattan is one of the most desired retail corridors in the world. But the stretch from 49th Street to 59th Street commands $2,700 per square foot in asking rent versus about $900 per square foot in asking rent for the stretch between 42nd Street and 49th Street. Many public investors will value the two corridors equally. Lastly, tangible real assets provide downside protection against impairment.

Permanent impairment can result from misjudging the long-term earnings’ power of operating companies such as Valeant, banks (during the subprime mortgage crisis), Dexter Shoes, and Blockbuster. On the other hand, our real estate companies are backed by physical, hard assets, which act as a tangible floor for downside protection.

We’re highlighting this outperforming segment to better serve our partners. We’re also taking two key initiatives on this front. First, we will continue to create special-purpose vehicles (SPVs) for high- conviction real estate ideas going forward. Our inaugural SPV was received with enthusiasm by partners who shared our high conviction. Offering SPVs will allow our partners to allocate additional capital toward this outperforming segment. Second, we will be investing additional financial and human resources to uncover more high-conviction real estate ideas. Our nagging bottleneck is a lack of human resources for putting boots on the ground and seeing the physical assets in person. The pandemic has also made it harder to travel. We plan to add a new team member with deep real estate experience. Finding even one additional idea each year could dramatically improve Rhizome’s returns going forward. Finally, we will continue to build out our real estate track record. Our goal is to eventually establish a reputable brand in the public markets, so that news of Rhizome’s investment in a real estate company can result in closing the gap between the company’s stock price and its private market value. When our reputation precedes us in this way we increase the chances of catalyzing our investment.

Evolution of Our Portfolio Composition

Since inception, we’ve held a 27% average balance of cash and SPACs. During times when the S&P 500 compounded at 15.7%, this conservative allocation became a heavy anchor, dragging down our returns. We also allocated about 12% to workouts and special situations. As a result, our exposure to general investments that correlated with market fluctuations has been only 61%. From 2013-2015, we invested in liquidations with claims to cash in the bank accounts at pennies on the dollar.

Cash and Cash-like Holding

2013

2014

2015

2016

2017

2018

2019

2020

2021

Avg

Cash

18%

31%

17%

24%

25%

16%

2%

12%

-1%

16%

SPACs

16%

10%

21%

28%

12%

1%

0%

0%

0%

10%

Total Cash and Cash Equivalent

35%

41%

37%

52%

37%

17%

2%

12%

-1%

27%

Gross Exposure

2013

2014

2015

2016

2017

2018

2019

2020

2021

Avg

General

20%

34%

40%

43%

59%

68%

87%

85%

99%

61%

Workouts/Special Sit/Hedged

41%

18%

18%

4%

4%

14%

10%

2%

1%

12%

Short Stock

5%

7%

4%

1%

0%

1%

1%

1%

1%

2%

Total Exposure

65%

59%

63%

48%

63%

83%

98%

88%

101%

73%

We recently received a final cash distribution in Point Blank Solutions. This brings our return to almost double our cost basis. Point Blank Solutions is the last remaining liquidation investment held in a side pocket in the fund. We expect to have zero side pockets in the fund by early 2022 after we close out the last side pocket. We are proud that all side pocket investments have returned cash distributions significantly higher than its “going in” valuation. We never had an impairment in a side pocket investment. Separately, we once paid a $4mm valuation for a liquidation that had $12.7mm of cash in the bank account against $5.0-$6.5mm of claims including contingencies. We received cash distribution equal to 193% of our cost basis in about a year. Our liquidation investments are some of the best investments on a risk-adjusted basis because we were buying cash at pennies on the dollar. We are being paid to be patient. We would have generated these returns whether the S&P 500 Index returned 15.7% or -30%. Had the S&P 500 Index suffered large drawdowns, we could have added tremendous value via our workout investments. The lack of distressed opportunities and the lack of liquidity associated with liquidations caused us to scale back our efforts in this area. We provide this analysis to help you assess our risk-adjusted returns.

Since 2019, we have evolved to fully invest our partners’ capital and focus on picking structurally advantaged companies. To protect our portfolio, we allocate about 1-2% of the partners’ capital toward buying tail hedges. We routinely assess our portfolio quarterly to evaluate various risk factors that may emerge. The optimal strategy often involves buying 20% out-of-the-money puts on the S&P 500, the Russell 2000 Index ETFs, or buying puts directly in our portfolio companies. Going forward, we will fully invest our partners’ capital, coupled with buying tail-risk hedges. We believe this approach will lead to the best risk-adjusted returns. It will also solve the problem of market timing associated with a strategy of holding large cash balances.

Historical Hedging Performance

Unlike many small funds, we have an active history of hedging. Since inception, we’ve created 7.8% positive return through hedging. During most years, hedging generates a 1-3% drag on investment returns. This pattern likewise underreports the significance of the 2020 hedging results. We wound up with a cash balance of roughly 20% in the spring of 2020. Throughout 2020, we were able to redeploy that capital into attractive investments that have yielded amazing returns. This hedging strategy is much like buying insurance on your house. You expect to lose money most years, but it’s a life changer when you need a payout.

Year

Gain/Loss

Comments

2013

N/A

2014

-0.4%

2015

-2.9%

Lost 1.7% for hedging a large event driven trade

2016

-0.7%

2017

0.0%

2018

2.0%

Hedging gains offset losses in Calumet and HHC

2019

0.2%

2020

10.9%

Bought OTM puts to hedge Covid risk in early 2020 and received large cash windfall

2021

-1.3%

Cumulative

7.8%

Hedging is typically a drag on performance except for market crises

Ourcalculation methodology is gains/losses each year divided by the average of the partners’ capital at the beginning and at the end of the year.

Why do we hedge? Is it truly necessary? These are valid questions. In his book The Psychology of Money, Morgan Housel wrote that we’re heavily influenced by our own experience with money. As a young investor starting out, I witnessed the bursting of the technology bubble and the subprime mortgage crisis. From year-end 1999 to year-end 2009, the S&P 500 experienced a -1.0% compound annual growth rate (CAGR), with dividends reinvested. That number is not an error. That ten-year stretch was commonly referred to as the “lost decade” of investing.

S&P 500 Index

S&P 500 Index

Year

Total Return

Year

Total Return

1999

20.9%

2011

2.1%

2000

-9.0%

2012

15.9%

2001

-11.8%

2013

32.1%

2002

-22.0%

2014

13.5%

2003

28.4%

2015

1.4%

2004

10.7%

2016

11.8%

2005

4.8%

2017

21.6%

2006

15.6%

2018

-4.2%

2007

5.5%

2019

31.2%

2008

-36.6%

2020

18.0%

2009

25.9%

2021

28.5%

CAGR

-1.0%

CAGR

16.4%

Source: https://www.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls

Note the deep contrast to the decade that just ended, from year-end 2011 to year-end 2021, when the S&P 500 experienced an impressive 16.4% CAGR, with dividends reinvested. As the S&P 500 continues to perform well, the drumbeat insisting that the S&P 500 is the solution to all your investing needs grows louder each year. This assumption took hold in the late 1990s as well, when investors expected forward returns in the market to be in the high teens to low 20s. The bulk of my personal liquid net worth is invested in Rhizome Partners, right alongside your capital. My goal is to avoid a potential lost decade and to compound our wealth at an attractive double-digit rate. We believe the most important tools for avoiding a potential lost decade is to (1) hedge against potential macro tail-risk events, such as the subprime mortgage crisis and the Covid crisis, and (2) avoid permanent impairments, such as investing in companies like Pets.com during a tech bubble or ailing banks during a housing bubble. We believe the final piece of the puzzle is buying structurally advantaged operating companies and good real estate at a deep discount to private market value. If we execute on all three fronts, we should be able to avoid a potential lost decade.

2021 Portfolio Updates

Contributors and Detractors of Performance in 2021

We had many contributors to performance during 2021, with Clipper and FRP Holding generating 12% gross gains combined. We also had performance contributions of 2-3% from seven different companies. We lost about 1.5% from the expiration of out-of-the-money index options during the year. We ramped up hedging when the Delta variant of the Covid-19 virus started to surge during the summer. Our largest detractor was a 3% loss associated with Aspen Group. (Please see the discussion at the end of this letter for a detailed analysis.)

`

2021 Contributors

InvestmentType

Estimated Portfolio Year End Contribution Position Size

Commentary

Clipper Realty & Calls

General Undervalued

7.5%

17.2%

Clipper is a bet on New York City recovery following Covid. Sentiments have shifted. We expect strong rent recovery in 2022.

FRP Holdings

General Undervalued

4.5%

16.7%

The Maren achieved 90% leasing and has been consolidated. The Company hosted its first investor day in the fall. The passage of the infrastructure bill will lead to higher royalty.

Cross Country Healthcare

General Undervalued

3.0%

4.3%

Founder returned as CEO and moved to reduce expenses increasing EBITDA margin from 3% to 8%

Berry Global

General

Undervalued

2.5%

7.2%

Berry generated about a $1 billion of free cash flow in 2021. Debt metrics have improved.

Howard Hughes Corporation

General Undervalued

2.5%

8.3%

Howard Hughes bought a new MPC in Phoenix and sold the Chicago office tower for over $1bn. The Company continues to recovery from Covid.

INDUS Realty Trust

General Undervalued

2.5%

8.0%

INDUS acquired 1mm sqft of warehouses and raised $261mm of equity in 2021. The company also completed its REIT conversion and successfully rebranded.

Univar Solutions

General

Undervalued

2.0%

4.2%

ERP Implementation is complete and business performances are starting to normalize to pre-Covid levels. Free cash flow is staritng to inflect.

DuPont, Corteva, & IFF

General

Undervalued

2.5%

0.0%

DuPont completed the IFF Reverse Morris Trust transaction. We fully exited to re-allocate into more attractive opportunities.

Ashtead (Sunbelt Rental)

General

Undervalued

2.0%

3.3%

Sunbelt has executed well during 2021. Passage of infrastructure bill will create healthy demand for equipment for the next few years.

Hedging via OTM Puts

Hedging

-1.5%

0.0%

We ramped up hedging during the Delta Variant surge. Most options expired worthless.

Aspen Group

General Undervalued

-3.0%

0.2%

The first cohort of the new BSN program are experiencing difficulties passing the Arizona NCLEX test. This is the KPI to our thesis and we are tracking to see if they can improve the performance.

Real Estate Updates

We estimate that the private market value of FRP Holdings is now roughly $90 per share and will go to $110 by year-end 2023. Aggregates, multifamily, and warehouses are all experiencing strong fundamentals. The stabilization of Bryant Street project in Washington, D.C., and the two Greenville, SC, projects will likely result in an additional $40-60 million of net income being recognized in 2022, by generally accepted accounting practices (GAAP). Both projects are reallocations into opportunity zones and will likely achieve more than 20% IRR on invested capital. Since our 2015 investment in FRP Holdings, we believe the company’s management has generated greater than 15% IRRs on all its development projects. Owning FRP Holdings is a way for us to buy into the private real estate holdings of a benevolent billionaire family (the Bakers) at half price. Yet the family and FRP Holdings’ employees continue to create value for minority shareholders for a management fee of less than 1%. This is an absolute steal compared with real estate private equity investments.

In Q4, Howard Hughes Corporation (HHC) announced the sale of its Chicago office tower for more than

$1 billion. The building was 85% leased at the time the sale was announced. HHC contributed the land, valued at $85 million, and an additional $5 million in cash. The expected pre-tax proceed to HHC is estimated at $270 million. This is an outstanding outcome for an urban office development project delivered after Covid ravaged the office sector. The company also gained approval for its $850 million development project on the site of the former parking lot in the Seaport in New York City. This is an important milestone after a long and contentious zoning process. HHC also bought a 37,000-acre shovel-ready master-planned community in Phoenix, AZ, for $600 million. We still believe that the company is an excellent developer and each community continues to strengthen with the development of new amenities. This strength will eventually be manifested in rent growth, ample net operating income (NOI) upon stabilization, and simplification of the story over time. The market does not yet appreciate these unique characteristics of the Howard Hughes missions. We’ll continue to wait patiently for the market to agree with us.

Fundamentals in the warehouse and logistics sector have been red hot. In our opinion, INDUS Realty Trust has finally gotten through its “brisket stall” phase, breaking out of the narrow $60s trading range into $80 at year-end. The company has moved quickly to acquire buildings, develop warehouses, and move into new geographies, such as Nashville, TN, and Charleston, SC. The company also raised $261 million of equity capital during 2021 and built out a new shareholder base. INDUS acquired 1 million square feet of warehouse space in 2021 and has several development projects in the pipeline. Daily trading volume exceeds $2 million today, which is about 10 times the daily volume when we bought our position. We’re excited to see what the CEO and the former team at Gramercy can accomplish at INDUS Realty with a low cost of equity capital. We believe INDUS Realty Trust can compound at 15-20% per year for the next few years. To hedge our broader warehouse risk, we’ll buy puts in Prologis.

The market is finally starting to agree with us on Clipper Realty. Apartment inventory in New York City is tight. Apartment rents in December 2021 hit a record high. The year 2021 has been good for Sunbelt multifamily apartment REITs. We believe 2022 may be the year that coastal apartment REITs like Clipper, Avalon Bay, and Equity Residential experience strong gains. We’ve noticed other investors are now more receptive to the Clipper thesis when we explain it. They thank us for a good way to play the New York City recovery rather than debate us about the city’s future. Rents and occupancy are both strong and sentiments appear to have inflected. We look forward to Clipper reporting strong growth in NOI and funds from operations (FFO) in 2022 and beyond.

LAACOs Updates and Lessons Learned

Laaco, Ltd was sold to CubeSmart in Q4 2021 for roughly $9,800 per unit. We performed a detailed scenario analysis in 2020 on whether to hold onto the Laaco units or sell and redeploy into other investments. We explained to our partners the issues with master limited partnerships (MLPS), K-1 reporting, lack of liquidity, and how Laaco tested our patience, which means incremental shareholders would be hard to find. In addition, a family office/private equity fund had asked us to approach Laaco with a bid that was significantly higher than its trading price at the time. Without providing any explanation, Laaco told us it was not interested in the bid. Hence, we sold our units and redeployed the capital into FRP Holdings, Clipper Realty, and Sun Belt multifamily REITs, such as NextPoint Residential, and Preferred Apartments. The returns on the new investments range from roughly 40% for FRP Holdings, 63% for Clipper Realty, 74% for Preferred Apartments, over 10 times in Preferred Apartment calls, and 150% in NextPoint. These new real estate investments totaled about 36% of the partners’ capital at year-end 2021, and meaningfully contributed to our 2021 performance. We believe FRP Holdings and Clipper will continue to contribute meaningful performance in the coming years. Their contribution pales, however, in comparison to the roughly 400% gain on Laaco, since CubeSmart bought it for roughly 5 times our cost basis.

`

What are the right lessons to be learned from these developments? First and foremost, we believe we made the right decision based on all the facts. To consider this a bad decision is to suffer from what’s called resulting bias. I did lose sleep and suffer quite a bit of mental anguish for a couple of days. With a cooler head, I analyzed the information available at the time. The decision to sell largely boiled down to the uncertainty concerning when the Hathaway family might sell the company. Since they turned down our bid, we thought a sale was at least five years away, more likely ten. Keeping the Laaco position would have come with a real opportunity cost, since it would have precluded our redeploying into FRP Holdings and Clipper, which we can underwrite to 3-4 baggers in 3-5 years. The probability of the FRP Holdings and Clipper transactions working was substantially higher than the possible benefits of remaining invested in Laaco.

The one outlier scenario was whether the Hathaway family might sell Laaco to the highest bidder. To our surprise, they did just that and it sold at a much higher price than many market participants anticipated. CubeSmart paid a 3.7% capitalization rate based on fully synergized NOI that assumed higher occupancy, better rent, and taking out excess selling, general, and administrative (SG&A) expenses. We thought a $6,000 per unit price (3 times our cost) would be a blue-sky scenario. With Covid-19 continuing, self-storage wound up becoming one of the hottest asset classes and the buyer was willing to pay 3.7% fully synergized NOI, based on potentially peak results. We simply do not underwrite to such blue-sky scenarios. After the passage of time and some walks on the beach, I’m quite convinced that we’d make the same decision again.

What More Can We Learn from This Experience?

What are the key lessons learned from the Laaco investment? First, MLP structures do warrant a deep discount to a C corporation given their tax complexity, lack of willing shareholder base, and the operational issues they present for a fund. The structure severely limits the addressable shareholder base.

Second, having the right structure/vehicle to house the investment is very important. Perhaps we could have set up a separate SPV to accumulate units in Laaco, with the understanding that it would be expected to throw off a 4-5% yield and large “catch up” in IRR upon a sale of the assets in 5-10 years.

Laaco traded at a roughly 10% capitalization rate and was the crown jewel that every self-storage REIT lusted after. Matching the expectation and duration of an asset to our investors’ needs is critical. For Rhizome Partners, a diversified portfolio, Laaco created operational complexity. As a single stock SPV, with an objective of safe yield and a large future kicker, we may have created an amazing yield vehicle for the right investors.

Third, sometimes it’s wiser to sit on our butt and do nothing. The outsized returns from holding real estate in supply-constrained markets, such as Southern California and New York City, often comes from the market’s inability to add supply and the constant inflation of replacement costs. Such patience is not sexy and often as boring as watching paint dry. But there are many wealthy real estate families with average or even subpar business operations. Based on our experience, the forces of land constraint and large barriers to new construction can easily compensate for suboptimal operating performances. This circumstance is a stark contrast to that of a normal operating business like a restaurant, where execution is crucial and customers are won and lost daily.

Lastly, we need to be vigilant in assessing why a company may attract a new shareholder base that will cause shares to re-rate. The only exception to this eventuality is if the company can compound organically at a rate greater than 15% over a decade. For most small-cap investments, we need to assess why a new shareholder base may emerge within three years. In the case of Griffin/INDUS, it took Gordon Dugan joining the board to get investors excited. In the case of FRP Holdings, the market generally views the management team as shareholder friendly. The stabilization of various FRP Holdings’ projects will also help re-rate shares higher. Going forward, we will consider this exercise a critical piece of our “pre-mortem” analysis.

Non-Real Estate Companies

In Q4, an activist published a letter to Berry Global, proposing the company start buying back shares and explore sale lease back transactions of its owned real estate. Berry has since reduced the debt-to- EBITDA ratio to below 4 times. The company has taken more environmental, social, and governance (ESG)-friendly initiatives, using more post-consumed feedstocks and investing in recycling capabilities. Berry has also increased its capital investments to drive more organic growth and has become more ESG-compliant. From a financial performance perspective, the EBITDA and free cash flow performance resembles that of a AAA bond. But investor sentiments appear to be changing and shares traded up to

$74, about 30% higher than year-end 2020. Since its initial public offering (IPO), Berry has compounded at just under 20% CAGR. Yet it’s seemingly one of the most hated companies in the public market.

We’ll continue to invest in packaging companies going forward. This sector is generally made up of oligopolies or large players competing against small, fragmented operators. The active shareholder base generally focuses on short-term earnings beats and misses. We believe we can earn good returns by underwriting to a three-year holding period.

Our two staffing companies performed exceptionally well during 2021. Both HireQuest and Cross Country benefited greatly from sharp rebounds of operating results over 2020. Both companies are also jockey bets. We’re excited to watch Rick Hermanns continue to acquire staffing operators and convert them to franchises. There is likely a multiyear runway to roll up various smaller players. Cross Country has impressed us with cost-cutting initiatives that improved EBITDA margin from around 3% to around 8% today. Kevin Clark’s return to the company as CEO has been instrumental to these transformations.

Univar Solution reported a sharp rebound in performance relative to 2020. The company has largely completed its integration of the Nexeo acquisition, with little business interruption, a sharp contrast to Calumet Specialty’s experience. Univar is starting to show its true earnings power. Ashtead (Sunbelt Rental) continues to execute well. It is perhaps one of the most impressive companies we own in terms of execution, culture, capital allocation, and organic growth. The passage of the infrastructure bill has made Ashtead a bit of a darling. We recently added a 2% position in Fairfax Financial, having attended Fairfax annual shareholder meetings for the past decade. Despite our continued interest, we never owned shares—largely because of Fairfax’s obsession with shorting the S&P 500. A few key changes prompted us to start buying shares: We’re entering a hard market for property and casualty insurance. Fairfax has gotten rid of the S&P 500 shorts and plans to IPO its Indian technology investment, Digits. We believe Fairfax may finally rerate after trading in a narrow range for the past decade.

Aspen Group is the largest detractor to performance during 2021. The company offers affordable nursing degrees at roughly 50% of the cost charged by competing for-profit nursing programs, such as the University of Phoenix. The CEO appears to be a mission-driven fanatic about using technology to drive down the cost of higher education. For example, Aspen’s all-in cost for a high school graduate is about $37,000 for a Bachelor of Science degree in Nursing. We’ve invested a small amount and tracked the company for some years now. In the last few years, the company offered many innovative solutions to address the nursing shortage and even started its hybrid online and campus-based solution for nursing students. Because it needs to add staff before enrolling students, the company has lost money while growing 40-50% a year. It does sport a healthy gross margin of roughly 55%, which we think can lead to 20% EBITDA margin when growth slows. We were backing the CEO in his aim to create an affordable and less punitive way for high school graduates to improve their lives by earning valuable college degrees that generate high returns on tuition. Aspen inverts the financing of these degrees by having roughly 20% of the students apply for student loans and 80% pay out of pocket, given the low cost. We thought Aspen offered a revolutionary product that was better for the students and better for society. In short, we bet on it being a better mousetrap.

In 2021, we became aware of alarmingly low passing rates for the National Council Licensure Examination (NCLEX) of the first cohort of nursing students. Only 63% passed the test, which is significantly below the 80% minimum standard set by regulators. This disconfirmed our theory that Aspen is a better mousetrap. Although Aspen did offer a lower-priced nursing study program, the students’ inability to pass the tests was alarming. We sold the bulk of our shares at year-end 2021—in light of our mistaken theory—to harvest tax losses. We’ll be monitoring the Aspen’s NCLEX test-passing rates, since we believe this is a critical key performance indicator (KPI) in our investment thesis.

Inflation/Interest Rate Hedging

We have a hunch that this may be the time to short long-dated Treasuries and corporate bonds. Consistent with our buying puts and shorting in the past, the goal is to hedge against certain risk parameters in our portfolio. The Fed has stopped using the word transitory to describe inflation and has publicly disclosed that it will increase rates multiple times in 2022. Wage gains have been substantial and will likely be sticky to the upside. We shorted the 20-year Treasury ETF and some long- duration corporate bond ETFs. We do not view shorting these ETFs as alpha-generating investments. Our real estate companies have interest rate exposure. Shorting these ETFs should help mitigate the effects of interest rate increases on our real estate companies. With a 1.9% yield for the 20-year U.S. Treasury note, shorting them has minimal downside, given the background. If we’re wrong and interest rates decline, our real estate holding companies should outperform. In short, shorting the long-dated fixed income ETFs dampens the impacts of interest rate movement from our real estate underwriting.

Operation Update

Total assets under management by the investment manager is $32 million, giving us the most robust resource in Rhizome’s history. As a result, we’ve been increasing allocation to research tools, subscriptions, and travel budgets. I want to further grow the main fund, Rhizome Partners, and bring on a full-time operation member. This candidate also has extensive private real estate experience and will strengthen our core capabilities.

We switched auditors from Patke/Wipfli to Spicer Jeffries. Wipfli acquired Patke a few years ago and have dramatically increased our fees. This is despite our tax preparation and audits becoming simpler as we eliminate K-1 forms from investing in Master Limited Partnerships (MLPS), and side pockets. In addition, Wipfli often finishes its audit around late summer. Upon the recommendation of a peer that I deeply respect, we interviewed Spicer Jeffries and found them capable and transparent. We also expect them to finish K-1s by end of February and audits by April. Switching to Spicer Jeffries also results in significant savings. The combination of switching auditors and growth in assets resulted in fund expenses dropping to a run rate of 33 basis points in December 2021.

After almost nine years in business, we’ve had only two partners redeem their capital. We’re very happy that all our investors have seen substantial gains over their cost basis—something we’re very proud of. We have excellent and thoughtful partners, which allows me to focus on hunting for interesting investment ideas. Existing investors may add capital at the beginning of each month. If you know of any interested investors, we would love an introduction. Historically, introductions by existing partners have led to the best fit. We’ll likely be traveling during 2022 to visit more real estate sites and meeting with private real estate operators on the East Coast. One of our objectives is to expand relationships with real estate operators that can provide local insights.

Please feel free to reach out to us if you have any questions. Sincerely,

Chong Tong “Bill” Chen

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.



Source link

Leave a Reply

Your email address will not be published.