“Fish Deeper, Fish Alone” — Paul Sonkin

Paul Sonkin is managing member of the Hummingbird Value Fund. He has worked at the SEC, Goldman Sachs, Royce Funds, and First Manhattan Company. He holds an MBA from Columbia, where he teaches courses on applied value investing.

GD: What is your take on the market right now? There seems to be some divergence of opinion among investors currently about where we are in the cycle.

PS: What’s going on now is that many of the people I am talking to, many smart, savvy investors, think that the second and third shoe is going to drop. For that reason, I think there is a tremendous amount of money sitting on the sidelines. And,because people expect it, I think it’s not going to happen. An example that I was talking about the other day is 9/11. I think that there are a lot of commonalities between Lehman and 9/11.

Basically, what happened is that Lehman set off a chain reaction — sort of a negative feedback loop. I think it was a Thursday morning, October 11th when the Reserve Fund announced that they had a lot of exposure and they broke the buck. I re- member that we were thinking, “Our cash may not be safe.” Wachovia had failed and you were having these huge bank failures and the world became a very, very scary place. Everybody pulled back. The country just shut down for a quarter, which is very similar to what happened after 9/11, although, I think that was more psychologically driven. You had this huge exogenous event, which introduced a huge amount of uncertainty in both cases.

When people are faced with uncertainty, they really don’t know how to react so whatever they are doing, they just stop. They go into conservation mode. I am a big proponent of evolutionary psychology. It is sort of like the fight or flight reflex. If you are faced with a huge shock, you get this huge adrenaline bump and it is kind of like an automatic response. I think that is what happened in the fourth quarter. What I am starting to see now in the press and in anecdotal evidence coming out of these companies on a grass roots level is that people are starting to spend money again. They aren’t going to spend as frivolously as they did in the past, but they are going to spend money when they need to spend money.

What we are seeing with a lot of our companies is that people are making necessary expenditures, but they are revisiting all of their other expenses. You are still going to go out to dinner, but maybe you go out to the less fancy place. In our portfolio companies, I think that one big beneficiary of that is a company called Avantair that does fractional planes at basically half the cost of NetJets. It has actually been taking a lot of share from NetJets. I think this happens at every level. People want to downsize a little bit, but they don’t want to be eating cat food when they’ve been eating caviar. They’re not going to go from one extreme to another. You have intelligent people making intelligent decisions about spending and there are companies that are going to be beneficiaries of that.

Getting back to the 9/11 analogy, the “next 9/11” is not going to be as much of a shock. If you have another horrific incident where 2,000 people were killed in say, San Francisco, the country would just react differently because it has already happened once, and I think that when it happens the first time there is this huge reaction. When it happens the second time, people become desensitized to it. Mauboussin talks about is what’s called “robust consensus.” You have manias and panics when you don’t have a robust consensus. If you are in a boat and everybody is sitting in the middle, you’re fine. If everybody goes to the bow then it’s going to sink. If you have a robust consensus and people’s expectations are evenly distributed then you’ll have an equilibrium, but if everyone expects the same thing then you will have disequilibrium. So what happened in the bubbles is that you had this disequilibrium and then you had this shock to the system that brought it back to equilibrium.

What you have now is more of a robust consensus. Everybody doesn’t have the same view now. You have these widely differing views, and because you have these differing views there is a lot of cash sitting on the side- lines and one of those two constituencies is going to be right. There is either going to be another shoe to drop or not. But I think a lot of that other shoe dropping has already been priced into stocks such that you have companies that are trading as if they are going bankrupt. I think it was back in February when GE was $5.80. It was trading as though it was going to go bankrupt, and Citi was trading as if it was going to go bankrupt. There were a lot of other companies. Those companies have rallied off of their lows, but still you have a lot of people who still believe it. I was on the phone the other day with two really intelligent guys. We were just kind of chat- ting and I said, “What do you think? Do you think that it is a head fake or the beginning of a new rally?” And one of them said it was a head fake and the other said it was the beginning of a recovery, and they said it at the same time.

GD: Some have speculated that the recent “robust consensus” is more shorts covering their positions and buying back shares in decent size.

PS: Yeah, but we are also hearing that people are starting to put capital to work again and that stocks look cheap. Prices are clearly made on the margin and the volume would not be indicative of short covering per se.

GD: Playing devil’s advocate, very few people predicted this would happen or that it would be this bad. But if you didn’t catch it the last time, what makes you think you can predict the macro environment today?

PS: I don’t. I don’t think that anybody can. What you will see is that guys with very small funds don’t think a lot about the macro environment. I could talk about the macro environment, just like I could talk about the Yankee game or whatever the topic du jour is. But when you have a large cap fund or a large fund complex, you have to really be able to opine intelligently on where the macro economic situation is going because you are the market. If you have $20 billion under management, you are the market. If you have $20 billion under management, you either have a huge position in a lot of tiny companies, in which case you are fairly exposed to the overall market or you have concentrated positions in large cap companies in which case you are really exposed to the macroeconomic environment. But if you have a small portfolio with little companies, you are not as exposed. You don’t really need to have a view. We could get down in a granular way and say that even in a severe recession that Avantair is going to perform relatively well — not as well as it is going to perform in a recovery, but it will still per- form. Or a company like Fortress International, which we own, or a lot of these other companies will be able to perform quite well, irrespective really of what the overall economy does.

As a microcap investor, what you are looking for is something where it can grow against the industry returns or grow against negative economic trends. What we have experienced is that when you have a crisis, everything is correlated. Since June 2007 and until very recently, there was nowhere to hide. The only place where you would have been safe was short-term treasuries. If you were in equities then you would have gotten killed. I think that there are some people that call these things and there are some people who are ahead of the curve and they are lauded as geniuses. A former student of mine has a $2 million fund and was up 40% last year be- cause he had one long that did really well and one short that did really well out of only five positions. Statistically you are going to have a few of those. Wayne Garzarelli called the 1987 crash. John Paulson called the sub- prime crash and made a ton of money. You can’t look at those guys. You have to look at the Seth Klarman, who have consistently been able to sidestep these disasters. You can’t really look at the one-offs.

We had a horrific year last year. We were down 40%, just like everybody else.What I find very surprising is that people said for a microcap fund, if you were only down 40%, that was pretty good. The Russell 2000 was down around 33%. What killed us was illiquidity. Usually, we are long illiquid names. That usually works out well over the long-term as long as you don’t have any major panics. If you want to sell a house today, it is a very illiquid asset, but if you want to sell a house over six months then it is more liquid, de- pending on the price. It is the same way with our stocks. In the short term they are illiquid, but in the longer term, they are very liquid.

GD: You mentioned Klarman as a positive example. Are there any things that you are doing to emulate his risk management?

PS: It is not really what we do. There are funds that have very open charters and funds that have relatively close charters. We have a very narrow niche that we seek to dominate and operate in. For Seth Klarman, it is like the book Bringing Down the House. These guys had six different tables and whichever table that was hot, they would play at that table. Klarman just wants to have as many different tables as possible to play at and plays where the best opportunity is. Our investors want us to play at a specific table and we tell them that it is going to be volatile. It doesn’t work all the time, but over very long periods of time it works. Over a ten year period, we are up over 50% while the markets are at 12 year lows.

Over the long-term, we expect that we will have pretty good returns. If you look forward ten years from now, I think the returns are going to be absolutely extraordinary because stocks are just so cheap and the luxury we get is that you’ll see the significant rally in the broader market but it takes a while to trickle down to our names. So we are able to get some confirmation and then we will start seeing some people picking through our names. What we are seeing is that, name by name. they are starting to get picked over and the stocks are starting to perk up. Essex Crane (HYDQ) got down to $3 per share and now it is at $5.40 bid and $6.40 offer, but still down from $8. They put out good results and things look good going forward, great fundamentals, with a great management team.

One of our other names that we are extremely bullish on is Fortress International. They basically perform a lot of technical consulting, construction management, and server farm facility maintenance. This is a huge growth industry. They have had some problems in the past but they have identified what those were and are fixing them. We ran some numbers.

The stock is at $1 per share with 12.8 million shares outstanding with $12.5 mil- lion in cash. They have $6 million in debt, giving them an enterprise value of about $6.3 million. You can buy the whole business at $6.3 million. This is a business that will do $80 to $100 million in sales and they could easily do 5% EBITDA margins, probably closer to 10% over time. However, over the last six months, they have done $2 to $2.3 million in EBITDA so you figure, even if they do $500,000 in each of the next two quarters, they are trading at 2x EBITDA. You get all the growth for free, margin expansion and their growth in the space. Plus, you get a great management team. We have companies like this in our portfolio which are just incredibly cheap.

Another company that we own, just to give you a really extreme example, is a company called TNR Technical (TNRK). They distribute batteries. The stock is at $8.50. They have 306,000 shares outstanding so the market value of shares outstanding is $2.6 million. They have $2.55 million in cash so you can buy the entire business for $47,000 dollars and in the last 12 months they have generated $700,000 in operating income with no debt. It is an $8.50 stock price with $8.35 in cash — a 15 cent enterprise value and in the last 12 months they earned $1.55. We have been sitting on the bid and whenever anyone comes in to sell, we buy stock. It is a $22 offer so at the offer it looks quite different. At that price, it has a $6 million enterprise value — just 10x earnings. They had a large dividend a couple of years ago so they distribute cash and buy back stock. You are able to find these things if you just know where to look.

GD: So how to do you find your ideas?

PS: I have known TNR for years and years. I have a database in my head of thousands of companies that I have a database in my head of thousands of companies that I have been looking at over the last 20 years. I started out smiling and dialing at a regional office of a wire house, Dean Witter Reynolds in 1986 so I have been in this business for 23 years. I have always loved micro and nanocap stocks. We don’t really do small cap if you define small cap as $1 to $2 billion. We really specialize at the sub-$100 million, which is the smallest of the small. We are trafficking in the smallest 40 basis points of the U.S. market where there are still 8,000 companies. So there is still tremendous opportunity.

GD: How much capacity is there to manage against that kind of benchmark?

PS: Chuck Royce has had very good performance managing $1.5 billion in microcaps. Their microcap fund has a geometric average of $200 million and
$600 million under management in just that one fund. So you can run a lot of
money. But I think $100 million is a good level for us. We peaked out at $130
million and now we have about $50 million. We will get back to about $100 million and then we will start to give money back.

GD: It seems like your search process is a large part of where you think you
get an edge over the market. Is that fair to say?

PS: Where we get an edge is by being where nobody else is. We fish deeper and we fish alone, and I think that’s really it. We are looking for companies that are unloved, there is no institutional sponsorship, there’s no analyst coverage, where there’s very little liquidity, and where management
is pretty quiet — they have been sort of “run silent, run deep.” So you go from unloved, no institutional sponsorship, no analyst coverage, little liquidity,
and quiet management, to — these stocks become loved, they get the institutional sponsorship, the analyst coverage, more liquidity, and management starts selling the story.

GD: Given the segment of the market in which you operate, do have a higher
hurdle rate for the type of return you are looking for?

PS: Clearly, we are always looking for a stock that can return a multiple on our
money. We look for situations where the stock could easily double. With these
small companies, we’ve seen stocks go private at double where they were trading. We had one that went private at 7x and one that went private at 10x, so we see those from time to time. Usually, when you see these really ridiculous moves, the insiders have a controlling interest, so unless the buyer is willing to pay up, management isn’t willing to sell.

GD: With your strategy, it sounds like time is your friend, so clearly your investor base is important. How do you communicate that issue with your clients?

PS: You need to manage your investor’s expectations very carefully. What we try to do is write very honest, sober letters and we tell our investors that we are not the place to put all of your money. You ideally want to have less than 5% of your net worth with us because it is a very risky strategy. Of course, we don’t feel it’s all that risky.

GD: I guess that’s a matter of how you define risk.

PS: Right, the risk of a permanent capital loss. So, in terms of risk, it’s the permanent capital loss versus volatility. We think our permanent capital loss risk is low,but volatility risk is high. Unfortunately, what we’ve had over the past 18 months is continually falling stock prices. But that creates the opportunity. The issue is that investors who have just lost money just
want the pain to go away. That’s why they sell at the bottom. And when things
are going well, it’s like they just don’t want the juice taken away. People just
don’t want to sell when things are going up and that’s why investors tend to
sell at the bottom and buy at the top. It’s just human nature. Look at Fidelity
Magellan, it has compounded at whatever rates it has, but if you look at the
rates of what investors have made, it is half because people get in and out at the wrong times.

GD: So clearly, illiquidity is a particular challenge in managing your portfolio. You mentioned earlier that you embrace diversification by holding a relatively large number of stocks. But how do you deal with particular stocks getting cheaper and not being liquid enough to take advantage?

PS: A lot of investors will sell something cheap to buy something cheaper. I don’t really see a lot of that be- cause when something goes wrong, it’s priced into the stock in this kind of environment. What I see happening in this kind of environment is, let’s say a stock is trading at $8 and has an intrinsic value of $12. Let’s say that, later, the intrinsic value falls to $6. In this environment, the stock will go to $2 from $8. So, with a lot of these companies, the spread between the price and the intrinsic value gets wider as the business deteriorates because investors just don’t want to own it.

GD: So, even if you have the opportunity to do that, a lot of times you might not because the names are so illiquid?

PS: Well, one thing we do is hold cash to redeploy. That’s one of the advantages of our arbitrage portfolio. Our arbitrage investments turn over and convert to cash constantly, so our portfolio generates cash flow that we can redeploy into such situations. We have a situation now that we’ve been waiting on for a year and we are going to get a huge slug of cash from it; we are going to go from 10% cash to 20% cash pretty quickly.

GD: What kind of situation is it, merger, spin-off, SPAC?

PS: Actually, it’s a merger/ spin-off/liquidation, a little bit of everything. There’s this company called Smith Investment Company that has always owned a control- ling interest in another company called AO Smith. Now, AO Smith is buying Smith Investment Company for stock. For every share of Smith, you’re going to get 2.84 shares of AO Smith, so its kind of a spin-off in that sense. However, Smith Investment Company also has two or three other businesses, which they spun-off into a liquidating LLC. We actually made money be- cause we were able to create Spinco at a negative valuation. And we have a spread on the arbitrage which will collapse.

GD: How much work do you put into a name like that?

PS: It was a big position, so we put a lot of work into it. Typically, you start out with a small position and you put a little bit of work into it. As you start to build on the position, you do more and more work. Eventually, your biggest positions are the ones you’ve put the most work into.

GD: Do you think of your fund as two different portfolios, arbitrage opportunities and general value opportunities?

PS: It’s all one portfolio, but liquidations are the best places to be. Totally not followed by the market and you are doing a pure liquidation analysis. We’ve been in business for ten years and we’ve had just one down quarter in our liquidation portfolio. But the beauty of arbitrage is that they are not as correlated to the market. However, it can become correlated, like in the cur- rent environment, when credit is scarce and deals are broken. So you will get some correlation to the market in the tails, but arbitrage is a wonderful place to be.

GD: A lot of value investors have been creamed lately, but that doesn’t mean they aren’t good investors. If you can’t judge a manager based on recent performance, what should you look at to evaluate an investor? How would you want to be assessed?

PS: I think you need to look at the process and relate the process to what has and hasn’t worked historically. We have tried to determine what works, which part of the market is the richest pond to fish in. Then we’ve tried to identify which bait is the best to use, we fish deep and we fish alone. If you stick to your discipline, then you won’t get into too much trouble. We stuck to our discipline and we are still down 50%, so people have asked us if we are will change our discipline — I said absolutely not. I lot of the damage has already taken place. Again, it’s this issue of people just wanting the pain to go away, they just don’t want to look at it any- more. Now, we are probably in the best time in a generation to be investing in these kinds of companies.

GD: You made the comment about having a discipline and sticking to it and about not deviating. A lot of guys that have come to Bruce Greenwald’s seminar class have talked about trying to make some tweaks to what they have done in the past because of the huge volatility in the market. The most popular comment has been, “We’re going to pay a lot more attention to macro now.” Would that send you running to the hills as an investor?

PS: It’s like closing the barn doors after the horse has gotten out. Everybody saw the signs, but you just didn’t think there would be this huge catastrophe. There are a few guys that had insurance against a huge catastrophe and a few guys that thought there would be a huge catastrophe. But I think it was just a very low probability scenario that actually played out. So would I do anything differently? I make mistakes every day and I try to learn from those mistakes. Everybody makes mistakes, but the fact that so many people are paying attention to macro economics…it’s not going to be there because that’s where everyone expects it.

GD: So with the companies you are looking at, you must be looking for companies that can dominate the very specific niche industries in which they participate. For these small companies to have pricing power, it must be in a very specific niche industry.

PS: For example, a battery distributer we own. I have seen this business model many times in the past. They carry a lot of SKUs in inventory. If you need three of some kind of battery and you need it tomorrow, you can get it from these guys. The only other option is to order 2,000 from China with a six month lead time. I’ve seen this model many times; they have a low ROA, because of all the inventory, usually about three years worth. They do it because they are able earn high margins. When you speak with them, once they showed me an invoice where they bought the product for a nickel and sold it thirty-five cents.

They’ve generated 10% operating margins as a distribution company. When have you heard of a distribution company with 10% operating margins? Their customers are paying for the convenience. That is the type of businesses model that we really look for and they are out there, and they’re cheap.

GD: You have some experience working for the SEC. How has that influenced the way that you think about the regulatory environment?

PS: In the class that I taught, I used to bring in an SEC lawyer to talk about insider trading and compliance issues. The most interesting thing from that perspective is that everything is a grey area. What I would try to press upon the students is that one bad decision could affect the rest of your career. Before you make any decision, I just want you to hesitate for an instant and think about what you are about to do.

GD: OK, ground rule: you can’t pick Buffett. Who’s your favorite investor?

PS: Oh, I wouldn’t have picked Buffett. Seth Klarman.

GD: Why do you say Klarman? You mentioned earlier that he is a very different investor than you are. What about him, is it his record?

PS: It’s not the record. It’s more the quality and clarity of thought, the discipline, and the creativity. Another investor I have a lot of respect for is Walter Schloss. He kept it really simple, he kept it small, and he has tremendous discipline. He also had a long, consistent track record. I think he had the longest unbroken track record, I think it was about 45 or 46 years. It was about 500 basis points for 45 or 46 years. And he just kept it really simple; buy cheap stocks. If you ask me who I admire, I guess it’s Buffett, but I think there are five different Buffetts. My Buffett would be Buffett #1 from the Buffett partner- ship. There’s Buffett the value investor with Berk- shire. The third incarnation is Buffett the rock star. The fourth incarnation is Buffett that buys and holds businesses. The fifth incarnation is Buffett the philanthropist. So I identify most with the first and a little bit with the second.

GD: We were hoping to talk a little bit about your involvement with the Pershing Square Challenge [Editors note: Sonkin taught a master class this year at CBS in connection with the Pershing Square Stock Pitch and Philanthropy Challenge.] First of all, what did you think of the final output?

PS: The quality of the work was really excellent. I was very pleased with the effort that most of the students put in.

GD: Where do you think students make the most mistakes?

PS: The most common mistake that students make is when a boss, for example, asks him for a red umbrella and then he comes back with a blue one and an explanation for how it’s going to keep him dry. If you have seven different teachers, you might need to learn how to do something seven different ways. Then you can just absorb it and decide what suits you. Then when you go to work, you’re probably going to need to learn to do it in an eighth way. Arguing with your boss is just not a good idea.

GD: On that note, maybe you could talk about some of the mistakes you have made personally.

PS: Well, recently, we were in cash for so long that as soon as we saw opportunities present themselves, we pounced on them. We should have waited a little longer and husbanded the cash a little bit more.

GD: Was that a market direction issue mark-to-market, or is it that you didn’t realize how much the businesses would deteriorate?

PS: I think it’s more a mark- to-market issue. There are some companies we own where their business models have fallen apart, but you’re just going to have those, particularly in a portfolio of microcap companies. But for the most part, stock prices have really been irrational. Stocks are just trading way below cash on the balance sheet or replacement value. It’s staggering.

GD: Thank you, Mr. Sonkin.