Guy Gottfried — The Value of Capital Allocation

Fall 2014

Guy Gottfried is the Founder and Managing Partner of Rational Investment Group, LP, a Toronto-based investment firm following a concentrated, risk-averse value approach. Prior to founding Rational, Mr. Gottfried was an analyst at Fairholme Capital Management. He began his career at Veritas Investment Research, Canada’s largest independent equity research firm. Mr. Gottfried graduated with a BBA with Honors from the Schulich School of Business at York University, where he was a President’s Scholarship recipient.

Graham & Doddsville (G&D): Can you tell us about your background and how you became interested in a career in investing?

Guy Gottfried (GG): It was during the junior year of my undergraduate studies in Toronto when I realized I had to get a good summer internship in order to land a desirable job after graduating. Everyone at my school was flocking to accounting, marketing, or investment banking, none of which appealed to me. One of my professors that year, Anthony Scilipoti, was (and still is) a partner at Canada’s largest independent investment research firm, Veritas Investment Research. I worked hard to excel in his class and, through that connection, was able to summer at Veritas. I ended up parlaying that into a full-time position.

I enjoyed the work right away and toward the start of my summer position, I decided that, if I was going to potentially pursue investing, I should learn as much as I could about the discipline. I asked the president of the firm if there were any books he could recommend, and he suggested Graham’s Security Analysis. I read that and followed it up with every Berkshire Hathaway letter to shareholders, and by that point I was hooked on value investing. I simply couldn’t fathom how any other approach could even be considered investing; as Charlie Munger once said, “All intelligent investing is value investing — acquiring more than you are paying for.”

From there, I gobbled up anything I could get my hands on: Greenblatt, Klarman, Fisher, OID, articles and interviews. At Veritas, we had access to an article database called Factiva. Any time I’d come across a value investor or manager that seemed interesting, I’d search for every article that had ever been written about them and every interview they’d ever done and just devour them.

I also went to the very first Value Investing Congress in 2005. I paid for the tickets myself and flew from Toronto so I could learn first-hand from the likes of Klarman, Einhorn, and Ackman. The cost to attend the conference was a lot of money for me back then. Like a true value investor, I stayed in Midtown Manhattan at a two-star hotel, which was really a quasi-hostel with shared bathrooms. I certainly wouldn’t have guessed back then that I’d one day be a regular speaker at that very conference.

In any case, within a few months of joining Veritas full- time in 2004, I was promoted to sector analyst covering Canadian income trusts. It was a solid position for a twenty- four year old, but the more I delved into investing, the more motivated I became to excel at it, and by 2006 I resolved to work for a prominent value investment firm to further hone my skills. Fortunately, I managed to join Fairholme as an analyst. Despite having a multi-billion dollar asset base, there were only five of us on the investment team. Everyone else was roughly twice my age and I learned some valuable lessons there.

G&D: How did you get introduced to Bruce Berkowitz and the Fairholme Team?

GG: I knew that I was competing with Harvard, Columbia, and Wharton MBAs with serious work experience, and here I was with an undergraduate degree from a Canadian school that many Americans had likely never heard of. I recognized that I needed to distinguish myself somehow. With that in mind, in 2006 I wrote a comprehensive research report on a stock in order to illustrate what I could contribute and sent it to 12 or so firms that I thought would be great to work for, one of which was Fairholme.

G&D: Can you share some key lessons you learned while at Fairholme?

GG: As I mentioned earlier, I had long been a voracious reader of books, articles, and interviews by and about countless great investors, going back decades. I picked up their unique insights and perspectives on investing and applied them to my own portfolio. My time at Fairholme reinforced many of those ideas and gave me the opportunity to be immersed in value investing every day.

For instance, Fairholme reinforced my appreciation for the value of cash. The first reason is obvious: it’s better to earn nothing in cash than to potentially lose money by making a risky investment that isn’t up to your standards. Second, and perhaps less intuitively, cash is a weapon. When a general market dislocation erupts or a compelling individual opportunity arises, it is only those who have cash — precisely when everyone else lacks it or is afraid to use it — who are able to capitalize. This was an important concept at Fairholme, and it’s a lesson that has served me well.

Also, one of the attributes that originally attracted me to Fairholme’s approach when I researched the firm was its disproportionate emphasis on management. At Fairholme, we wanted to understand exactly with whom we were partnering and to whom we were entrusting our capital, just like any sensible businessperson or private investor would want to do. Of course, none of this came at the expense of studying the business, industry, accounting, valuation, and so on. But I’d say that Fairholme prioritized, more than the average fund, the need to understand the insiders’ backgrounds, operating style and capital allocation throughout their careers and in different business environments.

G&D: You launched Rational Investment Group in 2009. What factors led you to launch your own firm?

GG: I’d always had the desire to start my own fund and hopefully one day become a respected value investor in my own right. I distinctly remember one day in the summer of 2005 when I was thinking about the last few market crashes and the tremendous investment opportunities that they created. I recall reflecting on how rarely these events occurred and thinking that the next time something like that happened, I’d do my best to pounce on it.

After Lehman collapsed in late 2008, the markets’ reaction was so severe, and the fear and irrationality so rampant, that it was like nothing I’d ever experienced. There was one week in particular — the week of October 6 — when every stock I was following fell 10% a day. I decided that the valuations I was seeing were too good to pass up.

I launched Rational in early 2009 with $500,000 in outside capital from one investor. I knew this would be a difficult climate in which to raise capital, but I figured that either the whole world was coming to an end, which was highly unlikely and in which case you’d be screwed no matter what you were doing in life, or this represented an extraordinary chance to exploit some unbelievable bargains and to start building a strong record.

Since inception, we’ve generated net returns of 21% a year. That compares to 13% for the TSX Composite Index in Canada, where the vast majority of our portfolio has been invested over the years. We’ve beaten the index by about 8% annually while averaging 24% cash.

G&D: How would you characterize your investment approach and philosophy?

GG: One of my favorite investing quotes comes from Benjamin Graham, who wrote in The Intelligent Investor, “Investing is most intelligent when it is most businesslike.” Suppose you were a businessperson considering taking a stake in a private company. What are the questions that you’d ask yourself? Chances are you’d ask, do I understand this business? Is the balance sheet sound? Am I partnering with the right people — is management capable and does it allocate capital shrewdly?

And, of course, am I getting a bargain?

And chances are that as a private businessperson, you’d probably insist on all of these criteria being met to your satisfaction; it would be too risky to do otherwise when tying up your hard-earned capital for multiple years. If you think about it, as a long-term value investor in the public markets, that’s exactly what you’re doing. Yet in the public markets, people often compromise on one or more of these criteria. For example, they’ll say, “This isn’t as undervalued as I’d normally like, but I really like the business,” or they’ll invest in a highly leveraged or mismanaged company because it’s statistically cheap. That happens all the time and it’s arguably due to the illusion of liquidity. Knowing that you can always change your mind and sell out of a position creates a subtle, subconscious temptation to loosen your standards, especially when the market is strong, and that’s often where people go wrong. I’ve found that it’s rarely worth making exceptions and that if you’re going to commit your capital to an investment, you should insist on the complete package.

G&D: What is your process for identifying opportunities?

GG: First, you can’t do the same thing as everybody else and expect different results; it is going to be difficult to find truly compelling investments that way. Many investors might start by screening for stocks with low multiples to their earnings or free cash flow. But the most attractive opportunities often involve businesses that are under- earning or even losing money and that therefore won’t be found in a screen. For example, when Warren Buffett first invested in GEICO for Berkshire Hathaway in the 1970s, it was mired in red ink and was facing financial difficulties. It is very doubtful that GEICO would have shown up on a computerized screen, but it was arguably the greatest investment that Berkshire ever made.

Because the best investments don’t necessarily stand out by conventional means, I try to look for special situations that are relatively unrecognized and underexploited. For instance, as I mentioned earlier, I formerly was a sector analyst covering Canadian income trusts. Income trusts resembled REITs and MLPs in that their structure allowed companies to avoid taxation. However, in a Canadian twist that was subsequently barred by the federal government, any business in any industry could become a trust.

Since income trusts tended to trade at premium valuations, many companies adopted the trust structure, including some that had no business paying out all of their earnings. However, if a trust ever reduced or, God forbid, eliminated its dividend, its shares would be cut in half like clockwork. When I was still at Veritas, I noticed that there were almost no professional investors who systematically sought out trusts that stopped paying dividends or cut them substantially. This unique special situation became a source of a plethora of bargains over the years, including several in Rational’s early days.

Another example involves dilutive debt recapitalizations. Suppose that a company has an upcoming debt maturity that it cannot pay off or refinance and is therefore forced to settle that debt with shares. As an equity holder, few things are likelier to make you cringe than your investment being massively diluted. However, a debt recap is like a built-in catalyst because the event itself can eliminate the very problems that precipitated it. It will often leave companies with a clean balance sheet and be accompanied by the arrival of intelligent lead shareholders and the replacement of incumbent management that got the company in trouble in the first place. Further, since firms that need to be recapitalized tend to already trade at depressed valuations and the announcement of the recap will cause their shares to plunge further, they can still be quite cheap despite the dilution. So here’s another case of a situation that causes indiscriminate selling and can therefore be an attractive source of undervalued investments.

Another example arises when you identify great owner- operators or controlling shareholders. Brilliant managers and capital allocators are rare, and when you find one, it can pay to ask, “What else is this person involved with?” On occasion, you’ll find that this individual may be present at other undervalued companies. For example, in 2009, we invested in a Canadian energy company called Paramount Resources. Paramount was founded and remains controlled by a phenomenal owner-operator in the Canadian energy space named Clay Riddell. What initially drew my attention to the stock is that it appeared to have a single asset that was worth more than the market value of the company, giving you the rest of the business for free.

As I dug into the company, I was increasingly impressed with Riddell’s capital allocation. Most notably, Paramount had leased a significant amount of acreage in the Canadian oil sands in 2001, before people were even talking about the oil sands. Then, in 2007, when the oil sands were all the rage, it sold a portion of its acreage for $1 billion, for a gain of $800 million. Consequently, I looked further into Riddell and found out that in the prior half a year, he had bought 15% of the outstanding shares of another Canadian public company called Newalta on the open market. Riddell, who had been a Newalta director for 20 years, had spent some $65 million on these purchases at double or triple the price at which it was trading at the time.

I delved into Newalta and found that it, too, was dirt- cheap, trading at just 3x to 4x free cash flow despite having a near duopoly in its core business of outsourced oilfield waste management. Rational ultimately invested in both companies and made approximately 170% on Paramount in nine months, and 175% on Newalta in a year-and-a-half.

In exceptional cases, you’ll find one security that exhibits multiple special situation characteristics. For example, among investments that I’ve discussed publicly, The Brick and Holloway Lodging suspended their dividends, underwent dilutive recapitalizations and had excellent lead shareholders come aboard in conjunction with their respective recaps.

G&D: These are great examples, specifically with how you identified Newalta. It reminds us of a recent comment from Seth Klarman about how “pulling threads” on an existing investment leads to additional investment opportunities.

GG: That’s right, and by the way, there’s no shame in using the same method multiple times. It’s so difficult to find truly compelling ideas that you have to take them any way you can get them. When I find some way of simplifying the process of locating bargains, I’m unapologetic about reusing it for as long as it works.

G&D: Can you share with us a current idea in your portfolio?

GG: Holloway Lodging is one of the ideas that I presented at the recent Value Investing Congress. Holloway is a Canadian hotel company that had historically been mismanaged. The company ran into severe problems last decade after the financial crisis and had to eliminate its dividend (Holloway used to be a REIT). That obviously hurt. The situation became even worse in late 2011 when Holloway announced that it would have to pay off a maturing debenture entirely with shares, diluting existing shareholders by some 90%. The stock traded at $5 at the time of my presentation compared to the $150 range, split-adjusted, before the crisis. Our average cost is around $4. Along with the recap, an activist investor took control of Holloway in 2012, replaced management, and significantly improved the operations. The company’s legacy portfolio is performing very well today.

Where it gets really interesting, though, is that Holloway just completed a transformative takeover whose potential I don’t think the market has caught on to. Specifically, it just closed the acquisition of another hotel company called Royal Host. Although Royal Host doubled Holloway’s size, it generated less than 20% of its free cash flow due to extreme mismanagement. The deal creates tremendous value, which I’ll demonstrate shortly.

At the time of the presentation, the stock traded at 7.7x free cash flow based only on Holloway’s and Royal Host’s combined trailing results, without any further adjustments. That compared to 11.7x for Holloway’s publicly- traded peers. If you normalized the results for actions that are already being taken to improve Royal Host, the stock would trade at just 5x estimated free cash flow.

Further, if you ignored Royal Host altogether and pretended the acquisition never happened, Holloway was still valued at 8.4x, equivalent to a 12% free cash flow yield and a 28% discount to its peers. In other words, the market was giving you Holloway at an attractive price and throwing in Royal Host for free.

What makes Royal Host such a tremendous opportunity for Holloway? The company was very poorly managed for close to a decade. From 2006 to 2013, it had three presidents or CEOs whose average tenure was just 13 months, and the rest of the time it was run by committee with no effective leader prior to the current chairman. Without adequate management, Royal Host didn’t pay attention to costs, underinvested in its assets and generally failed to do the basic blocking and tackling of operating a hotel business.

I’ll give you a couple of examples that illustrate the mismanagement. Both Royal Host and Holloway have hotels in Yellowknife, Northwest Territories. Royal Host’s hotel has 129 rooms; Holloway’s has 66. Royal Host’s is a full- service hotel with a restaurant and banquet hall, while Holloway’s has no food and beverage offerings. Yet Royal Host’s hotel only generates around 30% more net operating income despite being double the size and having the food and beverage business.

Second, Royal Host had a hotel it recently sold in Chatham, Ontario, where it was paying nearly double the property taxes of another hotel in Chatham owned by a rival company. Same city, same type of hotel, similar size, and Royal Host was paying approximately $100,000 more a year in property taxes. Amazingly, the company just never bothered to check competitors’ property tax records and appeal its own taxes. Royal Host has since made these appeals and was able to receive prior-year refunds for a majority of its hotels and generate ongoing savings of several hundred thousand dollars annually.

The magnitude of the cost- cutting opportunity at Royal Host is enormous. Some of these initiatives have already been achieved but have yet to flow through Royal Host’s trailing financials, let alone Holloway’s, as the acquisition only closed on July 1. Others are being worked on as we speak. Holloway is addressing virtually every major cost item at Royal Host such as property management, food, insurance, wages, etc. Overall, Holloway can generate millions of dollars in annual cost savings, a significant amount for a business with $12 million in trailing free cash flow. And none of these measures are herculean — this is just the result of running the business the way it should be run. I should also add that these are after-tax improvements, as Holloway will not be cash taxable for the foreseeable future.

As another case study, for years Royal Host under- invested in its most valuable asset, the Hilton in London, Ontario, which is now Holloway’s most valuable asset as well. Management estimates that by spending $5.5 to $6 million renovating the hotel, it can boost net operating income by $1.5 million per annum. At a 9% cap rate, you’d get a $17 million increase in property value on a $6 million investment.

Royal Host also has numerous hidden assets: it has a hotel near Toronto’s Pearson Airport which only earns cash flow (net operating income less capex) of $300,000 to $400,000 a year, but could probably be sold for $15 million due to its real estate value. If Holloway can divest this property and redeploy the proceeds into hotel acquisitions at a 10% cap rate with a 55% LTV mortgage at 6%, it would add $2 million to its free cash flow. And again, we’re talking about a company with $12 million in trailing free cash flow, so each of the actions I’ve discussed will provide a sizeable boost. There are likely $20 to $25 million in disposition opportunities in Royal Host’s portfolio.

So you have this huge growth opportunity due to the Royal Host acquisition that won’t take anything heroic to realize; it’s just cutting costs and capitalizing on under-earning assets. Factor this in and you wind up with an estimated valuation of 5x free cash flow. Then, beyond Royal Host, Holloway’s management is very capable and allocates capital intelligently, as the Royal Host acquisition attests. You have a multi-year horizon over which management can continue executing accretive deals. If Holloway can grow its portfolio from 33 (including assumed near-term dispositions) to 50 over four or five years, think about what free cash flow will be then. Ultimately, this stock will trade at a low single digit multiple, which is hard to find in any business nowadays, let alone a real estate heavy company that’s very well run and has years of growth ahead of it. What’ll the stock be worth at that point? Should it trade at 8x, 10x, or 12x? It’s hard to say, but it doesn’t really matter; the point is that your margin of safety is huge and that it’s hard to find a scenario where the shares don’t skyrocket. And insiders seem to agree: six of them have bought 9.5% of the company on the open market since May.

G&D: How have you evolved as a professional investor, and what are some lessons you have learned at Rational?

GG: I launched Rational during a very anomalous time when I was only twenty-seven years old, so I was bound to learn a thing or two. I’d say that one of my greatest regrets has been not reaping the appropriate rewards on some of my highest-conviction ideas, and that relates to the issue of portfolio concentration.

It’s fashionable to say you’re a concentrated investor, but in practice it’s very challenging. Rejecting an investment that clearly has a poor margin of safety is easy. The hard part is finding an idea that actually is attractive and still turning it down because it isn’t up to your high standards and you can do better, be it by adding to your current best holdings or by waiting for future opportunities whose timing you can’t know, but which invariably come around from time to time. That takes great discipline.

G&D: What is the size of Rational’s team now?

GG: It’s just me and our CFO. It’s unconventional, but I’m a control freak when it comes to the research process and being entrusted with other people’s capital. I’m very cognizant of the fact that just one unnoticed or misinterpreted detail can result in making the wrong investment or passing up the right one. Don’t get me wrong, our due diligence is heavily dependent on the knowledge and insights of an extensive network of people, including management teams, industry specialists, fellow investors, and others who may be familiar with a given business. You can’t attain and sustain the necessary conviction level in an investment entirely on your own. People are a critical part of the process; it’s just that for us, it’s been more external than internal in the form of having a team of analysts. That said, I certainly wouldn’t rule out adding an analyst or two over time under the right circumstances.

G&D: Other than your presentations at the Value Investing Congress, you tend to keep a low profile. What is your view on publicity as an investor?

GG: Actually, even the Congress opportunity came about by happenstance, after I was introduced in 2011 to the organizer, John Schwartz, by a mutual friend. But you’re quite right, I do tend to keep a low profile. Rational doesn’t have a website and it isn’t unusual for me to be contacted by prospective investors apologizing for calling or emailing me directly because they couldn’t find any other contact information and asking me to forward them to our IR person (which, of course, we don’t have).

I’ve worked hard to structure my life and work in a way where I can focus on being efficient, eliminating waste and clutter and being in total control of how I spend my time. Of all of Buffett’s great attributes, one of the most unheralded is the tremendous focus and productivity he achieves on a daily basis by structuring his life so that he can virtually always do what he enjoys and actually wants to do. I think I still have a long way to go before I perfect this, but that’s how I try tried to arrange things here as well.

One of the advantages of not doing much marketing is that the people who do tend to locate you are more likely to be like-minded investors. I’m really thrilled with Rational’s capital base — we have unbelievable partners. It’s very easy to take such things for granted, but it’s important to stress that regardless of your ability as an investor, you won’t be able to execute your strategy successfully over the long haul without a stable capital base.

Imagine that a market dislocation arrives and instead of being able to take advantage, you’re forced to use your cash to meet redemption requests from panicky investors while the opportunity passes you by. Not only is it counter- productive, but also psychologically, the anguish and helplessness of being handcuffed can leave you vulnerable to becoming irrational and making bad decisions. It is much easier to cope with temporary losses when you feel that at least you’re capitalizing on the environment.

G&D: We noticed you are one of the key speakers at Canada’s Capitalize for Kids Investor Conference this October. How do you view this philanthropic endeavor?

GG: There are countless prominent investing conferences in the US, so this may be hard to believe, but Capitalize for Kids is probably the first large-scale investment conference in Canada, let alone one that is devoted entirely to a philanthropic cause. What attracted me to Capitalize for Kids when I was first contacted about it by Kyle MacDonald, one of the co- founders, was that it targeted specific areas within The Hospital for Sick Children in Toronto that it identified as being underfunded or in need of special attention. The folks at Capitalize for Kids put a great deal of thought not only into organizing the conference itself, but also into how to best allocate the proceeds. I was impressed by that.

G&D: Can you share any advice with our readers?

GG: In one of his old partnership letters, Buffett makes the important point that in investing, there’s a difference between being conventional and being conservative. Since convention is dictated by the crowd, following it will frequently lead you in the wrong direction. This is in keeping with his philosophy of having an internal scorecard — of doing what makes sense to you and judging yourself by your own standards rather than the standards of others. This has been a guiding principle for me in building Rational. I’ve often done things that didn’t exactly help our marketability because they were right for me and enabled me to create an environment that was suited to my investing philosophy and personality. For instance, Rational has never engaged in short selling. Some allocators consider this blasphemous, and there’s no lack of managers who short mainly to justify their fees. Personally, I consider it virtually impossible to find any short that can come close to matching a well-researched long; not only is the upside capped and downside unlimited, but even those who do find great shorts tend to size them so small that they’d arguably be better off avoiding them. Sure, shorting can reduce volatility, but over time it’s nearly destined to underperform. There are many ways to get to heaven in the industry, but that’s what makes sense to me.

Similarly, I don’t have a team of analysts for the reasons I articulated earlier, which I’m sure turns some people off. I could go on, but you get the idea. You’ll go farther in the long run — and have a great deal more fun — if you do what resonates with you instead of worrying about convention and how you look in the eyes of others.

G&D: That is a valuable piece of advice and a great way to conclude our interview. Thank you for your time, Mr. Gottfried.