Greenhaven Road's Scott Miller On Value Investing & Capital Allocation
Kevin Harris from SumZero sat down with Scott Miller to discuss Greenhaven Road Capital, small-cap investing, and value investing. Kevin Harris, SumZero: What is the story behind the founding of Greenhaven Road Capital? How has your work background as an entrepreneur impacted your investment career? Scott Miller, Greenhaven Road Capital: The quick bio for me is that after college I worked at a small manufacturing business, not Goldman Sachs. After that, I went to Stanford Business School, worked in a private equity setting, and then went back to the operating side, starting a business that manages Head Start centers on long-term contracts with the Federal Government. This business grew to well over 1,000 employees, so I spent a lot of time on the operating side including as CFO doing things like hiring, selling, managing cash flow to make payroll, and raising capital. This kind of hands-on experience actually building a business and facing the associated challenges is fairly unique in the money management world.
During my time working as a business operator, I was investing my savings in public markets with great success. Eventually, I decided I wanted to invest in public markets full time, but my operating experience and personal investing experience did not translate well on a resume targeted at fund managers. I had been on a different path than the typical candidate, which I think made me somewhat of an ugly duckling. The only interviews I got were favors.
However, after a year of hunting, two friends from my business school class who had started a fund, and who I had gone through the investing track with took a chance on me. Then the financial crisis came along, the fund blew up for reasons we can discuss later, and I was back at square one. Again, nobody in asset management valued my background, or perhaps I was just not able to communicate it effectively. Either way, I wound up back in an operating role and continued to invest personal capital. I was up over 150% in 2009, but literally could not get a job in the investing world. Eventually, I decided to start Greenhaven Road because I thought I had faith in my own ability, and I was tired of trying to get portfolio managers to hire me and validate me. If I had a traditional pedigree, I don’t think I would have needed to start Greenhaven Road because it would have been easier for someone to hire me.
The reality is, I think my years working as CFO of a fast-growing company are very valuable to me as an investor. I have sat in management’s shoes. I have raised capital. I have communicated good news and bad news to investors. I have “missed” a quarter on several occasions. I can tell you from experience that sometimes customers do just delay a purchase decision. I interpret management actions and management statements through the filter of my work experiences. I suspect I have more empathy for management teams than people who did an analyst program at Goldman, jumped to SAC, and eventually started their own fund. I also think my time on the operating side has given me an appreciation for the difference talented managers can make to the trajectory of a company.
HARRIS: Could you describe the types of businesses that you invest in?
MILLER: I manage two funds. The first is a long-biased hedge fund called Greenhaven Road which I refer to as the main fund. We also have a fund of funds called the Partners Fund which we can discuss later. In the main fund, we typically own about 15 companies. Half are “special situations” such as spinoffs, rights offerings, SPACs, or turnarounds. The other half are high-quality companies that we hope to own for years. In both cases, I have a strong preference for high insider ownership, recurring revenue, expanding margins, and the ability to grow without additional capital. These businesses tend to be asset managers, software companies, and platform businesses. For example, we own Etsy which is a two-sided marketplace for unique items, TripAdvisor which is the leading platform to research and book travel, and Interactive Brokers which is the highest margin and lowest cost “brokerage” business. I put brokerage business in quotes because I think it is ultimately a software company with a massive market.
I think the inadequacies of GAAP accounting create opportunities. For example, we own a tiny software company, SharpSpring. For every dollar they spend on marketing, they generate seven dollars of lifetime value. As long as the marketing spend is that productive, they should be spending every dollar they can find on marketing. Profits should be zero, or less than zero. The future value of the customer base they are building does not show up on the balance sheet under GAAP. However, if you treat a portion of the marketing spend as growth capex the financials are far more attractive. The adjustments matter, the qualitative matters, the setup matters, customer value proposition matters, network effects matter, but these items are frequently obscured by GAAP accounting or lost in a simple P/E or price to book ratio.
HARRIS: What are your thoughts on the rise of quantitative strategies at the expense of more traditional value and activist strategies?
MILLER: The beauty of investing is that there are many ways to make money. Renaissance Technologies has one of the best track records of any fund using any strategy, and they are using a quantitative strategy. I actually want quantitative strategies to proliferate. I want money to pile into them, gobs and gobs of it. The more money into quant strategies the better, as I think they are likely to create distortions that I can take advantage of over time. You can have your backward-looking quantitative data and use that for the foundation of your decisions. I would rather understand the product, market, and management team of the companies I am investing in. Quantitative strategies tend to scale well allowing for large AUM, have a large number of holdings, and have short holding periods. Greenhaven Road is effectively the inverse of that. I want to be small, concentrated, and have a long holding period. I want to understand qualitative factors such as the competitive landscape, the customer value proposition, and the incentives of the team.
HARRIS: What do you hope to accomplish with the Partners Fund?
MILLER: Through my experiences running the Main Fund I learned first hand that generating very good returns is not enough to attract capital. I also recognized that this created an exploitable inefficiency. Simply stated, there are investment managers out there that are incredibly talented, but they have great difficulty raising capital because they are not proven quantities. Incredible talent combined with small AUM is the best recipe for market-beating returns. The trick is getting comfortable with the portfolio manager and the operating business of the fund early in their lifecycle. We are attempting to build something that can take advantage of these incredible managers before they have been discovered by the wider world. If I am right, the Partners Fund can generate attractive risk-adjusted returns over time.
I am fortunate that over the years I have built a strong network of like-minded investors that follow a similar strategy to the one that is used by the main fund. Essentially, simply getting to know these people was a multi-year diligence process. This process is strengthened by a simple framework that I think tilts the odds in favor of success. Namely, the funds that the Partners Fund invests with are characterized by:
- One-Person Investment Committee
- Concentrated holdings
- Reasonable amounts of capital (AUM)
- Significant personal investments (“skin in the game”)
- Original thinking
- Mindset: Getting Rich is Not the Point
HARRIS: Does being on "the other side" of the fundraising equation as a fund of funds rather than as a hedge fund change your understanding of the industry at all?
MILLER: Being on “the other side” has not changed my view of the industry. I think the way capital is allocated is broken. Way too much value is placed on funds being large. I have sympathy for folks tasked with allocating billions of dollars to managers. It is hard. They have to write big checks and the money they are investing is typically not their own, so they have real career risk. Their incentives and the realities of size dictate that the majority of their funds must flow to the largest of managers. Unfortunately, a lot of capital that is not similarly constrained follows the billion-dollar allocators into the multi-billion-dollar funds. The result is that the fund managers with the lowest AUM have the best chance of dramatically outperforming, yet they have the hardest time raising money. Nobody wants to be “early”. Nobody wants to be first. Nobody wants to be wrong. I am not suggesting that these allocators should invest with anybody who just started a fund, but there are some very very very talented managers out there with peanuts for AUM. There are guys that are compounding at more than 20% after fees, with significant personal investments in their own funds, and they have all of the safeguards such as 3rd party administrators. However, I think people’s fear of being “wrong” is far stronger than their desire to compound at high rates, so these small managers stay small. Therein lies the opportunity for the Partners Fund. We are not afraid to be first. We are not exposed to career risk, so we can afford to think outside the box, and blaze a path with unheralded managers.
Ironically, I think the Partners Fund may end up serving as a conduit for one or two large institutions to get exposure to emerging managers in a very curated way. The Partners Fund can effectively pre-screen managers and invite the institutions to some of our manager-only events to allow relationships to start early. The challenge is that I am spending zero-time fundraising for the Partners Fund, so hopefully one or two of the SumZero members looking for a curated way to invest with and build relationships with some of the best emerging managers will reach out to me.
HARRIS: After having now successfully allocated to several managers, what advice do you have for emerging managers looking to launch or grow their funds?
MILLER: Unless you have a very specific pedigree, you have a better chance of being struck by lightning than getting money from a large institution in the first couple of years of your fund. I know there are a few institutions out there that will be early investors, but they are so rare that if large checks early-on is your strategy, you should be prepared to starve while spending a lot of time on meetings and phone calls.
Early investors in funds are by definition independent thinkers. I would try to build a broad base of LPs by writing detailed letters that provide clarity into the investment process. Letters like this let people opt into the fund. My largest group of investors are portfolio managers / former portfolio managers. My second largest constituency of investors are entrepreneurs, and the final group is what I call “father/sons” where the son reads a letter and gets the father to invest. Don’t try to puff out your chest and pretend you are bigger than you are. There is a group of investors who will come precisely because you are small, because you are nimble, because of the quality of your investment ideas. Those are your people in the beginning. You can build a very strong fund $250K or $500K at a time.
I would also say keep your burn rate as low as possible. For most investment styles, you don’t need a team, and you don’t need fancy offices. Keep it simple. You need time – you need a runway. You are not going to be a better investor because of a higher burn rate. In fact, you will probably be a worse investor because you will be desperate for a quick score.
HARRIS: What is your take on the current state of small-cap investing? Where do you think that the most inefficiencies exist in the space and why?
MILLER: I think the small-cap space is a great place to invest in a very targeted way. I am not trying to own the index, and I don’t have a strong opinion on the Russell 2000 vs. the S&P500. But I do think in an investing landscape where people blindly plow money into index funds which then blindly buy whatever happens to be in the index in prescribed amounts, there are opportunities outside of those indices for people capable and willing to do the work to find relative and absolute value. I have the vast majority of my liquid net worth in the fund, so I don’t want to only own small caps, but about ½ the portfolio is invested in companies $500M and below. There is a universe of what Murray Stahl has labeled “invisible companies”. These are companies outside of the indices that generally have no analyst coverage. Within this universe, there are many companies that don’t screen well and are thus also ignored by the quants. I have found some very asymmetric (low risk / high return) opportunities in the small-cap space. One can gain an informational / analytical edge in the land of the ignored and forgotten. There can also be large price appreciation relatively quickly when other people start to pay attention. Forums like SumZero can be helpful, a well-written thesis can spur significant interest.
A simple example of a unique opportunity in the small-cap space can be seen with GAIA, a company I posted on SumZero in 2016. It was a company transitioning from selling yoga-related products such as mats and clothing to a video on demand business. There was massive turnover in the shareholder base as very few people who want to own a branded yoga products company also want to own a money-losing video on demand business. There was only one sell-side analyst, and he stopped publishing on the company. At the time, I would have been shocked if more than 10 people in the world had modeled out the new Gaia, but there was a lot to like. It did not screen well, in part because they did a large tender offer and the data sources such as Bloomberg were slow to adjust their share counts. There was 40% insider ownership, significant cash, a large video library. and a subscriber base that could generate cash flow if the business simply chose to grow less aggressively. Today, the shares are up 3x from where we started buying, and more than 2X from when we posted in October of 2016. So, there is opportunity in small caps if you are willing to do the work.
HARRIS: You ended a recent investor letter with “when the market does decline and volatility reappears, wonderful opportunities will be created”. If there is a downturn in the near future, where do you expect the most investment opportunity to surface?
MILLER: Unfortunately, I don’t have a crystal ball that tells me what will sell off the most. If I did I would be short a lot more companies. I don’t know the companies that will be oversold, or the cause of the next selloff, or when it will happen. In 2017 the S&P 500 had 4 days where it was up by 1% or more and 4 days where it was down by 1% or more. That strikes me as unnatural, and not how healthy markets should function. I was trying to highlight to my investors that while a sharp selloff would be short-term painful, given our small size and stable capital base, we are very well suited to take advantage of selloffs, and a sharp selloff could ultimately be to our advantage. Historically, during selloffs, we lose money with the market, but we have been able to benefit disproportionately during the recovery.
During periods of high volatility, the babies often get thrown out with the bathwater, and if you can do the work there will be opportunities to seize. There are patterns that tend to repeat, such as balance sheets being ignored, bad news being extrapolated too far into the future, and adjustments to earnings being shunned. When the sky is falling, most people don’t want to hear about normalized earnings or why we should backout non-cash non-recurring charges. People just want to hold cash. That is exactly the time that we want to be giving other people our cash and taking their shares in the right companies. We don’t buy the market, we buy individual companies. The fundamentals matter, the quality of the management team matters, the competitive landscape matters, product matters, cost structure matters. Sharp selloffs create opportunities. Short-term pain for long-term gain.
HARRIS: How has your investment process /philosophy evolved over time? What events were most pivotal in catalyzing this?
MILLER: I think I have evolved in two ways as an investor. The first is that I am less enamored with the 50-cent dollar than I was when I started. Buying cheap just because it is cheap used to really excite me, but I think it is just an inferior way to invest. Let’s say our analysis is correct and it really is a 50-cent dollar, then when the market corrects we should double our money. Everybody likes to double their money, but we are not guaranteed to see that gap close. What if the dollar is becoming less valuable each year because of competition? For a shrinking dollar, the gap may close by the value of the dollar shrinking to 50 cents vs. the 50 cents growing to the dollar. Or it might take several years for the gap to close, in which case the returns on an annualized basis will be underwhelming.
Over time I have come to place a much greater emphasis on insider ownership and the ability of a company to grow without additional capital. Today, I will take the right team, right incentives, and a long runway for growth without capital over “cheap” every time. When we are right on the 50-cent dollar we can get a double, when we are right on the owner-operator with a long runway for growth, we can do multiples better over a long time period. When you factor in taxes, the advantages are even more pronounced for pursuing the right setup over the cheapest stock.
Sometimes we can get both a 50-cent dollar as well as the potential for growth. We made an investment last summer in a company called Scheid Vineyards at what I believe to be a 50%+ discount to the asset values (Land+Production Facility + Inventory), and this discount was helpful in making the investment, but it was the fact that insiders owned more than 40% of the company, the land values were likely appreciating, and there was an opportunity to significantly grow earnings by selling their wines as finished goods as opposed to bulk sales to Gallo and other major distributors. If I am right it was a 30-cent dollar that can grow double digits for the foreseeable future.
The other evolution I have had is that I used to put a greater value on an idea being “my own”. The reality is, there is an investable universe of over 20,000 companies, you cannot cover them all. There are some very talented investors out there. I have to believe that our best chances of being successful as investors will come from collaborating with the right people. Sharing ideas is the spirit that SumZero was founded on, and I think it makes a ton of sense to be part of that ecosystem.
As I mentioned previously, we started a Fund of Funds, and it has proven to be a wonderful vehicle to collaborate with other managers. The existence of the Fund of Funds encourages conversations I simply would not have historically had. One of the goals of the Partners Fund is to increase the frequency and breadth of conversations with other managers. Ideally, I want to hear about an idea before it is posted on SumZero. I also vet my ideas with other managers. I am never going to be a “networker,” but I will actively collaborate with the 15 smartest investors that I can find. I need 4-6 good ideas a year. If I originate 2-3 ideas from the 15 managers in the Partners Fund and improve the decision-making on all 4-6, it is a home run.
HARRIS: How did being at a fund with large redemptions during the financial crisis impact your fundraising strategy?
MILLER: I worked at a fund during the financial crisis with some very very talented people who individually have done quite well, and if we had been able to keep the band together, I think we could have done fantastically well. To give you a sense, the fund’s largest position was Transdigm, which has been more than a ten-bagger since 2009. The problem that the fund had, was that 90% of the assets were in separately managed accounts where the two investors could see daily returns. These investors could also redeem on very short notice. Ultimately, the accounts were redeemed, which gutted the fund and ended my employment. That experience seared into my mind the importance of the terms of the money. Because the funds were redeemed, we were not able to realize the long-term returns that came from the Transdigms of the world. We simply could not stay in the game long enough. Equally problematic was the fact that because the capital was short-term in nature, our investment time horizons were shortened. There was real pressure to produce returns as fast as possible to retain the capital. Because of the daily reporting and redemption terms, we became very short-term focused. What companies were reporting earnings? What is the consensus earnings? Why do we think that consensus is wrong? I could not bring an idea to the portfolio managers that would work sometime in the next 3-5 years. We just did not have that luxury.
At Greenhaven Road, we have quarterly reporting and most of the money is committed for three years. I have the advantage of a much longer time horizon. I don’t have to “trim” a position because I think a company may miss by a penny. I can invest in companies that have no analysts, have no consensus, and have no immediate catalysts. I can wait.
I think even more important than the terms the money is taken on, is who it is accepted from. In this regard, I think I just got lucky. I did not start with a grand strategic fund-raising strategy. I am an introvert, I have never cold-called anybody to pitch the fund, and I have not sent unsolicited emails. It is not my personality. Thus, our “strategy” is pretty limited. I write quarterly letters to my limited partners, and I post them on our website www.greenhavenroad.com and that is it. In the letters, I try and let my LPs know how I think and what we own. I make the letters easier for others to access and receive. There are no passwords, and anybody can sign up for future letters on the website. When somebody invests in Greenhaven Road, it is not because we have had 20 meetings and 10 phone calls, it is because they have read 100 plus pages worth of letters written over several years and the approach resonates with them.
I think by being passive on the marketing front, it has allowed us to get the highest quality LPs. They are philosophically aligned, and they want to be in the fund. I know I am going to have down months, quarters, and years. That is just part of the deal when you are investing in a concentrated fashion in off-the-beaten-path companies. We are going to have rough patches. I need independent thinking, patient, long-term oriented investors who will accept some downs for some hopefully larger ups. The only way I know how to find those rare people is to let them find me.
Harris: In your most recent quarterly letter, you recounted turning down more money from a single LP than you raised in the first 5 years of the partnership. At what point does more (or more concentrated) money do more harm than good? Is size always the enemy of returns?
MILLER: Size is generally the enemy of returns. If I had to generate a 30% return, I would much rather do it on $100,000 than $1 billion. We were fortunate to be offered a very large amount of money from a very sophisticated allocator, but for me, the North Star is risk-adjusted returns, not size. Our design principle is to do that which gives our partnership the best chance at the highest risk-adjusted returns. This is very different from trying to make the most money in the shortest period of time. I think the partnership is healthiest if we are able to have a broad base of philosophically aligned investors on very stable terms. This allows us to invest in less liquid companies with a multi-year time horizon, and this allows me to focus on investing, not investor relations or fundraising.
HARRIS: Which books have had the largest impact on your investment philosophy?
MILLER: Joel Greenblatt’s “You Can Be a Stock Market Genius” was very helpful to me in understanding how frequent there are special situations, and how patterns play out across companies. He also reinforced that most people don’t do the work. If you poke around and look under enough rocks you can find the right combination of long-term incentives, quality business. and reasonable valuation. You too Can be a Stock Market Genius lays out many examples and helps to build pattern recognition.
HARRIS: Who do you credit as contributing most to your education as an investor?
MILLER: I think there are two major influences at this point. When I was thinking of starting a fund, Mohnish Pabrai was literally the only guy out there saying it was possible. He had come from an operating background, and he had successfully set up a Buffett-style partnership. He had put up excellent returns as a one-person investment committee, and he was not apologetic about it. He is also a prolific communicator, posting videos of lectures on YouTube all the time. I watch just about all of them. In his folksy way, he hammers home the power of compounding and the pursuit of opportunities with limited downside and large upside. He also urges people not to confuse uncertainty and risk.
My other major influence would be Chuck Royce, who is one of the pioneers of small-cap investing. I am fortunate to physically work out of his family office. The proximity means we end up talking a fair amount. Over the past 3 years, every investment I have made, I have discussed with Chuck at some point in the process. Sometimes it is after it is made, and sometimes when it is just an inkling. The value of talking ideas through with Chuck is that he has literally seen it all. One of the more valuable
lessons related to investing in small companies came when I was considering making an investment in a pretty illiquid company. I asked Chuck, “what kind of liquidity discount do you think is deserved here?” His response was that he cared less about the discount, but more that I was sure that they could get to the other side. He was saying that when it is illiquid, you have to make sure they are going to make it because you can be stuck for a long time. This means avoiding excessive debt or too much execution risk.
I think perhaps even more impressive than their investing careers, Pabrai, Royce, and Greenblatt have all given back in high-impact ways. Pabrai’s Dakshana Foundation efforts have social return metrics that are off the charts – he is literally changing the trajectory of lives. Similarly, Greenblatt with his Success Academies has children in NYC most economically challenged communities outperforming wealthy communities like Scarsdale. Chuck has been lower-profile in his philanthropy but equally thoughtful. Like many SumZero members, I am still in the resource gathering phase, but I think it is worth pointing out that these are role models outside of investing too. They are not just cutting checks to their alma maters they are finding inefficiencies and leverage points to make the world a little bit better. If I can be half as good at making it and half as good at giving it away as any of these giants it will have been a great run. https://www.forbes.com/sites/kevinharris/2018/07/27/greenhaven-roads-scott-miller-on-value-investing-capital-allocation/?sh=4df4795821af