April 24, 2018 David Kim
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Dear friends and investors,

For the quarter ending March 31, 2018 Forage Capital (“the Fund”) returned an estimated +9.6%, net of all fees and expenses compared to -0.8% for the S&P 500 Total Return Index.  At quarter-end, the portfolio was comprised of 12 companies with a median market cap of ~$26bn and its cash balance was 35% of assets (assuming the Ash Grove acquisition closes, the cash balance is more like 40%).

Gains were broadly distributed with the biggest contributor, AMZN, delivering around 1.8% to the Fund’s returns this quarter.[1]

Here’s an excerpt from Morgan Housel’s fine post, Ironies of Luck:

“If risk is what happens when you make good decisions but end up with a bad outcome, luck is what happens when you make bad or mediocre decisions but end up with a great outcome…risk humbles you as soon as it arrives, while luck humbles you down the road, once it vanishes…”

Recent volatility spurts have inspired predictable reactionary hand waving concerning the resurgence of risk.  But during the protracted stretch of unperturbed winning leading up to today’s jitters, how many considered themselves beneficiaries of luck?  Luck is an uncomfortable topic.  We want to assign good fortune to diligence and perspicacity.  But the truth is that you can buy a stock for the wrong reasons and look right for years; you can be vindicated by an outcome you never even considered; you can launch a career off a track record fueled by the good results of a few bad decisions.  In a probabilistic art like investing, it takes time and context to discern even a glimmer of skill, certainly more time than the 20 months that Forage Capital has been invested and more context than an environment where it seems even a dart-throwing chimp could have prospered.  While I’m confident that you’ll be pleased with the Fund’s returns over the next 5 to 10 years, what happens in any given quarter or even year is really anyone’s guess.

For a growing majority of companies on my watchlist, I am unable to impute compelling returns without recruiting the sunniest of sane assumptions.  Of course, I said the same thing several quarters ago and that opinion informed a heavy allocation to cash that has cost us dearly in forgone returns.  I mostly agree with the claim – made increasingly popular by the ascent of fast growing, “quality” companies – that if you are right about the size of the addressable market and you are right about a company’s ability to claim value within it, that company’s stock, even if purchased at what seems a lofty valuation, will work out fine over the long time horizons that most investors can’t abide.  But, price always matters – who would admit otherwise? – even for “compounders managed by outsiders”.

I find it sometimes helpful to start with an agreeable rate of return, cogitate on the outcome required to produce that return, and then gauge my conviction in that outcome.  For instance, Atlassian (which we don’t own) is a moaty, high flying SaaS trading at 15x annualized revenue.  Assuming 25% revenue growth per year for the next decade gets us to $8bn, which at 10x yields $80bn of enterprise value, in same hemisphere as Adobe and Salesforce.com today.  Atlassian: a category defining enterprise software vendor with the ubiquitous market presence that only a handful of its peers has achieved over the last 20 years?  That’s basically what you need to believe to earn ~20% per annum on the stock.  This question can’t be answered with spreadsheets and algebra.  It’s just a judgment call and fortunately, one I’m not forced to make.  So, that’s where it’s at with most stocks I have my eye on, especially in the enterprise software space: excellent companies with substantial growth opportunities that feel valued as such, reasonable purchases only if you feel very confident – notwithstanding vigorous competition and rapidly shifting industry dynamics – extrapolating today’s heady growth rates very far out.  So, that leaves me holding cash and waiting for better prices.

I made two meaningful trades this past quarter.  In early January, I sold Oaktree[2] and bought Red Hat.  Nothing about my opinion of Oaktree has changed, but the long-term drivers for Red Hat are far more compelling.  As excellent a manager as I believe Oaktree to be, what will fuel meaningful earnings growth from here are the prospective management and incentive fees earned by deploying the substantial dry powder earmarked for its closed-end funds.  This depends to a large degree on when the cycle turns and how deep that downturn will be.

Red Hat, meanwhile, has the wherewithal to capitalize on a seismic shift in enterprise computing that is in the early stages of unfurling.  At a high level, Red Hat stitches together open source projects that allow its customers to create and manage software.  But Red Hat does not passively yank code from open source communities, drop it inside enterprises, and simply support it.  It instead identifies the most technically advanced projects that will have the most significant market impact, brings those projects into a development community, and takes a lead development role as the number of 1 or 2 contributor.  This means that the company can influence project development and have the patches and upgrades from its enterprise clients accepted among a community of thousands of developers.

Legacy on-premise computing may have been half-built on Windows, but two of the biggest confluent themes in enterprise computing, hybrid cloud and the containerization, rely on Linux.  And Red Hat, with 70% share of Linux distributions, is assuming a leadership role in significant open source projects that are pivotal to its an enterprise landscape that is reconfiguring its computing patterns around open platforms and modular architectures.  OpenStack, a private cloud operating system demanded by large enterprises wary of vendor lock-in, is a key pillar of the hybrid cloud.  Container technologies have finally found a critical use case in a flourishing hybrid computing environment, as they allow applications to be developed and ported across different computing environments.  Docker and Kubernetes are by far the most significant container and container orchestration projects, respectively (and will only become more so as enterprises and public clouds coalesce around their open standards, virtuously drawing more contributors in turn), and Red Hat is the number two contributor to both.

This topic and this company are conceptually baroque.  Please check out the scuttleblurb blog for more detail:

[RHT – Red Hat] On a Bridge Between Cloud


Have a great Spring!

David Kim

[1] AMZN has also been the largest winner since inception, contributing 4% to gross cumulative returns.

[2] Including dividends, we made a modest return