Rubbing My Nose in It
The Mindset Value Fund 2022 Year End Letter
Disclaimer: The below post is my Year End 2022 Investor Letter that I sent to investors in the Mindset Value Fund about a week and a half ago. This post is NOT a solicitation. I talk about stocks that I own and my view of the future. It is imperative that you do your own due diligence and not rely on anything written below. I’m posting this in order to show how my writing translates to actual performance. With that, I hope you enjoy and gain insights.
Mindset Value Fund 2022 Year End Letter:
“You need patience and discipline and an ability to take losses and adversity without going crazy.” Charlie Munger
The Mindset Value Fund finished down 0.3% for the fourth quarter. The fund ended the year down 42.4% on a net basis.
Frustrating Month of December
To say that last year was frustrating is truly an understatement. The month of December was a level of hell that deserves a special mention. We were having quite a comeback through November on the back of very positive fundamentals from our specific investments and then December hit.
Congress once again did not include SAFE Banking and this disappointment set off a massive end of year selloff in the cannabis sector. Cannabis stocks fell between 40% to 50% for the month as investors basically gave up.
While I put the chances of SAFE passing at 50/50, I thought stocks might go down 10-20%, after all they were already down so much. Boy was I wrong. Many investors saw this as the final straw, and they gave up after this latest head fake from Congress. Playing into these emotions is the belief that a split party Congress makes it highly unlikely that any kind of Federal Reform will be accomplished anytime soon.
Outside of cannabis, with the stock market acting weak, there was additional head-scratching end of the year stock price movements to the downside. HireQuest (NASDAQ: HQI), our largest investment, inexplicably fell 20% in just six trading days on heavier than normal volume. (The stock has rebounded sharply in January and now just hit 52-week highs and is driving much better performance in January.)
All in all, December was surprising and frustrating to experience because it had absolutely nothing to do with the individual performance of the investments in our portfolio.
Sometimes the Market Can Be Wrong Especially with Micro Caps
We are invested in small and microcap stocks. Despite not using leverage, these stocks can whip around especially if there is a lot of volatility and if there is a big selloff. Further, we have investments in cannabis stocks that “touch the plant.” This means they are even more illiquid and have an abnormally large retail investor base, since most institutions cannot own cannabis stocks.
I believe the market is wrong about one of our investments: Glass House Brands (OTC: GLASF). The company reported in November soaring revenue and margins for their third quarter as they turned on their “Ferrari” of a greenhouse. Even though, they reported losses, the fact that they reported soaring gross margins at a time of such deep distress in California when other companies were reporting negative gross margins, proved our thesis that their unicorn of a greenhouse gave the company significant competitive advantages. But even further, our thesis is also that cannabis prices in California were far below the marginal cost of production and that California cannabis was going through its “negative crude oil price” moment. The stock with this as a backdrop nearly doubled from its lows as of the end of November.
We have done a tremendous amount of due diligence on the California cannabis market and are very confident in our understanding of the supply and demand situation. I was surprised when Glass House fell 51% in December due to the broader SAFE Banking related news. Why was I surprised? Because California cannabis prices were rising in December when they should have been falling. December is normally a time when prices should be falling due to excess supply from outdoor harvests that have been cultivated in what is known as “Croptober.”
And here we are near the end of January, and prices are bouncing materially higher. Multiple private operators tell me that prices are up at least 30-40% from the lows in September. If you read most commentary from brokerage reports or other investors, there is a belief that prices are “firming” and that prices are increasing slightly.
Here are a few quotes I heard from various cultivators in California in the last week:
“I wish I had more inventory. I don’t have any.”
“I am selling flower faster than I’m growing it.”
“I think we see $800 greenhouse flower by June.” (Note, it was around $375 in September)
I wrote a post about the looming inventory shortage of cannabis in California on January 12th. and wrote that we should be seasonally awash in cannabis flower inventory right now. We are not and there will not be any material supply response until at least November or the next major outdoor crop harvest.
But because prices are still not where they need to be for most farmers to make money and there is still no capital available (especially after SAFE failed to pass), farms are still going out of business, cutting back and not renewing licenses. Since I wrote my post two weeks ago, another 700,000 square feet of cultivation has not renewed their licenses and I estimate another 6 million square feet will leave the market by September, though it could be as much as 18 million square feet! In summary, the supply situation continues to worsen, as prices bounce higher.
On the other side is Glass House which should produce 300,000 pounds of cannabis biomass this year and is only utilizing 20% of its available capacity. Every $100 per pound increase in biomass pricing goes straight to Glass House’s bottom line in the form of an additional $30 million in cash flow. In September, Glass House was selling biomass for around $200 a pound. I estimate that they are now selling it for approximately $275 a pound, and with prices that will have to keep rising or much more supply will come out of the market. At some point, something has to give, and you could have soaring prices.
And Glass House will doubly benefit from flower prices rebounding because there has been tremendous competition on the CPG side of their business, which has struggled mightily. Smaller startup CPG companies have popped up and profited from the extremely low-priced flower thus enabling them to offer inexpensive CPG products made with that flower. Since those newer CPG companies don’t control supply, these competitors will be squeezed as prices go higher, which should finally provide relief to Glass House’s struggling CPG business.
Finally, Glass House completely re-engineered and reformulated its PLUS line of gummies, introducing a nano technology fast acting gummy, a solventless gummy, strain specific gummies and substantially improved packaging and branding. Remember that PLUS was a distressed asset when Glass House took the company over, and they have finally finished its overhaul. The PLUS re-launch was completed late in December, and we should start to see real benefits of the new improved PLUS line as the year progresses. Early consumer feedback has been positive especially from their strain specific line of gummies.
But then on top of this, right before I was to send out this report, news broke that California was moving on interstate commerce. Specifically, California’s cannabis department that reports directly to Governor Newsom asked the California Attorney General Rob Bonta to issue a decision to allow cannabis interstate commerce sales. There is a lot to this news, which I plan to write on soon, but the summary is that I think this news spells the beginning of the end of interstate commerce restrictions. This of course has enormous implications for Glass House, which cannot sell cannabis across state lines. There are interstate commerce scenarios, in which Glass House could earn more than $5 per share in annual cash flow. That’s twice the current price of the stock.
For all those reasons and despite being frustrated at the panicked selloff in Glass House, I remain resolute in not only that things are getting better for the company, but the upside remains enormous despite how the stock performed in December. We not only own Glass House common shares, we own warrants (which increase our volatility up and down but give us significant upside) and preferred equity which is paying us 20% a year.
Rubbing My Nose in It
Despite remaining resolute, I need to be honest that last year I made mistakes. I would like to share another Charlie Munger quote:
“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
In the spirit of Charlie Munger, let me spend a moment to rub my nose in my mistakes from the last year, some of which I’ve already discussed in my previous 2022 quarterly letters.
In hindsight, my first mistake was clearly having too much of our portfolio allocated to cannabis. Cannabis stocks on average fell about 73% for the year. Falling cannabis wholesale prices, failed Federal reforms, soaring capital costs, poor operating performance and thin liquidity with few real institutional investors made cannabis one of the worst places to be an investor in 2022. And in the end, it didn’t matter too much what company you owned in cannabis, the entire sector was hit to varying degrees.
My second and I think biggest mistake was not appreciating the downside risks in two of our investments for the fund: AYR Wellness (OTC: AYRWF) and Verano Holdings (OTC: VRNOF). The combination of ever-increasing debt and tax payables on top of falling wholesale cannabis pricing is a poor combination for equity investors.
Artificially high wholesale prices in limited license markets accounted for too much of the cash flow for these companies. As those wholesale prices came down, forward cash flow estimates evaporated like smoke. And now their debt levels cause them to be in a substantially weakened financial position. The quality of both companies’ cash flows was not what they should have been.
For disclosure: we still own a small position in AYR and do not own Verano anymore.
Further, I’ve come to believe that like in any industry, efficiency and cost structure will be the key in cannabis, not size. With a weakening economic backdrop and soaring capital costs, efficiency and speed will be the key to not only surviving, but will enable these smaller, more efficient operators to thrive. I wrote a post about how I was shifting my strategy to play Small Ball.
The downside protection that we were looking for in those two cannabis investments was not there. I won’t repeat those mistakes again.
Course Correction Started in Q2 Now Leads to Portfolio Yielding over 5%
Starting last summer, I started shifting our investments away from cannabis equities and into cannabis investments that would pay us a yield while we waited for Federal reform. These investments moved us up the capital structure to a more secured position and came with equity warrants so that we could still enjoy the upside when it came.
We invested in the following:
1. Glass House’s preferred equity offering that pays us a 20% yield and came with warrants as well.
2. We invested in a private cannabis company paying us an 18% yield that came with “penny” warrants.
3. We invested in a convertible note with Grown Rogue (Canada: GRIN) that pays us a 9% yield and allows us to convert into equity ownership of 6% of the company.
4. We ended the year investing a small amount into Body and Mind (Canada: BAMM) that pays an 8% yield that converts into the company at a very attractive valuation.
All these investments, plus the dividends from our investments give our portfolio as a whole a 5.5% yield with no use of leverage.
And not only do we have interest and dividend inflows coming in every quarter, but we also have tremendous upside remaining in our portfolio as well in the form of conversion rights and warrants. When our cannabis investments start performing, we won’t just make one or two times our money, but potentially thousands of percentage points. This time though, we get paid while we wait and while our companies who are free cash flow positive or about to be free cash flow positive, continue to grow.
HireQuest and Consorcio Ara are Poised for Big Years
HireQuest, as a reminder, is a staffing company that is rolling up the mom-and-pop staffing industry with its franchise model that has been honed by over thirty years of experience of creating the right incentives to work. The company closed a big acquisition in December that brings the company’s annual earnings power to $1.75 per share. These earnings translate almost fully into free cash flow.
The idea that we can buy a company with near 60% operating margins, minimal debt that is a free cash flow machine for 11 times earnings with one of the best CEOs I’ve ever invested in, seems silly to me.
It was especially silly in December, when at one point it sold for 9 times my earnings estimate. And it was apparently even sillier to insiders. The CEO and a board member stepped up and bought shares in the company on the open market.
HireQuest is now a free cash flow machine, and they have a full pipeline of potential acquisition targets. I continue to believe the company is headed towards $2-$3 per share in annual earnings and is worth 20 to 30 times that number. That would indicate the stock is worth $40 to $90 per share compared to its current price of $21 per share. A reminder that we started buying the stock at $6 per share. The company was also just recently mentioned in the Wall Street Journal with a quote of how demand was so high for temporary workers.
Consorcio Ara (Mexico: ARA) is another fundamentally mispriced stock trading at 35% of book value and 27% of my estimate of net asset value with no debt. One of Mexico’s leading homebuilders, ARA not only pays us a 6% dividend from its cash flows but is sitting on a massive land bank in a country that is experiencing a shortage of housing combined with a very young population.
We have written about how well positioned ARA is, but I want to highlight two specific parcels that the company is sitting on that have enormous value. They own 1 kilometer of beachfront property in Cancun, which is currently breaking tourist records. And they also own another 1 kilometer of beachfront property in Baja California right next to the new Four Seasons. I don’t know what exactly those parcels are worth, but my gut tells me it is a significant number compared to ARA’s paltry $270 million market cap.
What makes ARA such an interesting investment right now is that the investment world is starting to shift its attention to how capital and jobs are flowing to Mexico as a “nearshoring” opportunity to bring supply chains closer and lower American companies’ reliance on China and Asia. The Mexican peso has a very strong to start the year and several Mexican ADRs that trade in the US have moved significantly higher. ARA has had a very positive January as well. But if I’m right about the demographic boom coming to housing in the next three to five years, I think ARA could go up more than five times in value.
Summary
We took our lumps last year, and we have course corrected where we made mistakes. I was hoping after the momentum of October and November that I would have great end of year news to share, but it wasn’t in the cards.
I’m confident you are going to see different results this year and we are seeing a very strong January. As always thank you so much for your trust and support. Stay tuned there are a lot of great catalysts ahead, and now we are getting paid while we wait for those catalysts to drive our portfolio significantly higher.