When Do You Reevaluate an Investment You Believe In?
Mindset Value Fund Third Quarter 2021 Results
Disclaimer: The below post is my 2021 Q3 Investor Letter that I sent to investors in the Mindset Value Fund. 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.
The Mindset Value Fund was down approximately 12% net of fees for the third quarter of 2021 and is up approximately 18% net of fees for the year.
Selling Nintendo on Lackluster New Games
Earlier in my investing career I would double down on stocks that were falling, even if they were underperforming fundamentally. Surely these undervalued stocks would rebound since the valuation was so low, right? Most of the time, these undervalued stocks went nowhere and stayed undervalued. While I did not lose more money, I did not appreciate the opportunity cost of not investing in stronger, better performing companies, whose stock prices would keep rising.
I mention this because Nintendo’s valuation is low, yet it fell 18% during the quarter. The stock has 30% of its market cap in cash on its balance sheet and is generating a ton of cash flow and is quite inexpensive on earnings estimates, and that is without valuing its stake in Niantic or the Pokémon Company. And as I have written in the past there is ton of optionality to Nintendo and their IP.
The problem is that this year Nintendo has dramatically underperformed in the one area I thought it would be strongest: new game releases. Frankly, I’ve been shocked at how mediocre the new game releases have been.
And the paucity of new games is showing up in critical data reports. In September, for the first time in years there was not a single Nintendo game in the top ten bestselling games list. Nintendo may not be able to control chip shortages, but they should be able to control software game output.
With the lack of blockbuster new games and the chip shortage affecting the launch of its new OLED Switch, estimates for Nintendo will have to come down. We simply have too many other companies and investments in our portfolio that are firing on all cylinders to keep capital invested in an underperforming company. And while the Mindset Value Fund is a value fund, the goal is to own the best companies who are executing and performing not just invest in cheap stocks. And so, we sold the stock, but are actively watching for certain changes to re-enter the position. I wrote more about the decision in a recent post:
Cannabis Sector Sells Off, But Fundamentals Could Not be Stronger
While Nintendo dragged down performance, the biggest hit to our portfolio came from our sizable investment in the cannabis sector. And here things are quite different from the situation with Nintendo. Our cannabis companies are growing, executing and have ten plus years of runway ahead of them.
The problem is not the fundamentals which are stellar. No, the problem is limited liquidity, a lack of institutional investment and a regulatory environment that restricts financial institutions from investing in the sector. Add in regulations that relegate US cannabis companies that “touch the plant” to trade on secondary or tertiary Canadian exchanges, and you have the perfect storm of a sector that can easily trade up or down. It’s almost as if these are private companies with illiquid trading stubs that allow you to participate at absurdly low multiples.
And our portfolio got hit this quarter due to investors selling off cannabis names on disappointment with the legislative progress of Federal legalization. But the longer that Federal legalization takes, the better it is for the top ten to fifteen cannabis companies who have a cost of capital advantage the likes of which I have rarely seen. I wrote about it here:
There is a crazy amount of inefficiency in the cannabis market because 96% of institutional investors are not involved, not working on the sector, and leaving wide open opportunities. And after about a year of writing and talking to several investment professionals about cannabis and frankly wondering when investors will see the opportunity, I decided that if no one else will step up, then I will, and that is why I decided to launch a dedicated cannabis fund.
I never intended for the Mindset Value Fund to become a cannabis focused fund, and I love our investments in HireQuest (NASDAQ: HQI), Nelnet (NYSE: NNI) and Consorcio Ara (Mexico: ARA) to name a few and I don’t want to sell them, if anything I want to buy more. But the opportunity in cannabis is too big to ignore. So, what this means is that we are going to cap the cannabis exposure in the Mindset Value Fund at around 25% to 30%.
Launch of the Mindset Value Cannabis Fund
In 2011, I was buying homes on the courthouse steps of Gwinnett County, Georgia and I remember wondering why it felt like I was the only one seeing the generational opportunity to buy homes and how the US housing market was an amazing investment. But where were the institutions?
I wasn’t alone in buying homes, others like Doug Brien were also there, but the supply exceeded demand. Doug, who eventually merged his company Waypoint with Starwood and became the CEO of Starwood Waypoint saw the same opportunity I did. Starwood Waypoint (NYSE: SWAY) eventually sold to Colony Capital. Doug is now the CEO of Mynd, a next generation property manager that is very close to unicorn status.
Doug and I will never forget the day that Colony and Blackstone (through Invitation Homes) showed up at the foreclosure auctions and home prices went up 50% to 100% overnight. When US cannabis companies can trade on US exchanges, you can expect something similar or greater. But cannabis is not just a trade for revaluation. Again, the single-family rental market is a great comparison. Prices and housing activity kept going far after 2012 and 2013. Consider that just this summer in 2021, Invesco gave Doug and his Mynd team $5 billion to buy single-family rentals, ten years after the bottom for what many institutional investors told me was just a “trade.”
Both Doug and I see an opportunity to invest in an industry that is going from $100 billion in sales, albeit most of it illegal ($25 billion in legal sales) to $200 billion, with most of it being legal sales. That is why we are partnering together on launching this fund to take advantage of this historic opportunity.
But how do you deal with the volatility, illiquidity and not knowing when things will change on the Federal level. The goal will be to marry the right long-term risk capital that believes in the thesis and is happy to sit and wait for as long as it takes. If the opportunity is to make five or ten times your money in ten years, should we really care if it all happens tomorrow or in year 7? Sure, the IRRs will be much higher if it happens tomorrow, but what if you miss it, don’t time it perfectly or can’t put your capital to work quickly enough? Too many investors think too highly of their ability to predict short term events or catalysts.
I’m happy to accept uncertainty of timing for something that I know will happen. When cannabis is rescheduled, decriminalized and US companies are allowed to trade on US exchanges, I’m confident they won’t trade at a valuation of 5 times next year’s cash flow like AYR Wellness (Canada: AYR.a).
I have been researching the cannabis space for over three years and the opportunity in cannabis in 2021 is like investing in housing in 2011. I wrote a whole white paper on it, if you would like to read more, here is a link: Cannabis Manifesto.
The Mindset Value Way: Low Downside, Uncertain Upside
The Fund’s investment strategy is to research and invest in undervalued, misunderstood, or unfollowed publicly traded securities that offer limited downside over the long term, but also have an uncertain upside. The portfolio will consist of investments that offer a “heads I win, tails I don’t lose” strategic approach to investing. To use baseball as an analogy, we are focusing on hitting singles and doubles, but just might have a shot at hitting a homerun, but whatever we do, we don’t want to strikeout.
Summary
I wrote this last quarter: “The stock market from the bottom in March 2020 has gone almost straight up. It would not surprise me to encounter downdrafts, volatility and more.”
And we did experience a bit of a downdraft this past quarter. I continue to be very excited about our portfolio while making sure that my excitement does not cloud my judgement when companies underperform. We want to own great companies that have low downside and where fundamentals are improving.
While I have no idea how our stocks or the stock market in general is going to act in the short run, I’m very excited about the long-term prospects of our portfolio. As always, if you have any questions or comments, feel free to reach out to me anytime.
Sincerely,
Aaron M. Edelheit