GreenWood Investors Fourth Quarter 2022 Letter

Dear GreenWood Investor:

Please pardon the delayed delivery of this fourth quarter letter. As telegraphed in the third quarter letterfrom December, we had decided to open a third co-investment fund in the fourth quarter. This, along with the research we have published on our other co-investment names, consumed much of our publishing efforts during the quarter. Going forward, we will continue to lean into communications on our three co-investment funds but will now write to investors about the rest of the portfolio on a semi-annual basis as opposed to quarterly basis. Our goal is to provide meaningful commentary and insights on our portfolio. Accordingly, a semi-annual review will have more meaning as well as have more fundamental developments to digest.

We look forward to providing expanded commentary in the first half of 2023 letter, which will be available in the coming weeks, given we are about to close the quarter this week. But rather than wait, we wanted to write about our actions taken in the second half of last year.

As the third quarter letter discussed, we simplified our efforts on the short side to only hedge portfolio exposures via macro index funds. We found that trying to match heavier portfolio exposure to underlying great individual shorts consumed a lot of energy and resources. Furthermore, shorts turned over substantially more quickly than the rest of the portfolio — and require the same amount of work, yet were implemented with smaller position sizes.

The relief rally that occurred in the fourth quarter helped to accelerate this shift, and many of the positions we covered in the third and fourth quarters proceeded to rise throughout the quarter as well as the following quarter.

However, this short portfolio took off -8.1% from our performance in the fourth quarter, substantially offsetting the +9.3% contribution from our long portfolio. Overall performance of 1.3% in the fourth quarter trailed the market’s performance of +9.8% in the fourth quarter. This meant that for the full year, our fund’s -28.8% performance trailed the market by approximately 10%, given the MSCI ACWI index finished -18.4%. We continued to reduce our short and hedge portfolio subsequent to the quarter and find the current market environment highly opportunistic. For the full year, shorts contributed +8.8% to the portfolio, while longs detracted -37.4% from our Global Micro Fund.

Key Quarterly & Annual Performance Drivers

“Fashions fade, style is eternal.” Yves Saint Laurent

We can isolate the lag in our performance to the index largely to three companies that the market decided to sell as being out of fashion. These three companies detracted 1.3% in the quarter and 17.5% for the full year: MEI Pharma (MEIP, -7.6% for the year), S4 Capital (SCPPF, -5.3%), and Verano (VRNOF, -4.7%). The Verano performance includes that from the ETF MSOS that we owned for a brief period to harvest tax losses.

Investors shunned the cannabis stocks as hope for new banking legislation faded. Even still, Verano is free-cash-flow positive despite onerous double taxation of its operations. It continues to organically expand its footprint in attractive regulated states, while maintaining its industry-leading profitability and free-cash-flow margins. As the Biden administration heads into an election year, we are optimistic about the sectors’ potential to come back into fashion as the President looks to de-schedule the substance, and therefore eliminate the onerous double taxation. That will bring Verano’s free-cash-flow yield from 5.5% today to over 15%.

As discussed in prior letters, a dramatic overreaction by investors to a delayed reporting of full year results in S4 Capital caused a significant drawdown in Sir Martin Sorrell’s disruptive digital ad and services business earlier in the year. While a delay in the audit caused investors to flee, the audited figures released a couple months later showed immaterial changes from the preliminary unaudited figures. Furthermore, the company’s consistent market share gains have continued, and it maintains one of the best growth rates in the industry — which it continues to disrupt.

While digital advertising is currently out of favor, as is the cannabis industry, these companies continue to grow and position their businesses for the future. Both companies are managed by substantial owners of the business, and they continue to build their businesses with multi-year time horizons. While the fashions of Wall Street change fairly rapidly, owner operators do not change their style simply to accommodate the trends of the day. It is for this reason, we believe, they often underperform at the later stages of economic cycles, yet outperform significantly both in the drawdowns as well as the very significant recoveries from recessions.

Lastly, MEI Pharma not only suffered from the pronounced underperformance of the biotech segment overall, suffering one of the worst multi-year sell-offs in industry history, but also from the FDA’s unwillingness to approve its later stage drug candidate based on previously agreed upon data that the company achieved. Accordingly, we saw price-agnostic selling in the company as investors used an unfashionable industry with bad news as an excuse to liquidate holdings at less than a quarter of the cash on the balance sheet. We took advantage of this price-agnostic selling subsequent to the quarter and welcome efforts by owners to assert more control over this company. We believe owners manage businesses better than independent agents that are more often appointed to run businesses. It’s one reason why we’ve decided to lean much harder into being more constructive owners, as explained in the last letter.

Leaning Into Constructivism

“I’m not a believer in the automatic recurrence of the past. The future is always built.” Sergio Marchionne

Overall, our co-investments outperformed the market, however, this was a tale of two cities. CTT dramatically underperformed, taking off -10.5% for the full year (but adding +5.8% in the fourth quarter). Leonardo added +7.2% to our portfolio for the year (+4.2% in the quarter). Both companies remain materially undervalued. And ironically, they both had similar underlying financial performance during the year, with each company’s market capitalizations lagging the underlying growth of their fundamental drivers. As such, we concentrated our portfolios in these two positions, as the valuations are not only compelling but defy the earnings accelerations we see happening at both companies.

Exhibit 1: 2022 Co-investment Financial Performance (Adjusted for 1-time Items, M&A)

Click to enlarge

One of the biggest surprises of 2022 was the valuation drawdown of CTT. Despite the company being positively skewed to higher interest rates, fears around the freight cycle overwhelmed the trading volumes, and the company got substantially cheaper during the year. This is despite committing to a reasonable but ambitious medium-term plan to roughly double operating income by 2025, and making important progress on the balance sheet optimization. To us, this represented a great buying opportunity, and we used the drawdown to add to our position in CTT.

Also, as a result of naming Chris as co-portfolio manager earlier in 2023, we have now been able to add the CTT investment to all investor accounts. I have also decided to grant him full autonomy in position sizing our co-investments. This will keep the decision-maker on sizing these positions independent of any conflict or bias. I believe Chris is incredibly well-informed, and his temperament is reliably steady in making these decisions.

Adding this important position to all investor accounts comes as we are increasingly convinced in the durable earnings growth of the company, paired with an exceptionally interesting valuation. Due to the conservative balance sheet that has yet to be monetized, as well as its strong FCF generation, we are pleased that CTT recently announced a share repurchase program, which further allows us to take advantage of this undervaluation on a daily basis by increasing our ownership of the company.

While our second co-investment, Leonardo, is not yet taking advantage of its own depressed valuation, a recent credit ratings upgrade by Moody’s to investment grade brings the company one step closer to increasing shareholder remuneration. Since its public market debut, Leonardo has yet to have a board that represents the majority of its shareholders — non-governmental investors.

Of course, while the Italian government remains an important stakeholder, shareholder, salesman, and customer of the company, we were delighted that, subsequent to the quarter, investors entrusted our board slate and voted overwhelmingly in favor of our owner-oriented candidates. Each of GreenWood’s board nominees recently purchased shares in the company using personal capital, and we are bringing a level of passion to the governance of the company that emulates other owner-operated businesses.

Owner Operators

“The basic principle which I believe has contributed more than any other to the building of our business as it is today, is the ownership of our company by the people employed in it.” James Casey, UPS Founder

We’ve also used the past few months, where we’ve kept a lighter public publishing cadence, to finally finish a white paper that I’ve been working on for quite some time. This paper analyzes the performance and behaviors of owner-oriented boards and management teams. Unsurprisingly, this large group of businesses outperform their benchmarks by a long shot. In leaning into more constructive activism, we are hoping to bring these behaviors and more sustainable approaches to business building to more targets.

While we engage thoroughly with all the management teams in our portfolio, the non-activist portion of our portfolio is now made up entirely of these owner operators. It’s not that these companies are all perfect, but they are managed for medium- and long-term value creation — as opposed to the whims and fancies of the current fashions on Wall Street.

As the market is increasingly driven by a few companies that are wrapped up in the latest fad of Wall Street, this is particularly important today. It also just so happens that this group of owner-managed companies trades at a bigger discount today to the index than it ever has since we’ve started tracking this group and its behaviors.

This is a great time to be an owner operator. Companies run by agents without skin in the game are increasingly changing business strategy to appeal to the latest fad of the day. The distortions that this is creating in the market are not only creating more opportunities for those managing their businesses with a steadier hand on the wheel, but they are also creating a compelling opportunity for investors to leave the indices, which are increasingly causing these vulnerabilities to emerge.

We have moved forward in early 2023, undeterred by the rapidly changing fads, and are ready to also take advantage of these strange distortions. We have unique visibility and confidence in our two largest positions, and the others are being managed by owners for the long-term owners. They are cheaper today than at any time since we started investing in our co-investments, and that undervaluation is mirrored by the owner operator class as a whole. We think this represents a compelling opportunity to ignore the fashions which inevitably fade and remain committed to the style that produces highly attractive returns to those focused on the medium to long-term.

We thank you for your partnership and remain committed to delivering on this opportunity set.

Committed to deliver,

Steven Wood

This letter has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities mentioned, or to invest in any investment product or strategy related to such securities. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this letter. Persons reading this letter should seek professional financial advice regarding the appropriateness of investing in any securities discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this letter may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC. Past performance is no guarantee of future results.

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