Moi201206 superinvestors pasikov

Value-oriented Equity Investment Ideas for Sophisticated Investors
© 2008-2012 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com June 2012 – Page 6 of 180
Exclusive Interview with Barry Pasikov
We are pleased to share with you our interview with Barry Pasikov, managing
member of value-oriented investment firm Hazelton Capital Partners.
While we have been aware of Barry for some time, one of our members recently
sent us the following note: “I have been an avid reader of your Manual of Ideas
publication over the last couple of years and have truly enjoyed the content,
which is both professional and a source I have come to trust. I especially enjoy
when you interview some of the less well known investment managers. Many of
these managers provide an insight into their investment framework that I have
found especially helpful. In that light, I have recently come across an investment
manager whose quarterly letters I have found to be of the same caliber. His
name is Barry Pasikov and he runs Hazelton Capital Partners.” We always
welcome our members bringing talented investment managers to our attention,
and we are glad to have had an opportunity to interview Barry Pasikov.
The Manual of Ideas: Please tell us about your background and the genesis of
your firm. What motivated you to set up Hazelton Capital and what operating
principles have guided you since then?
Pasikov: Hazelton Capital Partners was launched in August 2009. The fund’s
investing process incorporates many of my experiences covering equities,
options, fixed income, currencies, commodities, as well as a strong focus on
portfolio management. I began my career on the floor of the Chicago Mercantile
Exchange in both the Eurodollar and currency options. After four years, I left
the floor to take a position with Bank of Montreal in the foreign exchange
dealing room in Chicago. During the Asian currency crisis, I was asked to move
to Singapore to manage Bank of Montreal’s foreign exchange dealing room.
After two years in Singapore, I had a brief one-year stay in Toronto to head up
the bank’s Canadian sales desk, before returning to Chicago. I then decided to
move away from foreign exchange and took a position with Peak6 Investments,
a firm that focuses on trading and managing equity and equity option volatility.
After two years with Peak6, I started my own partnership that was focused on
trading and managing option volatility. The strategy centered on creating a
portfolio made up of “cheap” and “expensive” options trading below and above
their intrinsic value. After nearly five years, I left the partnership, pursuing an
investment process that I had refined from the experiences, strategies,
disciplines and portfolio management I had utilized over the years. That
investing process became the foundation of Hazelton Capital Partners.
Hazelton Capital Partners utilizes two investing strategies: The Core
Strategy and the Overlay Strategy. The Core Strategy’s objective is to create a
concentrated portfolio of 15–20 equities that are selected based on how cheap
they are priced compared to their intrinsic value. It focuses on a number of
metrics including revenue, margin expansion, the company’s balance sheet, and
the management. The Overlay Strategy is used to complement the Core Strategy
and its goal is to provide short-term cash flow, as well as hedge a position or a
portion of the portfolio. This strategy uses options, and from time-to-time will
short indexes and individual stocks, use commodities and currencies, as well as
risk arbitrage/M&A to achieve its objectives.
I created Hazelton Capital Partners because it turned out to be the easiest
way to manage other people’s capital, as well as my own capital, all at the same
“Hazelton Capital Partners
utilizes two investing
strategies: The Core
Strategy’s objective is to
create a concentrated
portfolio of 15–20 equities
that are selected based on
how cheap they are priced
compared to their intrinsic
value… The Overlay Strategy
is used to complement the
Core Strategy and its goal is
to provide short-term cash
flow, as well as hedge a
position or a portion of the
portfolio.”

time. From the beginning, the partnership was designed as an investment vehicle
to allow people to invest alongside of me. As one of the fund’s largest investors,
I truly manage the fund the same way I manage my own capital.
MOI: When it comes to stock selection, your criteria include predictable
revenue and growth, a solid balance sheet, and shareholder-friendly
management. What types of businesses have you favored historically and why?
Pasikov: It truly varies. Currently, the fund’s top five holdings are companies
that specialize in M2M [machine-to-machine] communications, technology,
manufacturing, services, and engineering, and the companies range in size from
under $100 million to $100 billion. Since the number of positions within the
portfolio is limited to between 15 and 20, each position is selected not only on
its competitive advantage, but also on how the addition of the company will
impact the overall portfolio.
A company whose stock price is cheap in relation to its intrinsic value will
definitely catch my eye. However, the decision on whether that company is
added to the portfolio will also be based on the company’s competitive edge
(what do they do better than their peers and why?), whether or not the company
can maintain that competitive edge (does the company have a scarce resource?),
and how adding this particular company to the fund’s current holdings will
impact the overall portfolio. I would say that the one common theme within the
portfolio is that a number of the companies operate in a niche business. A niche
business is often its own barrier to entry simply because it limits the amount of
outside competition, helping those that are on the inside maintain good market
share and profit margins. Those companies wishing to enter into a niche market
frequently find that even if they are willing to spend a significant amount of
capital, it will not guarantee them a place at the table. These companies are left
with two alternatives: Pack their bags and go home or open up their checkbooks
to purchase an established company.
MOI: If a company is extremely cheap but has a less-than-attractive business, to
what extent would you consider it for inclusion in your portfolio?
Pasikov: That is a good question. It comes down to a two-step valuation
process. First, I need to understand why the company is cheap. Is it because of
the company or that the industry is going through a dynamic change – and not
for the better, or is it because the company is unloved by the investing public?
Getting a clearer picture of why a stock is cheaply priced will mean the
difference between investing in a value trap or a potential opportunity.
Assuming my research confirms the company is not a value trap but a
misunderstood/unloved company with a strong margin of safety, then the second
step of the process is to determine what percentage of the portfolio should be
allocated to this position. In doing this, I look at a number of factors such as:
How this particular position will impact the entire portfolio. Does this particular
company replicate a current holding? Is it a better opportunity than any of my
current holdings? Does the company have downside protection like a robust
balance sheet, dependable revenue, or a share buyback program that is currently
being executed? All of these, as well as other metrics, will help me determine
how to size the position.
MOI: How do you assess the quality and incentives of management, and what
CEOs do you admire most?
“I need to understand why
the company is cheap. Is it
because of the company or
that the industry is going
through a dynamic change –
and not for the better, or is it
because the company is
unloved by the investing
public? Getting a clearer
picture of why a stock is
cheaply priced will mean the
difference between investing
in a value trap or a potential
opportunity.”

Pasikov: Assessing management incentives can be easily evaluated. You just
need to look at the proxy statements to get an idea of how management is being
rewarded: Do they own stock in the company? How is their bonus determined
and is it paid in the form of stock or cash?
The quality of a company’s management is much more difficult to gauge.
The best way I have found to get comfortable with a company’s management is
to read and listen to what they say and balance that out with what they do. A
good example of this would be Xerox [NYSE: XRX] and its CEO, Ursula
Burns. In 2009, Xerox acquired Affiliated Computer Services (ACS) for $6.4
billion in a deal that included $2.3 billion in debt, cash and new shares of Xerox
stock. Soon after the deal was announced, Ursula Burns laid out a detailed map
of how the acquisition was going to impact Xerox’s balance sheet and a timeline
of what steps were to be taken to return the balance sheet to the pre-ACS levels.
To date, the company has executed on all of its promises to pay down debt and
buy back shares even while it has had to deal with a Japanese tsunami, a
stagnating European economy, and unscheduled pension liabilities. Xerox’s next
step is to boost its dividend. Do I admire Ursula Burns? I don’t know if I admire
her as much as I have come to trust her, and for me, trust is more important than
admiration.
MOI: How do you generate investment ideas?
Pasikov: Originally, a majority of my ideas were generated by a screening tool
using metrics like price/sales, revenue growth, margin expansion, cash on the
balance sheet, debt reduction, 52-week lows, etc. The results were as you would
expect: names of companies that met my criteria but frequently did not have the
long-term results or earnings power that I was looking for.
My searches then began to progress from quantitative to qualitative
valuations. Unfortunately, I don’t know of any screening tools that can search
for a company with a sustainable competitive edge, operating in a niche industry
with high barriers to entry, requiring little to no capital expenditure, and of
course, is cheaply priced when you fully understand their business model. I
found that the trick to finding these companies is not to search for them. Instead,
study the types of industries where investment opportunities may be hiding; an
industry that could conceal an unloved, abandoned, sometimes vilified company
lacking sex appeal.
I also do a fair amount of reading and two of my favorite magazines are
BusinessWeek and Fortune. I am not reading them for investment
recommendations; I read them because both magazines do a great job of giving
a quick and concise overview of different companies and their industries.
Knowing which facts and metrics to focus on is extremely helpful when
researching a new company. This has helped me to invest in a few companies I
would definitely have overlooked simply because they would not have popped
up on a screening tool. I have also found websites like the Value Investing Club
to be very helpful. Besides the steady stream of new ideas, I have found the
quality of the write-ups to be very professional and the research to be well
balanced.
Additionally, I have also been very fortunate to build a strong network of
friends who are also investors, many of which run their own hedge funds. I
speak with them frequently, and we exchange and challenge each other’s
investing ideas. Recently, a good friend of mine, Vitaliy Katsenelson, began
“Do I admire [Xerox CEO]
Ursula Burns? I don’t know if
I admire her as much as I
have come to trust her, and
for me, trust is more
important than admiration.”

organizing a conference in Vail, Colorado called VALUEx Vail. The
conference, which is limited to only 40 people, centers on bringing investors
from a wide variety of backgrounds, strategies and experiences together for the
event. Unlike other conferences, each attendee is expected to make a 15-minute
presentation followed up by a 15-minute Q&A session. Fifteen minutes is not a
lot of time, so the presentations really need to concentrate on only the key issues
– think of it as the proverbial “elevator pitch,” or since the conference is held in
Vail, the proverbial “gondola pitch.” I really like the structure of VALUEx
because it does three things extremely well: First, it’s a great chance to quickly
move up the learning curve on a company or industry, and with the number of
presentations, you definitely walk away with a good cross-section to choose
from. Second, because it is a small conference and because everyone is required
to make a presentation, those who attend understand that active participation is
expected, which adds to the quality of presentations, questions, and discussions.
And third, along with the cross-section of industries and strategies comes an
opportunity to continue to expand your network of peers. I am attending again
this year in June.
Ultimately, there are a number of ways to generate ideas, and like strategies,
an investor should pick the ones that best suit his investment style. The one
common thread is that doing your own homework is mandatory. Even though I
get a good amount of information flow coming in from very trusted sources, I
still find it necessary to do my own research. More importantly, when you do
your own research, it makes a big difference in truly understanding whether the
swoon in the price of a company’s stock is an opportunity to add at a more
attractive level or whether your valuation of the company was misunderstood.
MOI: Would you outline the summary thesis behind one or two of your best
ideas at this time?
Pasikov: I will talk about our two largest holdings which are Telular and
Western Digital.
Telular [Nasdaq: WRLS] operates in the $8.4 billion M2M (machine-to-
machine) wireless industry which is expanding in both size and scope. The
company focuses on three small niche segments within the industry: security
alarm monitoring, storage tank monitoring, and a newly acquired unit, SkyBitz,
which uses satellite technology to track fleets, shipping containers, and heavy
equipment. All segments follow the same business model, which breaks even on
the sale of the wireless communication units while making all money from the
recurring monthly revenue Telular charges to monitor those units. The key
metrics to concentrate on are the size of the subscription base, the monthly
ARPU [average revenue per unit], and the churn rate [the portion of subscribers
canceling their service]. These three metrics provide clear insight into the
company’s future revenue.
By investing in Telular, Hazelton Capital Partners gets a company which
generates a meaningful amount of free cash flow along with a 5.5% dividend
yield. But embedded in the price of the stock is a synthetic free call option. The
embedded free call option comes from Telular’s nascent tank monitoring
business which has had little impact on current revenue. If the business were to
gain traction, its impact on future revenue could become meaningful. In essence,
when you purchase Telular, you are paying for the alarm and tracking business
and getting the tank business for free.
“Western Digital and
Seagate control between 85-
90% of the market, with
Toshiba filling in the rest. A
year ago, there were five
manufacturers, but Seagate
bought out Samsung’s HDD
unit and Western Digital
bought Hitachi’s HDD and
solid state drive (SSD)
manufacturing businesses. In
the past, Hitachi and
Samsung were bad players in
the market simply because
they would often sell HDDs
at cost in order to drive sales
to other segments of their
business where the margins
were more significant.”

The second holding, Western Digital [NYSE: WDC], is a hard disk drive
(HDD) manufacturer. Over the life of the HDD, the number of manufacturers
has collapsed from over two hundred down to just three: Western Digital,
Seagate [Nasdaq: STX] and Toshiba [Tokyo: 6502]. Western Digital and
Seagate control between 85-90% of the market, with Toshiba filling in the rest.
A year ago, there were five manufacturers, but Seagate bought out Samsung’s
HDD unit and Western Digital bought Hitachi’s HDD and solid state drive
(SSD) manufacturing businesses. In the past, Hitachi and Samsung were bad
players in the market simply because they would often sell HDDs at cost in
order to drive sales to other segments of their business where the margins were
more significant. Now that these players have been removed, and since the two
largest players have approximately equal share of the market, there is no
incentive for them to sell units at cost.
The Thai floods in the late summer of 2011 have negatively impacted the
HDD industry, and in particular, Western Digital. Seagate escaped unscathed,
but Western Digital had all of its Thailand production facilities shut down due to
the flooding. Both company’s supply chains were impacted by the floods, which
meant that Seagate felt some impact as well. The end result was that inventories
were drawn down and ASPs increased by 50%. Even though unit production fell
over the last two quarters, the ASP increase has more than made up for the
shortfall and both companies have reported revenue and margin increases. I
expect that the average selling price will decrease as supply and demand once
again reach equilibrium, but not back to the previous levels when Hitachi and
Samsung were sellers of HDDs.
The initial reason to add Western Digital to the portfolio was not simply
because it was cheap, but because it is misunderstood. SSD is the next
generation of digital storage. It is smaller, has a faster transfer rate, uses less
energy, has no moving parts and is perfectly suited for the burgeoning mobile
device market. It is widely believed that the SSD will soon supplant the HDD.
My research tells a different story. It is true that the cost differential between
HDD and SSD has been falling. However, even though the adoption of tablet
computers, like the iPad, has disrupted purchases of laptops that would have
housed an HDD, demand for digital storage is still growing around 25-30% per
year. In 2011, demand for digital storage equaled approximately 400 exabytes of
which 100 exabytes was met by the SSD platform. Demand for storage is not
coming from laptops or desktops, it is coming from enterprise data storage like
Dropbox, Facebook, YouTube, streaming video sites and an endless amount of
applications that execute and store data in the cloud. I recognize that SSD is a
superior data storage format. Yet, there just isn’t enough SSD manufactured to
replace the HDD. And with current demand only increasing, the tipping point
may take longer than people had originally expected. To replace the current
output of HDD with SSD would take an investment of nearly $500 billion. The
reason I chose Western Digital over Seagate was that Western Digital’s
purchase also included Hitachi’s SSD manufacturing unit. Movement into the
SSD market will provide a good hedge against HDD obsolescence, as well as
positively impacting profit margins.
MOI: You complement your “Core Strategy” with an “Overlay Strategy” that
includes options, short selling, investing in commodities and currencies, and risk
arbitrage. Give us some insight into how you use the Overlay Strategy to
decrease risk in your portfolio.
“The reason I chose Western
Digital over Seagate was that
Western Digital’s purchase
[of certain Hitachi assets]
also included Hitachi’s SSD
manufacturing unit.
Movement into the SSD
market will provide a good
hedge against HDD
obsolescence, as well as
positively impacting profit
margins.”

Pasikov: As I mentioned before, the Core Strategy is the main focus of the fund,
while the Overlay Strategy was constructed specifically to generate short-term
cash flow and/or hedge a position(s) within the portfolio. Just like a surgeon will
have a wide variety of instruments at his disposal when operating, the Overlay
Strategy provides a variety of tools should an opportunity arise. Of all the
components, options are used most frequently as a way to enter into, add
additional shares, or remove a Core Strategy Holding.
As an example, Hazelton Capital Partners recently sold out if its position in
Aeropostale [NYSE: ARO] using an options spread. With Aeropostale’s stock
priced around $19.30 per share, the fund was able to create an option spread that
would limit the fund’s downside to $19 per share (should the stock price retrace
below $19 per share) while also allowing Hazelton Capital Partners to
participate if Aeropostale’s stock price were to appreciate up to $21 per share.
Another benefit in using this particular option spread was that the fund got paid
$0.40 per share to execute the spread. In other words, Hazelton Capital Partners
generated short-term cash flow of $0.40 per share to insure that a Core Strategy
holding was protected from a sudden price swoon all while still being able to
participate in the upward movement of the stock. In April, when the options
expired, Hazelton Capital Partners sold out of Aeropostale at $21 per share.
MOI: How has market volatility over the past three years affected your
investment process, and have you tweaked your approach in any way as a result?
Pasikov: Our investment process has remained very stable over the past three
years. The only part that has changed is the margin of safety we require before
making an investment. But to be fair, our margin of safety has never been
written in stone and is always reflective of the current level of uncertainty. I am
always adjusting our margin of safety based on the makeup of the portfolio and
whether I am finding a significant amount of “cheap” or “expensive”
opportunities. Uncertainty is not a recent phenomenon; it has been embedded in
financial markets for centuries. However, until recently, it was frequently
camouflaged by investor optimism and greed.
As an investor, you do not have the luxury of only investing when the
outlook appears cheerful and the market is cheaply priced, mostly because these
variables are polar opposites of one another. Instead, you need to stand ready to
take advantage of opportunities whenever they present themselves. This can
happen at any time during a market cycle, but time and again, the best
investments are the ones gift-wrapped in uncertainty.
MOI: What is the single biggest mistake that keeps investors from reaching
their goals?
Pasikov: I would say discipline. Investing is easy to understand, but challenging
to execute and that challenge comes in the form of remaining disciplined. All
investors begin their journey with only the best of intentions, but frustration, and
temptation, mixed in with a little self-doubt can lead anyone astray.
There are four disciplines that I rely on to guide me down the value
investing path: 1) stay true to your strategy; 2) recognize overconfidence; 3)
control your emotions; and 4) patience. Let me go into more detail about them
and explain what I mean. The first discipline is staying true to your strategy.
One of the key components of a successful investment process is the investing
strategy. Inevitably, there are going to be times when an investor will lag behind
a chosen benchmark. The worst decision an investor can make is to drastically
“In most cases, inaction is
not the lack of a clear
decision. Inaction is the
thoughtful patience and
discipline needed to include
only the best positions at the
most favorable prices into the
portfolio. The problem many
investors have is that they
are highly influenced by
short-term results and lack
the discipline to focus on the
long-term opportunities.”

change strategies mid-stream. Let me be clear: I am not speaking about
tweaking or even adjusting aspects of an investment strategy. What I am
referring to is a total departure from the original strategy and adopting the more
popular “flavor of the month.” We often can fool ourselves into believing that a
move to a tangential strategy is actually just an updated version; call it “Strategy
2.0.” However, the answer should be clear: If your decision to change your
strategy is based purely on your short-term results rather than reevaluating the
process, then you are lacking the discipline needed in achieving long-term
success. The trend is not your friend.
The second discipline is recognizing overconfidence. Confidence is a key
component in becoming a successful investor; however, overconfidence is what
destroys successful careers. In order to recognize overconfidence, it is crucial
that an investor remain objective, open-minded, and thoughtful, and look upon
each investment, whether new or old, with fresh eyes. The media is full of
“experts” making very compelling arguments as to why a particular stock is a
great investment. It is imperative that an investor do his own research.
The third discipline is control your emotions or they will control you. Fear
and greed are seen as the enemy of an investor and the reason many investors
were buying into the market when it was achieving all-time highs in 2007, only
to sell everything 18 months later. Warren Buffett is famous for advising
investors to “be fearful when others are greedy and greedy when others are
fearful.” There is no doubt that the power of emotions can play a significant role
in the investing process. However, a disciplined investor will harness that power
to his advantage instead of letting it hijack the process.
The last discipline is patience. This is probably the hardest discipline of the
four, because all of our lives we have been “programmed” to take action. There
is a quote that I have hanging in my office: “Don’t just do something – stand
there.” It really sums up the core foundation of investing. In most cases, inaction
is not the lack of a clear decision. Inaction is the thoughtful patience and
discipline needed to include only the best positions at the most favorable prices
into the portfolio. The problem many investors have is that they are highly
influenced by short-term results and lack the discipline to focus on the long-term
opportunities.
MOI: Can you recommend one or two recent books that have given you new
insights into the art of investing?
Pasikov: There are three books I would recommend to everyone regardless of
what profession they are in: Outliers, by Malcolm Gladwell, Talent is
Overrated, by Geoff Colvin and The Talent Code, by Daniel Coyle. These three
books all have a very similar message: Talent is not bestowed, it is earned. It is
earned over 10,000 hours of deliberate and deep practice, dedication, and luck.
As I mentioned before, investing is easy to understand but challenging to
execute. If you are willing to put in the time and effort, you are well on your
way to becoming a successful investor.
MOI: Barry, thanks for sharing your ideas and insights with our members.
“There are three books I
would recommend to
everyone regardless of what
profession they are in:
Outliers, by Malcolm
Gladwell, Talent is
Overrated, by Geoff Colvin
and The Talent Code, by
Daniel Coyle.”

Moi201206 superinvestors pasikov

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