The investments of Henry Ellenbogen’ s New Horizons Fund are particularly interesting since they span both public and late-state private markets. While his late-stage private investments are only about 2-3% of the total assets of the New Horizons Fund, they have disproportionate visibility. Since he joined the fund in 2009 Ellenbogen has invested in five to seven private companies per year.
Ellenbogen’s investing results speak for themselves. Barron’s writes: “Ellenbogen, is up an average of 23% a year over the past five years, versus 14.7% for the Russell 2000.”
1. “I like it when the company has come up with a product, service or strategy that is unique and visionary enough to change its industry.” Ellenbogen is looking for a business with an underappreciated ability to create or extend a moat in a big market. The asset must be available at a price which is significantly below its value. As is the case with any asset, Ellenbogen wants to find a business with “a fundamentally better business model” (unique) which is “durable” (sustainable). All of this is consistent with fundamentally sound investing principles and many funds do this. What makes Ellenbogen unique and attracts most of the interest people have in his fund is the late-stage private investing. Yes, other mutual funds do late-stage private investing (as do some hedge funds), but few do so as often, as consistently or with the same level of success and influence.
In the case of Ellenbogen’s late-stage private investments, there are several potential sources of mispricing that can create an investment opportunity. First, the ability of the business to create or extend the moat can be underappreciated since the investment thesis is contrarian or not recognized since it involves optionality. Second, Ellenbogen’s fund can be offered a discounted price since it is willing to hold assets which are not very liquid. Third, the shares may be discounted since the business raising the funds values staying private to avoid scrutiny or delaying the compliance obligations of a public company. Fourth, the business may need to raise cash quickly and is not ready for an IPO process so Ellenbogen is given a favorable price due to his ability to act swiftly. Fifth, Ellenbogen’s fund may be given a favorable price since they do not impose onerous governance requirements. Sixth, the fund may be allowed to buy at a favorable price since Ellenbogen is putting a seal of approval on a company prior to an IPO given his track record. The combination of factors involved in valuation and setting deal terms (e.g., any liquidation preference) of a given late-stage private investment will vary based on the unique circumstances of the business and the current state of the markets. But it seems that private businesses often find that Ellenbogen offers a particularly attractive combination as a late-stage investor.
2. “The appeal of the small-cap growth firms I buy is that they reward patient buy-and-hold investors.” “The trick is identifying companies and having the patience to hold onto them. Both parts are equally hard. Sometimes one of the best things I do is resist the desire to trade.” Ellenbogen invests in firms that are less liquid and less traded than big public companies since they are small-capitalization or private. This means the assets are more likely to be mispriced. The trade-off is that the value of the fund’s assets can be more volatile and irrational at times. This approach requires discipline and the ability to stay the course not only from Ellenbogen but the fund’s investors. Ellenbogen is saying that sometimes the best thing to do is nothing.
3. “I tend to have a high quality screen. I focus on free cash flow per share. Those companies tend to be able to fund their own growth. That tends to make them less volatile over time.” Ellenbogen is focused on the ability of a business to generate free cash flow. Businesses which are not reliant on the constant kindness of the capital markets for new cash are less volatile. People too often forget that sometimes, without warning, the ability of a business to come up with new sources of cash from third parties can completely disappear. This is potentially dangerous since the only unforgivable sin in business is to run out of cash. If a company can generate its own cash Ellenbogen believes the business is of higher quality.
4. “I look for businesses that I am confident can grow their earnings at above-average rates —15–20 percent — for at least the next 10 years. Consistency is the key. I shy away from red-hot companies with soaring growth that get all the headlines. Those stocks often crash and struggle to recover when growth slows or investors find something more exciting. Sustainable growth gives me the discipline to hang on to a stock year after year.” These are the some of the same qualities in an investment which are sought by Warren Buffett and other value investors, the only difference is that Ellenbogen includes technology investing within his circle of competence. While Ellenbogen is sometimes labeled as a growth investor and his fund a “small-cap growth fund,” I see a fund that is run with value investing principles in mind. While he is not a cigar butt investor, Ellenboggen appears to me to be a Phil Fisher-style investor who wants to buy good companies at good prices. One of his tests for “goodness” is consistency. A very smart friend of mine points out: “If you are only looking at trailing twelve month numbers on earnings growth and ROIC, then you can’t distinguish from a company being truly high quality or just at a peak in its business cycle.” Looking at trends lasting for several years is what is important for an investor like Ellenbogen.
5. “The ability to grow revenue at a double-digit pace is really, really hard to do over an extended period of time, and to be able to compound wealth at 20% or more is very rare.” “We own 250 stocks, and among our top 20 holdings, it’s rare to find a name that was added to the portfolio within the previous three years. There is a very long tail at the bottom with position sizes smaller than 25 basis points [one-quarter of a percentage point]. These tend to be early-stage companies – some of them privately owned – and there is a high failure risk.” Managing a portfolio of 250 stocks is not an easy task for Ellenbogen or any fund manager, especially when it consists of small capitalization stocks and late stage private investments. You can’t do this successfully without a lot of hard work and a sound process. For example, position sizing is critical (position sizes in his portfolio will not reflect a bell curve). It is worth pointing out that another fund holding 250 large capitalization public stocks would be closet indexing. Ellenbogen is able to avoid this problem only because his is a small capitalization and late stage private investor.
6. “Warren Buffett credits the compounding of interest as one of the keys to his wealth. But it’s also the compounding of earnings growth over long periods of time that pays off big. A company whose earnings growth averages 20 percent a year for 10 years will see earnings rise six fold over that time, thanks to compounding, and I expect to see its stock price rise by that much as well.” Both feedback and compounding are everywhere if you know where to look. Charlie Munger puts it simply: “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” Buffett was once asked how someone can get smarter. Buffett then held up a stack of paper and said: “read 500 pages like this every day. That’s how knowledge builds up, like compound interest.” Lots of other things in life compound, like hiring great people or retaining happy customers. Ellenbogen is saying that earnings also compound and that this compounding will inevitably be reflected in the stock price over time.
7. “If we can find one or two outlier companies, and — it’s a big ‘and’ — we have the discipline to hold on to them over an extended period of time, that is the majority of the battle.” It is not frequency of success but overall magnitude of success that determines return. Ellenbogen understands what Michael Mauboussin calls “the Babe Ruth effect.” You can win big even if you strike out lot, if you hit a lot of home runs. Ellenbogen is also saying that being a contrarian is hard and requires significant discipline.
8. “Companies that do require a lot of borrowed capital have a hard time maintaining consistent growth rates. They often can’t borrow at favorable interest rates when they need money the most—during downturns in the economy.” Markets love to loan money to companies when they don’t need it. But when companies do need to borrow in a downturn or cash cunch, the price of leverage is high. Mistakes are magnified in periods like this. Ellenbogen particularly likes companies such as Amazon, which can benefit from “negative working capital.” Bill Gurley describes the phenomenon of business with negative working capital: “They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.” As another example, businesses which can benefit from cash “float” like Amazon, Berkshire and large “too big to fail” banks have a structural advantage.
9. “One question we ask here is: Does management have the mindset to lead the company to a second act, which is what you need to become a billion-dollar company” “Every once in a while we see a business that can become much larger that’s also run by a person who has the ability to make it larger.” When someone is investing in the late-stage private market they are typically investing in a company that has substantial momentum. In such a case the question for Ellenbogen is: can it scale in a much bigger way? He is searching for a second layer of optionality that from the optionality which took the business to where it is when he invests. In other words, what he wants to find is a business which most people don’t realize has the equivalent of the second stage of a rocket that will send it even faster into space.
10. “We make our share of mistakes.” The most important thing to do if you find yourself in a hole as a result of making a mistake is to stop digging. What is past is past. What is sunk is sunk. Thinking you don’t make mistakes is a one-way ticket to Hubrisville. Your investment decisions won’t always succeed, but as long as you win often enough to come out well ahead, you have a sound investing process. Your frequency of success as an investor will never be perfect. Any individual failures must always be considered in relation to magnitude of overall success.
11. “We have a view of what fair value is. We use ranges as opposed to absolute points.” Any estimate of the value of a business is an estimate since future payments are not an annuity from a risk free issuer. Even the concept of intrinsic value Warren Buffett calls “fuzzy.” Value is best thought of as a range and it is better to be approximately right than precisely wrong. Your goal should be to buy an asset at a bargain which is so big that your investment will be profitable even if the estimate is fuzzy.
12. “…we pay attention to the macro environment, but it’s not what drives our focus. We are looking for companies that compound wealth over extended periods of time, through economic cycles.” That the macroeconomic environment is interesting and that people love to speculate about it does not mean that the information is actionable. To If you focus on the micro (the value of the individual business) the macro (the state of the economy) takes care of itself.