June 30, 2016
2016 Semi-Annual Report
Net Performance / Q1 / Q2 / Year-to-Date / Trailing Twelve MonthsBrookdale Equity Long/Short Fund / 6.94% / 0.81% / 7.81% / 10.37%
HFRI Equity Hedge Index / -1.71% / 1.09% / -0.63% / -5.23%
HFRX Equity Hedge Index / -2.93% / -1.01% / -3.91% / -8.32%
S&P 500 TR Index / 1.34% / 2.46% / 3.83% / 3.98%
“We anticipate market volatility to remain elevated in 2016. In addition, a modestly tighter monetary policy combined with global economic challenges will likely not be beneficial to an already sluggish domestic economy. This landscape should be favorable to Brookdale’s investment strategy and trading approach.”
~Brookdale Capital Management, December 31, 2015
The first half of 2016 exemplifies the benefits of the four pillars of Brookdale’s investment strategy. By remaining objective, we capitalized on extreme valuations driven by human behavior while following our disciplined, quantitative portfolio construction methodology. We are confident the current market climate of elevated volatility will continue; therefore, it is an opportunistic time to employ the Brookdale strategy. Year-to-date, the strategy has generated good absolute and risk-adjusted returns, most of which have been driven by company-specific news and events, not macro headlines. We’ll touch on specific contributors and detractors a little later.
As many of you know, we solidified a strategic partnership with Mercer Park, L.P., a New York based family office. Mercer Park, L.P. is managed by a successful Wall Street veteran who has conducted in-depth due diligence on our team and investment strategy. We are excited about the validation and the upcoming changes to Brookdale. This strategic partnership will help to further enhance the firm’s institutional infrastructure and operations. Some of the immediate changes include new office space and an increase in investment and operational staff.
Year-To-Date Performance
Performance during the first half of 2016 was in line with our expectation. Although we had more profitable positions than not (52%), what was more appealing was the ratio of large winners (>0.50%) to detractors, which was 3 to 1. The magnitude of our winners was greater than the severity of our losers – a primary objective.
Whether market volatility is due to interest rates, the infamous Brexit fiasco, or some other market event, when volatility subdues, the ultimate price of a security will be dependent on fundamentals which far outweigh short-term market sentiment. If there is sufficient dispersion among securities, we will capitalize on this human behavior and extract excess performance.
On average, our portfolio will have approximately 100 positions almost equally split between longs and shorts. During the first half of 2016, we were involved with 169 companies. The increase in the number of companies was due to both, market volatility and re-rating of some positions. However, in spite of the increased volatility of the stock market, specifically in Q1, there was not a material increase in volatility of the Fund.
In addition to strong alpha generation from stock picking, it is important to highlight how the portfolio behaved during a period of stress, specifically January 2016 and June 2016 (Brexit vote). Below is a comparative illustration of the widely used S&P Volatility Index and the strategy’s cumulative gross year-to-date performance. Because of how we construct the portfolio and the flight-to-quality nature of the sectors we are active in, losses were limited in January/February when the Volatility Index peaked at 28.
As you know, we do not change the portfolio’s net market exposure, even during times of market stress. Instead, we focus on company-specific opportunities. It is important to understand that this portfolio construction approach does not result in a static beta to the broad market. Because we are value investors and focused on a niche part of the market, the portfolio’s beta tends to contract during periods of market stress. This is predominately a function of beta expansion of our short book. Beta of valuation-rich companies tends to expand during periods of stress or uncertainty. Valuation-rich companies are generally the first sold during a period of de-risking. As a result, the beta of the short book expands and the net beta-adjusted exposure of the portfolio falls. To illustrate this, we took the portfolio’s trailing 20-day beta to the S&P 500 Total Return Index and pulled it back 20 days to better match the period of the analysis. For example, the portfolio’s 20-day beta on January 29th is plotted as January 4th.
When the broad market sold off aggressively in January 2016, the portfolio’s beta steadily contracted. Again, in June 2016, before and after the Brexit vote, the portfolio’s beta contracted. It is this market and portfolio dynamic that allows us to manage the portfolio at a static 50% net market value.
Looking forward, we are excited about the current level of corporate actions, specifically merger activity. The increase in merger activity has been driven by lower interest rates and a slow growth environment. Within our investable universe, we have seen several tuck-in acquisitions and a few take-outs of large capitalization companies. Merger activity routinely misprices securities, leading to very attractive risk-reward opportunities once the merger is complete. In our last letter, we briefly touched on a couple of post-event opportunities, B&G Foods and Post Holdings. Both are good examples of how merger activity can lead to great risk-reward opportunities.
Top Contributors & Detractors:
Contributors / Attribution / Detractors / AttributionCentral Garden & Pet / 1.54% / Endo International / -1.29%
Energizer Holdings / 1.46% / John B. Sanfilippo & Son / -0.94%
United Natural Foods / 1.27% / PharMerica (Short) / -0.58%
SpartanNash / 1.13% / LDR Holdings (Short) / -0.56%
B&G Foods / 1.02% / National Beverage Corp. (Short) / -0.50%
Contributors
Central Garden & Pet (CENT/A) produces and markets products for the lawn, garden and pet supplies markets. The company continues to be a profitable long position through the first half of 2016. The company has traded higher on strong positive fundamentals, specifically cost reduction initiatives and higher revenues. Cost reduction has been both operational and financial (debt refinancing). Increase in sales has been organic as well as through acquisitions. Central Garden & Pet continues to be a long position in the portfolio.
Energizer Holdings (ENR) manufactures and markets batteries and lighting products. The stock contributed 146 bps to Fund performance for 2016. This spin-off has traded higher in Q1 because of strong fundamentals. It then traded higher in Q2 after announcing the acquisition of Handstands Air Freshener for $350 million. Year-to-date, the stock is up approximately 45%. We have captured our gains but Energizer continues to be a long position in the portfolio.
United Natural Foods (UNFI) engages in the distribution of natural, organic, and specialty foods and related products. The long position contributed 127 bps to performance. The bulk of the stock’s upward move in 2016 came in June after the company released better-than-expected earnings. Although revenue was slightly below expectations, the company improved gross margins and guided higher for the remainder of the year. The company continues to trade at an attractive valuation as negative sentiment remains because of potential new competitive entrants in the natural foods space.
SpartanNash (SPTN) engages in the distribution of grocery products to military commissaries in the U.S. The stock rose in February after reporting strong earnings. In addition, the company guided to lower capital expenditures, further improving free cash flow. SpartanNash continues to be a long position in the portfolio.
B&G Foods (BGS) manufactures, sells and distributes a diverse portfolio of shelf-stable foods and household products. The stock jumped after reporting its first quarter post the GreenGiant acquisition. We continue to be excited about this post-event name that still trades at a very attractive valuation. The market has not yet fully appreciated this new revenue stream that was acquired at an attractive price. The stock is up approximately 33% year-to-date.
Detractors
Endo International (ENDP) detracted 129 bps from performance. This is an outsized loss for Brookdale. Throughout the year, specialty pharma has been closely followed by regulators for aggressive pricing tactics. Brookdale’s aggregate pure-play specialty pharma exposure was 2% of NAV – an acceptable sub-sector concentration. The loss on this position exceeded our expectations. Because of the risk of potential structural change in the company’s business model and the severity of the loss, we exited the position. Although we continue to think that Endo International offers an attractive risk-reward opportunity, we think it is prudent to cut our losses and move on.
John B. Sanfilippo & Son (JBSS) is a food company specializing in processing, marketing and distributing culinary, snack, in-shell and ingredient nuts. The long position has traded lower throughout the year as gross margins declined. Although sales volumes increased, they were at “competitively lower prices”. The company is attractively priced and recently announced a special cash and stock dividend. We have been adding to the name on weakness.
PharMerica (PMC) is an institutional pharmacy service company which provides pharmacy management services to hospitals, specialty infusion services to patients outside a hospital setting, and offers the only national oncology pharmacy and care management platform in the United States. PharMerica is a short position that cost the Fund 58 bps in the first half of 2016. We continue to be active in the position because of its rich valuation.
LDR Holdings (LDRH) is a medical device company which engages in designing and commercializing novel and proprietary surgical technologies for the treatment of patients suffering from spine disorders. On June 7th, LDR Holdings received an offer of approximately 63% premium or $36.99 from Zimmer Biomet which is paying more than 5x current year revenue. This was a costly short position. We exited the position soon after the merger announcement.
National Beverage Corp. (FIZZ) develops, manufactures, markets and sells a diverse portfolio of flavored beverage products. Their most popular product is La Croix – all natural, carbonated water. This brand is growing at a double-digit rate and expanding margins. We continue to hold our short position and think the company is more than fairly priced for its growth. Year-to-date, the position has detracted 50 bps from Fund performance.
2016 Outlook
It should be no surprise that the low level of interest rates has lifted the valuation of the broad equity market. This is purely mathematical and financially driven based on current market environment and relative investment opportunities. Although low interest rates can increase the value of a company’s stock price, they do not insulate the company from the normal business cycle, including economic contraction. Therefore, higher valuations simply imply larger downside risk, specifically for companies that are more sensitive to economic recessions, and for highly levered institutions.
Given the uncertainty of the path of interest rates and the complex geopolitical environment, we continue to think a relative value strategy is the best approach in this market environment. In addition, our unlevered, defensive portfolio construction will further protect the portfolio in the event of an unforeseen market or economic shock.
Business Update
Our investor base continues to expand with the addition of several new relationships in the first half of 2016, including platforms and fund of funds.
We are excited to announce the increase in investment and operational staff as well as new office space. Please note our new office address and contact information below.
325 N. Saint Paul Street, Suite 1240
Dallas, Texas 75201
972.677.7245
Thank you for your continued trust.
Adnan Rehmatullah
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