Cannell Capital LLC – an employee owned long/short market neutral equity hedge fund was founded by J. Carlo Cannell in 1992. Prior to founding the investment firm, Cannell worked for San Francisco based investment bank Dakin Securities as an analyst. Cannell is essentially a value-oriented manager that typically invests in small capitalization listed companies and aims to achieve superior returns under the premise that inefficient markets offer grater returns potential than efficient ones. The hedge fund manager believes less than perfect distribution of information creates opportunities for above-average returns.
After obtaining his degree in sociology from Princeton 1986, the non-conformist Cannell went to the Oxford’s Templeton College business school where he “dove into the investment process from a highly academic, theoretical standpoint.” However, before joining Templeton College, he worked as a freelance journalist in Fiji and worked for two Japanese firms, before setting up his own company using desktop publishing technology to produce musical scores. Needless to say Carlo Cannell wasn’t the quickest to pursue a career in investing, though both his father and grandfather had founded their own investment firms. “I’m sure growing up around investing and the conversations you hear from the backseat of the car had some influence on my occupation, even if that wasn’t always obvious early on,” Cannell said in an interview to Value Investor Insight in 2006.
In June 2004, Cannell briefly stepped down as the head of Cannell Capital “to spend more time” with his family, turning over the management of three hedge funds – the Cuttyhunk Fund, the Tonga Fund and the Anegada Fund, along a pair of separate accounts, to longtime employees Kenneth Heller and Annabelle Wong, leaving his family’s money in them. “Whoever has the most gold when they die doesn’t win. I seek a break. It may be six months. It may be forever,” Cannell had famously announced. “This in no way suggests a lack of confidence in the management or investment style of Cannell Capital. We will still be amongst the largest investors.”
He left the firm on a roll; the three funds had $765 million under management and Tonga Partners and Cuttyhunk Fund had gained 23.4% and 19%, respectively, over the previous year. Before stepping down in June 2004, the firm had returned 15% capital across all funds in February. “The mortality rate of hedge funds with more than a billion dollars of assets under management is very high. I think about that every time we rise to that level through retained earnings. I would like to think that we practice prudence over greed,” he had observed.
However, Cannell’s departure proved short-lived and he returned after seven months to take control as the firmed reported sluggish growth in his absence. Tonga Partners was up a mere 2.8%, while Anegada Fund and the Optima Cuttyhunk Fund gained 4% and 2.3%, respectively, during the first eight months of 2004. There was no word on Wong and Heller’s future after their departure, and Cannell said they were not fired.
Between 2004 and 2006, Cannell returned $300 million to investors to stay nimble, while assets under management still grew to $900 million during the period. “The great disadvantage of our investment approach is that it’s not very scalable,” said he. By September 30, 2009, Cannell had trimmed his holding to approximately $168 million, investing in 85 companies. He continues to create investment opportunities by going long and short since there exists “imperfect distribution of information.”
Cannell’s central premise for making investments is that market inefficiencies provide bigger potential for returns (the non-conformist doesn’t believe in the “Efficient Market Hypothesis”) than efficient markets and imperfect information distribution exists for a large amount of companies in the investment universe. Hence, the firm focuses on dullards, promising turnarounds and investment misfits that are generally shunned by the investment community. One of the key metrics that the company assigns before investment decisions is the “analyst ratio” – the number of analysts following a prospect. The lower the ratio, the better, he says. At one time in 2005, 65% of the companies in Cannell’s portfolio had no analyst coverage.
For identifying a dullard or misfit or potential turnaround, the firm starts with the screening of ‘value’ stocks – which could be a P/E ratio less than the RoE ratio, a low price-to-net-assets ratio, a low premium or discount to book value or a discount of the market value to revenues for certain industries. Cannell has also developed different screens that try to project free cash buildup for targets. A company that generates more cash than their capex requirements should hopefully do things that benefits shareholders, he argues.
While trying to identify patterns, the combination of inputs Cannell uses to predict and correlate is somewhat unique to the firm, he believes. For example, in identifying a potential short sales, an interesting correlation is the decreasing inventory turnover ratio for a company not audited by the ‘big six’ accounting firms.
An increasing difference between Cash Flow from Operations (CFO) and net income combined with greater analyst coverage can also give out subtle hints. Pre-paid assets are another grey are since they are not well scrutinized, he reasons. Companies assign higher insurance or advertising expenses to justify higher pre-paid expenses, but basically they are slush funds. That combined with a little lower gross profit margin may indicate that the company is trying hard to hide rising cost of goods sold.
Alternately, companies with improving working capital cycles, higher cash reserves, lower pre-paid assets and decreasing receivables make for good investment opportunities even if the income statement is not currently looking great.
A company’s growth potential is extremely important to Cannell and an undervalued stock’s most predictable precursor for an eventual price jump is revenue and earnings momentum. Once the underbrush targets have been finalized and the basic quantitative model is done, he starts looking for positive elements of change in them, like changing regulatory environment, newer markets, shift in competition or fresh management blood that suggest a more stable and predictable earnings growth potential in future. As the perception of value pivots from the balance sheet to the income statement, Cannell finds considerable opportunity in growing companies as a lot of value investors drop out during the transition and growth investors are slow to identify the opportunity until its has become obvious.
Carlo Cannell is not emotionally attached to any business or sector, but his preferred habitat is the energy sector, including oil and gas, and solar power. However, in October 2010, he told MarketWatch that he’s shorting German solar companies that are burning through a lot of cash and have high debt levels since many governments in Europe are slowly withdrawing subsidies. He also likes businesses with great niches that have above-average economic characteristics and are well managed. These businesses typically have a lower capital cost, higher scalability because of a strong brand, pricing power and a competitive moat.
SHAREHOLDER LETTERS
MEDIA
Value Investing Congress Speech – May, 2009
Bogus hedge funds — those with no short positions — will not survive the next market downturn
Cannell betting against solar companies
Cannell to Step Down as hedge fund chief
Carlo’s way – This zany hedge fund manager preaches peace–and wages war
J. Carlo Cannell: Investor set for proxy fight with Niles-based MFRI
Founder Returns to Helm at Slumping Cannell
Carlo Cannell Announces He is Stepping Down as Manager of Cannell Family of Hedge Funds
Cannell Returns 15 Percent of Capital across All Funds
VIDEOS
QUOTES
Quote 1 (on returning shareholder capital and not letting the fund become too-big): “The mortality rate of hedge funds managing over $1 billion is very high. I would like to think we are exercising prudence over greed.”
Quote 2: “We are always looking for areas of fear and panic. It could be an industry-wide problem – we all know industries go in and out of favor. It could be a scandal, such as over not filing financial statements. There are periods of inefficiency that come from fear about the future. We’re not timid in taking positions in those companies during those moments based on somewhat reliable historical information. The media actually does a very good job of temporarily destroying the valuation of certain enterprises. Ace Greenberg (the long-time CEO of Bear Stearns) once told me that the media’s maligning of otherwise good businesses was the #1 source of wealth-creation for him by creating great buying opportunities.”
Quote 3: “We’re looking for elements of positive change – fresh management blood, a changing market, a changing regulatory environment, a shift in competition – that suggests a future characterized by reliable and increasing earnings. We have to be predictors of growth to be able to buy at bargain prices.”
Quote 4 (on growth companies): “We find in growing companies that there can be considerable opportunity as the perception of value pivots from the balance sheet to the income statement. A lot of value investors drop out as that is happening, while the growth investors are slow to pile on until the growth is more obvious.”
Quote 5 (On management): “We favor companies that are lean and managed by people who have substantial equity positions. We look for certain behavior patterns in management that are consistent with an efficient and prudent guardianship of our assets. If we visit a fan manufacturer in Texas and the CEO meets us at the airport in his Lexus, spends five hours with us and then takes us out to an expensive restaurant and buys $300 bottles of wine, that is suggestive of somebody who isn’t as prudent as we would like. On the other hand, if we go to a company and see that they only painted the front of their building to save on paint, that the CEO’s office is right off the factory floor and that he makes us buy him lunch, which consists of a bologna sandwich out of vending machine, that is suggestive of a more prudent steward of our assets. We try to meet management of all the companies we own, but I must say that over the years I’ve become more skeptical and less believing of people. I don’t really want to know or like these people any more than I need to. We generally think it’s more interesting to talk to industry salespeople, ex-salespeople and customers of the company’s products to truly understand what’s going on.”
