Interview with Sean Westropp of Deep Sail Capital
Welcome to the first in a series of written interviews with emerging fund managers.
For this issue we had the pleasure of interviewing Sean Westropp, Founder and Manager of Deep Sail Capital LLC.
(We have more interviews being published soon, so make sure to add your email address to the list so you don’t miss any).
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Hi Sean, thanks so much for taking time out to do this interview. Can we start by asking how you got started in investing?
I have been an investor in some form or another since I was 14 or 15 years old. My infatuation with the stock market grew out of watching CNBC in the summers of my youth.
My dad set up a custodial online brokerage account for me to start investing on my own around that age. It was right at the beginning of online brokerages starting up.
At the time the online brokerages were an excellent tool for someone with limited market experience, but the trade fees were very high compared to today. I remember I paid $19 per trade when I started out, which made trading costs quite high, especially because I only had about a thousand dollars when I started.
Walgreens was the first stock I purchased because I believed that cold and flu season happened every year, so they had recurring demand.
Not a bad thesis for my first investment, but at the time I had no idea how to do fundamental research, so this thesis was purely qualitative.
Since then, I have tried many different strategies including day trading forex, technical chart trading options, dividends, value, and cryptocurrencies. My current strategy now is Growth at a Reasonable Price (GARP) with a focus on high quality companies.
Can you provide a brief introduction to Deep Sail Capital - what is the strategy?
At Deep Sail Capital, we utilize a long-short equity strategy with a natural bias towards net long. Our strategy is best described as a "growth at a reasonable price" (GARP) strategy.
Deep Sail Capital was born out of an incubator fund that I started in 2012 to manage some family and friends’ money. I started the fund after graduating from the University of Chicago Booth School with my MBA. The strategy of the fund is a growth at a reasonable price (GARP) strategy with three areas of focus: quality, microcaps, and special situations.
We use a framework that I developed called "The Four Pillars of an Exceptional Investment" to evaluate all our investments. This framework was born out of my study of many of the great current and past quality investors like Chuck Akre of Akre Capital, Thomas Gayner of Markel Corp., and Terry Smith of Fundsmith.
The four pillars of an exceptional investment are a high-quality business model, an outstanding management, substantial long term growth prospects, and a reasonable valuation.
The fund is always net long, with gross and net exposures of 110-160% and 50-90% of NAV respectively. The short portfolio is meant to provide both a source of alpha and a means to increase leverage on our long portfolio.
For your short strategy, what are the red flags you look for?
The short portfolio is meant to provide both a source of alpha and a means to increase leverage on our long portfolio while attempting to keep our beta hedged.
We focus on short positions that have the following characteristics: potential frauds, pump and dumps, broken or declining business models, industry fads, initial public offerings (IPOs) with upcoming lockups, and overvalued moonshots. We will not short companies purely on valuation without an identifiable catalyst.
Running a short portfolio is by far the most difficult investment strategy to execute well. Anyone considering running a short strategy should do so gradually over time, as nothing prepares you for running a short strategy like running a short strategy.
A short strategy requires many different complex inputs on top of those inputs one would use in a long strategy, like valuation, business evaluation, and management evaluation.
In a short strategy, you need to consider short interest, borrowing rates, market sentiment, market structure, float outstanding, index ownership, and a variety of other inputs.
The red flags I look for in our short portfolio vary wildly based on the target. The main ones I look for are managements that are highly promotional, issue lots of equity, miss their targets, frequently change their business model, frequently change their C-suite, or have businesses that don’t make sense financially or require significant capital to get to break even. Fintwit (financial twitter) does a great job of identifying companies that fit these criteria.
The difficult part of shorting is not identifying short targets; it is correctly timing them and managing your risk (borrow rates, position sizing, and avoiding short squeezes).
There are plenty of good places to look for shorts. I will highlight a few here that I feel are great starting places for anyone looking for shorts.
IPO Hangovers. IPOs are designed to inflate the valuations of companies, that’s literally the job of IPO Investment Banks. IPOs are structured in such a way that the float is generally constrained right after the IPO and then slowly eased. Low float IPOs are especially good at manipulating the float (see $GPRO, $SHAK, $TLRY, and currently $MBLY). According to my historical analysis and experience, the best time to short an IPO is approximately 2 to 2.5 months prior to the IPO lockup date, which is usually 6 months after the IPO date but check the filings for confirmation.
Industry Bubbles. Industry bubbles are when an entire industry gets "hot" and inflated, usually on the backs of retail excitement of a "new industry." Examples of this are the cannabis bubble, the EV bubble, the metaverse bubble, or what seems to be the current AI bubble. The best way to short these types of industry bubbles is usually using a basket approach, in which you select 4 to 6 individual stocks in the bubble to short.
Pump & Dumps. These are usually obvious and can even be identified by watching disclosures around paid promotions. Pump and dump schemes typically involve management needing capital to further invest in the business, so they embark on a promotional campaign to artificially inflate stock prices (all of which is legal if properly disclosed). These are generally small cap stocks in which the float is already tight, so any buying may drive up the price a lot. Once the price is up, management will generally drop a share offering or some type of funding raise on the market to take advantage of the higher share price. This will then end the promotional campaign and dilute shareholders, which drops the share price. Some companies are so good at this, they do it every few years.
Cyclical Winner. Cyclical stocks that are doing well, generally do badly in a year or two. I keep a list of highly cyclical stocks and keep an eye out for any of them that hit a 52 week high and watch for technical breaks or earnings misses.
Where in the markets are you finding good value today for your long positions?
Small and microcaps growth stocks. Small and microcap stocks are at near all-time lows in terms of valuations. I have been finding ample opportunities to own growth-oriented companies with solid management teams at extremely cheap valuations.
Companies in OECD markets outside of the US, like Canada, the UK, and Western Europe, are particularly attractive as they usually have a valuation discount compared to US peers.
At Deep Sail Capital, we have a specific industry focus list that includes about 15 industries that we consider part of our universe.
Within that group, we are particularly excited about cell and gene therapy picks and shovels in the medical device space, payments, and infrastructure software.
Can you talk about two stocks you're bullish on and what was the thesis for investing?
Atlas Engineered Products (AEP)
Atlas Engineered Products is a serial acquirer in the truss, wall paneling, and floor truss industries. I did a full writeup of my thesis in my Q3 Investor Letter, which is posted on our website deepsailcapital.com.
The truss business has all the industry dynamics that make it a perfect market to employ a serial acquirer strategy. The industry is highly fragmented and regionalized due to high shipping costs, which make it prohibitive for wide distribution from a central production location.
Management is highly seasoned. The current CEO, Hassi Abassi, is the company’s founder and has 30 years experience in the Truss business. On the board is Paul Andreola, a seasoned small cap investor with extensive public market experience. Paul assists with the M&A strategy at Atlas and has been integral to their serial acquirer strategy. Atlas checks every box I look for in a serial acquirer.
The truss and wall paneling businesses are highly fragmented in both Canada and America. There are many forced sellers within the market due to many retiring Baby Boomers that are willing to take either cash or stock in exchange for their truss business. But there is no natural buyer within the market, as the size of the acquisition targets is too small for private equity to be interested in.
From a valuation standpoint, the equity trades at 3.8 EV/EBITDA TTM and a forward P/E of about 7 based on my estimates.
Mercado Libre (MELI)
Mercado Libre is a unique company that might be best described as 1/3rd Alipay, 1/3rd Ebay, and 1/3rd Amazon of Latin America (Latam). Aside from that, Mercado Libre is essentially Latin America's sole internet behemoth.
Latam has lagged the rest of the world, especially compared to North America, in terms of adoption of the internet, e-commerce, and investment in internet startup companies for the last 15 years, but that adoption has accelerated in the last 5 years.
Specifically, in the last 3 years, the Latam VC landscape has exploded, with a multitude of new Latam startups emerging to service the growing e-commerce and internet users of the region.
Many of these startups are founded by former Mercado Libre employees. I mention this to highlight the key position that Mercado Libre holds within the Latam market, it provides a lot of the payments, logistics, and credit that allow these startups to scale.
The business is broken into four main verticals: Mercado Libre (Marketplace), Mercado Envios (Logistics), Mercado Pago (Payments), and Mercado Credito (Credits). While the overall business is still running at extremely high growth rates even after post COVID's deceleration, the most exciting part of the business is Mercado Pago, the payments segment.
Mercago Pago is a payment system modeled after the successful Chinese payment system Alipay. Mercado Pago grew its off-exchange payment volumes by 122% in the 3Q to $21B.
This off-exchange growth is just beginning, and we believe this, coupled with high moat businesses in Marketplace and Logistics sets Mercado Libre up to be the backbone of commerce in Brazil, Mexico, and other Latam countries for many years to come.
It is extremely hard to value Mercado Libre at this time due to various segments of the business still being in high growth mode, but overall, the valuation is about 25 times 2024 EBITDA, which is high but not unreasonable given the huge opportunity and market position that Mercado Libre has.
What's the hardest thing about managing a fund?
The hardest thing about managing a fund is that it requires several different distinct disciplines to be successful. You need to have strong investment, operational, and marketing skills to be successful. Emerging funds like Deep Sail Capital are in tough competition with other funds to raise funds from various sources.
It takes a lot of time, effort, and discussions with potential investors to get them comfortable with your strategy and ultimately with you as a person. Managing a fund can be very dynamic as well, one day it may be all analyzing earnings reports, and one day you’re dealing with vendors or tax issues.
Thanks Sean for a great interview.
To learn more about Deep Sail Capital LLC you can visit their website
You can also follow Sean on twitter @DeepSailCapital
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This interview is for informational and educational purposes only, and should not be seen as investment advice. Please do your own research before thinking of investing in any company mentioned.
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