David Zorub - Navigating Hedge Fund Headwinds at Parsifal (EP.434)

26:40you're going to be able to see changes in narrative, perhaps changes in risk, unencumbered by the baggage of having had to follow something very closely for long periods of time. The flip side from the specialist perspective is you're under a lot of pressure day in and day out to always like and always hate something. But what if your sector or your subsector is simply out of favor? That can give rise to some perverse incentives that we try to avoid. You mentioned at the onset that just the fundamentals aren't driving securities the way they used to. How do you think about how to monetize the fundamental work that you've done?

27:17When we think about monetization, there's the old saying that there's a big difference between finding a security that's mispriced and actually making money from it. And this is an area where I think we and just about everyone have really had to evolve your process over the last several years because markets have become increasingly efficient in many ways at defining expectations and calling quarters. A lot of that has to do with the rise of the platform model where these are very smart people with a lot of resources. So for us, what that's meant is first and foremost, placing an even higher emphasis on the concept of inefficiency.

27:52And in particular, doing it in places where we think we have less competition and where it's harder for the market mechanism to be as efficient around what those expectations are. So typically what that means is situations where there aren't expectations to begin with that are well -defined, where we're not playing head -to -head against the platform or other participants. But it also has meant being able to tolerate more volatility, candidly, and knowing that our fundamental underwriting, our ability to define distributions of outcomes, good and bad, more accurately, and then sizing to those outcomes in an effective manner has become really important.

28:33Ultimately, in our process, concentration is our lifeblood. We have our highest hit rates and our highest slugging ratios in our highest conviction ideas. When you find something that you can have a superior understanding of, you want to take a lot of risk to it. But it's also a reflection of the fact that mediocre ideas tend to cancel each other out in the end, and they consume a lot of time and bandwidth. And so core to our process is I tell the team, don't spend any time on something that we don't think has the characteristics of becoming a large idea. Now, it may end up not being that as we move through the research process, but just by making that one simple mental adjustment of, hey, if I don't envision this having the characteristics of something that could be five to 7 % or more of the book, I'm not going to spend time on it.

29:15That behaviorally weeds out a lot of unsuitable ideas. What are the types of things that have those characteristics? For us, it's the inefficiency. So maybe I can give you an example that will crystallize this. When you transition from analyst to portfolio manager, it's a big and often difficult transition. But one of the most important things that you learn is as an analyst, your job is to know everything there is about an idea. And when your idea is not playing out the way you want, the temptation is to say, I'm right and the market is wrong. What you learn as a portfolio manager is actually know the market is usually right and that you've got a problem and you need to go back and test.

29:54So that's usually the concept I'm trying to bring out. And how do you balance those two? So something isn't going well, what do you do with that position? First, you lean on the value of the process. So the value of our process in documenting every step of it, what we thought we were signing up to, what we thought we were underwriting, the key assumptions, that now gives you a reference point to go back and say, hey, is what we thought would happen playing out or is something different playing out? If what we thought was playing out is playing out and we're still not getting rewarded in the way we thought, then we need to ask, well, does the market actually care about something else or not?

30:29Separately, if what we thought should be playing out is not playing out, then we need to go back and actually re -examine the root cause. But time and time again, I've seen in my career, when you think that you're right and the market is wrong, the market is almost always right in the end. And you need to go back and fundamentally revisit your entire thesis and the premise for what you were doing and not ignore that signal. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? Partner with a company that's been defining the future of dealmaking for nearly two decades instead.

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32:02I think there's a spectrum of how managers think about risk management. At one end, there are some managers who say, look, my research is my risk management, my understanding of this situation, my analysis of it. And then I'm just going to put that idea into a portfolio. And that's the extent of my risk management. I think at the other end of the spectrum are those who put a lot of effort in telemetry around really understanding not just the idea, but how does that idea interact with a portfolio and what are the characteristics of that portfolio? And so when I think about Parsifal, we're very much at that latter end.

32:37We put a lot of time and effort into really asking one question, which is, is the risk that we think we're taking the risk that we're taking? Or are there risks in here that we are not aware of or that we don't want to be taking? We first embed that risk management for sure in the fundamental analysis. By definition, if we're identifying a pool of alpha that we think exists, it should be more variant. It should be less crowded. If we're applying that credit mindset, there should be strong fundamental support for the valuation. And then we have a process that we use to build the portfolio and to allocate capital objectively across different ideas.

33:16And then once we have a portfolio of opportunities constructed, we just rigorously analyze it over and over again through different lenses. We use the Bara models. We have built our own scenario modeling and stress modeling, and we are constantly just measuring the risk and making sure it's behaving the way we think it should behave. What you have in your portfolio is equities long and short, credit, some event -driven situations. I'd love to go through each and talk about some of the challenges that the markets have brought up. We can start with equity longs. Have you navigated the strength of the MAG7?

33:53It's been tricky. We ply our trade in small to mid -cap parts of the market. We are global, and we are looking for more complex situations. And the unusual nature of the current business cycle has been reasonably hostile, actually, to all of those. It's the job of any manager to adapt to that. But the kinds of things that we like to do have been more out of favor. And what we've seen is that the rise and dominance of MAG7 has led to a real bifurcation of markets and opportunity sets. The rise of MAG7 is really distorted bottoms -up investment outcomes and decision -making. It's distorted, I think, allocator and behaviors.

34:36For us, what that's meant is just staying true to our strategy, knowing that we can identify opportunities with conviction and not succumbing to being forced into the MAG7 trade. What's so insidious, I think, about what is potentially going on, and having lived through this in the late 90s with dot -com is the concentration of that kind of performance and so few securities, it really will ignite fear of missing out or fear of lagging. And eventually, it will cause people to make bad decisions. The most important thing has been staying true to our process because we know it works really well over time, taking the opportunities as they're given to us, identifying opportunities that we think will thrive in that environment.

35:18And in general, we've adapted pretty well, but I do think that we're coming into an environment that will be even better and less averse as a result. How have you managed your short book? It just seems like with all of the volatility, it's gotten harder and harder on individual stock shorts to be able to generate alpha, let alone make money. In the 22 or three years that I've been shorting stocks, every day that goes by is the hardest day that it's been short. You are well aware of all the practical challenges of managing risk, of frictional costs, of things like that. And then I think what has also changed the last few years is, again, going back to something I mentioned a few minutes ago, obviously the rise of the platform model, given how much it's grown and then it's levered on top of that, has created a lot of incremental demand for single name short capacity, as have the style baskets.

36:11The combination of that plus the rise of the retail meme trader have presented new challenges. Practically what that's meant is we remain as dedicated to single name short selling as ever, but we've had to diversify the portfolio. There was a time when I probably would have preferred to short with more concentration. Bigger positions really extract a lot of alpha through slugging, but the volatility, the short -term reaction function when you get something wrong on the short side can be so much more severe now. And then the rise of the retail meme type risk is not something that you can easily mitigate even through sizing.

36:49So for us, what that has principally meant is we've grown our team. We've created more research bandwidth. That in turn has allowed us to create more inventory of actionable single name short ideas. And from that, we've been able to diversify the book more, but also trade at the extremes. Take the IWM, the Russell 2000, and just look at last year. That index probably went up or down 8 % to 10%, six or seven times in one year. So that creates a lot of actionable trading in your short portfolio to cover at the lows, put those same ideas back out on recovery, identify new opportunities. And so I think that's been the single biggest adaptation, maybe coming at it a slightly different way as well.

37:34In mid -23, I wrote a letter to our partners where we actually looked at our short performance, the hard data inception to date. And at that time, I guess we had maybe north of 50 months of data. And what we saw was in the vast majority of those months, we had very, very good short performance. But there were four to six episodes when we ended up disgorging a fair amount of that short alpha, the biggest one being Jan 21 with Melvin and that whole meme meltdown. So what we concluded was that our process was very effective, but we just needed the ability to be more tactical in the extreme swings of volatility that we were experiencing.

38:10How do you think about the use case for shorting now? I still think it's as compelling as ever. Maybe I'm a dinosaur in that regard, but what is the value of shorting? Well, first, it absolutely makes you a better investor. It forces you to be open -minded, forces you to be skeptical, not cynical. There's an important difference. It forces you to really question market narratives. So I just think it requires more objective process discipline. And if we weren't shorting, I think we would be more prone to succumbing to not challenging key assumptions the way that we should. I think that is very valuable.

38:48Certainly within a portfolio like ours, I think in our first conversation at Columbia, I wished for a world that looked more like David Swenson's original formulation of long short, where he was putting a four to five percent short rebate into his target returns. Well, guess what? At least for right now, we're getting a four to five percent short rebate. So if we can then create alpha on top of that, that's quite powerful. And then, of course, the ability to just help protect capital and fund our long book, particularly our concentrated long book in our model is very critical. And to be more explicit about that, we have our highest hit rates and our highest slugging ratios in our ideas that have been 7 % or more of capital at risk.

39:31And I have a cohort of roughly 38 of those ideas inception to date. Our ability to put those into a portfolio and manage them versus some short risk, I think helps us to get to even better outcomes. Why do you think that percentage or the hit rate of the slugging percentage has been that high? It goes back to really what we discussed earlier, which is we have a very specific rubric that we're looking to populate. So inefficiency that we can exploit, very asymmetric, low risk of permanent capital loss, high degree of research ability that we can build conviction, and then specific catalysts. And when that fact pattern comes together, our underlying portfolio construction algorithm says, be big in this now.

40:16So it's really just about being patient and waiting effectively for a fat pitch that we can elucidate very clearly, check all the boxes. Maybe another way of saying it, it's usually not the case that something comes into the book in that smaller part of the sizing and then scales up over time. It happens. It's usually where we come across a fact pattern that is so compelling that we want to be big from the get -go. So Dave, what's an example of an idea that crosses these different areas of inefficiencies? I think a very prototypical bread and butter Parsifal opportunity is the investment that we've made starting about 18 months ago in a company called Shark Ninja.

40:57They're a designer and manufacturer of household appliances, vacuums, hair dryers, toaster ovens, et cetera. This company, which is an American company, it's based in Boston, but for most of the last decade has been owned by a Chinese corporate parent. And at the end of July, 2023, that corporate parent just listed Shark Ninja in the US market with no fanfare. It was a spin out to existing shareholders. There was no IPO process, no existing research. There was just no institutional knowledge of this company. When you think about those structural, behavioral, and informational sources of inefficiency, it literally exhibited characteristics of all three.

41:42Structurally, you had a spinoff. It was a change of corporate structure. There were classic spinoff dynamics as existing shareholders got the shares and sold them and created a lot of technical selling pressure. Informationally, there was no market narrative whatsoever. There was no Wall Street coverage. There were no public filings. As a foreign -controlled issuer, they didn't have to make regular 10K, 10Q filings. There was just very limited disclosure of the business. On top of that, you had a Chinese foreign -controlled entity. There were various related party dynamics that were potentially quite significant, governance -related issues.

42:19And then behaviorally, the business came out at a time when the world was very concerned about consumer risk and no one wanted to hear about what sounded like an undifferentiated designer and manufacturer of home goods. And so we had some knowledge of Shark Ninja as a competitor because we had followed iRobot from a research perspective for many years and we had seen what Shark had done in competing with iRobot. It was clear to see why it was inefficient and it came out at something like eight times current year EBITDA, so very cheaply. But when you opened the public filing, you saw it was a very different situation.

42:58You saw a business that had grown organically at very high rates for the better part of 15 years. It had 45 to 50 % gross margins and high teens EBITDA margins, a very clean balance sheet. And when we purchased data from NPD that showed point of sale for all the different categories they were in, you saw a business that when it enters a new category, very regularly gets to 30 to 40 % market share. So this was at the time a $4 billion business growing very fast and had shown a proven ability to grow organically, to innovate and to disrupt. And when we put that through our process, we came up with something that we thought was very radically mispriced and extraordinarily asymmetric.

43:44So I think that's an example, again, where we and others are creating the market narrative where it didn't exist and that there were very specific, explicit, and concrete inefficiencies that one could exploit if you were just willing to apply the proper process. I'd love to take a step back and talk a little more about your journey over the last six years. There's a big difference from launching and then attracting capital to be where you are today. What were some of the success factors for you in being able to raise capital for the strategy? Much like every day that goes by is the hardest day to short that's ever been, I think probably every day that goes by is also probably the hardest day that it's ever been to raise a dollar of institutional capital.

44:26It is incredibly competitive to do so. Our mindset really from the beginning has not been one of raising capital. The mindset has been one first and foremost of defining what we want to do that we think we can be good at. And maybe that's a subtle distinction, but when I sit down to meet with a potential partner, our first meeting is basically an hour of me telling them probably why we're not a good fit for each other. We invest in a very specific way. We take a lot of single name concentration risk. We invest globally across different asset classes. We can kind of almost do anything we want with your money within reason.

45:08Our strategy will be volatile. We like to go into more complex situations or parts of the market. They may be hard for you to understand or articulate to your constituencies. And the nature of our strategy is that we know over time, it will generate alpha if we execute it faithfully. There can be some real ups and downs along the way. So really, it's a process of trying to, more so than attract capital, find folks for whom it's a good match and let them opt into that conversation and then just build a relationship over time. So our approach has really been one of saying, look, this is who we are.

45:45If it's interesting to you, please let's talk about it, but let's build a relationship along the way. Let's give you complete transparency into what we do and see what happens. Just putting a lot of persistence around building that relationship. So those relationships often take time to build. When When you're starting, you actually need capital to manage to be around for when those relationships may turn your way. How did that play out in the early years? Blackstone anchored our partnership from day one, and they've been fantastic partners. And I think that played a critical role in allowing us to put that stake in the ground and say, this is who we're going to be from day one and not succumbing to what I think a lot of managers are forced to adapt or modify their strategy to do things they don't want to do early in their life in order to raise capital.

46:34We didn't have to do any of that because we had a very strong anchor. And then we were fortunate to be able to partner with some other very thoughtful, stable sources of capital who will partner early in the lifespan of a manager and who are able to allow us to do what we do. And then there's serendipity involved. There's a lot of luck that's involved, but you have to perform. And so we were fortunate enough not just to be able to perform, but to perform in a laboratory that was pretty rich for how we want to invest. The onset of the pandemic and its immediate aftermath, while challenging to navigate, I think that gave us a lot of proof of concept to folks who we were building relationships with to then allow us to continue to scale in the ensuing years.

47:19What have been some of the biggest challenges along the way? Gosh, where to begin? Building a team and a culture through a pandemic, not easy. There was a period of time where we weren't in the same room together or the same office, and you're trying to forge your identity. And I give tremendous credit to the professionalism of the team. I think it would have been easy for a lot of newer firms to splinter. And instead, we came together and built our identity and our culture. That certainly was a challenge early on. I think continuing to build those partner relationships and giving transparency into process through the ups and downs because it hasn't been all up into the right.

48:01We went through a period of underperformance in mid -22 where we had a drawdown and just managing through that, that's for sure been the most challenging aspect. The drawdown itself wasn't out of line with what you would consider maybe for a strategy like ours, but it still wasn't fun. Like many things in life, you think you have a plan and then it gets tested and it's not what you think it is. And we had built our risk posture in the spring of 22 for probably four to 5 % inflation, but not 10. To my point about concentration earlier, that was the one time when it worked against us. And so empirically, we had to navigate through that period and reset the portfolio and manage risk.

48:41And I think one of the things that came out of that in a very positive way is some of our best LP relationships today were born of that moment. They were folks with whom we had been building that relationship and that dialogue from inception. And then they came in and they said, effectively, we've been waiting for a moment like this. We were expecting it for a strategy like yours. You behaved in the way that we would have hoped you would have behaved. You explained it in a way that we would have hoped you would have explained. This is our time to partner with you. And from that moment, we've been able to build some of our best, most resilient relationships.

49:14That's been a positive at the other end of it. What are some of the most important lessons and adaptations that you've made from how you thought about managing capital six years ago to today? I would say that the core strategy, the philosophy has not changed. We are as committed as ever to high active share concentration, appropriate duration, working across the opportunistic mandate, the commitment to the short side. Where we've had to adapt is mostly around implementation of that. So a few examples would be what I talked about on diversifying the short side. Increasing our research velocity because volatility in the markets and the dispersion it's creating has meant that sometimes your window to access an opportunity is more fleeting and you've got to be prepared to move.

50:02We've worked hard to build more inventory of ideas, even if they're not actionable in the moment, when we see that price signal or that opening that's consistent with what we have underwritten, being ready to move. Within the team process, most of our team interactions are geared around opportunity identification. And we've put more formal structure around how we communicate information to each other in the hopes of not just sharing insight by generating ideas. What opportunities are you most excited about as you look forward? I'm as excited today about our opportunity sets as I have been probably since the early onset of the pandemic.

50:42We talked earlier about some of the distortions that the concentration of large cap tech, MAG7, were having. They've literally left very compelling situations lying in the middle of the street, the proverbial $20 lying on the sidewalk. Without making political statements, the change in leadership, the Republican sweep is, we believe, a big deal for our opportunity sets. It is creating a lot of dispersion because of the uncertainty of the policy shifts, but the de -emphasis on regulation, the animal spirits that we believe are being unlocked, we think will ultimately be good for event -driven and special situations.

51:17We think there's a lot of pent -up corporate action demand that will come out here in the coming months and year. We think that regulation has been a real burden to small and medium -sized businesses who bear that regulation disproportionately. They employ something like 82 % of people in this country. And all the real -time telemetry that we're getting, so data sets, business formation, conversations that we're having with corporate, suggest that the confidence that you're seeing broadly emerge is real. The animal spirits emerging are real. And ultimately, what needs to happen here is a broadening of earnings growth from the large cap part of the market to this mid -cap.

52:00But we think that's happening and we think it's happening at a time when it's been largely ignored in both passive and active flow. So I'm very excited about that. We're excited about the international opportunity, Ted. About a quarter of our risk today is outside the US. I think three of the last four long ideas that we put into this concentrated portfolio are international opportunities. We have risk in places like Korea, Japan, Southern Europe, the Nordics, Asia -Pac. So we're seeing it broadly. And that's because the large cap AI trade, it's not just sucked capital out of mid cap, it sucked it out of pretty much every asset class and country globally.

52:37So we're pretty excited about the dispersion that we're seeing ex -US and then just long short, we're seeing real dispersion, which was not the case really from like, I don't know, 2005, 2006 till maybe a few years ago, there was much less long short dispersion. we're really excited about our underlying opportunity sets. And that's being validated in our bottoms up work, where our velocity of new ideas into the book and just the pace and different types of ideas that we're seeing long and short is quite robust as well. What are you most worried about? I'm by nature, someone prone to worrying. So obviously the flip side of what I just said is that we have a new administration that can be quite volatile in terms of day -to -day decisions or unpredictability.

53:25And with that comes, I think, a heightened risk premium. I think you just have to underwrite a wider distributions of scenarios in everything that you're doing. From a macro perspective, it doesn't take much to destabilize markets. The market is not just all on one side of the boat. Everyone's in the bow of that boat, and it will not take much to potentially tip it and create a major risk -off event. So I think for us, it's about staying within our risk box parameters here from a gross net exposure balance of the kind of tilts that we're taking while still identifying those handful of high -conviction ideas that we think we can exploit in that environment.

54:05But I think it's still one where you need to be careful about the risk you're taking, as careful as you've ever been, careful about balance sheet risk, careful about operating leverage and the fundamentals of the companies that you're underwriting. In many respects, it's still credit 101. What are the things that can get you into a lot of trouble? Balance sheet, liquidity, operating leverage, customer concentration, crowding, and just making sure that you're not exposing yourself in excessive ways to those types of risk at this point in the cycle. So if you look out six years from now and we sit down to do this again, what are you hoping Parsifal will become?

54:40We've always wanted to be in the IRR club. So my hope will have been that we've distinguished ourselves through very strong performance that's diversifying for our partners and has helped them reach and achieve their end objectives. Along the way, I hope that we've continued to build out and promote from within a very talented team and a team and culture that is self -perpetuating. In many respects, the Achilles heel of organizations like ours is the key man risks that sits with someone like myself. I've always been very open about that, both internally and externally, that for Parsifal to thrive and succeed means that I have to make myself redundant over time.

55:23I need to attract the best talent possible, groom that talent, put those individuals in positions of more success and responsibility over time, ensure that our process is not between the ears of just one or two people every day, but is really a self -perpetuating process of how we execute. So I think if in five or six years, we've been able to continue to perform in the way that we expect of ourselves to meet our partner's objectives, and I've been able to make myself much more redundant, I think we'll all be in a happy place as a result. I have a whole new set of closing questions to ask you.

55:59So let's have at it. What's your favorite hobby or activity outside of work and family? I really enjoy just being outdoors in general. I think I mentioned last time I grew up in a sporting family. I like to be in the woods. Maybe what I'd add to that is as a child, I skied and then for a long time, I didn't ski. And then as my children discovered it, I rediscovered as an adult the joy of skiing. And that is truly something that I really look forward to once or twice a year. What was your first paid job? So I spent a lot of my life growing up in Italy. My mother is from the north of Italy and our family has a family apparel business there.

56:36In sort of the middle school and early high school years, my uncle put me to work as a translator. And even though he speaks pretty good English, we'd spend our summers there and he'd have me translating copy or things that came over to facsimile, which in those days was cutting edge technology, or sometimes just getting on the phone with him and helping him translate when he was dealing with wholesale customers or things like that. So that's probably my earliest memory. And I got paid in clothes, by the way. How's your life turned out differently from how you expected it to? I don't know that I ever had an expectation of how my life would turn out.

57:12I've been very fortunate to have won the life lottery in the sense that very loving family, loving parents. I won the life lottery. My wife, Katie, is amazing. We're blessed with four children. I get along great with my in -laws. So I don't know that I ever had any expectation other than maybe of hoping to have that kind of life that I observed my parents and loved ones having. And so in that sense, it's turned out better than I ever could have imagined. But it may surprise you, I never thought I was going to work in finance or Wall Street. So in that sense, it's turned out quite differently. I think if you had asked me in my formative years, what I would end up doing, I think I probably thought I would have been an academic, like a professor, a research role, maybe an editor, or maybe working in the CIA or the FBI, doing analysis, the same kinds of things, but things like that.

57:59I genuinely didn't think I I would end up on Wall Street. What's a mystery that you wonder about? My youngest child is 11, is obsessed with the planets, probably like many children her age, astronomy, looking through a telescope at night. So together, we've been on this journey of what is the universe? What are planets? Where do we come from? Are there other forms of intelligent life? And it really has caused me to go down this rabbit hole and contemplate the mystery of the universe, I guess. And when you go down that rabbit hole, it's extraordinarily humbling and provocative when you really get into what are the mysteries of our universe and questions of other forms of life or higher forms of life.

58:43So we've enjoyed that together. And trying to communicate with an 11 -year -old about these things is quite challenging and has been quite humbling in its own regard. All right, Dave, last one. If the next five years are a chapter in your life, What's that chapter about? I hope for me, it's really just about service. Service to what we've tried to build and will continue to build here at Parsifal in service to our partners. Service to my team here in terms of helping them achieve their career, skills, development, aspirations. Certainly service to my family as my children go off to college and into their own lives and beyond that.

59:19and to my broader family and service to my community and to a handful of things that Katie and I are really passionate and supporting. Dave, thanks again for coming back on and giving us an update on what's happened over the last six years. Thanks, Ted. It's been a real pleasure. Thanks for listening to the show. To learn more, hop on our website at capitalallocators .com where you can join our mailing list, access past shows, learn about our gatherings and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one and see you next time.