2020 April CAD

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.74% MTD

-.99% YTD

Knowledge and Conviction

Dear Partners,

For the month of April, the Caravel Capital Fund Ltd returned 0.74%

Over the past four months, the memos written by Howard Marks have made for great reading. Howard is one of the founders of Oaktree Capital, who’s primary focus is investing in the debt securities of companies in financial distress.  When things seem complicated, Howard is able to convey the explanation in simple terms. His most recent memo focused on knowledge. The John Galbraith quote is similar to one that was popular on Richardson Greenshields’s bond desk.  It was modified to be more relevant for traders and investors:

"There are those who know, those who don’t know, and those who don't know they don't know."

Jeff enjoys using that expression and likes to couple it with -

"It is important to throttle your conviction proportionate to the level of your knowledge."

Both axioms relay our perspective on current market valuations and have been the cornerstone of our stability this year. The simple fact is that no one knows the answers to the following questions:

1) Will we have a vaccine? If so, when?

2) Is it possible that people can be susceptible to COVID-19 twice? 

3) When can we go back to running businesses like they were in December? 

4) What is a company’s value if it loses a material portion of its staff, suppliers, customers or capital base, and is exposed to losing materially more?  

5) When will Joe Consumer want to go to his favorite busy restaurant again? The one where you need to know the maître d’ to get a table?

6) When will we be comfortable enough to gather in large groups for weddings, graduations, corporate events, sporting events, or birthday parties?  

NINETY MILLION people in the United States are either over 60 or have major health risks. What does an economy look like when 25% are reluctant to participate? That was rhetorical,  It’s a mess and makes securities analysis hard.

Knowledge... None of us have enough information to formulate reasonably accurate valuations, and yet markets are speculating that corporate earnings will recover 90% of the earnings forecasted in January.  Recall the pre-COVID January letter when we wrote that earnings had not risen since 2018 while stocks had risen 24%? And now markets are looking at those same targets for earnings. 

Conviction...Straight up, it is our belief that the majority of participants who are purchasing securities in this market are those who don't know they don't know.  Buyers are a combination of retail (fear of missing out) investors, algorithmic strategies, and managers with no skin in the game who shadow the S&P500 (in our humble opinion).  

Taking a brief pause on this tantrum, we want you to close your eyes and consider what this November might plausibly look like - We may be nearing the tail of a second wave of illness with high death rates, as the virus collides with the common flu season. The Federal Reserve now owns $10 trillion of debt securities, up from $4 trillion in January. The US Federal Government has spent another $5 trillion on aid to get people back to work or keep them happy at home. 175,000 Americans have died, and the US has passed Greece in Debt to GDP……. The Democrats win the Whitehouse, the Senate, and the House.  Hint: LOWER!

So, back to the part about Caravel Capital.

The fund has a defensive posture. The long-dated calls on the S&P500 we bought near the bottom of the March sell-off were 25% out of the money. They are now IN THE MONEY. Rather than sell them as the market rose we chose to short the underlying ETF instead, which locks in returns and turns the calls into puts. Against this position, we have purchased shares in money managers whose values are still down 40%, but assets under management are down only 10%. We own holding companies at 20% and 30% discounts and are short their public subsidiaries.  With the current volatility, these have been a nice low-risk winner.  We have shorted some takeover targets where the consideration is all cash and the acquirer is borrowing the money. We are reducing our holdings in the Special Purpose Acquisition Companies that we bought in the depths of March, as they have substantially returned to their pre-COVID high’s.

Something neither of us have looked at since January of 2009 is buying the senior debt of public companies. In many cases, we believe they currently offer better return profiles than the common equity. In short, maybe not short enough (double entendre intended): when knowledge is scarce, keep your conviction in check. We are very flexible and will pivot at the drop of a hat if circumstances change. Unlike 1987 and 2009 when the Fed rescued the markets and we jumped in with open wallets, today we feel that the Central Banks are not the answer.

Until we have a vaccine, we will throttle our conviction proportionate with the level of our Knowledge.

We thank you for your confidence and capital.

Caravel Capital