For the month of March, the Caravel Capital Fund Ltd returned -1.91%
We want to share with you the four pillars we use to monitor fund strategy and how it played out in the month of March:
I) Examine the situation II) Identify the actions that yielded positive outcomes III) Analyze the actions that didn’t yield positive outcomes IV) Determine our plan of action moving forward
I. The Situation: A Breakdown of March results
Our profits came from:
Our losses came from:
II. What did we do right? We held cash, loads of it. We didn’t buy into the herd mentality rally from Oct to Feb. When risk rose we exited strategies as per our investment guidelines, and remained focused and calm. Glen and I have worked through a combined eight 30% or greater drops in market prices and used this to our advantage. We identified opportunities with excellent risk reward profiles under extreme stress and put capital to work. Sadly, it is worth mentioning we had a whale on the line at one point and let it go. In late January we identified a statistical anomaly that told us there was severe complacency in markets. The S&P 500 ETF had gone 71 consecutive days without a 1% move… which is statistically very rare. We purchased an option position in the VXX (which tracks stock market volatility) that would profit from volatility increasing. In early February the VXX index indicated market volatility was 12% annualized which is exceptionally low, so we purchased $15 calls and sold $12 puts for a zero net cost to the fund. In early March, we exited when the VXX was around $21 with a nice profit as we believed markets were adjusting valuations from excessive to fair value. This was 10 days prior to the publishing of the now famous Imperial College Study on COVID-19. That position, if held until expiry, would have contributed a 4% profit to the fund for the month. We didn’t know the possible impact of the pandemic for more than a week after we sold. It was an investment based on purely quantitative data…something we do all the time. Continuing to hold would have been betting your money on a black swan event we didn’t know about. This particular Black Swan only appears once in 3.5 million occurrences. Basically, this time our lottery numbers hit and we won. We just didn’t risk the extra money to play the Powerball… which sadly also hit.
III. What could we have done better? We were overly eager to get money to work, our frustration was evident in our letters. As soon as we found some attractive valuations on risk averse assets, we deployed some of the cash we had been sitting on. These investments were backed by US treasuries and had a maturity under 15 months, the unlevered risk-free returns were around 7%-8%. Then, liquidation from over exposed funds and ETF redemptions occurred and prices fell to extreme levels offering unlevered returns in the teens and we cautiously added to these positions. By month end these assets recovered nicely and we reduced our holdings by almost half. We remained smaller than we would should have been on short positions in cash takeovers on companies that are highly sensitive to economic conditions. We didn’t see the magnitude of the pandemic until we read the Imperial College study. We got a 1-day lead before a massive 17% fall in stocks to add to a short cash arb that fell 70%. We decided to hold when we could have sold two economically sensitive convertible bond positions, which we had stress tested following conversations with management, and confirmed both had sufficient cash to repay the debt. Unfortunately, with High Yield funds and ETF funds selling, the markets became indiscriminate and dislocation caused these holdings to cost the fund 2%. We continue to hold these with yield to maturity in the high teens but are watching them very closely. Over the previous four months we had lost money trying to short the market and had become somewhat numb. Simply put, we took our pucks and sticks and left the rink just before the 1980’s Oilers showed up to help us.
IV. What are we doing now?
The uncertainty for the next 12 months cannot be understated. The massive recent rally in North American stock prices makes us wary. The fund is currently skewed to the short side. We are short shares of companies that are targets of cash takeover offers. We are confident the buyers are looking for ways to either reprice or walk away from the bid all together if they can. We purchased long dated calls at the depth of the sell off in the US stock market that are now at the money. In reaction to this monster bear market rally, we have shorted higher strike calls against them to lock in some profits and shorted high beta securities against the remainder. We have 25% of the fund in cash again and are using no margin. We are actively trading what can only be described as a massive dislocation between related securities, as well as the dislocation between companies that are the haves and companies that are the have nots. We share Goldman Sachs’ view that the impact to corporate earnings of this pandemic and ensuing shut down of the world economy will be something similar to Paul Volker’s 18% anti-inflation interest rate policy which lasted from 1980 to early 1982. The effect was essentially a shutdown of economic activity to kill wage cost inflation. Both today’s and Volker’s solutions to crises were draconian but essential. However, we believe that a vaccine will be developed within 12-18 months, quicker than the 24 months Volker held interest rates above 14%. The impact of effectively shutting off the service economy for three months at a minimum, and likely a further eight months to regain some of the business lost will be devastating to the economy and the consumer. To help quantify this, let me ask you these simple questions: are you fearful of movie theatres, restaurants, shopping malls, or hotels? If you’re worried about being in any area where you could be touching something that a stranger may have touched in the last 6 hours, you’re probably not going to the local Apple store. For our investors who own and operate factories, how are your employees feeling about crowded factory floors? For the investors who work in downtown office towers, are you fearful of going into an elevator with 18, 12, or even 6 people to ride 20 floors every morning and night? Non-essential services are NON-ESSENTIAL by definition. That covers the demand-side damage of the equation.
Now for the supply side. Companies have to pay fixed overhead and service their debt during this period of you not buying 100% of your usual stuff. Monetary and fiscal stimulus are nice thoughts, but they won’t keep earnings (2019 S&P 500 Index earnings were $152) where they were, not even close. From our past letters, you will recall S&P 500 earnings were flat over the last 2 years. Last year’s stock market returns were 85% due to increased valuation multiples and 15% due to increased profits. So a 17% drop off of the 3390 Feb 19/2020 market-high yields a 2850 Index level, which happens to be 18.5 times 2019 earnings. Now start subtracting due to a drop-in earnings. Hint, it isn’t 2800 which was Thursday’s close for the S&P 500. Even if you go out to 2021, you may be lucky and get 2019 earnings after 12 months of looking for a vaccine. The current stock market is way out over its skis. We will be ready when this market fairly prices the lack of transparency that exists, but until then we will trade this market in order to generate alpha returns.
Our job is not to speculate, but rather to use our skills to identify miss-priced investment opportunities and quantify their systematic risk. For the reasons discussed in this letter, the fund is moving cautiously and has added some strategic hedges in case of a pullback. As always, we are here for you if you would like to talk.
We thank you for your confidence and capital,
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