2021 December CAD

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1.20% MTD

30.78% YTD

What Governments Want, Governments Get

Dear Partners,

For the month of December, the Caravel CAD fund was up 1.20%, bringing the total net return for 2021 to 30.78%.

We hope to establish some credibility before getting into our 2022 outlook by reflecting on our December 2020 letter. After outpacing the major indices on an absolute and risk-adjusted basis, we like to think it wasn’t all luck. In the December 2020 letter, we stated that the market was expensive and that any material returns in 2021 would likely be driven by a continuation of the substantial stimulus major economies received in 2020. That turned out to be true thanks to the G7 governments spending like drunken sailors.

We also told you about some investments we took with us into 2021.

The Oil Trade

 “The oil call position has a 10:1 payoff if oil trades above $60. Since entering this trade, oil has risen from $38 to $53 per barrel. Stay tuned!”

How did we do? We sold the option position as oil moved up between $55 and $70 and sold the remaining portfolio of oil stocks up 50%-150%. Our approach is to always sell on the way up. This leaves something on the table for the next buyer as we believe pigs get slaughtered. After selling our initial oil trade, we bought two new oil names. Both are extraordinarily well-run and fundamentally cheap, and we still hold them as we write this. One is up 32% and has paid us an additional 15% in tax-free capital distributions to make it a ~50% return so far. The other name is also up ~50%, and management is closing in on a game-changing acquisition. We expect both to provide solid returns in 2022.

The Economy

“The cash that has built up in checking accounts, the restocking of store inventories, and the pent-up demand to consume soft and hard goods equates to a 7-15% increase in the developed world’s 2020 GDP. It’s a perfect setup for a very hot economy in late 2021.” 

The economy was hot all year, so we weren’t exactly right there. Let’s read on.

“Higher interest rates lead to a steeper discounting of far-in-the future cash flows. Think downside on Zoom, Tesla, Shopify, etc. We believe valuation multiples will drop for growth names as their share prices fall or stay the same, and valuations will rise for traditional names as corporate earnings massively rebound later this year into a hot economy.”

Elevated values persisted through 2021 for most of these names. Central Bank balance sheets didn’t shrink, and material monetary tightening didn’t occur. We see signs of both in 2022. That said, if you owned the bottom 80 stocks by market capitalization of the NASDAQ 100 Index, it was a brutal year. Spoiler alert: this isn’t over, and we believe Big Tech is next. But we will get to that soon enough.

The Opportunity Landscape

“We see incredible opportunities this year in the markets for Caravel’s investors.”  

A 30% 12-month return is about double what we target for our investors in an average year, and we believe that qualifies as our “incredible opportunities” call. So, our 2021 outlook would appear to carry some weight.

Now we’d like to share some of our thoughts for 2022. They are connected by a common theme:

What Governments Want, Governments Get

The Reddit Train Runs Out of Steam

News flash for the meme stock home gamers – the final buzzer sounded, the score is 8-1, and you lost. Cheap money from the federal government is gone. Without the free lunch money from Ottawa, Washington, or the EU, the meme stock traders are just a bunch of speculators with nobody to refill their wallets when they bet on red, and the wheel comes up black.

We further expect that this is the year tech hits the deck (this prediction looked better when we first drafted this letter on January 3rd). We’ve mentioned what rising rates do to these names. The high-flyer IPO window has all but closed after the 2021 IPOs’ performances. Caravel has a long/short basket of tech names in which we are long, relatively inexpensive bellwethers and short names with the best possible scenario ever priced into their shares. We usually hold these kinds of positions for downside insurance, but we expect them to be a source of outperformance this year. We know we can be wrong, and things always take longer to play out than you think. Because we know this, we always hedge our bets.

As for crypto, we prefer not to make any prognostication as the rate of commercial adoption will drive the value of certain coins. We expect the speculators to be selling meme coins like DOGE (at a massive loss) for their bus fare.

If You Can’t Beat the Fed, Join Them… In the Banks.  

Think about how much money banks make on deposits when overnight rates are 0%. Hint - nothing. The first 100 basis points of overnight interest rate hikes are free money to the banks. All the money in your checking and savings accounts earn zero, while the (commercial) banks roll it into overnight loans with the (central) banks and boom–free money. In addition, these companies have been held back by governments from returning any of their excess capital to shareholders for years, fearing they would hemorrhage with credit losses. Government stimulus checks all but eliminated bad loans. The banks are trading well below market multiples, right when the government is unshackling them. They will buy back massive amounts of stock in the billions of dollars, increase their dividends, and their earnings will rise as their biggest driver (Net Interest Margin) picks up 50-100 basis points. We own this exposure through call options to mitigate the downside of a market correction and because the call options are so cheap due to the banks’ low volatility.

Green is the Color of Money

Find the cyclical stocks connected to the green transition and supported by environmentalist government policy: nuclear, electricity storage, and everything clean energy. There are billions and billions of dollars of sovereign funds with a new mandate to find and invest in environmentally friendly industries. The adoption of a new global energy source requires enormous capital commitments to facilitate this kind of paradigm shift. We see this as a massive M&A and consolidation opportunity, and we intend to be there in advance. Watch for new technology that accelerates the adoption timeline, as well. This strategy has long legs.

To the above, we would add one caveat – oil is in transition. The silver lining here (for our partners) is that big money won’t fund big oil projects anymore. But we are still 10-15 years away from green air travel and intercontinental ocean freight. Less capital flows mean cheaper equities, which means better future return potential, hence the win for our partners. Find oil companies with exceptional management and commitments to return capital, and you will be handsomely rewarded.

What Governments Want, Governments Get – this works for punishment, too.

Mega cap tech could face restrictions, fines, and, if investors are lucky, breakups just like Mabell (ATT) in the ’80s or the seven sisters of Standard Oil in the ’30s, unleashing a tsunami of hidden value, or possibly the kill shot for the ones at lofty valuations. We likely won’t do anything here, but G7 governments are tired of tech companies playing Master of Information with little accountability. We will watch from the sidelines and deploy capital only if we see an appropriate use for it.

In Closing

The partners reinvested all their performance fees from the 4th quarter. As is our policy, we also report that Jeff redeemed $500K of his units to pay for the build of his house. If you would like to discuss anything further or just chat, we are happy to talk to our partners at any time.

We thank you for your continued confidence and capital,

Jeff and Glen