2022 February CAD

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1.02% MTD

2.17% YTD

What goes up must come down

Dear Partners,

In February, the Caravel CAD fund was up 1.02%, bringing the total net return for 2022 to 2.17%.

February’s selloff resulted from the atrocities being committed against Ukraine more than the deflating of 2021’s exuberance. We, therefore, prefer to keep our review of February’s performance succinct.

• The fund generated gains in the Canadian oil producers we own and have discussed in past letters.
• We exited 2 of the names, and the last one we sold 1/3rd of the position late in February, 100% above our purchase price in July.
• We protected the gains in our bank exposure by selling our deep-in-the-money call options and purchasing much cheaper options out-of-the-money.
• We generated profits in our short Nasdaq Index trade, which is hedged against holding select more affordable large-cap tech companies.
• We also profited from holding call spread exposure to Uranium producers as Russia’s aggression will lead to a fuel shortage.
• Finally, the merger arbitrage and convertible arbitrage investments generated returns above the 15% net annualized return threshold we target for the fund.

Rising Cost of Goods and Increasing Cost of Money

The two factors directly affecting equity values that keep us awake these days are the rising cost of goods and services and, relatedly, the increasing cost of money. For the twenty months following the start of the pandemic, inflation was driven by supply chain problems. Although those will likely persist to some degree, our inflation concern now is the future energy supply-driven price shock. The second factor that raises concerns is the rising cost of money set by the central banks, which has been telegraphed ad nauseam for the past eight months to a deaf investor base. The consequence of both these factors is playing out in global equity returns so far this year. For reasons we can’t explain, a large cohort of investors believe the “buy the dip “approach will work again this time. This group is not just amateur investors with a Robinhood account; they include delusional Cathy Wood disciples whose institutional mandates appear to be to buy at any price. These groups are often endorsed by the cable business programs with no fundamental understanding of securities valuation. Eventually, their wealth will disappear like a Russian Oligarch’s.

"My formula for success? Rise early, work late, strike oil." - John Paul Getty

Putin’s autocratic act of war will have long-lasting consequences on the developed world, resulting in significantly higher energy prices (hydrocarbons, battery components, and nuclear). We expect prices to rise above previous all-time highs. We want to be clear; this is a supply issue. We don’t believe this energy crisis will see demand/supply start to rebalance until a barrel of oil exceeds $150. We think it is impossible to supplant the 5 million barrels a day of Russian exported crude production for at least 12 to 18 months. Remember – the massive sovereign wealth funds and ESG committed funds can’t provide capital to fossil fuel production. The lack of capital makes it difficult to just maintain global production. If Mr. Putin halts or significantly reduces the Russian crude he exports combined with the current oil embargoes from US, UK, Canada, Australia, etc., $150+ oil is likely a reality. At the time of writing, oil is at $110. It’s easier and wiser to stockpile energy in these uncertain environments, so prices will likely continue to rise.

It’s important to mention the fund purchased put options on crude that serve as a hedge on our oil exposed equity portfolio. Why did we do this, given our views on the direction of the commodity? We have a whiteboard in the office with lessons learned that we reference regularly. Lesson 1: When someone hands you a cheque for a million dollars, say thanks and cash it. That is what the puts effectively enable us to do. We don’t stand around patting ourselves on the back when we are handed an unexpected win due to a black swan geopolitical event. If the price of oil were to stay above the put options strike price, our holdings would generate ~$35 of free cash flow for every $100 of stock we hold, a true win-win.

"When I hear complaints about less liquidity, remember there is such a thing as too much liquidity." - Paul A. Volcker

We believe stock prices will remain under pressure in 2022. Interest rates MUST come up to levels in line with inflation or higher. Stock prices go lower when we combine higher interest rates, the soaring cost of goods and services, and the current geopolitical theatre. As for the Caravel Capital Fund, we love our portfolio and believe The Fund’s performance speaks for itself. We hope the world finds a brilliant solution to its current woes, but we are prepared if it doesn’t.

If you would like to discuss anything or simply want to say hi, we love catching up with our partners any time.

We thank you for your continued Confidence and Capital,
Jeff and Glen