The Caravel Capital Fund was up +1.15% for January.
We reached these returns utilizing strategies we have highlighted in our past letters. Merger Arbitrage, Call Options we hold in the Canadian banks (more on that later), the oil company we continue to hold, which rose 25% in the month and paid a 5% capital distribution, and the Convertible Arbitrage strategies all generated material profits. Those strategies that did not perform well for the month immaterially impacted the fund’s overall performance because we tend to own our risk tails (i.e., try to protect our returns if we are wrong). We continue to focus the partners’ capital on strategies that benefit in an environment experiencing rising interest rates. We recognized the increasing pricing pressure on goods and services in August of last year and examined the impact the coming battle to tame this pressure would have on different sectors.
The most straightforward opportunity was in the bank stocks. We all know too well that banks pay nothing on deposits. The issue over the past two years has been that they had little opportunity to invest this free money profitably. Short-term money paid nothing - literally 0.00%. Imagine the money a bank finds every morning when they get 100 or even 200 basis points on the free deposits they held- we are talking billions and billions in new free cash flow every year.
Our expectation for rising rates in past letters has been well telegraphed. In the past 12 months, 10-year bond yields have jumped 100% from 1.00% to 2.00%. Get ready for another 50% increase or more from here. We feel that 3% 10-year money is needed at a minimum because overnight money will approach 2% or higher. “Really?” you might say. Ask yourself if you will divert your consumption of goods and services into savings because a three-month investment will yield 2% annually? Or if you would curtail your business investment if your 1-year borrowing costs went from 3% to 4%? We didn’t think so.
Back in September, we accepted this as fact and bought bank call options whose underlying equities (if we exercised our right to own the shares) would have equated to a 10-12% weighting in the fund. This conservative-capital-at-risk approach has rewarded the partners with 3.00% of net return while total capital at risk has never exceeded 1%. This was partially accomplished by continually selling the options as they got deeper in the money and replacing them with less expensive out-of-the-money options. This approach not only locked in our returns but reduced the risk capital materially by taking profits off the table. At the time of writing, we continue to hold the same strategy.
We will expand on the other strategies in the coming letters as we all look back in awe and ask ourselves how interest rates got here? It is essential to accept this fact - for the past 35 years (since 1986, the year Jeff got into this business), Central banks have only raised rates to slow down an overheated economy and NEVER to attack inflation.
Other than the guys who are ten years Jeff’s senior, no one has seen how hard it is to arrest inflation once you get wage-push pricing. Do we have wage-push inflation? Let’s see; input prices are rising by 7-9% according to this week’s CPI (Consumer Price Index) and PPI (Producer Price Index). Every company we listen to says they are having trouble attracting new people.
The largest employers globally, both private sector (Walmart, McDonalds, Amazon, etc.) and public sector (Municipal and Federal Governments), have raised the minimum wage 30-50% in the past twenty months. In the past week, both Starbucks and Heineken publicly stated they have no more room to accept higher input costs, so they are passing the increase on to customers. If you know how to stop this kind of input price pressure other than raising the cost of funds, the Nobel Prize in Economics is yours for the taking. Sorry for the buzzkill.
The partners again reinvested all their performance fees from the 4th quarter; there were no redemptions this month. If you would like to discuss anything further or say hi, we are happy to talk to our partners any time.
We thank you for your continued Confidence and Capital,
Jeff and Glen.
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