2023 April CAD

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-0.07% MTD

-4.50% YTD

Mr. Market goes for a checkup

Dear Partners,

For the Month of April, the Caravel Capital Fund returned -0.07%.

When we buy a car, a house, or something of significant value, we like to look closely at what we are getting. A closer look than, say, we’d give to purchasing a cup of coffee or a pen. We know the big decisions will affect us for some time and require a considerable allocation of our financial resources, so the examination process is time well spent. When buying a car, we take time to read reviews from independent sources, experience the performance with a test drive, and ensure the price reflects its value. Similarly, when purchasing a home, we hire an inspector to assess the quality of the build and the materials used and enlist an appraiser to give a fair market value opinion of the property. When we choose investments for the Caravel Capital Fund, we rely on these same instincts in conjunction with thorough assessments to realize how much risk Mr. Market is willing to accept in exchange for a return on investment in North American equities.

All the assets we examine are domiciled in the same or similar countries (i.e., G-7), and those countries’ economies are all reasonably fair, balanced, and well-functioning. Within that universe, we don’t dispute the axiom that a diversified portfolio of high-quality equity investments offers the holder better returns over the long term versus holding cash or sovereign bonds. What can be debated are the risks those returns carry in the short-term.

Holding Cash

Holding cash will always offer the most conservative risk profile. As a result, the prospective returns of all opportunities are measured against cash in terms of risk. If cash offers better long-term returns over equities or long-term bonds, capital flees the investment arena in favour of cash. For a sacrifice in return, cash provides the lowest risk profile. If you left 100 dollars in a bank (given current issues, let’s assume a well-run, AAA-rated federally-backed institution), the balance would most likely be about $102.50 in one year (after tax). However, there is no certainty of your reinvestment opportunity in one year. If the past ten years of history and central banks’ current rhetoric are your reference point (think consumer reports for your car purchase), the prospective returns on cash won’t be higher in twelve months than they are now. However, it’s important to note you will have not less than 102.5 in 3 to 5 years. That is certain—no risk to that fact.

Holding Sovereign Bonds

Purchasing a portfolio of sovereign bonds today (government-backed) will yield a return of about 3-4% per annum over the medium to long term (5-15 years) with near certainty. Five-to-ten-year bonds are currently paying 3.50%-3.75%. So, a bond portfolio with a ladder of maturities and reinvesting the maturing principal each year into long-dated maturities will earn $2 per year on a $100 investment after tax. The advantage over cash is you would have some certainty of that return over a 10-year horizon. The risk? 

Consider 2022’s returns for US treasuries ranging from -10% to -40% (ouch). 2022 was a natural reset in bond prices following thirteen years of Quantitative Easing by central banks, which kept yields artificially low and, therefore, prices artificially high. For the first time in over a decade in 2022, Mr. Market determined where long-dated bond values should be. The point is that seeking a return beyond cash can yield cataclysmic results. It’s like finding out the electric car you love so much tends to catch fire after driving 20,000 miles. If we want to make any argument in favor of a long-term fixed-income portfolio, we must extend the investment window to as far back as 30 years to the early 90s, a period that saw interest rates decline from 10% to zero. As for risk, in 2022, bond portfolios gave back 50% or more of the return they had generated over the previous twelve years. Since inflation averaged about 1.5% during this time, you actually lost purchasing power if you invested in bonds from 2010 to 2023. I think we just discovered the Ford Pinto or the Chevy Corvair of investments.

Holding Equities

If we go further and look at a portfolio of equity securities, we see something very different. The pre-tax return profile from 2010 to 2023 is in the high single-to-low double digits, depending on your market of choice. One significant benefit of holding stocks is the tax treatment of the investment. Equities are capital property. The increase in value is capital gain and is typically taxed at half the rate of income or less. Therefore, returns on equity assets are near 8-9% after tax. How can they be so much higher than bonds and cash? Are they just that much better? What about the risk to capital? Is this where the rubber hits the road? If you invested in the S&P 500 in 1993 and held without selling anything, the portfolio’s value would have dropped over 50% once, more than 30% three times, and 20% or more five times over those 30 years. Despite that volatility, your annualized return would have been about 6% after taxes. Why is the return almost 50% higher from 2010 to 2023? 

Because like a shiny car or a stylish new house, these investments appear attractive at first glance. But just like after a house inspection that finds mold and rot, a closer look at equity values shows US equities will likely underperform long-term historical returns until the long term gets back to 6% after tax. Current valuations for the Nasdaq and SP500 using the underlying companies’ next 12 months’ forecast earnings and EBITDA calculations were significantly elevated relative to historical instances when cash earned 5% and bonds earned 3.5%. 

Investors are not anticipating better results from their constituent companies; they depend on earnings that exceed expected results. Yet when we listen to central bankers talk, they are adamant interest rates will remain elevated until inflationary pressures (wages and labor supply, among other things) weaken. After 2022, we know who holds the most power. The first lesson of professional investing: Never fight the Fed.

So how do equities really look right now? Mr. Market, it's time for a check-up.

If we look at the performance of the Nasdaq this year, we see it is up almost 30%, the SP500 is up nearly 10%, and the Dow is unchanged. Let’s use some of the tools above to see how these markets perform on a test drive. After leaving the lot, the performance of these same indexes from the beginning of 2022 until today is worse than the Chevy Volt: the Nasdaq is actually still down -14%, the SP500 is -10%, and the Dow is -5% on a total return basis (includes all dividends). So, to summarize, we know equity markets offer the best long-term returns, but they also possess the highest risk. Mr. Market has pushed stock prices up 10-30% at a time when lower-risk assets (bonds and cash) are offering some of the most attractive returns in 15-20 years. The fundamentals (earnings and cash flow) supporting the year-to-date equity returns continue to break down. Earnings expectations for the next 12 months have dropped 14% over the past 12 months at a time when valuations should be coming down in acknowledgment of higher returns offered by less risky assets. If this isn’t enough, Mr. Market is still being challenged by Central Bankers who continue to scream, “I’m not done yet!”.

We are not trying to justify or obfuscate our performance by penning these sentiments in our letter. Instead, we are trying to put it into a context that an 18-29-year-old could appreciate (first home or car). The principal reason behind writing a letter every month to our investors is so they understand what we see and how these observations impact our decisions. We want nothing more than to make money. 

One of the mantras we repeat regularly is, “We only accept measured risks to limit our losses.” Our job is not to generate market returns while incurring market risk. Vanguard offers that for free with their index funds. In my 34 years of investing, I have lived through 3 major market resets: 1990-1992, 2001-2003, and 2008-2010. All were more frustrating than this year’s NHL playoffs (speaking as a Canadian).

It feels like we are somewhere between the 5th and 7th inning of this reset as I type, and Mr. Market is not willing to accept the reality of a reset quite yet. Simply put, we believe 1 of 3 things need to happen:
1)Earnings have to rise
2) Risk-free rates have to drop
or
3) Stock prices come down.
If you’re considering taking the NSADAQ for a test drive, you should fasten your seatbelts for a bumpy ride. If you’re considering making an offer on SP500 Index stocks, your first offer should be 8% below the current ask.

We thank you for your confidence and capital,

Jeff and Glen