Lions Bay 2024 Year End Commentary: Reflecting on Volatility, Preparing for Growth

Section 1: Performance Review

For the fourth quarter of 2024, the Lions Bay Fund returned -1.83%, resulting in a +1.20% return for the full year of 2024.  Our results for the year are disappointing on both an absolute basis and relative basis, falling meaningfully short of the standard of performance we hold ourselves to.  Despite our recent stretch of underperformance, Lions Bay still commands a strong track record of generating returns for unitholders, with an annualized return of 17.03% since inception.  Most importantly, these returns were generated with a 0.30 correlation to the S&P 500, and 45.31% lower volatility than the S&P 500.

We are proud to share that this long-term track record won recognition at the Canadian Hedge Fund Awards this year.  In its first year of eligibility for awards over a 5-year time frame, Lions Bay earned first place for Best 5-Year Sharpe Ratio (a measure of risk adjusted returns), and second place for Best 5 Year Return. 

We want to assure our readers that the investment strategies that built our long-term track record have not been compromised by some change in market structure or in the Fund’s ability to execute our process.  Simply put, 2024 presented a perfect storm of headwinds for our strategy: an incredibly narrow market where high multiple mega cap growth stocks dominated the index returns, the absence of any market sell-off of meaningful magnitude or duration, and an absence of attractive active trading opportunities. 

There is a saying in our industry: “If you want your portfolio to beat the market, build a portfolio that doesn’t look like the market.”  This wisdom failed to hold true this year, and while our aversion to crowded trades and momentum has served us well over our career, it certainly did not this past year.  All year long, what worked were the same ones that had been successful in the recent past: crowded trades became more crowded as the largest and most widely held securities were the best performing for the year. 

We resolutely believe that the challenges of 2024 have made us better investors, and we are confident that we will return to the standard of performance our clients expect.  We have not sat passively through this period of disappointing performance. Instead, we have taken valuable lessons from the experience and have fine-tuned our processes, particularly within the hedging portfolio, which we will expand upon in section 4.  We are happy to report that these adjustments have helped contribute to a promising start to 2025 for the Fund, and we are enthusiastic about the money-making opportunities we see ahead of us this year.

Section 2: Review of the Fourth Quarter

The fourth quarter of 2024 proved to be a challenging one for the Fund, as we experienced a return to the market dynamics that dogged us in the first half of the year.  We observed an encouraging market shift in early July, with value stocks and smaller cap companies catching up to the mega-cap growth stocks that dominated the first half of the year.  While we were rewarded for this positioning in the third quarter, we saw a sharp reversal of this trend into year-end, with many of our core holdings having a challenging finish to the year.  We believe the way many of these stocks closed the year positioned them for considerable upside in 2025. We capitalized on the late-year weakness to meaningfully increase our position in several of our long-held investments.

The best way to represent the challenges that Lions Bay faced this year is to compare the performance of the equal-weight index to the market cap weighted S&P 500, as it reflects how idiosyncratic risk performs relative to the broader market which is uniquely dominated by a small number of very large companies, a phenomenon we wrote about extensively in our Q2 commentary.

1 YEAR COMPARATIVE PERFORMANCE OF S&P 500 VS. EQUAL WEIGHT INDEX

Source: Bloomberg.

As the chart above shows, after dramatically underperforming the S&P 500 for the first half of the year, the equal-weight index began to catch up meaningfully in early July.  The Fund was positioned for this rotation, and as our conviction increased following the outcome of the U.S. Presidential election in November, we continued to allocate capital to investments that would benefit from this trend continuing.  Frustratingly, this trend reversed sharply in early December as investors were content to continue to chase crowded winners into year-end, with the equal weight index declining by 6.6% in the final month of the year relative to the S&P declining by 2.5%.

While it is early days, 2025 has thus far proven to be a more favourable environment for us, and we are witnessing a broader market rally to start the year along with a number of compelling opportunities for our active trading portfolio.

Section 3: 2025 Outlook and Positioning in Core Portfolio

We are not positioned for a broadening out of the market, as the mega-cap growth names that drove the S&P 500 in 2024 remain incredibly crowded and expensive – and they can stay in that condition for a long time.  We believe that attractively-valued idiosyncratic businesses are poised to outperform this year, supported by evidence of a resumption in economic growth in the U.S., and a meaningful rebound in CEO confidence and small business optimism. 

As the economic recovery broadens out, the Magnificent 7 are no longer the only game in town.  As the chart below shows, the rest of the market is catching up in earnings growth, with quarterly earnings for the S&P 500 ex-Mag 7 inflecting upwards in Q4 2024 and posting double digit growth throughout the year ahead. 

AS MAG 7 EARNINGS GROWTH DECELERATES IN 2025, THE REST OF THE MARKET CATCHES UP

Note: Numbers are forecasts based on consensus analyst expectations. Data are as of November 15th, 2024. Mag 7 includes AAPL, AMZN, GOOG, GOOGL, META, MSFT, NVDA and TSLA. Earnings estimates for 2024 are forecasts based on consensus analyst expectations.
Source: FactSet, J.P.Morgan Asset Management.

As you can see in the chart below, optimism about business conditions for small businesses has spiked to the highest level in five years.  

National Federation of Independent Businesses (NFIB) Small Business Optimism Index

Source: Bloomberg.

Increased confidence in business conditions, a more favourable tax and regulatory environment under the new administration, and clarity on interest rates should all lead to an increasing willingness by CEOs to make meaningful capex investment decisions, as well as to pursue mergers and acquisitions.  Recent comments we’ve heard from executives since the election certainly reflect this theme.

“My prediction is, other than 2021, which was an aberrational year, this could easily be the best M&A year we’ve had in, say, 10 years.” – Paul Taubman, PJT Partners

“M&A Pipelines are the highest they’ve been in 7 years” – Ted Pick, Morgan Stanley

“America is open for business again. The endless amount of regulatory and litigation induced paralysis is over. So when I’m with a group of American executives, whether it’s from telecommunications, the consumer space, whether they voted for Trump or for Harris, from the perspective of building their business, they are smiling from ear to ear.” – Ken Griffin, Citadel

“We’re stepping into the most pro-business, pro-growth, pro American administration perhaps seen in my adult lifetime.” – Bill Ackman, Pershing Square

The two charts below show how as a percentage of GDP, capital markets liquidity and M&A volume are set to inflect upwards from considerably low levels.

2025 OUTLOOK: INCREASED M&A ACTIVITY

Note: Data as at October 31, 2024.
Source: Preqin, Bank of America, Bloomberg, KKR Global Macro & Asset Allocation analysis.

We have added new investments to our Core Portfolio, as well as to our Active Trading portfolio, to specifically benefit from an upcoming resurgence in M&A.  While we continue to own Houlihan Lokey, which we admire for its defensive characteristics as well as its exposure to small and mid-cap M&A, we have added asset managers Brookfield Corp. (BN US) and Blue Owl Capital (OWL US).  Many of our readers will be familiar with Brookfield Corp. as it is a Canadian capital markets champion and a business we owned for many years before the pandemic.  Their business will continue to benefit from the secular tailwinds of increasing capital being allocated to alternative asset managers. Additionally, we expect them to have significant cyclical tailwinds of increased monetization activity and higher economic growth.

Blue Owl may be less familiar, as the company has only been public for four years.  As an alternative asset manager with its roots in direct lending, it has expanded its capabilities across various lending verticals including corporate, asset backed, liquid, real estate debt, as well as a thriving business in GP Secondaries and a recent entry into insurance.  Despite having industry leading operating margins, in the high 50s, and industry leading average management fees, at over 140 basis points, shares still trade at a discount to their peer group, trading at 23x 2026 estimated earnings vs the average of 25x.  The stock pays a 3% dividend yield, maintains a conservative balance sheet, and has a strong track record of returning capital to shareholders. 

LONG IDEA: BLUE OWL CAPITAL (OWL)

Source: Bloomberg, Wealhouse Capital.

A significant portion of our core investment portfolio continues to be committed to securities which will benefit from a resumption in luxury goods spending. Ferrari (RACE) and LVMH Moet Hennesey (LVMUY US) continue to be amongst our top 5 holdings.   We believe that fears of a slowdown in Chinese spending are well understood by investors, and that following four consecutive quarters of negative comps for luxury goods spending, we feel that investor expectations are too pessimistic on the prospect of a rebound.  We saw evidence of this on January 16th following the release of Richemont sales, which soared 10% in Q4, exceeding expectations of less than a 1% increase.  While these results were driven by jewelry sales specifically, the double-digit share price rally enjoyed by the entire sector speaks to how one-sided positioning was entering the year.  

Section 4: Hedging Portfolio Outlook

We are always looking to optimizing our processes and adapt to evolving market conditions.  Our hedging strategy has always been designed to benefit from equity market dislocation that is meaningful in both magnitude and duration.  While this helped tremendously in years like 2020 and 2022, it was a big drag on returns in 2024.

We generally do not take profits on hedging gains earned from a sharp and short-lived sell-off, in fact the reason our hedging strategy was so profitable in 2022 was that we often allow our notional short exposure to increase on the first leg down in a sell-off.  Without getting overly technical, during the first leg-down in a market move, we will roll down and upsize our hedges, to best protect our portfolio from a 2-3% decline turning into a 6-10% decline.  In a rolling bear market, this strategy does a marvelous job of not just protecting from market declines but indeed allowing us to profit from these events. 

In 2024, while we had several bouts of turbulent price action, we experienced violent snap-backs in each and every case.  At no point this year did the market go more than six weeks without making a new all-time high.  This means that by allowing our notional short exposure to increase on the first 3-4% pullback, we gave all these gains back in short order.

We believe there are several factors at play that have changed the nature of these pullbacks, and we have adapted our strategy to account for them going forward. 

One of the factors is the presence of large institutional sellers of volatility on a 1-day basis – the 0DTE phenomenon.  These investors are stepping in daily to contain or “collar” large sell offs and rallies by writing massive amounts of one day expiry S&P 500 options, including both puts and calls.  While volatility remains untethered on a close-to-open basis, it has been greatly suppressed on an intra-day basis.  The fact that these players survived the vol explosion of early August says to us that they have real staying power as a market force, and we need to be thoughtful about their impact on our hedging practices. 

Another real factor has been the explosion in the assets under management of ‘pod shops’ or multi-manager Funds and the strict stop-loss limits they utilize.  Millenium Management is one of the largest and most successful hedge funds that uses this model, with assets under management of over $70 billion.  It has been reported that their ‘pods’ have hard stop loss risk controls that will result in portfolios being liquidated at a 3% decline.   This results in sell-offs being vicious, yet brief and ultimately shallow, which is conducive to equally vicious snap-back rallies. 

Respecting both of these factors has led us to adapt our process and be much more active in monetizing and rolling our portfolio hedges.  We can still protect our portfolio from drawdowns but our approach has evolved.  Instead of implementing hedges that will profit from a 5 or 10% market decline, we are buying hedges that are closer to the money, and aggressively rolling them out in time during sell-offs. This allows us to realize some hedging profits, extend our portfolio protection out in the calendar, and reduce the risk of seeing these gains evaporate on a snap-back rally. 

Another trading strategy we are employing this year is utilizing more ‘delta one’ trades when our hedging book shows a profit.  In the past, we would often roll some of our hedging gains into call options to get upside exposure to a volatile rally.  In snap-back rallies where volatility collapses rapidly, buying delta-one exposure takes volatility out of the equation, and we believe this is better suited to the current market dynamic. 

Lastly, we are being guided by the lessons we learned under the previous Trump administration, which is that price action in response to political headlines needs to be monetized quickly.  Trump’s negotiating style makes for dramatic headlines and violent price reactions, but his opening salvo tends to be the most aggressive, which supports the case for taking profits quickly on trading gains. 

One recent example from the Active Trading portfolio is International Seaways (INSW US), an oil tanker stock we owned coming out of the pandemic that we bought in late December for $36.74.  A deep value stock and tax-loss selling victim that was added to the portfolio to add some protection against the risk of a resurgence inflation. INSW surged early in January on Trump’s threat to take military action against the Panama Canal.  We were happy to quickly ring the register on that trade when the market began to price in the reality of such a threat, rather than wait around to see if it materialized.

We remain extremely optimistic about the money-making prospects in the year ahead.  We see a pro-growth economic backdrop that will benefit our core portfolio balanced against a geopolitical landscape conducive to bouts of volatility which should lead to profitable opportunities for our active trading and hedging portfolio.  This backdrop should lead to tailwinds for each of our distinct strategies, in sharp contrast to the challenges we dealt with last calendar year. 

Disclaimer

This Commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Wealhouse has no duty or obligation to update the information contained herein. This Commentary is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Wealhouse believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

Lions Bay

Lions Bay is an equity fund designed to prosper in a volatile market. Our goal is to protect and participate. We protect the downside through active trading and disciplined hedging, while a core portfolio of long-term investments in outstanding businesses allows us to participate in rising markets. Outperforming during market sell-offs positions us to take advantage of asset mispricings when they are most attractive. Our fund is comprised of three cyclically balanced strategies, that can each thrive in different market environments.

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