Lions Bay Fund Q1 2024 Commentary: Steadfast Approach to Market Euphoria
For the first quarter of 2024, the Lions Bay Fund returned +0.64%. The S&P 500 has enjoyed a very strong start to the year and was up +10.55% for Q1. Over the past five years, Lions Bay has generated an annualized return of +22.67%, relative to the S&P 500 at +15.02%.
Quarters like this are a reminder that uncorrelated returns, unfortunately, work both ways, as the defensive and hedged nature of our strategy underperformed the market in a quarter characterized by high complacency and low volatility. As volatility returned to markets early in the second quarter, our strategy performed as designed, and the Fund has stayed positive MTD despite a meaningful pullback that at one point saw the S&P down over 5% on the month.
In this commentary, we will review how each of our three strategies performed during the quarter and our outlook for each. We are skeptical that the tranquility the market has enjoyed for the past two quarters can continue, and firmly believe we are entering a period in the market where investors will be rewarded for investing in a strategy that generates uncorrelated returns.
Our hedging portfolio faced substantial headwinds last quarter as the market continued to experience an unabated rally off the late October lows, with no meaningful pullbacks. As the chart below shows, the rally off the lows was 28.4%, yet never had a pullback of more than 2%.
UNABATED RALLY OFF LOWS CHALLENGING FOR HEDGING PORTFOLIO TRADING STYLE
Note: S&P 500 October 27th 2023 – March 29th 2024
Our hedging strategy is not designed to protect against 1.9% pullbacks. We do not take profits on our hedges on such a shallow pullback, because we are always concerned about a 2% pullback turning into a 5, 10 or 15% drawdown. Our aim is to protect our clients from meaningful drawdowns, which served us well in September and October last year, for the entirety of 2022, and for the past three weeks.
Our core portfolio was also challenged last quarter, as some of our largest holdings underperformed the market. Most notable was Zoetis, an animal health company and a long held core name within Lions Bay. We believe the recent share price weakness is an opportunity, and it is for opportunities such as this that we always carry a large cash balance. We’ve increased our investment in the company to over 3% of our portfolio.
Our transactional portfolio was a bright spot during the quarter and has continued to be a source of alpha into Q2. We describe our transactional or active trading portfolio as the area of the Fund in which we can take short term positions in businesses which don’t meet the rigid criteria we have for our Core Portfolio. Historically, these have been catalyst driven situations or cyclical companies where we express a macro view.
We have been getting increasingly interested in cyclical companies which we believe will benefit if the Fed’s “pivot” turns out to be premature and inflation proves stickier than market participants were anticipating at the start of 2024. Copper specifically was interesting to us as a derivative play on demand for AI, as the massive investment in data centres needed to meet the insatiable demand for computing power. This demand meets a copper market that is already facing a favourable supply/demand imbalance.
When trading in cyclical businesses, our philosophy is to diversify as much as possible to avoid exploration & production risk and maximize liquidity. These are trades, not investments, and we want to have the ability to change our minds rapidly. As Canadians, we have too often seen investors suffer from the illiquidity of small cap cyclical stocks.
We choose to take a basket approach, using ETFs where possible, or several highly liquid stocks with leverage to our underlying theme. One of the ways we structured our view on the copper market was through call options on COMEX futures for copper out to July. We traded these extremely actively to get our cost base low as the price of the commodity rallied, creating a ‘free option’. The chart below shows the actions we took as copper rallied and is a case study in the value that can be added by the transactional bucket of the Lions Bay Fund.
TRANSACTIONAL PORTFOLIO: COPPER OPTIONS GAINS
Notes: *Chart data as of April 25, close. ** All numbers are estimates. *** Values are from closed positions.
Looking into Q2 and beyond, we are thrilled to see the departure of the “goldilocks” narrative in the market over the past few weeks. We couldn’t reconcile a world with sub 4% unemployment and multiple rate cuts yet stable inflation. We believe the fight against inflation is going to be choppy and volatile, and we expect the same to play out in financial markets. This will be a great opportunity for the Lions Bay Fund. When you add in an election year with some actors who have proven to be historically unpredictable and volatile, we suspect the tranquility of Q1 will be a distant memory when we sit down to write our Q2 and Q3 comments.
