Lions Bay Fund Q3 2023: Adapting to Market Challenges
Senior Portfolio Manager, Justin Anis, explores Lions Bay’s success, its 5-year milestone, and the strategic approach to investments. Additionally, the Q3 commentary delves into the fund’s focus on consumer staples, active trading, and hedging strategies, providing valuable insights into how it continues to navigate evolving market conditions.
Performance Review
For the third quarter of 2023, the Lions Bay Fund appreciated +3.69% while the S&P 500 declined by 3.27%. This brings our year-to-date performance to +7.36% relative to the S&P 500 +13.05%.
The Lions Bay Fund marked an important milestone this quarter, as we celebrated our 5-year anniversary in August. Since our inception in August of 2018, Lions Bay has generated an annualized return of 21.47% compared to 10.24% for the S&P 500.
We are pleased with the returns we have generated on an absolute basis, but we’re particularly proud of the low level of volatility that accompanied them. Over the same period, Lions Bay had a correlation of just 0.36 to the S&P 500 with 45% lower volatility.
We would also like to mention that the Lions Bay Fund was recognized this week at the Canadian Hedge Fund Awards, where we won second place in the category of “Best 3-Year Sharpe Ratio”. The Sharpe ratio is a measure that aims to quantify investment returns relative to how volatile those returns are. This is our second consecutive year to win an award in this category, after placing first last year.
We sincerely thank all our unitholders for their trust over the past five years, as well as the phenomenal team at Wealhouse Capital Management, without whom none of this would be possible.
Core Portfolio Update – Boring is Beautiful
We have never been so excited about such a boring area of the market: consumer staples and “defensive” stocks. A perfect storm of factors has created what we believe to be some exceptional long-term investment opportunities. We have meaningfully increased our investment in McDonalds, and made new investments in Campbells Soup and spice and seasoning company, McCormick & Co.
The first factor is that slower growth “defensive” stocks like staples and utilities tend to trade inverse to bond yields, as they are often seen as bond proxies. The dramatic rise in global interest rates has been a headwind to the sector’s performance this year. While the rise in bond yields this year has been relentless, we continue to see increasing evidence that inflation has peaked and continue to hear Fed governors communicate that they are at, or very close to, the end of the hiking cycle. We envision this headwind turning into a tail wind in 2024 if yields start to pull back.
PERFORMANCE OF THE CONSUMER STAPLES ETF (XLP) VS. THE 20+ YEAR TREASURY BOND ETF (TLT)
The second factor that’s been hurting these companies similar to the one we profiled last quarter with Danaher: the post-pandemic boom effect.
Pandemic-related logistical issues led to the largest companies (with the most sophisticated supply-chain solutions) gaining significant market share over private label and boutique products, and that trend has been reversing for the past two years. In the restaurant industry, consumers flush with savings went up market and away from quick service companies like McDonalds. We believe we’re reaching the end of this boom/bust cycle and should see normalized demand patterns return, particularly if we’re entering a slowing economy.
The third factor which has created this opportunity, is investor concerns related to the emergence of glucagon-like peptide 1 drugs (GLP-1), such as Ozempic, which have shown some remarkable results in helping individuals manage weight loss. Investors have taken a ‘sell first, ask questions later’ approach in the face of the unknown threat that this phenomenon presents to consumption patterns. The chart below shows just how relevant these drugs have been in corporate communications with investors.
REFERENCES TO WEIGHT-LOSS DRUGS BY MANAGEMENT TEAMS
The market has a habit of pricing in multi-year trends within a very short timeframe, as we saw earlier this year with the AI boom. However, in contrast to that boom which led to some wild price increases in highly speculative companies, investor concerns over GLP-1’s impact on consumption patterns has led to some dramatic share price decreases in very high-quality companies.
Consumer packaged goods companies like Campbells Soup and quick service restaurants like McDonalds have a long history of not just overcoming new diet trends but turning them into profitable opportunities. A recent Goldman Sachs report confirms our view that this fear is overblown as their comprehensive analysis showed that except for weight management bars, snack foods are not seeing any material underperformance relative to general levels of food consumption.
The multi-year chart below shows just how technically oversold McDonalds got lately, with shares down over 16% in the first six weeks of the third quarter. In the bottom panel of the price chart, we’ve included the Relative Strength Index (RSI) of the company, which is a technical indicator measuring whether a security is overbought or oversold. We’ve marked the last four occasions shares were this oversold, and readers can see that the short-term price action is historically bullish following readings at these levels.
MCDONALD’S (MCD)
We believe all these factors have created an exciting opportunity for our core portfolio to buy some high-quality businesses that we hope to own for a very long time. We’re further encouraged by the fact that these are precisely the types of stocks we want to own in an economic slowdown, which we believe is unfolding presently.
Active Trading Update – Hedging a Consumer Slowdown
We enjoyed a welcome return to volatile markets this quarter, which translated into some profitable trading opportunities for Lions Bay. In last quarter’s commentary, we highlighted the emergence of some intriguing shorting opportunities in single stocks, after finding very few opportunities in the first half of the year. Our readers will recall that we outlined the short thesis for two Recreational Vehicle manufacturers, as we were increasingly concerned about the risk of a slowdown in consumer spending.
By late summer, the market was waking up to the impact of higher interest rates on consumer spending patterns, in addition to the resumption of student loan payments.
CONSUMER STAPLES ETF (XRT)
The above chart shows the S&P Retail Index (XRT), which declined by 12.9% over the last 6 weeks of the quarter.
The trades we discussed implementing in our last commentary paid off well. Over the months of August and September, the two RV businesses we identified, as well as a retailer exposed to similar end markets, declined between 10 – 17%, allowing us to protect our core portfolio while also providing us with dry powder to take advantage of opportunities like those discussed above.
The current environment continues to be opportunity rich for this area of our portfolio, and we have been extremely active in the first few weeks of Q4.
Hedging Portfolio Update
Our hedging portfolio benefited in the third quarter as the high level of complacency in the market finally reversed in early August, and markets selling off on fears of higher for longer interest rates and increasing geopolitical tensions. While we systematically employ portfolio hedges on major stock indexes, when we see volatility markets that we believe to be exceptionally underpriced, we will go further and trade the VIX Index directly – a direct bet on volatility rather than the direction of a security or index.
VIX CALL SPREAD EXAMPLE
In early September, we bought a November call spread on the VIX Index that would lead to a significant payoff in the event of a rapid rise in the VIX. By trading the position actively, we managed to take all our cost out of the trade, leaving us with a very attractively priced structure that will continue to protect our portfolio if volatility rises further.
We will continue to manage our hedging portfolio actively to ensure that our portfolio protection is implemented prudently and cost-effectively in a volatile environment.
