Lions Bay Fund has remained defensively positioned – which led to a profitable first half of the year due to hedging practices and active trading. In this most recent commentary, Senior Portfolio Manager, Justin Anis, details one of this quarters successful trades.
Q2 in Review
For the second quarter of 2022, the Lions Bay Fund was up 5.03%, bringing our year-to-date gains to 22.99%. The S&P 500 was down 16.12% in the second quarter. Year-to-date, the S&P 500 declined 19.96%, which holds the ignominious distinction of being the worst first half of a trading year in over five decades.
In this commentary we will provide some detail on our winners and losers this past quarter, as well as provide a detailed case study on a successful short trade. We’ll go on to discuss our view of the current market environment and how we’re positioned into the balance of the year.
The Best of Times, the Worst of Times
The first of half of 2022 marked the first time the S&P 500 had consecutive quarterly losses since 2015. During the recent quarter, the US Federal Reserve hiked interest rates by 50 basis points in May and a further 75 basis points in June, the latter being the largest rate hike since 1994. Consumer sentiment hit an all-time low as gas prices hit a record high of $5 a gallon and 30-year mortgage rates nearly doubled from the start of the year. The volatility index (or VIX) was up 66.72% for the first half of the year and averaged 26.33 for the period, a third higher than its average level last year.
This level of turbulence led to an incredibly profitable six months for our hedging practice, as well as a phenomenal environment for active trading. It was a very challenging period for our core portfolio. In isolation, our core portfolio YTD was a drag of approximately 12.5%. However, our systemic hedges generated profits close to twice this level. Active trading had an outstanding first half as well, generating a return of over 8%.
Our biggest losers YTD in our core portfolio were Disney (-158bps), Airboss of America (-137bps) and Houlihan Lokey (-129bps). Entering the year, we were overweight stocks geared towards a re-opening of the economy and a resumption of travel. These positions suffered as recession fears increased and consumer confidence declined. We continue to own businesses in this sector that we feel have unique assets such as Vail Resorts and Disney, but we booked losses in our casino investments; Churchill Downs and Las Vegas Sands.
Gains in active trading for the first half of the year were a product of short selling. Early in the year most of these gains were from a basket of highly speculative securities such as money-losing software companies, electric vehicle manufacturers, and businesses leveraged to the cryptocurrency ecosystem. This theme, in aggregate, generated just over 2% for the first half, or approximately 10% of our total profits YTD. More than half was from a single security (which we will profile shortly).
As the first half of the year unfolded, we began to see evidence that the real economy was being impacted by tighter financial conditions. We highlighted the underperformance of the transportation sector in our last commentary and, upon further research and leveraging some of the great work by Craig Fuller at FrieghtWaves, uncovered compelling evidence that there was a material slowdown occurring in trucking and shipping.
Outbound Tender Volume Index, (Unites States of America)
By late March outbound tenders showed that trucking volumes were at the lowest levels in a year (ignoring holidays). While March is normally a good month for trucking, this year it was softening. While we assumed some was due to consumers shifting away from spending on goods towards services, inflation was also a big factor. In an inflationary environment you get less quantity of goods for a given dollar spent, thus shipping volumes decline. This occurred at a time when warehouses were already filling up as inventories were growing due to double-ordering in the face of shortages last year.
Dow Jones US Total Market Trucking Index
We were able to profit from put options on a two large North American trucking companies and a US container shipping business. In aggregate, we generated approximately 1.15% from active trades against ‘real economy’ stocks such as transportation businesses, auto retailers, construction machinery businesses, and a large conglomerate with insurance and railway operations.
“Our point of view is being a leveraged, bitcoin-long company is a good thing for our shareholders.” – Michael Saylor on CNBC, July 30, 2021.
As a general policy, when discussing short selling or hedging operations, we do not disclose individual companies, opting instead for a general description of the business and our rationale for the trade. However, given the exceptional gains we realized in the first half this year in a specific active trade, we will provide a specific case study of the thesis and structure of the trade.
We reaped meaningful gains in the first half of this year through a short position in MicroStrategy (MSTR), which was structured as a series of put options. Total profits from the short YTD are more than 100 basis points – almost 5% of the total profits we have generated this year.
There are many factors that are present in a successful short: balance sheet risk, overvaluation, suspicion of accounting irregularities, and an overhyped fad or questionable management to name a few. While compelling, no combination of these factors is enough to justify a short if there isn’t a meaningful catalyst to spark a decline in the shares and draw Wall Street’s attention to the risks in the business.
It was our view that rising interest rates and tighter monetary policy would be a sufficient catalyst to spark a sell-off in the most speculative areas of the market. Highly valued cloud computing and software-as-a-service (SaaS) companies, electric vehicle stocks, and anything in the cryptocurrency ecosystem fit this bill. You can imagine our excitement at discovering an overvalued SaaS company that decided to reinvent itself by investing its entire balance sheet and incoming cash flow into bitcoin – even going as far as to issue debt to do so.
MicroStrategy is – or was – a business services company that provides analytics solutions to enterprises to better process and manage data such as improved reporting, inventory, and supply chain management. MSTR was founded by Michael Saylor, Chairman and CEO, in 1989.
On August 11th of 2020, in a departure from the conservative balance sheet management that many other CEOs were practicing during the depths of the pandemic, Michael Saylor decided to spend $250 million of MSTR’s cash on Bitcoin. He has since turned the stock into a leveraged bitcoin bet, having invested approximately $4 billion on Bitcoin. As of March 31st 2022, MicroStrategy owned 129,218 bitcoins at an average cost of $30,700. At the end of 2019, MSTR had a pristine balance sheet with a net cash position of over $550 million. Today, they have over $2.4 billion in debt.
Bitcoin ended Q2 at $18,731, down 59% for the first half of the year, and well below MSTRs average cost. MSTR shares plunged 69.82% during the first six months of the year as investors began to grow concerned about large write-downs and balance sheet risk.
MicroStrategy Share Price
Structuring a trade correctly is as important as being right on the direction, particularly with shorts. When dealing with single stocks we almost always prefer to structure our shorts using put options as we find the payoff profile, as well as the risks, much more attractive than being an outright or “delta one” short.
We initiated our trade in MSTR on January 13th of this year when shares were trading around $490. If we conducted a typical short sale (borrowing stock and then selling it with the hope of covering it at a lower price), our maximum gain on the trade would be $490 if the stock went to zero, a maximum return of 100%. Meanwhile, our risk would be unlimited as there is no limit to how high the share price can rise.
Instead, we elected to buy put options and then, as the trade went our way, we systematically rolled our options down in price to take our cost out while maintaining exposure to further declines and potential profits. The risk in a put option is limited to the premium you pay, while your payoff is potentially many multiples of that premium.
On January 13th, with shares trading at $490, we bought put options that expired February 18th with a $420-strike price – we acquired the right to sell shares at that strike price up until that date in time. We paid $13.67 for these options and wound up selling them a few weeks later at a large gain, spending the profits on longer dated options at a lower strike price, thus we had taken all our cost out and were only trading on profits at this point. We continued to roll our expiries out to March and eventually to July at successively lower strikes to maintain exposure to future price declines. We closed the position entirely on June 13th, with MSTR trading at $155, for total gains of over 6 times what we spent on our initial premiums.
Importantly, these gains were realized during a bear market. 100 basis points of excess returns during a bear market is much more valuable to us than 100 basis points of excess returns during a bull market, when one values that capital based on prospective returns available in the market. This is the entire philosophy behind the risk management and trading practice of Lions Bay: Earn alpha when it is most valuable.
Putting Out Fire with Gasoline
Credit to the legendary David Bowie for the above line, from the single “Cat People”. We find it perfectly describes the decision making we’re already seeing from some politicians who, to provide “inflation relief”, are handing out cash to citizens.
On Sunday, June 26th, California Governor Gavin Newsome announced a plan to hand out $17 billion dollars in “inflation relief” to qualifying citizens of the state, which, somehow, includes households with a joint income of up to $500,000. Households with joint income of $150,000 or individuals with income of less than $75,000 and at least one dependant will qualify for the maximum payout of $1,050.
Not only are the economics of this action completely backwards – you do not fight inflation with helicopter money – we also find it a highly dubious action to take ahead of the California gubernatorial election in November. While California is just one state, if it were a standalone country, it would be the fifth largest economy in the world. This bill alone will increase inflation at a national level, but much more concerning is the precedent it sets and the risk that further states or other nations will follow suit.
We believe one of the major risks to the stock market recovering is this type of policy gaining traction. The economic fallout from the pandemic was so short-lived because both monetary and fiscal policy were united and moving in the same direction. If they cannot stay on the same page in combatting inflation, we would grow very concerned about the prospects for a market recovery.
The good news is that we are finally seeing evidence that inflation has peaked. It hasn’t yet shown up in the CPI numbers but, based on what we are hearing and seeing from corporate management teams, we believe the worst of the hot data is likely behind us.
In the past few weeks Amazon, Google, Microsoft, and most recently Apple, have all announced that they will be limiting job growth and slowing down hiring. On July 16th the Airline Reporting Corporation revealed data showing air fares were being pushed lower to help stimulate demand. Meanwhile, the Goldman Sachs Commodity Index has declined over 17% in the past three weeks. These are just a few examples of signs that the worst of inflation may be behind us, and we believe we will get more evidence in the coming weeks as companies report earnings, an opportunity to discuss inventory drawdowns and price cuts.
We remain defensively positioned with a high cash balance as we anticipate choppy markets to continue. While sentiment has deteriorated significantly, we haven’t yet seen a level of distress or extreme value emerge that would get us excited to be more aggressively positioned. We believe it will continue to be a trader’s market, and are confident that we have the tools to protect and participate in such an environment.