Lions Bay Q2 2024 Fund Commentary: Market Realities & Positioning for Future Opportunities

For the second quarter of 2024, the Lions Bay Fund was -2.74%, bringing our year to date returns to -2.12%.  Our returns have been disappointing thus far in 2024, both in an absolute sense and relative to the broader market.  With the exception of April, when we were up 0.34% relative to the S&P 500 declining by over 4%, it has been a challenging environment for our Fund to generate alpha. 

While at times disheartening, such periods of underperformance during times of market exuberance are a painful reality of this strategy.  Over the almost 6-year life of this fund, we have always been rewarded for sticking to our process and patiently waiting for conditions to change.  At present, our excitement about the near-term prospects for Lions Bay outweighs our disappointment over recent results.  For reasons we will outline in the following commentary, we believe the stage is set for a meaningful rebound in performance.  We are expressing this sentiment in the most direct way possible: by investing more of our own personal capital in Lions Bay each month. 

We know that the first six months of 2024 have been challenged, our five year track record still remains a respectable +21.42% annualized, down from a 5 year annualized return of +22.67% at year-end 2023.  We know the start to this year has been frustrating, we certainly feel it as well; however, we believe our strategy for disciplined stock picking and prudent hedging will bode well for investors on a long-term basis.

Performance Recap

 Three main factors have contributed to the recent underperformance of Lions Bay.  We view these factors as temporary setbacks and believe they have the potential to reverse in the quarters ahead.

 1. Underperformance of several of our core portfolio investments.

Many of our core portfolio investments have underperformed the market thus far in 2024, as gains at the index level have been driven by a small group of very large companies – we will discuss this phenomenon at greater length later in the commentary.  Relative to the double-digit gains in the market YTD, many of these core holdings remain down double digits. Dislocations like this are why we like to carry a large cash position; it enables us to take advantage of these opportunities when they emerge. 

Below are some examples of core portfolio holdings that have been buying recently, with their year-to-date and 10-year annualized returns as of July 5th:

StockYear-To-Date Return10-Year Annualized Share Price Return
Accenture (ACN)-14.75%+15.81%
LVMH (LVMUY)-4.05%+18.11%
McDonalds (MCD)-15.32%+12.40%
Union Pacific Corp (UNP)-8.33%+10.74%
Zoetis (ZTS)-11.35%+19.01%
Source: Bloomberg.

It is rare for us to see so many compelling investment opportunities at a time when the market is at all-time highs and investor sentiment is this exuberant.  We view these as competitively advantaged, best in breed companies with stellar track records of creating wealth for shareholders.  We intend to hold these stocks for the long term and view the recent weakness as a gift to patient investors who are willing to look one to two quarters ahead.

The investment community is seemingly uninterested in some of the best run businesses right now, as capital continues to chase the AI boom.  This creates an incredible opportunity for our unit holders, as our exposure to a rebound in these companies is much higher than our exposure was to their recent decline. 

2. Extreme narrow market breadth coupled with rich valuations.

Over a rolling 12-month time horizon, market breadth is as narrow as it’s been since 1965 (see Chart 1 below), with less than 30% of the S&P 500 outperforming the index.  Indeed, it is a limited number of very large companies that are driving returns at the index level.

CHART 1: VERY FEW STOCKS ARE KEEP UP WITH THE INDEX

Source: Morgan Stanley

This environment is extremely challenging for our strategy.  Most of our core portfolio is comprised of idiosyncratic businesses, such as the ones highlighted above, rather than the mega cap tech champions that have led this rally. NVDA alone is responsible for 35% of the total return for the S&P 500 year to date. This anomaly has led to the index trading at extreme valuation levels (see Chart 2), with the equity risk premium now the lowest since the dot-com bubble. Simply put, the compensation investors are earning for taking equity risk is the lowest in 22 years.

CHART 2: S&P 500 EQUITY RISK PREMIUM AT 22 YEAR LOWS

Source: Morgan Stanley

3. Benign volatility environment.

VIX is down over 23% since the end of Q3 2023, but this doesn’t tell the whole story with respect to the level of complacency in the market.  We have now gone over 380 days without experiencing a sell-off greater than 2.05% – this is the longest streak since the great financial crisis. The fact that we are experiencing five-year lows in the cost of hedging at the same time as the market is trading at multi-decade levels of overvaluation is incredibly compelling set-up for our strategy.

As always, it is a matter of when, not if, risk returns to markets.  The longer this complacency lasts, the more it acts like a coiled spring with an inevitably more violent release. 

One area of the market we pay attention to that does not get as much mainstream coverage, is the growth in structured products linked to investing in equities like the S&P 500 by trying to control for the level of volatility in the strategy.  Without going into a mathematical treatise, let us summarize by saying that when markets are realizing very low volatility (as in the recent past), these strategies are “forced “into buying more equities; when volatility spikes, they are “forced” into selling equities. 

Right now, some of these strategies have more than $1 of exposure for every $1 of equity, as the chart below shows.  If the market were to become more volatile (usually this happens when markets decline), we may be in store for exacerbated volatility as these structures would have to deleverage and liquidate equity holdings. 

We look at a plethora of market intelligence to help us guide our hedging decisions.  According to estimates from various investment dealers, there are several hundred billion dollars in these strategies, and this is an area of the market we pay close attention to.  Chart 3 below shows the level of exposure in these Funds.

CHART 3: EXPOSURE OF VOL TARGET FUNDS NOW OVER 100%

Source: Bloomberg

A History of Market Champions

We have always found it insightful to study the history of financial markets, as the lessons from past cycles can be helpful in understanding the present environment and forecasting what is to come.  While the stocks may change, investor psychology is a constant over time, and the biases which lead to anomalies like panics and manias are persistent over generations.  A recent study by Bridgewater and Associates, a firm with a deep appreciation for market cycles, compared the current environment with past markets similarly dominated by a small number of large ‘champions’.  The Top 10 largest U.S. companies now account for almost one-third of total market cap of U.S. equities, a level not observed in decades.

The study profiled past market champions over 120 years and found that the consistent characteristic amongst these cohorts was a first mover advantage in a secular growth industry benefiting from rapid innovation, with a competitive moat in place enabling them to maintain this dominance.  When the lifecycle of these champions was broken, it was inevitably due to the erosion of one of those two factors – or regulatory intervention. They created a composite of following market champions:

  • Railway monopolies from the 1900s to 1930s (Penn Central, Union Pacific, New York Central, etc.)
  • Chemical conglomerates from the 1930s to 1960s (DuPont and Union Carbide)
  • Auto conglomerates from the 1920s to 1960s (The “Big Three”: GM, Ford and Chrysler)
  • Oil champions from 1900s to present (Standard Oil, Exxon, Mobil, Chevron, Marathon, etc.)
  • Telco champions of the 1930s and 2000s (AT&T)
  • Information Technology Champions of the past 20 years (e.g. Microsoft, Meta, Nvidia, Alphabet, etc.)

The chart below shows the path of each cohort, as measured by % of total U.S. market cap over time.  As you can see, the current cohort has gone parabolic precisely at the time the average historical analogue begins to unwind.

CHART 4: TOP 10 COMPANIES BY DECADE (SHARE OF TOTAL U.S. MARKET CAP)

Source: Bridgewater & Associates

As risk managers, what is most concerning to us is that these champions now make up the largest concentration of investors’ portfolios (see Chart 5 below), precisely at the time when history warns us that the prospect for future returns is dimming.  The average large-cap fund has one third of its portfolio in just five stocks, up from 26% in December 2022, while a quarter of all large-cap funds have more than 40% of their portfolio in five stocks.  Along with illiquidity and leverage, overconcentration is one of the cardinal sins of risk management, and it is currently rampant among institutional money managers as well as retail investors.  It is critical to remember that stocks rise only when there is a marginal buyer.  No matter how great the underlying business is, if everyone knows it and everyone owns the stock, the shares will have a hard time rising.

CHART 5: INVESTORS PORTFOLIOS HAVE THE MOST CONCENTRATED EXPOSURE TO U.S. CHAMPIONS IN DECADES

Source: Bridgewater & Associates

We would humbly suggest to investors who have enjoyed outsized returns through exposure to these champions, that it may be prudent to have a look at diversifying some of those gains into uncorrelated strategies such as Lions Bay, which has exposure to a diversified portfolio of high quality businesses trading at a discount to their long term multiples.  Furthermore, as we enter into a back half of the year which is fraught with event risk, the Fund is poised to profit from the inevitable return of volatility to equity markets after such a prolonged stretch of complacency.  As shown below in Chart 6, seasonal trends over the past 33 years also support a rebound in VIX as we move into Fall.

CHART 6: VOLATILITY TENDS TO SPIKE IN AUGUST/SEPTEMBER

Source: Bloomberg, Barclays Research

We believe the opportunities we’re seeing in the core portfolio strategy merit further discussion and have highlighted two businesses which we have been buying in earnest recently.

Accenture (ACN)

Market Cap: 193bn

Dividend yield: 1.68%

YTD: -14.75%

Source: Bloomberg

Accenture 5 Year Price Chart

Accenture is a global consulting powerhouse and has proven to be a stock that has handsomely rewarded long term investors, with a total return of 2,856% or 15.89% annualized since its 2001 IPO.  Shares have pulled back meaningfully lately, and now are currently trading at the same share price they were three years ago, despite expectations of revenue +28% and EPS +35% over that time.  Shares are currently trading at 20.1x 08/25 earnings estimates, and 17.6x 08/26 estimates, relative to a 7-year average of 23.9x one year out estimates – presenting almost 20% of potential share price appreciation solely on a return to historical multiples. 

We believe the company is emerging from a recent downturn in demand, with the company calling out a reacceleration in trends for 2025 and beyond.  In addition to a cyclical recovery in demand post the 2022 slowdown, the company stands to be a beneficiary from the new tailwinds in GenAI demand.  Accenture has the scale and expertise to gain share through the recent downturn and be a global leader in consulting to help the largest companies adapt to the new technological changes.  This was highlighted on their last call when they reported 92 clients with bookings over 100 million, an increase over the 85 reported this period last year.  As further evidence of their ability to gain share, the $1.2 trillion IT services market has grown 4% annually over the last 4 years, while Accenture has averaged 10% sales growth.

We view Accenture as a quality core holding whose share price should benefit from a rotation out of the crowded mega cap tech names.  Shares have upside potential through multiple expansion, share gains through the recent cyclical downturn, a broad-based cyclical reacceleration from their customers as well as emerging trends such as AI investment, which they have been heavily investing in.

Zoetis (ZTS)

Market Cap: 80.1bn

Dividend Yield 0.98%

YTD: -11.35%

Source: Bloomberg

Zoetis 5 Year Price Chart

Zoetis, a spin-off from Pfizer, is a global leader in the animal health industry, focusing on drug discovery, development, manufacture and commercialization for companion animals as well as livestock.  Animal health is a $45 billion dollar industry and is growing mid to high single digits driven by a secular increase in pet ownership and higher spending on pet care.

Zoetis is a company with multiple ways to grow.   Beyond the secular growth in the market, Zoetis has augmented organic growth with a powerful innovation engine through R&D and drug development.   A clean balance sheet (4.7bn of net debt relative to 3.7bn in trailing EBITDA) allows the company to invest heavily in R&D, with over $4 billion invested.  This investment in R&D is a competitive advantage over their peers and the fruit of this investment can be seen from blockbuster drugs like Simparica, which is their second largest product after only 2 years on the market.  Furthermore, this balance sheet and strong free cash flow generation will enable to company to complement organic growth with tuck-in acquisitions in new verticals, such as diagnostics.

Companion animal health is an outstanding business, as pet owners tend to be price inelastic when it comes to pet health solutions.  As an example of this pricing power: despite vet visits being flat year over year due to challenging comps, average revenue per visit was up 7%.  This high margin segment of their business now accounts for 60% of revenue, expected to increase to 70% by 2027.  An example of the hyper growth in some of these markets is their canine allergy medication which has experienced a 25% revenue CAGR over the past five years. 

We believe the recent stretch of share price weakness is an opportunity to build a larger position in a unique and outstanding core portfolio company.  ZTS is now our second largest holding at close to 3% of NAV.  Shares have languished recently on concerns over the launch of a recent osteoarthritis drug, but we believe these headline risks are well discounted in the shares.  Like many other high quality growth companies that trade at a premium to the S&P, ZTS has also experienced multiple compression in the face of higher rates.  ZTS is trading at a 15% discount to its 5 year P/E multiple despite a forecast for revenue to grow by 14% in the next two years, with free cash flow growing by over 40% over the same period, and EBIT margins increasing from 35.3% to 39.2%. 

As we head towards the second half of 2024, we remain optimistic in the potential of our three strategies. The core portfolio investments are poised for considerable upside, while the hedging strategy is tactically positioned to take advantage of any return of market volatility. Anticipating opportunities ahead and committed to delivering strong performance for our investors, we encourage you to reach out with any questions, comments, or ideas. Thank you for your continued trust and partnership.

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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