Lions Bay Q3 2024 Commentary: Tactical Gains & Opportunities Amid Market Volatility

Performance Recap

For the third quarter of 2024, the Lions Bay Fund generated a return of +5.29%.  The S&P 500 was up +5.88% in Q3, with positive returns every month, despite short-lived bouts of volatility.  In a refreshing change, equity markets broadened from the narrow, tech dominated leadership that characterized the first half of the year.  The current environment is attractive for the strategies we employ at Lions Bay, and this quarter provided a great case study to examine the money-making opportunities we can pursue in all three of our strategies. 

Macro Recap

This was an extremely busy quarter on the macro front ushering in a return of volatility to equity markets after a long stretch of complacency.  Following an average level of 13.84 for the first half of the year, the volatility index, or VIX, averaged 17 for Q3, with a closing high of 38.57 on August 5^th.  July saw a rotation our of crowded tech shares following a hot CPI print, August a violent unwind of the Yen carry and September saw a China growth scare, followed by a massive rally in Chinese shares after a large stimulus package.  The conflict in the Middle East continued to intensify, leading to violent price moves in energy shares and safe havens like gold and silver.  Closer to home in September, the Fed finally cut rates and delivered a larger cut than market participants had expected at the start of the quarter. 

The current environment is characterized by rapidly shifting narratives, with the path of monetary policy being repriced rapidly with every incoming data point.  While market participants were talking about an imminent recession just one month ago, there is now talk of upside risk to CPI given the shift to a global easing cycle and a resilient economy.  Every data point is a live one, and we expect volatility to remain high as investors seek to navigate this increasingly complex economic environment. 

With the added uncertainty of the US election less than a month away and continuing escalation of the Middle East conflict, we believe the quarters ahead will be rich in opportunities for an actively traded Fund like Lions Bay, which has the tools to profit and protect from volatility. 

Review by Strategy

We will start with a review of our Transactional Portfolio, where we were extremely active this quarter in beaten up cyclical stocks.  After a quiet start to the year, we anticipate this portfolio will continue to be a profit center for our investors in the quarters ahead.   Following a review of our hedging portfolio and how we navigated the drawdowns in July, early August and early September, we will review some new and existing core portfolio investments that we made during the quarter.

Transactional Portfolio

Our Transactional Portfolio is one of our three principal strategies at Lions Bay.  Highly opportunistic in nature, this portfolio is very actively traded and allows us to take advantage of shorter-term trading opportunities in securities that may not fit our criteria for a Core Portfolio investment.  Many of these businesses exhibit a high degree of operating leverage, tend to be cyclical in nature and may have balance sheet risk.  These are stocks we tend to trade with a short-term time horizon and are quick to take profits after a large price move or exit positions if our catalyst fails to materialize.  We adhere to the mantra “Do not treat your investments like trades, and do not treat your trades like investments”. 

Starting in the weeks leading up to the FOMC meeting and continuing until the close of the market after the rate cut announcement, we established new positions or increased positions in the following sectors: base metals, precious metals, energy, chemicals, transportation, casinos and Chinese technology stocks.  We felt that many of these stocks were also under pressure from tax-loss selling, given their large underperformance year-to-date, and experience has taught us that these pressures tend to peak in late October given many large mutual funds have their fiscal year ends at this time.  The chart below gives an example of how washed out the sentiment has gotten towards energy, and we observed a similar dynamic in many other cyclical sectors. 

MONEY MANAGERS TURN NET-BEARISH ON OIL

In the days after the FOMC delivered a 50bp rate cut, the Chinese government unleashed a torrent of fiscal and monetary stimulus in the form of a lending program to support equity prices, a swap facility to provide liquidity to financial firms, reverse repos as well as targeted measures aimed at stimulating the housing market.  This combination of factors led to large rallies in the aforementioned sectors, allowing us to take some profits in many of these short-term ideas.

As we mentioned at the start of this section, this is not a buy and hold portfolio, and we were extremely nimble in trading these positions in late September and the early days of October.  Our thinking around our Chinese exposed trades highlights how quickly we can pivot in this portfolio.

• Kraneshares China Internet Fund (KWEB).  Bought February 30 calls on September 23^rd, and after overwriting and rolling up strikes several times, exited the position completely on October 4^th for a total realized gain of $728k USD over 10 trading days
• Wynn Resorts (WYNN) following an initial purchase of 20k shares on September 13^th and subsequent purchases on September 17^th and 18^th, we sold 25% of our position on September 26^th +14.5% from our initial purchase, and the balance of our position on October 7^th for 106.49, for a total gain of $805k USD over 17 trading days

Following the Chinese stimulus, sentiment shifted violently characterized by a huge chase for upside call options on Chinese equities.  The iShares China Large-Cap ETF (FXI) rallied 31.52% in the two-week period ending October 4^th.  Despite Chinese markets being closed for the first week of October, ADRs continued to rally unabated into the October 7^th China’s National Development and Reform Commission, on the expectation of even more stimulus.

KRANESHARES CSI CHINA INTERNET ETF (KEWB)

In our view, our thesis towards these stocks had played out.  Sentiment had shifted from completely washed out to euphoric in a manner of weeks and these stocks were certainly no longer tax-loss selling candidates.  It was our belief that the amount of good news that had been priced in by this point had gotten ahead of itself, and it wouldn’t take much for markets to be disappointed and we made the decision to unwind these trades before the Chinese markets re-opened.

While we have hedged some of our gains in other cyclical sectors such as base metals, we continue to believe in the secular tailwinds that copper enjoys and have been adding to these positions with some of the transactional proceeds we earned. 

Situations like this highlight the positive optionality that carrying cash provides to us, as we can nimbly and decisively deploy capital when we discover compelling opportunities.

Hedging Portfolio

With the S&P 500 posting monthly returns of 1.21% in July, 2.42% in August and 2.13% in September, investors could be forgiven for thinking it all rosy in the third quarter. 

The reality was very different, as each month experienced a large sell-off, and we’d like to profile how Lions Bay performed over these drawdowns.  As shown by the table below, Lions Bay was able to navigate these drawdowns well, as our hedging portfolio functioned effectively to protect the portfolio. 

While these brief drawdowns were short-lived and followed by sharp rallies, this snapshot is a reminder to our investors that Lions Bay can generate significant outperformance during market drawdowns of greater magnitude and duration. 

As shown in the chart below, both investor positioning in equity futures, along with investor sentiment as measured by the American Association of Individual Investors (AAII) are closest to the highest levels in the past 5 years.  Given this level of one-sided investor sentiment against the backdrop of the myriad of geopolitical risks and uncertain path of monetary policy we discussed above, we are excited about the prospects of the Hedging Portfolio in the months ahead.

INVESTOR SENTIMENT AND INVESTOR POSITIONING AT 5 YEAR HIGH

Core Portfolio

In sharp contrast to the short-term nature of our Transactional Portfolio, or Core Portfolio is where we make investments in high quality businesses that we intend to own for a long time.  We patiently wait for opportunities to buy these stocks during periods of market distress, when shares are on sale.  The way our Hedging Portfolio and Transactional Portfolio operate, we are often in a position to re-deploy short-term realized gains earned during periods of volatility into the long-term investments that comprise our Core Portfolio.  We were able to do so this quarter, taking advantage of the sharp selloff in technology shares to establish new positions in Dell Technology.

We took an initial position in Dell Technologies (DELL) on August 13^th, buying shares at $97.72.  At this share price and with the company estimated to generate $6.4 billion in free cash flow (FCF) for the fiscal year ended Jan 2026, shares were trading at approximately a 9.2% forward FCF yield.  We viewed this as a very attractive entry point to gain some exposure to the secular tailwinds of investment in AI infrastructure, and it was a stock that Wealhouse’s analyst and resident technology expert Devon has been extremely excited about. With shares up 23.8% in the eight weeks since our initial investment, we can see that his excitement was warranted. 

LONG INVESTMENT: DELL HOLDINGS (DELL US)

We will close with a quick update on our two largest core portfolio holdings: Houlihan Lokey and LVMH. 

We were very lucky to have the opportunity to meet with the CFO of Houlihan Lokey (HLI), Lindsey Alley on a recent trip to Los Angeles.  The company continues to do an admirable job of executing its business plan.  Their recent acquisition of boutique M&A advisor Waller Helms is a great example of what we like about our investment in HLI. 

As shown in the chart below, the sponsor-backed M&A market has been in a two-year downturn since the 2021 peak but is showing an inflection higher with 1H 2024 announced deals coming in higher than 1H 2023.  Unlike their more cyclical peers, Houlihan Lokey does not have to simply sit on their hands during period of depressed deal activity.  Because their large restructuring practice provides a counter-cyclical revenue stream during downturns, they are well positioned to deploy capital and consummate acquisitions ensuring they emerge from industry downturns in a stronger competitive position. 

SPONSOR BACKED M&A ACTIVITY

Waller Helms was an advisor specializing in financial service firms, but specifically they were the leader in advising on the sale of broker dealers, a niche market that was a big gap in HLIs coverage.  This fills a hole in their coverage and gives them a leadership position in this sector, while providing talent and capability to support other business lines such as fund raising and financial sponsor coverage.

A long time investment for the Fund, LVMH is now our second largest investment, and at a 5.5% weighting at quarter end.  Simply put, we believe LVMH is of the best global luxury brands in the world, a structural market share gainer that consistently creates value for shareholders through consumer spending downturns.  The luxury goods market has several attractive characteristics such as enduring brands, inelastic price demand of customers and large and defensible margin profiles.  We believe the management team of LVMH is the best in the business, and by making smart acquisitions during downturns they’re able to emerge from slowdowns with greater market share over their competitors, while commanding industry leading EBIT margins, as shown in the charts below.

LOUIS VUITTON: ESTIMATED GLOBAL MARKET SHARE FROM CALENDAR 2008 TO CALENDAR 2023

DIOR COUTURE: ESTIMATED GLOBAL MARKET SHARE FROM CALENDAR 2008 TO CALENDAR 2023

TOP 5 LUXURY BRANDS

As of October 15^th, shares are down20.96% YTD and are trading at the same levels that they were at the end of 2020, despite estimated revenues for fiscal 2024 of a record EUR 85 billion versus and EBIT of 21.6bn vs 64bn and 17bn respectively for fiscal 2021.  The company pays a 2.50% dividend and has a 5 year annualized dividend growth rate of 17%.  Furthermore, the company is set to exit 2024 with the lowest net debt since 2018, which positions them well to capitalize on the broad industry downturn and consummate another value-added acquisition, and we believe their recent investment in Moncler demonstrates this commitment to creating value for shareholders.  We believe the investor reaction to their most recently reported quarter on Oct 15^th represents a point of maximum pessimism towards the shares, and we have been eagerly adding to ADRs in the mid $120s.

Wee believe that the market shifts we experienced this quarter, which created a much more favourable investment environment for the Liosn Bay Fund, are set to continue in the quarters ahead.  We are very excited about the opportunity set through year end and into 2025, and we look forward to reporting to you again in the New 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.