Navigating Volatility: Q2 2023 Review and Future Opportunities

As the 5-year anniversary approaches, Senior Portfolio Manager, Justin Anis, reflects on Lions Bay fund’s year-to-date performance and how it compares to the S&P 500. The quarter was marked by a narrow breadth in the market, with mega-cap tech companies driving most gains, proving to those without overweight positions in those names to be challenging to outperform. Despite the challenges, the fund remains optimistic about the opportunities in the second half of 2023.

Performance Review

For the second quarter of 2023, the Lions Bay Fund declined by 1.54%, bringing our year-to-date performance to +3.54%.  The S&P 500 was +8.74% for the second quarter, ending the first half at +16.88%. 

Unfortunately, this quarter was a reminder that a strategy designed to generate uncorrelated returns will sometimes result in disappointing short-term performance relative to the benchmark.   As we look to celebrate the 5-year anniversary of the Lions Bay Fund next month, we hope that such stretches in the coming five years are short-lived and infrequent.  After a brief review of the quarter, we will discuss the exciting opportunities we see ahead in the back half of 2023.

Second Quarter in Review

As has been widely reported by the financial media, the vast majority of the 2023 gains in the equity market were driven by mega-cap tech.  For the first six months of 2023, the NYFANG Index, an equal weighted index of the most highly traded growth stocks such as Meta, Apple, Amazon, Netflix, Google, and NVIDIA, was up a staggering 74.24%.  By contrast, the S&P 500 ex-Tech index, which strips out these companies, was up only +1.86%.  If, like us, you did not have overweight positions in the very largest tech companies, it was a very difficult environment to outperform.   This narrow breadth to the market is reflected in the chart below, showing a record number of stocks underperforming the index – more extreme than the 1999 Nasdaq bubble.

A RECORD LOW NUMBER OF NAMES ARE OUTPERFORMING TODAY

As seen in the chart below, the move in the equity market year-to-date has been entirely driven by multiple expansion. What this tells us is that investors expect a tremendous amount of earnings growth and productivity gains from innovation such as generative Artificial Intelligence, as reflected by their willingness to pay more today for future, uncertain earnings.  Our process entails staying disciplined on valuation and avoiding crowded trades, which means that we will be on the sidelines when the market is driven by euphoric “stories” as opposed to improving fundamentals and reasonable valuation levels.

PERFORMANCE YTD IS ALMOST ENTIRELY DUE TO P/E EXPANSION

Lastly, what made this quarter particularly challenging for our strategy was the dearth of volatility.  Volatility drives gains in our Hedging book while also providing short-term profit opportunities for our Active Trading strategy.  For the second quarter, the VIX index, which measures equity market volatility, declined by over 27%, with an average level of 16.4 for the quarter, hitting a low of 12.91 in late June – a level not seen since before the pandemic.  By contrast, in 2022, a year in which we generated considerable alpha, the average level of the VIX was 56% higher at 25.6.  As we’ve written in the past, volatility equals opportunity.

The Opportunity Ahead

As much as the first half of 2023 was challenging for our strategy, as we evaluate the present environment, we are incredibly excited about the prospects for the second half. 

Core Portfolio Outlook

The silver lining from the narrow breadth shown in the chart above is that despite the strong move in the index YTD, many stocks have yet to participate.  We continue to find fantastic companies that have not enjoyed any of the broader market gains this year, and in fact have added some new core holdings.  We expect these positions to catch up to the strength shown at the index level so far this year, while presenting far less downside should the economy deteriorate.

One company we’ve recently added to the core portfolio is Danaher (DHR), a high quality business with a long track record of creating shareholder value.  Danaher has followed the pattern of many businesses that had tremendous growth during the pandemic.  The COVID boom was followed by a bust as the pandemic ended.  Shares have languished as they digest a period of tough comparables, and the business faces a long destocking cycle.  In our view, this creates an opportunity for investors who are willing to look past short-term challenges to invest in an outstanding franchise. 

DANAHER 1-YEAR PRICE CHART

The company recently cut FY23 guidance for the second time, and we believe with shares down 9.4% YTD, the stock is now meaningfully de-risked and pricing both the extended de-stocking cycle as well as fears of a freeze in biotech funding post the collapse of Silicon Valley Bank.  While the slowdown in biotech funding is cyclical, we believe the trends driving emerging biotechnology research are secular.   After a flat to down year in 2023, we expect earnings to return to double digit growth next year. 

Like many high-quality companies, shares have always traded at a premium multiple to the market, however with the recent headwinds, DHR shares are now at a discount to their 10-year average multiple relative to the S&P 500.  Management has a long history of value-added M&A, consolidating what is a very fragmented market.  We believe the broader industry weakness will be an opportunity for management to create value through acquisitions at a time when they sit on the most balance sheet firepower in corporate history.  Through recovery in end markets and value-added M&A, we expect share price appreciation from higher earnings as well as a multiple re-rating. 

Active Trading Outlook

The strong move in the market year to date has also presented a number of intriguing trading opportunities, both long and short. 

Long Trades

From the long side, we are increasingly attracted to commodity companies.  Commodities and cyclical businesses will never meet our criteria for a core holding, but as we did in Q1 2021, we are always open to these trades when the right conditions emerge.  If inflation continues to decline and the Fed has reached the terminal level for interest rates, there is a strong argument to be made that the US dollar will decline meaningfully from here.  As shown below, the trade weighted US dollar has already broken down with a major decline month to date.  Dollar weakness is generally positive for commodity prices. 

TRADE WEIGHTED U.S. DOLLER INDEX

While the technology sector has dominated investor interest for years, highly capital-intensive businesses like mining companies have been starved for investment and have been unable to bring on meaningful supply.   We believe commodity prices have upside in both a blue-sky scenario where we enjoy a soft landing and increasing economic demand for commodities is faced with declining supply, or a scenario where the Fed is required to rapidly resume easing in response to a crisis.

We like the contrarian nature of this trade and believe that a barbell approach with long positions in commodity producers, coupled with high quality investments in our core portfolio, could be a meaningful source of alpha in the quarters ahead. 

Short Trades

For the first time in the past 12-18 months, we are finding intriguing shorting opportunities in single stocks.  We have recently initiated short positions in two Recreational Vehicle manufacturers.  Following a massive boom during the pandemic, we believe the market could see significant demand decline in the quarters ahead.

Total RV shipments peaked at just over 600k units in 2021, which was 18% higher than the prior peak in 2017.  Shipments in 2022 declined 17% year-over-year, while 2023 YTD shipments are down 54.4% from this level last year. 

These businesses are challenged by higher rates, both due to significant balance sheet leverage as well as their customers’ need for reliance on purchase financing. Furthermore, if our commodity thesis plays out, they will be doubly hit by rising steel prices while facing a demand decline with rising oil prices. 

We believe demand could be further challenged by an increase in supply from the pre-owned market, as a large portion of the buyers from the 2021 boom were first time customers.  We’ve already seen evidence of this playing out in many other big ticket ‘pandemic purchases’ such as off-road vehicles and motorboats.

Share prices of the companies we are shorting currently sit at 52-week highs and are up between 30-45% year-to-date.  We have taken advantage of the low level of volatility in the market to structure these bearish bets with long dated put options, which limit our risk to the premium we pay at the outset, with the potential reward being many multiples of that if our thesis plays out.

Hedging Overview

Lastly, we are quite excited about the go forward set up for our hedging portfolio. We aim to be thoughtful in our hedging as it comes with a cost to do so.  As we stated earlier, volatility as measured by the VIX has declined meaningfully on an absolute basis, but we find it undervalued on several relative measures as well.  The MOVE Index, which measures bond market volatility, is down 7.5% this year, while the VIX is down over 38% as shown in the chart below.  We monitor our hedges continuously and are not shy to rebalance them or adjust as needed.

EQUITY VOLATILITY CHEAP RELATIVE TO BOND VOLATILITY

Conclusion

We firmly believe the market environment today is much more conducive to alpha generation than what we faced in the first half.  High levels of complacency, lofty valuations and cheaply priced volatility all add up to a target rich environment for our strategy in the quarters ahead.