Charlotte Lane Capital letter to partners for the second quarter ended June 30, 2016.
Charlotte Lane advanced 0.6% in June and 1.2% for Q2, generating alpha of 1.6% for the quarter1.
As of June 30, 2016, the strategy was 49% net short, at 82% long vs. (131%) short, as I believe stocks in general are overvalued for reasons discussed at length in past letters. Little changed on that front during the quarter and the US and global economies remain very weak. Corporate investment spending remains weak, unit labor cost inflation is far above corporate pricing power, and inventories remain bloated. Distended inventory balances present a clear and growing risk to industrial production. Meanwhile, the yield curve continues to flatten in the US and trillions of dollars of sovereign debt globally are priced such that the lender must pay the borrower to lend them money. This is crushing banks and killing their incentive to do anything but liquidate balance sheets or increase risk without a commensurate increase in risk-adjusted return.
Owners Act Differently Than Hired Hands. Corporations are bullishly positioned on their balance sheets and in their employment behavior. At least they were on the latter condition until the May nonfarm employment report, if that wasn’t anomalous. The problem continues to be profit pools are not growing fast enough to satisfy the return goals of corporations. Said another way, the rate of internal capital generation for corporations is higher than the growth in addressable profit pools, which is deflationary.
Capital velocity and margins are in decline across industries (Appendix exhibit 1), which means returns on capital are in decline and each incremental dollar of invested capital is yielding fewer and fewer dollars of marginal earnings. For the market as a whole (ex financials and materials, for which historical data on Bloomberg are truncated), returns on incremental capital are below zero.
Normally, farsighted fiduciary duty or scarcity of capital would lead management teams and Boards to act proactively to liquidate balance sheets and reduce expenses. This may not happen today for two reasons: (1) Capital is the least scarce resource in the world today and, (2) My 17 years of buyside experience indicate to me management teams are often not at all farsighted and are often poor fiduciaries, as discussed in past letters.
This reminds me of a story my Mom told me the other day. She recently had lunch with a woman around her age, who was very proud of her husband’s accomplishments as a C-level executive at a Fortune 500 company. My mother was a talented manufacturing executive and CEO of her own company and observed she thought executives without their own capital on the line act differently than those who are truly on the hook. Her lunch partner did not take that very well. Actually, my Mom used the phrase “hired hand” to describe the lady’s husband. OK, not too delicate, but the point is valid.
Executives at very large publicly traded corporations often don’t act the same as principals do. Far too many Fortune 500 executives get rich no matter how a corporation does, thanks in part to compensation consultants, poor proxy access by shareholders, and Boards of Directors stocked with people who wouldn’t dream of crossing management for fear of losing a lucrative and prestigious sinecure.
Management teams of S&P 500 corporations get incredibly rich if the company does well and if it doesn’t, they get new options packages and retention bonuses. They don’t have to live with the economic consequences of their actions the way owners of private businesses do, so that naturally colors their risk preferences.
There are few consequences for poor economic performance today, actually, thanks in part to the Fed. Markets are complex adaptive systems that work efficiently because they are comprised of many different participants pursuing a diversity of strategies. I believe strategic diversity is declining in capital markets, which is a negative condition if I’m correct. Most equity and credit market participants are very bullishly positioned right now. I’m not talking about what they say – sentiment surveys don’t mean much to me and cocktail party talk is purely anecdotal. What matters is actual positioning.
Charlotte Lane Capital – What People Say Doesn’t Matter Very Much; Positioning Matters
Long/short funds are as bullish as ever, based on their net long positions expanding to around 70% during the quarter, credit spreads have tightened again, margin debt is near record levels in the US, residential real estate prices to household income are approaching 2005 bubble highs, real yields are negative in OECD markets, and active management is losing capital to passive, which doesn’t hold discretionary cash but actually invests it.
Vanguard founder John Bogle said at a recent Morningstar conference, “I think whatever your view of the world is, you have to invest…The alternative is – I mean, the only way to guarantee you will have nothing at retirement is to invest nothing along the way.” This is another form of the “TINA2” argument and is a straw man appeal. No one said one should invest nothing over the course of one’s life. But one doesn’t have to commit capital at each step along the way or remain fully invested in equities. There certainly are alternatives, which is what we’re doing with Charlotte Lane.
Late June is a good example of how our short position allows us to take advantage quickly of momentary dislocations in the market. We were able to invest from a position of strength while the market flipped neurotically from panic selling to panic buying.
Unfortunately, this moment was brief. In this case, the Brexit sell-off allowed us to take positions in three very well positioned, family-controlled enterprises in Hermès (RMS FP), Richemont (CFR VX), and Inditex (ITX SM)3. I have studied all of these for ten years or more and have owned two during that time. Inditex is simply the world’s most fearsome competitor in apparel. It collapses multiple wasteful steps in apparel design, production, and retailing and shares that value with consumers via low prices and extreme product freshness presented in High Street locations globally.
Hermès and Richemont produce for a small set of consumers highly differentiated, high-priced, highquality items that are designed to last for generations. They are backed by fantastic balance sheets and centuries of heritage that are carefully guarded and shepherded forward by Boards and management teams that have billions of dollars of hard capital on the line.
Watchmaker Patek Philippe has one of the most memorable advertising taglines in the luxury category: “You never actually own a Patek Philippe. You merely look after it for the next generation.” If only Congress, the Boards of Directors of corporations, and voters thought the same way. At this point in time, we are focused on investing in companies that do think this way (I’ll buy junky deep value when the returns are asymmetrically positive – they are not now). Let’s look at the insider positions at some of our companies:
High insider ownership certainly does not guarantee stock performance, however. Stock performance depends