Charlotte Lane Capital letter to partners for the second quarter ended June 30, 2016.
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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 on the interplay of expectations embedded in the stock price at time-zero, fundamental corporate performance that follows, and expectations embedded in the stock price at the end of the holding period, + / – dividends reinvested. What happens when we have high insider ownership, high embedded expectations, and an ego at the top that proposes the acquisition of a capital marketsdependent related party entity of which he is the largest shareholder and which members of his family operate and own?4 We are short this unnamed stock.
In announcing the proposed acquisition, the CEO commented this deal can result in the first trillion dollar market cap in the history of the world. That’s nice – the combined market cap of the two entities is $34B. Perhaps he was encouraged by the blandishments of a large shareholder, who claimed on CNBC last month this could become one of the largest companies in the United States.
I see this company as being a very poor manufacturer with a massive need for continuing capital raises, which need will only be exacerbated by this acquisition, should it go through. The faster a badly positioned and badly managed company invests in ill-chosen pursuits, the quicker it destroys value. As a short, I am 100% in favor of this proposed deal. We had a 7% short in this stock going into the deal, which was a gift, because I see the fundamental performance of this company deteriorating daily. That’s not an exaggeration – we have access to screen scrapes showing the daily sales of this company falling, and not by a little. By a lot.
Because holders of the stock have called in their shares to vote on the deal (vote “yes,” shareholders, please), the borrow has tightened considerably. Following the negative reaction of a market shocked by this deal announcement, we covered a good portion of the position before the short squeeze. We’ll be back in size once this has passed. I like the short very much without the deal going through and love it if it does.
Quarterly Scorecard and Positioning
We made money on both sides of the ledger in the quarter, with 1.4 percentage points of contribution from our longs and 0.4 percentage points of contribution from our shorts, before interest, fees, and other (please see appendix exhibit 2).
On the basis of ROA, our long ROA was 2.0% and our short ROA was 0.3%, before interest, fees, and other. So, for every $100 we borrowed, we got paid $0.30 to take on those liabilities and for every $100 we invested, we made $2.00. We like float that pays us to take it on before we even invest it.
Net positioning going into Q3 was little changed from the average position we maintained throughout Q2. I continue to see good short opportunities in Consumer Discretionary (particularly autos & auto parts manufacturers and restaurants) and Industrials (particularly in transports and capital asset providers).
If there is a theme that pervades the portfolio, it is this6: We are longer low leverage, family-controlled, strategically secure companies and shorter higher leverage, capital intensive, strategically indifferent, and cyclically overcooked companies run by management teams who are overly aggressive and don’t participate very fully in shareholder downside. This won’t always be the case, however. We will get long ugly value when the time is right, which is normally in the depth of a recession or a capital markets event that forces discipline upon a company or industry.
Capital will not always be so plentiful and investors won’t always price equities such that they offer little to no compensation for the risk of recession, credit events, and interest rate changes. I’d be happy to own companies like Hermès or Richemont for a decade or more, but there may come a time when we can get better risk-adjusted returns elsewhere. My analytical time horizon is 10-20 years because that is most often the equity market’s discounting horizon7 and I believe that is the way to buy businesses, based on a fundamental forecast of cash generation potential and incremental returns on capital. In moments of extremis, however, the market will shrink the discounting horizon for poorly positioned companies to five years, two years, or even at a negative level while quality companies embed longer horizons of value creation. At those points, we will tilt more heavily toward the lower-quality names.
Averaging As a Crutch
I have no favorites and I am not religious about anything other than seeking out excess returns, wherever they can be found in mid- and large cap. I am not religious about turnover, which has become a bit of a Shibboleth in the value investing community. If something needs to be sold because there’s a problem that has not been discounted or there is something better to be had, I will do so. I believe many value investors use “low turnover” as a crutch to avoid the unpleasant thought they are wrong. I also believe many value investors average down too quickly for the same reason.
Every value investor who averages down thinks it’s warranted due to the lower price offering even greater value and a greater margin of safety. My averaging behavior incorporates not just the distance between price and intrinsic value but behavioral elements as well as quantitative. One should have an idea of the base rate of how often averaging turns out poorly and take that into account before averaging. Given how often averaging is wrong, you shouldn’t see it as often as you do in value investors’ portfolios. However, the magnitude of gains when it’s successful argues against the idea that averaging is bad. That’s where the quantitative element comes into play.
Investors would do themselves a favor to familiarize themselves with the distributions of returns across sectors and across 50+ years of market history. The financial services sector exhibits a highly negative skew in the monthly annual distribution of its returns over the long term. Buying at book value doesn’t vouchsafe a margin of safety or high future returns. History shows that sector can go to a 10% discount, a 30% discount, or more and that the skew toward negative returns is way below what one finds in a log-normal distribution.
I’ve owned things at a 90% discount to book and at 1x the forward earnings estimate8. You’re done if the company issues equity at that level – that’s a permanent impairment of capital. It may also be a ten bagger or more if it works. That doesn’t help the poor soul who rode it down from 100% of book value, however. Another non-normal distribution of returns can be found in the technology sector. This sector’s returns follow a Pareto distribution, with huge number of failures relative to a normal distribution and a comparatively tiny number of 50- and 100-baggers.
I size individual positions, pace averaging speed, and watch risk aggregations according to not only valuation, but behavioral factors and historical return distributions. As popular as the Kelly Criterion has become in the last ten years in its applicability to portfolio construction and position sizing, it can be applied disastrously when wielded too aggressively. This is particularly problematic if a PM is overconfident and narrowly focused on low multiples to consensus estimates or historical balance sheet accounts like book value.
I will buy quality growth, compounders, junky value, left skewed distributions, log-normal distributions, and Pareto distributions; it all depends on what offers value at any particular time. I also view these as diversification axes and will often be present in all to some degree, with tilts when values are at an extreme (in frothy markets as well as bear markets). I will never fit into a style box because there is no one right “style.” Those who believe there is narrow their search areas and subject their investors to regime rigidity, which can result in years of underperformance relative to more flexible passive investment options.
Conclusion
Markets remain volatile and generally overvalued, which offers us the opportunity to generate excess returns across the spectrum of situations. As markets churn along, we will probably grind along too as I pursue our goal of increasing your after-tax purchasing power across business cycles at a risk-adjusted rate greater than the market offers.
I appreciate your trusting me with your capital and look forward to being in touch. I leave you with a picture of me and our namesake on Father’s Day. Charlotte and I were talking the other day and she asked me what my five favorite things are. When I asked the same, she replied “Horses, horses, horses, horses, and horses.” Oh, no. Please tell your friends about Charlotte Lane Capital.
Dale Wettlaufer
July 2, 2016
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