Hazelton Capital Partners commentary for the first quarter ended March 2021.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Hazelton Capital Partners, LLC (the “Fund”) returned 11.9% from January 1, 2021 through March 31, 2021. By comparison, the S&P 500 returned 6.2% during the same quarter.
The Quarter in Review
Hazelton Capital Partners ended the 1st quarter with a portfolio of 16 equity positions and a cash level equivalent to 10% of assets under management. The top five portfolio holdings, which are equal to roughly 55% of the Fund’s net assets, are: Micron Technology, Inc. (NASDAQ:MU), Renewable Energy Group Inc (NASDAQ:REGI), Caesars Entertainment Inc (NASDAQ:CZR), USA Technologies (USAT), and Apple Inc (NASDAQ:AAPL). Hazelton Capital Partners’ top five holdings were responsible for 75% of the quarter’s overall return as the market’s upward momentum continued into Q1. The biggest change to the top five portfolio holdings was movement of Renewable Energy Group from the Fund’s top holding to its second largest after Hazelton Capital Partners sold approximately half of its position in mid-February. In addition, the Fund’s overlay strategy was uncharacteristically active throughout most of Q1 generating over 200 basis points of the Fund’s quarterly return. The increased activity came from selling option premium.
The Overlay Strategy
Hazelton Capital Partners uses two investing strategies: The Core & Overlay. The Core Strategy, as its name suggests, is at the center of Hazelton Capital Partners’ long-term, concentrated investing process and gets most of the attention (good and bad) in these quarterly letters. The Overlay Strategy was designed to complement the core strategy and has been operating in the background with little fanfare year over year. Focused on generating short-term cash flows, providing a pathway to enter or exit a position, or hedge a specific position or segment within the portfolio, the Overlay Strategy uses a combination of options, risk arbitrage/M&A, index offsets, and commodities to achieve these goals. Throughout the first quarter, Hazelton Capital Partners was uncharacteristically active in selling options against many of our current and potential holdings.
During extended market rallies, it is common for investors to regularly purchase downside put options to protect their equity positions against a market decline. As demand for downside put options increases, so do their premiums; as a result, those options become more expensive with respect to their corresponding upside call options, generating what is known as a put skew. These put skews become even more pronounced during a quick and meaningful market selloff, as investors try to stay ahead of the market downturn. In the first quarter of 2021, the market underwent three quick market selloffs leading to a spike in overall volatility, as measured by the VIX index.
In addition to the elevated put skew, Hazelton Capital Partners also witnessed a call skew develop in several of its holdings. A call skew (the upside call premium is more expensive than the corresponding put premium) is often triggered by market speculators/momentum traders who use call options as a less expensive proxy for being long shares of a stock. This common strategy became a key trading tool for the “Reddit Traders” who targeted short positions (stocks that were sold short) of well-publicized hedge funds.
Even though Hazelton Capital Partners did not own any of the key speculative “Reddit” names, the Fund took advantage of upside speculation in a few of our positions by selling calls with elevated premiums. The remaining options sales were downside puts in positions that the Fund either wanted to initiate a position or add to a current holding at a price below the current market level. The spikes in volatility throughout the quarter helped the Fund execute these option trades. Although the overall options speculation has cooled off, the market uncertainty has not. One should expect that future volatility spikes will once again hit the market and bolster buying of speculative upside calls and downside protective puts. Hazelton Capital Partners will continue to participate when selling options premium matches our long-term investing outlook.
Micron Technology (MU) Current Holding
In 2006, data analyst, Clive Humbly, coined the phrase “data is the new oil.” Just as oil fueled the industrial revolution, data is the feedstock that is powering the ongoing technology evolution in artificial intelligence, machine learning, e-commerce, communications, autonomous driving systems, and social media, lying at the heart of nearly every industry. However, for data to be useful it needs to be stored, distilled, and processed which is exactly what the semiconductor industry does. Whether it is a GPU, CPU, DRAM, or NAND, semiconductor chips are embedded in practically every device that either runs on electricity or battery power.
Today, we are witnessing firsthand just how dependent the global economy has become on semiconductors chips. Even though chips only account for about 1% of a new car’s average selling price, the electronic sensors, high-end driver-assisted technologies, and infotainment systems that rely on those semiconductors make up over 40% of the cost of the most popular and profitable car models. In their recent earnings releases, the global automobile manufactures have warned investors that an ongoing chip shortage has slowed, stalled, or even stopped production, forcing manufactures to redirect their supply chain to focus on their best-selling models. The shortage can be traced back to the recent “Texas Freeze,” a fire at Japan’s Renesas Semiconductor Manufacturing Co, and auto manufactures and their suppliers (with “just-in-time” inventory) who miscalculated the demand for new cars during the Covid pandemic. Unfortunately, for the auto manufactures, the electronics included in their leading car models require complex semiconductor chips whose lead times now can range over 6 months. The disruption from a shortage in chip supply is now cascading down into other industries, impacting PCs, consumer electronics, cloud and data storage, and even Apple, which produces its own chips, announced that its Mac and iPad products will be impacted by the shortage in the upcoming quarter.
During Micron’s recent Q2 earnings call, CEO Sanjay Mehrotra described the current DRAM environment to be in “severe shortage” and is being felt across all of Micron’s segments. He expects the disruption to continue through 2021 and possibly the early parts of 2022. The NAND side of the business has been in oversupply for a several quarters, but as the industry has been transitioning to a higher number of layers on their 3D platforms, the bit per wafer growth has been slowing, helping to rebalance supply and demand. As cars, mobile devices, consumer electronics, and servers run more applications, all of which require faster interactions, they are integrating a higher level of capacity for both DRAM and NAND. This, on top of the demand that was pulled forward from the Covid “work from home” environment, is underlying the supply and demand imbalance in DRAM. In the past, this type of demand driven environment would have been met with increased capital expenditures by Micron and its competitors (buying more manufacturing equipment to increase output), but over the last few years, Samsung and SK Hynix have been more deliberate about their roles in the memory and storage industry. With just three competitors in DRAM and about five in NAND, rational behavior seems to have found a stronghold as DRAM and NAND manufacturers focus on their profits and return on invested capital.
As an investor in Micron, Hazelton Capital Partners likes to see a healthy demand for their products. However, in the short run, a lopsided market (“severe shortage”) can often lead to bad behavior and unintended consequences within the industry. Over the past three years, Samsung, SK Hynix, and Micron have all reduced their capital expenditures by about 25% per year, focusing mostly on maintenance capital expenditures. It takes about 18-24 months lead time to get new DRAM and NAND manufacturing equipment installed and another 6-8 months to get the line up and working at full capacity. Even though it does not appear that the industry will be adding any meaningful additional capacity anytime soon, there are still headwinds to be mindful of like the increasing cost of silicone, continued supply chain issues, and erratic quarterly demand. Hazelton Capital Partners will keep a watchful eye on the industry, especially the capital expenditures, but remains encouraged by the “mature” behavior of the DRAM and NAND industry.
Renewable Energy Group (REGI) Current Holding
“Just when I thought I was out, they pull me back in.” – Michael Corleone “The Godfather part III” Hours after his inauguration, President Biden signed 17 executive orders, two of which (rejoining the Paris climate accords and revoking the permit for the Keystone XL pipeline) were meant to send a clear message that his administration was serious about campaign promises focused on the environment and climate change. That sentiment provided a strong tailwind for “clean energy” stocks, helping to boost REGI’s share price over 65% in the first forty days of 2021, and 113% since Biden won the presidency in early November.
At the start of Q1, Renewable Energy Group was Hazelton Capital Partners’ largest holding. By mid-February, the Fund sold out of half of its shares. It is important to remember that except for some position trimming in late 2020, this is the first major sale of REGI shares in the roughly 6 years Hazelton Capital Partners has invested in the company. The decision to reduce the position was driven primarily by two key factors: 1) REGI had grown to become a significant portion of the portfolio, eclipsing all the other top five holdings, 2) the company’s share price had gotten ahead of its valuation driven by a speculative fervor in “clean energy” stocks. Hazelton Capital Partners still believes that there is a continued runway of growth for Renewable Energy Group, with that growth emanating from the proposed expansion at its Geismar renewable diesel facility and the possibility of additional future expansions. It will take a few years to bring new production capacity online, and in the meantime, the company will continue to work on improving its profitability with both upstream and downstream projects. Had REGI’s stock price appreciation been more measured during Q1, it is more than likely Hazelton Capital Partners would have continued to trim its holding but probably would not have cut the holding in half.
During REGI’s earnings call at the end of February, the company announced guidance for the upcoming quarter below consensus due to a scheduled Geismar turnaround and a decision to increase their RIN inventory. For a company, whose shares are being priced as a “growth” stock, there is no room for disappointments. Over the weeks to follow, Renewable Energy Group’s stock continued to trade lower. In mid-March, the company announced a secondary share offering in which the capital raised would be used to underpin its balance sheet and finance capital expenditures related to the expansion of their Geismar renewable diesel refinery. The market was disappointed REGI did not offer shares when the stock was trading at or near its highs in mid-February. Of course, the company was in its quiet period during that time and could not announce any corporate actions. Nevertheless, REGI shares have remained weak since the secondary even though management has guided that the ROI on the expansion project would be greater than 20%. The capital raise does not preclude the company from using debt financing at some future date if they choose.
Another headwind impacting REGI’s share price was the spike in soybean oil price by over 30% in the first quarter and over 60% by mid-April nearing highs not seen since 2008. Renewable Energy Group has proven to be particularly good at managing its costs by buying and storing feedstocks when the prices are low (often during the winter months) and having the flexibility to use multiple feedstocks at the same plant without having to slow down production. Historically, it takes a few months for downstream prices to adjust to the increase in feedstock prices, but with all the dislocation from ancillary markets over the past year, it is difficult to determine whether the spike in soybean oil is a temporary shock or a changed condition that will be with us for a while. In the past, Renewable Energy Group was able to leverage its size, multifeedstock footprint, and logistics system to continue to operate profitably while other refiners were forced to reduce their capacity or idle plants. Hazelton Capital Partners expects that to be the case going forward.
Shares of Renewable Energy Group have fallen over 50% from their high in mid-February and Hazelton Capital Partners has taken advantage of the decline to rebuild its position. As of writing this letter, the Fund has nearly re-established the number of shares it held before it began trimming its holding in late 2020.
Administrative: Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest alongside me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners’ assets in the same way I manage my own capital. The best source of introduction to potential investors in the Fund has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me.
Please do not hesitate to call me at (312) 970-9202 or email me email@example.com with any questions or concerns.