Striving to Consistently Outpace The S&P 500 Index
0% Management Fee, Performance Fee Only
1/1/2022 – 6/30/2022
Semi-Annual Letter to Limited Partners
Cavallini Capital LLP.
Greg Cavallini
5445 DTC Parkway, PH 4.
Greenwood Village, Colorado 80111
Results January 1, 2022 to June 30, 2022
Cavallini Capital, including dividends reinvested (hereinafter call CC) had a negative return, Please contact Greg at greg@cavallinicapital.com for results. The S&P 500 Index including dividends reinvested (hereinafter called the S&P) had a negative return of 19.95%.
Cavallini Capital Investor Gains vs. The Competition
Below you will see 5 separate results:
1. An average of all U.S. stock mutual funds. These Funds are actively managed by individual(s) who are the smartest and brightest in selecting stocks.
2. Results from a typical mutual fund that is invested in a similar manner to CC. T. Rowe Price (PRDGX) has Assets Under Management (AUM) of about $14 billion. PRDGX represents a prototypical fund for an ordinary investor seeking to put money in an investment vehicle focused on stocks. Results are represented net of fees.
3. The S&P which is passively managed.
4. Investor gains in CC net of fees.
5. Results of CC.
To view track records, please contact Greg Cavallini at greg@cavallinicapital.com.
Top of Mind For Investors During The First 6 Months of 2022
Undoubtably it has been a tough first 6 months in 2022 for the markets. This includes both for stocks and bonds (SPACs and Crypto even worse).
The 30-year Treasury bonds fell 9% in April, the worst month since January 2009. Bonds have performed so badly that a tradition 60/40 portfolio (60% equities / 40% bonds) is on pace to lose 49% for the year as of beginning of May. This would be the worst annual return on record (records only go back to 1945). Investment-grade bonds, as measured by the iShares Core U.S. Aggregate Bond ETF lost 11% in the first half of 2022, the worst start to a year in history.
As for stocks, well the situation is not much better. As of June 20th, the S&P is down more than 23%, good enough for its worst start since 1932. A more updated number, Jan 1, 2022 – June 30, 2022, the market is down 19.95%, which is the worst start since 1970.
There are many speculations as to why this down turn has occurred. They included the war in Ukraine, which has created a spike in oil / gas prices. It should be noted that a major component of the inflation measurement is comprised of oil / gas prices. Other people have blamed supply chain problems as the major cause. China continues their zero tolerance policy towards Covid-19 outbreaks, which means factories and ports are temporarily slowdown or shutdown. This creates long lead times to receive goods, which exacerbate the entire logistics chain.
However, from my point of view, the largest contributor to the down turn in the markets has been the Fed having to raise interest rates to tame inflation. This has always been the real threat and now the real result of a tough market. Let us discuss why raising interest rates typically causes down turns in the markets, but particularly the stock market. When the Fed raises rates, it makes it more expensive for companies to pay interest on money borrowed. Companies borrow money for all sorts of reasons, maybe they need to hire more people, or spend money on R&D, or just maybe they need the cash injection to help them survive the next 6 months or whatever the case may be. Furthermore, young companies that are not yet profitable, but are scaling quickly are unable to borrow money to fund those expansions. As a result of these consequences, companies typically freeze hiring (already happening) or begin laying off workers (also already happening). The direct result is that people who have some money, hold on tight to their wallets and won’t spend and those who don’t have much money lose their jobs and can’t spend.
Federal Reserve chairman Jerome Powell concluded mid last year that inflation would be transitory. Understand that he has access to the best and most up to date data. He and his colleagues are extremely well versed on macroeconomic issues. Thus, market participants, for the most part, heard what he had to say as the most likely outcome. It is safe to assume that the Fed made the wrong call. As a result, the Fed is now playing catchup to lower inflation. The problem is that when the Fed raises rates aggressively instead of gradually, the very real result could be a recession. Case and point, in the last meeting, the Fed decided to raise interest rates by 0.75%, the largest increase since 1994. One might notice that in 1994 the economy did not fall into a recession. However, at that time, inflation was running at about 2.7%. This means that the Fed got ahead of inflation in order to avoid such problems. Today, we are in a very different situation in which the Fed is behind inflation. Their job now is to raise rates while hoping for a soft landing (no recession).
During these trying times, it is important to look at historical numbers to gives us some sort of guidance. Since 1950 there have been 12 big tightening cycles (when the Fed raises rates). In 9 of those 12 occasions, the economy tipped into a recession. Typically when a recession strikes, the market on average since 1946 has declines 24%. It should be noted that the longer a market declines drags on, the longer it will take to recover. Two instances come to mind: 1) The quick 35% drop in Feb / March of 2020 which lead to an extremely quick recovery 2) On the flip side, the long market draw down in 2008 which took a very long time to recover. We also have to recognize that “the Fed put” is no longer in play as it has been since the 1980’s. Traditionally since the 1980’s, the Fed has supported risky assets whenever they show signs of trouble. It seems that the Fed is now allowing the market to take care of its own problems.
The Silver Lining
Given the information above, where does that leave us as investors? I believe this is a good opportunity to buy more of the stocks the Fund owns. Stocks are trading at low valuations at the moment. For some context, as of June 21st, the S&P is trading at 15.4 times its next 12 months expected earnings. That is below the 15 year average of 15.7.
Since 1950 when the market has dropped 15% or more, 11 of those 17 times, the market did not bottom until the Fed began to signal dropping rates. You might ask: why not go to cash until such event happens? There are 2 answers to this question: 1) It is not 100% certain the market will only start recovering once the Fed signals the dropping of rates. In fact it is only about a 65% chance that that will occur. 2) most importantly, the market anticipates these actions ahead of the Fed. Thus, you could miss out on the most important part of the recovery.
S&P balance sheets are sitting at very good levels of debt. As an investor, what you want to see now is companies increasing their dividends and share buybacks in the face of lower profit growth and falling productivity. Net debt to EBITDA is currently very low for these companies. As an example, in 2003 companies had about $5 of debt for every $1 of profits, while today that ratio is $1 to $1. Given the discount in stock prices, companies should be buying back as much stock as possible.
The market is a forward looking mechanism. It seems the market has already baked in a recession by dropping stock prices. This could lead one to believe the worst may be over. However, the main point is that great companies are trading at very low valuations. It is precisely the time to buy more. We can never anticipate when the bounce back will begin. But what we can control is buying when things are at a discount. This does not mean the market will be higher in 6 months or whatever the case may be, it may be lower. What we know is that buying a great company at a 20% discount is a great deal. It’s possible the price continues to go lower, but eventually it will recover. You may not get the company at the absolute best discount (lowest stock price), but a markdown of 20% is very good. As a side note, the market goes into bear territory (20% drop from its highest point) once every four years going back to 1926. Meaning, you are buying at a discount that typically only comes around once every 4 years. TAKE THE DEAL…..
One final note on potential positivity for the back end of 2022. When the S&P 500 has fallen 15% or more in the first half of the year, second half results for that year have been very strong. At least a 15% drop in the first half of the year occurred in 1932, 1939, 1940, 1962, and 1970. The average gain in the second half of those years was 24%.
It's important to understand the types of companies that CC takes on as investments and how CC takes on those investments. Companies in CC have a proven long term track record of low debt, high free cash flows, and have revenues that are increasing while maintaining their margins. As interest rates rise, companies that will be most punished (stock prices dropping anywhere from 60% to 90%) are those that have high debt levels, little to no profits, and / or no real free cash flows. Think Teladoc, Zoom, or Carvana as examples. The use of some or heavy leverage would be the second pathway for a portfolio to have such a collapse. As Warren Buffett once said “You don’t find out who’s been swimming naked until the tide goes out”.
You can rest assured that CC does not use leverage and does not invest in those companies as it goes completely against CC’s investment process. However, this does not mean that some of the stocks in the fund will not go down, but it does mean that the odds are unlikely that CC’s equities will be punished to such a degree. In bear markets, it’s portfolios that lose the least or are close to major market indices that are the winners.
Ana and I have the majority of our investable wealth in CC and so long as CC is in operation, this will always be the case.
I can’t promise results, but I can guarantee that our wealth will be in lockstep with yours.
Sincerely Yours,
Greg Cavallini
Notes:
The record above displays Cavallini Capital’s track record since inception on July 1, 2017.
Disclaimer: Greg Cavallini, as General Partner of Cavallini Capital, LLP, makes no representations or warranties to investors regarding the probable success or profitability of Cavallini Capital, LLP, and the Track Record, Results and Comparisons set forth herein shall not be used as an expectation on benchmark for any new investments or ventures.