Q1 2021
Kinsman Oak Investor Letter Q1 2021
April 16, 2021
MARKET COMMENTARY
Financial markets have remained eventful, and the signal-to-noise ratio continues to trend in a more erratic direction. Two major themes have dominated headlines and asset prices lately. First, at a macro level, rising ten-year Treasury yields have seemingly spurred a rotation from growth to value. Second, at a security-specific level, short squeezes and family office/fund collapses have caused extraordinary volatility.
While headlines imply retail trading activity ignited parabolic moves, we suspect institutional players had a much larger impact. We wonder how many other family offices with ~$10-15 billion in assets under management are quietly levered up more than 5x across multiple prime brokers. The Robinhood fiasco certainly poses interesting ethical and moral questions about the role it played in gamifying markets, but we doubt its users were solely responsible for multi-billion-dollar changes in market capitalization by purchasing out of the money call options. We will learn more in the coming months once the dust settles.
Sentiment Check
Broadly speaking, speculative excesses and elevated investor sentiment from last year have trended higher so far this year but we are beginning to see early signs of waning euphoria. Anecdotally, we sense unfettered bright-eyed and bushy-tailed optimism transforming into angst and nihilism. Animal spirits are notoriously fickle though, and the mood may shift drastically before we even hit the publish button.
For instance, SPAC gross issuance proceeds were ~$83.3 billion in 2020 which is almost double the amount raised in the previous ten years combined (~$47.8 billion). Gross proceeds year-to-date are already more than the entirety of 2020 and total ~$100 billion as of March 31, 2021. According to Bloomberg, SPAC listings have recently slowed to a crawl and deals have been postponed as the insatiable hunger for new listings has cooled.
Most stocks in our short squeeze / greater fool bubble basket referenced in the annual letter are much lower than they were when we last published, but the majority still have positive returns year-to-date. Again, this suggests sentiment remains elevated, but the froth may be dissipating. Numerous post-merger SPAC transactions have also come under heavy scrutiny and are significantly below their all-time highs. Investors piling into these vehicles at the top were quickly disillusioned. On top of that, many high-flying stocks popular with retail investors experienced significant drawdowns as interest rates moved higher.
The Bond Market, Rising Yields, and P/E Multiple Rethink
Rising yields caught fixed income investors flat-footed and dealt a swift blow to the Treasuries market. Losses were concentrated on the long end of the yield curve as the 30-year Treasury experienced a total return loss of 15.7% this quarter. For reference, this is the worst quarterly performance since 1976. Investment grade corporate bonds were down 4.7% and junk bonds were up 4%. Rising rates were trouble for long-duration risk-free assets, but stronger economic data and a rebound in the energy sector reduced junk bond default risk, more than offsetting the impact of interest rate changes.
We wonder if rising yields and inflation expectations will cause a P/E multiple rethink. Valuation multiple compression occurs during inflationary bouts despite the widespread belief that equities are the place to be invested during these times. Sell side price targets are a function of two things: earnings and multiples. Generally, these analysts do a decent job projecting earnings which is where most of their time and effort is spent. But common practice is taking last year’s multiple and applying it to this year’s earnings. Projecting EPS trajectory is easier than selecting the correct multiple.
Fundamental vs. Valuation Risk
We are always conscientious of risks posed to our Fund’s holdings and try to evaluate potential opportunities in the context of whether we are being adequately compensated to take on additional risk. Two main types of risk exist: fundamental risk (a specific business fails to execute/perform adequately enough to meet investors’ expectations) and valuation risk (investors ascribe a lower multiple to future cash flow streams). Balance over a cycle is key, but sometimes leaning into one over the other is advantageous.
At this juncture we also know two things to be true. The economy is rebounding from historic lows and valuation multiples are more expensive now than at pretty much any other point in history. For this reason, we believe skewing the Fund’s risk profile towards fundamental risk and reducing valuation risk will provide better risk-adjusted returns for the foreseeable future.
CARNAGE BENEATH THE SURFACE
Analyzing returns in a vacuum at an index level would paint a very misleading picture of the moving parts beneath the surface. Factor rotations throughout the first quarter have been volatile and violent, to say the least, and plenty of stocks on our watch list remain significantly below all-time highs.
Long Duration Tech Disguised as “Tech is Eating the World”
Expensive software companies trounced the market most of last year. The narrative justifying this extreme outperformance was tech is eating the world. The pandemic pulled forward years of behavioural changes on the adoption curve for many businesses. On the surface, this explanation sounds plausible enough. Certain stocks deserved to be higher than where they started the year, but the harder question is calculating exactly how much higher. Many went through the stratosphere to the point where valuations made little, if any, sense.
We believe this quarter unveiled the real reason behind last year’s price action. In essence, these ultra-long duration tech stocks were simply a function of interest rates more than anything else. Technology is just as much eating the world today as it was at the beginning of the year yet, from mid-February to late March, these stocks were clobbered.
Internally we track a basket of TAM narrative bubble stocks referenced in our annual letter. Yields rose ~50 basis points in six weeks (Appendix B), and stocks in this group experienced an average drawdown between 30-40%. The implied duration of this basket is shockingly high. At the trough, many ultra-long duration tech stocks in this basket were up less than the median stock in our re-opening euphoria basket from the beginning of 2020 to Q1 2021 lows. Perhaps both baskets were just duration plays the whole time.
The Great Inflation Debate
The most consensus trade in the market right now is the shift to secular inflation driven by fiscal spending and the beginning of a commodity super-cycle. Short-term inflation is virtually guaranteed. Every company we track mentions it, there are supply chain disruptions all over the place, and year-over-year comparisons will be easiest in April and May. Headline inflation numbers will be high, and we suggest using month-over-month figures or two-year figures to filter out some of the noise.
We believe it is premature to conclude that an era of secular inflation is upon us. The change in commodity spot prices is largely driven by temporary supply constraints rather than structural shortages. Almost every commodities futures curve is in backwardation which suggests this elevated market tightness will dissipate over time. The big question is whether elevated demand in the future can offset easing supply interruptions and result in sustained higher prices. Further, one year from now inflation comparisons will be from a much higher base so it is conceivable to think inflation can sink below 2% again. Our base case scenario is that the market is underestimating short-term inflation and overestimating long-term inflation.
The strong performance in energy and financials can be partially explained without a secular inflation or a commodity super-cycle narrative. Rising spot oil prices were certainly a tremendous tailwind for the energy sector this quarter. But perhaps the recent rotation has more to do with rates than investors are willing to admit. If the performance in technology stocks last year was essentially a long duration play, this sector rotation could simply be the reverse of that. As yields rose, investors rushed from ultra-long duration assets into ultra-short duration assets. Energy and financials are the ultimate short duration sectors.
LOOKING AHEAD
Markets continue to be priced for perfection in an imperfect world. In a weird way, the new normal is like the old normal. We are back to an environment with high uncertainty, low prospective returns, elevated risk appetite, and the perception that clear skies lie ahead. We see numerous long-term headwinds for equity indexes broadly speaking, making stock selection a more important component for future returns.
Sincerely,
