Past repeating… or a new paradigm?

Whilst the E.I. Sturdza Funds plc – Strategic Long Short Fund only launched in November 2022, the team at Crawford Fund Management has been managing the investment strategy utilised by the Fund in a domestic US product for the past 14 years.

As such we are delighted to provide you with the following update regarding our views of the market and strategy performance in 2022, as well as our outlook and positioning for the strategy for the year ahead:

Market & Economic Review

The market and the economic paradigm shift that began in late 2020 continued to unfold throughout 2022, resulting in one of the worst combined stock and bond market performance years in the last century. 1931, 1937, and 2008 were much worse for equities, but at least bonds made positive contributions during those years.

Beyond the general market declines, speculative sectors such as SPACs, IPOs, hypergrowth and crypto were crushed in a manner reminiscent of the 2000 tech bubble bursting. Our contrarian scepticism, which we have held for the past few years became the full-blown consensus opinion in 2022.

60 / 40 Stock / Bond Annual Portfolio Returns

Total nominal return in US stocks and bonds, for each year 1871 to 2022 (%)

Stubbornly high inflation and rising interest rates continue to be a strain on consumers and businesses, especially small businesses and lower / middle-income consumers, where essential expenses are a larger portion of their household budgets.

We continue to believe that, since inflation has several structural and behavioural causes, it may not go away easily or quickly. It is conceivable that interest rates will still have to rise meaningfully from current levels to restore markets to a stable equilibrium.

It should not be a surprise if long-term bond yields normalise upward to their historical averages, or if short-term rates need to be raised above the rate of inflation to control it. Despite the repeated recent rate increases, real rates are still negative.

US 30 YR FRM Rates

This emerging paradigm is unfamiliar to many current fund managers, reordering the investments that perform well and those which do not. It also places stress on leveraged companies and consumers who are only beginning to process the impact.

The spike in mortgage and auto lending rates should have a significant cooling effect on those industries, and the upstream industries which supply them. Housing affordability for new buyers has declined dramatically given both rising monthly interest payments and home price appreciation, due to supply shortages and an influx of speculative capital.

Drivers of Affordability

Layoffs are the next looming problem, and we believe they are likely to be focused on high-income and well-qualified workers. Over the recent years of nearly zero-cost money, thousands of public and private ventures were funded with hundreds of billions of dollars and benefitted from further trillions pumped into their securities, partly fuelled by government stimulus and investors‘ FOMO.

The resulting extreme embedded expectations made it imperative that the ventures post repeated spectacular growth results to justify the prices. To show growth, the companies claimed ever-increasing TAMs (Total Addressable Market) and hired employees at a breath-taking pace to validate the progress.

Young companies were doubling or tripling their headcounts every year, creating the daunting task of onboarding, training, organising and motivating thousands of new employees in a very short period of time. HR departments were staffed up quickly so all departments could staff up quickly.

Power and influence came to be measured by the number of people on a team rather than the cash flow it could generate. We note that the real trick, however, was that thousands of these ventures convinced people to work not primarily for cash, but for the modern incarnation of scrip – i.e. stock compensation.

Clearly managing large numbers of new employees, and working on a proliferation of new projects (e.g. the metaverse) is inherently difficult. It didn’t take long for bloat and disarray to set in for many ventures, exacerbated by COVID-era work habits, causing communications and collaboration to weaken and project timelines and sales cycles to lengthen.

With pervasive remote work, dog-walking was sometimes given equal priority with closing sales, which was already hard enough with unproven products. Insider and founder shares were heaped onto the market along with secondary offerings until the market started choking on the flood of paper. Many stocks have now crashed, 70% to 95% leaving the companies with a huge employee incentive and morale dilemma.

Should deeply underwater options and unvested stock be repriced or supplemented to retain workers even if it means huge dilution for shareholders?

If no dilutive repricing is done, will the best employees leave (since they have other opportunities), leaving the company with only the least productive employees? Does any of this matter if the company is burning so much cash that it must reduce expenses to survive?

Our view is that we are at the beginning stages of a massive wave of layoffs that will ultimately accumulate to millions of workers, many of them highly-paid professionals whose aggregate spending is important to the broader economy.

For those not laid off, witnessing friends and colleagues fired will also impact the psychology of consumption. Some tech companies are already demonstrating that they can cut 50% or more of their employees and continue to operate. It doesn’t take long for this to become a strategic imperative across the young public company and VC-backed universe.

Tech layoffs since COVID-19

While SPACs and IPOs reached irrational levels, crypto was most symbolic of hubris in this bubble. Celebrities were hired as pitchmen. Naming rights to professional sports venues were purchased.

Highly respected financial institutions committed billions to ventures lacking audits or complete financial statements. Donations were doled out to non-profits and social causes to bolster a sense of trust. We’ve noticed that the more vociferously a company trumpets how virtuously it is serving society, the more likely it is to stumble on execution and disappoint investors.

Management knows when things are not going well or when expectations are not achievable, attachment to social causes can be an enticing cover to distract from fundamental business problems and buy more time to keep illusions alive to raise capital. A cynical view for sure, but one that has sniffed out a few disasters before they were apparent.

We find the potential confluence of intractable inflation and high-income job loss to be concerning and would not be surprised to witness a difficult consumer and business recession combined with a second chapter of this bear market.

Consumer Discretionary spending seems particularly at risk, and a large wave of bankruptcies could hit highly leveraged economically sensitive companies. Credit spreads are poised to widen, and hundreds of public equities are becoming zombies and could be forced to delist from the major exchanges.

These trends should result in tailwinds and new business for our holdings Houlihan Lokey, the top provider of restructuring advice, and OTC Capital markets, which operate the major exchange for micro-cap stocks. There are also interesting long opportunities emerging in this sea of destruction.

Some of these crashed companies have viable growing businesses and are much more appealing trading at 1x to 3x EV/Sales rather than 20x to 30x. We may be near a point of maximum pessimism for some of these stocks and could be entering an age of activism, where focused shareholders and new management can cut expenses and refocus resources to earn high returns on today’s depressed prices. We have added a few of these ideas to our long book in recent weeks.

In Q4, we raised our net exposure as longs became much more attractive after the steep selloff. Overall, we believe the projected forward expectancy of the current portfolio is well above our long-term average, with a 65% average appraised upside in the long book, while puts remain moderately attractive due to recession and company-failure risk.

In general, we tend to get longer during oversold markets and shorter during overbought markets. When we have plentiful compelling long investment ideas, we like to be as close to 100% gross long as possible on a cash basis. We’ll then hedge a portion of the long exposure on an opportunistic basis depending on the number, nature and attractiveness of short ideas as well as how they may correlate to our long positions.

The following summarises our key long-short investment selection principles, whilst highlighting some of the major factors that distinguish our long book from our short book, and describes how we view the essential differences:

1. Most of our long investments are profitable cash-generating businesses (or are on a clear trajectory to be so), whereas many of our short / put investments are burning cash and depend regularly on the capital markets for funding.

2. Our long book has strong incentive alignment, with senior management and key board members owning substantial stakes in the companies. Our short / put companies by contrast more often have less incentivised management or an overhang of shares being actively liquidated.

3. Our long companies tend to be leaders with franchise positions in the market or niche they occupy or are pioneering a new niche, whereas many of our short / put companies are secularly challenged share-donors or unproven ventures up against incumbents with far greater resources.

4. A meaningful proportion of our long companies exhibit high levels of customer satisfaction with their products and services, while a meaningful portion of our short/put companies have either not noticeably distinguished themselves in a major positive way or have meaningfully negative perceptions among customers.

5. The vast majority of our longs have financial flexibility due to strong balance sheets, and those with meaningful leverage are often in a mode of actively de-levering. Meanwhile, a significant group within our short / put companies have excessive leverage, often combined with deteriorating or secularly challenged businesses.

6. A meaningful portion of our long companies are actively repurchasing their shares at discounts to our view of fair value, which is accretive to intrinsic value per share, whereas many of our short / put companies are diluting shareholders via repetitive share issuance, often to fund years of cash burn and large stock compensation.

7. Our long investments trade at a substantial discount to our estimate of fair value. The long portfolio’s aggregate weighted average upside to our appraised target prices is about +65%, much higher than usual. Our short / put companies have a substantial aggregate downside to our view of fair value, typically due to prices embedding expectations of an unrealistically high level of growth and profitability, or an impairment scenario where value is destroyed due to an external shock or internal problem.

8. Our long investments are subjected to our “pre-flight checklist” of potential warning flags (qualitative and quantitative criteria that have correlated to prior investing mistakes). We generally steer clear when 5 or more (out of a possible 31 flags) are present. The average number of flags is 2.1 for our longs, while many of our shorts / puts have 8 or more – which we believe implies an investor is likely skating on thin ice.

Whilst, given the length of the Strategic Long Short Fund’s track record, we are unable to publicly provide performance information at this time, we would be happy to provide any additional information or assistance upon request to info@ericsturdza.com.

For more information visit the Strategic Long Short Fund page and /or contact Adam Turberville.

Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

 

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The views and statements contained herein are those of Crawford Fund Management LLC in their capacity as Investment Advisers to the Fund as of 12/01/2023 and are based on internal research and modelling.