Finding the best opportunities as the "everything bubble" deflates
The baffling rise and fall of cryptocurrencies has come as no surprise to Ben McGarry, Portfolio Manager at Totus Capital, it’s just one of many short positions the portfolio has taken over time. In fact, he ventures that Coinbase (NASDAQ:COIN) is ground-zero in the current crypto crisis we are seeing.
As a long-short equity manager, Totus is uniquely positioned for the coming market turbulence – the portfolio can benefit from both rises and falls. In fact, while energy might be raising concerns in some investors, McGarry sees it as an opportunity on the long side.
The war in Ukraine and years of backseat driving by the ESG investing movement have created a once-in-a-decade setup for energy commodities on the long side. You have listed companies with no debt trading at double-digit QUARTERLY free cash flow yields. That is something you don’t see very often.
It stands to follow that energy commodities are a large exposure in the portfolio.
In this interview, McGarry shares his views on hedge fund investing in inflation, cryptobubbles and the company he is most excited about.
How does the current market environment of rising inflation and equity market volatility influence the appeal of hedge funds?
Historically, periods of persistent inflation have been bad for stocks and bad for bonds. For investors that need to be exposed to markets, having something in your portfolio like a long short hedge fund that can benefit from falling asset prices as well as rising ones is an obvious way to mitigate some of the risk that inflation and market volatility poses to typical portfolios that tend to be heavily long-biased.
What are some of the most exciting opportunities you see in the current market environment?
The war in Ukraine and years of backseat driving by the ESG (environmental, sustainability, governance) investing movement have created a once-in-a-decade setup for energy commodities on the long side. You have listed companies with no debt trading at double-digit quarterly free cash flow yields. That is something you don’t see very often.
On the short side, almost anything that was a big beneficiary of zero interest rates and fiscal and monetary stimulus is going to struggle going forward. It is one of the best (if not the best) environments for short selling I have seen in my career.
Where does this type of strategy fit within a retail portfolio (core versus satellite)? And what type of investors are best-suited to this type of investment?
While I can’t give financial advice, our investors (primarily fund of funds, family offices and high net worth individuals) are typically long various unhedged investments and they like the diversification that an investment in Totus brings.
Our work suggests that a 50/50 investment combining the Totus Alpha Strategy (which has had very low or no correlation to Australian equities) and the ASX 300 index over the last 10 years would have delivered a higher overall return net of fees, lower volatility and a smaller maximum drawdown than an investment in the ASX 300 index alone.
Can you discuss some of your successes and failures of the past?
Totus’ key point of difference is that we have delivered positive returns, on average, in both ASX up months (1.58% on average vs the ASX 300 avg of 2.78%) AND in ASX down months (0.87% on average vs the ASX 300 avg of minus 3.3%). The combination has lead to material outperformance for the fund over the last decade since inception (16.3% p.a. net of fees vs the ASX 300 incl. dividends of 9.5% p.a.)
Our biggest mistake in the past 10 years was being slow to realise the impact that stimulus would have on markets during 2020. Having started the year up 10% in Q1 2020, when markets got wrecked we gave back all of that performance and ended the year behind the market and down smalls in 2020. Although painful in the short term it was also a huge learning experience for us and our investors have been enjoying the benefits of those lessons in 2021 and 2022 so far.
One simple lesson for us from 2020 was that after a fall in markets the best way to get long is to cover shorts, not add to long positions. This seems obvious in hindsight but is one of those things we had to learn the hard way.
How much of your portfolio is currently positioned on the long side versus the short and how has this shifted since you launched the fund in 2012?
From the onset, our objective has been to focus on capital preservation and capital growth in equal measure so we have always carried shorts in the portfolio (less of them in strong markets, more in weak markets).
Our average net exposure (longs less shorts) since inception has been 38% but we are currently running a net of under 20% (the long book is just slightly larger than our short book). Our view is that until inflation is back under control and/or valuations and growth have materially reset, running a lower than average net and gross exposure is prudent.
Which sectors hold the biggest weightings in both your long and short portfolios?
Unprofitable/cash burning tech and tech-enabled businesses still make up a significant proportion of our short book. Given the risk of an economic slowdown impacting our long exposure to energy commodities we have been shorting some cyclical and less established niche commodities (such as green metals) to reduce our net exposure to commodities.
What are the hurdles companies need to clear before making it into your long portfolio?
Our criteria for long investments is pretty simple.
We like profitable, cash generative businesses in industries with good market structures and some kind of tailwind for their business. Many of our long investments have significant founder ownership. If we had to focus on one indicator of quality for a long investment it would be Return On Invested Capital (ROIC) and our best longs have high and rising ROICs.
What are the red flags you watch for before deciding to initiate a short position in a company?
Unfortunately there is no single red flag that makes for a good short. Rather, it is a combination of factors that, when combined, create the potential for a good short.
These typically include things like unprofitability, unsustainable business models, low quality of earnings and reliance on external capital (debt and equity) to compete and grow. Even when all of these factors are present, a short might still not work without the most important ingredient, which is timing.
What is one company in your portfolio that you’re currently most excited about?
In a sell-off like we have seen in tech, some babies inevitably get thrown out with the bathwater. One of these is German-listed HelloFresh, the world leader in meal kits. There is undoubtedly near-term risk to earnings but it is position we would like to add to on weakness.
The HelloFresh business model has structurally higher margins than supermarket retailers and should be able to price competitively against them in a rising price environment. Ecommerce is highly discretionary, but we believe HelloFresh is more staple-like in nature and has a recurring customer base that drives most of the profitability. The business is both profitable, free cash flow positive and still growing sales at over 20% (after more than doubling during the COVID-19 boom).
We love alignment and we love insider buying. HelloFresh has bought back stock during this sell-off and the CFO recently bought shares on market.
Can you discuss any specific short positions you’ve held in the past and how they performed within the portfolio?
Carvana (NASDAQ:CVNA) is a US-based online used car retailer that benefited enormously from COVID-19-induced stimulus and a pandemic-driven shortage of new cars. The company saw explosive revenue growth throughout 2020 and 2021, and significant share price appreciation, but we had underlying concerns regarding the make up of its gross profit. It remained unprofitable on a GAAP (Generally Accepted Accounting Principles) basis and never generated Free Cash Flow.
As used car prices rose significantly during the pandemic, the company enjoyed significant margin expansion from both the car inventory it was selling and the on-sale of car loans as Asset Backed Securities. The sustainability of these gain on loan sales in a low interest rate environment was key to the short thesis. Any deterioration in used car prices or increase in interest rates would be meaningful headwinds for CVNA and lead to significant margin contraction.
By looking into the publicly available data on the Asset Backed Securities of CVNA’s car loans, we found delinquencies were starting to rise rapidly at the beginning of 2022 and a quarterly report from its competitor Carmax highlighted that used car demand was slowing. We increased the short position leading into the company’s Q1 result which revealed an extreme deterioration in the business, far greater than we had anticipated.
The company was forced to raise over $1 billion in equity and $3.2 billion in debt in order to finalise an acquisition it had committed to late last year and to maintain its loss-making business activities. CVNA remains deeply cash flow negative and unprofitable, but after an 80% decline over the preceding two months, we elected to cover the vast majority of the position and move on.
COIN is a cryptocurrency exchange that benefited disproportionately from the stimulus in 2021 as investors piled into crypto. COIN has many of the characteristics that we look for in shorts such as aggressive accounting, unprofitability, and a highly competitive industry.
Digging into COIN’s numbers, we found that approximately 90% of its revenue came from retail investors who are charged a transaction fee as a percentage of the crypto asset they are trading. Furthermore, most of this revenue came from non-stable coin trading which is extremely speculative and higher margin. This created incredible operating leverage as the total market capitalisation of cryptocurrency expanded. As crypto markets collapse, that operating leverage works in reverse. In May, we noticed that Robinhood (NASDAQ code: HOOD), a competitor to COIN, was losing monthly active users, suggesting that retail investors had started to lose faith. This was the catalyst for us to size up our position into earnings.
As financial conditions tighten around the world, speculative assets like crypto with limited utility in the real world get hit the hardest. COIN is ground zero for the crypto bubble.
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