Dear Investors,
I will no longer be reporting performance publicly based on recent marketing regulations issued by the state of NC. During the period, the S&P 500 returned 7.5%. We ended the quarter with 52% of the portfolio in cash and equivalents. Earnings have not, and I believe will not, reset to sustainable levels until later in 2023 or possible 2024, after the Federal government and Federal Reserve shot two massive stimulative bazookas at the US economy during 2020-2021, leading to record home prices, used car prices, and prices for pictures of monkeys (mysteriously named NFTs).
Q1 2023 hedge fund letters, conferences and more
As an example, and it is one of many I could give, Pool Corporation (POOL), a pool products distributor that has historically been quite expensive, now trades for what seems like a fair valuation on an EV/EBITDA basis of 15.5x, compared to a 10-year average of 18.2x.
However, what sticks out to me about POOL’s long-term historical performance is that 1) growth rates have averaged high-single digits prior to 2020; and 2) EBITDA margins have steadily improved prior to 2020 to 11.5%.
What has happened since 2020? Sales have increased 93% from 2019-2022, a 24.5% compound growth rate. Additionally, EBITDA margins increased from 11.5% in 2019 to 17.5% in 2022. Every dollar of sales represented 50% more profit dollars in 2022 than it would have in 2019.
In total, EBITDA increased nearly 300% from 2019-2022, a span of 3 years, and a 43.0% compound growth rate. Knowing what you can observe about the business, does it seem likely this superhuman performance is likely to repeat or even be sustained? Clearly not. What would this business be worth if it had more normalized sales and margin performance of 7% growth and a 12% EBITDA margin? Well, that would indicate 2023 estimated sales of $3.7 billion, vs. 2022 sales of $6.2 billion; 2023 EBITDA would be $439.6 million vs. 2022 actual results of $1,079.4 million.
Given an EV (Enterprise Value) of $15.0 billion, I could argue that POOL is trading for 34x a more normalized EBITDA. Is it possible that I am wrong and POOL can sustain or maintain its 2022 plateau? Its certainly possible, but a reasonable person would likely conclude they end up somewhere between $440-1,079 million of EBITDA, and who knows how many years it will take for POOL to eclipse these results.
As I mentioned, there are many more examples like this. Among our top holdings, Ferguson (FERG) and Alphabet (GOOG) are the only companies whose financial results could reflect some growth has been pulled forward. I do also feel that the magnitude of that pull-forward is less significant than the example I just provided.
EXISTING PORTFOLIO ACTIVITY
Sold: VZIO, HEI, TIG
I sold Vizio, Heico, and Trean Insurance Group, for three different reasons. Most simple to explain is Trean (TIG), which announced an agreement to go private. This was disappointing to us as the company stumbled significantly out of the gates as a public company and management opted to participate in the upside privately through a take-under at prices 60% below its IPO price, and about 56% below my purchase price.
Heico was purchased as a small starter position that never got very large, and trades at a very high valuation today. Believing I would not likely add to the position in the near future, I decided to sell with a 55% gain. I’d love to own Heico at a more reasonable valuation.
Vizio I sold with a ~59% loss. I still really like Vizio’s opportunity to transition from a low-margin TV manufacturer to a smart TV operating system seller, with recurring revenues derived from advertising on their smart TV OS. Unfortunately, the company is only marginally profitable today, and they still derive a significant amount of revenue from TV manufacturing. Because this transition will take years to play out, and depends in a bad economic environment on their balance sheet strength, I felt the current environment was not an opportune time to own this business, and that there were lower-risk ways to earn satisfactory returns. This investment is an example of me stretching to find interesting companies with longer-term growth stories, many of which have seen significant declines similar to what has occurred with VZIO.
NEW PORTFOLIO ACTIVITY
Bought: VGSH, ANGL, BXSL
I was much more focused this quarter on buying credit than equity. Both ANGL and BXSL are diversified bond funds with different mandates that can earn equity-like returns from here in a wide variety of environments. ANGL is known to people who don’t think in terms of stock tickers as VanEck Fallen Angels High Yield Bond ETF. They own a collection of fallen angel bonds, which are defined as bonds of companies once considered investment grade, but that now classify as “junk” or non-investment grade.The historical research on this class of bonds is very strong, indicating elevated returns with lower credit risk. The belief behind this outperformance is that most investment-grade companies take pride in their easy access to debt, and despite temporary shortfalls they will work hard to return to investment-grade over time. I tend to think of this as a programmatic approach to value investing in the debt markets. The last several years, yields in this space have been very low, but recently the yield on this investment increased towards 7%, providing us an opportunity to earn a respectable return even if some negative credit events happen within the portfolio, and if interest rates decline, this investment has modest appreciation potential.
BXSL is known as the Blackstone Secured Lending Fund. They own the most secure tier of bonds that each of their portfolio companies issues. A high percentage of the loans held by this fund represent highly-leveraged portfolio companies of Blackstone’s private equity arm, and pay a floating rate coupon. Currently the fund pays a 10.9% dividend, which again provides a nice return in the present that should offset any credit events within the portfolio, and if rates decline we could see some level of capital appreciation.
Both ANGL and BXSL are relatively small positions, while my purchase of VGSH was much more significant. VGSH represents 37% of the portfolio currently, and in some ways this is a substitute for cash. VGSH is Vanguard’s short-term government bond fund, with a >4% yield, very low expenses, and low duration of ~2 years.
I would expect to see these positions in the portfolio until a moment occurs where I can purchase investments at more reasonable or even depressed valuations.
CONCLUSION
Clearly our portfolio composition has shifted in the direction of credit, which I expect should serve us in good stead as we continue through 2023. If I preserve and modestly grow your capital during times like these, I believe this will be a satsifactory result. Current conditions, I believe, are a dangerous combination of generally high valuations, strong investor sentiment around anything AI driving index returns year-to-date, and a decidedly hawkish Fed policy. I will endeavor to survive until there is a more opportune time to make aggressive investment bets. As I’ve mentioned in prior letters, “the effects of higher interest rates can take years to develop, as the most rate-sensitive corners of the investment universe are also the most illiquid (venture capital, private equity, and real estate). Debt re-pricing often takes years to occur and investors either do not currently believe rates will remain high or they have not begun to factor in higher interest expense on company cash flows.” Those words remain relevant, and we believe we’ve found a couple of investments during the period since Q2 quarter-end that should provide us a quality hedge with positive carry (we get paid to hold it) should the economy weaken.
Until August,
Argosy Investors
