Bronte Capital Callisto Fund commentary for the second quarter ended June 30, 2024.
In July the fund returned 0.93% while the globally diversified MSCI World Index grew by 1.61%. We did not get to write a letter at quarter end because we were travelling. This is the same problem we had last quarter (where we wrote lengthy February and April letters but an abbreviated March letter). That said, the whole period has been described by rising markets, regularly taking out previous all-time highs – with a seeming slight downturn in the second half of July.
Strongly rising markets are not where we shine. We run a low net exposure to markets – and should underperform sharply rising markets and outperform falling ones (even though we realistically expect to have some draw-down when the market turns sour).
The year until 30th June was relatively benign – and a letter then would not have said much.
But July was not benign. Some long-short-funds where the managers attend idea dinners (and hence would have held crowded positions) got hurt badly as many crowded shorts squeezed upward. There are horror stories around, but mostly of individual stocks (as opposed to whole books). We were unscathed. We would like to say our performance was because of our relatively idiosyncratic stock selection.
And it probably was. But to be honest there is a dose of luck as well.
Anyway – to remind you –the portfolio has had certain biases for a while.
a) We are net long large-cap stocks – both European and American (by a lot)
b) We are net short US small cap stocks (by a lot)
c) We are net short Australia (but only by a little)
d) We are net long Japan (including small caps) but only by a little.
e) Within US small caps our biggest short sector is biotech – especially small cap biotech which we regard as highly promotional.
A market where Europe is down, American large caps are down, and American small caps are up is normally actively hostile for us. It is worse when there is a broad biotech rally.
This doesn’t happen much – but it usually presages a moderately bad time.
Alas this happened aggressively in July on several days including one aggressively tough day described below.
To add insult, an index of highly shorted US small caps was up 16% and an index of highly shorted US small cap healthcare stocks was up 17%. In this actively hostile market we were marginally up in USD. We are not happy with the result (we would like to be further up) but, given the circumstances, these results are fine.
But let’s take the bad day. 11th of July was – on the broad numbers – the most hostile single day to our strategy since we started running the Bronte funds.
- S&P 500 was down 0.88%
- The Nasdaq was down 2.24%
- And the Russell 2000 small cap index was up 3.57%
On the face of it our loss-on-the-day should have been significant. It might have been one of the worst days in our history.
Instead, our losses were well below 1.5 percent. We know it won’t always be that comfortable – but July in general, and particularly the 11th of July, was a stress event for the portfolio and we handled it just fine.
The prior quarter was mostly benign. Markets regularly made new highs (and that is not an environment where we will beat our competition). But there was no real stress. There was an exciting week when “Roaring Kitty” came back on the scene (described below) but even that stress was short-lived.
Over the first six months of the year our shorts cost us about 1 percent gross. This is a good result for six months in which the MSCI ACWI was up 10.32% and the S&P 500 was up 14.48%.
Given that, let’s divert to talking about philosophical issues in stock selection and how they apply to us.
Thinking about good businesses and traps in stock selection
On the long side we want to own quality businesses. There are different ways of determining what is a quality business – but broadly speaking you can do it from the top down (does it have a high and stable return on capital deployed or other accounting indicia) or from the bottom up (does it have a business model that is hard to displace and does it add substantial value for its customers.)
There are advantages and disadvantages in both methods, and there are traps for the unwary, including traps we have fallen into. Because of this anyone sensible does this in both directions – choosing good companies partly from the numbers but also from business understanding.
A top-down disaster
Here are the key ROE numbers for a company we’ve looked at (but where we’ve never had a position).
From the top-down this really looks like a wonderful business. The return on equity is pushing 30 percent. The growth rate in revenue is double-digit in most years and the growth in earnings is over 20 percent.
If you chose stocks by accounting metrics of what was a wonderful business, you would buy it at any reasonable multiple – and it traded at a seemingly reasonable multiple. When the growth slowed it traded at what might appear an astonishingly low price.
Alas it was a disaster. The stock lost over 90 percent of its value, and it eventually went private after having lost money for over a decade straight.
The stock was French Connection UK – the fashion company that (loudly) announced its presence with T-shirts that said FCUK. That slogan worked well for a few years – though the shock-value faded, and the brand faded as well. Fashion risk is a thing – but for us at least it is hard to predict.
It is not just fashion risk too. Kodak had peak returns on equity of almost 40 percent before its destruction by digital photography.
If you choose long term holdings from the top-down there is more than a reasonable chance of a bad result and the reason is that you are:
a. Buying a company where the good results are always visible (and the stock is priced for it), and
b. The top-down analysis will miss a break of whatever it was that made the wonderful business, whether that be a fashion change (French Connection) or a technology change (Kodak).
Marimekko and fashion risk – an interesting edge case
The simplistic Wall Street view of what happened to French Connection (above) was “fashion risk”. No matter how good the numbers are for a clothing company, the logic goes, you can’t pay up for it because it could unpredictably become unfashionable.
But we are not sure that is always true. The French luxury good companies have grown with fantastic returns for decades – and surely, they have fashion risk. We have never owned them (and that is mostly a source of regret).
But an edge case that interests us is Marimekko Oyj (HEL:MEKKO). Marimekko is a Finnish fashion label that appeals both to middle-aged women in the West – but also to some demographics in Asia (especially Japan). It is characterized by very colorful prints that seem to have very long fashion lives. It has a “mid-century style”. Here is a picture from their cooperation with Uniqlo.
They also have home-wear products (that present the same mid-century modernist aesthetic).
By their own description they do not try to follow fashion. To quote:
Marimekko is not about trendy fashion, with a few minor exceptions. We make lasting and timeless products. Timelessness may, however, occasionally come into fashion by chance, like now.
That quote is from 1978 – but it is still true.
Here are Marimekko’s numbers:
The growth rate is not as good as French Connection at its peak. But the numbers have been sustainably good since 2016 (which coincided with a management/strategy change), and we have chatted to management, and they are eminently sensible.
We own this – but in very small quantity. It is illiquid, we try to limit the illiquidity in the portfolio – and that would stop us buying much more anyway. Secondly, we are a bunch of nerdy mostly middle-aged guys with less fashion sense than the average poorly dressed politician. It would be presumptuous to make a big bet.
But we are making a bet here. If a toy company has great numbers but sells yoyos or hula-hoops you might think it a craze. If it sells Barbie dolls it might (or might not) be more sustainable. We are betting floral prints with mid-century designs that have had a long-life are more likely to have a fashion life closer to a Barbie doll than a yoyo.
And we are betting on the management, who we think are excellent.
We would not have bought any of the stock if the accounts were awful. And we would not have bought any of the stock if we thought this was a fad. We have a top-down and a bottom-up view on the business.
Even if this stock could be bought in large quantity we would not do so. We think that Marimekko is more sustainable than French Connection because mid-century modern seems more sustainable than FCUK. But we really are not qualified to make that judgement with any certainty. Generally, we tend to prefer technical products sold business-to-business as investments. We feel more equipped to judge the sustainability of a technical edge than a fashion brand.
Buying businesses with good numbers
Big market participants are not normally crazy and good numbers like French Connection’s are easy to screen for. Most companies that have good numbers are either:
a) Very expensive, that is the market has liked what it has seen and bid up the stock, or
b) Subject to the sort of risks that are hard to quantify and which the market does not like (e.g. fashion risk).
For this reason, we tend to do a lot of things from the bottom up. We want to understand why the company is sustainably good. But that leads to interesting problems too. We explain by example:
Takasago
Takasago International Corp (TYO:4914) is a company that obsesses us, but where we have never had a position in the stock. It is a flavors and fragrances company based in Japan. Twenty-five years ago people talked about the big four flavors and fragrances houses. They were International Flavors and Fragrances, Givaudan, Firmenich and Takasago. Nobody today would think of Takasago as a big flavors house.
Flavors and fragrances is a great business. Technical flavoring products are critical to making pre-packaged food taste good. The example we usually give is of a flavored yogurt. This tends to have a very consistent flavor all year even though several of the ingredients are “natural” and should have seasonal differences in their flavors.
A customer buys a consistent product and expects a consistent flavor. If the flavor is somehow different the customer is likely to think the product is defective in some way and may change brands. This makes the brand company dependent on the technical skill and consistency of their flavor provider.
But it is better than that. The gross margin of the yogurt may be 23 percent. The flavors are maybe 2-3 percent of the cost of goods sold. If the price of flavoring goes up by 20 percent, it barely affects the yogurt company, but it makes the economics of the flavoring company extremely good. Flavors are a small but critical part of a big thing (processed food) and hence have pricing power.
We have a high single digit percentage of your portfolio invested in flavors and fragrance companies. So obviously we looked at Takasago.
Takasago should be a good business, and the pedigree is of an excellent business. But the numbers are awful.
Sure this company grows a little but at low single-digit returns on equity. Competitor margins are 15 times higher, and competitors have returns on equity in the mid-twenties.
Top down you would never buy Takesago. It simply does not make enough profit to make the shares a worthwhile investment. But bottom up you might. It is in a very favourable business. It still has market share in some important markets (such as Indonesia).
If we thought that Takesago could earn margins consistent with competitors we would buy the stock. John regularly tries to get senior flavors and fragrances executives in private conversation, and he tries to find out why Takesago is so lacking in profits. We haven’t got an answer that makes us think things will turn for the better but if any reader has an opinion please get in contact.
We found the company looking from the bottom up (the nature of the business) but rejected the company from the top-down. This is the process for most of Bronte’s long book.
And like much of the long book, if we thought (after say talking to competitors) that there was reason that Takesago earnings might one day reflect their potential then we would ignore the top-down numbers and buy the stock anyway.
That of course would be an aggressive bet because, on the current numbers, Takesago is a flat-out-awful business.
Our short book
Through July the market had been making new highs for months. We consider ourselves extremely good short sellers – but you would rather be an average long-investor than an extremely good short seller in such a market environment. Mostly however, and given the environment, which was actively hostile to short selling, we have done fine. There were a few days which were unpleasant in July (as discussed above), but nothing has been threatening.
Other than the July squeezes the most prominent thing that happened to short books this year was the return of Roaring Kitty.
The return of Roaring Kitty
Our portfolio of almost 700 shorts performed well but there are still occasional losses from shorts that squeeze us. With that many shorts there will always be a few that are susceptible to the mania we saw post COVID.
The second quarter saw the return of Keith Gill, known in social media as “Roaring Kitty”. Mr. Gill was the main protagonist in the 2021 short squeezes and personally made almost a quarter of a billion dollars (disclosed when he tweeted his portfolio) all from a grub stake under $100K. He did this by squeezing over-committed short sellers. We are very careful not to be overcommitted short sellers. Roaring Kitty even indicating a highly shorted stock might go up is enough to send it up 100 percent. With 700 shorts we are likely – indeed almost certain – to get thumped by a few of these moves sometimes. And we were.
The late 2020, early 2021 Roaring Kitty squeeze was much stronger than the 2024 squeeze. The profits we earned after Roaring Kitty retreated in 2021 were very nice. We are expecting less profit this time.
Other happenings during the quarter
Hibbett
In the December letter we told you all about the only fashion company we have ever bought a meaningful stake in. It was Hibbett, largely a shoe retailer to underserved communities in the US. We bought a five percent stake and promptly had to deal with a takeover offer from JD Sports, a shoe retailing giant.
We didn’t like the deal thinking it underpriced our asset. It wasn’t like Swedish Match (where we actively hated the deal). It is just that we thought we deserved more.
We spoke to other shareholders who were considering rejecting the deal too. But then Nike put out bad numbers and being a retailer of sneakers no longer looked attractive. The deal closed and the investment measured up okay but we were not entirely happy with the outcome.
First Citizens and UBS, a follow up
A couple of years ago we shorted Silicon Valley Bank, Signature Bank and Credit Suisse. These were the only three banks we were short at the time. We picked well. All three collapsed and were merged into other banks in distress.
Buying a distressed bank from the regulator (or at the behest of and with the assistance of the regulator) is either a great bargain (the normal case) or a disaster (when you import all the bad assets and culture).
We have seen both cases. In the global financial crisis JP Morgan was strengthened by buying Washington Mutual from the FDIC. By contrast Lloyds Bank (by far the best UK retail bank at the time) nearly destroyed itself buying Halifax Bank of Scotland.
We are very interested in distressed mergers of banks because – with some analysis – they offer opportunities for profits.
We got these mergers right. Our thoughts at the time and outcomes:
- We thought Signature Bank was an awful bank and the bank it merged into (New York Community Bank) was not much good either. We were not interested in buying the acquirer (New York Community Bank).
- This was a good decision as New York Community itself has had to be rescued.
- We thought (as stated in our March 2023 letter) that Silicon Valley Bank was probably the best bank ever to fail. Ultimately it was an excellent asset. We never even looked at First Citizens Bank (the acquirer) but we figured buying a good bank at a distressed price was likely to work out very well.
- This was a great decision. We now have a high regard for First Citizens management, and they have preserved almost all the good things about the old Silicon Valley Bank.
- We paid $919.28 per share for our First Citizens stock. The company is likely to earn somewhat over $200 per share this year. We could not be more pleased.
- We are likely to hold First Citizens Bank for a long time.
- We thought that Credit Suisse was not a good bank, but that its problems were quantifiable and, with new management, fixable. The acquisition involved the cancellation for no-consideration of roughly $17 billion in Credit Suisse obligations (the AT1 securities). We thought the acquirer (UBS) was not an awful bank and it would be left with an extremely strong (hence profitable) position in Swiss corporate banking.
- That was an okay decision. The problems are a bit slower to sort out than we thought they would be originally, and the regulator is acting to limit UBS’s profitability in the Swiss market, but what we thought would play out is mostly playing out.
- We have sold most of the UBS position at a nice profit and the last bit will probably be sold sometime too.
The decisions to buy these banks was made rapidly in fast moving and distressed markets. But they were made with excellent knowledge of the collapsed banks and some knowledge of the acquirers. We knew New York Community Bank well and UBS somewhat. Surprisingly the one we did not know as well (First Citizens) is the one that has turned out best.
Do they ring a bell?
A favorite Bronte book is “The Money Miners: The Great Australian Mining Boom” by Trevor Sykes. In meticulous detail it runs through the mines and their linked and promoted stocks (both real and fantastical) in increasingly lurid detail. Each fantasy about infinite wealth seems more absurd than the other. And then Sykes interrupts the narrative:
Did you hear a bell ring just now?
No?
Then join the rest of the human race because you have proved yet another old market adage which says that nobody rings a bell at the top. If there was a bell it would have run just three days ago, because that is when the market peaked.
It was December 29 [1969 for this boom], the first trading day after Christmas. The market was looking great. The gallery was packed with speculators, binoculars glued to the boards…
At the risk (almost guaranteed) of looking stupid John (but not Simon) thinks bells are ringing now. [This paragraph was written slightly before month-end –and at publication the bells may be chiming more audibly.]
There are a lot of things that can go wrong, and we do not know how any of them will play out.
- The rise of protectionism – we are all protectionists now
- Deeply disruptive technology change – e.g. electric cars, artificial intelligence
- The rise of militarism (and above all troubles in Taiwan)
- Demographic issues catching up with the world generally
And then some issues that affect our portfolio specifically. For instance, we have been long Google for years. It is our largest position. Google capex used to run at about 5-8 billion USD per quarter. It is now running at 13 plus billion per quarter. The driver of all that additional capital expenditure is the requirement to buy Nvidia chips to keep up in the artificial intelligence race. There is no guarantee Google gets a great return on that investment and if they don’t then Google stock is overpriced.
We have trimmed a little Google (now traded as Alphabet) but many of the businesses we think are superior also contain similar stock specific risks and there is no guarantee you are being compensated for those risks either.
It may be wishful thinking for John when he suggests we are near a top. We would like it to be – we are committed short-sellers. And the observation that nobody rings a bell applies to us too. (John’s ringing bell is possibly tinnitus.) But the market does feel “toppy”.
Simon, by contrast, isn’t as certain. Everything is going swimmingly well. Earnings are fine. Inflation is abating. The buy-the-dip crowd are ready to swoop on the slightest market fall, and market bounces have often proven detrimental to our returns. Perhaps counter-intuitively, a bullish market perspective is a conservative one for Bronte given our portfolio construction. And that befits the guy responsible for risk management.
Either way, be careful out there.
And thanks again for the trust you have in us.
John, Simon and the Bronte team