Striving to Consistently Outpace The S&P 500 Index
0% Management Fee, Performance Fee Only
7/1/2020 – 12/31/2020
Semi-Annual Letter to Limited Partners
Cavallini Capital LLP.
Greg Cavallini
1080 Brickell Ave. Miami, FL 33131
Results July 1, 2020 to December 31, 2020
Cavallini Capital, including dividends reinvested (hereinafter called CC) had an overall gain of 21.89% from 7/1/20 to 12/31/20. The S&P 500 Index including dividends reinvested (hereinafter called the S&P) had an overall gain of 22.18% from 7/1/20 to 12/31/20.
To view track record, please contact Greg Cavallini at greg@cavallinicapital.com.
Cavallini Capital Investor Gains vs. The Competition
Below you will see 5 separate results.
1. An average of all U.S. stock mutual funds. These Funds are actively managed by individual(s) who are the smartest and brightest in selecting stocks.
2. Results from a typical mutual fund that is invested in a similar manner to CC. T. Rowe Price (PRDGX) has Assets Under Management (AUM) of about $17 Billion. PRDGX represents a prototypical fund for an ordinary investor seeking to put money in an investment vehicle focused on stocks. Results are represented net of fees.
3. The S&P which is passively managed.
4. Investor gains in CC net of fees.
5. Results of CC.
*Annual Gain does not include 7/1/20 - 12/31/20
To view track record, please contact Greg Cavallini at greg@cavallinicapital.com.
Calendar Year Basis
It should be noted that on a calendar year basis (January 1, 2020 to December 31, 2020) CC had a total return of 33.92%. The S&P had a total return of 18.40%.
The Avg. Stock Mutual Fund gained 19.10% in the calendar year while PRDGX gained 13.61% respectively.
Presidential Election
The presidential election this past November raised many questions with investors. Many speculated which party would be best for their portfolios based on tax cuts or hikes, stimulus plans, infrastructure, and many more factors. The conventional wisdom is that Republicans are better for markets because they prefer smaller government with less taxes and limited regulations. However, some may argue that Democrats spend more, which can boost the economy. When it comes to stocks and financial markets, I always like to take a deep dive into conventional wisdom and theory. It is this very skepticism that has produced great results thus far in the Fund and hopefully will continue to do so in the future. Having said all that, let’s look at some numbers to see if we can make a determination whether one party is better than the other. When looking at numbers, instead of popular opinions, one can come to a true objective conclusion. The numbers below are as of World War 2. The first chart illustrates the returns of the S&P during a Democratic held White House and a Republican held White House. The second chart gives the results of the S&P based on Presidency / House / Senate composition and the respective returns.
*Note the the above chart returns are as of end of October 2020.
Since 1952 to 2020 the stock market annualized gains under Democrats have been 10.6% compared with 4.8% for Republicans. When the Democrats have held the White House, they have presided over 5 economic expansions and 2 economic recessions. While the Republicans have held the White house, they have managed over 7 economic expansions and 10 economic recessions. It is a fact that the stock market has performed better under Democrats than Republicans. However, I do not think this implies cause and effect. For example, Republicans were in charge during the recession of the early 70’s, most of the internet bubble, and the majority of the 2008 great recession. These 3 events had a severe impact on the tally since WW2, but I do not think it can be conclusively said that because Republicans were in charge that that was the cause for bad results. Wall Street’s and investor’s obsession with presidential picks seems to be mostly misguided. Bull markets and bear markets come and go and they are more a function of business cycles than who is the president. When it comes to stocks, my conclusion is to keep presidential politics outside of investment portfolios.
2021 Outlook
As you may know by now, I do not spend much time on predictions in the short term regarding the market. However, we have some unique circumstances in the market that could give us some clues to how 2021 could shape out. At the current moment, there seems to be a great deal of cash on the sidelines. This cash typically comes from three sources: cash on hand, credit, and income. As of end of Q3 2020, the four major banks in the US were sitting on more deposits than ever before and considerably higher than in 2019. Below is a comparison of 2019 vs 2020 in trillions of dollars.
1) JPMorgan: 1.5T vs 2.0T
2) Bank of America: 1.4T vs 1.7T
3) Wells Fargo: 1.3T vs 1.4T
4) Citigroup: 1.1T vs 1.3T
Banks at the moment are offering anywhere between 0.01% to 0.08% on savings accounts. Customers seem to be accepting the deal for now. We have to assume it is because most people are uncertain of their job status given the Covid-19 pandemic. Another piece of evidence that cash is sitting on the sidelines is the U.S. personal savings rate. It hit an all-time high in April 2020 of 33.7%, but has since come down to 14%. For some perspective the usual savings rate during “normal” times is about 6% to 7%. Moving to the second component, the head of the Federal Reserve (Jerome Powell) has stated that the Fed will keep interest rates at rock bottom levels for at least the next two years. Interest rates act like gravity on stocks, the higher the interest rate the greater the gravity pull down on stocks. It will be difficult for investor to get any meaningful yield from fixed income to keep up with a target inflation rate of 2%, let alone a decent return. The third component that I think will give some tailwinds will be assumed gridlock in Washington. Even with the Democrats winning the Senate, the count remains 50 Republicans and 50 Democrats. A 50/50 split on a vote would be decided by the Vice President. Democrats will need the support of all the party to pass hotly contested issues such as taxes in the Senate. Tax reform heading into the elections was the one major issue Wall Street seemed to be concerned over.
To that end, with a great deal of cash on hand, interest rates remaining at near 0%, and gridlock in Washington, one could believe that the future looks bright for stocks. The real question is when will the consumer come back to normal spending habits and reduce their cash on hand. This will be the key driver, but nearly impossible to predict. Driving that behavior will be the availability of the Covid-19 vaccine to the U.S. population (best estimates are between March and May), people feeling safe taking it, and finally world wide availability and acceptance. It can also be said that the good news may already be baked into the market, though again, impossible to predict. As always, the most important factor is making sure the stocks that one owns are undervalued or fairly valued. What an investor pays for a stock is always critical.
Dollar Tree
Dollar Tree (DLTR) is a retail store that operates in a very niche market against few competitors. In the past, the biggest competitors to DLTR were Dollar General and Family Dollar. In 2015 DLTR was able to buy Family Dollar bringing its total stores to about 15,000 locations (McDonald’s has 14,400 locations in the US). This created a duopoly, Dollar General and Dollar Tree. Family Dollar stores tend to be located in more urban centers, while DLTR stores tend to be located in more rural areas. The deal certainly increased DLTR debt levels, but not to an overwhelming amount. Consider that its Debt-to-Equity ratio before the merger was at 0.38 and post-merger it was at a healthy 1.67. The following year that ratio was lowered to 1.17 and the subsequent years it fell below 1 (the lower the better, ideally below 1). Its current ratio was also in good condition given that its premerger level was at 2.31 versus post-merger of 1.88 (the higher the better, ideally we want that number to be above 2). In 2018 DLTR had an interest coverage ratio of 6.7 and by 2020 it had improved to 9.7 (10 and above being ideal). It seems DLTR was able to purchase Family Dollar without taking on burdensome levels of debt. It should be noted that DLTR did dilute their share count in order to fund some of the purchase. However, I believe it was necessary to keep pace with the competition while maintaining low levels of debt. Family Dollar was by far the least efficiently operated of the 3 while DLTR was / is the most efficient. Logic would dictate that DLTR would bring their management expertise to Family Dollar and make it as efficient. This seems to have come true as comp store sales, gross margins, operating margins, and sales per store have all drastically improved (though not to the level of DLTR).
Of the remaining two, only Dollar Tree offers all of its products for a dollar or under (Family Dollar does carry items between $1 and $5), thus making it the only true player in the space. Dollar General provides products between $1 and $5, thus not making it a true dollar store. Other key metrics looked to be in good shape as well. Revenues were growing at a clip of about 10% pre-merger. Post-merger revenues grew in 2016 from 15.5B to 23.6B in 2020. In 2019 it had Same Store Sales (SSS) increase of 2.4% respectively. In the current year, gross margins for DLTR came in at 34.9%, while Dollar General came in at 31.3%, and Family Dollar at 26.8% respectively. Post-merger, operating margins were nearly halved as they worked to renovate the old Family Dollar stores. Net margins took an initial hit after the merger (as expected), but seem to be on their way back to their normal levels pre-merger.
I believe it will take some years to return to pre-merger net margins as they figure out how to optimize Family Dollar stores. Return on Equity was also hit hard after the merger, but has since recovered to a healthy 20%. This is a crucial metric because it shows us how effectively management is allocating capital. An ROE of 15% is considered acceptable, but ideally an investor would like to see 20% or above.
Importantly, Free Cash Flows from Operations increased from $943M to currently at $2.589B. In 2019, DLTR took a one-time expense hit attributed to Family Dollar store closures, store closure write offs, and payroll due to overtime and temporary help to renovate the Family Dollar stores. This one-time expenses hide the true positive effects of the turnaround for Family Dollar stores. Reviewing the Proxy statement revealed the CEO held 121,000 shares of the company, worth an estimated $12.1M, while his salary was $1.4M (very much in line with his counterpart). It is reassuring as a shareholder to see the majority of the CEO’s wealth coming from his stock while not selling large amounts to the market. On average he sells about 5,000 units of stock every 2 months which is normal.
As is well known, retail has been hit hard not only by the recent pandemic, but the effects of online retailors for several years. Covid-19 helped to accelerate this process. Big box retailers like Amazon, Wal-Mart, and Target have increased their footprint and collapsed many retailers. This is what initially attracted me to the space. A beaten down sector can at times provide good deals to investors, but one has to be careful not to invest in a particular stock in a down and out sector simply because it is down and out. It is nearly impossible for Amazon to compete against a true dollar store like DLTR. Amazon’s shipping cost (even with Prime membership) alone puts like items at a cost above a $1. The same can be said for Wal-Mart and Target. Furthermore, DLTR recently added a frozen food item section to many of its locations. The initiative has produced great results. DLTR, and similar stores, tend to outperform during downturns in the economy, yet another reason to like the story. DLTR revenues and net profit increase in 2007, 2008, and 2009. When times are tough, people look for discounts wherever they can find them and what’s lower than $1 items?
The valuation of the stock, I will keep close to my chest. However, one should not have to input a complicated formula into Excel and wait for it to spit out a number to know if the stock is cheap, fair, or overvalued. As the saying goes, you don’t have to know a man’s exact weight at 400 pounds to know he is overweight. Having said that, as a backup, I do use a 3 stage DCF model along with 3 other conservative models using EPS and dividends (when applicable).
The question then becomes, why did the Fund buy the stock starting in March of 2018 and subsequently completely sell out of it in March of 2020. The answer is in the opportunity that the Covid-19 market sell off gave us. I had been tracking a company for over 2 years but it was always overvalued. Thus, when a general market sell off (including DLTR) came, it gave me the opportunity to buy a better business.
Some of the tranches of shares that I had bought in DLTR were underwater, thus giving a tax benefit by realizing losses. The capital was then immediately reallocated to the new business, which I thought would gain back its losses quicker (given the nature of the business) and get to a higher level than pre-crash (it did). In March, I sold out of DLTR stock at about $78, as of this writing, it is trading at about $109 (not exactly great timing). If there had not been a general market sell off and had DLTR sell off been isolated to only its self, then the strategy above would not have worked. This would have meant that I would sell at rock bottom to buy another business at an overvaluation thus negating the great upside. If only DLTR stock had collapsed but the rest of the market continued on its upward trend, I would have had to analyze why the stock took such a beating possibly indicating trouble in the business. This was a simple case of reallocating capital to a better business because of the unique opportunity that was presented. And who knows, maybe in the future DLTR will once again be included in the portfolio.
Registered Investment Advisor
The process remains on a positive path. I am hoping it will be finalized before the beginning of the new fiscal year.
Note:
Ana and I have the majority of our investable wealth in CC and so long as CC is in operation, this will always be the case.
I can’t promise results, but I can guarantee that our wealth will be in lockstep with yours.
Sincerely Yours,
Greg Cavallin
Notes:
The record above displays Cavallini Capital’s track record since inception on July 1, 2017.
Disclaimer: Greg Cavallini, as General Partner of Cavallini Capital, LLP, makes no representations or warranties to investors regarding the probable success or profitability of Cavallini Capital, LLP, and the Track Record, Results and Comparisons set forth herein shall not be used as an expectation on benchmark for any new investments or ventures.