Striving to Consistently Outpace the S&P 500 Index
0% Management Fee, Performance Fee Only
1/1/2021 – 12/31/2021
Annual Letter to Limited Partners
Cavallini Capital LLP.
Greg Cavallini
350 S. Miami Ave. Miami, FL 33130
Results January 1, 2021 to December 31, 2021
Cavallini Capital, including dividends reinvested (hereinafter call CC) had a positive return. Please contact Greg at greg@cavallinicapital.com for results. The S&P 500 Index including dividends reinvested (hereinafter called the S&P) had an overall gain of 28.72%.
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 $14 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.
To view track records, please contact Greg Cavallini at greg@cavallinicapital.com.
Year in Review
In 2021 management teams had to deal with four major headwinds unlike any other year.
1. Supply chain disruptions.
2. Large jump in commodity prices (inflation).
3. Labor shortages.
4. Delta and Omicron.
Let’s look at each one of these individually starting with supply chain issues. Supply chain issues come from 2 different fields that are very much related to one another. The first component is the goods that are not being produced because of factory slowdowns or shutdowns. Asia in particular has extremely tight controls when they sniff a Covid-19 breakout. This causes factories to work at much lower capacity than usual, directly affecting how much product they are able to ship out to meet consumer demand. The U.S. is heavy reliant on Asian manufactured products compounding the problem.
The second component of the supply chain disruption is the logistical aspect. Ground zero for this disaster are the ports of Los Angeles and Long Beach. These two ports account for an estimated 70% of all inbound cargo into the U.S. At the time of this writing, there are more than 80 vessels waiting in line to dock at either one of these ports ready to unload cargo. For perspective, the typical amount of ships waiting to dock, and unload has been close to zero. A large container ship today can transport approximately 21,000 containers. Not all vessels awaiting to dock, and unload are this large, but it gives one an idea of the problem. However, the problem does not end at the ports. Reports estimate that there is shortage of about 50,000 truck drivers at this moment needed to accommodate demand. As a result of these two components, businesses are not able to meet demand, which leads to the second headwind.
As I reported on the semi-annual letter, commodity prices have increased dramatically in 2021. At the time of the last writing, gas prices were up 102% for the year, that has come down slightly since then but still up more than 70%. Most products are made from either a commodity or a synthetic version of the commodity. It stands to reason that if the underlying base of a product has increased in value, so will the end product. Furthermore, the rate for a 40-foot container from Asia to the U.S. west coast increased from about $4,000 to a peak of almost $20,000. As of today, that rate sits at about $15,000. This means that all products made in Asia and sold in the U.S. have had an increased in freight rate, which is then passed on to the customer (perhaps now would be the right time to scale back portions of the tariffs on Chinese goods, which is a cost that is passed on to the consumer).
But what seems to be truly causing inflation is the combination of demand outpacing supply and supply chain bottleneck issues (more on this topic later in the letter).
The third driver of headwinds in 2021 was the labor shortage. As briefly mentioned above, truck drivers are just but one example of the problem. A recent article in the Wall Street Journal reported that there are more job openings than there are people looking for jobs. This puts companies at a disadvantage and tilts the balance in favor of the worker. As such, workers have more leverage to ask for higher wages. This is exactly what has been happening to large companies all over the U.S. Usually two events happen when labor is handed such an advantage: 1) Labor that is unionized demand better terms such as higher wages. If they get the terms, everyone moves on, but if they do not, they go on strike causing factories to slow down production of goods. 2) Companies are forced to hire a new workforce at higher wages.
Let’s look at two examples. The first is Kellogg Co. which had strikes at several factories, some lasting more than 2 months. It has recently been reported that the company and labor have come to an agreement. The other example is FedEx. FedEx incurred a $470 million dollar increase to expenses ending in November for things like wage increases and overtime. They are also looking to hire tens of thousands of workers for the holiday season, which will no doubt demand higher wages than the previous year. All this, once again, leads to higher prices (inflation).
And last but not least are the two variants of Covid-19, Delta and Omicron. Both seem to spread very rapidly and more easily than the previous variants. Businesses have to manage work conditions for their employees. Many times, this means limiting the number of in person employees. Particularly hit are businesses that need factory workers to assemble products.
All four headwinds mentioned above lead to inflation. The government has begun to take steps to neutralize inflation. However, this can have adverse effects on certain businesses, which is the topic of our next subject.
An important note on inflation, stocks as an asset class have been the best hedge against inflation in the last 100 years. If inflation is your fear, then stocks are your best friend. For more recent data, look no further than Q1, Q2, and Q3 of S&P 500 companies which as a whole increased profit margins in 2021.
Why Valuations and Balance Sheets Matter
The central bank and Fed. Chair Jerome Powell announced that they would be aggressively dialing back its monthly bond purchasing program (also known as tapering). Previously he had announced that it would wind down in June 2022, but he has since said it will now be in March of 2022. This is important because the Fed needs to end the program before hiking interest rates. The central bank explained that they are now forcasting 3 rate hikes in 2022. This is quite a difference stance from just a few months ago when they announced they would see no rate hikes until at least 2023.
What does all this mean for investors? In the simplest form, it tells investors that companies who are currently borrowing large sums of money or will need to borrow large sums of money will take a hit to their stock price. Companies that currently do not turn a profit or do not have enough cash on hand will have to pay higher interest on money they borrow. This will cut into their profits (or increase their losses). Some stocks have already taken a large hit because of this dynamic. Stocks like Snap, Twitter, Pinterest, Peloton, Zillow, and Beyond Meat are just a few examples. In 2021, these stocks have dropped anywhere from 10% to as much as 70% when the S&P 500 Index is up more 28% in the same time period. No doubt other factors have contributed to their declines, but a major piece of the puzzle was the high valuation and the lack of profitability. By no means are these great company’s dead in the water, hopefully they will recover as they have very smart management looking for solutions. A final note on this, a recent study compiled by StoneX Group identified more than 300 companies that are unprofitable who have lost more than 50% since their peak in 2021.
The key take away from it is that no one knows with enough time when interest rates will rise or fall. No one knows if the economy will run too hot or too cold, and this is what makes the central bank move interest rates. The central bank has 2 objectives, help the economy reach full employment and influence money supply by raising or lowering interest rates. As we have recently witnessed, even the fed itself did not see inflation sticking around. If the Fed can’t correctly predict this, how is an investor going to make a more informed decision as to when interest rates will go up or down or make a prediction into the future?
An investor cannot make the correct prediction on a constant basis in the long run on when or by how much interest rates will rise or fall. This creates a problem when investing in stocks like the ones mentioned above. So long as things remain as is, the stocks will perform. The problem is when the announcement comes (or more likely when Wall street predicts it) these types of stocks take outsized losses hurting the investor’s portfolio. It comes back to the point that when picking stocks, it’s prudent to invest in companies that have low debt levels and produce plenty of free cash flow along with profits. This will at least partially shield the investor’s portfolio from stocks that creator.
Share Buybacks and Their Importance
Share buybacks are an important tool that companies deploy to return cash to investors. Buybacks shrink the number of shares outstanding for a company, thus making the remaining shares outstanding worth more. Buybacks also have the added benefit of reducing the tax burden on shareholders. Unlike dividends, which are taxed on the shareholder’s account, buybacks do not produce a taxable event. A company simply buys back shares in the open market from free cash flows the company has produced. Companies will approve share repurchasing programs for a given amount during a given period. For example, Microsoft recently announced it would buy back $60 billion of its own stock. When properly administered, share buybacks are a wonderful source to boost earnings per share. However, when deployed incorrectly, buybacks can have a detrimental effect on shareholders.
Buybacks are essentially a form of purchasing part of a company. Instead of a company buying part of another company through purchasing their stock or a merger, the company is buying part of itself. Once this concept is understood, the very next questions should be: At what valuation is that part of the business being bought? Here is where buybacks can create a negative effect on investors. When a company authorizes a large buyback plan, the idea is to repurchase the stock during a dip in the stock price or when the shares are undervalued. Unfortunately, many companies fail to do so, such evidence is plentiful. In Q3 of 2021, companies spent a record $234.5 billion on share buybacks, which topped the previous record in Q4 of 2018. Experts predict that buybacks will reach $236 billion in Q4 of 2021. Valuations at this moment are quite high, thus buybacks should have been more muted during Q3.
During Q1 of 2020, buybacks reached $199 billion, but in Q2 of 2020 that number dropped to only $89 billion. Recall that the market peaked on Feb 14th of 2020 before the pandemic caused a 34% dip in the market reaching a low on March 20thof 2020. It is precisely during Q2 of 2020 that companies should have been setting records for repurchasing shares by taking advantage of the drop in stock prices. In other words, buy part of a great business at a great discount. This is exactly what Cavallini Capital did during March and April of 2020. Heavily deploying capital into the great business that were being offered on sale. Granted, some businesses wanted to conserve cash given the uncertainty of Covid-19 and how it would impact the economy. However, many large companies that had a great deal of cash on the sidelines during that time, could have repurchased their shares and should have done so aggressively.
Another important factor to take into consideration is the actual reduction in shares outstanding. When a company announces a repurchase program to be implemented during the next 3 to 5 years, the outstanding share count should go down. Often times companies will announce that they spent $5 billion in repurchasing their own stock during the last year, but the actual number of outstanding shares never went down. Typically, this means that management is enriching themselves and employees in the form of stock options. In other words, using money that belongs to shareholders to increase their wealth. Meanwhile the $5 billion has not added any value to shareholders as the same amount of share outstanding before the purchasing began remained the same. If a company announced a share buyback program to be implemented during a 3 to 5 year plan, check to see if the share count diminished, say from 400 million to 320 million during that time. Check a company’s outstanding fully diluted shares from 5 years ago and see if it is lower today than it was at that time.
In conclusion, share buybacks are a great tool to bring value to shareholders. Buybacks are much more tax efficient than dividends. Companies should buy back shares when their stock price has taken a hit and / or is undervalued. Furthermore, make sure to see that the fully diluted outstanding shares from 3 years ago is lower than during present day.
Cavallini Capital is accepting investor capital at this moment. If you are interested, please contact Greg at greg@cavallinicapital.com.
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 Cavallini
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.