Dear Investors,
I find great joy penciling this commentary because it marks another milestone for Warhawk One Capital. This marks the first commentary for the fund since our live launch in the first quarter of 2023. I am extremely grateful for the trust that you have given us to be a strong steward of your capital for many generations to come. In this quarter’s commentary, our goal is to share our insights and perspectives on the recent developments of the markets and our portfolio- giving you a glimpse of the thought process behind our capital management strategy.
Introduction
After a dismal 2022 for the markets, they have rebounded resiliently in 2023, with the Dow Jones Industrial Average, S&P 500, and NASDAQ all posting positive returns in Q1 2023. This is in the face of macro uncertainties, high profile corporate layoffs, bank failures, and restrictive Fed policy that have dominated market sentiment. The recent crisis surrounding regional bank failures and new economic data have nonetheless prompted fresh concerns of a recession that could derail any optimistic market reaction in the near term. As a result, long-term yields have fallen dramatically, causing further inversion of the yield curve, as the bond market wrestles between the possibility of sustained above average inflation and a recessionary environment. Additionally, the recent regional bank failures could also be a blessing in disguise if contagion is contained, especially as it can result in less rate hikes by the Fed- which has been one of the primary driving forces for asset price weakness in the last 15 months.
Here We Tech Again
Declining Treasury yields led to a resurgence in tech stock performance in the first quarter- specifically, mega cap tech stocks as they performed extraordinarily well, with the top 6 mega-cap tech stocks returning an average of 42.39% in the first quarter. Collectively, those 6 stocks make up 23% of the S&P 500 but account for 56% of the S&P 500 gains so far in 2023. In fact, such performance is reminiscent of mega cap tech stock outperformances during periods of low interest rates prior to 2022.
For investors, there are several differences between this year’s tech outperformance and the prior era of low interest rates. Firstly, the 40-year downtrend in interest rates that existed prior is now reversing. A reprieve from higher rates this year due to recessionary concerns has facilitated an echo of the prior era, with tech stocks surging as interest rates wane. However, trading on the knee-jerk reaction of such reversion should come with cautionary signs as the sustainability of such outperformance comes into question. Drawing upon historical comparisons, we can gauge how things have played out in the past. For example, Nvidia is the best performing stock in the S&P 500 in 2023- returning a whopping 90% in the first 3 months. This is the stock’s best quarterly performance since the fourth quarter of 2001 when it soared 144% in the midst of a recession and bear market that spanned three years. The following year in 2002, Nvidia would go on to crash 90% (from peak to trough) before finding its support in October 2002. Secondly, the resurgence of the mega-cap tech stocks has re-introduced tremendous stock market concentration risks, which could increase market volatility and an over-reliance on a handful of highly correlated stocks for return and risk contribution. For example, Apple and Microsoft alone account for 13.2% of the S&P 500 composition- the highest level since Bell System and IBM ruled the S&P 500 in 1978.
As these mega-cap tech companies have announced large number of layoffs to protect margins in the face of a growth slowdown, the positive reaction to their stock price thus far could prove pre-mature, potentially leading to larger pullbacks in the future should expectations fail to materialize.
Labor market is cooling, contrary to what consensus believes.
US jobs data were just released as of this writing. US employers added 236,000 jobs in March, providing an argument that the labor market is still too hot to get employment cost pressures and inflation under control. But upon deeper review, it is clear that prospects of the labor market are already cooling, and policymakers risks unnecessary economic harm if they ignore the signs.
Top-line employment numbers are heavily influenced to the upside by extreme and well-known structural worker shortages in private education, healthcare, and leisure and hospitality. Together, these 3 categories accounted for 72% of the private payroll increases in March. If we remove government and these three categories from the picture, the net increase from the remaining employment categories added just 52,000 jobs, well below the pre-pandemic average of 97,000 (between 2017 to 2019). Aggregate payrolls in goods-producing sectors have begun to decline, as well as those in the financial services and construction sector. Payroll growth in information (media, telecom, and data processing) have slowed significantly. If the Fed waits for payroll growth in healthcare and leisure to slow, it is likely going to overshoot its target rate.
In areas like nursing, worker shortages are so pronounced that employers are likely going to keep adding workers regardless of how high interest rates go. Burnout, retirements, and an aging demographic have contributed to the supply and demand imbalances in the industry. Additionally, leisure industries’ payrolls are still recovering after suffering from a plunge in immigration rates during the pandemic. Overall employment numbers are still below pre-pandemic levels. In some areas, companies would have to be put out of business for payroll growth to halt. If the Fed keeps pushing rates higher until headline payroll growth meets its definition of acceptable, it could render a harsher than necessary recession.
Wage inflation is also another indication that the labor market is under control per the Fed’s inflation goals. Average hourly earnings are now rising at a three-month seasonally adjusted annualized rate of 3.2%, which is near pre-pandemic norms and close to the Fed’s inflation goals. Assuming a 2% inflation goal with a 1.5% productivity growth rate, it would imply that anything under a 3.5% wage growth should be acceptable. Annualized wage growth is running at 3.2% today, below the average pre-pandemic pace.
Despite these numbers, 2-year Treasury yields jumped 13 basis points after the jobs data release. This knee-jerk reaction indicates the reliance on unemployment and payrolls headlines more than the underlying data. This more than likely cements another 25-basis point hike when the FOMC meets again in May. The Fed governors are already getting the labor market cooling that they are looking for, they just have to look beneath the surface. With this data, it is our expectation that we have most likely reached peak inflationary levels and the economy is going to decelerate. Long-term interest rates are expected to decline as the Fed is close to reaching the peak in its Fed Funds Rate. Our portfolio positioning is therefore structured to reflect this outlook.
Attribution
In the first quarter, Warhawk One Capital Fund returned -7.78%, with losses primarily driven by three holdings that accounted for 80% of the loss. All three holdings- Azul S.A (AZUL), c3.AI (AI), and Coinbase (COIN) are held in the short side of the portfolio that experienced dramatic price increase in the quarter. The price increase throughout the quarter triggered our stop-loss markers, as we position sizes were trimmed after the stop-loss triggers. The fund has exited its position in AZUL and AI. Nonetheless, the losses were offset by gains in our long portfolio that benefitted from our overweight to quality factor stocks, and gains from our tactical short exposure to a handful of overpriced vaccine manufacturers.
The portfolio’s net exposure was 5% at the end of the first quarter, meaning that we have a slight overweight to the long side of our portfolio. We were highly selective in the deployment of cash, especially during the two weeks of the regional banking turmoil. I am proud of our team in managing the volatility during that week, with the fund only experiencing one down day during that period, while the market was down in 6 of those 10 trading days. We’ve took the opportunity of the sell-off to build a few long positions in what we believe to be a handful of fundamentally sound and well-run companies within the Financial sector. The Charles Schwab Corporation (SCHW) is one of the aforementioned companies.
Contributors
Academy Sports Outdoors (ASO) continues to be a stalwart for the fund as the long-position shares appreciated strongly with investors cheering management’s ability to leverage long-term growth opportunities through consistent operational excellence, financial discipline, and execution on its store and omnichannel expansion plans. With inflation and a slowing economy taking a bite out of consumers’ wallets, ASO has appealed to value-oriented consumers as spending shifts away from higher priced retailers. The company also announced a 20% increase in its quarterly dividend, which is well supported by its robust free cash flows.
First Solar, Inc (FSLR), a U.S based solar panel manufacturer experienced strong stock price increases with the company well-positioned for strong earnings growth potential driven by the high demand for its domestic manufacturing capacity as solar developers aim to gain the 10% Investment Tax Credit addition to the Inflation Reduction Act (IRA). FSLR is one of the biggest beneficiaries of the Act as the company plans to scale its U.S manufacturing capacity, doubling production volumes from 4.3 GW to 10 GW by 2027. The company beat its earnings estimates and raised its guidance for 2023, one small “bright” spot among a sea of downward guidance revision during the first quarter’s earnings season.
Novavax (NVAX) contributed positively to our portfolio on the short side. After evaluating company’s expectations for vaccine sales and financial goals for 2023, we believed that those expectations seemed overly optimistic given the significant decline in COVID-vaccination rates towards Q4 of last year. Additionally, despite record sales NVAX was able to generate from the pandemic, those sales failed to translate into any real profitability, as gross margins remained deeply in the red. With the headwind of slower vaccine sales, financial performance goals seemed unattainable, resulting in our tactical short exposure in the name.
Detractors
C3.ai (AI) negatively impacted performance as the Artificial Intelligence theme received mainstream hype in 2023. Investor fervor led to tremendous buying and volatility in the space, increasing our borrowing costs and run up in AI’s stock price. Because of the increase in implied volatility, cost to borrow, and stop loss triggers, we fully exited our position in C3.ai, but will review opportunities to get back in once some of those factors subside. Nothing has changed to our original short thesis of the company, with severe questions regarding its product, revenue model, cash burn, and credibility of the company. It is our belief that the stock price has run up ahead of its fundamentals, with neither the company nor analyst raising guidance or profitability targets given the newly found opportunities. Additionally, the company has tremendous aspirations with its business and market leadership, but so far has little to show for in execution. Finally, despite a near 90% collapse in its stock price since it went public in 2021, neither insiders nor management have once repurchased stock.
Coinbase Global (COIN) contributed negatively to performance in Q1 after a run up in bitcoin prices with traders exploiting volatility in financial system and increasingly betting on a Fed pause. Our short thesis in COIN stems from the skepticism we have regarding their business model. As an exchange, users and volumes are ultimately the deterministic drivers of revenue growth. COIN has benefitted from the rally in crypto prices with their high “Take Rate” (a.k.a commissions) which is a function of crypto prices. However, relying simply on prices for revenue growth can be very fickle, as those prices are subjected to extreme volatility. Additionally, COIN’s take rate should continue to decline as more competition with a more efficient crypto system would lead to profit erosion. Users and volume growth have already declined to a 3-year low, and increasing regulatory pressures from the SEC could put further pressure on an already fickle business model. Risks we are continuously monitoring is that outrageous prices can become more outrageous, and having the right risk management system in place can dramatically mitigate that.
We held a short position in Azul S.A (AZUL), a Brazilian regional airline, primarily due to their bleak capital requirement needs. They would require a substantial capital raise if they did not reorganize and shore up their capital structure given how capital intensive the airlines business is. They announced their earnings in March that importantly included a renegotiated lease term agreement with their debtors to convert some of their debt to equity- which extended their obligation requirements and capital lifeline. Additionally, they extended a bulk of their debt maturities by another 5-years after the conversion which provided some breathing room. We were surprised that they pulled it off and the stock increased +81.47% in March which led to a -3.25% impact to the portfolio, making up 72% of the portfolio loss in March. We have trimmed the position for risk management reasons but still have an existing small short position in the stock.
Looking Ahead
Weaker economic outlook is likely to be expected with signs of economic slowdown across most macro-level data. Stock markets’ valuation multiples are now more in-line with historical averages. Most of the exuberance in market valuations diminished last year as the Fed embarked on its restrictive policy campaign. As a result, markets are relatively cheaper but are not necessarily cheap by historical standards.
On the bright side, markets may be converging on the likelihood of a recession, but they are also beginning to look through it. It may be too early to call for a market bottom right now, but we may not be too far away from one either. The yield curve may have to invert further or even fall, while equities may have to take another cycle down before it recovers- usually around the time monetary policy pivots and leading economic indicators trough. We see these patterns time and time again and are positioning the fund to benefit from such patterns. We believe that weak economic data is positive for the markets, but negative for company fundamentals. Therefore, we are continuously monitoring the markets for opportunities to pair fundamentally strong companies against fundamentally weak ones, while keeping the beta of both stocks relatively equal to mitigate the impact of the market factor. As the Fund continues to own companies with compelling business fundamentals, skilled management teams, and recurring cash flows, we believe our portfolio will be resilient through the economic cycle. We look forward to communicating our progress to you over the next few quarters.
