Dear Partners,
Q2 2023 performance of -7.86% improved from our Q1 performance of -10.21% but we continue to trail our benchmark through the first half of the year. 2023’s results have been underwhelming as we’ve given back some of the profits generated from last year. Our short portfolio has been the main laggard contributing to negative performance while our long portfolio continues to perform well. With that said, we’ve taken this short episode of downside volatility as an opportunity to adjust our portfolios and upgrade our risk management parameters (primarily within our short portfolio). We believe this will better position the fund for a stronger and more sustainable recovery. Further details will be elaborated later in the commentary.
Stretching out on a longer time horizon, Warhawk One Capital’s continues to outperform our benchmark and the overall stock market since inception, both from an absolute and risk-adjusted basis. Since inception (November 2021), Warhawk One has returned +26.78%, Equity Market Neutral Index +23.50%, and the S&P 500 -2.40%.
In 2022, our short portfolio returned +34.20% while our long portfolio returned +12.12%, for a combined total return of +46.32%. In 2023, our short portfolio is down -25.60% while our long portfolio is up +8.33% for a combined return of -17.27%. The recovery of depressed short assets in 2023 along with deployment of new capital in those same assets were the main driver of losses. 60% of the short portfolio losses in 2023 came from 5 companies, driven by their quick recovery (within the tech sector). Those 5 companies are Affirm Holdings (AFRM), C3.AI inc (AI), Nvidia Corp (NVDA), Root Inc (ROOT), and Coinbase Global (COIN). We have exited out of 4 of those 5 positions, with Affirm Holdings remaining in our short portfolio to date.
Commentary on our shorts
Affirm Holdings (AFRM) was our largest detractor in returns year to date. The company operates as a Buy-Now-Pay-Later financial lender of installment loans for consumers to use at the point of sale. Our bearish outlook on the stock is predicated on business model weakness, exacerbated by higher interest rates, and the tightening of consumers’ wallets due to higher inflation and erosion of excess savings. The company lacks any real economic moat and competitive advantages, offering a relatively commoditized product whose margins are heavily reliant upon stronger consumer spending and looser financial conditions (both of which we believe are less likely). The industry is also plagued with many uncertainties and risks, given the nascent nature of the Buy-Now-Pay-Later industry. We expected and continue to expect AFRM to run into margin pressures (especially in a higher rate environment), with no clear path to profitability any time soon. We initiated a short position in the company on August 24, 2022, at an average cost basis of $30.33 per share. The trade resulted favorably for the fund in 2022, as the stock ended last year at $9.67 per share, for a +68.12% gain. However, In the first six months of 2023, the stock is up +58.53% (going from $9.67/share to $15.33/share), with most of those gains generated between May 1 to June 12, 2023, where the stock almost doubled (+93.80%). Our fund was negatively impacted by this position due to our new capital deployment strategy. As we received new capital flows into the fund this year, we deployed the capital into the same depressed positions within our short portfolio. This significantly lowered our cost basis in those holdings- Using Affirm as an example, our cost basis went from $30.33 per share to $10.81 per share. From May 1 to June 12, the stock surged +93.80% to high of $18.85 per share, triggering multiple layers of our stop loss limits along the way, resulting in a negative -4.32% loss contribution to our total portfolio return. From an investment perspective, $18.85/share is still below our initial cost basis of $30.33/share when we initiated the short position, but our decision to allocate new capital into a position that has sold-off resulted in us getting caught in a retracement. We experienced a similar fate in multiple other short positions that sold off last year but recovered this year despite deteriorating fundamentals.
This lesson has led us to institute our first adjustment to the portfolio. We instituted a standard to short into rallies, not sell-offs of fundamentally broken securities. In other words, we will continue to execute on our fundamental research and screening process to identify weak market groups that are already in a downtrend and fundamentally broken. However, we plan to only get on board during countertrend bounces, and where the strength of the bounce is beginning to fade. This is critically important as timing in short selling is extremely critical. This would mitigate the probability of us initiating a short position at the beginning of a retracement, only for our stop loss limits to trigger, and being forced out of our exposure with a loss.
Secondly, weak market groups are not all going to experience a countertrend when it is convenient for us. Therefore, there may be instances where our fund receives new capital, and that new capital will be deployed in other market groups/positions that we currently do not own. We will be patient in identifying and deploying new capital into holdings that fit our investment criteria and to carefully deploy into existing positions should it fit our initiation criteria. In the event that we cannot find a market group to deploy new capital in, we will either deploy short-term option strategies to hedge against our market exposure, and/or invest in liquid risk-free instruments such as short-term T-Bills. This is the second adjustment we have made in our risk management framework that will be implemented moving forward.
Avoiding Big Story Stocks
The hype surrounding AI and technology stocks continued its momentum in the second quarter. Although it can be argued that some of the upward revaluation was warranted, the speculative fervor that ensued signals cautionary signs which historically do not end well for investors. Whether it is AI, crypto, cannabis, gene-editing, real estate, ecommerce, the Internet, commodities, or the next big thing, market hype can remain exuberant longer than rationality dictates, often driven by the emotion of greed and FOMO. Consequently, stocks that are grouped within the hype are plagued with extreme volatility, both on the upside and the downside.
Prior to the hype around AI, we initiated a short position in C3.ai (AI) 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 despite the large addressable market. Additionally, the company has little to show for with their execution. Recent channel checks indicate little to no traction for their product or service relative to its competitors. Finally, despite a near 90% collapse in its stock price since it went public in 2021, neither insiders nor management have once repurchased stock.
Despite our thesis, the stock is up over +270% year to date and has negatively impacted our performance, contributing a negative -3.86% total to our returns this year. We have exited our exposure to C3.ai but are looking for opportunities to re-engage once the hype dissipates. The third adjustment we are making is we will be avoiding shorting big story stocks moving forward whether we initiated the position before it became a big story or not. The unpredictability and irrationality that often comes with big story stocks makes it challenging to manage and goes against our principle of prudent risk management.
Alpha Generator
Academy Sports Outdoors (ASO) is a sports and outdoor retailer based in Houston, TX, with 268 locations across 18 states. ASO is concentrated in the south and southeast, which contain many of the fastest growing markets in the country in terms of both population and labor force. Of ASO’s current footprint, 40% of stores are in Texas with another 40% spread across Florida, Georgia, Alabama, North Carolina, South Carolina, Arkansas, Oklahoma, and Tennessee – all states in the top 20 for net migration since 2020. ASO recently hosted an investor day where they presented their plan to reach $10 billion in revenue, 13.5% operating margins, and 10% net margins by 2027, with a 30% ROIC. This plan includes 120 - 140 new store openings and 3% average same-store sales for existing stores. The company emphasized that these targets were calculated with the assumption that there may be a recession in 2023 or 2024. While there are typically a lot of risks associated with a retailer or restaurant expanding into new markets that aren't familiar with the brand, we believe ASO has a good track record of doing this successfully and profitably.7 All ASO's stores are profitable, including stores that are the only Academy location in the state such as in West Virginia, Virginia, or Illinois. In fact, ASO's stores are so profitable that even its worst quartile of stores generates the same amount of operating income ($2 million EBIT per location) as its largest competitor's average store. Two of ASO’s three distribution centers are currently operating at only 50% of capacity, giving them plenty of space to grow into with lower incremental capital needs. If the company executes on its guidance, it will generate $3.5 billion in free cash flow cumulatively from 2023 - 2027. Given this FCF build (assuming no buybacks or dividends), ASO's enterprise value in 2027 (at the current stock price) would be $1.8 billion or 1.1x 2027 EBIT. The 75th percentile of ASO's retail peer group trades at 14.5x FY2 EBIT. Achieving these targets over the next four years would cement ASO among the best-in-class public retailers, coming in above the 90th percentile in value-driving metrics including revenue growth, margins, and ROIC. However, even if ASO is valued at just the current median EV/EBIT multiple of the peer group (8.5x) in 2026, it would result in an enterprise value of $11.5 billion. If one adds on the estimated $3.2 billion in net cash in 2027, this will equate to an equity value of $14.7 billion or $184/share, 234% upside from today's price of ~$55/share or a 48% 3-year CAGR. This assumes the management team can more or less hit the targets they laid out at their 2023 investor day in April--but should they whiff, there could be a downside buffer (or further upside) if there is any value-additive capital allocation along the way.
Looking Ahead
We feel we are taking the correct and necessary steps to right the ship. Much like our thesis portends that a handful of stocks make up most of market gains, a handful of stocks have negatively impacted our portfolio in 2023. Five stocks contributed to most of the losses in our portfolio. We’re conscious that stocks that do poorly in the long term can perform magnificently in the short term. Mr. Market often pendulates between greed and fear, optimism with pessimism, but we firmly believe that solid businesses will continue to create value and grow their valuations while weak one’s will falter. Often, it requires an entire, and sometimes multiple business cycles to fully capture the value discrepancies between strong and weak businesses.
As for our portfolio positioning, we feel confident that the portfolio is poised to generate alpha. Our conviction in our bottom-up research process remains strong given our long portfolio’s weighted average cash flow yield of over 10%, combined with low leverage, strong growth potential, robust dividend growth, and friendly shareholder policies. With an uncertain economic environment in the second half of 2023, we have a bearish bet on the overall consumer. We believe markets are underestimating the impact of the resumption of student loan payments on consumer purchase resilience and its impact on retail sales. We are focusing on companies with strong brand reputations and clean balance sheets on the long portfolio, while shorting companies that lack the economic moat to distinguish itself in tough environments. Additionally, we also believe that our portfolio is positioned in an environment that is supportive for alpha generation.
Volatility as a tailwind
Prior to 2022, the ultra-low interest rates and quantitative easing by the U.S. Federal Reserve and other central banks helped drive investors into risky assets, which was a tailwind for all stocks. That helped reduce dispersion among individual equities, tightening the range between best- and worst-performing issues, and depriving fund managers of alpha opportunities.
Now, however, with price moves that are more frequent and extended, a much broader range of opportunities opens for a variety of hedge fund sectors. For example, in Equity Market Neutral, sharper price movements can push long and short positions farther in their trading ranges, potentially boosting profits.
Short rebate inflates
Rising interest rates provide yet another direct benefit to highly hedged strategies like ours. When the fund sells borrowed shares, the cash proceeds from the sale generate interest, which belongs to the lender of the stock. However, the fund is typically entitled to a portion of that interest, known as the short rebate.
With the effective federal funds rate at 0% in nine of the last 13 years, the short rebate had zero benefit for equity long/ short funds. But with federal funds exceeding 4% at the start of 2023, the short rebate is expected to be significantly additive to long/short equity returns.
As I conclude this commentary, I want to end by assuring you that the Warhawk One team will rise to challenges, we will meet them, we are well prepared for them, we’ll get through them, and at the end of the day, we’ll emerge on the other side stronger. Thank you for your trust in allowing us to be the best stewards of your capital.
Portfolio Positions
