Drawdown – February 2018

Drawdown

The past few weeks have brought with them volatility that has not been seen for 2 years. With that, you may be wondering how your portfolio fared during this period. While the S&P 500 saw a drawdown of -10.44% between January 29th through February 8th and the Eurostoxx50 went down 7.43%, Somar’s performance was -3.07%. At no point was Somar’s performance negative for the year, unlike the S&P 500 which reverted back to November levels (please see the table below for more information.)

 

Day Somar S&P500  

Eurostoxx50

 

1/29/2018 -0.15% -0.67% -0.12%
1/30/2018 -0.46% -1.08% -0.96%
1/31/2018 0.27% 0.05% 0.07%
2/1/2018 0.20% -0.05% -0.76%
2/2/2018 -0.68% -2.11% -1.51%
2/5/2018 -1.38% -4.10% -1.26%
2/6/2018 -0.41% 1.75% -2.41%
2/7/2018 0.49% -0.50% 1.76%
2/8/2018 -0.95% -3.74%  

-2.24%

 

Total: -3.07% -10.44% -7.43%

Table 1

Note: Returns above represent gross performance for each of the calendar days mentioned

 

While we do not intend to report our daily performance in the future, we chose to do so on this occasion as it marked the first correction your portfolio was exposed to since inception. During downturns our performance is helped by our ~50% net portfolio exposure. This means that we would expect to have losses in drawdowns that are half of the market decline. Of course, that also means that our returns should be half those of the market during rallies. At least that is the theory if we had a 1-to-1 correlation with the S&P 500.

 

However, Somar does not have an exact correlation with the S&P 500, which comes down to our ability to select and invest in transformative companies that have defensible competitive positions, a large addressable market, and trade at a sensible price, and to short names that are losing market share, are not delighting their existing customers and which trade at unreasonably high valuations. This philosophy served us well during this correction, and we believe it will continue to serve us well through future market swings.

 

From Table 1 you can see that based on the S&P 500 movement a reasonable investor would expect Somar to be down slightly over 5% during the period (based on the Eurostoxx 50 we would predict a loss of about 3.72%). Our loss of 3% during that period showed that we outperformed this expectation by about 2 percentage points (or roughly 65 basis points against the Eurostoxx 50).

 

We believe there are two reasons behind the outperformance:

  • the drawdown occurred in the peak of earnings season when most of our long names reported strong earnings while a lot of our shorts disappointed; and
  • much of our exposure on the long side is not included in the S&P500 indexes and therefore didn’t face the selling pressure from investors reducing their passive investment/ETF exposure.

 

Our risk management and high conviction in our positions supported by our fundamental analysis allowed us to avoid being forced sellers during the downturn. Instead, we could play offense and look for opportunities created by the market’s volatility.

 

A 10% correction materially alters the risk-reward profile of most stocks. Somar updates our assessment of the risk-reward of the companies we track daily and is ready, willing and able to act accordingly.

 

  • Our first step is to determine what fundamental changes caused the market correction and what impact that change has in each of the companies we track.
  • Our second step is to assess the fundamental impact the market correction itself may have on the companies’ fundamentals.
  • Our third step is to update our view of the up and down potential of each company which combined with the market price yields our assessment of the investment case risk-reward for each stock.

 

This work uncovered new attractive opportunities created by the market volatility. During the drawdown, Somar added to some of our highest conviction longs at attractive prices and covered some shorts that hit our price targets.

 

Recovery

Your portfolio has recovered well since the drawdown to February 8th. While the S&P500 increased 5.32% since then and the Eurostoxx50 increased 1.85%, Somar’s portfolio increased 4.69%.

 

We want to make it clear that we are not calling February 8th the bottom of the market. We have no idea what the market will do in the future. What we intend is to highlight how your portfolio reacts to moments of market volatility and how your team at Somar handles the risks and opportunities created.

 

We are pleased with the way the portfolio performed in February amidst the volatility. The asymmetry of protecting the downside while capturing the upside is what we strive for at Somar.  We would caution you to not extrapolate this type of outperformance for every volatile period. During February we also benefitted from the earnings season that mostly provided encouraging data points for our investment thesis. That said, we would be disappointed in the future if volatility doesn’t prove to be an opportunity for Somar’s performance and portfolio construction.

 

Short Illustration

“Your margin is my opportunity”, Jeff Bezos – Amazon Founder and CEO

 

Key to the asymmetry we experienced in February is a thoughtful and asymmetric short book. This means a short portfolio that provides a large downside potential while offering limited upside.

Some mature packaged good companies present such an opportunity.  The past few decades, these companies built leading positions supported by strong competitive advantages:

  • Scale – provides lower production, distribution and marketing costs
  • Brand – over the years these leading brands built strong brands on the consumers’ minds, that in some cases came to represent the product category (e.g. Kleenex – synonymous of soft personal paper tissues)
  • Distribution – companies leveraged their strong brands and large scale to establish and crystalize an advantageous distribution position. In a typical supermarket the top brands occupy the largest and most attractive (eye level) shelf space.

These companies did a wonderful job using the above advantages to expand their market share and lower their costs. As a result, they achieved extremely attractive economics for its owners: Operating margins of 20% to 30% and ROIC of more than 20%.

This steady performance coupled with these businesses’ relative resilience to the economic cycle allow these companies to trade at high multiples of earnings. They came to be known as consumer staples and perceived as low risk, dividend paying investments.

 

Fig. 1

Source: Somar

The emergence of digital commerce and social media is eroding some of the advantages that brick and mortar retail has provided these companies. Our work suggests that these companies have entered a period of decline in their life cycle and are in a process of inexorable loss of market share.

  • Scale is less important
    • Small businesses can now get nationwide or even international distribution online either directly or by partnering with platforms like Amazon or Alibaba
    • Social Marketing allows innovative companies to reach millions of customers in a very cost-effective way[1]
  • Traditional brands are being challenged
    • Traditional leading brands have poor connection with customers while successful innovative brands emerge with a strong social media fan base that is highly engaged
    • Distributors both online and offline are putting additional emphasis on developing and promoting their private label offers
  • Distribution is exploding
    • Online commerce offers an infinite shelf space
    • Online platforms / marketplaces like Amazon and Alibaba are in control of which brands get displayed on top and some are demanding higher advertising fees for the better positioning
    • Online native competitors are taking a larger share of online commerce. According to One Click Retail, which measures sales on Amazon, “No Name” brands are significantly outselling traditional brands on Amazon (Fig. 3)

Fig. 2

Source: Amazon, Somar Analysis

Fig. 3

Source Ascential

 

With very high (20%+) operating margins, full market penetration, lowered barriers to entry, consolidating distribution channels with higher bargaining power and well-funded new innovative players, the future of these traditional brands appears to be a gradual decline. Given their optimized cost structures and pricing, and the inherent operating leverage of their operations, the slowing of sales growth or even decline will put pressure on their operating margin and operating profit.

A large portion of these companies trade at a premium to the overall market in terms of price / earnings multiple. Our DCF models show those prices can only be justified if we assume continued market share growth and margin expansion. Our research suggests this is highly unlikely. We see limited upside potential for these stocks and a material downside. Somar has built a short position in some of these companies.

 

 

[1] For an example of a very successful viral marketing campaign please check the Dollar Shave Club add at https://www.youtube.com/watch?time_continue=4&v=ZUG9qYTJMsI which has more than 25 mn views.

 

 

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