Letters

The Invisible Giants

April 2021

The Invisible Giants

One of my daughters’ favorite books was “The BFG” by Roald Dahl. It tells the story of a group of giants that would come into the city at night and spread mayhem. People could see their impact but would not know who caused it. One of the giants is friendly and after being discovered by a little girl, strikes a friendship with her.

The last few months in the equity financial markets have felt like a real-life version of this story. Occasionally, we have witnessed massive, unexplained movements in particular stocks without any fundamental changes in their businesses to justify the moves. Moves like this, in the absence of news, seem to defy common market rationality. A few weeks later, we find out who the “giant” was and why he was behaving that way.

Let us quickly revisit three recent examples:

  1. Last summer, there was a sudden and substantial rally in large cap tech and growth stocks. We found months later that this was due to a leveraged acquisition of stocks and options by Softbank Group. The firm has been able to keep most of these positions and there has been limited reversal of the initial move.
  2. Earlier this year, there was a violent rally in the stocks of Gamestop, Koss, AMC and other so-called “meme” securities. A few weeks later, we learned the rally was being fueled by a group of retail investors communicating in the WallStreetBets subredditt. They identified stocks with a high short-interest and medium to low market capitalization. Through their combined buying power, they forced the hands of short sellers. Some funds, like Melvin Capital, were caught in the process and suffered significant losses. While covering their short positions, these funds added more buying pressure amplifying the original rally. Since then, most of these stocks have retraced the gains from this period.
  3. In the last few weeks we saw other stocks such as Discovery and ViacomCBS stage a remarkable rally. Their prices rose between 200% and 500% in a matter of months. Then, in just a few days, these stocks gave up much of these gains. The sharp drop was partly fueled by secondary block sales in the middle of the trading day: something I had not yet seen in my career. A few days later, we learned that a family office, Archegos, had been buying these stocks. They financed these purchases mostly with debt from several banks. It appears that each bank was unaware of the extent of credit provided by the other banks. After the unwinding of Archegos’ positions, some of these banks were unable to fully recover their credits and suffered billions of dollars of losses.

Episodes like this fly in the face of the premise of efficient markets. This premise has been the theoretical basis for the strong growth of passive investing. Ironically, the growing share of price agnostic trading by passive instruments is creating conditions for the amplification of these volatile episodes making the market even more inefficient. At Somar, we expect a continuation of these episodes in the future: more frequently and with more volatility.

If that is the case, we would expect our short-term returns, and that of the market as a whole to be noisier. This can be distressing for investors that need the reassurance of periodic returns to stay the course. For investors that investigate the soundness of the business decisions made both by your portfolio manager and by the managers of the companies we own, this noise will be understood for what it is. Frequent and open communication will be critical to keep the steady hand needed for great investment results.
There is a silver lining though: this additional volatility source also creates additional opportunities. They can appear either on the long and short side of our investments. Somar is ready to take advantage of both.

We have not fared badly in the three episodes mentioned above. We have managed to profit slightly from them. This is encouraging. We intend to take advantage of these large imbalances in the future when they present themselves in companies we know well and follow closely. We will also keep managing our risk tightly, so we do not end up on the wrong side of an irrational and excessive move.

Through it all, Somar will continue to communicate openly with our investors. As you know, we are always happy to receive your messages and calls and to answer any questions you may have. Investment success is a team sport, and great teams communicate frequently.

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Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice.Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees. 

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