Q3 2023 Letter - A World In Motion

Equity markets have been spooked by climbing treasury yields with the 10-year now hovering at 5.0%. Equity performance year-to-date continues to be concentrated in a small group of stocks.

Quarterly Performance

Third quarter results were choppy with the S&P 500 finishing down -3.27%. Seaside Private Capital (SPC) finished up 1.02% for the quarter, which outperformed the market and helped us gain ground on our YTD results relative to the index. This brings SPC's YTD result to 10.89% vs. the S&P 500 TR at 13.07%. The S&P 500 Equal Weighted Index is flat YTD, highlighting equity returns YTD are primarily attributed to the Magnificent Seven. We continue to be saisfied with our performance as SPC's portfolio is structured significantly different than the indexes and we believe our portfolio currently trades at a 40% discount to intrinsic value.

Source: LVS Advisory

A World In Motion

The main theme for the quarter is that long term treasury yields continue to march higher, which has led to some major carnage for bond investors.

The market as a whole seems to be in a transition period trying to adapt to a "new normal". Bonds have been in a bull market for over 40 years dating back to the 1980's. Most investors out there, including myself, have not lived through an environment where interest rates have been constantly increasing. When rates go down, the cost of borrowing becomes cheap, which fuels returns for owners of assets (stocks, real estate, private equity, etc.). This has been the case over the past 4 decades. What happens when rates no longer go down.......but up?

This is a question I have been asking myself quite a bit lately. Home prices in California, for example, have gone on an amazing run and just about any homeowner has been trained to "buy the dip" since it has always worked out for them. But I'm not so sure that will continue to be the case, especially as housing affordability has reached an all-time low with mortgage rates nearing 8.0%. One factor I'm currently monitoring are vacant homes, of which there are 10.95 million in the U.S. as of Q4 2022 according to the Census Bureau (roughly 10% of the current U.S. housing stock). Of this number, 6.66 million homes are intentially held off-market for various reasons: second homes, under renovation, preparing to sell, etc. With a rising cost of capital, rental prices moderating, possible recession, and consequently rising unemployment, maybe that second home that's used a few tiems a year might not be worth the cost owning afterall (property taxes, insurance, maintenance, etc.). If a small fraction of those homes eventually make thier way to the for-sale market that will dramatically impact housing prices as the current inventory shortage seems to be the only thing holding the housing market together right now. I can't predict with any certainty how this will play out, but I think at current prices, housing market risks are skewed asymetrically toward the downside. Either prices will need to come down or incomes will need to increase substantially. Fundamentals matter when money is no longer free.

Stocks are in a similar position. Fundamentals have started to matter again as increasing discount rates lower intrinsic valuations. Companies that produce solid and growing free cash flow with strong balance sheets have continued to outperform companies that either don't produce cash flow or have significant refinancing risk. A clear example of this divergence can be seen in the small cap space in the chart below.

Source: Palm Valley Capital

Ultimately we think that this transition to a higher rate environment is a good thing. We just need to be astute investors and focus on partnering with high quality companies that have pricing power and strong balance sheets that are able to withstand whatever economic environment may lie ahead.

Portfolio Update

During the quarter we continued to build a larger cash pile while patiently waiting for an opporunity to present itself. With money market funds yielding over 5.0%, sitting in cash is a uniquely atttractive proposition that we have not seen in a long time. There were no purchases or sales that occured during the quarter.

We recently released our Investment Analysis on Warner Bros. Discovery (NASDAQ: WBD), which is a company we are very bullish on. We didn't add any shares during the quarter as the company is already a significant position in the Fund. However, we are monitoring the company's progress in hitting management's $5 Billion FCF for the year (earnings will be announced on Nov. 8) and are looking to add to our position if prices drop further.

We look forward to a more in depth discussion on our holdings during our 2023 Annual Letter. Hope everyone enjoys the Holidays and I look forward to finishing 2023 on a strong note.

Sincerely,

Daniel Fas