Tourlite Fund, LP Founder Class returned 4.5% for the Second Quarter of 2022[1] compared to a decline of -16.1% for the S&P 500[2] . The majority of this return was generated from the fund’s short exposure. As this is the first letter since the Fund’s inception on April 1st, we thought it would be useful to discuss our investment strategy and market outlook as well as highlight several positions within the portfolio.
Our investment philosophy is derived from the belief that a business’ long-term ability to generate cash flow is the primary driver of value. We are focused on purchasing high quality businesses at attractive valuations and aim to take short positions in companies with poor fundamentals trading above fair value.
Our objective is to achieve above-market, risk-adjusted returns over the course of a cycle by capturing the spread between our long and short portfolios. With a lower correlation to the market and economic cycles, we believe this offers us flexibility with the portfolio’s exposures and the ability to use leverage.
Generally, the portfolio’s exposures will fall within the following parameters. Net exposure between 0% - 50%, with a typical exposure closer to 15% - 20%, and gross exposures between 180% - 250%. We view net exposure on a beta adjusted basis. We consider a blend of the company specific opportunity set and macroeconomic factors in determining our exposures. For example, a robust opportunity set, with an abundance of attractive short positions, allows us to reduce the portfolio’s net exposure and increase our gross exposure (leverage) to capture the expected spread in future share price performances.
Our fund launched at an interesting time. In February, Russia invaded Ukraine. The people of Ukraine and their families remain in our prayers. At a time when inflation was already rising in the high single digits, the escalation in Ukraine resulted in a rapid spike in oil prices, to a high of $130, a level not seen since July 2008.[3] In March, the Federal Reserve began raising interest rates to combat soaring inflation and has continued with an additional 50 basis points (bps) hike in May and 75bps in June.
The current US Federal Funds Effective Rate is now over 1.5%, compared to 0% as recently as March. The market is currently pricing in an additional 7 hikes before the Fed begins to reverse course in May of 2023.[4]
Over the quarter, market tone shifted from fighting inflation with tightening monetary policy to recession fears. Even with the market correction over the first six months of the year, the S&P 500 returned -20.0% and the NASDAQ Composite declined -29.2%[5] , we believe we are still in the early stages of a bear market.
Since the beginning of the year, consensus estimates for the S&P 500 Ex-Energy have declined 50bps for 2022 and 13bps for 2023. Current consensus estimates imply a year-over-year increase of ~13% for 2022 and ~11% in 2023.
Past Peak to Through Declines[6] [7]
As a result, we see further downside risk to earnings in the case of economic contraction. We continue to remain cautious, and are positioned accordingly, as we believe the U.S. economy may have already entered a recession.
The current dominance of macroeconomic factors (inflation, interest rates, etc.) and price action primarily driven by factor exposure (value, growth, momentum, volatility, etc.) has resulted in a high correlation between securities in the market. We measured the increase in the correlation, from 2021 to the first half of 2022, between the top five companies on key “Factors to Watch” on Bloomberg and the entire current holdings of the ARK Innovation ETF (ARKK).
Increase in Daily Correlation Among Top Constitutes[8]
Most of our portfolio is invested in the consumer (~45%), industrials (~35%), and technology (~20%) sectors.[9] The Fund’s net exposure has remained near market neutral, on a beta adjusted basis, during the second quarter. While our gross exposure has fluctuated between 140% - 180%, it has remained lower than our expected range (180% - 250%) would be under favorable conditions. The Fund’s gross exposure at the end of the quarter was approximately 140%.
Despite the current market environment’s high levels of correlation, we believe once correlations break down, there will be a strong opportunity for fundamental investors to capture the resulting spread. The vast market sell-off that began in the first quarter has created the opportunity to acquire high-quality businesses at more attractive prices. We see opportunities owning businesses with strong pricing power and high return on capital.
While many overvalued and speculative stocks have underperformed in recent months, the influx of hundreds of low-quality IPOs and SPACs over the past two years continue to present a ripe opportunity set for short selling. More specifically, we see opportunities to short companies with earnings tied to discretionary consumer spending and those likely to require near term access to the capital markets.
Until we see a shift in the market regime, from macro towards share prices driven by business fundamentals, the Fund remains focused on downside protection while addressing the optimal time to start playing offense. We plan to aggressively increase our gross exposure as correlation between factors break down and as the anticipated spread between our long and short portfolio increases.
Our core investment principles focus on acquiring high quality businesses trading at a discount to fair value based on normalized earnings. In our view, the most attractive businesses have strong value propositions, formidable barriers to entry, predictable cash flow, and exceptional managers.
Our target holding period is 3 years for our core long positions. This may fluctuate as business fundamentals evolve (positive or negatively) or the gap between fair value closes. We like to limit our top long positions to less than 10% of capital at cost, with a typical core position size in the range of 5% - 7%. Currently, our top long position is approximately 6% of the portfolio.
Below is an overview of four of our long positions:
Perimeter is the sole qualified provider of aerial fire retardant for many applications. This mission critical product represents a small portion of its customers’ spend, and revenue is recurring in nature as long-term secular tailwinds (growth in number and size of fires) support growth. Perimeter is led by what we consider to be an experienced, best-in-class, capital allocation focused management team. We view this as a high-quality business, with limited downside to earnings and the ability to continue compounding capital, generating close to 90% return on capital and trading at an implied 2023 FCF yield greater than 6.5%.
Alphabet is an attractive business with sustainable growth prospects and a strong moat due to its significant advantage in online search (Google) and network effect of user created content (YouTube). The secular trend towards online advertising and increased consumer spending will continue to support strong topline growth. Google Search is synonymous with online search and captures 85%-90% of the global search market. On a consolidated basis, Alphabet generates a 50%+ return on equity, has limited debt, and trades at ~5% forward free cash flow yield.
Amazon is at the forefront of two key secular trends, cloud adoption and e-commerce penetration, and had begun trading at the low end of its historical valuation range on a revenue and EBITDA multiple basis prior to the overall market correction. Amazon faced what we consider to be a onetime headwind after reporting first quarter results. Sell side estimates for the first half were too high and included Amazon Prime Day which was moved to the third quarter. In addition, a significant one-time loss resulted from the decline in its stake in Rivian Automotive (RIVN).
ironSource provides software solutions to help mobile app developers acquire users, increase engagement, and grow revenues. Sonic, the core product, is appealing to mobile game developers as it allows for a high return on advertising spend for developers to acquire users and for advertisers wanting in app ads for those users.
On July 13th, ironSource announced it was going to be acquired in an all-stock deal by Unity Software (U). The deal valued ironSource shares at $4.33, a 94% premium. Prior to the announcement, ironSource’s share price declined ~75% since its 2021 SPAC merger. However, ironSource has exceeded its guidance issued when it went public and is profitable and cash flow positive. In our opinion, ironSource “bit the bullet” in the second quarter when they lowered their guidance for the remainder of the year.
We saw margins bottoming out in the second quarter and an uptick in the back half of 2022 as the integration of their acquisitions progresses. For a business growing revenue >25% and cash flow at a higher rate, we believed its pre-deal valuation (~4.5% free cash flow yield) was attractive as the business continues to scale.
We believe a fund’s short book is fundamental for a successful long/short portfolio. The objective of our short book is to capture short alpha and positive spread between our long ideas. In a down market, this should allow us to hedge market risk, reduce volatility, and the ability to redeploy capital to our long book at a lower cost basis.
Our typical holding period for short positions is 6 - 12 months, which is significantly shorter than for our long portfolio. For risk management, we generally limit short positions to less than 4% of capital. Currently, the size of our average short position is just under 2%. The combination of higher turnover and smaller position sizes forces us to spend more time on short idea generation.
We look at our short portfolio with a barbell approach consisting of a blend between traditional fundamental theses and aggressive short positions (frauds, zeros, fads, etc.). As we try to limit our exposure to “aggressive shorts,” the majority of the short portfolio falls under the “traditional shorts” bucket.
Below is an overview of four of our short positions:
We are short an industrial packaging business that has experienced significant tailwinds from growth of e-commerce. We believe the recent growth and margins are unsustainable as competition from competitive offerings intensifies. In addition to fundamental headwinds, we find several red flags in the company’s financial reporting and corporate governance. The stock is down over 60% since we began shorting it at our fund’s inception.
This European company owns a U.S. asset which represents a significant portion of the business. Based on a deep dive into this U.S. asset, we believe management of the European parent have not been straight forward with their investors regarding the financial health and prospects of the U.S. asset since the acquisition.
The production of this asset is essential for the Company to maintain its current dividend. Based on our analysis of publicly available financials and industry data, there is a high probability the European parent will need to cut or reduce its dividend, creating a negative catalyst. We expect this catalyst to play out over the next 12 months, if not sooner.
With a current valuation fueled by multiple expansion combined with several near-term fundamental headwinds, we view this as an attractive risk/reward opportunity. Over the past two years, the Company has seen a spike in same store sales growth and gross margins due to increased consumer spending and higher ticket sizes. We see revenue growth and margins retracing back to historical levels as consumer spending trends normalize.
We are short a group of automotive manufactures that we believe to be the most overvalued and current market positioning offers the greatest downside to current valuations. We believe these businesses will never generate the cash flow necessary to justify their valuations based on overall market trends and profitability and well as several near-term catalysts.
In addition, the largest contributor to the fund during the quarter was a short position in a used car retailer which is facing significant macroeconomic headwinds as the used auto market slows.
Thank you for your trust and support. Please feel free to reach out to me with any question.
I named Tourlite after the Tourlitis lighthouse in Andros, Greece. The original lighthouse, constructed in 1897 on a stone column shaped by thousands of years of natural erosion, was destroyed during World War II. Around 50 years later, the lighthouse was reconstructed. Tourlitis’ history is a symbol of hope at a time when many parts of the world need rebuilding.
[1] Any net returns presented herein reflect the returns of the Fund assuming an investor “since inception”, with no subsequent capital contributions or withdrawals. These returns are not necessarily indicative of your net returns in the Fund, and you should follow-up with Tourlite if you have any questions about the returns presented herein.
[4] Bloomberg World Interest Rate Probabilities
[6] Bloomberg data. Trailing EPS except for current period
[7] S&P 500 Ex-Energy from January 2022 to June 2022
[8] Tourlite analysis. Growth = 5-year actual sales growth. Value = PORT US Value. Volatility = 3 Month Volatility. Momentum = PORT US Momentum.
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Additional disclosure: IMPORTANT NOTES This letter is being furnished by Tourlite Capital Management, LP (“Tourlite”) on a confidential basis to recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer or solicitation of an investment in Tourlite Fund, LP (the “Fund”) may be made only by delivery of the Fund’s confidential offering documents that contain a description of the material terms relating to such investment, of which this letter is not a part. The information and opinions expressed herein are provided for informational purposes only, are as of the date indicated, are summary in nature, are not complete, are subject to change and should not be relied upon by any person in making an investment decision. An investment in the Fund is speculative due to a variety of risks and considerations as are detailed in the confidential offering documents of the Fund, and this letter is qualified in their entirety by the more complete information contained therein. This letter is strictly confidential, and the information contained herein or provided herewith may not be disclosed or distributed by the recipient to any other person (other than the recipient’s affiliates, partners, members, directors, officers, employees and advisors and other agents who have a legitimate need for such information in connection with evaluating the recipient’s investment). Your receipt and review of this letter constitutes your agreement to comply with these provisions. An investment in the Fund involves a significant degree of risk, and there can be no assurance that its investment objectives will be achieved or that its investments will be profitable. This letter contains various estimates, targets and projections that are based upon various assumptions made as of the date such estimates, targets or projections were developed. Actual realized returns on unrealized investments and proceeds will depend upon various factors including, but not limited to, future operating results, the value of the assets and market conditions at the time of any disposition, any related transaction, operational and other costs and the timing and manner of sale. While estimates, targets and projections provided herein are believed to be reasonable approximations based upon available information available to Tourlite as of the date of this letter, no guarantee or assurance can be provided as to their accuracy or that such estimates, targets or projections will be achieved or met. Unless otherwise noted, the performance results of the Fund included in this letter are presented on a net-of-fees basis and reflect the deduction of, among other things, underlying management and performance fees and expenses as well as brokerage and/or custodial fees and expenses. Performance results also include the reinvestment of dividends and other earnings. Certain of the performance information presented in this letter are unaudited estimates based upon the information available to Tourlite as of the date hereof, and are subject to subsequent revision as a result of the Fund’s audit. An investor’s actual performance and actual fees may differ from the performance information shown due to, among other factors, capital contributions, withdrawals and eligibility to participate in “new issues.” The value of investments can go down as well as up. Past performance is not necessarily an indication of future performance or profitability. References to Dow Jones, S&P 500, NASDAQ, Bloomberg and other indices herein are for informational and general comparative purposes only. There are significant differences between such indices and the investment program of the Fund. The Fund does not invest in all or necessarily any significant portion of the securities, industries or strategies represented by such indices. References to indices do not suggest that the Fund will, or is likely to, achieve returns, volatility or other results similar to such indices. Certain information set forth in this letter is based upon information obtained from various third parties believed by Tourlite to be reliable. Neither Tourlite nor any of its affiliates has independently verified any such information and they shall not have any liability associated with the inaccuracy or inadequacy thereof. This letter and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events. The information in this letter is not intended to provide, and should not be relied upon for, accounting, legal, or tax advice or investment recommendations. Each recipient should consult its own tax, legal, accounting, financial, or other advisors about the issues discussed herein. © Tourlite Capital Management, LP