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Jan 17, 2024

4Q23 Opportunity Equity Quarterly Review

Christina Siegel Malbon

Strategy Highlights

During the fourth quarter of 2023, the Patient Opportunity Equity Strategy generated a total return of 17.6% net of fees. In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned 11.7%.

Using a three-factor performance attribution model, interaction, selection and allocation effects all contributed to the portfolio’s outperformance. Expedia Group Inc. (EXPE), Coinbase Global Inc. (COIN), Karuna Therapeutics Inc. (KRTX), OneMain Holdings Inc. (OMF), and Citigroup Inc. (C) were the largest contributors to performance, while Mattel Inc. (MAT), Canada Goose Holdings Inc. (GOOS), Kosmos Energy Ltd (KOS), Alibaba Group Holdings Ltd (BABA) and S4 Capital plc (SFOR LN) were the largest detractors. 

Relative to the index, the Strategy was overweight the Consumer Discretionary, Communication Services, Financials, Energy, and Industrials sectors on average during the quarter. With zero allocation to Real Estate, Utilities, and Consumer Staples, the Strategy was underweight these sectors along with the Information Technology, Healthcare, and Materials sectors.

The portfolio added four positions and eliminated four positions during the quarter, ending the quarter with 41 holdings where the top 10 stocks represented 52.1% of total assets compared to 30.9% for the index, highlighting the portfolio’s meaningful active share of around 102.6%.

Portfolio Review

The market is a complex adaptive system, constantly updating and adjusting to the latest information and investor behavior. Just as the third quarter pullback was caused by concern about a Fed policy mistake and fears of a hard landing, the fourth quarter was driven by the exact opposite. As the Federal Reserve continued to hold rates flat and the dot-plot forecast three rate cuts in 2024, the market returned to its soft-landing scenario and stocks were off to the races. The fourth quarter marked the 14th highest return fourth quarter for the S&P500 Index going back to 1927 and the fifth highest return fourth quarter for the portfolio.

Many names that were pricing in recession scenarios rebounded aggressively. Stocks move from revisions in expectations, and we saw just that. Consumer Discretionary, particularly our travel names, rebounded from the hit they took in the third quarter. At the time it was clear they were pricing in a hard landing despite fundamentals continuing to show strong demand. We took the opportunity to add to our highest conviction ideas which benefited us in the fourth quarter rebound. Financials were a standout in the quarter as investors began to price in lower short-term rates.

Our exposure to Financials continued to increase throughout the year as we saw a disconnect between underlying fundamentals and market expectations. With current expected credit loss (CECL) accounting standards forcing banks to reserve for full-cycle losses, bank fundamentals already reflect an unemployment rate much higher than where it stands today. Unemployment has remained subdued, and charge-offs have remained in line with historical trends. Unless this changes, the buildup in reserves will need to be reversed over time, providing an attractive tailwind to fundamentals.

Our financial exposure (OMF, C, UBS, COIN) is concentrated in high-conviction, high-quality names with management teams we have confidence can manage the business in any scenario. Citigroup Inc. (C), run by Jane Fraser since 2021, is on a multi-year journey to reorganize the business and reach return on tangible common equity of 11-12% by 2025-2026 (and higher further out). Citigroup is finally taking the hard actions necessary, cutting unprofitable departments, taking out middle management layers, and reducing overall headcount. We have high confidence Citi will hit its targets.

UBS Group AG (UBS) is a name we opportunistically purchased following the banking crisis earlier in the year. UBS benefited from buying its largest local competitor, Credit Suisse, for an 80% discount from where it was trading before the crisis. We bought after the deal, believing the market’s myopic focus on short-term integration risks failed to properly value the attractive set of assets. While the stock has done well since then, we still believe it is underappreciating the long-term return potential of the business.

OneMain Holdings Inc. (OMF) is a name we have owned for years. It’s a high return, well-managed franchise that has successfully navigated credit cycles for nearly a hundred years. The stock has continued to climb higher with prudent risk management and an 8% dividend yield.

Coinbase Global Inc. (COIN) was a standout as anticipation of a Bitcoin ETF approval brought attention back to the sector. We believe Coinbase is building a crypto platform and should benefit by the continued advancement and evolution of the opportunity.

We benefited from Bristol-Meyers Squibb Co.’s (BMY) acquisition of our holding, Karuna Therapeutics Inc. (KRTX), in the quarter for $330 per share, a 53% premium to where the stock was trading. We were pleased to see our acquisition thesis play out. We continued to pare back our biggest winners, reinvesting in new high conviction ideas.

New and Eliminated

This quarter we entered four new positions, while exiting four positions. Our largest new position was Crocs Inc. (CROX). Crocs is a well-known consumer brand in the footwear industry. Despite continual calls over the years as a fad, Crocs has shown impressive growth and staying power. Since 2017 the company has increased sales at a 20%compound annual growth rate (CAGR) while maintaining industry leading operating margins of 27%. The stock sold off recently as the HEYDUDE brand it purchased in 2022 faced challenges. A combination of market oversaturation, and still limited brand awareness has made HEYDUDE a drag on the overall business. This is more than priced in at current levels with the stock trading at a P/E of 8.5x below peers at 14.3x and their historical average of 15x since 2019. The company is making progress on fixing HEYDUDE with growth expected to return in the 2H24. Overall, we view the child piece of the core Crocs product as a consumer staple and believe people are underappreciating its staying power as well as the ongoing improvements in the HEYDUDE brand. We believe you can buy a high-quality company, at a low multiple, with top FCF yield (13%) that is committed to both debt paydown and buybacks.

We built up a position in Royalty Pharma plc (RPRX) during the quarter. Royalty Pharma is the largest buyer of biopharmaceutical royalties. The stock traded down throughout 2023 hitting a low of $26.21 in October below its IPO price of $28 in 2020 despite revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA) being materially higher. The company is in the business of buying royalties, originally funded by debt with profits recycled into new opportunities. As interest rates rose throughout the year, the stock came under pressure as fears of a smaller spread between royalty deal IRRs and the cost of capital hit the stock. This fear looks overblown with only 21% of current debt being variable and the majority of its fixed rate debt not due until after 2030. With an average cost of debt of 5% and 2023 deal internal rates of return (IRRs) averaging low teens, we believe the model still works. This environment has only served to grow the total addressable market. Run by a proven business leader, we believe the company can continue to invest at attractive spreads. Trading at just 8x earnings, we believe you are getting an attractive entry point to own a leader in the space.

We entered Illumina Inc. (ILMN), another healthcare name, in the quarter. A previous market darling, Illumina has declined from a high of $524 in 2021 to a low of $92 in 2023. We started adding near the lows. The company is a leader in genomic sequencing but made an ill-advised acquisition of Grail, a blood-based multi-cancer early detection product, in 2021 for $8 billion. The company completed the acquisition before European regulators could complete their antitrust review setting off years of regulatory back and forth. A new management team, new board members, an activist campaign, and an ordered divestiture of Grail later, and we believe we were able to buy a market-leading compounder at the point of maximum pessimism. Despite increased competition in the genome sequencing space, Illumina continues to be a leader with ~80% market share today. With the divestment of Grail, the company will return to a pure-play sequencing company with a drastically improved margin and FCF profile (22% operating margins core ILMN vs 8% with Grail) since Grail has been a cash drag of >$600m annually. Ex-Grail, we believed we were paying a market multiple on 2025 earnings for a market leader with strong cash generation and significant future growth potential.

We purchased a new energy name in the quarter, buying shares in Seadrill Limited (SDRL). Seadrill is the fourth largest pure play deepwater drilling specialist. The company emerged from bankruptcy in February 2022 with a net cash position. The company is set to benefit from limited supply and increasing demand in the deepwater drilling rig market. Nearly half of all deepwater drilling rigs in the world were scrapped during the last decade. In addition, player consolidation puts the industry in a more rational position than we have seen historically. As land-based oil production growth comes under pressure, offshore production is receiving renewed interest. With a highly specialized rig base, the company is benefiting from increasing prices which are leading to strong FCF yields given the limited need for capital expenditures (CAPEX). The company has committed to returning 50% of FCF to shareholders via dividends and buybacks. Since September 2023, the company has repurchased 8% of shares outstanding. As old contracts roll-over and new contracts are signed at the higher day rates, operating profit and FCF are expected to expand dramatically. Seadrill could either consolidate the space or be acquired.

We exited Karuna Therapeutics Inc. (KRTX) and Splunk Inc. (SPLK) following their announced acquisitions as the stocks traded up close to their agreed purchase price. We exited Ovintiv Inc. (OVV) in the quarter as we looked to concentrate our energy exposure around higher conviction names and we used DXC Technologies (DXC) as a funding source.

Top Contributors and Top Detractors

Top Contributors Ticker Net Contribution (bps)
 Expedia Group, Inc.  EXPE 325 
 Coinbase Global, Inc. COIN  255 
 Karuna Therapeutics, Inc. KRTX  169 
 OneMain Holdings, Inc. OMF  146 
 Citigroup Inc. 143 
Top Detractors Ticker Net Contribution (bps)
Mattel, Inc.  MAT  -85 
 Canada Goose Holdings Inc. GOOS  -72 
 Kosmos Energy Ltd. KOS  -59 
 Alibaba Group Holdings Ltd BABA  -43 
 S4 Capital plc SFOR LN  -35 
*Contribution illustrated above are provided net of fees and includes cash.

Top Contributors

Expedia Group, Inc. (EXPE) was our largest contributor in the quarter gaining an impressive 47.3%. Despite the strong move in the stock over the last quarter, we still see attractive upside from here. We initially purchased Expedia in the middle of 2022 when the company was nearing the end of a multi-year business and tech transition to a single platform. 2024 begins with a unified tech stack, efficient marketing program and the potential for improved relative growth, margin expansion and free cash flow (FCF) generation. Despite the improving growth and margin profile, EXPE still trades at a material discount to Booking Holdings Inc (BKNG). If previous correlations were to hold, this would imply more than 50% upside as Expedia’s multiple rerates to match its improved financials. The company continues to buy back stock, reducing the share count by 11% over the last year. As the company continues to execute, we believe the market will eventually give them credit for their improved fundamentals.

Coinbase Global, Inc.(COIN) climbed an incredible 131.7% in the quarter outpacing the 57% gain in bitcoin over the same period as investors became excited about the potential approval of a Bitcoin ETF in the new year. Coinbase continues to stand out as the lead survivor in an industry of fading and failing leaders. Cost savings initiatives taken earlier in the year have resulted in three quarters of positive EBITDA leading to expectations for “meaningful positive adjusted EBITDA” for the full year 2023. We continue to believe COIN has the potential to be the platform for crypto with $5B in liquidity providing the ability to invest and weather any crypto winters.

Karuna Therapeutics, Inc. (KRTX) gained 87.2% in the fourth quarter following its announced acquisition by Bristol-Myers Squibb (BMY) in December. Bristol Myers Squibb agreed to purchase the company for $330 per share, a 53% premium from where the stock was trading. The acquisition is expected to close in June of 2024. The valuation was in-line with recent transaction in the space and was part of what we believed made Karuna an attractive investment given its material discount to these levels.

Top Detractors

Mattel, Inc. (MAT) fell in the fourth quarter following increasing concerns around toy industry demand. We believe Mattel is in a unique position given the recent strength of the Barbie movie which hit theaters in July and immediately became a blockbuster hit becoming the highest grossing film of 2023 at more than $1.38B worldwide sales. The Barbie movie is the beginning of Mattel’s multi-year journey to transition to an IP-driven, high-performing toy company. As growth returns, margins should expand, benefiting from overall cost reduction and fixed cost leverage. As the company executes its IP driven transition, returns on invested capital and free cash flow generation should improve allowing the P/E multiple to expand.

Canada Goose Holdings Inc (GOOS) continued its decline in the fourth quarter hitting its lowest per share valuation in November, since being a public company. The low was sparked by the company cutting its annual guidance. Luxury spending has been under pressure since 2022 following the period of overindulgence during COVID. As the company continues to invest in new products and geographies despite the macro-weakness, margins have been hit. The company is taking the opportunity to right-size the cost structure and reorganize investments, taking out 10% of non-store headcount, while also continuing to buy back shares. The company trades at a P/E multiple more in-line with non-luxury peers rather than true luxury brands. The market is still skeptical of the company’s luxury brand reputation, but we believe the company will prove itself out over time.

Kosmos Energy (KOS) declined from the high seen at the end of September following energy prices lower. The company was also hit as they marginally increased CAPEX expectations and hinted at the potential for their first gas delivery out of Tortue being delayed to 2Q24 from 1Q. Kosmos is an exploration and production services company with assets in Africa. The company is differentiated in the Exploration & Production space because of its growth profile (+30% YoY in 2024), long reserve life (>20yrs, nearly double the sector average) and focus on liquified natural gas (LNG). While the market is focused on near-term risk of production delays, we believe it is ignoring the long-term value of the underlying assets. As we move into 2024, production should inflect higher, climbing 30% YoY, while CAPEX comes down, declining 20% YoY. Together this leads to attractive growth and free cash flow generating asset providing the company the ability to pay down their debt and to return capital. At these levels, the company will generate more than its current market cap in FCF over the next 5 years at $90 Brent prices. With the combination of gas-heavy reserves and inflecting cash flow generation, we think Kosmos is significantly undervalued and a potential acquisition target.

4Q23 Opp Equity NOF Attribution
Market Proxy is S&P 500. Returns greater than 1 year are annualized. Source: Bloomberg and Patient Capital Management

The data provided is from APX and Patient Capital Management, LLC and is believed to be reliable, but is not guaranteed as to its timeliness or accuracy. Percentages and returns may not sum to 100% due to rounding effects. A three-factor attribution consists of the allocation effect, selection effect, and the interaction effect, which sum to the portfolio's performance relative to the benchmark. 
Allocation. The allocation effect represents the portion of the portfolio's excess return attributable to differences in sector weights between the portfolio and the benchmark index.
Selection. The selection effect represents the portion of the portfolio's excess return attributable to differences in the weights of individual securities within each sector between the portfolio and the benchmark index.
Interaction. Most complex and sometimes counterintuitive, the interaction effect represents the portion of the portfolio’s excess return attributable to combining sector allocation decisions with security selection decisions, and is often thought of as measuring the accuracy of manager’s convictions.

Please note that the methodology used by our independent third-party attribution software vendor will at times present sector allocation effects that are counterintuitive. For example, the software may calculate a negative sector effect even when the portfolio, on a weighted average basis for the period, was overweight an outperforming sector. Under the vendor's methodology, allocation effects in recent months may overwhelm the allocation effects from earlier in the period, particularly over longer time frames.

Returns illustrated above are provided net of fees and include cash. Total portfolio return figures provided above reflect the sum of the returns of the holdings in the representative account portfolio due to price movements and dividend payments or other sources of income.
The S&P 500 Index is a market capitalization-weighted index of 500 widely held common stocks. Investors cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

The new accounting standard introduces the current expected credit losses methodology (CECL) for estimating allowances for credit losses. The standard is effective for most SEC filers in fiscal years and interim periods beginning after December 15, 2019, and for all others it takes effect in fiscal years beginning after December 15, 2022.

Price-to-earnings Ratio (P/E Ratio) is the weighted average of the price/earnings ratios of the equities held by the Fund.

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income

Free cash flow (FCF) is the cash a company generates after taking into consideration cash outflows that support its operations and maintain its capital assets. 

Free cash flow yield is a financial solvency ratio that compares the free cash flow per share a company is expected to earn against its market value per share.

Compound annual growth rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer than one year.

This information does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. All investments are subject to risk, including the possible loss of principal. There is no guarantee investment objectives will be met. Neither Patient Capital Management, LLC, nor its information providers are responsible for any damages or losses arising from any use of this information.

The Opportunity Equity composite performance figures reflected above include the deduction of a model investment management fee of 1% (the highest fee for separate accounts under our fee schedule), paid quarterly and certain other expenses. For important information about Opportunity Equity Strategy performance, please click on the Opportunity Equity Strategy Composite Performance Disclosure. Past performance is no guarantee of future results.

All holdings and portfolio data are reflective of a representative Opportunity Equity account.

Performance in attribution table is not official strategy returns. The return is sourced from APX and is net of fees based on the strategy’s representative account.

Contributors detailed above represent the top five securities that contributed positively to performance during the quarter. Detractors detailed above represent the top five securities that detracted from performance during the quarter. Information detailed above is provided net of fees, includes cash, and is based on a representative Opportunity Equity account. Contribution listed above represents the period when the security was held during the quarter. For additional information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to the representative Opportunity Equity account performance contact us.

The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. References to specific securities are for illustrative purposes only. Portfolio composition is shown as of a point in time and is subject to change without notice.

The views expressed in this commentary reflect those of Patient Capital Management analyst(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Patient Capital Management disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

Click for the Opportunity Equity Strategy Composite Performance Disclosure.

©2023 Patient Capital Management, LLC