RISK-SEEKING.
“Long-term consistency trumps short-term intensity.”
Bruce Lee
A lot can change in four months. Tariff announcements began shortly after Inauguration Day and from late February to April 8th, the Russell 2000 fell 23%. Bear markets usually take time to materialize, but this was among the fastest ever, joining such infamous selloffs as COVID-19, Black Monday and 1929. The next day, a 90-day reprieve was granted, and small caps went on to rally 26%.
I wrote in May that addressing trade imbalances and improving US competitiveness is a valid goal, but thought tariffs were more likely to raise costs than spark a domestic manufacturing renaissance. Markets wanted two things entering 2025, lower rates and affordable goods, and tariffs jeopardize both. While there’s debate about whether importers or consumers ultimately bear the cost of tariffs, neither is good for business. Either margins fall or consumers buy less, potentially both. Since interest rates began rising in 2022, consumer resilience has been the saving grace of the American economy. I feared tariffs would push said resilience to its breaking point.
My larger concern was that the ad hoc nature of their introduction was bound to be disruptive. While unpredictability may be a useful negotiating strategy, I don’t think Corporate America liked being the bargaining chip. After decades of building a global supply chain with knowable costs, the on-again/off-again nature of trade policy via tweet with numerous carve-outs, exceptions and timelines left executives resembling deer in headlights. Reshaping global trade was never going to happen quickly, and it’s hard to make plans when you don’t know the rules.
You’ve no doubt read your fill of tariff commentary, so I’d prefer to elaborate on what I’m doing about it. I’ve tried to espouse the wisdom of getting invested deliberately. If your first goal is capital preservation, time is your friend. It may mean foregoing some quick upside but removes the risk of starting a fund on the cusp of a bear market (which I inadvertently did).
This chart shows how Epigram Capital (dark blue) has performed relative to the Russell 2000 (orange) since January. The turquoise line is how much capital I’ve invested, which is subject to inflows. My decision to invest slowly was extremely beneficial in February and March. It has been less helpful in the subsequent rally.
Last month, I walked through my top ten holdings and how I believed many to be less reliant upon a strong economy to do well. Most are durable, defensive businesses, with robust capital return policies, sound balance sheets and high returns on capital. Unfortunately, since April 8th these are the stocks that have performed the worst.
The tariff reprieve created a maelstrom of short-term profiteers, who sought risk at any price. When your time horizon is 90 days (the tariff reprieve), markets can temporarily misplace their judgement. Meme stocks are a thing again (Opendoor was up more than 400% in a month), junk rallied and fundamentals were ignored. Since April 8th, the unprofitable components of the Russell 2000 are up 35.3% while those with strong balance sheets are up 18.8%. A popular index of small cap dividend payers is only up 13.8%. In times like these, risk aversion is a handicap, not a benefit.
My strategy has always been to find low-risk investments capable of earning above average returns. Small caps are known to be a risk-on asset class which makes them attractive in times of risk seeking. I content myself knowing that every so often markets throw caution to the wind and I will likely underperform (fourth quarter of 2023 wasn’t dissimilar). When sell-offs happen, which they inevitably do, the portfolio tends to hold up better. I like this trade off; it suits me. Ultimately, I know that investing is like marriage. Trying to be right all the time usually doesn’t end well.
All 17 of my limited partners are within a rounding error of their high-water mark. Had I been fully invested day one, this is unlikely to have been the case. If I followed the market and bought junk in March and April, results would no doubt be better. But the reprieve would inevitably end, and I’d be left holding low-quality securities with dubious prospects. It’s worth noting that because short-term gains are taxed at 40%, you need a 20% pretax return to yield 12% after-tax. Some investors may be able to pivot from high-quality to low-quality stocks when advantageous, but I’m not one of them.
There were no new partners accepted in July, which I attribute to vacation schedules. I continue to meet with our community’s affluent and explain my plan to preserve what is best about active management (differentiation, diversification and conviction). I remain convinced that I can achieve above average returns with below average risk through sound security selection. No one can look right all the time and long-term outperformance requires being out of step with the market which happens to be the case right now. This is a feature, not a bug.
Thank you for your continued support.
Sincerely,
Dan Walker