Quarterly Letter

October brought a significant increase in market volatility and a broad equity sell-off to match the late-January through early-February move lower. From the September 21 high of 2941 to the (so far) October 26 intra-day low of 2628, the S&P 500 fell a bit more than 10%. At this point, it is still hard to know what to make of the move. Equity valuations remain very high. This is true even when one accounts for a sustainable shift in profit margins, the asset-light mix of US companies, and market structure[1] that all argue for higher-than-historical average market multiples. Valuation presents a bad setup (but, that is not new). On the other hand, like the move lower in January, signs of increasing risk aversion (e.g. significant widening of credit spreads and narrowing of market participation) that typically begin developing months before a full bear market takes root, did not precede the current move lower. A near-term rebound would not be a surprise and we have added some equity exposure near the recent lows. Yet, given valuations and recent opportunistic transactions, we still have large positions in cash and Treasuries that should mute a continuation in the sell-off.

In equity accounts, we were active this quarter. Corporate transactions allowed us to realize meaningful gains in two equity holdings: Express Scripts and Zoe’s Kitchen. We also closed an index position at a loss, added to an existing holding, and purchased two new securities. In fixed income accounts, we have made zero changes this year. The core of the fixed income portfolio remains a barbell between long-duration US Treasury bonds (stability) and floating-rate bank loans (growth). A meaningful move in the price of gold (signaling a change in inflation) and/or credit spreads (signaling a change in growth and investor risk-aversion) would provoke a shift in fixed income portfolio structure. Despite the equity market volatility, both of these series have remained relatively stable this year. Below we detail each of the transactions from the quarter.

Sale – Zoe’s Kitchen (ZOES)

Last quarter we wrote in detail about our June 8 initial purchase of Zoe’s Kitchen. On August 14, just prior to the company’s second quarter earnings announcement, we added to our position. Given our conviction in the idea, we wanted to have a larger position if the “strategic initiatives” they were pursuing developed sooner rather than later. We increased the size of the position to 5% of account value.

On August 17, Zoe’s announced an acquisition by privately held Cava Group, Inc. for $12.75 per share. Despite the $12.75 deal price, we were able to realize an average sale price of $13.25; our best guess as to why the stock traded at such a premium to the deal price is short covering. With an average cost basis of $9.18, our total return was approximately 44% over an average holding period of a bit more than one and a half months.