Q2 2024 Letter - Rough Waters Ahead

The U.S market continues to perform well with a strong showing in Q2, but there are storm clouds forming on the horizon with economic data showing signs of a slowdown.

Quarterly Performance

Seaside Private Capital (SPC) continues to follow-up on our strong performance from Q1 and closed-out the 1st half of 2024 up 25.98% vs. the S&P 500 at 15.19%.

Rough Waters Ahead

SPC had an amazingly strong Q2, outperforming the S&P 500 TR by 10.69%. Our outperformance for the quarter derived primarily from two new portfolio holdings, as we continued to execute on our portfolio transformation strategy. We continue to shift our assets from a classic value fund to a portfolio of long-term tax efficient high quality compounders.

The market as a whole continues to be driven by the major tech giants: Apple (AAPL), Nvidia (NVDA), Microsoft (MSFT) and Amazon (AMZN), Meta Platforms (META), and Google (GOOG). Tesla (TSLA) is the only "Magnificent 7" stocks that is down so far this year at -11% YTD. The remaining stalwarts are all up double digits. Meta is up over 35%, and Google is up over 21% YTD, for example. Nevertheless, the "Magnificent 7" accounted for 61% of the YTD returns we've seen in the S&P 500 while the remaining 493 companies in the index accounted for only 39% of the returns. Overall the Mag 7 is up over 33% YTD while the rest of the S&P 500 is up only 5% (see below).

Source: JP Morgan Guide to the Markets

Although the market as a whole has done very well YTD, as we write this letter we are noticing a shift in market sentiment. Even with potential rate cuts on the horizon at the September FED meeting, the market has started to become a little more turbulent over the past few weeks. Q1 GDP numbers came in at 1.6%, after increasing 3.4% during Q4 2023, a pretty rapid slowdown. The unemployment rate has also gradually increased from 3.4% last year to 4.1% in June and now 4.3% in the latest reading for July. There is a caveat that the economy is still normalizing from the pandemic, but manufacturing activity from the Institute for Supply Management (ISM) dropped to an eight-month low in July at 46.8 (anything below 50 indicates contraction), which in addition to the consistent uptick in the unemployment rate was worrying. We are not economic forecastors and we don't invest based off of this data, but it's something we are cognizant of, because it could be a sign of market turbulence ahead which are great opportunities to deploy capital.

I believe the FED has done a pretty good job at tackling inflation. Keeping rates in the 5.25% - 5.50% range is probaly better for the economy in the long-term, especially in the housing market. Housing prices specifically have been in a bubble due to the excessive monetary policy we've seen over the last decade. We're finally starting to see the housing market soften with inventory levels rising and price cuts becoming more common. Housing affordability is currently unsustainable so this recent shift in housing market data is a good thing.

As for interest rate projections, economists were projecting 6 or 7 rate cuts back in January and now the market is factoring in just 2 rate cuts, starting at the September FED meeting. At a high level I think the FED will only cut rates when necessary (ie. economy weaking, unemployment spiking, etc.). Although the economy seems to be slowing/normalizing, which has led to an uptick in the unemployment rate, it's still pretty low. Historically the unemployment rate has hovered around 5.8% (January 1948-September 2020) vs. the current reading of 4.3%. Overall, I don't think the FED needs to be pressured into making a particular move at this time. It will all depend on the economic data and the balance of risks between the FED's dual mandate - price stability and unemployment.

Portfolio Update

During the quarter we were active on the acquisition front and added two new holdings to the portfolio- UnitedHealth Group Inc.(UNH) and Wyndham Hotels & Resorts, Inc.(WH). Both of these companies are high quality componders that were trading at reasonable valuations. Since our purchase, UNH is already up 16.33% and WH is up 4.88%. Additional detail on both companies can be seen below.

Wyndham Hotels & Resorts - New Purchase

Wyndham Hotels (WH) is a hotel franchisor that operates in the U.S. and internationally. Popular brands within their portfolio include: Super 8, Days Inn, Travelodge,Howard Johnson, La Quinta, Ramada, Wyndham Alltra, Wyndham Garden, Ramada Encore, Microtel, Wingate, Wyndham, Wyndham Grand, and WaterWalk Extended Stay by Wyndham. WH is the largest hotel franchisor in the world by number of hotels with over 9,000 hotels in over 80 countries. The company currently has a 40% market share of the economy and midscale segments in the U.S. They also have 3 of the top 4 ranked brands in each segment (Microtel, days inn, Hojo in the economy segment) and (Wingate, La quinta, AmericInn in the midscale segment). 

Hotel franchisors are great business to own as they are asset-light, produce recurring revenue, and generate strong free cash flow. The opportunity was presented to us after the failed hostile takeover by Choice Hotels (NYSE: CHH). Choice valued WH at ~$90/share, but WH quickly traded down to ~$70/share once the transaction fell apart. WH was adamant that the offer undervalued the company. We agree with managements decision. We believe WH is better off as an independent company, which can compound EBITDA at ~8% and grow earnings by 12-14% per annum.

We purchased shares at $70.92 and think fair value is conservatively around $95 today. If the company trades in-line with similar hotel franchisor peers we think the value today is over $100/share. WH management acknowledges this discount and is aggressively buying back stock. The board just approved a $400MM share buyback, which is ~6.7% of the shares outstanding at the current market price. We underwrite our base case to generate a 16% IRR over 4 years.

UnitedHealth Group - New Purchase

UnitedHealth (UNH) is one of the largest diversified health care companies in the U.S. The company operates under four segments: UnitedHealthcare, Optum Health, Optum INsight, and Optum Rx. UNH is the prime definition of a high quality compounder. Over the past 5 years the company has grown revenue at 11.5% per annum, earnings per share at 13-14%, cash flow per share at 12.7%, and produced an average ROIC of 21.51%. We were excited to initiate a position during a rapid sell-off in April due to a large cyber security attack, which we think is a short-term temporary issue. On UNH's most recent earnings call, our intuition was validated as the financial impact from the cyber attack seems to be negligable.

We purchased shares at $439.56 while shares currently trade at around $572. We think fair value is around $635 today. We underwrote UNH to produce a mid-teens IRR over our holding period.

Concluding Remarks

As we enter the second half of the year we remain cautious on the markets and look to continue building our cash balances. We were surprised to find two different companies to deploy capital into, which ultimately helped us outperform in Q2. We look forward to providing our next update in our Q3 letter.

Sincerely,

Daniel Fas

Founder & CIO at Seaside Private Capital