Leaven Partners Q4 2024 Letter To Partners

Click to enlarge

Click to enlarge

Dear Partners,

Click to enlarge

In the fourth quarter of 2024, total fund assets declined by -1.9%. For the three-year period, the fund is up 12.2% ¹ compared to the S&P 500 return of 28.9%.

We embarked on this year with a strong start, buoyed by a solid first quarter. However, the following three quarters were not as kind, as we slid backward and lost considerable ground to the domestic markets. The stock market’s bubble-like dynamics made it difficult to maintain the same level of performance I aim to deliver, particularly given the daunting task of competing with the market’s frothy conditions.

Despite navigating these turbulent waters, we managed to eke out a positive return of 5.8%. Yet, I realize this outcome might come as a disappointment to you, as it does to me. Post-Covid, the domestic markets have left us in their wake, and since fund inception, I have failed to deliver above-average returns. It felt like running uphill, but I’m determined to take lessons from this experience to heart. It is quite tempting for me to make excuses for our disappointing results by placing the stock market bubble as the scapegoat for all our ills. But at the end of the day, there remain plenty of wonderful opportunities in the underbellies of markets around the world that offer enticing returns. It is up to me to do a better job of finding them.

While fate can have a hand in our fortunes, I believe that over the span of time, the depth and authenticity of our strategy coupled with the discipline to execute on that strategy will be the true testament to my efforts. In essence, it comes down to delivering on my expectations for the fund over the long haul, and I am wholly committed to this endeavor. While there’s always an element of unpredictability in our yearly outcomes, I am committed to digging deeper and finding new ways to enhance our strategies. The confidence you’ve placed in me is something I hold dear, and I am focused on improving my approach to navigate the complexities of today’s market and to find more effective ways to steer us toward better outcomes.

Click to enlarge

Following a promising start to the year, performance in the fund languished for three consecutive quarters and finished in positive territory of 5.8%. Suffice it to say, it proved to be a disappointing year both on absolute and relative returns.

The hedge strategy contributed minimally in the quarter. The upward trajectory of the domestic markets prevented my position signals from flashing on, which caused the strategy to lay dormant for most of the quarter. Recently, however, trends have shown some reversal which triggered the strategy to take on a small, short position in the Russell 2000. For the year, the strategy continued to be a drag on overall performance with a return contribution of -4.5%.

Our core holdings had lackluster results in the quarter and finished the year with a return contribution of 5.4%. The majority of the losses were from previous unrealized gains given up in the current quarter. This highlights the difficulty in determining when to sell a security, which is the most challenging part of my job. Given the poor quarter, there were few highlights to note. One in particular, Money Partners Group (TSE: 8732.T), increased 94% from our purchase price when it was bought out by one of its competitors, Gaitame.com Co, at ¥474 per share in the fourth quarter. The gain on the sale provided a return contribution of 1.5% for the year.

Our foreign exchange strategy was the lone shining star this year, providing a return contribution of 3.0% in the quarter and 4.9% for the year. It has done its job of providing some stability to our exposure to foreign currencies and adding some yield to our portfolio.

U.S. equity markets have reached lofty valuations, increasing both the difficulty in keeping up with market performance and the heightened call for both caution and thoughtful positioning. It is a time to harken to respected voices like Cliff Asness and John Hussman who I think offer sound insights into the implications for investors. While their perspectives differ slightly, they converge on the point that stock prices are elevated well above historical averages.

In a recent Bloomberg interview, Cliff Asness, founder of AQR Capital Management, suggests that while current stock prices are undoubtedly high, they do not necessarily constitute a “bubble”. He emphasizes the distinction between high valuations—where caution is prudent—and markets exhibiting the irrational exuberance typical of bubbles. Asness points to the lack of speculative excesses in some areas of the market, noting that today’s elevated prices may result from prolonged low interest rates and a scarcity of high-quality investment opportunities. His view underscores that elevated prices do not always translate to an imminent collapse but warrant a vigilant and measured approach. ²

From a valuation perspective, it suggests that investors are accepting lower compensation for risk, a dynamic often seen in periods of heightened valuations. While this does not signal immediate danger, it highlights the importance of maintaining discipline.

Conversely, John Hussman, president of Hussman Investment Trust, offers a more doom and gloom perspective. In his most recent published commentary, he highlights that U.S. stock valuations have surpassed peaks seen in 1929, 2000, and 2022, warning that such extreme valuations often precede significant declines, with potential losses of 50-70% before stabilization. Similar to the Buffett Indicator, that I have referenced in previous letters, Hussman tweaks the Buffett Indicator by measuring the ratio of total market value to the size of the economy (MarketCap/GVA) to frame his concerns, noting that historically, such conditions have led to lower long-term returns. ³

One of the most striking indicators Hussman highlights is the Margin-Adjusted P/E ratio (MAPE), which adjusts for cyclical profit margins. The MAPE is now at its highest point in history, surpassing even the tech bubble of 2000. These metrics suggest that we are in an environment where the margin for error is exceptionally thin, and the potential for downside risk is substantial. ⁴

In a recent Financial Times article, Hussman highlighted the role of speculative narratives, particularly around artificial intelligence (AI), in driving valuations. The article notes that AI-related companies have seen extraordinary price appreciation, often detached from near-term earnings potential, creating a belief in a “new era”. This dynamic is reminiscent of past speculative frenzies, where the promise of transformative technologies fueled outsized gains before fundamentals could catch up. ⁵

While innovation in AI is undoubtedly significant, history cautions us to remain grounded in fundamentals. Elevated valuations driven by speculative themes can be vulnerable to sharp corrections. Hussman wisely notes that profit margins before interest and taxes have been roughly the same for the past 70 years. Hussman calculates that the drivers behind the recent rising profit margins, that markets have celebrated, have come from reductions in corporate tax and interest rates—not from the magic of a new era.

While these insights are sobering I try to approach them with humility and a recognition of the inherent uncertainty in markets. History often rhymes, but it does not repeat exactly. With this in mind, I remain focused on executing our strategy with care and discipline.

Our hedging strategy, while contributing negatively so far, remains a component of my risk management approach. Time will tell if I will be proven to have been overly cautious, but the strategy is designed to protect the portfolio during sustained market downturns and provides an important layer of defense against extreme outcomes—that may finally come to fruition.

While the future is always uncertain, my priority is to safeguard your investments and position the portfolio for long-term success.

As always, my own capital is heavily invested alongside yours, aligning my incentives with yours.

In Closing

I am grateful for your participation in Leaven Partners, and that you have entrusted me with managing your assets. I look forward to reporting to you at our next quarter-end.

In the meantime, if there is anything I can do for you, please do not hesitate to contact me.

Sincerely,

Brent Jackson, CFA

Click to enlarge

Click to enlarge

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.