The Palos-Mitchell Alpha Fund 2023 Year End Report

Performance Sheet :?PAL300 Performance (as of December 31, 2023)

For the fourth quarter of 2023 (Q4) The Palos-Mitchell Alpha Fund returned +2.3% net of fees. For the full year 2023 the fund returned 30.3% net of fees. Full year returns for the fund topped both indices that are included in the fund’s benchmark, namely the S&P/TSX Composite Index (+8.1% for 2023) and the CAD adjusted S&P500 Index (+21.3% for 2023). The benchmark, which is used for comparative purposes, is comprised of a 50% weighting in the Canada-based S&P/TSX Composite Index and a 50% weighting in the U.S.-based S&P500 Index, adjusted to Canadian dollars.

Although the fund underperformed its benchmark in Q4, the objective over the final three months, as noted in our Q3 report, was to preserve gains made in the first nine months. We implemented a defensive hedging strategy using put options on the NASDAQ index as well as selling call options on several holdings in the fund; the latter generates cash which inherently reduces risk. On the flip side, returns were enhanced by several short-term tactical trades that were event driven and are intended to capitalize on new information. Typically, an event driven opportunity occurs when an earnings report falls below the collective expectations of analysts. Impatient traders will often sell on what they interpret as bad news, which can create an opportunity to invest in a good company at a discounted price.

The energy sector was challenged by falling crude oil and natural gas prices in Q4. West Texas Intermediate (WTI), which is the benchmark for U.S. crude oil, closed the year slightly below US$72/barrel; a significant decline from the Q3 closing price just above US$85/barrel. We saw similar price action in natural gas markets where prices fell from around US$3.50/MMBtu to US$2.51/MMBtu. We crystallized some gains and reduced exposure in the energy sector in Q4. However, we maintain our view that the Canadian oil patch is in its best shape in decades. We speak with management teams on a regular basis and the messaging we receive is consistent; returning capital to shareholders is a priority. Returning capital is facilitated through a mix of increasing dividends, paying off debt and buying back shares in public markets. Buying back shares reduces the share float which benefits all shareholders.

After peaking in February of 2022, the Canadian Bank stocks turned bearish. Using the BMO Equal Weight Banks ETF (ZEB) as a proxy, Canada’s “Big Six” saw a 30% correction over the 20-month period between February 2022 and October 2023. Over the final nine weeks of 2023, the ZEB rallied by a whopping 19.2%. The fund was able to capitalize on the move using bullish call options on Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Royal Bank (RY) and TD Bank (TD). The options markets in Canadian banks are highly liquid which enables us to implement a low-cost strategy for investing in banks while also limiting capital at risk. The fund crystallized gains in BMO and RY while we continue to hold March and June call options on TD and March calls on BNS.

With interest rates moderating in Q4, we increased exposure into the communications sector. Canada’s Telcos are characterized as reliable dividend payers and we currently hold BCE Inc. and TELUS Corp. BCE’s dividend yield was around 7% at year-end while TELUS hovered around 6%.

The communications sector is interest rate sensitive and as a result, these companies generally perform better in a falling interest rate environment (which we are currently in). Alphabet Inc., formerly known as “Google”, is also classified as a communications company. Alphabet shares rose 59% in 2023 and we sold the position earlier in the year to lock in gains and de-risk the portfolio. We reinitiated a position in GOOG in early December at what we felt was an attractive point to reinvest. We also view GOOG as an excellent way to gain exposure in the burgeoning artificial intelligence (AI) industry.

In 2023, we witnessed incredible outperformance from the “Magnificent Seven” group of stocks. This group includes renowned companies like Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla. Collectively, the “Mag Seven” accounted for roughly 76% of 2023 gains made in the S&P 500. Enthusiasm for AI had many companies in the industry ripping higher throughout most of the year. Breathtaking gains in leading AI chip makers NVIDIA (+239%) and Advanced Micro Devices (+128%) led the way. Other companies at the heart of AI enthusiasm include Alphabet (+59%), Amazon (+91%), META Platforms (+194%), and Microsoft (+57%). The fund sold its holdings in META and Microsoft to lock in gains and reduce exposure but continues to hold shares in NVIDIA, Advanced Micro Devices, Amazon and Alphabet. Remarkably, the market capitalization of the Mag Seven is comparable to the total valuations of the entire stock market capitalization of Canada, Japan and the UK combined! ?????

As an asset class, commodities (energy, metals, agriculture) were the best performing class in 2022, along with U.S. treasuries. In 2023, the tables turned as commodities went from best to worst. Falling commodity prices are certainly good news in the battle to reduce inflation but, ironically, lower prices is not necessarily bad news for commodities producers. Rising prices tend to weaken demand so there’s a sweet spot where demand and supply are balanced. If the world economy avoids a steep recession, we can anticipate a reversion to the mean in commodities prices. Copper, iron ore and lumber could excel if an economic recovery ensues (especially in China). Precious metals (gold) outperformed in 2023. As the year ended, gold was challenging what chartists call a quadruple top around the US$2,100/ounce level. A breakout above this level would be good news for gold mining companies, which have yet to catch up to the move up in bullion. ?

In 2023, the dominance of the Mag Seven stocks was widely recognized as the driving force behind a good year for returns. But this left the “other 493” companies in the S&P 500 out in the cold. The fact that a select few companies carried the performance football throughout 2023 left many market observers believing the rally is not sustainable. Market breadth, which measures the number of stocks advancing in an index versus the number of stocks declining, is a closely followed measure of overall market strength. Poor market breadth in most of 2023 created bullish skepticism. However, as the year ended market breadth continued to improve, an encouraging sign for bulls.

With a new year upon us prognosticators and Wall Street strategists are clamoring to publish their price targets for the upcoming year. This is an annual ritual amongst the “experts” and as usual such predictions must be taken with a grain of salt. We’ve been around long enough to know that nobody has a crystal ball and that trying to predict the future is a fool’s errand. We believe the best ways to protect and grow the value of any portfolio are to prioritize the protection of capital, focus on profitable companies that have a competitive advantage, distribute risk factors (i.e., optimize security and sector diversification), and follow an active style designed to quickly capitalize on new investment opportunities as they arise.

It seems that market participants have become overly focused on the projected pace of expected interest rates cuts. While falling interest rates act as a bullish catalyst for stocks, there’s much more to the story. The interest rate conundrum is, should the Fed begin to cut rates aggressively, some will perceive the decision to be related to signals of a weakening economy (i.e., possible recession?). Conversely, if the Fed was to hike rates further, some will interpret this as the battle against rising inflation being far from won. We believe the larger questions are whether companies can grow earnings in the current rate environment and secondly, is the Fed likely to succeed in creating a “Goldilocks” economy; not too hot and not too cold. In fact, interest rates have normalized (mean revision) and this gives the Fed the capacity to stimulate a weakening?economy with rate cuts, if deemed necessary.

In the year ahead we have a Presidential election in November, ongoing geopolitical risks (Ukraine and the Middle East), and persistent concerns over interest rates and inflation. This presents the potential for periods of heightened volatility. Volatility, while sometimes unnerving, also offers opportunities to invest at attractive prices (i.e., when stocks go “on sale”). We know that markets don’t march higher in a straight line and savvy investors understand this. To be successful, investing requires patience, discipline, and having a long-term perspective. Diversification is equally important.

The Palos-Mitchell Alpha Fund will mark its five-year anniversary on January 29, 2024. The fund had its best calendar year performance in 2023 with a 1-year return of 30.3%, after fund fees. By comparison, the fund’s benchmark, which is comprised of an equal weighting in the S&P/TSX Composite Index (Canada) and the S&P 500 Index (U.S.), returned 14.6%. The fund’s returns were essentially double the benchmarks. Since the fund’s inception (January 29, 2019), the fund has generated annualized returns of 11.2%, after fund fees. We firmly stand behind our conviction that active management is the best strategy for protecting capital and achieving superior long-term returns.

William Mitchell CIM?

Portfolio Manager, The Palos-Mitchell Alpha Fund

DISCLOSURE: Comments on specific securities held in the fund should not be interpreted as investment advice. The Palos-Mitchell Alpha Fund is an actively managed fund that may change strategies and holdings frequently and without notice. The fund’s primary focus is on North American, large capitalization companies. The managers use risk mitigating strategies and opportunistic rebalancing to optimize performance.