Investor Letter 2022

‍July 12, 2023

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Dear Investors,  

2022 was a historic year for Thai Capital. We faced the largest drawdown in the history of the fund, a staggering -77%. Fortunately, it was a temporary market overaction. The companies we hold in our portfolio are durable businesses that generate more cashflow than necessary to maintain and expand core operations. They continue to deliver products and services that their customers want and need.  

The negative performance and its root cause is not new to us. We had a similar experience in 2018 and will likely experience a similar short-term event again in the future to varying degrees. However, such high volatility is the nature of a long and concentrated portfolio. High performance is earned through pragmatic patience, discipline, and perseverance, rather than relying on Nobel winning financial theories.

What happened last year has not caused us to change our approach to investing. If anything, it reinforced my belief that we do indeed have a superior strategy. What we have done and are willing to continue doing is uncomfortable for many market operators. And this is precisely why challenging times like these provide the opportunities to forge a long-lasting outperformance.

Here are some numbers to highlight the magnitude of our portfolio movement over the past 12 or so months. In the final 9 months of 2022, our net asset value dropped by -77%, or more than 3 quarters of the portfolio. The 6 months following the trough, we’ve recovered 84% of that loss. Another way of putting it: we went from -77% to -12% drawdown, which means we went from needing 347% return to “only” needing 14% to fully recover. We’ve “returned” a net 293% increase in 6 months as compared to the bottom.

Naturally, substitution of the word “returned” above with the word “recovered” is appropriately true. And it’s very likely that many of you reading this letter will prefer to use “recovered” because suffering the heavy setback we faced would be considered by most as unacceptable. I think it is understandable for investors to shiver at the idea of such a massive drawdown. That said, I am also confident that there are some investors who will see January 2023 as a rare opportunity to invest.  

Thank you for investing alongside me and mine. Thank you also for not calling me even once during the year to ask about the market, only about the tragedies my family faced. Your support and trust over the last 7 years has made my job so much more enjoyable, even during the toughest times.  

Sincerely yours,  

Danny Thai

What Happened?

The rapid surge in inflation was the source of fear that gripped the market and economy in 2022. This triggered one of the most aggressive rate hikes in recent history. Before discussing the problems of 2022, it is beneficial to first lay the foundation through historical context. The potential for rising inflation was not unforeseen. Many economists had contemplated this possibility since the central bank intervened during the Great Recession. They were convinced that the massive expansion of the central bank's balance sheet, coupled with other relaxed monetary policies such as low interest rates, would eventually lead to a significant spike in inflation once the economy recovered. They believed that injecting substantial liquidity into the financial system would ultimately increase demand for goods and services, pushing prices higher. Nonetheless, consumer price index (CPI), a Fed's favorite inflation measure, remained below the target rate of 2% for the majority of the decade.

Economic predictions are often ambiguous. For example, what exactly constitutes an "economic recovery"? Suppose we use GDP growth as the benchmark. If GDP was growing faster than expected while inflation remains tepid, we will likely receive new lessons as to why some other parts of the economy are accountable for the lack of recovery. The goalposts in economic prediction are constantly moving, a convenience for the forecasters of course. Furthermore, there is always a counterargument. Those who defended the Fed's policies during the 2010s were generally unconcerned about inflation. They cited factors such as the severity of the 2008 recession and the weakness in the labor market. They argued that the primary objective of quantitative easing - a monetary policy that increases money supply and liquidity - is not designed to create inflation, but to stabilize the financial system, lower long-term interest rates, and promote economic growth. They also emphasized that the relationship between money creation and inflation was not as direct as some people assumed, particularly in the wake of a severe financial crisis.  

In retrospect, the anticipated inflation spike did not materialize in the years following the implementation of quantitative easing (QE). Experts, per usual, have since proposed various explanations, including excess capacity in the economy, slow wage growth despite low unemployment, and mediocre global economic growth. However, the factors that suppressed inflation during the QE periods after 2008 were no match for the subsequent developments: an even larger QE with a zero-rate policy, combined with pandemic-induced shutdowns and reopenings that strained supply chains and unleashed pent-up demand. The COVID-19 response in early 2020 laid the groundwork for several significant causes for concern. Even without the advantage of hindsight, everyone, including yours truly, had concerns about the economy as stimulus checks were distributed, interest rates reached zero, massive liquidity entered the market, the Fed's balance sheet expanded by 75%, and unemployment rates soared. These factors, culminating over a two-year period, formed the perfect inflationary storm. This storm arrived in 2022, coinciding with Russia's aggression against Ukraine.

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I am not opposed to hedging when we have a compelling reason to believe a significant economic shock is coming. Our result in Q1 2020 supports this assertion. Predicting the COVID-19 crash was relatively straightforward given the information regarding the virus's high lethality, airborne transmission, and high degree of contagion. It was logical to deduce that, due to globalization, there was almost no chance of the virus being contained within China's borders. Ingenuity was not required to infer the severity of the virus based on the Chinese government's reaction - locking down 30m people in Wuhan. Furthermore, it didn't take an economic expert to predict that the virus would have a materially adverse impact on most of the economy.  

Under this premise, the "hedges" aren't necessarily just for hedging, but are more or less an "opportunistic" or "event driven" bet. However, I wouldn’t classify this as a strategy-drift, as we neither sold shares in any of our holdings due to the pandemic nor added companies thought to benefit from pandemic-induced trends (e.g., Zoom). Deciding to hedge before the pandemic wasn't the challenge; the real difficulty involved determining when to withdraw the hedge, which required assessing the crisis's extent and repercussions.

Even as the economy reopened towards mid-2020 and vaccines more widely distributed, my concerns surrounding COVID-related issues persisted. It never escaped me that rates were trending in the negative territory. I fully recognized the indication from the inverse yield curve, where long term bonds yield lower than short term bonds, famed for its recession prediction power. I was also uncomfortable with the potential inflationary pressure from the global lock down, the stimulus program, the massive QE, and the continuation of decade-long loose monetary policies.

Adding to the frenzy, a wave of speculative mania stemming from main street flooded the market at the end of 2020. Fueled by stimulus checks, lockdown boredom, work from home, social media, and easy-to-use trading platforms advertising "zero commissions", millions of new investors entered the market with ill-informed and short-term focused "investment strategies" (YOLO).  With this development in mind, we held our hedge positions for the rest of 2020 and into the first quarter of 2021.  

As time passed, though, none of our bearish sentiment materialized. The economy continued to hum along. Sure, pockets of the economy had inventory and supply side problems, but nothing unexpected. For a while, inflation appeared under control (the Fed insisted inflation was "transitory"), and stocks continued to rally to new heights (although many people expressed skepticism about the Fed’s view). By around mid-2021, we allowed our hedged position to expire. And just to be clear, market and economic related matters were not the deciding factors as to why I chose to let our hedges run off. Like many others, I was skeptical of the market rallies and equally confused by the lack of fear given the economic disruptions. The decision to unhedge primarily stemmed from our investment philosophies.

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A fellow investment manager once said, "one hedges when one is unsure". While I am unsure on future economic direction, I am absolutely certain about the quality of the businesses in our portfolio. So instead of relying on an unreliable activity - predicting the economy - I rely on this tenet of my investment philosophies: highest quality companies will survive the worse economic conditions while their weaker peers will struggle and perish.  

Economic problems are not idiosyncratic, they will affect everything under their purview. Everyone will contract, some more than others, and at the end of the crisis, the well managed companies emerge and are able to capitalize on any voids left by failed competitors. That is the way of the free market. And without easy money to finance, uncompetitive companies will not be able to sustain their existence. Let me be clear that I am not insensitive to the fact that there are unprofitable enterprises that may be meaningful in other ways outside of providing a profit, and they should be subsidized accordingly, but that's a topic for another conversation.  

So, with that assessment and self-reflection, I decided against maintaining our hedges. Despite the various unnerving events, there were no obvious or compelling catalyst that would increase my ability to accurately time a correction. After all, we had been anticipating a market correction for 2 years after the Covid crash and its subsequent (unprecedentedly speedy) recovery, and it never came despite tons of reasons why the market shouldn't do so well.  

Another conclusion drawn from my self-reflection relates to capital preservation. Preserving capital is not only achieved by hedging. It can also be achieved by not realizing unrealized losses. Obviously, the latter can be just as tricky as the former. Consider the banking crises in early 2023 - if depositors had not panicked and sparked bank runs on the vulnerable banks, would they have collapsed? Probably not. So clearly, it's not always a possible option to continue holding on to losing positions. Nonetheless, we must prevent our emotions from taking over the steering wheel, and we must do the best we can to preserve capital. If we missed the first line of defense (hedging), we will do everything in our power to prevent faltering on the second (conviction).  

Naturally, the correction materializes shortly after our hedges expired…

As the market continued to sell off, again I followed another one of our investment disciplines: hold ground, and at certain drawdown intervals increase our exposures. On the topic of selloffs, there's a certain indiscriminate characteristic of a selloff that defies logic and it’s during these illogical situations where I believe we’ve gained most of our returns in the past.  

Outlook

2020 and 2021 were years of mass euphoric speculation; 2022 was the year of reckoning.

The US institutions managing the economic system are robust. The regulating bodies overseeing the financial markets are strong. As a country, we have been through multiple economic and financial crises, sometimes massive enough to bring us to the brink of collapse. The 20th century saw two devastating World Wars that rearranged the world order, a Great Depression, hyperinflation, and multiple speculative bubbles sponsored by new and complex financial engineered products that enabled excessive leveraging. The start of the 21st century started with the popping of the tech bubble of 2000, and more wars. The Great Recession was caused by yet another speculative bubble that reached every corner of the economic system, and an airborne pandemic that claimed millions of lives and temporarily ground to a halt the entire global economy.  

Yet, we're still here. Moreover, each and every time we've exited a crisis, an improvement to the system is made. The pace and duration at which our economy can expand are longer, and the pause between economic crises seems to have lengthened. I do not think that the sustained economic expansion and the bull market from 2008 to 2021 is by any means a simple accident. Likewise, I do not think that the pace at which we could move past the dramatic events spurred by the pandemic was a stroke of luck. Sure, we can point to the potential repercussions, and I'm sure there are negative consequences, but I'm also confident we'll figure out a way to solve those challenges when the time calls for it. After all, economic problems are similar to social problems in that a solution to one problem will likely father another.

Do these institutions from time to time fail miserably at their job? Absolutely. There are times where they present opaque communications, and sometimes they outright lie to the public in an attempt to maintain confidence. They have also from time to time been slow to intervene or do not intervene strongly enough to prevent lasting damage. The Federal Reserve and other regulating institutions cannot predict the direction of the economy. For all the criticism they’ve received for not knowing what they're doing, they seem to have a pretty decent track record. Our economy has not derailed, our financial market has not collapsed, and the greenback still carries significant weight around the world despite calls for its replacement by digital options.  

Fear of the myriad of problems our economy is facing today is normal – high inflation, geopolitical tension, and enormous national debt to name a few. Considering all of this on the table, it’s even more challenging to see all these uncertainties and maintain a disciplined posture in our investment convictions. Here are some observations I hope can alleviate some of these concerns. We do not invest in tech companies, internet companies, chip companies, advertising companies, financial companies, or any other specific category companies. We concentrate capital in high-quality companies with remarkable economic moats established over years/decades of either exceptional leadership and/or irreplaceable products/services (value). Our companies operate in a wide range of industries (diversification). We believe we have acquired these companies at a fair or better price (margin of safety). We also recognize that from time to time the market will collectively decide that, despite facing and overcoming multiple economic cycles and disruptions (misunderstood/contrarian), these wonderful businesses were going to suddenly cease to be competitive overnight. Our portfolio today is stronger than it was 7 years ago when I launched the Fund. And the rigor of our underwriting process will ensure that our portfolio continues to exhibit this strength for the foreseeable future. As for my overall economic outlook - rates, inflation, economic activities - these are all naturally fluctuating factors that create the inevitable ebbs and flows inherent in the economy. Therefore, I still believe the safest investment option, relative to the rest of the world, is in American enterprises.

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Disclaimer

This disclaimer applies to the performance results and other data provided by Thai Capital Management, LLC (the “Company” or the “Fund” or “Thai Capital”) in this letter. By reading this letter, you acknowledge and agree to the following terms and conditions. If you do not agree with these terms and conditions, you should not use the information provided in this letter.

1. performance results of Thai Capital are presented on a gross and net-of-fees basis. Gross and net performance includes the reinvestment of all dividends, interest, and capital gains, and reflects the deduction of, among other things, brokerage commissions and administrative expenses. Net performance reflects the deduction of accrued performance fee, if any. All performance provided herein assumes an investor has been in Thai Capital since its inception date. Depending on the timing of a specific investment and participation in “new issues”, net performance for an individual investor may vary from the net performance stated herein. Performance data for the period described in this document is estimated and unaudited and provided by Interactive Broker account report.

2. The inception date for the Fund is January 1, 2017. The performance data presented in this document for the market indices is calculated from January 12, 2017. The market indices shown have been selected for purposes of comparing the performance of an investment in Thai Capital with certain well-known, broad-based equity benchmarks. The statistical data regarding return on invested capital and the indices has been obtained directly from Interactive Brokers reports, and the net returns are calculated and provided by the Fund’s independent administrator. The indices are not subject to any of the fees or expenses to which the funds are subject. Thai Capital is not restricted to investing in those securities which comprise any of these indices, its performance may or may not correlate to any of these indices and it should not be considered a proxy for any of these indices. The volatility of an index may materially differ from the volatility of the Fund. Past performance is not an indication of future performance. All investments involve risk including the loss of some or all principals. It should not be assumed that investments made in the future will be profitable.

3. This letter, which is being provided on a confidential basis, shall not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product which may only be made at the time a qualified offeree receives a confidential private placement memorandum (“PPM”) which contains important information (including investment objective, policies, risk factors, fees, tax implications, and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this letter and the PPM, the PPM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This letter is not intended for public use or distribution.

4. Thai Capital may currently or in the future buy, sell, cover, or otherwise change the form of its investment in the companies discussed in this letter for any reason. While all information prepared in this letter is believed to be accurate, Thai Capital makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors, appearing in the letter. Thai Capital hereby disclaims any duty to provide any updates or changes to the information contained here, including, without limitation, the manner or type of any Thai Capital investment.

5. This letter also contains forward-looking statements, which reflect Thai Capital’s views. These forward-looking statements can be identified by reference to words such as “believe”, “expect”, “potential”, “continue”, “may”, “will”, “should”, “seek”, “approximately”, “predict”, “intend”, “plan”, “estimate”, “anticipate” or other comparable words. These forward-looking statements are subject to various risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements.

6. Investing in the Fund involves significant risks, including the possibility of loss of the entire investment. The following are some of the risks investors should consider before investing in the Fund:

1. Concentration of Investments: The Fund is exposed to a concentration of investments, which could exacerbate volatility and investment risk.

2. Investment Opportunities: Thai Capital may fail to identify suitable investment opportunities. In addition, the due diligence performed by Thai Capital before investing may not reveal all relevant facts in connection with an investment.

3. Derivative Instruments: The Fund may invest in derivative instruments or maintain positions that carry particular risks. Short selling exposes the Fund to the risk of theoretically unlimited losses.

4. Capital Redemption and Transferability: Opportunities for capital redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interest, and none is expected in the future.

5. Leverage: Leverage may be employed, which can make investment performance volatile.

6. Investment Objective: There is no guarantee that the investment objective will be achieved.

7. Global Financial Markets and Economy: Adverse changes affecting the global financial markets and economy may have a material negative impact on the performance of the Fund’s investments.

8. Changes in Laws or Regulations: Changes in laws or regulations, or a failure to comply with any laws and regulations, may adversely affect Thai Capital's business, investments, and results of operations.

9. Dependence on Danny K. Thai: Thai Capital is dependent on Danny K. Thai, and the loss of his services could have an adverse effect on the Fund's business.

10. Transferability of Shares: Ability of potential investors to transfer their Fund’s shares may be limited by the impact on the liquidity of the Fund’s shares resulting from restrictions imposed by ERISA and similar regulations.

11. Laws or Regulations: Thai Capital is exposed to changes in laws or regulations.

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