CCM 2Q and YTD 2019 Performance and Investment Update

Dear partners, friends, and fellow investment professionals –

In the second quarter of 2019, Clarendon Capital Management (CCM) returned 3.6% after brokerage expenses and the stated management fee. YTD, the CCM Composite has appreciated 11.6%. The significant underperformance in Q1 of 5.9% relative to the IVV benchmark was significant and may not be recouped this year. If positive returns are achieved and CCM remains conservatively positioned, working within our circle of competence, and following the framework such as the corridors and weightings, we will continue to achieve great risk-adjusted long-term results, even if trailing a benchmark.

Summary Return Statistics for CCM Composite

The fourth quarter of 2018 shocked many, declining 13.5% after the strong up trending market we’ve seen for the last decade. In Q4 2018, CCM did well — losing less — but still down 11.7%. CCM went into 2019 with more conservatism, explaining the YTD underperformance. This continues to be a richly priced market with fewer extraordinary opportunities. Until valuations change or a higher number of extraordinary investments are identified, I do not expect CCM to keep pace in an upward trending and momentum-driven bull market.

YTD 2019 Performance Attribution

It is rare to not have any significant negative contributors. The return of the special situations investments was 19.1% and short-selling was 18.8% relative to the amount of capital allocated — clearly areas of the portfolio that are performing well and merit more effort.

Select Investment and Portfolio Commentary

The reduced short weighting is a result of the decline in existing short investments as well as profit-taking. Two short positions were closed and one new one opened. All three current short positions are tied to the automotive sector, notably Tesla and CarGurus.

I attended the annual meeting and spoke with the management of a Midwest community bank investment. It remains overcapitalized since it is struggling to grow deposits, like many other community banks. But the bank remains flexible, maintains solid underwriting practices, and is aggressively returning capital to shareholders. Once a normal tier 1 capital ratio is achieved, ROE and earnings can grow significantly and the current 15x PE could be closer to 11x.

One special situation investment, the arbitrage of IBM’s acquisition of Red Hat, was completed sooner than expected, just after Q2 closed on July 8th. The five-month holding resulted in a 5.1% unannualized return. This was less than imaginative and followed Berkshire Hathaway’s same trade and was a better alternative to cash for a low-risk investment. NCR was also rumored to be of interest to large private equity buyers, but after further due diligence, the Wall St. Journal reported that the firms walked away.

Multiple positions were reduced, particularly in the insurance sector. One micro-cap was exited prematurely after significant appreciation, but before its latest earnings release where the expected backlog and turn around progress announced was revealed to be coming to fruition.

For the covered calls and options positions, we favor names with low valuations but high volatility or an announcement of a pending action or activist interest.

One of the smallest holdings, Luby’s, has performed poorly. It is an interesting case and qualifies as a special situation given the turnaround nature, private investor/capital source, and recent activist campaign. Despite poor execution of its turnaround plan and a massive destruction in shareholder value, Luby’s fought off an activist campaign from Jeff Gramm and Bandera Partners. Bandera and all shareholders are right to be angry. Unfortunately, management and the board control too many shares for Bandera to prevail. Luby’s is unable to generate profits from its franchise and restaurant operations and has a high amount of debt. But its large real estate portfolio is worth far more than the market capitalization. The current price indicates a level of fatigue or expectation that Luby’s will be run into the ground with continual operating losses for the next decade.

Summary Statistics

Relative to the stated target percentages and corridors, CCM needs to increase short exposure and special situation investments. We will also be searching harder for investments outside of financials and technology to modify risk exposure and concentration.

Since December 2016 when the portfolio strategy shifted to include a greater emphasis on special situations, short selling, and covered calls/options — the number of holdings has gone from 20 to 33, but top ten concentration has always been high.

Over the first six months of the year, the portfolio dividend and net interest (+ interest on cash + securities lending — short and margin interest) is 2.0%, unannualized. IVV has paid 1.2% based on the January 1, 2019 price.

The IVV PE ratio sits at a frothy 21.1x. Approximately 12% of the long positions in CCM’s core value portfolio do not have meaningful PE ratios. The weighted average, of the measurable companies, PE ratio is approximately 15x. And with 9.4% cash and 4.4% short, the portfolio leans even more conservatively on this valuation metric.

After making some adjusted calculations for recent transactions and the July monthly options expiration, the current beta of the CCM portfolio is 0.73. This is higher than the 0.67 as of May 14, when we published the Risk Measurement Blog, but still well below the 1.0 beta of IVV. On an individual security level, beta does not matter. Volatility helps long-term equity value investors, but it is indicative at the portfolio level of the risk positioning overall. It also, of course, explains a meaningful amount of CCM’s underperformance relative to the S&P 500 benchmark.

Combining these factors of greater breadth in positions, higher yield, conservative valuation, lower risk and volatility, and greater flexibility to be opportunistic in strategies going forward, the strategy and CCM are in a great position moving forward.

Miscellaneous

The most important thing I have written about this year is how to measure CCM’s portfolio risk. If you have not read it, I encourage you to do so: https://www.medium.com/@ClarendonCapMgt/ccms-return-and-risk-measurement-16fe8421905b

When reflecting on periods of underperformance, I make sure that I am continually learning, am improving processes, and understanding mistakes to avoid repeating them. I think I have done that so far this year while adding breadth to my skills and knowledge. I also am approaching an optimal point in my career — I have now built up an amount of expertise and experience that is highly valuable and I still have stamina and freedom to give maximum effort and focus.

In addition to the core value strategy I wrote about in this letter, I also actively follow ETFs and manage more balanced and diversified ETF strategies. These portfolios incorporate a value bias and make allocations to capture undervalued segments or characteristics such as increased industry exposure or dividend payers.

Lastly, as market valuations have remained high and clearly exceptional opportunities have not been robust, I have been active with an advisory engagement for the acquisition or potential succession of a small business. The search, which I am also referring to as Clarendon Search Partners, has a defined mandate as described here: https://www.clarendoncapitalmanagement.com/successionsearch. If you know of a business and owner who would have an interest, I would appreciate an introduction. If you would like to learn more about search funds or are interested in participating with CCM/CSP, I would be happy to have a discussion.

Thank you for reading. Best wishes,

Carlos P. Sava, CPA, CFA

Founder and Portfolio Manager

www.Twitter.com/ClarendonCapMgt

www.Medium.com/@ClarendonCapMgt

Disclosures and Disclaimers:

This message is not a recommendation, solicitation, or offer of any security. Investments are inherently risky and appropriate caution and diligence should be taken. Please conduct appropriate due diligence and consult a financial professional, attorney, CPA, and/or similar professional before making any investment decisions. Investment decisions should be made after careful review of your financial situation, risk tolerance, investment objectives, and time horizon.

Past performance is no guarantee of future results. Individual account performance may differ. Investment advisory services are described and provided upon completion of an investment advisory contract. Please refer to Clarendon Capital Management’s Form ADV 2 for additional information.

Information contained herein is from sources believed to be reliable, but we cannot guarantee its accuracy. CCM return results are the time-weighted return for the applicable period. Performance is shown after management fees and expenses. CCM performance and return results contained herein are unaudited and may not conform to all GIPS standards.