Q1 Zorik Capital Letter: 2024

Partners,

We came into the fund’s fiscal Q1 with a positive feel on the economy and stock market. This hypothesis proved to be correct. Therefore, the fund has deployed large amounts of capital over the past quarter into opportunities we believe will perform strongly in the forthcoming environment.

While we still believe the market has baskets of overvalued and overbought stocks (ie. the ‘Magnificent Seven’ technology stocks), we believe that the broader market is attractive. All the noise around tech and AI has led to an undervaluation and underappreciation in the ‘other’ stocks; we are actively taking advantage of this.

Therefore, the fund was excited to start building positions into several new opportunities, primarily within the small cap space–this will be elaborated on later in the letter.

Our View On The Economy

Looking ahead into the next year and beyond, we see a healthy economy. Consumer spending remains strong, consumer balance sheets are holding up, and job numbers persist at low levels. 

While inflation has recently ticked slightly higher, we are not concerned. CPI has remained high due to residual and stubborn lag associated with housing. Specifically, the housing category is still reported at 6% in CPI. Additionally, auto-insurance rates have been rising fast as of late, which contributes to the transportation category in CPI. Nonetheless, the lagging inflation in housing prices should start to come down again and  are rising fast but that should cool too. 

Thus, we sit with a positive view on the potential for rate cuts throughout the rest of the year–this is inline with what the Fed has discussed.

There is currently $6 trillion of cash sitting on the sidelines  in money market funds. As rates come down over time, and money market yields become less attractive, we believe that these funds will slowly shift back into the market, thus providing another reason for positivity.

We continue to be excited about smaller cap stocks which continue to trade at historically inexpensive valuation multiples.

Our View On The Market

At first glance, the S&P 500 sits at a fairly expensive value of 21 times 2024 EPS. However, once subtracting out the ‘Magnificent Seven,’ the index moves down to a fairer looking 16 times 2024 EPS; this value fits towards the lower end of the index’s average PE ratio value over the past 20 years. Thus, given we believe the economy is strong and that the market as a whole is cheap, we are positive on the markets and are looking to cut our current cash holdings.

Our Specific Focus:

The Russell 2000 Index–the key measure of small cap stocks–has remained low; the index currently sits close to 20% below its all time highs in 2021, while the S&P 500 has expanded a couple percent within the same timeframe. Thus, it should come as no surprise that market valuations (measured by PE ratio) sits at the largest small to large discrepancy since 2001. While the average small to large cap PE ratio is 1, the ratio currently sits at 0.7. This puts small cap stocks at a historic discount to large cap stocks. This information is portrayed in the graph below.

A key explanation for the current discrepancy in valuation for small versus large cap stocks is the current environment of higher interest rates. As a whole, small compared to large cap valuations tend to move inversely to interest rates. This is because small cap companies are more affected by a higher interest rate environment. 

Given we believe that interest rates in this current hiking cycle have peaked, we are excited to purchase long term investments in small cap businesses at historically low valuation multiples. Over the years, as interest rates normalize, we believe that the discrepancy in small versus large cap valuation multiples should close back to near average values. This should then lead to small caps outperforming the broader market.

Illustrating this point further, the graph below depicts that small cap stocks perform an average of 1100 basis points higher than large cap stocks throughout the first 12 months after the Fed’s first rate cut.

Given the Russell 2000’s bounce off of its 2023 lows has lagged the size of Russell 1000’s bounce by a factor of around 1000 basis points, there is still ample room for small caps to catch up in performance. Thus, while bullish on the broader market as a whole, we are specifically bullish on the opportunity to purchase small cap stocks that we believe will outperform the broader market over the next several years.

A Small Cap We Like: Mama’s

Consistent with our excitement of buying smaller cap stocks, we have recently been interested in Mama’s Creations (MAMA). Though I would not expect many to know of this quasi-monopoly with a sub $200m market capitalization, I would expect many investors to have tried one of their products.

Mama's is one of the few providers of fresh deli products to grocery stores nationwide. No other competitor has anywhere near the level of reach and economies of scale that Mama’s benefits from. Mama’s is present in all 50 states, being sold in 8000 stores nationwide. This includes every BJ’s and Sam’s Club in America as well as half of the Costco regions and several of the Whole Foods regions. Therefore, if you have tried products such as the store branded meatballs at Whole Foods,–that  93% of consumers would recommend–you have tried a Mama’s product.

According to Mama’s, stores earn a 1000 basis points greater net income margin through selling fresh deli food versus center aisle products. Thus, 75% of retailers polled say they are adding more shelf space to the prepared foods aisle next year and 64% of grocery executives said that the fresh department is the most important focus in the grocery store over next 12-36 months. As a result, the deli prepared foods industry is projected to grow at an annual rate of 4.5% over the next five years. As the largest provider of fresh deli food to grocery stores, Mama’s is primed to take advantage of this trend.

In addition to industry tailwinds, the company has numerous other opportunities to expand revenue. Upon arriving at the new job last year, the company’s new CEO, experienced Mondelez executive Adam Michaels, grew the selling and marketing team from one to eight members. We believe that the company should be able to expand its 20% penetration in deli-style stores (within the US) and the company’s average items carried per store of seven. 

Further, the company has an opportunity to develop a presence within convenience stores. While the company currently has zero presence within the sector, Mama’s has recently hired a selling and marketing representative focused on convenience stores as well as devoting resources to develop products with longer shelf lives. Though a small part of the thesis, any penetration into the thousands of convenience stores around the US growth here could lead to an area of upside revenue growth.

In addition to top line growth opportunities, the company holds an intriguing margin expansion story. Throughout Mama’s history, the company has been run as a family business rather than a profit focused one. As a result, when new CEO Adam Michaels arrived last year, he was able to bring the gross margin from 11.9% to 32%, within just a year, by cutting out on unnecessary expenses and inefficient logistics. We believe there is still work to be done on margins and think that the net income margin can rise from 7.5% to 10% over the next couple years; this is inline with company projections.

All in all, we feel very positive about the new management team and their ability to transform the family business into a larger, more profitable entity, whilst maintaining focus on quality of food. Afterall, the management team has money on the line with 20% ownership in the stock. 

Currently trading at close to 20 times 2024 EPS earnings, we believe that the company should be able to grow earnings at 12.5% annually over the next five years and expand net income (NI) margins from 7.5% to 10%. We then believe the PE multiple should normalize at 18 times earnings, a figure that reflects the premium quality of the company's quasi-monopolistic status and its high ROIC of 32%. This leads us to a 18% five-year internal rate of return, excluding any dividends or buybacks.

Risks to Our Positive Feel on the Markets:

While we are excited heading into the year, we remain cautiously excited.

We are watchful of the Houthi blockade of the Bab el-Mandeb strait (ships going through the Suez Canal must pass through the strait) and the potential for the situation to continue to cause Western ships to take the 10-14 day diversion around South Africa. While we do not usually attempt to predict the geopolitics and motives of terrorist organizations, we do recognize that a prolonged Houthi blockade of the Red Sea will likely lead to inflation. 

Given the market is factoring in several rate cuts this year, any event causing greater than forecasted inflation, which may cause the Fed to keep rates higher than expected, may shock markets. Thus we remain cognizant of the situation in the Middle East and look out for other potential events that could lead to higher inflation. 

Conclusion

Overall, we are excited about what the year holds for us. Our positive outlook on the upcoming economy and rate cuts signals a better environment for many of our more cyclical stocks which have struggled in the recessionary environment which we believe has passed.

We are excited to continue deploying capital over the next quarter and look forward to amazing returns ahead!

Thank you for your support!

Thanks,

Blake Zilberman