December 2023 Investor Letter

Fundamental Value finished the year up 21.3% net of fees, underperforming the S&P 500’s 26.2% performance. FV is now up 448% net since inception in 2016 vs the S&P at 161%, an annual outperformance of 11.7%.1 For monthly performance see our tearsheet.

Market commentary   Last year was only the second calendar year we’ve underperformed the S&P, and the first since 2019. Nevertheless, we are particularly proud of last year’s returns, as 2023 was an exceptionally difficult year for the relative performance of active value managers. More than half of the gains of the S&P came from just seven stocks – the so-called “Magnificent 7.” These mega-cap tech stocks climbed an astounding 75.8% during 2023, while the remaining 493 stocks in the S&P were up a much more pedestrian 12.3%.2   We were unsurprised by the strength of mega-cap tech. Though we have been very bearish the market as a whole and the tech sector in particular, we have been consistently pointing out the business strength and relatively reasonable valuations of mega-cap tech for the past three years. In our 4Q20 letter, Part II: Anatomy of a Bubble, years before “Magnificent 7” was coined, we called Apple, Amazon, Microsoft, Facebook and Alphabet “the transcenders” (we’ll stop trying to make that a thing):    The five mega-cap tech companies are truly transcendent businesses. They dominate huge markets and earn enormous – and growing – profits… Four of the five trade at lower earnings multiples than the Nasdaq 100… At times, some have traded at even lower valuations, valuations more appropriate for troubled companies than transcendent ones. When they did, we were thrilled to have big positions in them (see our Apple thesis from 2017 and our Facebook thesis from 2019)... These companies seem neither especially cheap nor outrageously expensive to us today. Instead, their size, quality, and relatively reasonable valuations have obfuscated the true extent of the bubble in more speculative securities.   Fast forward to the beginning of 2023, and many of those more speculative securities – “contenders,” “pretenders,” and “pump-and-dumpers” – had been decimated. Yet so had several of these transcendent businesses. We jumped on this unique opportunity; two of our largest positions throughout 2023 were Meta Platforms (née Facebook) and Netflix.3 When META traded around $110 a share, we said it was “one of the best investment opportunities we have seen in our careers… We can scarcely believe that the market has afforded us the opportunity to buy a transcendent business at such a wonderful price.”   Yet within just a few short quarters, we find that the massive gap between intrinsic value and market price has been mostly realized. We have sold our Netflix position, and significantly pared our Meta position. We remain short Tesla – a car company with car company margins, having an increasingly difficult time masquerading as a tech company with tech company margins – and have added a short position in Apple – a low-growth company trading at a high-growth valuation.   The Magnificent 7 and their ilk still have transcendent businesses. However, they no longer have very reasonable valuations. Given today’s unprecedented concentration (the top 8 companies make up more than 30% of the S&P 500), the fortunes of the major equity indices – and the fortunes of hundreds millions of Americans via their retirement savings and pensions – are increasingly tied to the performance of a few increasingly overextended stocks.   Revisiting old predictions   We published Part III: Apex of a Bubble in September 2021, over two years ago. We predicted severe declines for the most speculative growth names, strong relative performance for value stocks, and the rise of interest rates due to the return of inflation after decades of dormancy. We wrote: "Extreme valuations presage real returns that investors will find severely disappointing – and likely negative – for many asset classes over years to come."    It's become something of a tradition in our letters to talk about the events since “Apex of a Bubble” and contrast those events with the eerily resilient performance of the S&P. We’ve seen the largest reduction in fiscal stimulus on record, the fastest spike in real yields, the worst annual performance for Treasuries, the fastest pace of monetary tightening in generations, and the reversal of a decade of quantitative easing and zero interest rates. Despite the S&P's bubble-like valuations in 2021 and the subsequent upheaval in many corners of the financial markets, the S&P is up 16.5% since Apex of a Bubble.    At time of writing, the S&P trades at 24.5 times trailing earnings, for an earnings yield of 4.1% – just below the 4.2% yield on a risk-free ten-year Treasury bond. Thus, the equity risk premium, however you’d like to calculate it, is perilously thin. Since September 2021, long-term rates are up nearly 3%. We are surprised, and alarmed, that higher interest rates have not resulted in a higher discount rate applied to the market.   What explains the market’s resilience?   It isn’t trailing earnings growth. Earnings for 2023 for the S&P 500 Index are estimated to be 220.4, up from 199.2 in 2021.4 That 5.2% annual growth seems respectable if not outstanding… except that it’s actually less than 1% total real earnings growth over two years given the 10% inflation in consumer prices since 2021.   It might be optimistic earnings estimates. After two years of stagnant real growth, estimates are for S&P earnings to increase by almost 10% next year. While 10% growth is certainly possible, we find this estimate to be totally incongruent with market expectations for rate cuts in 2024.   Soft landing?   We wrote in our last letter:   Equities are priced for a Goldilocks economic scenario: not too hot, not too cold. A hot economy with stubbornly elevated inflation is a problem for valuations. A cold economy with recession is a problem for earnings. Our personal view is that the too-hot scenario is the most likely – the labor market and hence the consumer remains extremely strong – but either outcome seems possible.    The Goldilocks "just right" economy – where inflation falls rapidly back to the Fed's 2% target without significant pain for corporations, consumers or credit – is possible as well. However, this feels like wishful thinking.    Taking the data at face value, these Goldilocks soft-landing wishes seem to have come true. GDP growth has been shockingly strong. Unemployment remains near all-time lows. The Fed has signaled a pivot to rate cuts in the near future, implying they expect inflation is nearly vanquished. The market expects nearly six cuts to the federal funds rate in 2024.   Last May, this Goldilocks scenario was an upside risk. But now an immaculate landing is fully priced in, and only downside risks remain.   Furthermore, we must once again play the pessimist and insist that this Panglossian view still strikes us as unlikely. Six cuts in a year is possible. However, six cuts in a year is typically associated with a sharp recession – hardly an environment where we can expect earnings to accelerate from negligible growth to double digit growth. Monetary policy works with a long and variable lag; we may yet see more economic fallout as the Fed’s frantic hikes work their way through the system. Today’s higher rates have had limited effect for many consumers and corporations. Many corporations have only had to refinance a small portion of their outstanding debt; many consumers are flush with pandemic savings, and roughly 60% have mortgage rates under 4%.   Conversely, the market may be underestimating the stickiness of inflation. We view this as the most likely scenario.    The data itself still leaves plenty to be concerned about. For example, arguably the inflation data series we should be most closely following today is Services Less Rent of Shelter. (We should ignore goods prices for now because Americans are coming off a multi-year lockdown-induced goods buying binge; we should exclude shelter because shelter is a lagging indicator, as we've discussed at length.) This series printed 6.8% annualized in December – not an outlier, as it has averaged 5.5% over the past six months. This is consistent with growth in wages, which has been hovering just above 5%.    Additionally, first principles insist we take the likelihood of future inflation pressures seriously. There are unquestionably some strong deflationary pressures: automation, scientific advances and AI all promise to increase productivity. However, we are also seeing the slowing and even reversal of long-term secular trends that have put a lid on trailing inflation.    The post-war era has seen a massive increase in the available pool of labor globally. In the US, female participation in the workforce rose from 42% in 1960 to 75% in 2000. High fertility rates meant decades of increasing labor supply. Increasing globalization meant that previously unconnected and underutilized human capital was unlocked.    Now, however, these trends are reversing. International supply chains are bifurcating as “reshoring” or “friendshoring” has become the new clarion call after decades of outsourcing, when cost was the only factor that mattered. The supply of labor is set to contract. Female workforce participation has plateaued. Fertility rates in the US and across the world are alarmingly low. The developed world today has three workers for every person of retirement age; by 2050 there will be less than two. The US had 5.1 workers supporting each Social Security recipient in 1960. By 2023, that figure had fallen nearly 50% to 2.7 workers per recipient, and will only continue to fall from here. The age dependency ratio measures the number of dependents (children and elderly) relative to the working age population. After falling since 1960, the age dependency ratio is now climbing steeply across the world. This may very well end up being the defining social issue of our time, and it will have profound economic and political consequences.    Rapidly aging populations and deglobalization means an increase in the demand for goods and services relative to the productive power of the economy. Thus, we should expect the baseline inflation rate to be secularly higher in the future than it has been in the recent past.   Finally, and, most concerning of all, US fiscal policy remains unconscionable and unsustainable.   Fiscal policy   Over the past several years, we have been highly critical of the Fed – e.g., calling ZIRP policies "utterly inappropriate for a high inflation, high growth, low unemployment economy."   However, the Fed has since normalized monetary policy, taking long-term real interest rates from an irresponsible -1% in September 2021 to an appropriately restrictive +1.9% rate today. Now we must turn our condemnation firmly to fiscal policy.   Monetary policy captures much of the attention of the financial news because it has the most immediate effect on markets. However, in the long term, fiscal policy dominates. In its core responsibility of setting interest rates, the Fed merely changes the mix of government liabilities, exchanging Treasury bonds for dollars or vice versa. In theory, a mix which includes more low-yielding dollars relative to high-yielding bonds increases the “hot potato” effect of holding government liabilities, stimulating economic activity.5 When the Fed wants to loosen policy and lower rates, it buys Treasury bonds from the public and issues dollars, increasing the supply of dollars and correspondingly decreasing the supply of bonds. When the Fed wants to tighten policy and raise rates, it sells Treasury bonds and receives dollars, reducing the supply of dollars and correspondingly increasing the supply of bonds. Note that neither changes the outstanding stock of government liabilities. It would require a government surplus (tax revenues exceeding spending) to actually decrease the combined number of Treasury bonds and dollars outstanding.    Therefore, the Fed can change the mix of government liabilities in order to influence their velocity but cannot change the stock of liabilities. On the other hand, when Congress deficit spends, there must be an increase in liabilities, either Treasury debt or dollars. Those new obligations can be reduced in real terms by an offsetting budget surplus or GDP growth, or they will exert inflationary pressure as people try to spend their growing pile of government liabilities on goods and services.    Unfortunately, it appears vanishingly unlikely our gargantuan debt will be decreased by budget surplus or GDP growth anytime soon. Gross federal debt exceeds 120% of GDP – higher than at the end of World War II. That’s up from 60% in 2006, and up from 100% less than five years ago. From the end of WWII until 2001, deficits averaged a manageable 1.5% of GDP. During the 2000s, they averaged a worrisome 4.1%. And since 2020, they’ve averaged an exorbitant 9.5%.   The scale of deficit spending in the wake of the financial crisis and immediately following the pandemic is defensible. However, over the past two years, after the effects of the pandemic on employment and well-being had clearly receded, the scale of deficit spending has been unconscionable. The unemployment rate is near its lowest level on record, and the labor participation rate is near its highest. Real GDP growth over the past several quarters is essentially as strong as it could plausibly be. The economy is operating at or above its potential. This is precisely the time to be saving for the future! Instead, we are mortgaging it.   After the Great Recession, the economy languished for a decade at below-trend growth and below-maximum employment. Fiscal policy was unprecedentedly stimulative, and yet many would argue that the government did not do enough to bring the economy back to full potential in the face of corporate and household deleveraging. The labor market remained weak, and inflation remained subdued. The lesson collectively learned during this period seems to be that the government can deficit spend at perennially higher levels without consequence. That lesson is fundamentally incorrect. High deficit spending is only appropriate in an economy with slack, the polar opposite of the circumstances we face today.   In Apex of a Bubble, we fretted:   After the pandemic recedes, the CBO projects the next ten years will nevertheless average budget deficits of 4.2% of GDP… It is naive to think that pandemic-era programs will totally recede with the pandemic itself. As Milton Friedman once quipped, “Nothing is so permanent as a temporary government program.” We have established a new, higher floor for government stimulus, and that floor will only grow until a crisis precipitates a reckoning.   A mere two years later, and the CBO now projects an average budget deficit of 6.1% of GDP for the coming decade. In 2033, the CBO expects net interest on federal debt of 3.7% of GDP; over 20% of tax receipts would go just toward paying the interest on our debt. And we believe this is likely a serious underestimate, as it conveniently excludes all the debt the government has promised to pay to itself, and assumes only a 3.2% interest rate – well below prevailing rates. The government will likely find itself facing much higher funding costs much sooner. Over $8 trillion of Treasury debt – equivalent to nearly 30% of GDP – matures in the next year, and will need to be refinanced at much higher rates.   To balance the budget in 2033, Congress would have to cut 29% of spending. If we eliminated all spending on national defense, veterans affairs, agriculture, education and transportation, we’d almost be there!    Instead of acting in a counter-cyclical way, fiscal policy is now pro-cyclical. Deficit spending will overheat the economy and stoke inflation, rather than stimulate the economy back to its potential and generate employment. Now is the time we should be running a surplus, bringing the economy back into balance, and accumulating resources for the next downturn. The mistake of deficit spending in an economy operating at full potential is two-fold: it creates inflationary pressure, and wastes scarce resources that will be needed in future downturns. If we cannot find the political will to dial back spending with the economy roaring, what hope do we have to reduce spending when the economy struggles?   Now that monetary policy is normalized while fiscal policy remains so untethered from reality, should a new wave of inflation come, we expect fiscal policy will come to increasingly dominate political discourse. It will become apparent the problem is Congress, not the Fed. And as painful as it was to normalize monetary policy, reining in out-of-control spending will be an order of magnitude more difficult. The current haggling over minor cuts every time the debt ceiling looms is on a scale nearly immaterial to the scale of the issue. Outside of some fringe right-wing politicians, there is little political will in either party to make the deep spending cuts and entitlement changes that would be necessary to appreciably bring down primary deficits, let alone appreciably bring down the debt burden.    There’s no way to know when a reckoning will come, but it will, and it will be perilous for both our economy and our democracy.   Our opportunity   Despite the clear and present dangers for the market and the economy, we nevertheless believe Bireme clients are poised to continue to enjoy strong performance. When a portfolio enjoys a year with 20%+ returns, it often means that the portfolio is more richly valued, thus implying that prospective returns are lower. To avoid this fate, we have taken profits in several of our best-performing and most richly-valued positions, and rebalanced to more traditional value names with undemanding valuations. Our unique value investing framework – exploiting investor biases to find high-conviction investments in undervalued equities – has delivered strong real returns in both advancing and declining markets.   We continue to find enticing opportunities here in the US, and we also have increasingly looked overseas where valuations are much more attractive. We currently own stocks traded in the UK, Canada, France and Japan. Thus, we remain highly optimistic about our long book. And due to the recent pivot-driven euphoria, our short book has once again become very compelling. We maintain short positions worth over 20% of NAV, including some new shorts which we discuss below.    It’s not too late to join us at Bireme. Please reach out.

Portfolio commentary   Our investment in Old Republic (ORI) has performed quite well since our last letter at the end of May, up about 18% including dividends. The company’s General Insurance (GI) business has been thriving, offsetting the expected declines in Title Insurance profits. Over 2023, revenue grew 8.2% in that segment and margins were robust. GI underwriting has been extremely strong, with the combined ratio (insurance losses and SG&A as a percentage of premiums collected) down to 90%, well below the 2010-2020 average of 97%. We expect combined ratios to normalize from here, crimping underwriting profits, but increased income on the float due to higher interest rates should more than offset these declines. In line with this forecast, investment income grew 26% in 2023 at ORI. We forecast profits in GI to grow from $788m in 2023 to $1.2b in 2027. Consolidated net income at ORI should increase from $750m in 2023 to almost $1b. We believe investors misunderstand ORI because they are too focused on ORI’s floundering title insurance business. However, even if the title insurance business never fully recovers, we believe that the stock remains undervalued today at an $8b market cap.   Management seems to agree with our assessment, having repurchased $530m shares on the year. In conjunction with the substantial dividend, this puts the total shareholder yield over 10%.   Our worst performing position was RCI Hospitality, which declined more than 20% into the stock’s lows over the summer before rebounding in the fall. RCI is a nightclub and restaurant operator with over 60 locations across the US. The business has now gone through two consecutive quarters of SSS declines in the nightclub segment, with FQ3 down 7.3% and FQ4, ended in September, down 9.6%. Despite these declines, RCI’s revenue per store is still above 2019 (i.e., pre-COVID) levels and on a much-expanded number of locations. So while the firm seems to have given back most of the SSS gains from the post-COVID “experience spend” boom, we don’t think this portends a long-term decline in sales per location.   At its current market cap of around $580m, RICK trades for 9x EBITDA and less than 12x maintenance free cash flow. We still think this is too cheap. Since 2019, RICK has grown their nightclubs, primarily through acquisition, from 37 to 55. This increase in locations has driven revenue from $166m to $290m and EBITDA from $44m to $90m. Net income has also doubled from $20m to over $40m. Over the same period, shares outstanding have fallen from 9.7m to 9.4m due to occasional buybacks. RICK remains one of the only ways for small operators to sell their clubs, allowing RICK to acquire these assets on the cheap and improve earnings by professionalizing management practices. We remain long.   New short positions   As we entered the second half of 2023, the valuation of many consumer staples companies perplexed us. The SPDR Consumer Staples ETF traded at a healthy 24x earnings despite low-single-digit projected earnings growth and a dramatic rise in interest rates. On top of the rich valuations, many of the underlying businesses face long-term headwinds and have been papering over volume declines with price increases. We shorted a few of these companies in Q3, including Clorox.    In fiscal 2023 (ended in June), Clorox sold 10% fewer products than the year before. However, they raised prices by 16%, allowing the firm to report 4% revenue growth despite the sharp volume declines. This is not a sustainable way to grow a business. Tobacco companies operate similarly and trade at below 10 times earnings. In contrast, Clorox traded at more than 30x earnings when we initiated our short position.   Tootsie Roll Industries is another overpriced staples stock that we shorted. Like Clorox, the company has pushed through price increases the last few years, but prior to that revenue was stagnant over a long period of time. Consumer trends do not bode well for sugary treats that are terrible for your health and your teeth. Despite the company’s low-growth track record, the stock trades at about 30x trailing earnings. On a FCF basis, the valuation looks more like 40x.    Investors are under the impression that these companies are a defensive investment because consumers will need to buy staples in any economic environment. However, this valuation-agnostic viewpoint is patently absurd at these valuations. Stocks that trade at growth-like valuations but have no prospect of real growth are in no way defensive. They share all of the downside of other richly valued stocks but none of the potential upside. In our view, these companies should be priced at a generous discount to bonds, rather than a substantial premium. With staples stocks still less than 10% from all-time highs, we expect the sector to continue to underperform.   We also shorted Apple in Q3. At our average price of around $190 per share, Apple traded at 30x peak earnings and a $2.8 trillion market cap. While Apple is indeed a magnificent company, this valuation is simply too rich for a business with a substantial cyclical component. The company is projected to grow revenue at a mere 4% rate between 2022 and 2026. We think the total return on Apple stock will be lower than the market, and especially our long positions, over the next few years.   Another stock we bet against in the second half of 2023 was ARM Holdings. We find the valuation to be far too rich at more than 20x sales and 100x FY 2023 operating income. To garner such a large multiple in the public markets, majority owner Softbank seems to have pulled out all the short-term levers at its disposal. From the FT:   Arm is seeking to raise prices for its chip designs as the SoftBank-owned group aims to boost revenues ahead of a hotly anticipated initial public offering in New York this year. The UK-based group, which designs blueprints for semiconductors found in more than 95 per cent of all smartphones, has recently informed several of its biggest customers of a radical shift to its business model, according to several industry executives and former employees. These people said Arm planned to stop charging chipmakers royalties for using its designs based on a chip’s value and instead charge device makers based on the value of the device. This should mean the company earns several times more for each design it sells, as the average smartphone is vastly more expensive than a chip.   In our view this was a transparent attempt to boost revenue growth ahead of the IPO. This might work as a one-time boost to sales, but it is not sustainable and will anger and alienate customers. ARM’s largest customers increasingly choose to license just the ARM instruction set architecture (ISA) rather than purchase ARM’s off-the-shelf chip designs. They prefer to design their own chips so they can better optimize their hardware with their software, as Apple has done to great effect with its custom silicon. It is hard to imagine ARM getting significantly more revenue share while their value-add diminishes.    Should ARM persist with its land grab, in the long run it may push chipmakers towards using the RISC-V ISA, an open-source competitor to ARM’s ISA. Around the same time that ARM started telling customers about their pricing change, Google announced support for RISC-V in Android, making it clear in their keynote speech that they are in it for the long haul:   Lars Bergstrom, Android's director of engineering, wants RISC-V to be seen as a "tier-1 platform" in Android, which would put it on par with Arm. That's a big change from just six months ago. Bergstrom says getting optimized Android builds on RISC-V will take "a lot of work" and outlined a roadmap that will take "a few years" to come to fruition, but AOSP started to land official RISC-V patches back in September.   We believe ARM’s short-term price increases are unlikely to be converted to long-term revenue growth, but this is what is required to justify the current valuation.   Our final new short position is in a company called C3.ai. Originally named “C3 Energy,” C3.ai has changed its name multiple times based on whatever hot new trend they were supposedly capitalizing on. The “energy” theme was about smart grid and cap-and-trade. Then the firm changed its name to “C3 IoT” to attempt to capitalize on the Internet of Things buzz. After that trend fizzled out, the moniker was altered once more, with the company capturing the “AI” ticker in December 2020 – a savvy move if it wants to sell stock to credulous investors, but irrelevant to its business prospects. As Kerrisdale put it, the company is a “minor, cash burning consulting and services business masquerading as a software company.”    The company incinerated $200m last year and is set to burn more cash in this one. They may grow mid-teens this year after just 5% growth in FY 2023, but there is really no comparison to truly fast growing software businesses like SNOW (33% growth this year), Gitlab (31%), and Datadog (26%).    With an EV/sales multiple of 9x, we think the stock is grossly overvalued.   British American Tobacco   We initiated a new long position in British American Tobacco (BAT). While BAT is in the consumer staples industry like some of our shorts, the valuation is vastly different. After falling 25% this year, BAT trades at a mere 6x earnings, and is one of the cheapest stocks we own. This appears to be a case of social conformity bias, as ESG-blinded investors are ignoring the company’s brands, valuation, and strength in next-generation products.   BAT was formed in 1902 and owns some of the most beloved tobacco brands in the world, including Camel, Lucky Strike, Dunhill, and Newport. While tobacco use is on the decline, these brands (via annual price increases), generate a stable 8b GBP in profits. We think the stock is undervalued based on the earnings power of these brands alone.   But what sets BAT apart from all tobacco companies not named Philip Morris is its position in reduced risk products. These products deliver nicotine in a variety of ways other than burning tobacco. The most common reduced risk product in the US is e-cigarettes or “vapes,” which aerosolize a nicotine-filled liquid to create a vapor that is inhaled. This method of consuming nicotine, which does not involve ash, tar, and all of the cancer-causing chemicals known to be present in cigarette smoke, is vastly safer than smoking cigarettes. The UK’s Department of Health, in an extensive meta-analysis, stated that e-cigarettes appear to be “at least 95% safer than cigarettes.” BAT is the world leader in e-cigarettes, having unseated Juul as the largest brand in the US. Their e-cigarettes have over $1b in worldwide sales per year.    BAT is also the leader in “modern oral” nicotine pouches outside of the US. Like e-cigarettes, nicotine pouches deliver pure nicotine sans tobacco, and function as a safer and cleaner form of chewing tobacco. While still small relative to the cigarette market, sales from these pouches have been growing quickly. In the US, the most popular brand is Zyn. Zyn’s popularity enticed Philip Morris to pay 21x EBITDA for its parent company, Swedish Match. But while BAT is finding it difficult to compete with Zyn in the US, they are having success elsewhere. Revenues of their modern oral products were up 42% in the first half of 2023, to 241m GBP.   We think BAT is likely to generate 5b GBP of annual sales from reduced risk products within the next few years. By 2030, these products may account for 40% of the company’s revenue. At that point, the traditional story of tobacco companies causing harm will be flipped on its head, and BAT’s less harmful products will be saving millions of lives by allowing people to quit smoking. Nicotine itself may lose some of its stigma, given that it is responsible for essentially zero of the physical harm from tobacco products. At that point it would not shock us if BAT traded up to 15-20x PE ratio, in line with the broader market.   A key risk for BAT is the potential for a ban on menthol cigarettes in the US, something which the FDA says it will do. Contrary to BAT’s claims that the firm can retain 80+% of its menthol customers following a ban, we assume they lose the equivalent of about 40% of US menthol sales if the product is banned. Even in that scenario, the stock is too cheap, and we plan to buy more if the stock drops materially on final news of the ban.

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1 FV performance is shown net of a 1% management fee and 10% performance fee. Available for Qualified Clients only as SEC rules do not permit performance fees for nonqualified investors. Fee structures and returns vary between clients. FV inception was 6/14/2016.   2 Total return data from Bloomberg, UBXXSPX7 Index and UBXXMAG7 Index.   3 Netflix, while not canonically a “transcender” or a member of the Magnificent 7, is surely Magnificent 7 adjacent.   4 Bloomberg estimates as of 1/25/24.   5 Though this is the canonical representation of monetary policy transmission, it is not obviously operative today. Traditionally, dollars held on deposit by banks at the Fed did not pay interest. However, the Fed has been paying interest on bank reserve balances since the financial crisis at a rate roughly equal to the fed funds rate (~5.4%). Furthermore, the yield curve today is deeply inverted, so the average Fed holding of Treasury debt has an interest rate of roughly 4%. This means that whenever the Fed sells securities in an attempt to tighten policy, it is reducing the supply of dollars yielding 5.4%, and increasing the supply of Treasury bonds yielding roughly 4% – perversely decreasing the incentive for the public to hold government liabilities.   Thus, a case could be made that the Fed is actually loosening policy as it shrinks reserve balances today. Further discussion is beyond the scope of this letter, and frankly, we’re not entirely sure of the implications. To the best of our knowledge, no one else is talking about this issue. (Please bring it to our attention if you have seen discussion or if you think we’re missing something.) Regardless, our main point above remains true: the Fed can only change the mix of government liabilities, and not the total amount outstanding.

Advisory fees and other important disclosures are described in Part 2 of Bireme’s Form ADV. Reported performance is a dollar-weighted average of the securities in the Fundamental Value L/S Model Portfolio maintained at Interactive Brokers from inception through October 2023. From November 2023 onward, reported performance is a dollar-weighted average of the performance of all client accounts invested solely in the Fundamental Value L/S strategy with no client-directed customizations to the portfolio composition. Performance is shown net of a 1% management fee and 10% performance fee. Available for Qualified Clients only as SEC rules do not permit performance fees for nonqualified investors. Past performance is not indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. The SPY ETF seeks to track the performance of the S&P 500 Index, and the performance described includes both fees and the reinvestment of dividends and other distributions. Registration does not constitute an endorsement of the firm, nor does it indicate that the advisor has attained a particular level of skill. See biremecapital.com/disclaimer for important disclosures. Sources: Bloomberg Finance LP, Interactive Brokers LLC, S&P Compustat, Bireme Capital LLC.