Carnival Corporation (NYSE: CCL)

In February 2020 we initiated a short position in Carnival Corporation (NYSE: CCL). Our short position in Carnival was also profitable, as the stock declined 24% for the time we held our position.

However, what was interesting about Carnival, is that after we exited our short position, we actually subsequently took a long position in the stock. As we’ve said numerous times before, we are not married to any of our positions; we are simply always looking for value. At the right price—and the right situation—any of our long positions can become a short position, and vice versa. And we saw that play out with Carnival. Not only was it a profitable short position for us, but the stock has appreciated significantly since we initiated a long position—allowing us to capitalize on it on both the long and short side.

But what caused us to reverse course and take a long position in Carnival? In short, new facts emerged. We are always re-assessing our premises and theses for all of our positions, monitoring the facts on the ground, and continuously re-assessing what we believe their intrinsic values should be. When new facts emerge, or when we see a new development taking place that causes us to view the company differently—we act accordingly. Again, we are not emotionally tied to any of our positions—we are simply looking to capitalize on mispriced situations in the market.

Understanding companies—and what they are intrinsically worth—is complicated. A main reason for that is the inherent complexity behind understanding the competitive landscape in which a company is operating in—which is a critical part of the valuation process. For Carnival, as with all of our investments, there are numerous factors and data points that contribute to our ultimate assessment of what we believe the company is intrinsically worth. That being said, here are a few high-level data points which caused us to take a long position in the stock:

• We believed bankruptcy risk was dramatically reduced as the company demonstrated it would be able to raise capital and bring on strong partners to weather the COVID That included working with J.P. Morgan and other banks on financing packages to significantly fortify its balance sheet. Between the debt and equity offerings, the company’s existing revolver, and the large stake taken by Saudi Arabia’s sovereign wealth fund, we felt there was no way they would let the company go bankrupt.
• The stock was trading 76% below its 1-year high, pricing in tremendous risk and offering us significant upside potential should things turn around, which we believed they would.
• Massive capital costs and barriers to entry: The average ship costs approximately $700 million to build. And Carnival is the largest cruise line company, with 104 ships at the time. That’s about $70 billion of capital expenditures just to get to where they are today—not taking into account the significant additional costs, time, operational infrastructure, and management expertise that would be required to compete with them. Taking all of that into account, the company was trading at around a $10 billion market cap at the time.
• We had more time to understand coronavirus and were confident that eventually vaccines would be developed and the situation would be resolved.
• Unlike sporting events, concerts, or other events that are shorter-term, cruises extend for longer periods of time and are bigger events in people’s lives. Because of that, we thought that evenwithout vaccines, a portion of consumers would be much more willing to take a COVID test in order to go on a cruise, versus to attend a concert or other short-term events.
• Because of the state of the industry, we believed the risk of competition from new entrants was dramatically reduced. Startups and burgeoning cruise lines that were entering the industry would be knocked out as they didn’t have the balance sheets or size of the larger players to withstand the current As a result, there would be a higher chance for consolidation in the industry post-crisis, which would lead to stronger pricing power and even higher revenue potential than the industry had pre-crisis.
• Finally, we read customer surveys and studies that showed there was significant pent-up demand for cruises once this crisis was over. This made sense to us from a rational perspective—that after being cooped up at home for so long, people would be longing to go on cruises and vacations. This would have the effect of allowing Carnival to potentially earn even greater profits than it did previously.

As with all of the companies we research, the key is to take into account the numerous factors—analyze the company from every angle—and then place the proper weighting on each data point. Understanding businesses, and the complexities affecting their current and future prospects, is what has allowed us to capitalize on these types of opportunities since our inception—and generate the returns we have over the past 12 years.

Strong Risk Management

As important as it is to understand our approach to analyzing companies, we think it is just as important to understand our risk management methodology—which we briefly touched on above. Since our inception, our goal has been to make our returns sustainable. We wanted to ensure that, from a risk management standpoint, we are maintaining the same level of risk management we would want an investment manager to adopt if they were managing our capital.

A strong risk management approach is vital because the market can whipsaw and become highly volatile. In fact, that volatility and inefficiency is exactly what creates compelling investment opportunities. However, only by adopting a strong risk management approach can you buckle your seat belt and strap yourself in so as to not only handle that volatility but also take advantage of it.

We recently wrote a short piece titled “A Few Words on GameStop—and Risk Management.” We encourage you to read it, as it highlights key aspects of our risk management philosophy. As we explained in the note, our investment process rests on a foundation of well-designed risk management practices, including but not limited to:

• No options or derivatives
• Invest only in highly liquid, publicly traded companies
• Currently have approximately 30 long and 35 short positions
• Invest only in well-established companies (currently have a weighted average market cap of over $50 billion on both the long and short book)
• Strict position-size limits
• For every $2 billion in market cap, allow ourselves to take only a 1% short position
• Pre-defined leverage ratios that we adhere to by rebalancing on at least a monthly basis
• Maintain a long-term-value-based approach to each investment
• Diversify by investing in several different sectors on both the long and short side of the portfolio

Our goal with these parameters is to limit the downside while also allowing our investors to be comfortable—because they know exactly what they are getting with us. And here is perhaps the most important point: when a manager generates returns with these guidelines in place, we believe it is easier to assess whether those returns are sustainable or not. In other words, it is clear for all to see that the manager didn’t triple down on a specific derivative position that ended up generating a huge bulk of the returns by taking excessive and unwarranted risk. In our view, the fact that we have been able to achieve these results while maintaining these strict risk management parameters is a good indication of the sustainability of our ability to find and invest in compelling equity securities.

Another important element of our risk management philosophy is the types of companies we choose to invest in. Unlike in venture capital investing where individual investments may go boom or bust—and the portfolio manager expects a good portion of the investments not to be winners—we invest in established, publicly traded companies, with a minimum market cap of $500 million, that have proven themselves in the marketplace. We look to invest in companies that have an asymmetrical risk profile, i.e., high upside and low downside. The companies we seek out for our portfolio have strong competitive advantages and strong market positions, qualities that limit their downside, but at the same time they still have significant potential to grow their intrinsic earning power for many years ahead. To us, this is the wisest way to invest and achieve high returns—without all the volatility and downside risk that is inherent in venture capital investing. In short, we have a simple equation for what we look for in an investment: low downside and high upside.