Friends, partners, family – this is not the beginning of a wedding speech, these are salutations used by American money managers in their quarterly letters to clients. Cringeworthy addresses aside, the notes issued by companies that manage billions of dollars are a treasure trove of market insights, investment strategy and, in the case of bad funds, live case studies of cognitive dissonances that can lead to failure.
Without being clairvoyant it is very difficult to make investing in hedge funds pay, so the thoughts of managers can’t be interpreted as a guide to where the smart money is heading. Yet with monetary policy makers becoming less accommodative, the scope for fiscal stimulus uncertain and the spectre of trade wars looming, the global economy is arguably at or near an inflection point. Against this backdrop, the output of highly resourced research teams makes for interesting reading.
The equity premium conundrum
In two months, between 24 September and 23 November 2018, the S&P 500 fell almost 9.7 per cent. The third-quarter updates filed by managers during this time were already concerned about the ability of the US equity market to sustain its lofty valuation. Before the recent slump fully took hold, Howard Marks at Oaktree Capital was bemoaning the frothiness of the market. His note of 26 September highlighted the danger for new investors only active in the past decade, who have only known a bull market. Their psychological framing of possible returns is skewed to the upside and risk is seriously underestimated. Mr Marks is not alone in observing the trend towards riskier asset classes, thanks to lower yields offered on safe investments in recent years, which may come back to bite investors that have underestimated risk.
The equity risk premium (ERP) is probably not a concept inexperienced investors have heard of, but it is central to the sensitivity of the stock market to rising interest rates. Fundamentally, because capital is more at risk when invested in the stock market as opposed to safe assets such as US Treasuries, the implied returns from stocks should be higher than the risk-free yield on government bonds. Over the past 50 years the US ERP has averaged 4.9 per cent in real terms annually above short-term T-Bills and 1.9 per cent above Treasury bonds (Credit Suisse Global Yearbook 2018, Elroy Dimson, Paul Marsh and Mike Staunton). Rising interest rates mean rising risk-free yields, which puts pressure on stocks to deliver a higher return to maintain the equity premium. This is harder when the market is already expensive, and if companies cannot sufficiently increase cash flows the price of stocks must come down.
Rising interest rates aren’t just a risk in terms of triggering market reratings today. Steven Greenwood, founding partner at Greenwood Investors, wrote on 10 October that there could be ramifications for shareholder value in the future, if investors become too short-term in their outlook. Shaming General Electric (US:GE) as an example, Mr Greenwood argues that short-termism leads to the destruction of value for shareholders and customers alike over time, as quarterly margins and dividends are prioritised over capital investment.
By contrast, he praises the role founder-led companies out of Silicon Valley have had in breaking the myopic practice of managing just to beat quarterly guidance. The worry now is that other companies that have historically been good at investing for the medium and long term are now on high valuations and therefore their free-cash-flow (FCF) yield is low. Mr Greenwood points out that as interest rates rise, so do discount rates (the required rate of return) so these companies with a low FCF yield are vulnerable. “With higher discount rates, cash flows that will materialise far in the future will suddenly have a much lower value today than in a zero-interest-rate world.”
In the case of the megacap FAANG stocks (Facebook (US:FB), Apple (US:AAPL), Amazon (US:AMZN), Netflix (US:NFLX) and Google’s parent company Alphabet (US:GOOG), their prices may have to rerate further to reflect more muted growth outlooks and the fact that these companies will continue to prioritise innovation over becoming dividend-paying income stocks. Given the weight these companies have in the S&P 500 index, this rerating will contribute to further market volatility.
For smaller companies, Mr Greenwood says there is a risk that investors will see rising yields in other asset classes, which will “shorten their time horizons still further”. He says “corporate America will soon face an alarming dearth of investors willing to look beyond the next quarter or two”. Considering the wider context of technological progress, this could have a negative impact on society as innovation finds it harder to source funding.
The return of value?
The investment case for the highly priced FAANG stocks may be more sensitive to higher interest rates due to stretched multiples and the discount rates applied to future cash flows. Many of the write-ups say that it is too early to be pessimistic about all US equities, however. Ben Miller, at Miller Value Partners in Baltimore, is adopting a wait-and-see approach, given the unique set of circumstances. He recognises that in any orthodox interpretation of the long period of US economic expansion and the great bull market in stocks, inflation should be at the top of the list of worries: “Yet so far this year the core rate is 1.9 per cent. We just don’t know how long the expansion will last, how low unemployment can go, how long the bull market in stocks will continue, or just about anything else of economic significance as it pertains to what will happen in the next months or years.”
That was on 10 October, just as volatility was returning to the S&P 500, but the message from Mr Miller was sanguine: “It’s a bull market in stocks and it will continue until it ends, and no one knows when that will be. It will end when either the economy turns down and earnings decline, or when interest rates rise to a level where bond yields provide significant competition for stocks. I have seen some folks saying that will be at 3.5 per cent or more on the 10-year (benchmark US Treasury bond), which I find implausible as bonds will still be trading at close to 30 times a return stream that does not grow, while stocks are at just under 17 times next year’s earnings, and those earnings will likely advance about 5 per cent or a bit more over the long term. During the bull market of the 1990s, bond yields averaged 6 per cent. Today’s rates are still among the lowest in history, and only two years ago they were the lowest in history. Valuations of stocks do not appear demanding compared with returns available in other asset classes.”
Many managers are indeed betting that recent market turbulence is a changing of the guard in terms of the investing styles that will outperform, rather than the onset of a rout for all equities. With central banks worldwide unwinding the monetary policy experiments of the past decade, managers are confident strategies that deviate from market beta at last have scope to outperform. Central to this optimism is the belief that value investing is set for a comeback.
A boast for New York hedge fund Vilas Capital is that the average forward price/earnings (PE) ratio of their long positions is now just nine times (holdings include US pharmacy chain Walgreens (US:WBA), banks Citigroup (US:C) and Barclays (BARC), and Honda (US:HMC)) and chief executive and chief investment officer John Thompson estimates upside, on a weighted average basis, of 150 per cent over the next five years.
Regardless of whether you buy into such positivity, there are grounds to expect far greater dispersion in the performance of stocks in the post quantitative easing (QE) era. The third-largest position in Vilas’s portfolio is a short sale of electric vehicle manufacturer Tesla (US:TSLA). In his note, Mr Thompson delivered a damning verdict on Tesla, saying the company has too much debt, struggles to control its costs and operates in a market with insufficient barriers to entry.
New York hedge fund Vilas Capital’s third-largest position is a short sale of Tesla
The clear inference is that backing a company based on confidence in the long-term demand for what it produces is not enough, especially as factors underpinning the great stock market momentum trade of the past decade are changing. Without the boost of ultra-loose monetary policy, the differential in returns between good and bad companies will be greater.
Short-selling is risky, though, and one of the dangers funds face is being short-squeezed – having to buy stock to cover and exit a short position – which can be very perilous if the stock is illiquid. Tesla is also subject to short interest by East 72 fund, which justifies its very sizeable position by pointing out Tesla’s exceptional trading volume. The market cap turns over every 14 days and a 20 per cent holding can be turned over in three days.
Of course, history tells us confidence in any risky investment can quickly unravel. Ignoring short-selling, a more appropriate and useful lesson for private investors is to be found in the general commentary offered by the O’Shaughnessy Asset Management (OSAM) research blog. The firm of legendary investor Jim O’Shaughnessy, based in Connecticut, discussed value investing in this month’s post. It explains that value investing works through a rerating process, which begins when the market prices companies at a discount in the expectation that earnings will fall.
There is a tendency to go overboard, however, and investors can profit when the market realises it has placed too great a discount on shares. Underestimation of the likelihood and extent of companies’ eventual recoveries can create opportunities for some of the best returns. This is nothing new, but the OSAM team draws attention to the dispersion within value returns – namely there are fake (value traps) and genuine value companies. Some investors believe now is the time to become more discerning, rather than exiting equities, and look for signs that companies are well placed to make good on any previous investments and have manageable capital structures. For these people, increased volatility is an opportunity for stockpickers to sort the wheat from the chaff.
What of the real bears?
Crescat Capital of Denver, Colorado, is another company that is predicting a return to value-driven performance, although it is quite pessimistic on the outlook for the global economy. Crescat is short US stocks, because of high valuations relative to underlying fundamentals and “the abundant catalysts for near-term bear markets and a US recession”. They are also shorting the overvalued and weakening Chinese yuan and have contagion ploys for the unwinding of the Chinese credit bubble.
Crescat’s pessimistic tone is reflected in one of its favourite investment plays: buying precious metals. This is an asset class where returns are hugely volatile and depend entirely on price speculation, as no income is paid. Despite this, they believe precious metals are at record deep value compared with fiat currencies. US and global inflationary pressure are also cited and Crescat believes the Federal Reserve (Fed) is hamstrung to do anything about it.
Paraphrasing its note of 15 September, essentially Crescat’s argument is that inflationary pressures are reaching a critical level, but the Fed cannot prop up asset bubbles and fight inflation simultaneously. Rate rises have contributed to a recovery in the strength of the dollar (since Crescat’s research was published the dollar index is now at its highest level in more than two years), which has contributed to the bursting of asset bubbles in China and other emerging markets: “We strongly believe the US stock market is poised to follow the rest of the world down.”
When hedge funds get it wrong
An unpleasant aspect of investing is when people lose money. One of the more tragic Youtube videos doing the rounds this month was James Cordier, the chief executive of Optionsellers.com, choking back tears as he apologised to clients for their investments in his $150m fund being wiped out. The sincere hope is that the savings of widows and orphans weren’t being invested in strategies as risky as natural gas and oil price options, which are notoriously unpredictable and wrong-footed Mr Cordier. Even if the speculative investments were being made with capital its owners could afford to risk without damaging their lifestyles or prospects, the fund’s demise is still an unfortunate business.
Some of the notes explaining weak quarterly or year-to-date performance are less contrite and frame losses in the context of a fund’s strong performance since inception and investment principles of risk-reward. Artko Capital only made 0.5 per cent (net of fees) in the third quarter of 2018, but has delivered annualised returns of 18.2 per cent since it began investing in July 2015. Its small-cap strategy has, net of fees, underperformed the S&P 500 index over the past 12 months (16.4 per cent versus 17.9 per cent). Of course, this isn’t an appropriate benchmark – Artko has beaten the Russell 2000 and Microcap indices (which have made trailing 12-month returns of 11.5 and 11.6 per cent, respectively) but considering risk, buying a large-cap tracker would have been a better investment over the past year.
To its credit, Artko doesn’t shy away from risk in its update and is clear what the trade-offs have been for superior performance since inception. Portfolio manager Peter Rabover explains the approach: “First, investing is risky – especially in microcap public equities and special situation securities. Second, we are often wrong. However, as the saying goes, this is a feature not a bug. Recognising that we are fallible and that real capital impairment risk exists leads our investment decision process to think in probabilities of outcomes rather than decisive proclamations of certainties in the future performance of our investments.”
Some nuggets of real wisdom
New York fund Hayden Capital saw a third-quarter decline in its portfolio of –5 per cent (net of fees), largely due to the Chinese portion of its investments. This is versus 7.7 per cent total returns for the S&P 500 and 4.4 per cent for the MSCI World index in the same period. Since inception, in November 2014, the fund’s annualised net total return has been marginally ahead of the S&P 500 at 12.69 versus 11.92 per cent and the MSCI World has made 8.25 per cent a year. On a risk-adjusted basis it would be interesting to see how the fund had done against the S&P 500, but given the four years US equities have had, on an absolute basis to be ahead of that benchmark after fees is impressive. The reason for highlighting Hayden Capital is not its performance, however. As the last quarter shows, hedge fund performance can go sharply against investors, but some of the philosophy of managing partner Fred Liu is useful to bear in mind.
Mr Liu breaks equity investing into three components: 1) If you should buy a stock; 2) When you should buy the stock; and 3) How much to buy. The ‘if’ question is based on company quality – its competitive position, quality of management, its culture. The ‘when’ question is based on whether the valuation is low enough to imply a satisfactory return. The hardest part of the investment decision is ‘how much’ and Mr Liu thinks this is partly the trade-off between the quality and value dynamics, yet there is no definitive answer.
Whether investors prefer quality value or deep value ‘cigar butts’ will depend on their own risk tolerance and personality, which should be central to all portfolio management. Mr Liu likens investing style to dieting: “You need to find a method that fits with your inherent preferences. For example, if you love butter and bacon, you’d probably have an easier time with the Paleo diet than drinking green juice all day. It’s finding the right match of [personality and method] that’s more important for success (and increasing the odds of sticking with it).” Finally, his axiom on when to sell or buy a new investment is worth remembering – is the new investment any better than the weakest that’s currently held? A simple rule but one that can avoid unwieldy and difficult-to-manage share portfolios.
