A small hedge fund manager’s lament

We have just been through six years when almost any company that could be purchased by private equity and was potentially worth purchasing by private equity has been purchased by private equity.  With the exception of about eighteen months, PE firms could issue lots of low yield debt to buy the assets.  I am an equity manager - and in searching for good assets private equity firms are my competition.  I dislike them for it.  (Never have so many Harvard MBAs been concentrated on so many small cap stocks...)

There is only one exception to this - and this exception proves the rule: there are a few small companies that have a dominant (often family) shareholder where the (family) shareholder won’t or can’t sell for personal/legal/structural reasons.  Some of these companies might be reasonable value because the PE firms have not had a look in.  Indeed, we have about 10 percent of the fund invested in companies in France that fit this exception.  One of our most profitable positions has been a German company with a dominant (and immobile) family shareholder.

Private equity funds are also the biggest competitors to other private equity funds.  All this competition means that private equity shops are doing worse and worse deals.  Its got to the point where PE funds buy fake companies (see Carlyle with China Forestry and I suspect others).

Running a small hedge fund, I would usually want to buy small caps on which I had done superior analysis.   Alas, when I look at small caps - even medium caps I keep finding expensive, dodgy and well promoted stocks.  Small caps are a land of shorts.  The good stuff - and then the less good stuff left behind - has been picked over by numerous PE shops.

I do serious research.  I will pay someone to stake out a factory in China and count the trucks going in and out.  I talk to suppliers and customers.  And by and large almost all of that research is no good for finding longs.  You see the PE shops have more resources than me - and when they find something even half way good they issue low yield debt and buy it. The low yield debt that is everywhere is my competition - and I hate competing with someone whose capital costs less than a third of the returns I target.  The low yields that PE funds can issue debt have now resulted in low ex-ante returns for small cap investors.

Large caps by contrast are surprisingly inexpensive (however most of them have warts).

For instance Google - and I am just picking Google - has a PE ratio below 20 when you net the cash out - and has an enormous tailwind.  At the moment there are 3.4 billion cell phones in the world and only about 100 million connect intensely to the internet.  Most of those are iPhones.  In five years time Android phones with the capabilities of a current iPhone 4 will retail below $100 - possibly far below $100.  The dumb phone will cease to exist - and almost all phones will connect to the internet.  Google will dominate that ecosystem.  The tailwind is enormous.  Sure Google faces headwinds too (their search quality is being eroded by spam and Facebook is stealing internet time and even search loyalty).  But in a different environment you might say Google was cheap.

Microsoft is under 12 times historic earnings - and far less than that if you net out cash.  And sure it is problematic (I am writing this on a linux computer and in a few years the dominant computing device will be a phone - probably an Android phone).  But the cash flows look stable enough for now.  And the biggest mobile phone company in the world has just agreed to distribute their operating system.

Vodafone is at a PE well under 10 times - but it has a history where it has never failed to disappoint.  When I told a UK fund manager that my biggest position is Vodafone he looked at me with pity.  (It was of course their biggest position a decade ago - and what they were really feeling was self-pity.)

Now these are not historically stretched valuations - but they are not outright bargains either.  They are however a bargain compared to long term government bonds and they are absolutely a bargain compared to the average small cap.

I don’t particularly want to express a view on inflation or deflation.  Suffice to say we have seen a movie which had an unbelievably brutal deflation.  That was Japan.  Ben Bernanke has also seen that movie - and he has determined that it will not happen in America.  He will expand money supply to stop it.  A deliberate money supply expansion on this scale in response to a huge deflationary threat is an experiment and we do not know the outcome.  It could fail (you know the saying - you can lead a horse to water but you can’t make him drink).  It could succeed beautifully producing 4 percent inflation and getting the economy out of the rut.  Ben Bernanke said on 60 Minutes that he was “100 percent” sure that he could control inflation at the end of it.  I need to stand outside a factory and count trucks before I am 100 percent sure the trucks are not coming - but unless I have a method of direct verification I am not 100 percent sure of anything much.  Bernanke is a little too certain.  Whatever: put a weighted probability on inflation or deflation and you would conclude that long-dated government debt - or a deflation bet - is a very risky bet.  (It may wind up ex-post being a good bet - it may wind up being a terrible bet.  Whatever - right now it is a risky bet.)

Large cap equities scare me far less.  At least the starting valuation is lower.

Warren Buffett wrote an editorial in the New York Times on 16 October 2008 suggesting that people buy American equities.  He had already spent all of his non-Berkshire personal account - so most of his purchases were made with the S&P above 1000.  Warren is not stupid and his return expectations were at least 7 percent per annum.  (He is after all Warren Buffett and he is rather good at this stuff.  Better than me or any of my readers.)

Two years have passed - dividends have been a couple of percent per annum - so the current equivalent level S&P level (allowing Buffett’s 7 percent in the form of capital appreciation) is about 1100.  The S&P is currently about 1300.  Today you are buying 20 percent more expensive than Buffett suggested.  (That does not sound like a bubble to me.)

For most of Buffett’s purchases buying 20 percent more expensive than Warren turned out just fine.  And I suspect it would turn out just fine now too.

So here we are in a strange world where large caps are not bargains - but they are, by and large, not frighteningly expensive.  If you were to buy a diversified pile of American large caps and sit back in a decade you would probably be OK - indeed better than OK.  But small caps - the area on which my expertise would normally be most productively targeted - are frighteningly expensive - and the market is riddled with stock-promotes and outright frauds.

So - with exceptions such as my French and German “family stocks" we are mostly long large caps (eg Vodafone, Google) and short small caps (about 50 names, mostly frauds).

Alas I cannot analyse Google with any degree of precision.  A five year earnings estimate made by anyone at Bronte would be worthless.  I have no idea how many smart phones will be Android tied into Google and how many will be Nokia/Microsoft tied into Bing.  I have no idea how much damage Facebook or even Blekko will do to Google’s franchise.  The world is too big and too complex to pretend we know this stuff.  If you can predict this five years out then you are way smarter than me.

The same is true of most of the large caps in our portfolio.  I think on the balance of probabilities any one of them will be alright.  They are almost certainly going to be alright on average.  Predictions beyond that run the risk of pretending I know more about the future than I do about the past or present.

Still - having the overwhelming feeling that large caps are OK - and small caps disastrous I figured I could focus my attention on finding and shorting really dodgy small caps (which we have done to considerable success) and buying a diversified pool of large caps (where our success has been more limited).  That figures - I can add value on the small caps - it just happens that value has been on the short side.

Picking fund managers

If I figure large caps are on average OK - but that I have no expertise in picking them - then maybe I should buy the listed fund managers.  I understand them - indeed I used to work for a listed equity manager.  Equity managers are levered plays off large caps in general.  If the large cap equities perform well the managers will get flows - and they will perform doubly well.  Fund flows to domestic large cap managers have been terrible for some time - and a possible turn around in them is the source of the double leverage to the upside.

Flows however are not inspiring.  One of the better articles of late has been by Derek Pilecki of the very small firm Gator Capital.  He compares the flows of the majors and suggests buying Franklin Resources (NYSE:BEN).  The flows last year were almost 70 billion - the best in BEN’s considerable history.

We are impressed - but we are not exactly thrilled.  The flows - even at a mutual fund group with way-better-than-average flow data - is dominated by fixed income flows.  That capital going into fixed income is going to yield the intermediate bond rate (a couple of percent) minus fees (low but not trivial relative to a two percent yield) plus something for the extra risk the fixed income fund takes on.  There is no double leverage for us there!

And just to add insult to injury all those flows want to earn a little more than 2 percent - and the easiest way to juice your yield is a buy a few covenant-lite bonds from our friends in the PE shops. Franklin’s fund flow increases - rather than decreases - my lament about this market.

And thus this dumb-and-annoying market goes on.  We don’t want to fight: fighting the tape can be awfully expensive.  But whilst we won’t fight it we also don’t want to dance just because the music is still playing.

And hence we focus on diversified fraud shorts because we can add real value.  And the rest is invested very conservatively (meaning large cap equities).  We are adding little to no value there - but at least it is “better than bonds”.  Combined we are doing alright (indeed quite well) - but it is a day to day struggle.  Moreover whilst the frauds can be interesting - its a niche concern - and, besides, most of them I can’t or won’t write about.  So, for my readers, it results in less interesting blog posts.

Yours in lament.




John