Thursday, February 24, 2011

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.



Anonymous said...

John, thanks for your lament and for sharing your thoughts.

You state 'Moreover whilst the frauds can be interesting - its a niche concern - and, besides, most of them I can’t or won’t write about.'

1. China Agritech is a 'fraud' you wirte about - what prevents you from sharing the others?
2. How do you generate leads on potential frauds - you are short 50 (from a much greater pool of candidates?) so you must have a systematic approach to how you id these targets. What advice can you give to others wanting to follow your approach? thanks

Anonymous said...

RE: Diversified fraud shorts.

You have to get short and get loud. See what Kerrisdale did : they put out a report so convincing that even the longs have to say, " Yeah, the emperor has no clothes."

Sure made the fraud fold overnight too.

Another example is David Einhorn with Lehman Brothers: build a case so tight that the longs have to say, "Yeah, at best, Lehman is fudging the accounts. But more likely that there is acounting fraud going on."

Soldier on. And stop pussyfooting--kock out the frauds with one punch already.

John Hempton said...

Generating shorts has become a project...

There are tips that I am not going to share. For instance I know lawyers where every time their name has appeared in the SEC database within 4 years the stock has traded below 10c.

Every single time.

I guess these lawyers attract loser clients - every client - every one - goes out of business.

Do I want to tell you who they are?


Firstly that is a tool of trade.

Secondly - in the time I have written this blog 5 people have threatened to sue me.

I have no desire to make it six.


t said...

Hi John,

I appreciate your general point, but despite the relative performance of small caps vs large caps, still find plenty of value in the smaller co's.

My starting point is that growth is value. Fund managers are GENERALLY quite lazy, especially in long-only land, and take what brokers say at face value. However, analysts always (i) factor in mean reversion into growth, so fade it very quickly (if they don't do this, DCF's look 'stupid') and (ii) always underestimate margin expansion.

So if growth is value, where is the growth? Banks? Pharma? Telco's? Utilities? Those are all large-cap dominated sectors.

Of course, I generalise to make a point, but I'm still happy to look for longs in the mid- and small-cap space.

John Hempton said...

Well Mr T - always interested in names...

But you got to make it look better than say Walmart at 13 times or Target at a similar ratio or plenty below 10 times.


Best value is often loss making companies because nobody does the valuation correctly. I guess Sprint stands out as a possible...



Anonymous said...

FMG dec puts were cheap before and are a steal now after the asic ruling.... one lonely guy in the middle of nowhere, with one product and one customer who's ready to blowup any time, loading on debt. what could go wrong?

John Hempton said...

Oh, nothing could go wrong with FMG. Like nothing could possibly go wrong with Anaconda.


Anonymous said...

"in a few years the dominant computing device will be a phone - probably an Android phone" - That's a bold, if not pretty exaggerated forecast, don't ya think? reminds me of the countless number of "the death of the pc" ads that the MFool keeps sending out - year in, year out. And yet, the number of laptops and desktops combined continues to grow...
A phone will always simply be too small and uncomfortable for most stuff that is being done on laptops. the same holds for the grossly overhyped iPad - a nice toy and of great use for SOME - but for most it's just another nice-to-have but effectively unnecessary gadget.

regarding the subject of your lament, your observations regarding the low borrowing costs for PE shops are absolutely true. But is more than that: the helicopters of the bernanke Fed have effectively made any stock selection based on fundamentals a futile exercise - at least when it comes to outperofrm the overall market. not for ever, of course, as quality stocks will perform superior over time. As long as the fed keeps printing gazillions of fresh $ every day, though, the riskiest, most levered and most cyclical stocks will go up the most.
What to do? stick to cheaply priced quality stocks, precious metals and lots of cash. opportunities will come once the house of card comes crashing down - as it ALWAYS does. It will not be different this time.

NotATeabagger said...


Nice comments, dont read your blog too often, usually get directed here via Naked Capitalism when Yves finds a good link. I will def check it out more often.

Re Sprint...I'd say stay away. I was a hardcore long, dumped it around Q3. If you check out market folly you can find my reason for dumping it. Einhorn is long but i think he gets "BSX-d" on it (BSX was a prior losing long for GL).

think the competitive dynamics are just awful now for S.

I do think US micro/small caps over some serious value though. Old media stocks in the micro/small have been sold off because of long term business risk but circs have stabilized, cash flow is solid and you have 2012 with olympics and elections. so if u do your homework, fine broadcasters with good NBC coverage and have broadcasting and newspapers in battleground states like VA, OH, FL and then have rationalized their cost basis to the point where you get sick op leverage in 2012, u can get a 2-3 bagger.

I am also long an auto supplier that is at <4x ev/ebitda, very modest capex so cheap on p/cf basis. 40% insider ownership, <$100MM market cap, <$50MM EV.

Sells to the big 3 which are undergoing a resurgence of sorts. Plus when u are coming off 12MM annualized autos, u dont need to get to 15MM for these guys at this valuation to move up. nice little bump to 12.5MM would be nice.

In the US i think some may overlook that small/micro companies didn't benefit from the largesse the big boys did. HOG and HD converted into bank holding cos during the crisis. These small cos really had to make it on their own. This co restructured things in a way that their gross margins now are higher (50%) than they were pre crisis, dumping bad segment, etc and really turning things around.

For me anything <1 tang bv or even <1 book value (when intangibles = ip, licensing, tech that can be analyzed to have more than 0 write down val), and/or <5 ev/ebitda (provided low capex) is worth a quick look.

I will say I have lost the most on China stocks. just written them off entirely in the small cap area.

Robert in Chicago said...

Ah, yes. We entered this business assuming we would focus heavily on small caps, yet our long book is currently dominated by large caps. I spent years consulting to and analyzing telcos and generally think they are poor investments, yet we have owned three big telcos in size for over a year.

We are still finding some value in small caps, including one area relevant to your posts: We are net flat China small-caps, but get there by being short a number of them and long others. After digging into that group and following it for three years, we are fairly confident we have identified a few of them that are honest. If we're right, the valuations on the honest ones are ridiculously low.

John Hempton said...

By number I think the phone being the dominant computing device is kinda obvious.

3.4 billion handsets in the world - most of which are NOT computing devices. A billion computers.

In five years the handsets will have rolled over - and they will all be smart phones.

So there will be 3.4 billion computing devices called phones.

Whether they are the dominant computing device by computing power used - well that I doubt.

But as for ways people use the internet by number rather that in total - no doubt on that.


Anonymous said...

Great post John. I had wondered for a while why there seemed to be relatively better bargains in large caps than small, and PE explains it. (I don't know if it was, or should've been, obvious to people, but as a hobbyist speculator I didn't put those two and two together.)

It also explains why certain China stocks are trading cheap for their growth (I'm thinking of some of the solar shares in particular.) If they can't easily be bought out they aren't going to fetch this sort of PE premium that US small caps will have. (And I suppose there's a fraud premium too.)

najdorf said...

John I agree with you on small caps. Two I follow that have had silly moves are CRDN (up 67% since July from a somewhat cheap valuation, with no real signs of business turnaround, for a company whose main business, armor, has dried up severely, and whose secondary business, solar, has huge overcapacity concerns) and RAVN (up 60% since July from a reasonable valuation for a well-run supplier of niche industrial/ag goods to silly territory of 23x peak earnings).

NotATeabagger: I understand retail investors overlook these stocks, but its hard to believe that cash-rich competitors and PE shops overlook them at the same time. If they're that cheap in this environment they are probably pretty low quality and would blow up in a further recession.

I think one way out of the trap is some of the mid-caps that could be buyouts if PE shops start upsizing their deals again or could just get re-rated if management can gain market trust - stuff like WHR, ITT before they announced their split-up (getting close to fair value now), ENR, etc. The larger, more clearly high quality companies in those spaces are pricing in further growth from current historical peak margins/earnings, but some of the midcaps have been left behind because no one wanted to borrow $10b to buy them out and it's easier to get fired for buying ENR than PG.

Caque said...

As a french (very) small individual investor in small-micro caps, I'm surprised and interested that you do your shopping here.
Would you care to mention a few names (just out of curiosity) or your selection criteria ?
Anyway I'm starting a (modest) blog on this subject and would appreciate feedback on my own good / bad investing ideas.

Anonymous said...

Hi John, thanks for that post.

You may have to deal with this for a while. I added a little bit to the small vs large cap view at my global macro blog here:


Keith Hemstreet said...

I have enjoyed your posts for years now, and contrary to what you might think, the fraud shorts are great fun. You should seriously consider writing a book about them.

Unknown said...

John, for your first correspondent's benefit I would add the Asia Aluminium Group (now called Zaoquing Asia Aluminium), which left investors more than US700 million out of pocket, including some interesting names. Dodgy stuff.

Frank Canneto said...

this is a theme I have kept in my mind, with interest rates at zero bound, the world is awash in cheap money and this is causing distortions, it is likely causing a mis-alocation of capital, such as flowing into housing which was obvious but also into all the securitized products which was less publicised.

So as an small individual investor, I want to know where are the bloated sectors and what are those specific instruments.

THANK YOU for finding one for me, this is very important.

frank canneto

Rich said...

I share the perception that very little in small cap is cheap, yet I had several PE takeout bids from my portfolio in 2007, and none in 2010-11. The point you're making has been echoed by Grantham, but I still see some "sort-of cheap" small cap merchandise out there, and I expect that some of the PE use it or lose it money may become less discriminating before this round is over.

To add to the hopper of concerns, what has been troubling me is that there is such rapid technological change in every industry, that business has become competitive than ever. How does this change impact the risk premium that is supposedly required to invest in equities?

An answer might be to find those firms who are creating the disruptive technological change, but whenever I look in depth at an industry it seems that it's more than one firm doing the disrupting. That simple path, at least for me, hasn't provided acceptable investment opportunities.

To add complexity to the investment problem, demographics argue for a consistent period of dissaving as the baby-boom generation funds retirement expenses from savings withdrawals. Common sense would seem to require higher rates of return to compensate for the risk, yet the opposite seems to hold in markets for now.

And what IS the risk-free rate of return when short term interest rates have their price administered by the Fed, longer term rates are jimmied by QE2 and Chinese and Japanese government buying, and the key Asian- USD exchange rate prices bear no relation to a free market?

Quite lamentable!

GTT said...

John, your comparison with Buffett leads people astray. You neglect to mention the terms WB got on his massive equity injections into various companies in Oct 08 time frame of his famous "buy american" article. This is very sloppy analysis bordering on disinformation.

Anonymous said...

Looks like a robust recovery here--and American companies have plenty of cash to spend on more capital improvements, which should lead to more increases in output per worker.

The only potholes I see are these events we have nothing to do with--a Libya, some European debt problems, hurricanes etc.

Yes, long-term I would like less debt in the USA, but I think mild inflation will accomplish the same thing.

And if you can't find some seriously profitable, good quality companies to own shares of for the next several years, four, five, ten baggers, well what can I say. Short away, mate. Short away.

Nihoncassandra said...

indeed that may be half of it. The other half is the drag on large caps of cap-weighted ETF and market indices as the hedge of choice. This eliminates tail risk (on the short side) and allows guys (and they are guys) to get maximum bang for buck in using their weight of money to directly impact performance. A double- buggering awaits this trade during the next bout of risk-off deleveraging.

Alaric Investments said...

It is always tough investing at a top, even an interim top.

The question for you down there is how long it will be until the AUD breaks down; something must adjust to the serious purchasing power parity discrepancy down in OZ......

I cannot comprehend how ordinary people in OZ are coping with the high prices, particularly for property, but also for food and energy...

Philo said...

"The low yields that PE funds can issue debt have now resulted in low ex-ante returns for small cap investors." The same must be true for large-cap investors. Small cap and large cap are not two different worlds--short term rates are low for both. If rates are low, so is the expected return necessary to make a proposed business venture worth pursuing. Investors must accept relatively low expected returns on their equity investments when debt investments offer even lower returns. This is what the low-interest world looks like.

In short, you don't succeed in making plausible your claim that large caps are relatively cheap. (Given the greater number and greater obscurity of small caps, there will always be more small cap frauds than large-cap frauds. By the way, your work in ferreting them out is obviously socially very useful; and your posts on the frauds are quite interesting.)

"[I]t is a day to day struggle." C'est la vie!

Anonymous said...

After all of these fraud allegations over the last few months, how many do you think will fail an audit and/or get delisted in the coming weeks?

W/ the SEC investigation, it seems like this is finally going to be the breaking point when those "emperors with no clothes" companies get nailed.

Anonymous said...

I am curious whether you have looked into Benford's law and its applications in accounting forensics as a means of identifying fraud in companies you review.

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