Monday, July 25, 2011

Competition and managing money

I had a long chat the other day with a long-only global fund manager. He observed (correctly I think) that conditions for private-equity takeouts of companies are as good as they have ever been. Debt is very cheap (low interest rate loans with weak covenants seem readily available) and many private equity funds have plenty of money which they have to spend or give back to their investors.

He was putting together a basket of stocks which he thought private equity would buy.

I tried thinking this way and whatever basket I came up with contained some very unattractive stocks.

Private equity has been doing some strange deals and indeed we are reversing several private equity takeovers in the hope (probably vain hope) that the private equity firm will come to its senses and not close the deal. Private equity firms are buying frauds at an unprecedented rate - which is not much fun if you are short the said fraud. (And it is not just in China.)

But for the last 18 months being long a bunch of things that might get taken private has been a winning trade - those stocks have appreciated irrespective of whether they actually caught a bid.

And being long a bunch of things that have no hope of being taken private (eg large cap techs, family controlled German companies with dual voting structures) has under performed.

And I have been (at least on the long side) with the under-performers. But it feels safer to me...

A fundamental difference in the view of how you make money in markets...

Underlying this is a fundamental difference in view about how you make money in markets. I always had embedded - deep in my psyche - the notion that the best place to look for investments is where nobody else was looking. You wanted to buy what was unfashionable but better than current fashion suggests - straw hats in winter because summer would come - and in that case you would only need to wait six months. The best response to competition was to avoid it rather than compete with it.

My friend's basket of stocks contained only businesses that the new power on the street (private equity) was looking at.

My friend wanted to buy what was going up in price - and what was going up in price was what the private equity firms (who were loaded) were going to purchase next.

My friend's attitude to competition is buy what they want to buy and sell it to them later at a higher price.

And so far he has been right.

And I have been wrong.

The new "value" is in stocks that are too big or too difficult for Private Equity. Microsoft and Cisco both have cash adjusted PEs well below 10. They are too big. Target and Walmart are about 12 times earnings. Same story. The German family concerns could also be purchased at low levels. Coca Cola - the definitive Warren Buffett stock is back at 12-13 times earnings for the first time since Warren Buffett originally purchased it.

And frankly nobody is interested - these stocks under perform.

And if you buy something that is cheap you might find even more problems come out of the woodwork (try Yahoo and Alibaba for a recent high profile example).

Many of the great value orientated investors are having a bad time this year. If it were not for our shorts we would have not had a fabulous time either. I don't think the value guys are wrong here - but it has not been fun - and it sure is getting frustrating.

Maybe out performance will be if the market turns really sour and the value stocks only drop 15 percent whilst the stuff private equity never got around to buying drops 45 percent. But that is hardly the fun form of out performance.

We have had very strong performance and not done great on longs because our shorts have been so accurate. But many of the best investors I know are having a hard time - and I keep imagining and hoping their (and their client) suffering is temporary. Because I don't think I am going to buy my friend's long stock basket. Too hairy for me.

Meanwhile I am becoming totally reliant on the short book for out performance. I wish I had more arrows in the quiver.

For comment.



David Merkel said...

I have found this environment difficult as well. More difficult because for the first time, I am investing external assets, which is a real burden.

Anonymous said...

The tongue-in-cheek comment is that if you are long some large French banks (I recall you saying you were optimistic French banking--correct me if I'm wrong), you may lose more on those longs than you can ever make on you shorts :)

I am not too familiar with KO, but CSCO was showing very low sales growth and some pretty amazing cost increases last time I checked (maybe 6 months ago?), along with customer financing that I was uncomfortable with.

I am following AAPL, though, and I see a market cap that is approaching that of XOM (!?!). IBM is also making all time highs. BHP is close to all time highs. etc So I don't believe your statement of large caps being cheap is completely accurate.

As to the larger, private equity pushing up prices--that is somewhat true, but I think really the problem is that it's just too scary to short any market right now, and so there's no mechanism to return the market to short-term reality. In a speculative environment, the most speculative junk goes up the fastest. That's what we are in right now (not a frothy market--just a highly speculative one).

John Hempton said...

I am still long some French banks - but not the large ones. And I still like the stocks.

Credit Agricole - my favorite of the large French banks - has enough money lent out to periphery Europe to wind up in some trouble - but not enough to Greece alone.

Its Greek position however is that owns Emporiki - the number 5 Greek bank - not pretty.

We broke even on our Credit Agricole position (and I sold it). I am still short some European banks more generally so I am comfortable enough with that.

I do not own CSCO - and of all the large cap tech it is the one I am least comfortable with.

But I maintain my view that the stuff that PE cannot buy is acceptably priced as a rule - and the stuff they can buy is outrageous as a rule.

And we are up better than 50% this year - so I can't complain - but it has not come from the longs.


Richard said...

You are not the Lone Ranger ...
The behaviour of my "alternative" allocation is my only solice.

Anonymous said...

I believe that CA was also the best of the large French banks (I haven't looked at the small ones). My biggest (French) worry at the moment is BNP--then again, I'm just an amateur at this. Some of those Belgian and Austrian financials also look pretty scary.

Could you please explain why hedge funds are not doing the rational thing, which is to buy large caps and short small caps (PE targets) until the values realign? I could be wrong, but my understanding is that PE and the long/short hedge funds are in the end both basically both funded from the same pile of money--why, then, is the PE long camp winning?

50% is absolutely incredible--especially if you only got this from the short end!! (And NOG hasn't even panned out yet)

I wouldgot killed on that Yahoo mess...Not sure what real lesson to derive from it, except to not bet on foreigners' abilities to make money in the Chinese markets.

Great blog, btw

John Hempton said...

The Austrian financials are truly diabolical.

I own no big cross-border European banks - but I own some small ones which are (alas) indirectly exposed.

Our returns have been abnormally good - but from the short end and with puts and the like. Can't last.


Anonymous said...

What do you think of the Australian banks?

Do you own any Australian stocks?

Wilfried said...

Great post, good to see that the original JH is back.

Shorting frauds or going long PE takeover stocks are short-term strategies. Following success stories is basically medium-term, though the fun can last some time (e.g. AAPL). What about the long term? Here the macro picture will play the decisive role and I believe the future will be inflationary. Doubters should a)read today's FT piece 'Wheel of fortune turns for miners', b) note that the only ways out of the current debt morass are bust or inflation via currency debasement, and c) read C.Bresciani-Turroni's book 'The Economics of Inflation' which was anyway recommended by Marc Faber some time ago.

In inflationary times vertical integration is the appropriate corporate strategy. It happened on a large scale in Germany from 1919-1923 (e.g. executed by Stinnes). And the biggest companies with the most cash will buy smaller ones in the production chain. So the big miners will probably be integrators, or will Arcelor Mittal buy a miner? Plenty to ponder about in other industries as well. Insourcing is to be expected, too, so pick your takeover targets. And banks generally do badly in inflationary times.

John Hempton said...

1. I own no Australian banks. Too much risk for me. Not obviously bad lending - but clearly an asset bubble. And the AUD is high - so would rather buy non AUD assets.

2. We have been minting money on the shorts - and that money has been going into large cap longs which we think are cheap enough.

3. That has been mostly so-so - but we kept buying Google all the way down. That turned out OK.

4. I do not think large cap CHINA EXPOSED stocks are particularly cheap. BHP is outside my ken.

5. I wish I had as many profitable long-strategies - as I have profitable short-strategies. We got buckets of profitable things to do on the short side - and we need longs for risk management - I just wish I could make pots of money on the longs too - and I can not.


Anonymous said...

Would you agree it's a bit of a luxury problem?

Anonymous said...

this is the one big problem with vale investing: you are buying things which are out of fashion; when the fashion returns, they will all ramp up very quickly, but fashion is fickle and it could be a very long time until it comes back. there isn't much for it but wait. hopefully your low PEs have high dividends to collect while you wait?

curious to learn about your European bank exposure. do you hold any European bank sub debt?

John Hempton said...

Our returns are so good this year that problems of not taking enough risk on the long portfolio is a luxury problem.

But it was not last year. Calendar 2010 we actually lost money on Chinese fraud shorts! And we finished the year up 9% after struggling all year. It sucked.

And it will not be a luxury problem in the future.


Oh, we do not own any European sub debt - but have been looking at some pieces. Really a bet on sovereign solvency and the willingness of sovereigns to take pain.


Tsachy Mishal said...

I agree that the value is there in large cap tech. I believe a large part of the problem is that these companies hoard much more cash than is necessary.

CA Inc. is a good example of such a company. They trade at a forward free cash flow yield (to EV) of 14%. Yet they hold a net $1.5 billion in cash and are letting that number grow.

If companies such as CA and MSFT would buy back shares more aggressively I believe the valuation would correct rather quickly. For some reason tech CEOs believe they run companies for themselves, more so than in other industries, and could not care less what shareholders think.

Anonymous said...

If you are having great returns on the short side, just look for longs that will lose the least money.. risk management done!

John Hempton said...

I wish it were that easy - but I seriously doubt that we will continue making money on the short side like we have this year.

The last 4 weeks have not been brilliant either - but the year has been amazing.


Nah - I need more arrows in the quiver.

Anonymous said...

I realize you get paid to “manage” money, but at what point are you just buying longs for the sake of buying when you could be better servicing your investors by staying out of a market where the long case is tough to make and by all indications isn’t going to “run away from you” anytime soon. There’s still a lot of global instability and the chances the boat right itself quickly is very slim, IMO. Is something you’ve considered or are you basically obligated because of the fund style?

GB said...

Would love to hear further comments/posts from John (& Anonymous) on what it is about the Austrian financials that look diabolical. Which banks in particular? Is it exposure to eastern and southern Europe that's the problem (there doesn't seem to be an asset bubble within the country).

John Hempton said...

The real advantage of the longs is the inverse correlation to the shorts...


Tom said...

During the dot-com bubble, Warren Buffett was frequently insulted for his value-based approach to investing. What a fuddly-duddly old man, said the critics. Paint companies? Underwear companies? Insurance? That's old economy. The man's out of touch. He might be senile. The future is in selling pet food over the Internet.

After the burst burst, Warren Buffett became hailed as a genius.

True value will always be realized. It may take years -- it may take a decade -- but it will happen.

Adrian Meli said...

John, agree completely on the cheapness of a lot of larger companies. However, one thing that the static valuation analysis misses is that ultimately you are short M&A and the companies with huge cash hoards that cannot grow have an insatiable desire to grow. It would be one thing to make small tuck-in acquisitions, but we are starting to see the money burning holes in their pockets. Very few larger companies return most of the cash their businesses generate so the math on these businesses is tougher than it should be. Not many add value through acquisitions, etc.

Anonymous said...

I am no expert, just some random dude. But the elevated values of stocks that private equity may buy may be as much correlation as causation. Such companies are also often, though not exclusively, of poorer quality (lower ROA, etc.), and often have greater (though not unmanageable) debt. I'm not sure these companies have gone up because they are available for private equity to buy. These companies have hugely benefited from both extended low interest rates, and the rise in the economy, as their profit-growth started from a much lower basis point and, percentage-wise, has been greater. Whereas, a company like MSFT, in addition to being large, gets vastly less benefit from the low interest rate environment, and gets so irritated about it that it even starts taking on unecessary debt. I'm sure you know all of this, and vastly more. Anyway, I own shares of MSFT, GOOG, KO, etc. I think they all hold long-term value and will outperform over a full economic cycle. But I think if one wants quality longs that will truly outperform in this environment, one needs more of a Phillip Fisher outlook, with less focus on P/E, and more of a focus on PEG, management quality, and consequently a focus on stocks that will legitimately continue to grow faster than expected, and for quality reasons. At the high end of market cap, that points to an AAPL, while at the low end it points to stocks like ISRG, and in the middle COST, etc. Mabye WFMI, too. As I have watched my quality large caps languish, I have bought on lows (JNJ under $60, KO around $61, ABT around $47) and sought more "long" outperformance by buying 1/2013 LEAPS on my most confident pick, MSFT, which so far are up around 100%, though that is (and will remain for some time) an unrealized gain. I got hammered 18% on my CSCO purchase so far, though I'm holding it. I own every stock mentioned in this comment except WFMI and COST. But I'm an individual and not a professional investor, so what do I know.

Anonymous said...

KO is most definitely not 12-13 P/E. It is about 17x forward. Trailing earnings contain a large one time gain.

OB said...

John - I see a post about a year or two or three years in the future that says briefly:

I strayed from my style, I lost money, and I wish I stuck with investing in cheap cash-flows. It's better to be wise than a fool buying high to sell higher to an even greater fool.

Remember that risk is a component of returns...regardless of outcome.

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