Asset Management

Mind The Bubble: Should You Be Tracking Hedge Funds?

Hedge funds have filed their 13Fs for the reporting period of March 31 and the results are in! According to research conducted by FactSet, the top 50 largest hedge funds increased their equity exposure by 5.3% in Q1 2015. Exposure to the U.S. was increased as well as exposure to the energy sector. In addition, Apple (NASDAQ:AAPL) remained the top holding and the top purchases were Valeant (NYSE:VRX) and Qualcomm (NASDAQ:QCOM). At the sector level, the aggregate hedge fund portfolio was overweight in four sectors and underweight in six sectors relative to the S&P 500 at the end of the first quarter. The Consumer Discretionary (NYSEARCA:XLY) (16.8% vs. 12.6%) and Energy (NYSEARCA:XLE) (11.4% vs. 8.0%) sectors were the most overweight sectors, while the Consumer Staples (NYSEARCA:XLP) (6.1% vs. 9.7%), Financials (NYSEARCA:XLF) (13.4% vs. 16.2%), and Information Technology (NYSEARCA:XLK) (17.4% vs. 19.7%) sectors were the most underweight sectors.

The question is: Should we care? Well as a starting point, equity hedge funds returned 1.4% in 2014, 11.1% in 2013, and 4.8% in 2012. At first blush, these results are downright embarrassing compared to the S&P 500 (NYSEARCA:SPY) which returned 13.5% in 2014, 32.3% gain in 2013, and 16% gain in 2012. Does this mean we should conclude that tracking hedge fund ownership is a waste of time?

I would argue that the answer is no. There are many brilliant money managers out there and historically hedge funds have been able to deliver more impressive alpha than mutual funds and index funds. Past performance is no guarantee of future performance, yet lets not forget that some managers like Carl Icahn and Warren Buffett have been able to average double digit compounded annual returns over the course of their investing careers.

The problem is that this kind of success has created a large demand for hedge funds causing diminishing returns for two main reasons:

1) With the proliferation of demand, funds have gotten excessively large and managers have been pressured to allocate bigger percentages of their portfolios to large-cap stocks which are typically more efficiently priced. This has led hedge funds to track the market instead of beating it. Even Warren Buffet has famously stated that his performance would be far more compelling if he simply managed less money leading certain commentators to go so far as to say that his portfolio has become a mutual fund.

2) The second problem is tied to the fact that most managers only have a handful of great ideas. Although he gives higher weight to these ideas, he still allocates to many smaller positions in order to mitigate risk, deploy more total capital and thus extract higher management fees. This portfolio allocation ends up having a profound effect on total alpha generation.

Finally, there is one other issue inherent in the financial industry itself that investors should be weary of when tracking hedge fund ownership. In a recent Bloomberg article the author outlined the findings of a fascinating note released by Citigroup. In this note it was suggested that the financial industry, by its very nature, “is doomed to forever be blowing bubbles.” Why? Because the performance of an asset manager is often judged against a benchmark which doesn’t necessarily have much relevance to their particular investment approach. If the manager believes a particular type of asset, asset class, or even industry is overvalued he may be pressured into holding it because his supposed benchmark does. If he chooses not to, his investors may head for the exits in light of possible underperformance. This is what the Citi analysts had to say:

“A weary client once defined a bubble to us: “something I get fired for not owning”. It is career-threatening for an asset manager to fight a big bubble. For example, the late 1990s [technology, media and communications] bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fired many years ago.
Big bubbles are especially dangerous. TMT stocks already represented a large part of equity market benchmarks when they re-rated aggressively in the late 1990s. By contrast, Biotech stocks might currently be expensive but their small market cap means they are still not a big benchmark risk. You don’t get fired for not owning Biotech stocks now, but you did get fired for not owning TMT stocks in the late 1990s.
Bubbles are obvious in hindsight, but they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force sceptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these sceptics capitulate, of course they contribute to the bubble and so force other sceptics to capitulate and so on and on until there are no sceptics left to capitulate. It makes sense for an asset management company to manage its business risk but this can end up contributing to the madness. Through this, the modern fund management is almost hard-wired to produce bubbles.”

Nevertheless, tracking hedge fund ownership can be useful in order to train your mind to spot trends and find new stock ideas. The trick is to be able to separate the great ideas from the mediocre ones and spot bubbles before you join the crowd inside one.

Triumph of the Optimists: Berkshire Hathaway’s 50th Annual Letter

Most assuredly, America’s best days lie ahead of it. That is the refreshingly optimistic message that CEO Warren Buffett maintains in Berkshire Hathaway’s annual letter to shareholders released today.

Buffett has been writing such highly anticipated letters for 50 years and this year’s offering is no disappointment. Oozing with Buffett's rationality, calmness and decisiveness, it is a must read for anyone looking for guidance in the financial markets.

Here are some of its highlights:

On America:

Charlie and I have always considered a “bet” on ever-rising U.S. prosperity to be very close to a sure thing.

Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America’s problems, I’ve never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket).

The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead. (Page 7)

On Building Berkshire’s Per Share Intrinsic Value:

Charlie and I hope to build Berkshire’s per-share intrinsic value by

(1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares. (Page 7)

On Berkshire’s Performance:

Since 1970, our per-share investments have increased at a rate of 19% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the ensuing 44 years has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but our main focus is to build operating earnings. (Page 8)

On Investing:

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are Riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.

That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

…

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

…

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.” (Page 19)

On Berkshire’s Acquisition Criteria:

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3) Businesses earning good returns on equity while employing little or no debt,

(4) Management in place (we can’t supply it),

(5) Simple businesses (if there’s lots of technology, we won’t understand it),

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). (Page 23)

On The Next 50 Years At Berkshire:

First and definitely foremost, I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single company investments. That’s because our per-share intrinsic business value is almost certain to advance over time. (Page 34)

Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. Those who seek short-term profits should look elsewhere. (Page 34)

I believe the chance of any event causing Berkshire to experience financial problems is essentially zero. We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared. Berkshire played an important role as a “first responder” during the 2008-2009 meltdown, and we have since more than doubled the strength of our balance sheet and our earnings potential. Your company is the Gibraltar of American business and will remain so. (Page 34)

The bad news is that Berkshire’s long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won’t be great. (Page 36)

On The Future CEO Of Berkshire:

To further ensure the continuation of our culture, I have suggested that my son, Howard, succeed me as non-executive Chairman. (Page 36)

Character is crucial: A Berkshire CEO must be “all in” for the company, not for himself. (I’m using male pronouns to avoid awkward wording, but gender should never decide who becomes CEO.) He can’t help but earn money far in excess of any possible need for it. But it’s important that neither ego nor avarice motivate him to reach for pay matching his most lavishly-compensated peers, even if his achievements far exceed theirs. A CEO’s behavior has a huge impact on managers down the line: If it’s clear to them that shareholders’ interests are paramount to him, they will, with few exceptions, also embrace that way of thinking. (Page 36)

My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency. When these corporate cancers metastasize, even the strongest of companies can falter. The examples available to prove the point are legion, but to maintain friendships I will exhume only cases from the distant past. (Page 37)

If our non economic values were to be lost, much of Berkshire’s economic value would collapse as well. “Tone at the top” will be key to maintaining Berkshire’s special culture. (Page 37)

All told, Berkshire is ideally positioned for life after Charlie and I leave the scene. (Page 37)

On Why Berkshire Under Buffett Did So Well:

Only four large factors occur to me:

(1) The constructive peculiarities of Buffett,

(2) The constructive peculiarities of the Berkshire system,

(3) Good luck, and

(4) The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press. (Page 41)

3 Things To Think About When Investing In Startups

Recently I was out to dinner with a group of friends and one of them said to me: “Hey man I’ve invested in this incredible startup. You should really check it out and consider getting in.” This is a line that I have been hearing with increasing frequency over the last year and it is usually followed by some variation of “I’m so excited” or “they are doing something totally awesome”. As an investor in a tech startup I must admit that I too have fallen victim to such exuberance in the past but now with a bit more experience my attitude to such things has begun to change from one of blind optimism to one of realism or perhaps dare I say it (gasp) skepticism.

Why should we be skeptical when evaluating the merits of investing in a young company? We all know the entrepreneurial success stories that the media reports about ad nauseum; the Ubers, the WhatsApps, the AirBNBs, the Facebooks, the Twitters that went from zero to hero valuations at breakneck speed making their early investors wealthy in the process. In addition, it has become easier than ever for us to invest in such early stage companies through the proliferation of such ventures as well as online crowd funding platforms. In fact, the glamorous tales attached to these stories have become the stuff of legends immortalized by the news media and even Hollywood. Pay attention to the media and you could be led to believe that these golden boys are being minted everyday and thus the last thing you want to do is miss the next boat to adventure, freedom and prosperity. Time to jump aboard….right?

Make no mistake investing in a startup can be very lucrative as returns can go as high as 100 times your initial investment. But you can also lose your entire initial investment. So before you drink the Kool Aid and get into “the game” be aware of the following:

1) Are you ready and willing to lose every penny of your investment?

The bottom line is that making a startup successful is extremely difficult work. Contrary to the small statistical samples of success touted by the media, studies undertaken by Harvard Business School indicate that 3 out of every 4 venture backed start-ups fail to return investor capital. The numbers for tech startups are even worse at a 90% failure rate. Therefore, it is important to remember the precarity of any early success founders use as investor bait. For start-ups things can change very quickly and when things go wrong you probably won’t get any notice. Some common issues to be wary of are: What if the competition launches a new and better product which threatens the early traction the company has attained? (Not to mention that it has never been easier to launch a tech company given the availability of cheap developer tools and platforms.) What if Google or Facebook enter the space? What if another recession hits? What if one of the startup’s anchor clients decide to leave the platform? What if the company has a bad month of sales and can no longer meet expenses?

These very real possibilities beg the question: What kind of investor are you? As Dan Martell one of Canada’s top angel investors would say: “If you don’t have $150,000 you’re willing to put on black in Vegas and roll the dice, then you shouldn’t be angel investing.” To invest in startups requires a very high-risk tolerance and if you are not ready to write off your entire investment then look elsewhere.

Risk mitigation tips:

If you still want to invest I suggest investing no more than 10% of your money in startups and not investing it all in any single startup. Instead, it is quite possible, given the proliferation of online platforms, to invest equally in over 5 ventures enabling one winner to make up for any losers.

2) Are you going to need your money any time soon?

In investing parlance there is a crucial concept called liquidity. What this refers to is the degree to which an asset or security can be bought or sold on the market without affecting its price. In the case of startup shares there will be little or no liquidity and thus if you want to sell your shares you probably can’t or if you can only at a steep discount. Most likely, the only way you can get out is after the company has a liquidity event (IPOs or acquisitions) or exit (someone buys the shares hoping to make a profit during a round of financing).

The crucial takeaway is that these events take time to occur (often 3-5 years and sometimes even 10, if ever). Furthermore, be aware that although most companies die around 20 months after their last round of financing raising $1.3 million, many start-ups limp on for years, out of the public eye but still attached to the intravenous of early investor money. This is tied to the “hypomania” that many entrepreneurs suffer from that can be characterized by immense self-confidence, recklessness and over-optimism.

Risk mitigation tips:

Bone up on your behavioural psychology and spend time evaluating the personality of the founders. What kind of people are they? What kind of exit do they envision and how feasible is it? Also be prepared to lock up your investment for the next 5-7 years.

3) Be honest with yourself about your own business experience and expertise

We simply can’t know everything about everything and to be a successful startup investor it is essential to have a solid understanding of the business that you are investing in. This is the crux of good investing as without a good working knowledge of the performance metrics that matter in the particular industry or market niche within which the startup is operating you are setting out to learn a potentially painful lesson.

Risk mitigation tips:

If you are dead set on investing in a startup, first, try to create a list of what you know. Do you work at an advertising company, an online retailer, a medical technology company or a social media company? You may find that you know more than you think. Do your research and try to connect what you know to a startup that is trying to make something work in an industry you understand. This will help you make better decisions and may also allow you to help the young company grow once you have invested. Finally, if you haven’t the slightest idea about how to value a company I would strongly suggest taking an online course or at least reading a textbook on valuation and corporate finance.

Simply put, investing in a startup can certainly be a rewarding learning experience yet it is important to be prepared and to approach “the next big thing” with a healthy level of skepticism.