Episode #44: Invest with the House
Guest: Episode 44 is just Meb.
Topics: Last week’s solo “Mebisode” was met with lots of positive feedback, so we’re going to do one more in this format before we return to interviewing guests. Therefore, in Episode 44, Meb walks us through his book, “Invest with the House, Hacking the Top Hedge Funds.”
Picking stocks is hard—and competitive. The most talented investors in the world play this game, and if you try to compete against them, it’s like playing against the house in a casino. Luck can be your friend for a while, but eventually the house wins. But what if you could lay down your bets with the house instead of against it?
In the stock market, the most successful large investors—particularly hedge fund managers—represent the house. These managers like to refer to their top investments as their “best ideas.” In today’s podcast, you will learn how to farm the best ideas of the world’s top hedge fund managers. Meb tells us who they are, how to track their funds and stock picks, and how to use that information to help guide your own portfolio. In essence, you will learn how to play more like the house in a casino and less like the sucker relying on dumb luck.
So how do you do it? Find out in Episode 44.
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Transcript of Episode 44:
Welcome Message: Welcome to the Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investment and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinions of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor: Today’s podcast is sponsored by YCharts. YCharts is a web-based investing research platform that I’ve been subscribing to for years. In addition to providing overall market data that offers investors powerful tools like stock and fund screening and charting analysis with Excel integrations, it’s actually one of the few sites that calculates both shareholder yield as well as 10-year PE ratios for stocks, 2 factors that are notoriously hard to find elsewhere. The YCharts platform is fast, easy to use, and comes at a fraction of the price of larger institutional platforms. Plans start at just 200 bucks a month, and if you visit go.ycharts.com/meb you can access a free trial and, when you do, you’ll receive up to 500 bucks off an annual subscription. That’s go.ycharts.com/meb.
Meb: Hey, podcast listeners. This is Meb…here solo today. I’m in somewhat of a foul mood after Virginia got bounced, yet again, from the NCAA tournament by almost 30 points. The good news, I was watching the game on Catalina so I wasn’t too depressed out on the ocean having a few beers, but I thought today we’d do something fun. First, I’m gonna give you guys a gift. I’m gonna make available to every podcast listener a free copy of my most recent book. This is called “Invest with the House: Hacking the Top Hedge Funds.” This is a really interesting book and topic, particularly for me. It’s something that goes back all the way to the late ’90s, was when I started working on this research. I think there’s a lot of misunderstanding on this space so I really wanted to talk about the hedge fund space.
If you guys haven’t started watching “Billions,” it’s really a wonderful show. I know I’m a little late to the game there, but it’s a pretty great show. And so there’s a renewed, rekindled interest in hedge funds. So I wanted to read a few chapters from this book and see if you guys like it, but you can go download a free copy at freebook.mebfaber.com and you’ll get a PDF and then you can read that anywhere. So, we’ll get started. I’m gonna read but I’m also gonna interject a little bit, maybe with some comments, some stories, etc. And if you guys like this, I don’t know, we’re trying a lot of experimental things. You know, this could even be a weekly feature where we profile some of these managers, their holdings, what are they buying, what are they up to, ones you shouldn’t follow, ones you should. Let us know. Shoot us feedback at the mebfabershow.com.
Again, please, one caveat, by the way, since I’m giving you this free book…It’s only $9.99 but I’m giving you a free book…we’d really love a review on Amazon. It’s my least-reviewed book for some reason but, again, freebook.mebfaber.com. Let’s get started today with “Invest with the House: Hacking the Top Hedge Funds,” published in 2016. On the back cover of the book I have a quote, which also starts the book, and it’s from, I think, 94-year old Charlie Munger. I just went to the Daily Journal meeting a few months ago in L.A., and what a national treasure he is. Charlie is the best, one of the, still, brightest people you’ll ever meet. But here’s a quote, and I put this on the big letters in the back of the book and it says, “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting there and trying to dream it all up yourself. Nobody’s that smart.”
So, chapter one, we start with that quote and it’s called “The casino can be beat.” Stock picking is hard, really, really hard. The odds are stacked against you. My friends at Longboard Asset Management completed a study called The Capitalism Distribution that examined stock returns from the top 3000 stocks from 1983 to 2007. By the way, J.P. Morgan has also published a paper on this as well as another academic, we’ll link to them in the show notes. We’ve also had a great podcast with Eric Crittenden [SP] of Longboard and one of the earliest podcast episodes. Check those out. Anyway, they found that 64% of stocks underperform the broad stock market index. Thirty-nine percent of stocks were unprofitable investments. Think about that for a second, almost half. If you just picked a stock, threw a dart against a wall, almost half are unprofitable investments.
Nineteen percent of stocks lost at least 75% of their value and 25% of stocks were responsible for all of the market’s gains. Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic index fund and a 39% chance of losing money. Not only is it hard to pick stocks, but you’re also up against the most talented investors in the world. People like Ray Dalio, who’s a founder Bridgewater Associates, the world’s largest hedge fund. Dalio is fond of comparing stock market investing to a poker game and his description brings to mind the old saying that “If you sit down at a poker table and you don’t know who the sucker is, then you’re the sucker.” Dalio has spent oodles of time and money to make sure he’s not the sucker.
Here’s how he once described his investment methods using this poker analogy, “The bets are zero sum. In order for you to beat me in the game, it’s like poker, it’s a zero sum game. We have 1,500 people that work at Bridgewater. We spend hundreds of millions of dollars on research and so on. We’ve been doing this for 37 years and we don’t know that we’re going to win. We have to add diversified bets so it’s very important for most people to know when not to make a bet because if you’re going to come to the poker table, you’re going to have to beat me, then you’re going to have to beat those who take money. So the nature of investing is that a very small percentage of people take money, essentially in that poker game, away from other people who don’t know when prices go up whether that means it’s a good investment or if it’s a more expensive investment.”
With a superior stable of research investment talent, Dalio figures he can beat most of the other players at the table, and he does. His Bridgewater Fund posts investment returns that make others jealous. He does it year after year. Here’s what’s really interesting though, he’s not the only one. A special few have done it as well, beating the market year after year. They don’t all do it in the same way or with the same investments. Some have done it better than others and some eventually falter, but the fact is it happens and it does so with some consistency. Now, we make two assumptions that are vital to the arguments in this podcast and book. There are active managers that can beat the market i.e. the market is not completely efficient, and two, superior active managers can be identified ahead of time.
These two concepts are difficult for many investors as well. There’s a general feeling that the market can’t be beat and it is tough to get past that belief. The big challenge is separating luck from skill, but would anyone deny that some people are better than others at stock picking? Just like any other profession, the investment field has top experts who are paid handsomely for what they do. Warren Buffett of Berkshire Hathaway certainly comes to mind, one of the most famous stock pickers of all time with an estimated net worth of more than $70 billion. He’s also one of the richest people in the world. The 2014 Berkshire Hathaway annual report indicates that the per share market value of the company has increased at a compounded rate of 21% since 1965 compared to an average of about 10% for the S&P. The outperformance is striking.
In fact, there was a businessman from Singapore in 2014 that paid over $2 million in charity auction to have lunch with Buffett. But a lot of people don’t know that it’s possible to learn some of Buffett’s wisdom for a lot less. In fact, it’s possible to learn what stocks he’s buying and selling for free. One of the most basic principles of U.S. stock market is transparency, and it’s a characteristic that has helped make our stock market so attractive to investors around the world. Of course it isn’t always transparent and there are noticeable lapses in scandals and shenanigans. But in one particular area, transparency works very well and that is the area that forms the data source for this book. Under SEC rules, any professional fund manager with more than $100 million in U.S. listed assets must report their stock holdings.
That means great stock pickers, such as Warren Buffet, must disclose their stock picks. You may already be aware of this, but many are not. Thanks to the internet, you can now look up any of these fund holdings online from the SEC website. It’s one of the most valuable sources of market information around. It is simple and easy to access and it gives you a window into the trading activity of the greatest managers. Sadly, not many investors take advantage of it. Instead, most get their investment information from their brokers or TV talking heads or they pick up a stock tip from a friend or neighbor. As a recent TIAA-CREF study illustrates, people actually spend more time picking a restaurant or researching which TV to buy than they do planning their retirement investments.
But consider what you get when you examine these SEC filings. You have access to the stock picks made by fund managers who often spend millions of dollars and every waking moment thinking and obsessing about the financial markets. If you think this statement is an exaggeration, note there’s hedge fund managers who lease satellites to track the department store traffic and resulting sales estimates. These stock picks are the result of painstaking work done by people significantly more capitalized than you, who have way more resources than you, and who, if you select the right ones, are way better than you at picking stocks. The best ones know everything there is to know about a company before they invest.
Lee Ainslie, portfolio manager at Maverick Capital, who we exam later in the book, has to say this about how obsessive Julian Robertson of Tiger Management was when examining companies, “Julian was maniacal on the importance of management. ‘Have you done your work on management?’ ‘Yes, sir.’ ‘Where did the CFO go to college?’ ‘Um, um…’ ‘I thought you did your work?’ He wanted you to know everything there was to know about the people in the companies you invested in.” This is a competition. Do you know where the CFO went to college? Do you even know who the CFO is? Do you even know what a CFO is? In case you don’t, by the way, chief financial officer.
So to go back to the poker analogy, examining SEC filings is like getting a peek at the cards held by these investment managers. It’s a great way to learn from some of the brightest minds in investing in the world. Would you rather play with them or against them? This book and podcast will begin by examining a case study, how an investor could’ve bought Buffett’s stock picks to great success. We will examine the performance of his stock picks in the past and determine how well they performed, a process called backtesting. This can tell you how you might have fared if you had piggybacked on Buffett stock picks in the past. While it doesn’t tell you how a manager will perform in the future, it does give you a record of performance from which you can draw your own conclusions.
Logic suggests that a manager who outperforms consistently must be pretty good at what he does. Will he do it again next year? No one ever knows for sure but, again, logic suggests the odds are in your favor if you select and follow a manager who has a demonstrated record of success and then prudently add some of his picks to your own portfolio. Buffett is an obvious choice to start with. He’s the first of 20 of the best investors in the world whose background and track records we’ll examine. I provide a brief overview of the process of following these star managers along with some case studies that demonstrate the manager stock picks in detail and how the portfolios would’ve performed since the year 2000.
You can then build a stable of these managers and use them as your own personal Idea Farm for stock ideas to research and possibly implement to your own portfolio. The process I outline is an effective way to track and potentially copy the stock picks of some of the best stock pickers in the world. Let’s get started. “Berkshire Hathaway: Warren Buffett and Charlie Munger,” chapter two. “Techniques shrouded in mystery clearly have the value to the purveyor of investment advice. After all, which witch doctors ever achieved fame and fortune by simply advising, “Take two aspirins?” That’s Warren.
Warren’s one of the most famous investors of all time. His Omaha-based Berkshire Hathaway is one of the most successful investment companies ever. His pronouncements are so revered that they have earned him the nickname, “The Sage of Omaha.” Buffett practices a style of stock selection called value-investing and he’s always given credit for his success to the techniques and principles he learned from his mentor, Benjamin Graham who’s the author of the legendary tome “Security Analysis,” first published in 1939, and “The Intelligent Investor,” first published in 1949. Graham ran his own investment partnership for years, ground on the concept of buying stocks that were cheap compared to their intrinsic values. He preached buying securities that had a “margin of safety.”
But while Buffett has spent his entire life making money through value investing, Graham ended up reconsidering some of the basic tenets of the practice. Graham decided that the investment world had changed so much over time that the markets had become much more efficient, making it too difficult to make money by looking for undervalued stock gems. He began to adopt the efficient market hypothesis, which holds that the market is so efficient that stock prices always incorporate and reflect all relevant information, which make it all but impossible to beat the market through stock selection. Graham discusses his conversion in the market efficiency in an article from “The Financial Analyst Journal” in 1976. “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.
This was rewarding activity, say, 40 years ago when our textbook “Graham and Dodd” was first published, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalue issues through detailed studies, but in light of the enormous amount of research now being carried on, I doubt whether, in most cases, such extensive efforts would generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the efficient market school of thought now generally accepted by the professors.” And it’s funny, Graham came to this conclusion prior to the advent of the internet, Bloomberg, and other modern research tools.
The efficient market hypothesis that was making the rounds through academia and investing public at the time suggests it is nearly impossible to beat the market through stock selection. We’ll call it EMH from now on. So EMH is where Buffett and his mentor parted ways. Buffett has famously dismissed the EMH stating, “I’d be a bum on the street with a tin cup if the markets were always efficient.” For Buffet’s style of value investing to be successful, the efficient market theory must not be valid. If it were, there’d be no value stocks to be found. Buffett himself has said, “The disservice done to students and global investment professionals who have swallowed EMH has been an extraordinary service to us.”
It is my view that Buffett is correct on this point and, for proof, one need to look no further than his investment record or the records of any other number of successful managers who employ a similar value investing style that seeks to capitalize on market inefficiency. Today, an investor who wants exposure to Buffett’s investing acumen can invest in any number of mutual funds that share the Buffett investment style. When he closed his early investment partnership in 1969, he advised his investors to place money in the Sequoia Fund, which reopened in 2008 for the first time since 1995, which by the way, became a subject of a bunch of media scrutiny dealing with their valiant investment, which became a huge concentrated portfolio. Maybe we’ll talk about that later but I wanna skip over that for now.
Tweedy Brown family of funds was another good example. In fact, several employees of the old Graham Newman partnership founded the firm. While Buffett has gone on to deploy hedge fund techniques such as currency and commodity trading, merger arbitrage, convertible arbitrage, catastrophe bonds, pipes, and private equity, he’s mostly known for his stock picks. There’ve been numerous books that have tried to define exactly how Buffett goes about selecting his investments. The American Association of Individual Investors and Bolidia [SP] Capital Management have developed screens that are designed to find companies that Buffett would buy based on criteria he’s promoted through decades of public speaking, annual reports, and prior transactions.
AQR Capital even published a white paper entitled “Buffett’s Alpha” that attempts to distill his process down to a single algorithm. Some investors simply buy Berkshire Hathaway stock, gaining access to his portfolio management skills, exposure to the operations of an insurance conglomerate, an entry into the Berkshire Hathaway annual shareholder meeting, which I highly recommend attending, by the way. But why not just buy what Warren buys? We set out in this chapter to examine whether following Berkshire Hathaway’s investments through government filings could offer the investor the opportunity to piggyback on Buffett stock picks and consequently achieve outside returns. We will get there shortly, but first a little background.
In 1975, Congress passed section 13F pursuant to the Securities Exchange Act of 1934. This measure required the manager of every institutional fund with assets under management over $100 million to report its holdings the SEC once a quarter. Congress enacted this legislation to improve the disclosure and transparency of these big firms with the hope of increasing confidence in the financial markets. In the early days, accessing these records, called form 13F or form 13F-HR, was difficult and tedious. These days, the forms are uploaded to the SEC website and an investor can view the holdings 45 days delayed after quarter end. By reviewing the 13Fs you can see and dissect the holdings of every manager from Soros to Klarman to Carl Icahn to Warren Buffett, all for free.
The SEC maintains these filings on [inaudible 00:17:55] database and posts the electronic versions of 13F filings within a day of receiving them. Other websites including Edgar Online, Bloomberg, FactSet, Line Shares, aggregate the information in a more usable and searchable formats, often for a fee. The electronic data go back to late 1999, although the archives in Washington, D.C. contain paper records that go back further. There’s also a lot more websites in the back of the book under resources. Remember the book’s free, freebook.mebfaber.com, where you can look these up. So to reach the Berkshire filing page, all an investor’s gotta do is visit the SEC website, search under company name for Berkshire Hathaway, laundry list of filings pops up.
You can search through them for any of the 13Fs or you can narrow it by typing 13F in the type box. Since they’re published within 45 days after a quarter end, the quarter that ended June 30th, 2016 would be available around August 15th. Examining this 13F from Berkshire reveals a laundry list of longtime Buffett holdings you’ll be familiar with such as Coke, AmEx, Wells Fargo, and Coca-Cola. The SEC filing format is a little difficult to read and comprehend. Again, a number of websites publish the current holdings, like Whale Wisdom, in a much more readable format. And this information is, indeed, interesting but can it be of any value? After all, the data is 45 days stale when you see it and the manager may well not even own a particular stock by the time the 13F is posted.
In addition, he may have added a stock at the start of the 90-day reporting cycle so a new stock could have been purchased as long as 130 days ago. To further muddy the waters, some managers game the system by omitting certain recently acquired holdings and then filing an amended 13F form later. But even with all these delays, there’s plenty of rich data here that you can use by sticking with managers who have a long holding period. The delay in reporting time should not be a major factor in your own performance if you’re trying to piggyback them. In Buffet’s case, has stated that his favorite holding period is forever, so turnover should not be a big issue.
The major value added in investing process from the managers in this book we’ll examine is actually in stock picking, not in market timing. The portfolio’s I’ll track are long only, while most hedge funds are short, or long/short, and also use derivatives to hedge or leverage their ideas. But these positions do not show up in the 13F filing, they will not concern us here. So here’s the methodology. One, download all the 13F quarterly filings back to 2000. Two, create historical stock portfolios including all stocks that are no longer traded due to de-listings, buyouts, mergers, bankruptcies, etc. We also include all dividends, cash stocks, special etc. We then equal weight the top 10 holdings with a 10% weight for each stock.
In reality, if there’s more than 10 holdings I simply use the 10 biggest, as the majority of a manager’s performance should be driven by his largest holdings. Investors could also weight the holding similarly to how the manager weights them in his portfolio, but let’s just use a simple example for this book and podcast. In reality, it actually doesn’t matter that much. Four, rebalance, add and delete holdings quarterly, and calculate performance as the 20th day of the month to allow all filings to arrive. As for the backtesting, it’s not realistic for an individual investor to go and do this work on their own. Even finding historical stock databases is problematic. The good news is I’ve done this for you. You can follow along in the pages that follow.
So using the methodology that we just presented, the simulated results for the period 2000 to 2016 are found here. Let’s see, I’ve actually updated this through 2016. The book only went through 2014, but we had a laundry list of holdings. You’ve got Kraft, Wells Fargo, Coke, IBM, AmEx, Philips 66, all these good dudes, Apple, the big news lately, of course, the airlines, which they’ve started buying. First observation is how mediocre the returns have been for U.S. stocks over the past 16 years, which is right around 5% a year. That’s much less than the historical 10% that we’ve experienced back to 1900. How did the Berkshire portfolio do? They did 9.7%. Drawdowns were roughly about the same, the Berkshire portfolio, 43%. S&P had at 50.9% drawdown.
Buffet’s equity selections outperformed the indices quite substantially. Volatility was reasonable, which is a little bit surprising given that the portfolio only contained 10 holdings. If you ran a mutual fund with these numbers, you’d be one of the best performing managers in the United States. Again, that’s Buffett outperforming by five percentage points per year since 2000. There’s another study by some academics titled “Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway,” and it found a similar method to ours would have resulted in returns over 10 percentage points higher than the S&P if you went all the way back to 1976. In a more recent paper entitled “Buffett’s Alpha,” by AQR, found similar results.
So one question many readers and listeners often ask, how does the cloning strategy perform versus just buying Berkshire stock? So it turns out, the good news is either strategy works great and beat the S&P by about four to five percentage points per year and note that the outperformance has occurred while Buffett and Berkshire have underperformed the S&P since the bottom in 2009. In fact, this clone has underperformed the S&P 500, 7 of the last 10 years. We were unsure if 2016 was gonna be a underperform year or not, but I think he squeaked out, barely, by the end of the year by like 10 basis points. So 7 out of 10 of the last years he’s underperformed, which is a massive, massive amount.
All right, so now we have a decent base case upon which to build. Next chapter, we’re gonna examine some of the pros and cons of following 13Fs. I like to be honest about any investment approach and you wanna look back historically and make sure that you know both the good in the bad. “My mantra is diversity. I clone my mentors. I copy everything they do and then I innovate on top of it.” That’s Henry Markram. So to summarize some of the differences in managing portfolio based on 13F filings versus allocating an investment to an active hedge fund manager, the following list may be helpful.
Pros: One, access. Many of the best hedge funds are not open to new investment capital and if they are, many have high investment requirements, in many cases, in excess of $10 million. As Mark Yusko of Morgan Creek Capital says…and by the way, he’s got a great podcast episode earlier in the year…”We don’t wanna give money to people that want our money. We want to give it to people that don’t want our money.” A 13F tracking strategy allows investors to follow otherwise inaccessible managers.
Pro number two, transparency. The investor controls and aware of exact holdings at all times. If an investor was following the hedge fund Galleon Group during its insider trading scandal, the investor could simply sell all his or her stocks rather than waiting to redeem their allocation.
Pro number three, liquidity. The investor can trade out of positions at any time versus the monthly, quarterly, or multi-year lockup periods at hedge funds. Hedge funds have other special provisions like gates, which can be put up to prevent investors from withdrawing money immediately. Many investors were gated during the financial crisis when they wanted to withdraw their investments.
Pro number four…and this is a biggie…lower fees. Most hedge funds charge high fees. The standard is 2% percent management fee and 20% performance. Funds of funds layer on an additional 1% and 10%. The fees associated with managing a 13F portfolio is simply the investor’s routine brokerage costs, and that’s it, and that is a big deal.
Risk targeting is pro number five. Investors can control the hedging, leverage, to suit their risk tolerances. A number of hedge funds have blown up as a result of excessive leverage or derivatives.
Pro number six, fraud avoidance. Investors own and independently custody their assets, thus completely avoiding any custody risk like those in the Madoff scheme in which investors lost billions.
Pro number seven, tax management. Hedge funds typically run their strategies without regard to any tax implications while individual investors can manage their positions in accordance with their respective tax statuses. And the impact of fees and tax management are often minimalized when talking about hedge funds since the nominal returns is the sexy part of the story. I cover this a lot, the importance of taxes and fees, in the recent book “Global Asset Allocation.”
And there’s a great paper on this topic called “Rules of Prudence for Individual Investors” by Mark Kritzman of Windham Capital…trying to get Mark on in a future episodes. The [inaudible 00:26:28] stories that taxes have a significant impact on returns for the taxable investor. A hedge fund needs to return about 19% to deliver the same after-tax return as a stock index does that returns about 10%. This is due to the high turnover resulting in capital gains as well as large performance fees for the hedge fund. But to be honest, there’s also some potential negatives to not actually letting the fund manager run the portfolio on his or her own terms.
So, here are some cons. One, lack of expertise in portfolio management. The investor does not have access to the timing in portfolio trading capabilities as the manager. To be honest, this could also be a benefit if the manager is good at picking stocks but terrible at timing or position sizing.
Con number two, inexact holdings. Crafty hedge fund managers have some tricks to avoid revealing their holdings on 13Fs, like moving positions off the book at the end of the quarter is one of them. The lack of short sales, and futures reporting, means that the results will differ from hedge fund results. Managers can also get rare exemptions from reporting stocks on 13F filings.
Con number three, the 45-day delay in reporting. The delay in reporting will often affect the portfolio in various amounts for various funds. At worst, an investor could own a position and the hedge fund manager sold out a long time ago. Disclosure of a new holding by some famous hedge funds, like Dreamlight Capital, can also cause the stock to move sharply before an investor has time to build a position.
Con number four, high turnover strategies. Managers who employ pairs trading, or other strategies that trade frequently, are poor candidates for 13F replication.
Con number five, arbitrage strategies. 13F filings make sure that a manager is long stock, when in reality he’s using an “arb” strategy. The short hedge will not show up in the 13F.
Con number six, inconsistent manager skill. Like any active strategy, some managers lose their desire or skill over time. How do you determine when to cut a manager from your stable of funds? So also to note, just because you’re investing alongside a great manager, that does not spare you from painful drawdowns. The strategy is still long is a long-only stock strategy that will experience similar losses to the broad stock market. And if you remember the stock market, twice in the 2000s, declined about half, and all the way back in the Great Depression stocks declined over 80%.
However, we do tackle in the books some hedging ideas potentially to reduce volatility and drawdowns, if you want to read it. So there’s some investment styles to avoid. I can’t tell you how many times I’ve heard on TV people talking about a handful of 13Fs from these following managers and styles when it makes, really, no sense whatsoever to follow them. So an investor needs to be really careful when using these filings and understand both the strengths and the weaknesses. Since there are literally thousands of hedge funds and mutual fund managers to choose from, how does one go about narrowing the list of managers? This is not an easy question to answer and, unfortunately, an intimate knowledge of the hedge fund space is a big advantage.
However, I’ll outline a few of the criteria to look for as well as a list and selection of managers I admire to get started. Funds to avoid include those that fit the following criteria: short bias or short-only funds. Since they don’t show up in 13F filings, it’s impossible to track what your hedge funds are doing with their shorts unless they disclose them publicly. An example is Kynikos Associates and Jim Chanos. High turnover trading…if a fund trades too much. Quarterly filings and 45-day delay will not accurately reflect what the fund is holding. I focus primarily on value investors in this book, which typically have lower turnover. It is a bit fuzzy as to what level of turnover is too much. In general, the less is better. So an example of this would be something like Stevie Cohen’s SAC or Point72…black box.
While Renaissance’s Medallion has certainly performed head and shoulders above almost every hedge fund in existence, and that’s after a 4% and 40% fee structure, it’s shrouded in mystery. It also trades lots of derivatives, so that’s something you wanna avoid. And a similar cousin is Global Macro and other CTA-type of funds, many trade futures, forwards, currencies, and most CTAs are under this umbrella. Like, someone like John Paulson made a lot of money on housing. It’s impossible to replicate, so groups like Soros or Winton, Harding Winton…it doesn’t make a lot of sense. And lastly, we already mentioned this, but arbitrage. Pair trading is an example of one that doesn’t make sense, and Fairlawn Capital Management is example one.
So let’s talk about a few frequently asked questions real quick and then we’ll profile a couple managers and then slowly start to wind this down. Here’s the questions we hear most from people, and I think this is important because this will probably answer a lot that you have as well. So number one, “Holdings are reported 45 days after the quarter, so you may be buying a stock the manager no longer even owns. The delay makes it impossible to follow these managers, right?” So, the answer is, first remember all these simulated results mentioned in this book already include the effects of using the delayed data.
Also recall that if you put enough time and careful analysis up front, you’re likely only going to be tracking funds with lower turnover in the first place. However, way back in 2012, I did a study to try and quantify the effect of the 45-day lag. There’s some inherent biases no matter how you chop up the data, like how many funds include long/short only, entire universe, do you include dead funds, whether to regress returns based on turnout, yada, yada, but I looked at about 20 funds that I’ve been following for years on my blog. I compared rebalancing on the 13F filing date to rebalance support for the prior quarter.
So basically, a look ahead bias investors don’t have. It shows how a portfolio constructed without the 45-day delay compares to a portfolio with publicly available information. Tests go back to 2000, examine the total return data with no transaction costs. So does it matter? A little. All this wide variation in the funds, which is to be expected, the delay ranged anywhere from a three percentage point penalty for a few funds to a two percentage point benefit. Overall, the friction delay average is about 1.5 percentage points per annum, so not that bad. Another side is it doesn’t matter a whole lot when you rebalance after discloser as long as you just do it at some point.
Question two, “Shorts don’t show up on a manager’s disclosures, so you’re not really replicating the fund, right?” And so ditto for futures are an undisclosed. I think this is important because you’re only replicating the fund’s long stock positions. A firm like The Baupost Group, which we talk about later, may have most of its assets in real estate or distressed debt and only a fraction in equities. So clone portfolios will have serious tracking error in comparison to the underlying fund. However, in many cases, the clones and hedged versions of the clones perform similarly or, in some cases, superior to the underlying fund, and fees are a big reason why.
Question three, “Why shouldn’t I just pick the top stock? Isn’t that a manager’s best idea?” We see a lot of people fall under this mistake. We found that the top pick is usually the worst performer out of the top 10 holdings, and we discuss the topic more in depth later in the book, but the time the position becomes the largest holding is often due to appreciation and not necessarily conviction.
Question number four, “What fund should I track? Why can’t I track the whole universe?” We actually think tracking the entire hedge fund universe is a great idea for a short fund. An investor doesn’t want the broad market exposure of beta of hedge funds, which is likely to simply be S&P 500-like in nature. Investors want the alpha in hedge funds, and tracking the thousands of hedge funds, most of which are not long-term oriented value stock pickers is a really, really, really bad idea. You may also run the risk of being invested in stocks where there is a high concentration of funds invested in the stocks, imposes liquidation risks in the case of market stress. Let’s look to the recent Goldman VIP fund, which I think is a wonderful short and a terrible idea for an ETF. As far as what funds to track, we outlined 20 funds in the book as well as dozens of funds in the first book and on the blog. Build your own list of favorites through research and always through reading.
Question five, “Can I just filter the stocks by market cap or sector momentum, etc.? What about a stock small cap bias?” Answered is yes, you can, but realize that part of the benefit of tracking these managers is their ability to go anywhere. Also realize that any [inaudible 00:34:43] the portfolio will have resulting impact of potentially making it less diversified or sector biased. Some funds that are inherently sector-focused, which is a little bit slightly different, so examples are health care funds like RA [SP], Baker Brothers, OrbiMed, Palo Alto, etc.
Six, and this is a tough one we’ve talked about a few times on the podcast, is “How do I know when to stop following a manager?” So there’s a lot of ways and this is where it’s a little bit more subjective and hard, and domain expertise really helps. But something like style drift, lost enthusiasm, resting on their laurels, a nasty divorce, too many assets, went to jail, newer, younger, and hungrier managers, lots of reasons, but the criteria is subjective and it’s tough.
Number seven, last, “Doesn’t piggybacking on these managers make them angry? Aren’t you stealing their ideas?” I said. “Actually, I think these managers should be sending me cases of champagne.” And I said, actually in the book, “Actually, I’d prefer tequila,” but I think I’ve gone back to champagne or beer. Shockingly, none of them have yet, so why? By definition, people following 13Fs would be buying what these managers are selling, at some point. We’re now gonna take a look at some of my favorite managers’ track.
There’s no specific screening requirement to arrive at these funds, rather it’s a combination of years of study combined with qualitative as well as quantitative analysis. Another 15 fund profiles are included the appendix with a little bit shorter investment track records. I’ll offer a very brief introduction to each manager as well as the backtested performance, current holdings, and the most recent filing. They’re in alphabetical order but it seems fitting we start with the top performing fund and the first profile, David Tepper’s Appaloosa Management.
Let’s move on to our first of two manager profiles, Appaloosa Management’s David Tepper. He’s got a quote that starts the chapter. It says, “The key is to wait. Sometimes the hardest thing to do is to do nothing.” You’d expect any management fund that takes its name from a distinctive breed of leopard-spotted horse to stand out from the crowd. Appaloosa Management does just that, in large part because of the unique in idiosyncratic investing pattern of its founder David Tepper. Appaloosa has grown into one of the more influential and storied hedge funds, but its founder grew up in a modest neighborhood in Pittsburgh.
His accountant father hit the jackpot in 1986 with the winning lottery ticket. The payoff was $30,000 per year, a windfall for the elder Tepper at the time. These days, David Tepper earns more than that in an hour. He topped the 2014 Rich List for Hedge Fund Manager Compensation, published by the “Institutional Investors Alpha Magazine,” which estimated his 2013 earnings at $3.5 billion. It was the second year in a row he came out number one. What makes Tepper worth that much? A $20 billion hedge fund that he founded in Short Hills, New Jersey in 1993, Appaloosa Management regularly turns out returns that delight his investors and wow analysts. His flagship fund, Appaloosa One, produced an estimated 29% net annualized gain since its launch in July 1993.
Tepper’s not shy about tooting his own horn. He says, “I hope for it to be recognized that in the past 20 years I, arguably, have the best record and therefore may be the best of this generation,” he commented in an interview. Round faced and jovial, he projects the air of a film character actor, the simple but sincerest sidekick to a leading man. His diction retains the imprint of the working class neighborhood where he grew up so that when he says “the markets” it comes out as “da markets.” He once described himself as just a regular upper class middle guy who happens to be a billionaire. But while his pronunciation may not be perfect his pronouncements and investments tend to be spot on. Wall Street views him as an investment guru worthy of emulation.
These days, he has the power to move markets with a few choice words. When he was a guest on CNBC program “Squawk Box” in May of 2013, he offered a long and detailed explanation of why he thought markets were headed higher. S&P futures had been trading lower before he spoke. By the end of the day S&P had risen 17 points, a bump many attributed to Tepper rally. While Tepper is closely watched for his views on equity markets, his forte is actually debt. Early in his career before he was head of the high-yield desk at Goldman, Tepper worked as a finance analyst at Republic Steel Corporation of Ohio. It was there, in the midst of this financially insolvent steel corp, that Tepper learned to navigate the complex credit structure of a distressed company, a skill that would later come to define so much of his investing strategy.
By 1983, Tepper had acquired enough capital, aided by a partial cash infusion from his Goldman Sachs colleague Jack Walton, to open Appaloosa Management Investors. The general aim of the fund was to draw on his expertise by emphasizing investments in bankruptcies and distressed debt situations through a 70:30 debt-equity allocation in global publicly traded markets. But beyond those loose restrictions, the fund was open to any investing opportunity and Tepper prided himself on being sector-agnostic, event-driven, and often unorthodox. He has a reputation for taking bets contrary to conventional market wisdom, often earning windfall returns while others were nursing losses.
“The point is markets adapt, people adapt,” he once said. “Don’t listen to all the crap out there.” His style relies on macroeconomic and market analysis that he combines with deep and thorough research into specific investment opportunities. While he’s maintained the distressed debt specialty in the strategy, he’s ventured into other fields, sometimes taking a major position in a company and becoming an activist investor, pushing for changes to enhance shareholder value. In recent years, some of his best returns have come from equities leading other equity investors and analysts to closely monitor his portfolio. Part of his strategy is to move against the grain.
The turnaround situations are his strength, such as when he bought the sovereign debt of Argentina in 1995 when most investors sought cover from the financial crisis or, similarly, when he purchased futures in South Korean currency in 1997 as most investors were pulling out of the Asian markets. Tellingly, Tepper defies his approach with statements like, “We lead the herd. The street follows us, we don’t follow the street.” And, “We’re consistently inconsistent and it’s one of the cornerstones of our success.” Some of his most famous bets at Appaloosa were buying debt for pennies on the dollar in big bankruptcies including Algoma Steel, Enron, WorldCom, and Conseco.
He’s also made money by buying debt in banks battered by the 2008 economic collapse as well as airlines at a time when many were facing bankruptcy. Also, in late ’08, after the collapse of Lehman Brothers, he stabilized the fund by aggressively purchasing preferred shares of Wachovia and Washington Mutual for cents on the dollar. His buying spree continued and in 2009 he picked up the preferred shares of Bank of America, the junior debt of Citigroup, then a tranche of commercial mortgage-backed securities floated by AIG. By the time the market stabilized in 2009, this concentrated allocation of financials reaped rewards beyond anything Appaloosa has ever experienced. They raked in a 120% net of fee return, which amounted to $7 billion to investors and a hefty $4 billion to Tepper himself. Perhaps he put it best when he said, “I’m the animal at the head of the pack. I either get eaten or I get the good grass.”
He often wildly shifts around sectors. He is the textbook definition of an opportunity investor. A lot of his success has occurred to well time trades like the financial sector in ’09 to 2011. So maybe the best tactic, when tracking Tepper, is to pay attention to what he says at any given moment but keep an even closer eye on what he does with his portfolios. So, what do they look like? If you pull out a printout of Tepper…and we’ve included this up to 2016 since the book only goes up to 2014…his portfolio, which has names like Alargan, Google, Facebook, Allstate, Pfizer, has performed a whopping 19% per year compared to 4.9% for the S&P. That’s the highest we have in the book, and some pretty astonishing outperformance as well. So a really interesting one, and kinda to contrast that to Buffett who’s underperformed 7 of the last 10 years in the U.S., this Tepper portfolio has outperformed. I may have to go back to the tape on this one but it’s something like 13 in the last 16 years, so pretty incredible.
Next we’re gonna move on to one of the most classic, famous value investors on the planet and this is the Baupost Group’s Seth Klarman. We have quote, to start, from Seth. It says, “In capital markets, price is set by the most panicked seller at the end of a trading day. Value, which is determined by cash flows and assets, is not. In this environment, the chaos is so extreme, the panic selling so urgent, there’s almost no possibility that sellers are acting on superior information. Indeed, in situation after situation, it seems clear that fundamentals do not factor into their decision-making at all.” “The Intelligent Investor,” Ben Graham’s definitive book on value investing was selling in paperback for $12.97 on Amazon in November 2014.
At the same time, “Margin of Safety,” the out of print investment book by Graham disciple, Seth Klarman, was fetching anywhere from $2,000 to $4,500 on Amazon. What makes the latter so valuable is not just the scarcity, but also its author. For the chance to own a bit of Klarman wisdom, adoring fans will ignore the whole concept of buying at a discount that underlies the practice of value investing. Warren Buffett, who’s been called “The Sage of Omaha” for his value-investing acumen is in good company at the top with Seth Klarman, who’s been similarly dubbed “The Sage of Boston.”
Since founding Baupost Group in 1983, Klarman has grown into a hedge fund giant, managed over $30 billion. His flagship fund has churned out more than 17% annual returns since its founding, handily beating the S&P 500 and doing it while often holding 40% or more of its assets in cash. Like many value investors, Klarman’s likes to slowly build up concentrated bets, then he accepts long holding periods of three to five years. For example, Baupost spent three years amassing a 35% ownership state in Idenix Pharmaceuticals at Cambridge, Mass. When Merck and Co. announced a $4 billion takeover in June 2014, he realized nearly a billion dollars in profits.
So, how does he do it? He explained his basic philosophy to television talk show host Charlie Rose during a 2010 interview. “Investing is the intersection of economics and psychology. The economics, the valuation of the business, is not that hard. The psychology…how much do you buy? Do you buy it at this prize? Do you wait for a lower price? What do you do when it looks like the world might end? Those things are harder. Knowing that when you stand there, buy more or something legitimately has gone wrong and you need sell, those are harder things. That you learn with experience. You learn by having the right psychological make-up.”
He went on to say that, “Some people are born with the nerve and intuition to be great investors. For me, it is natural. For a lot of other people it is fighting human nature.” In “Margin of Safety,” Klarman credits success to the Graham and Dodd Model, claiming that one must be willing to walk away from an alluring investment through careful scrutiny and review, the investment does not provide sufficient room for error. Klarman hits his natural ability to value investing after working as an intern for two years in Mutual Shares Corporation under the tutelage of Max Heine and Michael Price.
A Harvard MBA, Klarman was soon recruited by one of his former professors there to run a family office. That led Klarman to launch Baupost in 1983 with $27 million, its name combining parts of the names of the families being represented. These days, its clients include Harvard University itself along with Yale and Stanford. Klarman has a special knack for complex transactions that often come with limited liquidity. He has purchased real estate that was acquired by the U.S. government in the savings and loan collapse in 1990s, dabbled in Parisian office buildings and drilled into Russian oil companies.
Baupost has made a killing in the aftermath of Bernie Madoff’s massive Ponzi scheme by buying claims from victims who figured they stood little chance of fully recovering their losses. Baupost bought $230 million worth of claims for $74 million then saw its investment more than double in value after a favorable court ruling on distribution of certain assets. Although Klarman seems to delight in fishing for opportunity in obscure and complex deals, he is no slouch when it comes to stock picking. He runs concentrated portfolios as evidenced by his positions in…and we’ll update this…but at the third quarter of 2014. The top five represent the lion’s share of invested assets, and that’s true today, the market value in the top 10 positions as of the last filing, 77%.
As a long-term investor, Klarman doesn’t spend much time monitoring the daily movement of markets. His office features a desk piled high with papers, a computer and some half-filled water bottles, with no Bloomberg terminal, the device with access to market data that traders rely upon. Klarmen runs Baupost with the same kind of deliberate planning. Rather than divide up his analysts according to specific sectors of the market like pharma, financial, oil, he assigns them to general areas of investment opportunity instead. Some focus on distressed debt while others are oriented toward post-bankruptcy equity, and still others work on spin-off and index fund deletions, and so on.
Processes allowed Klarman to remain diligent about mispriced securities, over-leveraged companies and misguided selling. And while Klarman cautions the investor against the uncertainties in the market and identifies the current economic environment as the most alarming in his lifetime, he still believes there are real opportunities to make sound investments. Klarman prides himself as much on not losing money as he does on making it. He’s only had two negative years…may have to update that…’92 and 2008. And also note that he invests in other assets besides stocks, including real estate bonds and cash and his top 10 clone would’ve had a 5 [inaudible 00:48:33] since 2000, because remember we’re talking about [inaudible 00:48:34] equities here.
When Charlie Rose asked Klarman to name his biggest mistakes, “The Sage of Boston” thought for a moment, came up empty. “I’ve never really screwed up a lot. Knock on wood.” How many investors who have been at it for three decades can say that? In summing up his investment philosophy he said, “I would be buying what other people are selling. I would be buying what is loathed and despised.” So what’s he buying these days? I printed out his recent 13F and it shows that if you go back to 2000, his performance, similar to Buffett, 10.2% versus 4.9% for the S&P, similar volatility, a little higher volatility.
One of the cool things about his portfolio is you end up with a hugely different holding list than you see with other hedge funds. So for example, there’s some names on here that probably many have never heard of ViaSat, VSAT, Synchrony Financial, Alargan, that was one we just mentioned, 21st Century Fox, PBF Energy, and Taro Resources, they’re advanced buyer pharma, Colony Northstar, Chinari [SP] Energy, all sorts of these. But one of the interesting parts is you can also invest in Klarman Arab outposts in a fairly large drawdown. He had a pretty terrible year in the latter half of 2014 and 2015. So he’s at levels that you haven’t seen since back to 2013 and probably, arguably, not quite 50% drawdown but not too far off, I believe. Anyway, one of my favorite investors…a really interesting one to follow.
We were gonna talk a little bit about fund groups and strategies. I’m gonna cut this short and we’re gonna see what everyone thinks about this sort of really long podcast. If you all really like it, let us know, or hate it. We got, you know, another dozen profiles in the front part of the book, another 20 in the back. We could start doing this weekly on a different day than Wednesday, adding them on at some point. Let us know what you think, positive or negative feedback on the mebfabershow.com. We’re gonna do a summary in implementation, a real quick summary of some ideas here. A reminder, you can download a free book for this podcast.
So let’s do the final two chapters and then we’ll shut this down. So I always like to read research paper book summaries in bullet format, maybe because I like to skip to the end, kind of like this podcast. Hopefully you enjoy the fascinating world of many of these fund managers and the ideas presented here will be a great starting point for more research and stock ideas. You can always follow along with my favorite ideas, as well, on The Idea Farm. So we’re gonna condense this 200-plus page book in less than 10 bullet points.
1. It is very simple to track holdings of institutional fund managers using 13F filings submitted quarterly to the SEC.
2. Following a subset of fund managers can lead to new investment ideas. Additionally, investment portfolios can be constructed tracking a hedge fund’s long portfolio performance without many of the traditional drawbacks of allocating to private funds.
3. Because value managers have long term holding periods and low turnover the 45-day delay in reported holdings should not be a significant drawback.
4. Case studies presented, examining 20 value investors, backtested results presented for the portfolio since 2000.
5. Results indicate that by tracking and rebalancing portfolios quarterly, an investor can effectively replicate the long holdings of value hedge funds without paying the high hedge fund fees.
6. Following the top value hedge funds can result in excess returns with in-line volatility compared with the equity in hedge fund indices.
7. An investor could invest in multiple managers…we didn’t touch on this today…to create his or her own fund of funds, again, without paying an additional layer of fees. Additional applications include constructing hedge portfolios, leverage portfolios, as well as sector portfolios.
So talk a little bit about implementation, so how does one go about implementing these strategies? First, you can track any one manager or build your own hedge fund or funds by choosing a group of your favorite managers. We demonstrate you could replicate most managers with their top 5 holdings, so even if you follow 20 funds that’s a fairly reasonable list of 100 stocks, and then if you exclude the top holding as a sub-optimal pick, that reduces the number to 80 stocks. However, it is very important to pay attention to commissions as well as spreads that an investor would pay to execute this portfolio. Thankfully, there are a number of brokerages that charge reasonable transaction costs as well as plenty that do not. Some brokerages to explore include Interactive Brokers, The Motif, Folio, TD Ameritrade and, including one that doesn’t charge any costs, Robin Hood.
There’s some other good sites that track 13F holdings, include Whale Wisdom and Insider Monkey, and newsletter such as “Market Folly” and “Super Investor Insight.” For those who don’t wanna track and trade 13F strategies, there are a handful funds, public and private, that are managed by professional investors tracking 13F strategies. A very enterprising research with time on their hands could find a stock database without survivor bias…Norgate’s a great one, by the way…and piece together backtests from publicly available databases. Other databases include Bloomberg, the SEC, and FactSet. Be forewarned, it is a tedious process.
So I’m gonna wind down today. In the appendix, there are other resources. Remember, freebook.mebfabershow.com to download this. You got the websites for 13Fs, you’ve got a list of conferences to learn more, you got a list of books that profile top hedge fund managers. Even cooler, suggested reading from top hedge fund managers including John Griffin’s Blue Ridge, Bill Ackman’s Persian Square, Seth Klarman’s Baupost, David Einhorn’s Greenlight, Buffett, Dan Loeb’s Third Point. All those have recommended reading.
So we’re gonna wind this down. Everyone, thanks for taking the time to listen today. Again, Jeff and I always welcome feedback and questions through the mailbag at firstname.lastname@example.org. As a reminder, you can always find the show notes and the other episodes at mebfaber.com/podcasts. Please subscribe to the show on iTunes and if you’re enjoying the podcast, leave us a review. Thanks for listening, friends, and good investing.
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