Portfolio Commentary : Fourth Quarter, 2010
Absolute Investment Advisors
By Jay Compson
February 4, 2011
For our 4Q commentary we have decided to alter our approach and provide direct insight into our managers’ thoughts by providing portions of their commentaries in a series of independent “short stories.” Collectively they represent many of the thoughts that we have utilized for writing our quarterly commentaries, but we feel the current environment offers a unique time to hear things “directly from the horse’s mouth.”
While each manager judges opportunities differently, several themes tend to resonate across the board. Specifically, these managers judge idiosyncratic security selection, valuation, and patience as key determinants for risk/reward decisions and long-term success, while the markets have become one large herd of “group think” whose behavior swings wildly from “risk-on” to “risk-off.” We believe this is due to the ever-increasing amount of capital controlled by people who are incentivized to take large risks with “other people’s money;” this is caused by massive moral hazard (bailouts, loose money), and not being held accountable (blame the markets). We point this out because we believe our managers, while not always getting it right, make real judgments about risk that greatly highlight their moral and intellectual integrity. This is what makes our Funds unique and it is why we are very optimistic about long-term performance in a world where both private and public money is largely controlled by those who have proven to be some of the worst and most inefficient allocators of capital in history.
The following is a collection of independent commentaries from several of our managers in both the Absolute Strategies Fund and Absolute Opportunities Fund. We have omitted manager names for compliance purposes as many of their partner letters are not for public use. The commentaries are in random order to illustrate the various philosophies and opportunities of our managers and they should be viewed as independent thoughts relating to each manager’s specific strategy.
Focus: Distressed/Event Driven
Asset class bets are “in” and security selection is “out,” and consequently the incremental capital being deployed into stocks right now is being spread wide and thin. This is ultimately positive for those of us who still think of equities as fractional ownership interests in businesses and invest as such. It means that we have less competition in evaluating companies and situations, particularly smaller ones that are harder to understand and require more elbow grease. Investors who own stocks mainly to gain exposure to equities as an asset class are also easily shaken out when the wind changes directions. This usually leads to indiscriminate selling and opportunities for the fund. Our investment decisions center on margin of safety, not any type of global asset allocation model. Some bemoan the death of stock picking. But buying businesses and assets for below a very conservative estimate of what they are worth has worked pretty well since the beginning of commercial enterprise on the planet, which is long before stock exchanges, modern portfolio theory, and your favorite CNBC guest economist were born. We are unable to find good reasons for why this won’t continue to work in the future, especially when it is done with healthy amounts of caution and patience.
Our market commentary and outlook remain mostly consistent with what we discussed in previous commentary. We are not seeing entire asset classes on sale like we did in 2008 and 2009 and though some of the bearish macro themes out there resonate with us, we haven’t drawn a bead on any geographical area or asset type that we are absolutely positive will become the next big distressed opportunity. The best we can say is that our search process is such that we are highly likely to take advantage of these types of meltdowns through individual securities once frenetic selling takes hold. Unfortunately, corporate debt spreads narrowed further in 2010. Since being clawed over by droves of desperate yield seekers holds little appeal for us, we are not particularly active in stressed debt. We are finding one-off situations in debt and equities in and around bankruptcy and we continue to pray nightly for harder times for serial corporate borrowers. But as of now the area does not offer the bounty that many dedicated distressed debt investors had prophesized.
We remain on-call for any market dislocations that could present wholesale buying opportunities, as we never like to let a good crisis go to waste. But our best guess is that our efforts in 2011 will be comprised mostly of stock picking-type activities.
Focus: Long/Short Equity
2010 continued to be a period where correlations across asset classes remained high. Idiosyncratic fundamentals took a back seat to a rapid “risk-on” or “risk-off” trade. The percentage of stocks moving in the same direction over the last 6 months of 2010 was nearly 80%. This has occurred only 2% of the time since 1972. Performance has had less to do with stock selection but rather more to do with market timing. While 2008 and early 2009 performance was all about risk reduction, Q2 2009 to present performance has been all about taking on risk. Looking ahead I would make the observation that 1) periods of high correlation tend to mean revert and 2) as stock market advances mature stock picking historically becomes more relevant.
In contrast to 2 years ago, short term Wall Street optimism is running quite high. Profit margins for the S&P Industrials are at all time highs (7.9%) and median estimated one-year earnings growth remains high (19.1%). Should the economic recovery continue, substantial profit growth will be increasingly dependent on revenue growth. Corporations have slashed employment and reduced costs, but going forward we’ll need to see significant growth in demand to satisfy expectations. Not insignificantly I would add the “Wall Street” base case generally dismisses worries regarding the U.S. housing market, geopolitics, sovereign debt, a Chinese economic hard landing, and fiscal/monetary missteps. In short the backdrop looks to favor stock selection more then we have seen over the past two years.
Broadly speaking we need private sector innovation and growth to take the baton from federal government stimulus. On an optimistic note, if you talk to enough entrepreneurs you’ll find a lot optimism to build on. As I tell prospective investors the hangover from this credit cycle is large but the turbulence we’re seeing within the capital markets is entirely consistent with past periods in history. As someone who has been very concerned with global imbalances for several years I can say I am at least encouraged to see that many of the problems have been widely recognized. The key to future prosperity will be our ability to grow. The driver of growth won’t likely be in the form of a new housing bubble, but rather through the companies that create new markets for goods and services and enhance productivity. We’ll be looking for those companies every day.
Focus: Concentrated Equity
Looking ahead, there is certainly room for optimism. Corporate earnings could rise to record levels. Valuations in some areas of the market remain attractive. The economy appears to be gaining strength. Business confidence coupled with healthy balance sheets could lead to increased merger and acquisition activity. An increase in investor sentiment could lead to further multiple expansions on corporate earnings, leading to further gains in the equity markets. The tax package will almost certainly stimulate further consumer spending. On the monetary side, the Federal Reserve continues its efforts to further ease credit markets with unconventional Treasury purchases, hoping that low interest rates spur more borrowing and force investors, perhaps unwillingly, into riskier assets to improve returns.
On the other hand, going into 2011 we wonder just how much of this optimism has already been discounted. Three straight years of positive performance in the equity markets has only occurred twice since World War II. In both cases, the third year saw average returns of just 1.7%. Will 2011 follow suit? We have no idea‐‐the year 2010 was a difficult year in which to handicap the financial markets. Despite what we see as an extremely disappointing economic recovery, the equity and fixed income markets performed extremely well. Looking forward to 2011, we do not know if the S&P 500’s return to the level it held before Lehman Brothers collapsed is a confirmation of the market’s strength or if the last marginal buyer has arrived and signals a temporary or perhaps longer term lasting market peak.
We have no desire to make any predictions for 2011 other than to expect a certain amount of the unexpected which will lead to at least some volatility in stock prices. At this moment, there are few desirable companies that can be bought with a decent margin of safety. This isn’t to say that there aren’t a lot of good companies whose stocks are worth continuing to own. But the unforeseen potholes that certainly lie ahead will once again give us opportunities to put fresh capital to work on more favorable terms. Being patient is not always pleasant, but the eventual rewards of being able to buy the stocks of solid operating companies trading cheaply are always worth the wait.
Focus: Short Credit/Event Driven
Occasionally, everyone steps on the top step of a ladder, despite warnings to the contrary and their own good judgment, to grab for something they just can’t reach otherwise. You rarely take the risk because the value of what is just beyond your reach pales in comparison to the pain you suffer if you fall from that unsteady top step. The analogy when looking at the capital markets is that its participants have grown unusually acclimated to working on the risky top step. Their feet are firmly planted and even extending to tiptoes and reaching with false confidence believing there is a safety net (the government and central banks) to catch them if they fall.
To adapt a well-known quotation to the current market environment: Government involvement in markets can remain irrational a lot longer than needed, creating complacency and extreme future valuation movements. So, in reality, the artificial demand creation for paper assets is the centerpiece of today’s monetary policy. We view these government actions as tantamount to capital repression where zero interest rates punish the prudently thrifty (including senior citizens, insurers, those seeking to transfer wealth to future generations). These savers are forced to take interest rate and credit risk in all forms of risky bond funds to meet near term income requirements. Some asset allocators participate in this “Great Reach” as they lack the intestinal fortitude to sit in low yielding (but safe) cash equivalents as the herd gallops nearby. Investors who seek to profit by constructing short positions in overly inflated paper assets will find it particularly painful as seemingly all market participants, including the central banks, have gone All-In with regard to the risks.
In 2010, as discussed in prior letters, we maintained the portfolio short exposure at roughly constant levels to provide our investors with significant profit potential should idiosyncratic credit risks emerge among the issuers and sectors where we have constructed short positions. We strongly believe this profit potential remains, and our plan is to maintain, and opportunistically grow, our short exposure as market conditions warrant it.
Focus: Convertible Arbitrage
Convertible arbitrage has had an excellent run the past 2 years, but the strategy continues to represent favorable risk/reward attributes for investors that remain cognizant of directional equity risk in the markets. The average convertible bond now trades at the equivalent straight bond yield of around 7%. The equivalent yield represents an expected return that is 3.5 times the risk less rate of 2% for 5 year treasuries (the bond that most closely matches the average duration of convertible debt).
Convertible arbitrage is a non-directional strategy as the expected return remains constant whether equity markets move up or down. The profile of the convertibles market has become more equity sensitive the past two years with the run-up in equity prices; therefore arbitrageurs are gradually increasing their short equity positions accordingly. As convertible arbitrage becomes more “short equity”, the strategy will benefit from an unexpected pick-up in equity volatility, especially to the downside.
Convertible arbitrage also offers idiosyncratic special situations that can boost returns beyond the “expected return.” Cash acquisitions, which traditionally represent more risk for the strategy, today offer upside reward as convertible takeover protection is now standard in the marketplace. Flush-out deals are also becoming more popular with the run-up in equity prices; deals where companies are taking advantage of higher equity markets and offering convertible bond holders financial incentives to convert early. U.S. convertibles market technicals are far more favorable today than just a few years ago when arbitrageurs made up close to 90% of the buyers. Barclays estimates that investors of convertibles today are split evenly between outright investors and arbitrageurs and that ratio seems to be moving even more toward outright investors. With hedge funds moving back into the minority, we should find a market with more opportunity for arbitrage as prices become less efficient.
To summarize, we still see convertible arbitrage offering investors a low risk, non-directional, unique risk/reward profile that is very difficult to replicate elsewhere in the marketplace.
Focus: Long/Short Equity and Credit
Despite hearing different prognosticators claim that equity investors now face no possibility of near-term losses, and that the coast is once again clear to ramp up risk, we remain unconvinced. Our skepticism is based in part on the Fed’s poor track record over the course of our careers, particularly during the past decade-plus, during which short-term stimulative policy often proved short-sighted and resulted in severe unintended consequences later on. The LTCM bailout emboldened risk-takers and inflated the tech stock boom. The multi-year negative real rates implemented to counteract the ensuing bust caused a far greater and far more insidious problem, a housing bubble. One needs only to compare what percentage of Americans own houses to that which speculated meaningfully in stocks, or how housing is inextricably linked to credit, while tech investments were primarily equity-driven, to understand how much worse it was to trade one problem for the other.
Quantitative easing may feel good in the short-term, but the long-term risks seem substantial. A weaker dollar increases energy and other commodity costs for Americans -- essentially a highly regressive tax on the middle and lower classes, who are already grappling with sustained high unemployment and negative home equity. Also, it seems likely that a steadily depreciating dollar will provoke a meaningful response from both our trading partners and foreign holders of USD-denominated assets. These fears seem already to be reflected in the bond market, where long rates have risen quite sharply since late August (from 3.5% to 4.3%) -- not exactly the lower long-term interest rates the Fed claims quantitative easing will engender to stimulate the economy.
As we look ahead to 2011 and 2012, we wonder if equity and credit markets are again in opposition, with certain credit markets suggesting that the recent uninterrupted smooth sailing for risky assets may be challenged. Our past focus on signals from credit markets -- from corporate credit in the summer of 2007, sovereign credit in late 2009 and early 2010 -- helped us avoid and profit from prior periods of difficult performance for stocks, including 2008 and the second quarter of 2010. Equity investors have historically been very well-served to heed the early warning signals of turbulence in the credit markets. While we are not suggesting we expect any imminent or sharp downturn in equities, we are of the mind that an awful amount of positive developments seem already priced in to stocks, and most potential negatives appear to have been brushed-off.
Focus: Global Long/Short Equity
Faced with the potential onset of a “double dip” in economic growth and continued concerns around waning corporate and consumer confidence, the Federal Reserve initiated its program for QE2 in an effort to lower borrowing costs, raise asset and equity values and reinvigorate liquidity. Investors did not fail to take the bait, taking risk with confidence that the most explicit underwriting of risk in the history of the Federal Reserve was in effect.
With corporate margins at historic highs and borrowing costs at historic lows, it is difficult to view rising commodity prices and explicit U.S. dollar debasement as supportive to corporate cash flow and a low cost of capital. The fact that cheap money increases risk appetite which leads herd-like momentum investors to drive historically high valuations even higher does little to actually improve the visibility of a stream of cash flows. However, it most certainly pulls forward future returns even if those cash flows should actually materialize.
And yet 2010 ended with investors having taken the “Greenspan - Bernanke” put to its extreme conclusion: equities will not be allowed to fall because they represent the last hope of a culmination of flawed fiscal and monetary policies designed to forever “kick the can” of inevitable correction of excesses down the road a little further. Thus, complex structural economic problems are now simply being addressed by a “buy high and sell higher” economic policy strategy.
Near record correlations across asset classes highlight that macro momentum still dominates asset prices. Risk management is effectively a choice between two trades – risk on and off, as the chart below shows increasing convergence of asset price movement. The “don’t fight the Fed” trade has reached extremes in its expression and its popularity. There is little diversification in investment classes choices. Short selling remains among the few strategies offering diversification from the ever increasing binary nature of asset returns.
Focus: Long/Short Equity
We continue to believe a large number of high quality equities remain attractively priced on an absolute basis. Additionally, the relative mispricing of high quality versus low quality has increased since June. Since the mispricing of high vs. low quality companies persisted despite the general decline in equity prices (over the summer), we continued to position the Fund to capitalize on this discrepancy. Much to our surprise, riskier equities dramatically outperformed their higher quality counterparts during the second half of the year as well. This outperformance was particularly puzzling given the highly attractive beginning valuations for high quality businesses, average to expensive beginning valuations of the lower quality businesses, and the unusually high level of uncertainty thought to be facing the world economy. Given our stance, the Fund performed better than we would have thought based on this outcome. This in large part was due to our individual stock selection.
It is obvious that the price paid for an investment is an extremely important factor in determining the projected return. However, over the last year, we doubt price was a primary consideration as investors repeatedly made their investments in lower quality, small-cap companies as opposed to attractively priced, higher quality, large-cap companies. Following the Russell 2000 outperforming the S&P 500 by 12% (wow!) in 2010, the S&P 500 recently traded at 15.8 times reported income while the Russell 2000 traded at 34.4 times.
That is a significant difference for which projected faster growth alone may not compensate. This differential in the prices investors are willing to pay to acquire presumably faster growing and more economically sensitive assets may make sense if the starting valuations were reasonable and robust economic growth seemed highly likely. Of course, right now is an unusual time. The Fed is flooding the market with liquidity while interest rates remain near record lows. Despite this, banks are not lending robustly. Sovereign debt levels throughout the developed world are approaching, or have reached, unsustainable levels. Municipalities are struggling with falling tax revenues and rising expenses. China, the presumed growth engine of the world, is trying to cool its housing market, tame inflation, and ensure the banking system can withstand questionable loans made through off-balance sheet local government entities.
With all of this, it seems odd for the strongest businesses in the world to be trading at such discounts. While small companies can indeed grow quickly, our long portfolio of larger companies are not done growing by any stretch of the imagination. They enjoy very strong balance sheets, limiting severe downside and they possess much greater exposure to global growth. For all this, we can buy them at valuations more than 50% lower than their smaller counterparts. Most importantly, the price at which we are being offered to buy the larger, higher quality holdings in our long portfolio suggests respectable stockholder returns if cash flow growth is medicore, but exceptional returns if growth does better than that. On the other hand, lesser quality equities are only available at prices that require better than mediocre growth just to breakeven on a return basis with their large cap counterparts. For accepting these worse odds, an investor in lower quality assets is also assuming greater risk! This is precisely why we are optimistic about our strategy (long high quality vs. short low quality).
*Definitions: The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks. The HFRI Indices are equally weighted performance indexes, utilized by numerous hedge fund managers as a benchmark for their own hedge funds. It is not possible to invest directly in an index or average.
Since the Fund utilizes a multi-manager strategy with multiple subadvisers, it may be exposed to varying forms of risk. The Fund’s net asset value and investment return will fluctuate based upon changes in the value of its portfolio securities. There is no assurance that the Fund will achieve its investment objective, and an investment in the Fund is not by itself a complete or balanced investment program. For a complete description of the Fund’s principal investment risks please refer to the prospectus.
The Fund is non-diversified and may focus its investments in the securities of a comparatively small number of issuers. Concentration in securities of a limited number of issuers exposes a fund to greater market risk and potential monetary losses than if its assets were diversified among the securities of a greater number of issuers.
The Fund may invest in small- and medium-sized companies which involve greater risk than investing in larger, more established companies, such as increased volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources.
The Fund may invest in foreign or emerging markets securities which involve special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets.
The Fund may invest in debt securities which are subject to interest rate risk. An increase in interest rates typically causes a fall in the value of the debt securities in which the Fund may invest.
The Fund may also invest in high yield, lower rated (junk) bonds which involve a greater degree of risk and price fluctuation than investment grade bonds in return for higher yield potential. The Fund’s distressed debt strategy may involve a substantial degree of risk, including investments in sub-prime mortgage securities.
The Fund may purchase securities of companies in initial public offerings. Special risks associated with these securities may include a limited number of shares available for trading, unseasoned trading, lack of investor knowledge of the company and limited operating history. The Fund may leverage transactions which include selling securities short as well as borrowing for other than temporary or emergency purposes. Leverage creates the risk of magnified capital losses.
The Fund may also invest in derivatives which can be volatile and involve various types and degrees of risks, depending upon the characteristics of a particular derivative. The Fund may invest in options and futures which are subject to special risks and may not fully protect the Fund against declines in the value of its stocks. In addition, an option writing strategy limits the upside profit potential normally associated with stocks. Futures trading is very speculative, largely due to the traditional volatility of futures prices.
Investors should carefully consider the Fund’s investment objectives, risks, charges and expenses before investing. This and other information is in the prospectus, a copy of which may be obtained by calling (888) 992-2765 or visiting the Fund’s web site: www.absoluteadvisers.com. Please Read the prospectus carefully before you invest.
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