| 11 May 2010
Portfolio Update (updated 11:16 CST)
As 2008 ended, I had a few very fat pitches I focused on. First, if you wanted to take risk, invest in distressed and high yield debt. That worked, with returns far exceeding the stock market. My favorite though was convertible arbitrage, which offered high returns and low risk. The strategy ended the year as the top performing strategy with the category up about 50%, and some of the top managers had returns of over 100%.
Unfortunately, I cannot point you toward such obvious fat pitches today. Instead, the obvious opportunities are of a modest, relative and longer-term nature (They should play out sometime over the next 12-36 months.) High Quality is more attractive than junky stocks. Higher return oriented absolute return strategies should outperform stocks. Overseas markets are cheaper overall, but not anymore than high quality US stocks. Long-short managers should do well…I guess that is about it.
The market has eliminated most of its gains for the year as of Friday (though making a bid to get some back today.) As expected we trailed on the upside and have way outperformed when the market declined. Some of that is due to large cash positions we are holding to deploy if, and when, things get cheaper.
Larry has been picking up select high quality companies with solid dividends on weakness. We define high quality fairly simply, high sustainable profit margins and little to no debt.
Update from Larry: Further important characteristics: Strong balance sheets with favorable debt to equity ratios, high returns on shareholder equity, sustainable and growing dividends with reasonable payout ratios.
Overseas our managers are concentrating on high quality balance sheets as well, with a large concentration in Asia. Not only have valuations been more attractive in Asia, but also we think the value of Asian currencies is likely to rise relative to other currencies, giving returns a bit of a tailwind. For a look at their thoughts on our current situation and their insights, about risk and margin of safety click here (pdf.)
Absolute return oriented trading strategies have languished over the past year, with markets one-way move since last June giving them few opportunities to set up trades. Mean reversion and trend reversal trades have not worked either. Of course, now that volatility has spiked they should get some traction. We will be adding exposure to these strategies going forward. You can read the thoughts of Steve Blumenthal, who oversees the collection of trading strategies we will be using, in his quarterly letter(pdf.)
Our absolute return oriented multi-strategy funds had a very nice 2009 and have pretty much done their job this year, steady returns on the upside, and protecting capital on the downside. After last week’s carnage, both are ahead of the S&P 500 YTD. In fact, one of the funds was up strongly even on Thursday. A key performance driver over the last month has been the long-short credit strategies used in the funds. Two of the managers do best when riskier bonds struggle, which they have recently, especially Thursday. This is an example of how strategies that do not need the market to go up can help steady your portfolio. I highly recommend the thoughts of Jay Compson (pdf) the manager of these two multi-strategy funds. He discusses how they see risk as mispriced in the markets today and why that drives their strategy.
You can find an interview with one of our favorite managers inside of the fund, Mike Blitzer and Guy Shannon of Kingstown Partners in the latest issue of Graham and Doddsville. Here is the introduction.
Mike Blitzer CBS ‘04 and Guy Shanon CBS ’99 are the Managing Partners of Kingstown Partners, LP, a $285M special situations partnership that has compounded at 17.2% net of fees since its in-ception in early 2006, versus negative returns for the S&P 500. The pair also teaches Applied Val-ue Investing in the Heilbrunn Center at Columbia Business School.
Reading it may give you some insight into why having niche managers who do not track the market not only can lead to higher returns, but also provide downside protection. You can find the interview here (pdf.)
A convertible arbitrage manager inside the fund, Mohican Financial Management, was recognized last year by Lipper as the best hedge fund in the convertible arbitrage category.
Another star performer so far this year has been our fund of tactically allocated debt strategies. Up strongly Thursday and well ahead of the S&P 500 for the year, the manager is well positioned for a potentially difficult market. That has paid off with steady gains despite the market turmoil, including a nice gain on Thursday.
Our strongest performer Thursday was our hedged equity manager. He is up modestly for the year, but if markets deteriorate, we expect his ability to protect capital until the market is more attractive, and then get more aggressive, to add significantly to your bottom line. I think a point he made a little while before the market started this current swoon is worth considering:
The first crucial observation is that high risk market conditions like we observe at present come with an "unpleasant skew." If you look at overvalued, overbought, overbullish, hostile yield conditions of the past, you'll find that the most likely market outcome, in terms of raw probability, is a continued tendency for the market to achieve successive but slight marginal new highs. While this movement tends to be fairly muted in terms of overall progress, it can be somewhat excruciating for investors in a defensive position, because the market tends to pull back by a only a few percent, followed by bursts that recover that lost ground and achieve minor but widely celebrated new highs. That is the "unpleasant" part.
The "skew" part is that although the raw probability tends to favor slight successive new highs, the remaining probability tends to feature nearly vertical drops, typically well over 10% over a period of weeks.
Finally, our Managed Futures exposure. For our accredited investors (the legal requirement is that you have a net worth of over $1 million) we use two funds. One is more of a short-term trading program; the other has a more intermediate term focus. They broadly diversify across numerous markets. They work well together because they do not move together. The short-term program has struggled; the other has done very well. Between the two of them, they have had a nice year so far.
Overall, not a bad year so far given our position. Larry and the rest of this talented group of managers have so far acquitted themselves pretty well.