One of the more prominent “Tiger Cub” hedge funds has become even more bearish than he was in the fourth quarter, as he points to zero interest rates as a double-edged sword.

In a Lone Pine Capital client investment letter reviewed by ValueWalk, cautious risk management is afoot as the hedge fund handily beat the S&P 500 by a hand full of multiples. The lead Lone Cascade fund product, for instance, was up 4.5 percent on the quarter while the S&P was positive by 1 percent.

Tiger Cub Steve Mandel, along with colleagues Dave Craver, Mala Gaonkar and Marco Tablada, are continuing to look abroad for opportunities but “valuations are stretched,” the siren song of many market observers who loved stimulus on the way up and are now concerned about an asset bubble that might pop.  This fits Mandel’s style, which is differentiated from the crowd by his independent portfolio construction even though he has an investment in Alibaba and similar stocks, which some fund managers consider “bubbly”.

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Bubbles are what low interest rates are all about

“The zero interest rate policies of global central banks are creating distortions in the equities markets as investors reach for yield,” the letter said.  In a somewhat similar fashion to Bridgewater’s recent analysis of Petrobras, the key is understanding the re-financing terms and loan roll issues.  The adjustment Lone Pine makes in their thinking is transforming the impact of changing interest rates not just of a company refinancing their loans, but also the impact rising interest rates have on stock valuations.

[drizzle]If future cash flows are discounted at today’s interest rates, stock prices are quite reasonable. Discounting those same cash flows at more “normal” interest rates, however, yields a different answer. This is the investment conundrum: rates will eventually return to normal levels. When they return is the big unknown.

Low rates have positives and impact one of Lone Pine’s M&A strategy sleeves

Low rates have had their positives, to be sure. They have encouraged significant merger and acquisition activity, for instance, impacting many of Lone Pine’s positions and take on “moar” debt.  The fund notes that “Apple has been the most visible example of a company more recently adopting this approach”.

The hedge fund uses a particular strategy sleeve to categorize these investment types. The company names read like a who’s who of recent M&A activity: Actavis, Charter Communications, Constellation Software, Energy Transfer, Endo International, Fleetcor, Mohawk Industries, Transdigm, Valeant Pharmaceuticals and Walgreens Boots Alliance.

In terms of foreign investments, Steve Mandel notes that the fund owns stocks “where changes in either shareholder orientation or ownership are catalysts for enhanced returns”, which include – Fanuc (where Dan Loeb is active), Vivendi (where Vincent Bollore is active), and Safran.

The most aggressive to take advantage of the merger and acquisition mania wrought by artificially low interest rates is Lone Pine, and his portfolio performance is an example of what low interest rates can do to M&A stock targets by increasing win percentage with the strategy.

In terms of operations the fund has a big announcement. Lone Pine is moving their Hong Kong office to San Francisco in the coming months.

The hedge fund believes that the time zone differences and distances outweigh the advantages of being on the ground in Asia. Furthermore, Lone Pine believes that a local presence in San Fransico will be more beneficial to global research than maintaining the HK office. Paul Eisenstein and Patrick Fu will be relocating from Hong Kong to San Francisco.

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