Grey Owl Capital Management letter to investors for the third quarter ended September 30, 2015.
“It seems to be a law of nature, inflexible and inexorable, that those who will not risk cannot win.” – John Paul Jones
“Wise men say, and not without reason, that whoever wished to foresee the future might consult the past.” – Machiavelli
“You’ve got to know when to hold ‘em…” – Kenny Rogers
“Never tell me the odds.” – Han Solo
The Grey Owl investment process starts and ends with robust risk management. Our goal with the Grey Owl Opportunity Strategy is to provide equity-like returns, but with lower drawdowns and volatility than the major equity indices. As such, we worry about the downside first. We do not want clients to fear opening their monthly statements, and we certainly do not want to put regular withdrawals at risk, regardless of what the indices are doing. Over the almost nine years we have run the Grey Owl Opportunity Strategy, we have achieved our goals as the table below illustrates.
In 2008, most investors were driving a fast car down a country road at night with no headlights. They ignored widening credit spreads and kept their allocation to risk assets too high. Value investors bought financial securities because they seemed cheap relative to book value, and neglected to size the position with any consideration to the idea that these entities had so much financial leverage, a bad quarter could entirely wipe out equity value. When cracks in housing finance became obvious, most investors neglected to do robust scenario analysis to determine their true exposure to the situation.
Our approach is different. We think about risk-management at the asset allocation level. Do we want to have more or less exposure to risky assets? When we size individual positions, upside potential matters, but risk factors like business variability and financial leverage have a larger impact. When a portfolio holding experiences a business shock or controversy, we use scenario analysis to assess and size the spectrum of possible outcomes. How much risk does the event really introduce? The current environment presents the opportunity to discuss all of these components of risk management in the following letter. First, here is the performance table for the Grey Owl Opportunity Strategy as of September 30, 2015:
Grey Owl – Market Environment – Risk Management via Asset Allocation
Widening credit spreads are one of the strongest signals that investors are becoming increasingly risk averse. From September 30, 2014 through September 30, 2015 credit spreads (BAA – AAA yields) widened 59bps from 76bps to 135bps. Market internals, as articulated by Lowry’s and other data sources, corroborate the credit spread outlook.
During periods of rising investor risk aversion, risky assets like US equities perform poorly. Haven assets like US Treasury bonds and gold perform well. HCWE, an economic consulting firm, recently published a table of US equity returns since 1975. The table is sorted into three categories: widening credit spreads, stable credit spreads, and narrowing credit spreads. In periods where credit spreads were widening as they are today, equities returned only 10% over two years on average.
Periods of widening credit spreads are also ripe for significant drawdowns. For these reasons, we now hold approximately 30% cash in our separate account strategy. This backdrop is also why we added to Annaly Capital Management (NLY) during the quarter. NLY owns government-backed mortgage debt and has performed well historically in weak market environments. Part of the appeal today is its 12% yield. In addition, we have lowered our net equity exposure in Grey Owl Partners. Depending on week-to-week movement in our market hedges, our equity exposure varies between market neutral and mid-teens net long exposure. We also increased our exposure to long-dated US Treasury bonds in Grey Owl Partners. In our fixed income accounts, we have lowered our exposure to credit risk, both domestic and foreign, and increased our US Treasury exposure. Across all of our strategies, we are moving toward a capital preservation mode.
Grey Owl – The October Rally
The S&P 500 rallied 8.4% in October. Despite this move, credit spreads remained elevated – moving from 135bps on September 30, 2015 to 137bps on October 30, 2015. In addition, the move was concentrated in mega-capitalization securities. A significant portion of the overall US equity market remains in the early stages of bear market territory. This signals a poor outlook for large capitalization indices (such as the S&P 500) as well.
In their October 30, 2015 weekly report, Lowry’s described the overall market situation at the new recovery high on October 28th: 55% of small-cap, 28% of mid-cap, and 20% of large-cap stocks in the Lowry’s “operating company only” universe were still down 20% or more from their bull market highs. In other words, investors are still showing signs of risk aversion. Until that changes, we will continue to shift our portfolios away from risky assets and toward haven assets.
Grey Owl – Valeant (VRX) – Past, Present, and Future
The Past – Managing Risk through Prudent Position Sizing
If you are not familiar with the Valeant story, you have not been reading the business news over the past month. For background on our Valeant Pharmaceuticals investment thesis, see our third quarter letter from 2013. Despite recently losing over half of its market value from late August through late October, we still show an almost 100% gain over the lifetime of our investment in VRX.
From the beginning, we recognized that Valeant is employing a unique and aggressive business model – from an operational standpoint, as well as through the use of significant financial leverage to finance acquisitions. Given the higher risk profile, we twice trimmed the position so that it did not grow to be too large a percentage of our overall portfolio. This is despite the fact that the stock never exceeded our fair value target by much and continued to perform incredibly well from an operational standpoint. The history of our buys and sells illustrates this point.
We first purchased shares in Valeant Pharmaceuticals (VRX) in January 2013 at an average price of $64. We added to the position in June 2013 at an average price of $84. We sold approximately half of our shares in January 2014 at $138. More recently, we sold approximately one-third of our remaining position in August 2015 at $231. After the recent sell-off, we added fifty percent more to our position on October 26, 2015 at an average price of $110. At $110 per share, our total return on VRX has been 97%. More importantly, if our current position (including the shares we just bought) went to zero, we would still show a modest positive return on our entire VRX investment of 16%.
The Present – Are we crazy to be buying VRX again? (Or, risk management via scenario analysis.)
On September 21, 2015, a story broke that a small, private pharmaceutical company, Turing Pharmaceuticals AG, acquired and then subsequently raised the price of a toxoplasmosis drug 5000%. VRX closed at $229 on that same day. Then, news