Dan Loeb Q2 2016 Letter: Game Of Thrones Investing full letter below
Review and Outlook
Watching Jon Snow’s epic “Battle of the Bastards” scene in the penultimate episode of this season’s Game of Thrones gives investors a sense of how it has felt to manage money during some periods over the past year. Surging enemies forming a seemingly impossible perimeter, a crush of fellow soldiers on the field, arrows coming in overhead, and the need to avoid panic and deftly use sword and shield to fight your way out of a seemingly impossible situation is a good analogy for the emotional experience of managing assets since last summer.
Nearly one year into this market cycle, a few truths of hedge fund investing are evident: 1) portfolio positioning matters as much as stock picking skill; 2) factor risk, not beta, has driven hedge fund underperformance in an up market; 3) crowded trades are a symptom of the prevalence of copycat investment frameworks practiced by hundreds of funds formed over the past decade to mimic the success of many of their investing legend mentors and therefore naturally share the same outlooks and biases; and 4) putting money to work in equities and credit today requires a thoughtful perspective on global events. Macro analysis is no longer just for macro traders.
The Brexit vote was a good example of the importance of being able to make decisions about the real impact of political and economic events in the midst of market turmoil, and many market participants were caught flat?footed. The idea that the outcome was unforeseeable is incorrect – the polls correctly forecast a coin flip – but elites dismissed the possibility. There is a lot to learn from this group?think pitfall, which we nearly fell into ourselves. Over the weekend following the vote, we investigated the actual impact of Brexit and, after concluding the average predicted scenario was too severe, we quickly repositioned our equities portfolio by covering shorts, adding to several long positions, and initiating a new position in a European event?driven situation. This helped generate positive returns for the month, for Q2, and so far in July.
As the Brexit episode showed, investing in this market must be viewed through a different lens. This year, we have applied our views about global risks to portfolio management and maintained a highly flexible, opportunistic approach. Our net equity exposures have ranged from ~40% to ~55% in 2016, allowing us to be proactive in periods of market sell? offs while still taking enough risk to generate returns. We came into the year with a short credit portfolio that we reversed sharply in February, getting long over $1B in energy credit, a trade we discuss further below. We have reduced our structured credit book of housing?related bonds from its highs and focused increasingly on new areas of opportunity in consumer lending. The year’s positive performance reflects contributions from nearly all of the strategies we employ; the top five winners include a constructive long equity position, a sovereign debt investment, high?yield debt investments in energy companies, an event?driven long position, and a short equity position in the pharmaceutical industry.
Our gains have also been the result of mitigating losses in individual investments (other than in Allergan, the year’s largest detractor). We believe that improved process initiatives we have practiced since 2009 – which have helped us annualize at nearly 16% net since then – have helped to avoid dramatic downside in more challenging markets over the past 18 months. A few key shifts have included: 1) moving away from a team populated by generalist event?driven investors to a firm of sector specialists focusing on three distinct areas of equity investing: event?driven situations, constructive/activist situations, and value compounders. In a market with low growth and fewer events, having more depth of knowledge in each sector and more types of equity investments available to us has resulted in better stock picking; 2) an increased focus on controlling net, gross, and factor exposures and shying away from most crowded longs and shorts has allowed us to be proactive in market sell?offs.
Looking ahead, we remain constructive on US markets and are primarily invested here. While observers claim the S&P is expensive, its dividend yield currently is greater than the 30 year bond yield, a relatively rare occurrence not seen since 2009. The dollar’s strength earlier this year had weakened overall S&P earnings and when combined with its softening, the Fed’s signals that another rate hike this year is highly unlikely, and tailwinds from low energy prices, we expect to see earnings improve in the second half. Share buybacks and M&A remain robust. Viewed from this perspective, alongside the observation that very few other asset classes or regions offer more attractive returns, we are content to have our capital in a well?diversified portfolio of US?centric credit and equities.
Quarterly Results Set forth below are our results through June 30, 2016:
A frequent question we are asked is whether we are too exposed to the health care sector. First, we think it matters where we are exposed; we see a significant difference between biotech and pharma companies, service companies like hospitals and HMO’s, and medical instrument and product companies like Baxter. As health care names in general have swung from darlings to pariahs over the past 12 months, we have consistently reevaluated both our exposure levels and specific investments. While there is temptation to dig in following the types of losses we have seen in the sector, we do not share some investors’ belief that every name that has gone down meaningfully will eventually revert to highs. Investors should be particularly skeptical of overleveraged companies with aggressive pricing practices in the current environment.
During the second quarter, we reduced our more concentrated long investments in health care, selling out of our stake in Amgen because we saw better opportunities elsewhere. We continue to hold our Allergan stake. Our largest investment in the portfolio is Baxter, a global manufacturer and supplier of health care products. Since its inception last June, the position has generated a nearly 20% IRR. Despite this meaningful move in performance, its current size is consistent with our conviction about the company and its leadership and the potential we see for meaningful upside from these levels.
Our active involvement in Baxter began last summer immediately following the July 1st divestiture of its biopharmaceuticals business, Baxalta. We believed Baxter had the opportunity to materially improve margins and increase shareholder value. Shortly after the Baxalta split and after we built our stake, Baxter’s CEO Bob Parkinson stated his intention to retire and, by the fall of 2015, Baxter’s Board of Directors had agreed to add two new members – Third Point Partner Munib Islam and Boston Scientific CEO Michael Mahoney. Munib also joined the search committee for a new CEO and in November 2015 the Board selected seasoned medical device executive and former Covidien CEO Joe Almeida to be Baxter’s next CEO effective on January 1, 2016. Mr. Almeida immediately outlined a three?part strategy to transform Baxter: