The environment is right for the first real value cycle in a decade; that’s according to value hedge fund Elm Ridge Capital.
Value’s underperformance compared to growth, has been well documented in recent years, with some market commentators even going so far as to say that value is dead in today’s central bank supported markets.
Elm Ridge believes the opposite is true. The fund is betting on value and against growth by taking the other side of the trade from growth-chasing hedge funds. Specifically, Elm Ridge is short high-rated hedge fund darling growth stocks and long equities it believes are undervalued, according to a Q2 letter reviewed by ValueWalk.
The equities Elm Ridge are targeting all the most popular and crowded H&H (Huge & Homogeneous) hedge fund trades. The fund describes hedge fund attitudes towards these companies as “bullet-proof” growth stories (e.g. FANG: Facebook, Amazon, Netflix, and Google), or “stocks you can trust.”
Elm Ridge: Betting against the big boys
So many hedge funds are now chasing so few positions that the industries become highly concentrated. Indeed, Elm Ridge writes that in one “family” of funds, comprising 40 in total and representing a capital base in excess of $100 billion, just ten stocks now account for 36% of aggregate holdings.
But many of these miracle growth stocks have seen growth figures inflated by financial engineering.
Take Facebook for example. As ValueWalk reported last month, a report by Calcbench and Radical Compliance shows Facebook reported GAAP net income of $3.7 billion in 2015 and non-GAAP net income of $6.5 billion an increase of $2.8 billion, or 76.7%. But it may surprise you to learn that almost all of that increase is due to an adjustment for equity compensation expenditures. In fact, the increase in equity compensation expense over the period amounted to just under $3 billion; income tax adjustments took $946 million off the total, and the amortization of intangible assets added an extra $730 million.
Inflated adjusted earnings figures adjusted figures have led to higher valuations across the board for growth companies, but the problem with financial engineering is that it can only last so long. Sooner or later the truth will have to come out.
Elm Ridge is betting that investors will start to see through this trend relatively soon. Even value funds have been chasing high-profile growth stocks since the financial crisis to try and improve returns. Very few of today’s so-called “value funds” actually own traditional value stocks. They are drawn to the H&H hedge fund trades as they seek to mimic performance.
So, Elm Ridge believes that there will be a resurgence in value when the H&H growth bubble finally pops. And to profit from this, the fund has built a long/short portfolio targeting overvalued growth stocks on the short side and undervalued value stocks on the long side.
Specifically, the fund notes:
But, just as most managers are crowding into the same stocks, most allocators are crowding into the same managers. How many of the folks tasked with allocating to hedge funds (as opposed to those whose assets are being managed) are working in an environment that rewards someone for taking on non-consensus risk (nevermind the employee/agent view that taking the same risk as the consensus is not taking risk at all) even if that risk is more than balanced by an outsized payoff? Are most of these people really going to look outside the box?
It seems to us that most of those complaining about the lack of creative thinking on the manager side are doing the exact same thing themselves. When we try and explain how a dose of value in one’s portfolio provides some useful balance to the H&H orthodoxy, we usually hear the same kind of responses. “How do I know that this is the right time?” “We understand what you do and why it should work, but it’s just too early to make the pitch.” “It’s too risky for my career.” “We’re allowed to get some things wrong as long as we do it with everyone else.”
It is no small coincidence that value has started to outperform just as its practice seems to have gone from a core part of a balanced portfolio to some archaic practice that can only be justified when the “time is right,” whenever that may be. We can’t answer that one. But just take a look at the charts below. Indeed, echoing the setting we saw in 2000, this is as ripe an opportunity as we’ve seen. And we see little potential competition as we profit from its (typically multi-year) resurgence.
We weren’t wired to be vanilla or trendy, but we were to do value. And we do value. And we’re looking for just a few more investors, who either own the funds they are investing or are at those organizations that have developed that same sense of ownership, to join us as the tide turns.
At the end of the second quarter, the average P/E of Elm Ridge’s long portfolio was 12.5. The average P/E of stocks in the short portfolio is 22.7. These figures compare to an average P/E on the long side of 25.14 for the wider hedge fund group and 18.3 on the short side. Around 30% of the short book can be characterized as cyclicals where the world is extrapolating recent good times. 15% can be thought of as non-cyclicals but still threatened by some kind of excess supply. 25% would forms the platform/financial engineering/excess leveraged bucket and around 20% are the supposedly safe-but-maybe-not-so group.
On the long side, Elm Ridge likes the energy sector with energy bets now taking up 40% of the fund’s portfolio. It appears that this is a classic value play. The oil sector crash that took place during 2014 and lasted into 2015 saw many institutional investors leave the space, and now the price of oil is recovering, fundamentals are beginning to look attractive.
Elm Ridge writes that according to its figures, even if oil moves steadily up to $75 a barrel by the end of 2017, and the North American oil industry start adding rigs at a rate of 100 per quarter, US production will still post the kind of declines next year that would imply shortages even in the face of zero demand growth. However, it seems few other hedge funds believe this trend will play out:
“We’ll wait to see when the H&H’s take notice. Maybe then, as opposed to a few weeks ago, our analyst will attend a presentation from a $20 billion market cap E&P CEO at a major investment conference and see more than a handful of other folks in the audience.”
Finally, the hedge fund has some (harsh) words about one of the newest trends, activist investing:
Indeed, the early success of the activists in reining in empire builders, pushing for more