Anchorage Capital, a primarily debt-oriented hedge fund with a certain degree of distressed equity investing, likes to add to exposure after a drawdown. And they see trouble ahead for US equities with the potential for spillover into not only corporate debt markets, but interest rates across the board could rise. In a July 30th 2016 second quarter investor letter reviewed by ValueWalk, the more than $15 billion fund manager said they are positioning the portfolio for market volatility and an opportunity to invest on a drawdown.
Sharp movements could produce significant opportunities, fund says
Anchorage Capital fund managers Kevin Ulrich and Daniel Allen are “looking forward” to “a market that appears more inclined to sharp and binary movements.” This outlook that multiple assets could be caught up in a trigger effect “should produce significant opportunities for the Fund.”
Ulrich and Allen are using politer financial verbiage to describe their outlook for market volatility and resulting lower equity prices. Having reduced long market risk by 10% of the portfolio’s net asset value, they believe volatility and a market decline “provides us with an advantage in capitalizing on the inefficiencies created when markets turn challenging.”
The current challenge, as they see it, is “anticipating inflection points and ensuring we are appropriately positioned to take advantage.”
Picking the exact stock market top and bottom, just like calling the exact time and date of a stock market crash to start, is more than challenging. In the past, analysts have identified the general conditions that have surrounded a stock market dislocation and bet on a stock market decline – and some quantitative analysts have predicted a flash crash after the market had been turning lower. Anchorage appears to be saying they don’t know when the market will experience a value adjustment, but they are ready.
“We are now seven years into the U.S. economic expansion. Low (and even negative) interest rates and cheap financing have clearly succeeded in protracting the credit cycle and allowing systemic leverage to continue to build,” they wrote, pointing to specific macroeconomic risks without saying as much. “There is no immediate catalyst to suggest that this dynamic is unsustainable in the short term, but our view is that investors should begin to prepare for the inevitable reversal of these trends.”
Without picking an exact top or bottom, the fund plans to patiently wait for the market to play its cards. “We expect to be conservative in our cash deployment and disciplined in making new investments as we look for new opportunities to achieve significant differentiation,” they wrote. “We continued our efforts to position the portfolio for a world that we believe should be more volatile going forward.”
Fund increases cash balances
In addition to reducing long market risk by 10% of NAV, the fund increased cash balances as it waited for “future compelling opportunities to deploy capital in liquid markets.”
This approach is consistent with the fund, which is down -1.48% as of June, as they claim to “have successfully taken advantage of volatility on both the long and the short side. These trading opportunities were more limited in the past quarter as markets grew calmer, with U.S. credit outperforming in the aftermath of the British vote to leave the European Union.”
Looking at pulling back long exposure, Anchorage just thinks risks are not being adequately compensated. This means lower quality high yield, commodities-sensitive businesses, and recent-vintage distressed areas are difficult areas to find credit value. The hedge fund also believes that volatility is coming and yield compression will lead to opportunities for shortselling securities.
Individual asset selection is important, but there are greater risks, such as political shock risk, the impact of quantitative easing on market credibility. For this the fund says they are prepared. “We continue to hedge our exposure to interest rates and foreign currencies in an attempt to mitigate the impact of macroeconomic factors,” they wrote.
It is a new game, Anchorage says, and they are ready to play:
Distressed and restructured investments have been the major driver of Fund returns coming out of the last cycle, and we believe that the idiosyncratic character of our holdings will allow them to continue to contribute positively. That said, year-to-date performance in this segment of the portfolio has been mixed, with some positions producing mark-to-market losses against the more volatile backdrop that prevailed between last October and this February. While these investments are clearly capable of experiencing volatility, our view remains that event catalysts such as sale transactions will be the key factor in future positive performance.
One inherited name Houghton Mifflin Harcourt subtracting from performance, while Irish telcom additive
On an individual name level, Houghton Mifflin Harcourt (HMH) was the Fund’s most significant negative exposure, subtracting -0.63% from second quarter returns and -0.91% from year to date numbers. Anchorage holds the company’s equity, having acquired it through a 2012 debt restructuring.
Despite the Brexit, performance among their European issues was generally flat over the month.
In the relatively few instances where we held names that were affected by Brexit, we were generally able to position ourselves to mitigate the impact. This was the case with our investment in the U.K. retirement homebuilder McCarthy & Stone, which detracted -0.40% from Q2 and -0.37% from YTD returns.13 We co-led a restructuring of the company in 2013, believing that the company’s 60% market share in U.K. retirement housebuilding would allow it to benefit from the combination of a fast-growing elderly population and recovering house prices.
In an Irish holding where the fund has a major stake, interesting macro developments are also at play. Anchorage is the largest single investor in Irish telecommunications company Eircom, and this is the fund’s third-largest investment. The company refinanced debt 9.25% to a 4.5% interest rate. Such activity was a reflection of the strengthened business and will offer material cost savings, they said. “The reduction in financing costs also demonstrates how European quantitative easing can benefit certain of our distressed and restructured holdings, even as it has limited trading opportunities in performing credit.”
The move led to a large sovereign wealth fund taking a position in the stock, showing how the stock is moving from distressed into a more normalized environment – an Anchorage specialty.