With most hedge funds struggling to turn a profit this year, any fund that has been able to achieve a double-digit return in the first half is worthy of a second look.
David Capital, a small hedge fund founded and managed by Adam Patinkin CFA, achieved a high-teens for investors during the first half of 2016 despite market volatility. In the fund’s second quarter and first half letter to investors, Adam Patinkin writes that these returns demonstrate “the value of uncorrelated, research-intensive stock-picking in an uncertain market.”
David Capital is at its core, a value fund. The partnership is looking for investments that are severely mispriced and have a clear event part to revert to fair value over a two-to-three-year time horizon. When it comes to shorts, David Capital is on the lookout for what it calls “unsexy” shorts. They tend to be boring, well-run businesses with honest management and no accounting irregularities. The company’s targets generally face a wave of incoming supply whether that means overproduction of a commodity, overbuilding of an asset class, or the entrance of one or more new competitors – that will disrupt pricing and likely lead to substantially lower future returns. Specifically, Adam Patinkin writes in the second quarter letter:
“We have been short iron ore miners, offshore oil-drillers, and chicken producers. We have been short a children’s tablet company as Apple Inc. (NASDAQ: AAPL) expanded production of the i-Pad, a consumer drone company as GoPro, Inc. (NASDAQ: GPRO) readied to launch its own drone model, and a chemical processing business just before several new competitors finished construction of new competing facilities. Today, an important theme in our short book is the hotel industry, which is seeing substantial new hotel construction (spurred on by cheap financing caused by near-zero interest rates) plus a second-whammy of supply from alternative marketplaces such as Airbnb, VRBO, and HomeAway.”
The importance of portfolio analysis
David Capital’s second quarter letter contains a fascinating few paragraphs on the fund’s portfolio management. At the end of the third quarter of 2015, David Capital conducted a comprehensive, data-driven review of the fund’s historical track record and reached several important conclusions about its performance.
First off, the data showed that the partnership had a poor track record of investing in negative FCF businesses. The fund’s returns in positive/neutral FCF businesses were excellent with a success ratio of 74% whereas negative FCF companies had meaningfully detracted from returns with a “batting average nearly one-third worse at 45%.” As a result, the fund has banned all negative FCF businesses from its portfolio.
Secondly, the research showed that when the fund’s gross exposure went above 200%, returns and volatility suffered. Therefore, gross exposure is now capped at less than 200%.
And finally, concentration was identified as a factor holding back performance. By targeting a slightly more diversified portfolio of 15 to 20 long positions, up from 10 to 12 long positions, David Capital believes it can reduce the risk of single-name downside volatility while enhancing flexibility to capitalize on market mispricings.
By identifying and acting on these three drawbacks, the partnership is already reaping the benefits.
In the quarter following the implementation of the changes, the fund reported gains in the mid-teens and in the three-quarter since returns have exceeded a third.
Here is a valuable lesson for investors. One of the most valuable skills in investment management is the capacity to step back and be objectively self-critical. After taking a step back to look at its historical performance, this fund became aware of the mistakes it was making and acted to rectify the issues.
Returns since the changes confirm that this was the correct action to take here.