Risk vs Reward – The Story Of Valeant And Sequoia Fund by Ben Strubel, Strubel Investment Management
There’s no shame in being a little bit above average. The goal of many hedge fund managers and value investors is to outperform the market by as much as possible. It’s not uncommon for hedge fund managers to target returns of 15% per year or more. (Keep in mind, the stock market returns 10% on average.) The only way to get extreme out-performance is to hold extreme portfolios.
By definition, to outperform the market, your portfolio must be different from the market. The greater the out-performance you want, the greater the difference needs to be. Take the S&P 500 for instance, an index of 500 of the largest US stocks. If you put together a portfolio of 450 stocks, you’d have a difficult time trying to beat the index because your portfolio closely resembles the index. Now imagine you had a portfolio of just three stocks. That portfolio would perform vastly different from the index. You’d have a much better chance of beating the index with a portfolio of just a few stocks.
Depending on what you picked, however, the difference could be worse or better. For instance, if you picked a portfolio of just Amazon (AMZN), Google (GOOGL) [I don’t care they changed their name to Alphabet, they’ll always be Google to me], and Facebook (FB), then you would be killing the market this year. Conversely, if you picked a portfolio of just Exxon Mobil (XOM), Wal-Mart (WMT), and Caterpillar (CAT), then you would have lost a substantial amount of money.
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My goal for most clients is a lot more modest than the average hedge fund manager. I’d like to outperform the markets by 1 or 2% per year after fees—nothing too crazy. If you think 1% or 2% doesn’t sound like a lot, remember it compounds over time so it ends up being substantial. The reason why I have a much more modest target has to do with risk management. My first and foremost goal for clients is risk management and not to blow up their portfolios in spectacular fashion.
I don’t care how great an investor you are, the world is a crazy, random place and everyone misses something every now and then. No one is perfect. Nothing illustrates the folly of improper diversification quite like the story of Valeant Pharmaceuticals (VRX). We wrote about Valeant in our last newsletter, so if you want to know more about what is going on with that company you can read about that here.
Many previously successful fund managers put a huge portion of their clients’ assets in Valeant. The Sequoia Fund (SEQUX), a mutual fund that Warren Buffett had recommended in the past, put around 30% of the fund into Valeant stock. I can’t emphasize this enough: They put almost a third of their clients’ money in just one company! Many other famous, successful investors, such as Bill Ackman of Pershing Square, John Paulson of betting-against-subprime-mortgage fame, and Jeff Ubben of ValueAct Capital, had huge stakes in the company (often close to 10% of their funds).
While the ultimate fate of Valeant is still unknown, there is and was ample evidence that something was just not quite right at the company. The business model made no sense, and now it appears the company may have issues with inventory building up in some European distribution channels. And there are more questions about just how widespread the “creative” insurance billing practices of their captive specialty pharmacies were. All investing involves risk, and everyone makes mistakes so I’m not criticizing any of those aforementioned fund managers for taking a chance on what was marketed as an exciting, growing, innovative pharmaceutical company. What I am saying is that a company with so many unknowns and with some many potential pitfalls shouldn’t make up such a large part of your portfolio.
This topic also relates to my next one. After years of telling everyone interest rate hikes were just around the corner, the Federal Reserve looks like it will actually raise interest rates at the end of this year or the beginning of 2016. Additionally, the recent budget deal passed by Congress should provide enough fiscal stimuli to allow the Fed to continue gradually to raise rates perhaps throughout 2017. The wild card in everything is the strength of the dollar. If the dollar continues to gain, then it will slow exports and increase imports (widening the trade deficit). A widening trade deficit would have a negative impact on the economy, and it might be enough to offset some of the minor fiscal stimulus we will see from the new budget deal. In any case, we are closer to the beginning of interest rates being raised than we have ever been.
With interest rates going up, it may finally be time to invest in the financial sector. Since the financial crisis, the financial sector has underperformed as low interest rates have hurt banks profitability. (I won’t get into all the gory details here.) However, things look like they are finally starting to change. Therefore, we are starting to look at investing in financial companies. Nevertheless, there is one problem.
The financial sector is probably one of the most difficult to analyze. For example, Citigroup’s last 10-K was 306 pages long compared to Altria Group’s 114-page 10-K. Now add into this the fact that it seems like every single big bank is part bank and part criminal organization. That adds another degree of difficulty to the equation. Banks have been investigated and “found guilty” (well, they usually are never actually forced to admit guilt) of numerous crimes and civil infractions and paid out more than $180B in fines since the financial crisis.
In an effort to take advantage of a rising Fed funds rate, which should benefit financial institutions, and also to avoid becoming the next Sequoia Fund, we are considering investing in a financial sector ETF. That way we won’t have a Valeant Pharmaceuticals situation on our hands with client portfolios having a concentrated position in a single financial institution with the risk something catastrophic happening to that company. We’d rather manage risk properly and settle for “just” being above average.
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