Hayden Capital commentary for the third quarter ended September 30, 2016. Hayden Capital is a long-biased investment firm that takes concentrated positions in market-leading companies. The hedge fund generally hold 6-15 core positions, and believe the best indication of a quality, “compounder”-type company is one that has a long-runway to invest capital internally at attractive rates of return.
Dear Partners and Friends,
[drizzle]It’s nice to finally get a break. It seems every quarter has had some variety of tumultuous event recently… Chinese currency devaluation, premature Federal Reserve rate hikes, China growth scares again, and Brexit. However, this past quarter was eerily quiet for the first time in a while. After a sharp 8% recovery in the three weeks following Brexit, the market remained range-bound. Volatility as measured by the VIX index reached its lowest levels of the year during this period.
The performance of the S&P 500 this quarter may make one believe that all is well in the world. However, what may seem calm and serene on top, masks the turbulence and rip currents lying below.
Going forward, there are plenty of issues to be worried about. The slowest economic recovery in decades, the highly watched reality-tv that is the US Presidential Election, low inflation, rising government debt, and over a third of global government bonds returning negative yields (investors paying governments for the privilege of holding their hard earned cash) are all concerns that could cause uncertainty and increased volatility in the near future.
I believe markets have yet to adequately price these events into the valuations. Until this occurs, we plan to tread carefully and select only the most high quality investments for our portfolios.
This cautiousness led me to increase our cash exposure during the quarter, to end the period at 35%. I’m happy to report that despite this “cash drag”, our portfolio managed to beat the S&P 500 by +1.26%. Over the third quarter of 2016, your assets at Hayden Capital appreciated 5.04% compared to a 3.78% gain in the S&P 500.
Some investors have questioned why I hold so much cash, and it’s true that if our portfolio were fully invested this year, we would have produced returns of 8.41% versus our actual return of 6.09%. Thus surpassing the market’s YTD return of 7.74%. This implies that my decision to hold cash has cost us 2.32% of performance, however, this is a trade off I am more than happy to make. The value of holding cash lies in its “optionality” value, which allows us to purchase cheap securities during market uncertainty without needing to sell existing positions (which would have likely become cheap themselves in a market sell-off). I believe at this point in the cycle, this “option” value is worth more to our investors than being fully invested.
I am not bullish on the S&P 500, but I am bullish on our companies. I am very satisfied with how our portfolio companies have performed year-to-date, and believe this will continue going forward. As the below exhibit shows, our equity portfolio is much superior to that of the broader S&P 500 index. Not only are our portfolio companies less expensive than the market, but in fact I expect it to grow 54% faster! More importantly, the companies are growing smartly through capital allocation, and reinvesting back in their business at +15% returns.
Additionally with interest rates at historic lows, it’s unlikely that the market’s P/E ratio will expand much further. This means that future gains will need to come from growth in the “E” portion of the equation. I believe our portfolio, with a growth rate 54% higher than that of the market (and cheaper valuation to boot), will have a great chance of outperforming going forward.
Too Much Of A Good Thing
Recently, I came across two articles titled “The Rise of the ‘Do-Nothing’ Investor” and “The Dying Business of Picking Stocks” in the Wall Street Journal. In the articles, it talked about the rise of passive mutual funds and ETFs, and how it is changing the investment landscape. Granted, this is not ground-breaking news; the debate between passive and active investing has been going on for at least a decade.
But being the contrarian that I am, my brain naturally thought to this cover. In 1979, Businessweek infamously declared “The Death of Equities”, after multiple years of low returns and predicted it would remain that way going forward. They couldn’t have picked worse timing. In the next ten years, the market tripled and proved them wrong. It is too often the case that when a topic becomes so popular that it starts gracing magazine covers, the trend is at an end and you should be doing the exact opposite (maybe I should start ordering Businessweek…).
In the last 20 years, the amount of money invested in passive products have risen 7,270%, to over $4 Trillion today. Passive funds now own 11.6% of S&P 500 companies, compared to 4.6% only eleven years ago. Now there is a good reason for why investors have flocked to these products. Fees are low, they’re easy to buy and sell, and investors are able to view the value of their funds on a per second basis. The fact that many traditional mutual funds have underperformed their benchmarks, partly due to their inherently flawed structure, has only added fuel to the fire (we’ve touched upon this in previous letters).
Passive funds certainly deserve a place in one’s portfolio, and I have encouraged some of our own investors to do exactly that. However like any asset class, whether actively managed or not, it does carry risk. And certainly placing an entire portfolio in passively managed products likely isn’t prudent. You can have too much of a good thing.
The issue is that passive funds make up over 34% of discretionary assets today – a figure that continues to rise at an astronomical rate. If the trend continues, the majority of investable assets in the world will be passively invested in a little more than a decade.
The risk with this is that ETFs and other tracking products don’t take into account the most important aspect of investing: valuation. In fact, it doesn’t take into account anything except for how large a company is within the index.
It’s easiest to see the problem with this, when taken to the extreme. In a world without active investors, the weighting of companies within an index would never change. Even if the largest company in the index were a cancer-causing, perpetual money-losing widget maker, with factories that emit radiation. In a completely passive world, such a toxic company would continue to attract greater amounts of capital than more beneficial endeavors.
It’s hard to miss the irony here. In this new universe, the original rational for passive investing – that markets are efficient so trying to beat it