Home Value Investing Horseman Global Fund March 2016 Letter: Why We Like The Short Squeeze

Horseman Global Fund March 2016 Letter: Why We Like The Short Squeeze

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Horseman Global Fund letter for the month ended March 31 ,2016.

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Your Horseman Global Fund fell 9.62% net in March.

Due to subscriptions and early April performance the AUM of the strategy is USD 2bn. The Horseman Global Fund is not accepting new money when AUM is above USD 2 bn. We are operating a waiting list.

It has been a very interesting year for active fund managers. As one client put it, most funds got crushed by their long positions in January and February and then in March the short positions destroyed the funds. The Horseman Global is obviously very short, and hence March was a poor month for us.

The first thing to note, and to repeat from last month’s newsletter, is that short squeezes and bear market rallies are part and parcel of running a fund that is net short. And I learnt a long time ago, things that cannot be avoided, should then be welcomed. I am sure some of you are asking how a nearly 10% drawdown can be welcomed? Well if we look at the first quarter, we find that commodities and commodity currencies had a large rally. Furthermore markets like Brazil are up 30% this year. The S&P, despite being down 12% at one point, has rallied to be up to 1% for the year. Despite such moves, we are only down 1% for the year.

Horseman Global Fund

A lot of this relatively strong performance came through the use of non-consensus trades such as long yen, Japanese Government Bonds and treasuries. This has meant that we have not been forced to cover our short book, and in fact remain record short. Many other funds have been forced to cover short positions, and are now less net short at much higher prices than six or seven weeks ago. The nature of short selling is that shorts reduce in size when working, encouraging us to add more when they have already fallen, and grow in size when rallying encouraging us to cover. But of course to follow such a strategy would be to flush capital down the toilet. If you wish to be short to make money (rather than to just hedge), then you need to tolerate big moves in the net short position.

For that reason, I have operated a very open policy on what I short. The reason for this is that investors that have been paying attention, should realise March would have been a poor month, but at the same time, if they share my views, should also view drawdowns as opportunities to add, which has indeed happened. This is one reason I welcome short squeezes.

Horseman Global Fund

The other reason that I like short squeezes, is that the best time to short is when other investors have suffered so much psychological damage from being short, they have promised themselves to never short again. Judging from the performance of funds with similar short positions to Horseman Global and short covering flow numbers that I have seen, March has seen many funds cover extensively. I find this very encouraging for future returns to the short book.

However, I can hear you say, how do you know this is just a short squeeze, and not the beginning of something much more substantial? While equities are trying to send a bullish tune, the 200 day moving average is now trending down for S&P, Dax and the Nikkei. This is not bullish. Furthermore, yield curves in the US, Japan and Europe have flattened. This is not bullish. Yen is rallying. This is not bullish. We have seen substantial covering by the market. This is not bullish.

To my mind, if you want to be short, this looks about as good as it gets. Your fund is short equities and long bonds.

Horseman Global Fund

Horseman Global Fund – Sector Allocation

This month losses came from the short equity portfolio, in particular from emerging market banks, oil exploration, refining and transport, and Asian real estate sectors. Gains were made in the discount retail and defense sectors in the long portfolio.

Vehicle leasing, whereby instead of owning a vehicle, the driver pays a monthly amount to use that vehicle over a set period of time (typically 24 or 36 months) and at the end of the agreement the car is taken back by the leasing company, has grown in popularity over the past few years. In most cases, lease payments are lower than loan payments, as the amount owed on a lease is largely based on the difference between the manufacturer’s suggested retail price and forecasted residual value. The car manufacturer warranty will normally cover the period of the lease and maintenance costs can be covered. The lessor benefits by earning income on the asset over the initial lease term and can realise additional revenue when the vehicle is returned and sold as used down the road.

However vehicle leasing has had a turbulent history in the US. After it grew rapidly in the mid 1990s as automakers and lenders promoted it to accelerate retail deliveries and push revenue growth, eventually, inflated residual values and lower used vehicle prices dictated in part by a surge in off-lease volume led to large losses for manufacturers, captive finance companies (lending companies owned by vehicle manufacturers) and banks.

Horseman Global Fund

With value retention well below the residual values set when the cars were new, bank and captive finance companies were left with portfolios full of used vehicles worth substantially less than had been expected based on forecasted residuals. The overall hit to lenders was estimated at $11 billion in 2000 and an additional $13 billion in 2001 (source: NADA Q4 2015 report).

According to Experian’s State of the Automotive Finance Market report (a credit database company) released in February this year, US car buyers have borrowed more money than ever to finance their automotive purchases as outstanding balances reached USD 987 billion in the fourth quarter of 2015. That’s an 11.5% increase from the previous year, and the highest level of debt on record since Experian began tracking the data in 2006. Leasing accounted for nearly 27% of all new vehicle transactions in the third quarter of 2015, up from 24.7% the previous year. It hit a record in February this year, representing nearly one-third of retail volume in the US. Similarly in the UK a form of leasing called Personal Contract Purchase (PCP), has become popular with small businesses and individuals. It is estimated that 80% of Mercedes sales in the UK now take place via this type of deal (source: BBC/BVRLA).

A reduced supply of used vehicles due to stronger demand combined with a recession based drop in new sales helped boost used vehicle prices and hence the profitability of leasing companies. The Manheim US Used vehicle Value SA index rose about 28% between the end of 2008 and end of January 2016, the highest level ever reached.

Horseman Global Fund

However, the rise in new vehicle leasing has a material effect on used vehicle supply and thus used vehicle prices. Research company J.D. estimates that in 2016 lease maturities are expected to rise by almost 800,000 units (up 33%). Off-lease volume is scheduled to grow by an additional 285,000 units in 2017 to 3.4 million.

According to Experian, one of the biggest shifts in the automotive lending industry during the third quarter of 2015 was the resurgence of captive lenders as they financed 51.6% of new-vehicle loans, up from 36.8% in Q3 2011. We are negative on carmakers globally, automotive financial services and US banks. For further information please refer to Russell Clark’s market note entitled ‘US Auto market – An update’.

Horseman Global Fund

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