The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

This morning, I got to listen to a (too short) discussion with hedge fund manager Ray Dalio of Bridgewater Associates at the Bloomberg Market 50 Summit (video here).

Ray Dalio is a fascinating guy . . . he has what some people describe as a very idiosyncratic approach, but I find it logical and intelligent. His numbers speak for themselves — $125B, 15+%/year, running the shop for 35 years. Those people who criticize his “Truth-driven, self-reflective process” tend to only trash his beliefs as, the numbers above reveal, they cannot trash his performance.

Following his presentation, I wanted to meet him and just say thank you. The guy was barely off the stage when he was mobbed by people pushing business cards and presentations into his hand. I utterly forgot what a pack of unruly jackals the Sell Side can be. I am mortified by the behavior, and go outside to grab an iced tea (Bloomberg events always have great food and drink).

As I head back inside, Dalio and the sea of hangers on are heading out. The salivating salesmen hoping for fat commissions seem to not understand his methodology, which does not have him waiting on a trading desk’s recommendation. He has a huge pile of business cards, and an assistant or Bloomberg aide has a stack of envelopes/presentations.

I hang back from the hyenas, annoyed by the thought I won’t get to meet him. But then there is the tiniest of pauses, and without thinking, I blurt out “Ray, I don’t have a business card for you, I just wanted to thank you for your emphasis on process.”

Dalio turns, extends his hand. I introduce myself, shake his hand, and add “I find your focus on self-reflection and error correction, on enlightenment refreshing compared to the rest of Wall Street.” or words to that effect.

He swivels around to face me full on, and says “Isn’t that what it is all about? If you don’t understand yourself, how can you ever meet your goals, in life or in investing?”

Exactly. I tell him the emphasis on what matters is inspirational –the rest of the Street is missing the big picture. We start to chat — I tell him a brief story from my sell side days about cognitive foibles and selective retention — he nods and laughs. Meanwhile, we’re talking a few minutes and I can feel lots of eyeballs staring hatefully at the one jackass not interested in commission dollars (the damned fool!).

I appreciated the moment, and say something to the effect of “I know you want to get to you car, I just wanted to say thank you again.” He shakes my hand again, and heads to the car (Some other crazy stuff happened that I will save for another day).

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If you want to learn more about his approach, I suggest you read Dalio’s dissertation on Principles. Its his Magnum opus, and explains his fundamental Life Principles as well as his Management Principles.

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See also
Bridgewater Discussions on Culture (Videos)

Observing a Bipolar World
Barron’s March 12, 2011

Mastering the Machine: How Ray Dalio built the  world’s richest and strangest hedge fund.
John Cassidy
New Yorker, July 25, 2011

MarketFolly.com puts out quarterly subscription research — Hedge Fund Wisdom newsletter — that follows what the top hedge funds are buying and explains why.

Its worth checking out. Below is a recent version of a portion of the newsletter.  You can find out more by emailing marketfolly@gmail.com.

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Reducing Equity Exposure

Dan Loeb’s $4 billion Third Point Offshore Fund has decreased equity exposure three months in a row.  At the end of July, Third Point was only 23.3% net long equities, down from 42.6% net long only two months earlier.

The latest batch of SEC 13F filings depicts a less drastic reduction in equity exposure by hedge funds as a whole, but nonetheless a reduction.  Our friends at Alphaclone submitted their findings that “total market value disclosed and attributable to equities” decreased 2% from Q1 to Q2 (see the chart below):

While some funds were more aggressively entering ‘risk off’ mode in Q2, the volatility in August will certainly ensure that more risk has been taken off the table.

Consensus Buys

We track 40+ prominent long/short equity funds, placing emphasis on managers with solid stockpicking performance and longer investment time horizons in an effort to follow true investors, rather than funds more prone to trading.  Glancing at their latest portfolios, you can easily single out a few stocks that garnered significant capital.

One of the ‘consensus buys’ among long/short funds in the second quarter was Sensata Technologies (ST).  The company was carved out from Texas Instruments in 2006 as part of a leveraged buyout (LBO) consortium led by Bain Capital.

Since then, the company IPO’d in March 2010 and hedge funds have built up stakes in the company.  This past quarter, Och-Ziff and Hoplite Capital initiated new positions.

Also, many prominent hedgies added to their pre-existing positions in ST including Scout Capital, Lone Pine Capital, Blue Ridge Capital, and Valinor Management.  The brand new issue of our premium newsletter Hedge Fund Wisdom analyzes the potential investment thesis.  (You can download a free past issue here.)

Numerous top managers also initiated stakes in Expedia (EXPE), as the online travel-booking company was a consensus buy.  In a highly anticipated event, the company announced it will spin-off its TripAdvisor segment as the company looks for appropriate valuation for its fast-growing social media property.  This is exactly the type of catalyst-based investment many of the hedge funds we track like to play.

Mosaic (MOS) was also a consensus buy as numerous hedgies took advantage of the secondary offering as the Cargill family unloaded their shares and removed a big overhang on the stock.  Southern Union (SUG) was also a name that saw a lot of buying as well.

Buying One Bank, Selling Another?

While the tendency of many hedge funds was to reduce exposure to financials in the second quarter, there was an interesting dichotomy between shares of two of the sector’s titans.

Prominent hedgies such as Paulson & Co (John Paulson) and Appaloosa Management (David Tepper) sold off shares of Bank of America (BAC).

Yet at the same time, some potentially contrarian investors were stepping in to buy shares of rival Citigroup (C) ~ Lee Ainslie’s Maverick Capital and Bill Ackman’s Pershing Square to name a few.  These ‘rogue’ funds are somewhat of an outlier, though, as more often than not, hedgies reduced exposure to financials.

Bruce Berkowitz Goes All-In on AIG

And speaking of rogue or contrarian funds, none fits the bill more right now than Bruce Berkowitz’s Fairholme Capital.  While he’s a mutual fund manager, Berkowitz certainly acts like a hedge fund manager by taking highly concentrated stakes in companies and getting involved with his investments.

In Q2, he more than doubled down on his already massive stake in American International Group (AIG).  This position now accounts for a whopping 23% of his equity portfolio.  For what he sees in the company, we extract a bit of analysis from our premium newsletter:

Based on the company’s latest reports, AIG’s core businesses can generate earnings of $2.50+, which would justify the current share price given that the sector trades at ~7x 2012 EPS.  Additionally, AIG has a book value of ~ $50 and trades at a little over 40% of that value, which is low compared to peers trading at 60-70%.

Also, AIG has significant deferred tax assets (DTA) from net operating and capital losses.  The reversal of the DTA valuation allowance, the successful IPO of its ILFC division, and stronger-than-expected sales due to the recapture of some previously lost distribution channels could unlock AIG’s value.

Conversely, AIG is a highly complex company with opaque financials.  The government still owns 77% of the company’s shares and will be selling them in doses over the next couple of years perhaps, which could put a lid on the stock.  You can read the bull and bear cases for AIG written by hedge fund analysts in our just released newsletter.

Hedge Funds Buy ‘Growth’ Tech, Sell ‘Value’ Tech

Over the past few years, Wall Street has witnessed a shift in the tech.  Customers traded in their Hewlett Packard (HPQ) PC’s running Microsoft (MSFT) Windows for new Apple (AAPL) iMacs.  Google (GOOG) replaced Yahoo! (YHOO) as the dominant search engine and itself became a verb (“google it”).

This shift has caused shares of MSFT, HPQ, and YHOO to trade at much lower valuations and all three were actually ‘consensus sells’ among the hedge funds we track in the quarter.  Yet in the carnage, there were a few notable value investors who found the valuation of MSFT too tempting to pass up.

Legendary investor Seth Klarman (Baupost Group) purchased a new $312 million stake in MSFT and David Einhorn’s Greenlight Capital boosted its position in MSFT by 63% and owned a $385 million stake at the end of Q2.

While those two widely respected investors took a contrarian stance, many other hedge funds were piling into the ‘growth’ plays instead.  Apple (AAPL) and Google (GOOG) were their preferred destinations as they were both consensus buys in the quarter.

And rounding out recent activity takeaways, we’ll close with a bit from Goldman Sachs’ Hedge Fund Trend Monitor.  The five most important stocks to hedge funds according to Goldman’s VIP list are: 1. Apple (AAPL), 2. Microsoft (MSFT), 3. Google (GOOG), 4. Citigroup (C), and 5. General Motors (GM).

Source:
MarketFolly.com,
Hedge Fund Wisdom newsletter

I’ve spoken to a variety of Hedge fund managers and traders this week who have been ridding this market up and down.

Consider this one Connecticut hedge fund manager I speak with regularly:

On the long side, he is heavy into gold mining and high quality multinations; On the short side, he’s been betting against large American and European Financials, Consumer Discretionary, Home Builders and Cyclical Semis.

Over the past month, we have been discussing the Economy, the Fed, the Markets and specific sectors. As to his own holdings performance, he writes:

“The performance this month is volatile to say the least: Daily returns this week, if monthly, would be too volatile for almost everybody out there. Monday: +8.2%. Tuesday: -3.8%. Wednesday: +5.5%. And not over yet. Get me some Dramamine.

Thursday (8/11) -4.09%; Friday (8/12) -0.89%; Mon (8/15), 1.67%; Tues (8/16), 1.1%; Wed (8/17), 0.82%; and Thurs (8/18), 5.32%. Numbers are gross, in more ways than one.”

-July, the fund was up +10%

-August (to date) is plus 23.7%; Quarter (to date) 33.3%.

Prior to the July/August period, the fund was down high single/low double digits.

The following data is taken from Congressional testimony of the well respected banking analyst, Bert Ely, illustrates how the Federal Reserve has gone from being a taxpayer subsidized monetary authority to one of the world’s largest and most profitable bank/fixed-income hedge funds.   Mr. Ely points out the pre-crisis Fed balance sheet (Table 1) consisted mainly of “Fed-issued currency intermediated into Treasury securities with both of those items compromising 90% of their side of the Fed balance sheet.”     On the income side, Table 2 shows that in 2007, which Ely calls the last “normal” year, the U.S. taxpayer provided a $5.7 BN indirect subsidy to the Fed by paying $40.3 BN (line 1) of interest of the Fed’s holdings of Treasury securities, of which a $34.6 BN surplus (line 17) was returned to the Treasury.

Table 1 also illustrates how, since the crisis began, the Fed has more than tripled the size of its balance sheet, increasing its Treasury holdings by $650 BN and purchasing of over $1 TN of MBS and Agency debt.   As of May, according to Ely, the Fed held 14 percent of the total debt and MBS issued or guaranteed by the three housing-finance GSEs and Ginnie Mae.   The balance sheet growth was financed almost entirely by the creation of bank reserves held as deposits at the Fed (line 10).   These reserves now account for almost 10 percent of total banking-industry assets, which, prior to the crisis was effectively a rounding error.

Table 2 shows the Fed’s net income has grown from $38.7 BN in 2007 to $81.7 BN in 2010 (line14).  Though the sharp decline in interest rates reduced the Fed’s interest income on Treasuries  from $40.3 BN to $26.4 BN, the more than $1 TN purchase of agency debt and MBS helped to generate $53 BN in interest income (line 3) in 2010, up from $.6 BN in 2007.  The Fed returned $79.2 BN to the Treasury in 2010 (line 17) and after accounting for the $26.4 BN of interest on Treasuries generated a $52.9 BN profit for taxpayers.

The risks?   Take a look the leverage ratio in Table 1 (line 13).  John Hussman points out the Fed’s leverage ratio in now higher than that of Bear Sterns and Fannie Mae with similar interest risk though less credit risk.  He writes,

The maturity distribution of these [Fed] assets works out to an average duration of about 6 years, which implies that the Fed would lose roughly 6% in value for every 100 basis points higher in long-term interest rates. Given that the Fed only holds 2% in capital against these assets, a 35-basis point increase in long-term yields would effectively wipe out the Fed’s capital…

To avoid the potentially untidy embarrassment of being insolvent on paper, the Fed quietly made an accounting change several weeks ago that will allow any losses to be reported as a new line item – a “negative liability” to the Treasury – rather than being deducted from its capital. Now, technically, a negative liability to the Treasury would mean that the Treasury owes the Fed money, which would be, well, a fraudulent claim, and certainly not a budget item approved by Congress, but we’ve established in recent quarters that nobody cares about misleading balance sheets, Constitutional prerogative, or the rule of law as long as speculators can get a rally going, so I’ll leave it at that.

We’re not sure of the endgame and when and how all this is going to play out.  But we do agree with Mr. Hussman that “the predictable outcome is instability.”   Toto, I have a feeling we’re not in Kansas anymore.

Hedge funds managed by women outperformed those managed by men over the past nine years.

autostart video after the jump

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Greenlight’s David Einhorn appeared on “In the Loop” with Betty Liu and Jon Erlichman. He said that too-big-to-fail sentiment curbs concessions and that he is not looking at the jobs story when he’s deciding on an investment right now. He also said Apple is a premium opportunity and that a St. Joe buyout would be would be “very tough

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Greenlight Capital’s David Einhorn on Bloomberg Television. Einhorn appeared on “In the Loop” with Betty Liu and Jon Erlichman.

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The AQR founder and manager on AQR Global Equity’s process and the difficulty of momentum investing through the downturn.

By Kathryn Young| 6-24-2010 12:55 PM

David Gerstenhaber was one of the first “Tiger Cubs”, a term for hedge fund managers who started on their own after having worked at Julian Robertson’s legendary Tiger Investment Management.

15:49

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Quote of the Day:

“If I get even a whiff of an investigation, I want to get out before the next guy, especially if I know they have illiquid stuff or I don’t know what they have. Everyone’s nightmare is to get stuck with the stuff in the basement.”

-Head of a fund of funds, speaking to the FT.com anonymously.

This SEC investigation promises to be quite interesting . . .

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See also:
SEC switches to undercover tactics (FT.com)

The WSJ is reporting the FBI raided the Connecticut offices of two hedge funds amid insider-trading case.

Marketwatch reports that the firms — Diamondback Capital Management and Level Global Investors — were spinoffs from SAC capital.

This which leads to the obvious question: Is the SEC chasing the big dog (Stevie Cohen), or was this merely a coincidence . . .?

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What say ye?