Like all industries, the hedge fund industry is highly cyclical. 2018 is proving to be a catastrophe for many of my fund brethren. Let’s face it; most hedge funds have produced pretty awful returns for the past few years—a time when the S&P (the global benchmark) has shot the lights out. There’s an obvious reason for this underperformance and it comes down to the demands put upon most hedge fund managers.
While funds theoretically can do whatever they want (within reason); if they want to actually raise substantial capital, they’re supposed to beat the S&P every month of the year, with a Madoff level of volatility, while providing monthly liquidity. As you can imagine, this is simply impossible to achieve, yet many of my friends try anyway. This is because the hedge fund industry is mostly about asset aggregation—rather than performance. Ironically, quite a few of my hedge fund friends that have great performance can never raise much capital. Investors may claim they want uncorrelated, idiosyncratic portfolios with plenty of alpha, but they can never stomach the volatility or periods of underperformance that those portfolios entail—despite consistent rolling 3-year out-performance. Is it any wonder that so many funds instead try to focus on achieving the impossible?
It seems that 2018 is the year when investors have finally grown tired of underperforming while overpaying for that privilege. The redemption requests are coming in hot and heavy. What happens when you have redemptions? You have to sell stuff. This, combined with general de-leveraging is creating mayhem—particularly in sectors that have already underperformed over the past few years. It also creates strange outlier moves—the death spasms of an industry getting liquidated.
Take Tesla (TSLAQ – USA) for instance. It is up almost 40% since the low in October, has outperformed the NASDAQ 100 Index (QQQ – USA) by 5000bps and its FAANG cohort by nearly 6000bps. Sure, they beat Q3 estimates, even if the “earnings” quality was horrid. However, I think the real reason for this outperformance was that Tesla had become the short hedge to every fund manager’s long book.
-Got exposure to industrials with waning end-market demand? Hedge with Tesla—it is an auto OEM with a demand cliff.
-Got exposure to companies with substantial overseas business that will be impacted by a trade war? Hedge it with Tesla—its overseas business is a substantial portion of overall revenue, but is vaporizing as newer products are introduced in its top markets.
-Got exposure to companies with questionable accounting? Hedge with Tesla—no one’s books are worse.
-Worried one of your positions is a fraud? Hedge it with Tesla—it has more red flags than a May Day parade.
You get the point. While short interest was only about $10 billion at the peak, that number doesn’t include the massive implied short through outstanding puts—which are many times the entire float. What happens when people take down their overall exposure through redemptions? They take down their longs AND their shorts. In this case, they liquidate their puts—causing the never-ending melt-up we’ve seen at Tesla. We can be sure it’s not due to financial performance, as it seems that most Q4 metrics are tracking negatively compared to Q3.
Moving to small caps; I’ve been involved in this sector for nearly two decades. I can only think of two other times where I have seen so much pain and frustration amongst my small cap friends. That would be the 2008 to 2009 period and to a lesser extent during the first few months of 2016. I am stunned at how many high quality businesses trade for mid-single digit cash flow multiples—despite strong balance sheets. I’m even more stunned at how many slightly leveraged businesses trade at low single digit cash flow multiples. It’s outright insane how many companies trade for massive discounts to NAV. Take a look at shipping for instance—you have dozens of companies where you can liquidate the fleet and double your money based on current vessel values. This is despite the fact that charter rates are up and values are increasing. Of course, this still doesn’t quite compare to anything exposed to the energy sector. These things are being given away as dozens of energy funds liquidate and sell everything they own. You could say that some of these businesses are challenged—they aren’t all challenged. Moreover, they shouldn’t all be declining by a few percent a day—with hardly an up day.
What is going on? You are witnessing a massive culling of the hedge fund industry as hundreds of funds are liquidated and thousands more get sizable redemptions. Many of these funds own the same companies—the outcasts from the indexed world, the cheap, the unloved; the same stocks that many other hedge fund managers own. With the hedge fund industry going in reverse, there is suddenly no natural buyer for what must be sold. As a result, you are seeing waves of forced sell orders and few buyers. It is creating rather insane bargains all around.
Like all trends, this one too will end. If your fund is facing a year-end redemption, you need cash in hand by December 31 and you probably finish selling a few days before then. Therefore, at most, there’s 9 ½ days left to make sales. It may get even uglier—it may not. No one knows how to time this. What I suspect, is that the pain will finally abate in two weeks. Or at least the forced selling pain will be done. If you look at Q4, despite only a small drop in the S&P, it has been one of the most painful that my friends or I can remember. There are lots of guys down 20% to 30% this quarter and suddenly forced to de-lever further, to get their risk ratios in order. This sort of pain and indiscriminate selling creates lots of opportunities.
I am bearish on the overall market—I am bearish on the economy. Increasing interest rates will matter more than people realize. There’s a reason that I sold so many positions this summer—I wanted less exposure. I was afraid this would happen. All of those positions that I sold are down substantially from where I sold them—even though most have reported great results. In a downdraft, even the good companies get hit.
Despite my bearishness, I have been putting capital back to work over the past two weeks. Many of the companies that I am buying are down more than half this year—some are down a whole lot more. It’s the most exciting opportunity I’ve seen since 2016—even though I have been a bit early in buying some names. I suspect that even if the overall market is down dramatically during 2019, the bargains of late 2018 will shine given their current valuations—especially as many institute buybacks to soak up the newly freed up shares hitting the market. Christmas has come early once again—at least in the stock market—I might as well take advantage of hedge fund Armageddon.
Disclosure: Funds that I manage are long Tesla put spreads