By Meena Krishnamsetty
We have read dozens of articles about hedge funds and hedge fund advertising over the last few weeks. None of them were 100% correct and most of them were filled with more than one inaccuracy.
The number one mistake they made was comparing hedge fund returns to the 100% long S&P 500 index. Hedge funds are almost always hedged, and thus, in some cases their market exposure can be negative.
In other words, you shouldn't be surprised that the S&P 500 index is beating hedge funds in bull markets, the same way that you shouldn't be surprised that the weather is extremely pleasant in Buffalo during summer months. You can predict when the winter is coming to Buffalo and avoid it. Unfortunately you can't say the same thing about the S&P 500 index. It is 100% long no matter what happens.
Historically, hedge funds' long stock picks did beat the market significantly; they are great at picking winners. To demonstrate this fact and help our readers beat the market, we started sharing the most popular small-cap stocks among hedge funds at the end of August 2012.
These are stocks with market values between $1 billion and $5 billion, and they are the consensus picks of dozens of prominent hedge funds. Over the last 11 months, this simple strategy has returned 55.9%, versus a 22.5% gain for the S&P 500 ETF (SPY). We also backtested this strategy, and it managed to outperform the S&P 500 index by 18 percentage points per year between 1999 and 2009 (see the details here).
The second mistake financial media made was claiming that it isn't possible to pick the best hedge fund managers. We may not be able to pick the better fund manager between two randomly picked hedge fund managers but we will know when we meet a great hedge fund manager.
The same phenomenon exists in sports. You may not be able to pick the better football player between two randomly picked players, but you know that Brett Favre or Tom Brady are among the best players.
Four months ago we published an article on MarketWatch with the title "3 stock picks from the next David Einhorn" and shared the stock picks of Michael Castor. Yeah, we know you've never heard of Michael Castor before. Castor's first pick, Cardinal Health (CAH) returned 21.3% since we published that article. Castor's second pick, NPS Pharmaceuticals (NPSP), gained 77%. The S&P 500 ETF's 8.5% return during the same period barely outperformed Castor's third pick, Anacor Pharmaceutical's (ANAC) 7.1% gain. Castor's three picks averaged more than 35% in four months.
Another great hedge fund manager
In this article, we will share a trio of stock picks by another great hedge fund manager, David Simon of Twin Capital, who demonstrated that he can generate an annual alpha of around 7 percentage points per year. Twin Capital's annual returns ranged between 6.5% and 13.2% for the years between 2008 and 2012. In other words, this means that David Simon underperformed the market during most of this period, yet managed to deliver a cumulative return of 53.4% versus a gain of 8.6% for the S&P 500 index during the same period. How is this possible? Because he is hedged and he can deliver alpha, David Simon managed to return 6.5% in 2008 when most of retirees' 401ks turned into 201ks.
Last month, we at Insider Monkey sat down with David Simon and asked him about his best investment ideas. Here is what he said:
"I think one of our best investment ideas is a triple net lease real estate investment trust called American Realty Capital Properties (ARCP). The symbol is ARCP, and it's yielding about 6.4% right now. They've done a lot of acquisitions lately, and they've grown from a market cap of 140 million to about 5 to 6 billion in the next three months. This is all this year. Their dividend right now is at $0.91, I think, and on October 1st, it goes to $0.94. We have it going to well over $1 next year.
There's one acquisition that's pending a go shop period which we believe will not be a problem. They've already issued stock to finance that acquisition plus another acquisition from GE Capital of QSR triple net properties. Then we believe there's one more acquisition on the back burner for October or November.
Once all these acquisitions are done, based on if they could still finance where we think they could finance 7-year paper, we think it's accretive to the tune of about 25% to 35% to next year's funds from operations. We think they'll grow their dividends at half the rate of FFO. So, they should grow the dividend at least 15%. It should go from about $0.94 to at least $1.08. So, at $1.08, you're talking about - based on what the stock price is now - well over a 7% yield."
David Simon's second stock pick is Liberty Global (LBTYK). Here is what he said about this stock:
"We're fans of Liberty Global. It's incorporated in London and trades here. They just acquired Virgin Media. The negative news today was that they made a bid for a German cable company while they were supposed to do a $3.5 million share buyback.
We think John Malone's philosophy is "Buy as much as you can now because interest rates are so cheap, then lock in your rates and own as much as you can," because he's very good with taxes and everything. The acquisition of Virgin Media increases the free cash flow of Liberty Global to the tune of 12% to 15% a year for at least 4-5 years, which is amazing.
Malone should pay down debt or whatever he wants and if he buys this other German cable company, he'll control basically almost all of Germany because it's contiguous to his other German companies. It's the biggest cable operator in Europe and Europe's growth rate in cable is probably over double what it is here. Attrition rates are much lower and telephony penetration is much lower. So, there's more opportunity there.
… But there are also different classes. There's Liberty A, Liberty C, also called Liberty K, and then there is the super voting stock, Liberty B which is what Malone owns. To us, Liberty K is the one to own if it's more than a 3% discount to Liberty A. Liberty K doesn't get any votes and Liberty A gets one vote, but the super voting stock gets 20 votes. If there's a takeover, K would get the exact same price as A. There's a strong probability that Vodafone (VOD) might buy all of Liberty if they sell their Verizon stake. That's something lurking out there as well."
We pressed David Simon for a third long-term investment idea and here is what he picked:
"There's a mortgage REIT called Chimera (CIM). The symbol's CIM. It's trading about $3.01 to $3.02. We believe they're going to issue 3 more dividends at $0.09 in the next three quarters, which basically brings your price down to around $2.75. We believe the book value is somewhere between $3.00 and $3.10. These companies tend to get taken over for 110% to 120% of book value. We think that the former parent will want to buy them for 10% above book. So, there's a rate of return play. You could buy this for $3.02, you get 3 dividends, and you'd probably get around $3.30-$3.40 in a takeover. So, you make $0.50 on a $3.00 investment in a short period of time."
One thing we agree with hedge fund skeptics in the media is that it is usually time to get out once a hedge fund becomes too big and starts investing in mega-cap stocks because on the average, they won't be able to beat the market by a large enough margin to justify their high fees or deliver adequate alpha for their investors.
Still, the fact remains that there are a lot of opportunities for investors who are willing to take a closer look at smaller, but talented hedge funds that invest in smaller cap stocks. David Simon is one of these hedge fund managers, and we believe his stock picks will outperform the market on the average.