This year in June I joined a major bank in Canada and decided to wind down my fund Pelorus Capital. After running it for three years, I can say I am proud of the performance, but more proud of the lessons and experience I gained from running it. There is no better teacher than spending every trading day for 3+ years engaged in the markets, doing research and making investment decisions.
In light of this large change in my life, I thought I would do a recap of the key investing lessons and experiences I garnered over the past three years.
Figure 1: Pelorus Capital Since Inception Returns
Note: All returns are gross of any fees/expenses that a normal fund would charge. All returns are in USD, and index returns/charts do not include the effect of re-investment.
When I started Pelorus, my primary goal was just to keep a record of the game I loved and still love to play: investing. I decided to have an unconstrained strategy: there was nothing off limits. If I saw attractive risk reward and understood what I was doing, I would take opportunities as they came along.
The best way I can describe this strategy is as a long/short, primarily equity, special situations fund. The primary focus was to be on investments which were significantly mispriced by the markets, mainly stocks. These investments would have some catalyst to close the "valuation gap": either a change in the business, improving fundamentals, takeovers, bankruptcies, activist shareholders, or anything else that provided a kick in the right direction for the stock. These companies were usually smaller, generally under $5 billion in market cap and were traded in the US and Canada, though it would include ADRs.
Added to this fundamental strategy would be some investments and hedges based on a macro thesis, such as interest rates staying low, or China having large structural problems in their economy. These macro trades would be expressed in the most efficient way possible: shorting highly leveraged commodities; using complex option trades; inverse/leveraged ETFs etc.
I also decided there would always be some short exposure in the fund. If I had no alpha based short ideas, I would simply short the indexes (the S&P 500, Nasdaq or Russell 2000 depending on my view of which was likely to be weakest or best hedge the portfolio) using either options or ETFs depending on my view of the relative pricing of options (e.g., if implied volatility was high, generally I would short the ETF; if implied volatility was low, generally I would use options). The rationale behind this tactic was this: if my best long ideas couldn't outperform the indexes, then I should find a different profession.
With this general outline out of the way, I'd like to explore 2013, 2014, 2015 and the first half of 2016, and then spend some time going over the key lessons I've learned from investing over this time.
2013 - An Easy Year (for Longs)
Those around in 2013 will remember the outstanding performance of the S&P 500 (total returns of over 30%). This came on the heels of 2012, which was effectively flat after the US Debt Ceiling debate and a European crisis involving Greece leaving the Eurozone.
Pelorus Capital started the year with no money invested and a very cautious outlook. I started trading in 2011, and boy was that a baptism by fire! We had swings of over 4% almost every day for a month in the S&P; something we haven't seen since!
I invested in a number of companies on the long side: TIO Networks (OTC:TNCGF) (which I'll go over later in more detail) EBIX, CRH Medical, Wanted Technologies and Vodafone were some of our largest positions on the long side. On the short side, I simply shorted indexes. One thing to note is that the largest 10 positions made up over 50% of the long portfolio: I have always favored concentration over excessive diversification.
By May Pelorus had invested most of its cash, and had an exposure of 80% long, 20% short. Fortunately for me, the market did extremely well in 2013, and our long exposure benefitted me immensely. In particular, the exposure to Vodafone (NASDAQ:VOD) (6% weight) and TIO Networks (7% weight) gave us a big performance lift.
My view on Vodafone was similar to that of Greenlight Capital at the time (which is where we got the idea): Vodafone's Verizon (NYSE:VZ) stake was worth $120-130 billion, whereas VOD was trading at roughly that valuation. We viewed the rest of the business being worth at least something, and so the stock presented attractive value, especially as VOD had said it was open to selling its 45% stake in Verizon Wireless.
My view on TIO Networks was the same as it has been the past 4 years: the business was undergoing a transformation, and was worth many multiples of what it was trading at. My view on the stock is detailed more in my write up on the stock.
Because of Pelorus' large weightings in these stocks, and others that performed very well, coupled with minimal short exposure, Pelorus ended the year up 32.78%. My view on the year was that I got lucky. I had invested in great companies, sure, but we got a huge lift from the overall market that year. I didn't expect to do 30%+ ever again: my target is 15% a year.
Figure 2: Pelorus Capital 2013 Returns
2014 - Surely We Can't do 30% twice!
Pelorus entered 2014 86% long and 23% short, with no alpha shorts. This changed over the year.
The long portfolio did not change. TIO Networks continued as our largest position (~8% weight), with VOD, CRH Medical, and Wanted Technologies also over 5% each. By the end of the year I had sold VOD as my thesis had played out: they had sold their stake, the remaining business was fairly (if not a little over) valued, and we had received a very large cash dividend.
Our largest add was Darden Restaurants (NYSE:DRI) in October. Starboard Value had just swept the entire board and published what must go down as one of the best presentations ever on proposed business restructurings. Shares popped on the news, but subsequently declined as the market corrected in August. This gave me the change to buy shares at a price below what the company was trading at when Darden took over the board! I viewed it, as Carl Icahn would say, a no-brainer. Darden primarily added to 2015's performance.
Another no-brainer was the addition of American Airlines (NASDAQ:AAL). The stock in October was depressed due to Ebola and also a market correction. However, with oil prices down significantly, the company was set to make $5 billion more in profit in 2015 than 2014; effectively, shares had traded in exactly the opposite direction they should have! I viewed Ebola as a non-issue, and the market correction as temporary, and so I added shares at ~$34 per share and shares ended the year at $53.
What changed most is the short book. In early 2014 I stumbled upon a presentation Jim Chanos gave on China in 2012, and I proceeded to spend about a month updating his information and doing my own due diligence on the situation. What I found alarmed me, and I came to much the same conclusion as Chanos: China's economy wasn't sustainable.
I proceeded to try and figure out the best way to short China. I couldn't access Chinese companies directly, and most of the ADRs were for large companies, such as China Mobile, that I had actually done a fair bit of work on and viewed as solid enough companies.
What I decided to do was use ETFs: MCHI, GXC and shorting YINN. I also shorted the Australian dollar.
I also, in perhaps a counterintuitive move, shorted gold in 2014. My view on gold is that it's a horrendous hedge: its correlation is all over the place, so it isn't a useful or reliable hedge; it has almost no intrinsic value (i.e. it's not USED for anything except looking pretty and taking up space); and if the world ended, I'd rather have a garden and a gun than the equivalent value in gold. Regardless, it was clear to me that the gold bubble was bursting, and so we joined in.
I also identified a number of companies we viewed as significantly overvalued: 3D Systems, VoxelJet, RocketFuel and others. All of these companies had either accounting issues, unsustainable business models, lost gobs of money or did all of them! The big risk was that the market could take a while to re-rate the shares.
I had identified Conn's as a large short opportunity in late 2013, and had established a large position in the stock, which I viewed as having an unsustainable business model: the company lent more and more money to subprime customers to fund purchases of consumer goods, and yet somehow its allowances for loan losses hadn't expanded AT ALL despite considerable growth in the business. Needless to say, when it all came crashing down early in 2014, I wasn't surprised. Even after shares plunged when credit losses ticked up, I maintained the short because the company did nothing (and even as of today has done remarkably little) to fix the problem. Indeed, the hardest part around Conn's was disagreeing with one of my idols, David Einhorn, and maintaining a short even after he took a long position in the company.
Finally, I got lucky with oil. In the middle of 2014, ISIS emerged as a threat in the Middle East, and made significant progress towards knocking out Iraq's oil production. I examined the political situation and concluded that ISIS's strength would be its undoing: the world would not sit idly by if ISIS got too powerful, and ISIS's method of operation (it was a state with an army, not an insurgent force that blended in with crowds and was hard to find) meant it would be (relatively) easy to get rid of. I shorted oil after ISIS came close to attacking Baghdad by shorting UWTI, a levered oil ETF.
However, as production from Libya started coming back, and it looked more and more as if there was a supply glut emerging, I decided to maintain my short, and actually expand its size. My view was that until shale capacity started to die off and restructure, we would likely see significantly lower oil prices. This "tipping point" didn't come until 2016, in my opinion, and so I kept my short on oil for two years.
Pelorus ended the year at 52% long, 45% short, with the long book effectively unchanged from 2013. 50% of our short exposure was to China, or China related themes (such as shorting copper, or AUD/USD) with the rest allocated to "crap."
The results were very good: Pelorus ended the year up more than 25% in large part due to the performance of the short additions mentioned above. Indeed, I remember 2014 as the year that subpar stocks started to diverge from the market: no longer was anything and everything going up, as had been the case in 2013.
Figure 3: Pelorus Capital 2014 Returns
2015: China Pop n' Drop
Pelorus entered 2015 with the long book still largely unchanged and I maintained our exposure to Conn's, Voxeljet, 3D Systems and RocketFuel. I also had the shorts on oil, gold and China. Our theses on these themes were unchanged: business fundamentals continued to deteriorate, China continued to be unsustainable, and OPEC continued to keep up supply in an effort to kill US and Canadian producers.
I also identified more companies to short as standalone names. These included
- El Pollo Loco (NASDAQ:LOCO): which traded as if it was going to grow gangbusters after a hot IPO. What most didn't seem to get was that a number of the company's former private equity owners had tried to do exactly the same thing with the company, and had failed over and over again. It was clear that using the same strategy again would result in the same outcome, and that it was happened. I shorted the company at around $25/share, and shares ended the year at around $13.
- Quicksilver (NYSE:KWK): the company was a zombie. Declining same store sales due to changes in fashion trends coupled with an atrocious capital structure meant that the company was destined for bankruptcy. I thought there was limited risk in an acquisition due to the company having tried numerous times to fix itself, and the fact the company's ethos and brand just weren't keeping up with where the fashion market was going. I shorted shares at around $2 and the company didn't survive the year.
- Valeant Pharmaceuticals (VRX): I viewed Pershing Square as an attractive investment, and I still have a lot of respect for Bill Ackman as an investor. But I disagreed with him on Valeant (my rule is if Chanos says the accounting sucks, the account does in fact suck), so I shorted VRX to hedge Pershing, but the more I dug into it, the more I liked it as a short. I went long Pershing in January of 2015, and shorted Valeant as a hedge at the same time at around $165 per share. I shorted a bit more at $225 as the stock and the valuation continued to run away. Valeant overall was a small short, no more than 2% of the book at its largest, and I didn't want to get carried away. Needless to say, watching its spectacular collapse has been interesting. My average cost was around $190 per share (similar to Ackman's) and shares ended the year at ~$92.
2015 presented some challenges in managing the now very large short on China I had. Early in the year, the Shanghai stock exchange saw very rapid appreciation reminiscent of 1999, and I immediately saw an opportunity to make my short bigger! While it was painful to watch as YINN in particular exploded upward, the fact I had diversified the macro theme across a number of names and currencies which didn't participate in the bubble helped immensely.
The time came to add more when the bubble burst. I have always been a believer that you stay out of the way of bubbles, but when you see a crack appear (for example, an index being down significantly more than a normal day's decline), it's time to act. This played out with China, and we saw significant gains into the end of the year on this theme as commodity markets around the world tanked.
For the record, I believe that China isn't over as a risk to the global economy: they haven't really fixed the structural problems they have.
On the long side, the star performer was TIO Networks, again, which went from $.80 at the beginning of the year, to over $2 by the end on the back of successful acquisitions and major improvements across the business. In the beginning of the year I added to the already large position, and by the middle of the year, the company represented 10% of the portfolio.
I also added shares of SunEdison after viewing a Greenlight Capital presentation on the company. In one of the greatest flukes in my short investing career, I liquidated the position at $30 per share (which was my price target) about two weeks before shares crashed. I watched the carnage and decided to stay away for the rest of the year as the situation unfolded. The big kicker for me was the company's decision to buy Vivint Solar: I hated Vivint's model, and I liked SunEdison precisely because it didn't do what Vivint did. The Vivint transaction DID bring my attention to SolarCity (SCTY), however, and that name has been a great short in 2016.
I also added a large position in Real Industry in 2015, the rationale for which can be found on Seeking Alpha.
Overall 2015 was a great year for Pelorus. 2015's theme of divergence continued: the broader markets were up, but lots of subsectors diverged hugely! Commodities tanked, bubble stocks tanked, SUNE tanked (woops) and the world suddenly became worried about China. Pelorus ended the year up 36% thanks largely to TIO Networks and fortunate commodity and China related shorts.
Figure 4: Pelorus Capital 2015 Returns
2016 - Tripled Assets, now Time to Go Home
2016 started great for Pelorus: because I was still short so many commodity and China related names, the selloff at the beginning of the year was a boon! We continued to be short Valeant, which added more fun at the beginning of the year. I lost on TIO, which declined from its rapid ascent in 2015, but took the opportunity to add to our position, which was now 12% of the portfolio, to bring it back up to 15%.
I also shorted Tesla (NASDAQ:TSLA), SolarCity, Twitter (NYSE:TWTR), Shake Shack (NYSE:SHAK), Peabody Coal and Deutsche Bank (NYSE:DB) at the beginning of the year. Most of my reasoning wasn't rocket science: Tesla, Twitter, SolarCity and Shake Shack were trading at absurd valuations; Peabody was a zombie; Deutsche was a ticking time bomb. All of these shorts have worked out well so far in 2016.
I also made the foolish mistake of going long SUNE. I underestimated the trouble the business was in, and the key lesson I learned from SUNE I will explore in the next section. What I did right, however, was investing in TERP and GLBL as well, and using those two entities as the primary investment vehicles: they have both performed significantly better than SUNE. I view TERP in particular as an acquisition candidate.
I invested over 20% of the funds capital in the Pfizergan deal. The spread was very attractive, and I was very nervous about taking on direction exposure at the beginning of the year. I reasoned that I liked the valuation of AGN on its own and could hold it or average down if the deal fell through, and my PFE short was unlikely to move against me much if the deal fell through. There was of course regulatory risk, but my research suggested the US Treasury wasn't likely to impose something too drastic, and regardless, PFE and AGN had structured their deal so it wasn't an inversion anyway!
I was wrong. The unwinding of the deal took a 3% chunk out of the fund, and I ended up selling AGN, primarily because the valuation environment for pharmaceuticals had changed so much due to Valeant's demise.
In another, much better ending, M&A investment, I bought into the Sandisk/WDC merger when the spread blew out earlier this year. I placed 10% of the funds capital into Sandisk as well at an average cost of around $64 per share. Shares very quickly recovered to around $76, at which point I exited.
Overall, for the first half of 2016, Pelorus is up over 21%, which is fantastic performance. This has largely been driven by Sandisk ((Long)), SolarCity (short), Valeant (short), TIO Networks, Tesla (short) and TerraForm Power (NASDAQ:TERP).
Figure 5: Pelorus Capital 2016 YTD Returns
These are not an exhaustive account of my wins and losses over the years but it provides a look into what I've spent most of three years looking at and doing, and how I've done it. Now, I'd like to reflect and try and summarize this into some investing lessons.
1) Do Your Homework!
There is one stock I owe a significant portion of my performance to: TIO Networks. TIO was the first no-brainer I ever saw. I heard about it and analyzed it at the fund I worked for in college, and, as I've detailed in my write up on the company, it was so obvious where the company was going but the market hadn't figured it out.
Because I had done my homework, I had the confidence to put 7% of the fund in TIO at $0.33 per share, and because I understood the business, and knew what markers to look for, I had the confidence to keep it there and let it compound as TIO grew. Most investment managers trim positions when they grow, but I let TIO balloon from 7% to 15% of the portfolio in three years.
The lesson from TIO is to do your homework! Doing your homework, and ceaselessly trying to understand everything you can about the business allows you to take larger positions, and also allows you to be a contrarian because you have the confidence to buy when others are selling and sell when others are buying.
Another part of doing your homework applies to idea generation. 80% or more of my ideas have come from reading the news, watching interviews, or reading fund manager commentaries. Very few come from screening. Often I'll read an article and wonder "how can I turn this into an investment." Usually the answer is I can't, or it's too late, but sometimes it works out. Realistically, I need and want 5-10 new ideas a year, and so it's not hard to generate that many just from paying attention to what's going on.
One thing you do have to be cognizant of is crowded trades. If you see that every hedge fund is piling into a company, the idea is often overdone and it's best to stay away (Valeant was a great example of this).
2) History Repeats
The most successful shorts in my short investing career have all been companies that weren't hard to identify. Conn's, Quicksilver, SolarCity, 3D Systems, VoxelJet, RocketFuel etc. They were all companies with deteriorating business fundamentals and absurd valuation!
These stocks always had a catalyst that I could identify (although I didn't know when it would occur): Quicksilver was going bankrupt; Conn's was going to have to report increased credit losses; 3D Systems was going to have to take goodwill impairments; RocketFuel and VoxelJet were never going to make money; El Pollo Loco already had a history of failure and wasn't doing anything new, but was valued as if it was; Valeant was just an overleveraged rollup. The list goes on and on: most of these themes you can find in books on how to be a short seller. There are slight differences in each case, but the key themes play out over and over again.
One doesn't have to be a genius to make money, just a student of history and human behavior.
3) You Can Borrow Other People's Ideas
Okay, don't plagiarize. But some of the best ideas I've gotten (Conn's, VOD, TIO, etc.) have been from reading and watching a LOT of interviews with fund managers, and watching their commentaries every quarter. It's a great screener: if you can find the smart guys and see what they're looking at, it's a great way to weed out the crap in the market.
The thing you have to watch, is that they can get it wrong. Never blindly follow an idea of someone else! Always do your homework and confirm every single "fact" you've read. I got inspired about China by listening to Chanos, but the first thing I did was watch every video I could from any well-regarded China bull I could find to see what the other side's story was. I also delved through 40 years of economic data, read about Chinese history, and accessed as many industry reports as I could find in order to draw my own conclusions. What I ended up doing, of course, is agreeing with Jim Chanos.
Similarly, when Bill Ackman bought Valeant, I didn't. I went and took a long look at the company, but ultimately decided I didn't like it. A big flag for me was that Jim Chanos didn't like it, and I could see exactly the same things he could. This plays into the lesson above (history repeats): an overleveraged rollup is not a recipe for success.
4) Position Sizing Matters
As I stated above, the returns I've seen are largely due to the confidence I have to take large positions in stocks I know well. I'm not the first to point this out: Joel Greenblatt and Bill Ackman have also noted this, and I'd argue Warren Buffett has as well.
On the short side, position sizing matters in a different way. In order to defray the risk of a single position moving too far against you, each position has to be smaller. Both David Einhorn and Jim Chanos run their books this way, and my rule is that the average short position was only half the size as the average long.
This saved me when the Shanghai index rose rapidly. My China theme was large, close to 20% of my fund at the time, but because not all of that theme was expressed by shorting the Shanghai index, but instead by shorting currencies and other indices as well, I was able to hold on and expand my position when it mattered most.
The same story played out in Valeant. The position moved well against me, and because it was not a large portion of capital, I was able to hold on and add more.
5) Objectivity is Key
Investors must remain adaptable, and constantly on the alert for changing situations. The first thing I try and do when I hear someone's opinion is prove them wrong. I did it when I heard about China, I did it with Valeant, and I do it for everything I invest in. I always want to hear the other side.
Always listen to shorts and always evaluate what they say carefully. The whole world is biased long, but I've seen more stocks go to zero than infinity, and often the shorts have very good things to say. They're wrong just as often as the longs are, but by understanding the arguments the other side makes, and by having an active discussion, you can avoid many potential pitfalls.
Similarly, by doing your homework, you can turn off your emotions when it comes to a stock. Let's say a company craters 20% on earnings. Many people freak out and sell, but I ask myself: did the value of the company decrease 20% today? Usually the answer is no. Often these sorts of earnings "surprises" are blips, and shares go on to recover. Indeed, many times these sort of reactions are great buying opportunities if you've done your homework. Regardless, not making a stupid, emotional, decision is key to long-term investing success.
6) Adaptability is Paramount
One of the things I value most is being able to express a view in the most efficient way possible. Sometimes it's through equities, sometimes through bonds, sometimes through options and sometimes through currencies. The examples I've given through this review have been either equities or currencies, but in a number of the cases I've actually expressed my view through options rather than just the equities.
Take American Airlines. I bought in when the stock was at $34, but I didn't actually express my opinion with stock, I did it via a vertical call spread (one of my favorite trades). I valued AAL at close to $60/share in 2014, and so I bought a $34/60 vertical call spread expiring in a year. I could have just bought calls, but I had done my homework and knew what shares were worth, and I didn't want to pay for additional upside beyond that. Similarly, options were relatively expensive, and I could defray some of the cost by selling the 60 strike calls against the 34 strike calls. For more information on this sort of trade, I encourage you to use Google.
There have been many times over the years where I have been able to structure an options position that gives me significantly better risk/reward, and expresses a view far more efficiently, than just buying the stock. Because I look across asset classes (remaining adaptable), I can access a far greater range of opportunities which allows me to select the very best risk/reward trades from a much much larger sample set.
7) Beware Complexity
The biggest blunder in my investing career has been SunEdison. I am a firm believer in alternative energy, and I believe that it has huge potential for investors. There will be a lot of money made here as time goes by.
I believed SUNE was the way to do this. I bought into Einhorn's analysis, and even though I did my own homework I didn't do it well enough. I underestimated the reliance of the company on capital markets, and I underestimated how the complexity of the business would work against me. Both of those factors caused SUNE's downfall, and from now on I stay away from businesses that are like black boxes (banks being the primary suspect here).
I used to like complex things: I think I am better able to analyze them than many simply because I am willing to put in the time. But as I look back on my investing career so far, all of my best ideas were no-brainers! My best ideas took hours and hours of research, but that research was confirming a very simple investment thesis. Usually I could see the thesis in under an hour of work.
With SUNE it took far longer. I'd never seen such complex accounting, and it was exceedingly difficult, even with Einhorn's work to use as a guide, to get a good sense of the real economics of the business. I'm now convinced, given how management acted during SUNE's downfall, that not even they really understood the business.
The lesson here is that if you can't independently verify facts and thoroughly understand something, don't invest in it. Basically this is do your homework all over again, but with a slight twist: if you've done your homework, and you still have a lingering feeling that you can't quite explain it all, move on. Life is too short to take sub-par investing ideas, and for every overly complex company, there is a great and simple company that will do just as well, if not better.
I absolutely love investing, and I love it more after having had this experience. I can say with a lot of confidence that I've learned more doing this than most 24-year-olds, and certainly more doing this than just studying investing academically. For those wanting to learn investing, the best way is to do it! Pay as close attention as you can to the best investors out there, they all have written books, and they have a ton to teach.
With that, I'll sign off, close Pelorus, and go enjoy my nice cushy job at a bank!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.