Sometimes you've got to look away from your usual hunting grounds to find bargains. Not many American investors will look closely at the London Stock Exchange (NYSE:LSE) and what's listed there. In fact, many U.K. institutional investors don't look at parts of the LSE.
I'm referring to closed ended funds which are also known as investment trusts. Among the many listed on the LSE are two American hedge fund managers, Dan Loeb of Third Point and Bill Ackman of Pershing Square.
Both have historically strong track records of making money for investors; and both have closed ended funds that can be bought on double digit discounts.
First up is Bill Ackman at Pershing Square (PSH) (OTCPK:PSHZF). Since inception in December 2003, his fund has compounded returns at 14.8% versus the S&P 500 return of 7.7%.
His LSE listed vehicle has the ticker (LON: PSH) and is denominated in pounds sterling. It hasn't been listed in London long.
He tends to run a concentrated portfolio. At present, he has ten long positions and only the one short. Running such a concentrated fund means performance can vary dramatically.
The past three years have been tough for Pershing Square as a long position in Valeant Pharmaceuticals (VRX) has gone very wrong. Plenty has been written about this episode, so I won't dwell on it for too long. What is important for future returns on PSH is that this position has now been sold in full.
The other high-profile detractor on PSH has been a short position in Herbalife. This position is still held and the investment rationale is detailed here.
When investing with any fund manager, one should remember that not every call they make will work out immediately. Whilst the three-year performance numbers for Pershing Square do not look very good, the longer term track record suggests Bill Ackman is a skilled long/short equity manager. Investors often make the same behavioral mistakes with hiring and firing fund managers as they do with stocks.
Academic research suggests that not only do individual investors lose money by selling under-performing stocks at the wrong time, but even professional fund selectors lose money by selling under-performing fund managers at the wrong time. It is important, therefore, not to get carried away by recent performance numbers.
Looking at the performance of these stocks year to date:
- Restaurant Brands is up 27.7%
- Mondelez is up 1.94%
- Air Products and Chemicals is 1.2%
- Chipotle Mexican Grill is up 19.6%
On the downside, the one short position has gone up; Herbalife (NYSE:HLF) is up 49.3% year to date, close to its peak of $81in 2014.
At the end of May, performance for the net asset value (NAV) of the fund was +4.3%
So, the manager's long positions are doing ok, the performance is just being held back by that short position. Given Herbalife is closing in on its previous share price peak, it's possible the manager has already taken much of the pain from this short position. If the manager's thesis is proved to be correct however, there's plenty of room for Herbalife to fall.
Overall, the manager is still running the same process that gave him success before, and short term (3 year) performance looks as bad as it does simply due to the concentrated nature of the fund. For portfolios needing the diversification brought about by hedge funds or alternatives exposure - this is a good option.
This is the second U.S. hedge fund that you can buy on the LSE at a discount. Dan Loeb has been running this strategy since June 1995. Since then he has generated annualized returns of 15.9%, compared to 7.8% from the S&P 500.
In recent years his performance has again not been the strongest - better than Pershing's but not at Third Point's (LON: TPOU) (OTC:TPNTF) historic annualized rate of return. Just like Pershing this 3-year performance has created the buying opportunity, as short term focused investors sold out.
Turning to Dan Loeb's portfolio and what he holds, we find that his portfolio is more diversified but the transparency isn't as good as Pershing. However, we can still read about a few of the holdings from his reports. For example, see his Q1 2017 report here.
The manager is bullish on:
- Honeywell International (NYSE:HON) - up 16.2% YTD
- UniCredit SpA - up 22% YTD
- E.On - up 31% YTD
These long positions are up by double digits so far, this year. At the end of May, his overall portfolio was up 9.9% in the year to date. This is ahead of the S&P 500, which is consistent with his past track record.
The performance which has sent the more fickle investors packing came primarily in 2015. That year, the fund's NAV was down between 2 and 3% depending on which currency share class you look at. This is hardly disastrous performance.
In 2016, the NAV rose 6.1% (for $ share class). However, investors lost money that year as the discount to NAV increased from 11.6% to 18.4%.
There is little to no evidence that suggests Dan Loeb's process has changed or will no longer work. It looks more like a short-term blip in an otherwise excellent long term track record. As such I believe investors should look past the three-year numbers.
So, where's the opportunity?
I've touched upon this, several times throughout - investors put far too much importance on short term manager performance. Behavioral finance experts call this the 'recency' bias. Smart investors try to minimize this bias in themselves and instead exploit the opportunities created by others.
Both the hedge fund managers referenced above have very strong track records. These were created by following a certain process. There is little evidence to suggest these processes will no longer work. In my opinion, they have both simply had a short blip. It happens to all fund managers.
Because these two managers have closed ended funds, investors suffering from the recency bias have created attractive discounts.
At the time of writing (mid-June 2017), Pershing Square sits on a discount to NAV of 12.7%. They have a buy-back program which could narrow this discount, as could an uptick in underlying performance.
Third Point Offshore is the even more compelling opportunity. Not only do I think it has the stronger manager, but the discount is 20%.
Back in 2013, Third Point had a fantastic year, where the underlying NAV rose 29%. Following this the shares traded around NAV. This was because investors, again suffering from this bias, were happily buying the fund.
If current rate of performance is maintained this year, it would be no surprise to see investors come back and that discount to narrow.
Why buy now?
On the opposite side to the buy argument expressed above; the discounts could widen further; the discounts could simply stay at those levels for a long time or underlying performance could suffer.
Dealing with the last one first, I would argue the process of these managers remains unchanged and those processes have generated market beating returns in the past. For discounts to widen then, it would take a further deterioration in underlying performance. This seems unlikely given the historic strength of these investment approaches.
In terms of the discounts staying the same, I would argue this is an example of where you can be rewarded for patience as an investor. In the meantime, you would be holding two hedge funds which historically have held up quite well against falls in the broader equity market. Given the current high stock prices, low levels of volatility and creeping complacency of investors, it strikes me as prudent to have some defensive positions in a portfolio.
A quick word on currency
Both can be bought in pounds sterling. This is the only option for Pershing (LON: PSH). With Third Point (LON: TPOU) I prefer the USD denominated share class, as it is the larger share class and easier to deal in bulk.
I personally don't try to speculate on currencies, but do use them for risk management. In other words, I'm happy having different currencies in my portfolio - I just try to avoid having excessive exposure to any one currency. I recommend other investors do the same.
Disclosure: I am/we are long TPOU.
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.
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