Don't believe the Hedge

Make money regardless of the economic conditions, word is bond fam. Using short/long/derivative/option/leverage/alternative/private equity/forex swab strategies- the list to riches is long and lavish dawg. Da most sophisticated homies in da game gonna outperform the market in every possible scenario and reduce ya risk yo.

Could it be so easy? Watch ya step. If the above sounds ridiculous, it's because it is. Yet this is a promise hedge funds expound like it was decreed by God to Moses. In 2014 so far the average hedge fund has underperformed in the rising bull market. In 2013 they returned an average of 7% while the S&P 500 index had a 29.1% return with dividend reinvestment. What perpetrates the hedge fund hype is overconfidence and affluent investor’s appetite for sophistication.

Let’s start with the halo effect and overconfidence. Here is list of Wu-Worthy hedge fund managers. It is a short list relative to the approximate 10,000 active hedge funds. The list of 21 successful hedge funders is not representative of all the successful hedge funds but mainly the exclusive ones. So what about the less exclusive hedge funds? Well as Josh Brown put it, in a stroke of statistical and empirical genius, “The odds of identifying an emerging manager from the ground floor who becomes Paul Tudor Jones are about the same as you making out with Kate Upton in an outdoor shower on a Tahitian beach”. This goes a long way in explaining why the average hedge fund has turned in a meager 3.9% return in 2014, doesn’t it. This is, of course, before you consider the standard 2% management fee and 20% performance fees- you didn’t think this was easy did you?

With the paltry recent returns hedge funds have generated it is insane their fees are so high. Especially when considering better returns and lower fees can be found in broad indexes. Paying high management fees for hedge funds is like tipping the register-clerk, who does nothing but take your money, at Chipotle. You wouldn't do that shit at McDonalds, tho they prolly deserve it. Don't even get me started on 20% performance fees- that's like saying "here you were so good at taking my money, have some more". 

Again, to be fair, there are hedge funds justifying rich fees. Alpha Attribution fleshes this out with a chart on the annualized return over the most recent three-year period, that they can roughly pin-point to value delivery.

Top Managers Demonstrating Consistent Stock Selection Skill over Last 3 Years

Fund	Annualized Security Selection Skill	Regulatory AUM	% of Reg AUM Disclosed in Public Filings
RA CAPITAL	43.8%	1.5 BN	51%
SRS INV. MANAGEMENT	25.1%	3.6 BN	67%
COLUMBUS HILL CAPITAL	16.0%	1.7 BN	61%
SCOPIA CAPITAL	13.6%	7.1 BN	35%
HOUND PARTNERS	12.7%	3 BN	77%
BRENNER WEST CAPITAL	11.9%	1.5 BN	60%
SENATOR INV. GROUP	11.1%	11 BN	85%
NEW MOUNTAIN VANTAGE ADV.	8.7%	2.4 BN	88%
LOCUST WOOD CAPITAL ADV.	7.4%	780 MM	90%
STEADFAST CAPITAL	7.4%	8.1 BN	64%
EGERTON CAPITAL	6.8%	10.7 BN	59%

Source: Alpha Attribution

The premise is built on disclosure and *gulp honesty. If RA Capital Management holds Achillion Pharmaceuticals (ACHN), which they do, and it increases by 15%, which I made up, but the biotechnology sector as a whole increases by 10% (made up) then they delivered 5% of value (the difference). This contributes to the 43.8% you see as their Annualized Security Selection Skill. Check the full study here. However, in a cruel twist of mean reversal, RA Capital Management has been hit hard this year. The 1.5 billion in assets under management has turned into a portfolio value just shy of one billion bucks. Sure some hot new hedge fund is bound to take it’s place atop this list, just like some hot new it girl is bound to grace the cover of Sports Illustrated next year, good luck speculating who.

Optimistic and eager youngins want a piece of that action (talking about hedge funds fam), and it is hard to blame them. But overconfidence mars them at every step and it trickles down to those who invest in their presumptuous presentations. Nothing highlights pompous behavior more than when we blame others for our mistakes as this tantrum, wonderfully covered by Morgan Housel, recently did. Reading that letter you wouldn't be wrong to confuse it with this one, but I digress. Instead of risk reduction we know that overconfidence can lead to an increasing exposure to risk, also see here.


The leading expert on confidence summarizes it succinctly:

“Hard to be humble when you stunting on a jumbotron”

- Kanye West “Devil In A New Dress”

Even harder I’d imagine when you’re dreaming of jumbotron worthy status.

The title of this post isn’t “Mother’s don’t let your children grow up to manage hedge funds”. More power to you boo if you got your sights set on delivering alpha. But let’s treat sophisticated investment products as just that, sophisticated. As the OG grand-master of errythang rational & the oracle from the movie Up says "only invest in what you know b". It starts by undressing these devilishly wicked funds and asking the tough questions: Correlation or Causation? Alpha or Beta? Icahn or Ackman? Method Man or Raekwon? This ish is far from easy fam, word is bond. 

Never forget the underlying rule in all things finance: “You need to crawl before you ball”- Yeezy in Paris. 

Follow Wesley Vaughan @bragavaughan

Stock U Over Da Head

“..and they wonder why I rarely smoke now, imagine if you’re first blunt had you foaming at the mouth.” – Kendrick Lamar “M.A.A.D. City”

It is entirely natural to attribute more weight to things that happen to us and are easily recalled from memory. Psychologists call this the availability heuristic and piss-poor rappers call it the grind. Ignoring the existence of biases is a foolish endeavor yet we do it all the time. Mostly it concerns frivolous bits, yet on decisions that really matter, and tend to be more complex, we go with the default; which is often ripe with irrationality.

The implications for investing are overwhelming. Take this report on a Federal Reserve finding that America is the most underweight on stock ownership than it has been in the last 18 years. What is holding the percentage of stock ownership from falling even more is the wealthy elite holding stocks at a new high. It would be remiss to attribute this as the sole reason for the growing disparity between the 1% and middle America but it certainly should raise some eyebrows in the midst of a surging bull market.

            One of the worst qualities in a money manager is overconfidence. Psychologists have a term for this too, it is called the illusion of validity. Like the trolling rapper posting in the comments section of a Chance the Rapper YouTube video with hyperbole like “I’m the lost member of Odd Future the next Jigga/Yeezy/K-dot y’all gotta check out my shitty soundcloud” it is painfully obviously the perils overconfidence can get you, and more importantly, others into. What makes overconfidence the worst quality in money managers is they attribute skill to success in one of the most unpredictable and dynamic environments in the world: the stock market. Sir Isaac Newton said it best, after losing a small fortune in the stock market “I can calculate the motions of heavenly bodies, but not the madness of people”. 

Of course some people can deliver market-beating returns over an extended period of time but they are as rare as finding a gem in the comments section of YouTube. Rarer I’d wager, as at least the rapper has control over the quality of his output, where the stock picker is at the mercy of many more uncontrollable and unforeseeable elements.

So what? Maybe middle America is best served by being underweight stocks. No this compensation is overconfidence in other assets and equally misguided as our stock picker. This can lead to people sticking their necks out trying to tease returns out of historically low return assets (Read: chasing junk). Over the course of time no asset class has come close to delivering the returns the stock market has averaged. The evidence for holding stocks in an investment portfolio is overwhelming- see here, here, and here. Patrick O’Shaughnessy makes the case very clear for the importance of stocks in a diversified portfolio, while also addressing some of the reasons why millennials, his specialty, are underweight stocks. To be clear, no case is being made for stocks to be the only asset you hold; diversification is as fundamental as protect ya neck. Designing a strategy suited to fit your neck exposure is a post for another day. 

Yes, stock market crashes happen. Millennials have unluckily experienced two major market crashes, one laced with subprime mortgages and the other being the infamous tech bust. However, forecasting the next market crash is as futile as the debate over who is the greatest member of Wu-Tang. A forecast should be treated as an opinion not a statistical fact. The real damage is done when the inevitable scares people out of the asset class all together. If you can deal with volatility, then your best vehicle to achieving wealth over an extended amount of time is the stock market. “Deal with volatility” is a big “If”  as is "extended time" and both are not easily realized. If these contingenies frighten you than stocks ain't nuthin to fux wit.

Some verbal courage for the stock-clan. The first from a renowned poet whose full poem is required reading in most high schools worth their weight in blunts. The second poem comes from an equally as renowned poet,  if not slightly more obscure. 

“If you can keep your head when all about you

Are losing theirs and blaming it on you,

If you can trust yourself when all men doubt you,

But make allowance for their doubting too;

If you can wait and not be tired by waiting….

If you can meet with Triumph and Disaster

And treat those two imposters just the same….”

- Rudyard Kipling “If”

“If you’re holding up the wall then you’re missing the point”

-Pharoahe Monch “Simon Says”

Follow Wesley Vaughan @bragavaughan

Gilead: Fear, Competition, & International Intrigue

Competition breeds improvement. 

A monopoly is the only model for successful and happy companies. 

The latter is the theme of Peter Thiel’s new book Zero to One: Notes on Startups, or How to Build the Future, highlighted in a new profile by Fortune on the billionaire pioneer and, yes, philanthropist. The former statement is one ingrained within us since grade school; whether conscious of this or not, competition is synonymous with capitalism. Or is it. Thiel, a contrarian by any stretch of the imagination- the man is a libertarian, gay Christian- expels the conventional notion of capitalism and competition. He states that they are “opposites….under perfect competition, all profits get competed away”. Instead the real money is in monopolies, “All happy companies are different: Each one earns a monopoly by solving a unique problem. All failed companies are the same: They failed to escape competition.”

It is upon this statement I wish to speak. News broke today that Gilead, an established biotechnology company, was in discussions with generic drug makers in foreign countries about partnering to bring it’s wildly successful Sovaldi compound, a drug that is shown to cure 90% of hepatitis C patients (a conservative figure), to other nations at an obvious discount. Never mind that this information should be built into the stock, when they announced these plans a month ago. Never mind that Gilead already does this with its HIV drug. Never mind that this expands Gilead’s reach in the growing hepatitis C epidemic. Instead the market sent Gilead down by as much as 8% today, touching $97.55 on volume exceeding average daily volume merely hours into the day.

Sure it would be a great time to take profits in Gilead after it has nearly doubled its share price in the last 52 weeks. But something about the volume today (Read: Fear, Panic, Pandemonium) tells me the people who sold haven’t been in this stock since it was trading at $58.81 52 weeks ago. These people didn’t fail to escape competition; they refused to compete in the first place, even when all signs said that Gilead was laying the groundwork for a global monopoly. This behavior is why capitalism and free markets succeed, let alone exist. There will always be emotional rip tides to profit from.

 Right now the biggest risk to Gilead is competitors competing with them on price. Well the first step to doing this is introducing a drug that is at least as effective or more effective than Sovaldi, something that has yet to be done. The day will come when Merck, or the other big pharms, come up with a successful and effective compound that cures hepatitis C, but it may be too late. They might be best advised to concentrate their efforts on curing fatty liver disease, a growing concern right here in the United States. Gilead has the advantage of being first and all the perks that come with it. They have an established product that cures one of the worst diseases in the world, albeit at a steep price. Ask Dell how it fared on competing with Apple on price.

By setting up shop in foreign markets, where hepatitis C inducing conditions can be even worse than in the U.S., Gilead is introducing dynamic pricing. Yes people get bent out of shape over the cost for the entire cure in India rumored to be less than the cost of a single pill in the U.S., but I’m sure I don’t have to remind you that in the U.S. a liver transplant costs half a million dollars. The best argument justifying Sovaldi's high sticker price comes from a July report from the California Healthcare Institute where near the end of the report they mention the following concerning Solvadi's  price:

Interestingly, previous treatment regimens for hep C cost the same or more (depending on the length of treatment), take at least twice as long to administer, are less effective and can often require other health care services.

  $84,000 is a significant amount of money and I am not trying to be deliberately insensitive here (okay, I am) but this tweet basically sums up my thoughts about these fearful investors: 

...and here i thought turkmenistan would be able to support sovaldi for 84k $GILD
— zach (@zbiotech) September 5, 2014

Fear is the killer of competition, and it leads to panic. Gilead’s stock closed today at $105.06, down 1.68% for the day, but a far cry from the $97.55 it plummeted to in haste this morning. I don’t need to lament how if you bought on the “bad news” you’d already be up a substantial percent. While the jury may still be out on Peter Thiel’s theory on monopolies one thing is for certain; the behemoth corporations that exist today didn’t get anywhere acting out of fear. Instead they preyed on it.

Follow Wesley Vaughan on twitter @bragavaughan

Disclosure: I am long Gilead. 

An E-mail to My Mom

Hola,

Listened to Mobileye’s (Israeli tech company) conference call today. They reported earnings as expected but are still a little overvalued which isn’t unusual in the current market, especially for an exciting tech momentum stock. They really are a fantastic company as they have technology that alerts drivers to dangerous conditions on the road and can employ the brakes to avoid accidents. They aren’t a fully automated driving machine but serve more as preventative insurance. Their main market right now is partnering with Auto’s (i.e. Tesla, BMW, GM) in installing their technology into the new lineup of these companies vehicles. Their secondary market is in after-market installations on new cars. It is a really small segment right now for them but this is where the real growth for them can come. The number one challenge for them is adoption, both in after-market and in their partnerships with the auto industry. Getting their product into automobiles is not an overnight thing. First off there is regulation they must pass, not an easy thing but more importantly not a fast thing. Their brass was quick to point out that the ball is moving in passing regulation, in fact they cited that many times. But I'm cautiously optimistic. Second, an automobile is obviously not an everyday purchase, leading to slower than realized adoption of their technology. Here is where the after-market can help them boost sales, but their products are still relatively expensive and not one deemed essential at this point. Mobileye envisions their after-market product offering to assimilate with consumers like GPS navigation systems but there is a little more risk involved in taking the wrong turn than avoiding an accident.  

The main problem facing the stock is expectations. When individuals see technology they immediately think speed, quickness, efficiency. Immediate gratification sets in. However, Mobileye's fate is innately tied to the state of the auto industry, adding more variability to the equation. This leaves Mobileye with very little margin for error- for example, the earnings beat the consensus estimate by 1 cent today, coming in at 5 cents a share, above expectations of 4 cents. But this wasn't enough for the investors as they sent the share price down 3% today.(of course it is up after-hours, but it tells you something about the volatility of the stock). It is also telling that a share earning 5 cents is priced in the $40 dollar range. Is this fair for Mobileye, after all they have been a public company for a little over a month now? No but the market could give a lick about what's fair. Overall I would wait for more information to come in before getting serious about this company. Let's turn to the Oracle right now: 

"You don't have to swing at everything--you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!". 

Adding to this I would say that most of those heckles are coming from the cheap seats. 

Best,

Wesley