Tuesday, August 17, 2010

Will The Real Smart Money Please Stand Up?

Peter Cohan of DailyFinance asks, Hedge Funds Bet on Inflation, Institutions Bet on Deflation. Who's Right?:
The smart money -- by which I mean hedge funds and institutional investors -- is placing its bets outside of the stock market. But the smart money isn't by any means in agreement about the direction of those bets: Hedge funds are doubling down on big inflation down the road by buying gold. But institutions are buying corporate bonds -- a wager on deflation, since bonds grow in value as prices and interest rates fall.

The only thing they do agree on is that neither group wants to invest in stocks. But should you follow them? And if so, which way?

Hedge fund honchos such as George Soros, Leon Cooperman, John Paulson and Erich Mindich are making big bets on gold because they see the specter of inflation ahead. Bloomberg reports that Mindich's $13 billion Eton Park Capital Management bought 6.58 million shares of SPDR Gold Shares (GLD) -- an exchange-traded fund that tracks the price of bullion. In that gold trade he joins Paulson -- operator of a $31 billion fund -- who personally made $3.7 billion in 2007 betting on the subprime mortgage meltdown.

Meanwhile, institutional investors who are tired of getting beaten up by their clients -- who are themselves tired of paying big fees for weak performance -- are starting to creep out a little further on the risk-return frontier from buying U.S. Treasury bonds to scarfing down blue-chip corporate bonds. According to Fortune, 10-year notes for Johnson & Johnson (JNJ) yield 2.95%, a mere 0.43 percentage points more than comparable Treasurys.

Yet institutions are clamoring to buy them, and companies are happy to lock in the cheap capital. What strikes me as interesting is that institutions are willing to pour capital into those low-yielding bonds when J&J's stock sports a much higher 3.69% dividend yield (dividend/stock price). This suggests that institutions are still too scared to buy stocks.

Common Stocks: The Bottom of the Liquidation Hierarchy

These times are heaven on earth for those in the bond trade. As PIMCO honcho William Gross told me in February 2009 -- a few weeks before the S&P began its 49% rise from around 735 to its current 1,098 -- we're in an era where owning stocks is pointless. He made an interesting argument: With slow economic growth, it makes no sense to take the risk of being at the bottom of the so-called liquidation hierarchy.

When a company files for bankruptcy, its bank lenders get first dibs on the proceeds from selling the company's assets. If there's any cash left over, it goes to bondholders, then preferred stockholders, and last of all to the people who hold the company's common stock. Gross argued that investors are better off buying bonds because with a reasonable risk of bankruptcy, such investors will be better off than stockholders.

This is a great argument -- except for the fact that it has proven to be wrong recently. And the odds of companies going bankrupt seem to be diminishing. Corporate America is in a cash-hoarding mood, holding $1.84 trillion according to the Federal Reserve. And since these companies can now lock in extremely low long-term borrowing rates, their balance sheets have been buffed up even as their common equity is out of favor with investors.

Can They Both Be Right?

One thing seems to clear to me: The gold bugs and hedge funds betting on inflation and the institutions betting on deflation can't both be right at the same time. It's conceivable that the institutions could be correct in the short and medium term, while the gold bugs end up being right in the long term.

Let's face it -- those hedge fund guys are the smartest and richest in the investment universe. But all the statistical evidence I've seen says inflation is dead and is staying buried despite the 140% increase in the U.S. national debt since 2000 from $5 trillion to $12 trillion.

Maybe the hedge funds buying gold are momentum traders -- in that case they're buying because everyone else is buying, and they're betting that they'll be smart enough to get out before that buying turns to selling.
It does strike me as odd that institutions keep piling into corporate bonds, but fears of deflation persist and with so much cash at hand, default risk has fallen dramatically.

One thing I don't like is how the article is slanted towards "hedge funds betting on inflation". Sure, some top hedge funds have increased their holdings SPDR Gold shares, but others have been busy buying many other sectors. I spent my day going over what the top hedge funds have been buying and selling. I pay attention to major increases in positions, and it's definitely not all about gold.

As I stated in my last comment, hedge funds tend to buy and sell often in a quarter, but they do hold core positions. James Altucher reports in the WSJ, What Funds That Bought POT Are Also Buying:

Potash (POT) is up a massive 30% today on the heels of a $38.56 billion unsolicited takeover bid from BHP Billiton. POT was listed in my top ten picks for 2010 at the beginning of this year. My quote from that article:

“People need to eat. Potash increases the yield of fertilizer. And in an overpopulated world with people moving into urban areas (less farmers feeding more mouths), demand will spike for whatever can increase that yield. Potash’s stock is closely correlated to prices of the product Potash.”

Some great value investors have been buying up shares of POT in the past quarter and its worth taking a look at other positions they’ve been buying:

Mohnish Pabrai, a known hedge fund manager who fashions himself after Warren Buffett (even his fund is structured legally the same way Buffett structured his partnership in the 50s and 60s) bought shares of POT in Q1. In the quarter ended 6/30 Pabrai’s biggest added position was to the “Canadian Berkshire,” Fairfax Financial (FRFHF).

Renaissance Technologies, perhaps the most successful hedge fund ever, owned $44 million of POT stock as of their latest filing. Other holdings they increased this past filing include: Microsoft (MSFT), Medtronic (MDT), and BP (BP).

One fund I’ve never heard of, Mak Capital, not only added POT as a new position in Q1 but it became quickly their largest position in their $400 million in holdings. They are probably having a party today. Other top positions of Mak Capital include THQ (THQI) and Mosaic (MOS).

When a hedge fund adds to a position like POT, or makes it the top position, you have to assume they’ve done enormous digging. This, of course, is not always the case, but with successful funds it generally is. That’s why its worth checking out what other funds have been buying POT and the stocks they’ve been accumulating.

Unlike pension fund or mutual fund managers, hedge fund managers have skin in the game. They're compensated on a 2% management fee and 20% performance fee and they are subject to a high water mark, so if they lose big in a year, they have to recoup those losses before charging performance fees again.

Most hedge funds deliver leveraged beta, but the top hedge funds are worth tracking. They're typically (but not always) way ahead of the retail and institutional funds. So when the WSJ reports that some big hedge funds have taken a liking to mortgage insurers in recent months, you should pay attention and ask yourself why.

Other big funds are paring back on stocks. Reuters reports that Harbinger's Falcone trims stock holdings:

Hedge fund manager Philip Falcone slimmed his stock portfolio by eliminating at least a dozen names and dramatically paring his top holding, a new regulatory filing shows.

The New York-based hedge fund manager, who is staking his reputation on a big bet that he can build a high-speed wireless network, eliminated stocks like Clearwire Corp (CLWR.O). and Mercer International (MERC.O) in his Harbinger Capital Partners Master Fund I.

Falcone also pared back Citigroup (C.N), which had been his biggest holding with 70 million shares in the first quarter, and cut telecommunications company Sprint Nextel (S.N).

At the end of the second quarter, the filing shows that he owned only 35 million shares of Citi, which has been remaking itself since being rescued with $45 billion in government bailout money. He also reduced his stake in Sprint to 35 million shares from 49.6 million shares.

During the quarter, Falcone owned 16 million shares of Palm Inc, having first announced his purchase days before computer maker HP agreed to buy the personal digital assistant manufacturer.

Falcone, whose strong returns last year helped earn him a spot as one of the industry's best-paid managers, also added 25.8 million shares of Spectrum Brands (SPB.N), known for selling everything from pet care products to small appliances like the George Foreman grill.

Recently he pledged 12.9 million of those shares as collateral for a $400 million loan he raised with the help of UBS.

Cameron International (CAM.N), a manufacturer of oil and gas pressure control equipment, including valves, wellheads, controls, chokes, blowout preventers, also appeared in Falcone's portfolio with 7 million shares.

Many other hedge fund managers made bets on energy companies whose shares had been depressed after BP's (BP.L) Gulf of Mexico oil spill.

Falcone has been one of the hedge fund industry's most closely watched managers since a savvy bet in 2007 that the U.S. housing market would collapse and that mining companies would gain, earned his investors a 116 percent return.

Since then, he has seen some ups and downs. His flagship fund was off roughly 10 percent through the middle of July of this year after having gained 46 percent in 2009. In 2008 he posted a 22 percent loss.

Money managers like Falcone who invest more than $100 million are required to file form 13-F within 45 days after the end of each quarter. The forms include only U.S.-listed equity securities and related derivatives. Bonds, other securities and short positions are typically not disclosed. Managers may also leave off U.S.-listed equities they own under certain circumstances or file some holdings on confidential filings.

For instance, in the case of Falcone, much of his funds' more than $2 billion investment in a wireless telecom company called LightSquared is not reflected in 13-F filings.

Finally, Mr. Falcone isn't the only one paring down stocks. Zero Hedge posted an excellent interview with hedge fund manager Kyle Bass who was quoted as saying "I don't know how I can be long stocks".

You may recall Mr. Bass was quoted back in February in a Forbes article on The Global Debt Bomb:

Kyle Bass has bet the house against Japan--his own house, that is. The Dallas hedge fund manager (no relation to the famous Bass family of Fort Worth) is so convinced the Japanese government's profligate spending will drive the nation to the brink of default that he financed his home with a five-year loan denominated in yen, which he hopes will be cheaper to pay back than dollars.

Through his hedge fund, Hayman Advisors, Bass has also bought $6 million worth of securities that will jump in value if interest rates on ten-year Japanese government bonds, currently a minuscule 1.3%, rise to something more like ten-year Treasuries in the U.S. (a recent 3.4%). A former Bear Stearns trader, Bass turned $110 million into $700 million by betting against subprime debt in 2006. "Japan is the most asymmetric opportunity I have ever seen," he says, "way better than subprime."

Bass could be wrong on Japan. The island nation (and the world's second-largest economy) has defied skeptics for so long that experienced traders call betting against it "the widowmaker." But he may be right on the bigger picture. If 2008 was the year of the subprime meltdown, 2010, he thinks, will be the year entire nations start going broke.

The world has issued so much debt in the past two years fighting the Great Recession that paying it all back is going to be hell--for Americans, along with everybody else. Taxes will have to rise around the globe, hobbling job growth and economic recovery. Traders like Bass could make a lot of money betting against sovereign debt the way they shorted subprime loans at the peak of the housing bubble.

So is Kyle Bass right? I think he's wrong on stocks as even Buffett was again a net buyer of stocks in the second quarter in marked contrast to the previous two quarters of heavy selling. Moreover, top hedge funds and banks' prop desks continue to bid up risk assets. But he may be right on Japan, and his views on pensions are definitely worth listening to (watch both parts of interview below).

But before you actively short JGBs or the yen, remember Mr. Keynes' famous quote: "The market can stay irrational longer than you can stay solvent". I've seen many "star" hedge fund managers succumb to the market because they were absolutely convinced they were right and the market was wrong. Unfortunately, no matter how "smart" the money is, the market always dictates the terms of the trade.

Part 1:

Part 2:

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