Veryan: Blackstone IPO and irrational investors

by Veryan Allen

23.3.07

Blackstone IPO? Markets, technology and financial products may innovate BUT investor behavior remains a reliable constant. It is comforting to see such irrationality surrounding such an obviously predictable event. A firm that extols the virtues of going private decides to go public itself! Naturally, the Blackstone IPO will be wildly overpriced by the underwriters but still more wildly oversubscribed. A few weeks later analysts at those same investment banks will then produce glowing reports saying Blackstone is cheap. Wonder what Goldman did to annoy Stephen Schwarzmann; did they dare to use GS stock in the comparables valuation pitch? Apart from some Fortress specifics, all I wrote on the Fortress IPO applies to the Blackstone IPO, only more so.

More irrationality abounds elsewhere, as Brian Hunter and Nick Maounis of Amaranth fame busily market their new funds. This is excellent news for good hedge fund managers and professional traders, especially in the energy complex. Let's hope they both raise $800 million, preferably $8 billion. The more dumb money out there, the more opportunity for smart money to exploit it. I haven't seen their presentation materials yet but no doubt there are plenty of "one off event, thousand year storm, just bad luck, never happen again, strict risk control" slides in there. Sorry but genuine top traders do not lose $6 billion, EVER. But it is terrific that there is a good amount of irrational money out there prepared to back them, even when there are 10,000 superior hedge funds already available.

Yet more irrational is that, as usual, hedge funds are now being blamed by some for the recent volatility. Since "hedge funds" comprise an extremely heterogenous range of strategies, doing different things in different time frames, short and long, it is difficult to see how "hedge funds" had much to do with it. If anything the mini-correction would have been a major correction were it not for hedge funds covering shorts. We have also seen weaker hedge fund managers blaming everyone but themselves for performing poorly. Here's a small tip for every market participant: if you lose money, it is YOUR fault. No-one else's. Events happen and risks are always present; if you are competent, you prepare for ANYTHING.

Shockingly, 83 hedge funds shut down last year! This is portayed as a negative for the industry which I find very odd. Firstly "shut down" does not mean "lost all the money", though, of course, a few did do exactly that, but that was due to uncooperative fund administrators or uncooperative weather, right?! Secondly, beta still bails out so many funds. We ought to lose easily the bottom decile if not bottom quartile ie 1000-2500 fund shut downs each year, but it is remarkable how few funds have disappeared. Hopefully the next bear stock market, credit collapse, economic recession will identify who has been swimming naked in the outgoing tide.

However, all of the above is good news for those with investment skill. Alpha can ONLY be generated when many others are wrong. It is a necessary condition for there to be as much greed, fear, illogicality, stupidity and emotion as possible in the markets. I would really start to worry and consider another career if no-one bought Blackstone stock, no-one gave money to Solengo Capital, and everyone loved hedge funds and blamed themselves for losing money. It would concern me if humans had suddenly become rational, calculating robots coldly optimising their utility. The markets might well become efficient and fairly valued. Thankfully this is clearly not remotely the case. Phew!

The best investments are often those that others consider crazy at the time. The most correct opinions are usually the ones most vehemently opposed by the "experts". Investors also have to be careful not to confuse intelligence with rationality. Some of the cleverest people around are very irrational. As John Maynard Keynes alluded to with beauty contests, don't buy the things you personally think are good, buy what others think are good. As LTCM and Amaranth found out, being intelligent and rational does not help very much if the market is stupid and irrational.

I use a lot of artificial intelligence to model and forecast the markets and hedge fund returns, but is "intelligence" the correct word. Sometimes it is artificial stupidity that is needed to identify and capture the vast inefficiencies created in the emotional financial markets. Contrarian investing is fine, but sometimes you have to be contrarian to the contrarian and just go with the flow. So while neither I, nor any of the Middle Eastern and Russian subscribers to this site, will be giving any money to Brian Hunter, I might try giving Blackstone some cash. But if I get in the IPO allocation, I'll be selling soon as possible and probably going short. Perhaps that birthday party will one day be looked back on like we now regard the Predators Ball.