Baupost Sees Opportunity In Volatile Markets

Baupost Group, the hedge fund managed by renowned value investor Seth Klarman, saw the value of its funds under management decline by a mid-single digit percentage during the nine months to the end of September, according to the fund’s third quarter letter to partners dated October 15th.

• Also see – Baupost Is Said To Decline 3.8% In September On Energy, Biotech by Sabrina Willmer, Bloomberg

However, during the first five days of October the fund erased 75% of these YTD losses, and Seth Klarman expects the market to throw up more opportunities for value investors to take advantage of in the near future.

Baupost Group: Performance since inception

Baupost: No pressure to perform

In Baupost's third quarter letter, Seth Klarman comments on the prevailing market environment. Specifically, Klarman writes that many investors have been lured into the financial markets based on expectations of continued low volatility, a result of extreme policy measures by central banks around the world.

However, Baupost has remained wary and has not been "captivated by this monetary siren song". Unlike other hedge funds, which have piled into crowded trades under pressure to outperform their peer group on a short-term basis, Baupost has continued to invest with a long-term outlook.

What's more, the fund's cash balance (Klarman's favorite hedge against volatility) has remained high throughout the year, at more than 40% of the portfolio -- despite significant buying. Another 8% in cash is held in the liquidation of the cash-rich Lehman debtors.

Baupost continued to invest its capital in new opportunities throughout the third quarter, despite volatility. The fund deployed cash buying public equities, additional Lehman claims, and real estate. All of the investments acquired during the quarter were purchased at a significant discount to Baupost's calculation of underlying value and were attractive even under very conservative assumptions.

According to Baupost's 13F SEC filing the fund added nine new equity positions to its portfolio during the quarter, including PayPal Holdings Inc., Twenty-First Century Fox CL B, Olin Corp., Twenty-First Century Fox, AerCap Holdings N.V., LifeLock Inc., Sunrun Inc. and Orexigen Therapeutics Inc. Klarman’s largest buy during the quarter was Alcoa Inc., which is now Baupost’s third largest holding after Cheniere Energy Inc. and Viasat Inc.

‘Adds’ for the quarter were Cheniere Energy Inc., Pioneer Natural Resources, Antero Resources, Atara Biotherapeutics Inc., Veritiv Corp., ChipMOS TECH, Bellatrix Exploration Ltd., Biotie Therapies Corp. and Sanchez Energy Corp.

Throughout the third quarter, Baupost spent $2 billion buying public equities, $250 million acquiring undervalued debt instruments and $175 million was spent acquiring real estate. Partially offsetting this buying were almost $500 million of public securities sales, $550 million of mostly profitable real estate monetizations, and $170 million of Lehman distributions in the quarter.

Baupost: Volatility, opportunity ahead

Baupost exited the third quarter with plenty of dry powder on hand and Seth Klarman believes that there will be plenty of opportunities to deploy this capital going forward.

Indeed, Klarman speculates that the markets are entering an era of greater market volatility, where trading algorithms and investor skittishness drive more frequent and wider swings in the market. Moreover, a great many excesses have built up since the 2008 crisis, many investors, starved of opportunity have piled into the market, exhausting cash resources in the belief that easy money policies will continue to drive returns for the foreseeable future.

Going into the fourth quarter, Baupost is excited about the enhanced opportunity set on offer but is wary of plunging in head first. The fund remains cautious. It is doing some buying, averaging down while constantly checking and rechecking analysis, validating assumptions, and comparing new opportunities to what's already owned.

Bunch O' Charts

Barclays bets on stock boom

Barclays has advised clients to jump into world stock markets with both feet, citing the fastest growth in the global money supply in over thirty years and an accelerating recovery in China . 

Ian Scott, the bank’s global equity strategist, said the sheer force of liquidity will overwhelm the first interest rate rises by the US Federal Reserve, expected to kick off next month. 

Global equities rose by an average 15pc over the six months after the last three US tightening cycles began, on average, and Barclays argues that this time stocks are cheaper. 

The cyclically-adjusted price to earnings ratio (CAPE) for the world’s equity markets is currently 18, compared to 25.5 at the beginning of the last rate rise episode in 2004. 

This is roughly 14pc below the CAPE average since 1980, though critics say earnings have been artificially inflated by companies borrowing a rock-bottom rates to buy back their own stock. 

Mr Scott said the growth of global M1 money – essentially cash and checking accounts – has surged to 11pc in real terms, led by China and the eurozone. This is higher than during the dotcom boom and the pre-Lehman BRICS boom. 

It is likely to ignite a powerful rally in equities nine months later if past patterns are repeated, although the lags can be erratic, and the M1 data gave false signals in the mid 1990s. 

Barclays said American stocks are trading at a 30pc premium to the rest of the world. This gap is likely to close as emerging markets - "the epicentre of negative sentiment" - come back from the dead. The pattern of foreign fund flows into the reviled sector has triggered a contrarian buy-signal. 

Everything hinges on China where real M1 money has ignited after languishing for over a year. Floor space sold is growing at 20pc and house prices have stabilized. 

Simon Ward from Henderson Global Investors says real M1 is now surging in China at the fastest rate since the post-Lehman credit blitz, though money data is cooling in the US 

Chinese fiscal spending has jumped by 36pc from a year ago and bond issuance by local governments has taken off, drawing a line under the recession earlier this year. "A growth revival is under way and will gather strength into the first half of 2016," he said. 

Barclays is not alone in calling the bottom in emerging markets. Amundi Asset Management is cautiously buying, based on a 'soft-landing' hypothesis for China. 

Kamakshya Trivedi from Goldman Sachs is also nibbling, though the bank remains bearish on China and has ditched its infamous `BRICS' fund to focus on a more coherent concept. 

Mr Trivedi said there is no going back to the "roaring 2000s" but the worst may be over after three years of dire returns. “2016 could be the year emerging market assets start to find their feet," he said. 

Capital Economics has been caustic about the BRICS for several years but said the hard data at last point to a tentative rebound for the emerging market nexus as a whole. "All told, there doesn’t seem to have been much justification for the alarmist talk that gripped the markets in the summer," said William Jackson, the group's senior emerging market economist. 

Sceptics abound. Nobody knows for sure what will happen to the most indebted countries if the Fed embarks on a serious tightening cycle. Dollar debts in emerging markets have jumped to $3 trillion, and much higher under some estimates. 

Private credit in all currencies has risen from $4 trillion to $18 trillion in a decade in these countries. Research by the Bank for International Settlements suggests that rate rises by the Fed ineluctably lifts borrowing costs everywhere. 

Barclays said the US rate rise cycle is a tonic for global financial companies. It has raised its weighting for banks, insurance companies, and other finance stocks to 31.9pc. 

“We think global banks are severely under-priced,” said Mr Scott. He likes AXA, Banco Popular, Citigroup, JP Morgan, Lloyds Banking, ICBC, MetLife, Intesa San Paulo, among others. 

Bonds are likely to suffer if global recovery builds and fears of 'secular stagnation' give way to an incipient reflationary cycle. 

The bank said the worst sectors at this phase of the cycle are real estate and utilities. 

Materials and commodities may instead make a come back. These are what it calls the "anti-bond" equities. They are trading at a near record 34pc discount to "bond-proxy" sectors. 

Materials and commodities may make a come back. Barclays is heavily overweight energy - at 11.9pc against the benchmark 6.8pc - backing Shell, Marathon, Total, Conoco, Suncor, and Valero Energy, as well as the fertilizer group Agrium. 

Mr Scott said "value stocks" - underpriced relative to fundamentals - are about to come into their own again. These are trading at the cheapest level relative to "growth stocks" since the dotcom bubble, based on the CAPE measure. 

Barclays is betting that the 12pc rout on global stock markets this summer was a false alarm - or a pause to catch breath - along the lines of the Asian financial crisis in 1998. The blast of stimulus that followed in 1998 drove a two-year boom in global equities before the cycle ended. 

The bank may be wrong but there are no signs of the complacency and wild 'animal spirits' that typically mark a speculative top. The bull/bear ratio tracked by Investor's Intelligence is far below previous late-cycle peaks. 

As long as markets are climbing the proverbial wall of worry, investors can take comfort. Pessimism is a fund-manager's best friend.

Is Value Set For A Comeback?

Since 2008, value investing has underperformed growth investing for the longest period on record. As a result, at the end of August, value was trading at its widest valuation discount to growth since the Dotcom Bubble of the late 1990s.

And value’s performance since the financial crisis has been unexpected. Value investing as a style has historically outperformed growth more. Still; past results are no guarantee of future performance, and there’s no guarantee that value will recover.

However, as Franklin Templeton points out when major global central banks begin policy normalization, the idea of mean reversion, or normalization, offers an intuitive argument for an eventual recovery in value. Securities trading at a discount to the fundamental value of their underlying businesses are not likely to maintain that discount indefinitely.

Value returns

Rare opportunity

For value investors looking to snap up bargains, there hasn’t been an opportunity like this since 2000. The price-to-tangible book value of the MSCI World Value Index vs. the MSCI World Growth Index is now at its lowest level since late 2000/ early 2001. Value-oriented stocks trade at a 75% discount to growth in terms of price-to-tangible book value — two standard deviations below the long-term average level based on figures to the end of August.

According to Franklin Templeton, it’s unlikely that value will continue to trade at a discount to growth indefinitely. The concept of mean revision offers an intuitive argument for an eventual recovery in value.

The post-global financial crisis era brought a new wrinkle to the idea of normalization: ZIRP—the zero-interest-rate policies pursued by the world’s most powerful central banks. Indeed, the rising tide of cheap, readily available credit has seemingly lifted all boats, delaying bankruptcies and restructurings and creating a broadly indiscriminate trading environment. Sustained high equity correlations still stand as a testament to the market’s indifference to bottom-up fundamentals.

Meanwhile, the almost non-existent yields offered by bonds perceived as “risk-free” has forced investors up the risk curve into higher yielding debt. Bond investors have also been forced into equities in their search for yield and equity investors chasing growth in a yield-starved environment have incurred a tremendous amount of volatility just to keep up.

“This is not how the market’s risk–reward proposition is typically framed over time. Dislocations have become extreme, and once conditions potentially normalize, the market’s eventual snap-back to its typical function as cash-flow discounter and value arbiter could be profound, much to the potential benefit of patient, value-oriented equity investors.” — Source

Tracking interest rates

Historically, the performance of value as a style has been closely correlated with the interest rate cycle. If you believe that interest rates will never head higher again, then value isn’t the strategy for you. But if we take the view that over the long-term, interest rates will head higher, value as a strategy is appealing for the long-term investor. The Fed’s long-term directional preference is clear when it comes to interest rates.

The entire discipline of value investing revolves around buying stocks when they are out of favor. Global stocks recently have been correcting, value has underperformed for the longest stretch on record, and we may be approaching the trough of a long-term interest rate cycle; what better time for contrarian investors to re-commit to value?

Extremely Narrow

The market has been extremely narrow this year and as a result YTD returns have been strictly about what you own. The tables below show how the 10 largest stocks in the S&P 500 have contributed more the 100% of this year’s 2% gain. Compare that to 2013 and 2014 where the largest 10 stocks contributed less than 20% of the year’s returns. Market leadership remains tied to a handful of stocks which is why it hasn’t been profitable to simply have been long the market this year.