After a poor start to the year, Dan Loeb’s Third Point redeemed itself in the second quarter, in which it posted a 4.6% return, bringing the YTD net P&L to +2.2%
True to his narrative form cultivated during his early activist “Mr.Pink” days, Dan Loeb second quarter letter starts off where his infamous Q1 “Carnage” story left off, and starts of with an almost literal bang, providing the most vivid visual of what it means to run money in 2016. As he puts it, “watching Jon Snow’s epic “Battle of the Bastards” scene in the penultimate episode of this season’s Game of Thrones gives investors a sense of how it has felt to manage money during some periods over the past year. Surging enemies forming a seemingly impossible perimeter, a crush of fellow soldiers on the field, arrows coming in overhead, and the need to avoid panic and deftly use sword and shield to fight your way out of a seemingly impossible situation is a good analogy for the emotional experience of managing assets since last summer.”
He continues:
Nearly one year into this market cycle, a few truths of hedge fund investing are evident: 1) portfolio positioning matters as much as stock picking skill; 2) factor risk, not beta, has driven hedge fund underperformance in an up market; 3) crowded trades are a symptom of the prevalence of copycat investment frameworks practiced by hundreds of funds formed over the past decade to mimic the success of many of their investing legend mentors and therefore naturally share the same outlooks and biases; and 4) putting money to work in equities and credit today requires a thoughtful perspective on global events. Macro analysis is no longer just for macro traders.
He uses Brexit as a case study of investing against the crowd and “being able to make decisions about the real impact of political and economic events in the midst of market turmoil.”
The Brexit vote was a good example of the importance of being able to make decisions about the real impact of political and economic events in the midst of market turmoil, and many market participants were caught flat?footed. The idea that the outcome was unforeseeable is incorrect – the polls correctly forecast a coin flip – but elites dismissed the possibility. There is a lot to learn from this group?think pitfall, which we nearly fell into ourselves. Over the weekend following the vote, we investigated the actual impact of Brexit and, after concluding the average predicted scenario was too severe, we quickly repositioned our equities portfolio by covering shorts, adding to several long positions, and initiating a new position in a European event?driven situation. This helped generate positive returns for the month, for Q2, and so far in July.
An interesting observation: Loeb flipped on his energy shorts and starting in February, he went long $1 billion in energy credit:
As the Brexit episode showed, investing in this market must be viewed through a different lens. This year, we have applied our views about global risks to portfolio management and maintained a highly flexible, opportunistic approach. Our net equity exposures have ranged from ~40% to ~55% in 2016, allowing us to be proactive in periods of market selloffs while still taking enough risk to generate returns. We came into the year with a short credit portfolio that we reversed sharply in February, getting long over $1B in energy credit, a trade we discuss further below. We have reduced our structured credit book of housing?related bonds from its highs and focused increasingly on new areas of opportunity in consumer lending. The year’s positive performance reflects contributions from nearly all of the strategies we employ; the top five winners include a constructive long equity position, a sovereign debt investment, high?yield debt investments in energy companies, an event?driven long position, and a short equity position in the pharmaceutical industry.
Why the flip on energy? This is what he says:
Investments in energy credit drove positive returns for Third Point during the first half of the year. We began 2016 short corporate credit with modest exposure consistent with our 2015 portfolio and an overall bearish market. There were a few signs that the market’s degree of pessimism was misplaced, as Goldman Sachs highlighted in a January note to clients:
“HY E&Ps are pricing in more losses than anything ever experienced, even in the CCC space…HY E&P spreads are implying a cumulative loss rate of 86%, assuming a buy and hold strategy on the current universe. This means an investor would still break even if 86% of the current HY E&P portfolio were wiped out. For context, data from Moody’s show that since 1985, the worst cohort of Caa?rated firms experienced a five?year cumulative default rate of 71%.”
Early in the year this (prescient) observation provided little comfort to investors who, having suffered through the 4th worst year in the history of the high?yield market in 2015 (only exceeded by the credit crisis years of 1990, 2000, and 2008), watched as oil plunged through $30/bbl and natural gas traded with a one?handle.
We shifted our portfolio in late Q1, driven in part by our analysis of the energy markets and our approach to cross?capital structure investing. In late January, Moody’s revised its 2016?2018 Brent forecasts to $33 / $38 / $43, triggering multi?notch downgrades for many E&Ps. Forced selling by index funds following such downgrades caused many bonds to gap down in price as a large portion of the space transitioned from trading on yield to expected recovery in a bankruptcy scenario. In mid?February, days after rumors of Chesapeake’s imminent Chapter 11 filing, another rumor surfaced that OPEC was willing to cut production. This led oil prices to bottom, finally.
Around this time, we saw the potential for a modest commodity price recovery and also believed the market was underappreciating the potential of a broad?based “equitization” of the energy sector (asset sales, equity raises, dividend cuts). As creation value through various credits reached levels that were too cheap to ignore and our view on commodities strengthened, we covered shorts and added quickly to opportunities on the long side.
While our team also evaluated expressing our view on energy via equities, and made some modest investments there, we chose to invest the bulk of our energy exposure in credit because we believed that the “fulcrum” securities available offered the best relative risk/reward based on the range of scenarios we analyzed.
We recently have monetized several investments that imply a more optimistic commodity price outlook than we are willing to underwrite. We are currently focused on debt of companies with high?quality assets and deleveraging catalysts where we can make good returns while limiting downside risk should commodity prices stagnate. As credit markets continue to reflect overall skittishness and volatility, we are optimistic that our flexible approach to investing in the space will continue to provide more opportunities for meaningful returns like the ones we generated during the first half of this year.
Finally, Loeb’s “constructive” outlook reveals that Loeb is a big believer in the Fed Model:
Looking ahead, we remain constructive on US markets and are primarily invested here. While observers claim the S&P is expensive, its dividend yield currently is greater than the 30 year bond yield, a relatively rare occurrence not seen since 2009. The dollar’s strength earlier this year had weakened overall S&P earnings and when combined with its softening, the Fed’s signals that another rate hike this year is highly unlikely, and tailwinds from low energy prices, we expect to see earnings improve in the second half. Share buybacks and M&A remain robust. Viewed from this perspective, alongside the observation that very few other asset classes or regions offer more attractive returns, we are content to have our capital in a well?diversified portfolio of US?centric credit and equities.
Full letter below.
via http://ift.tt/2ado0Jf Tyler Durden