Unlike 2017, when returns by Dan Loeb’s Third Point (whose AUM at June 30 was $17.7 billion) smashed left the S&P in the dust, 2018 has started off on the back foot, and as the fund writes in its latest letter to investors, its performance net of fees was +0.8% for the first half of 2018 (although he clarified that this “masks strong returns in several of our largest positions, including Baxter and Netflix”).
Just like David Einhorn, Loeb notes that “both single name and portfolio shorts lost money during Q2” although his longs more than offset for these losses. One place where Third Point got hit on the long side was its long exposure to Emerging Markets: “After generating strong returns in Argentine sovereign debt from 2014 to 2017, we recycled some of our realized profits into emerging markets equities, primarily Argentine banks. We overstayed our welcome in the region and took losses on those securities last quarter when EM currencies weakened dramatically.”
Meanwhile, his current modest investments in credit strategies, Loeb writes, “reflect the limited opportunity set and have made little impact on performance this year.” That said he remains hopeful that while he suffered some realized losses as well as a long list of “mark-to-market” declines in names, he expects these are temporary and the names “will rebound, including Nestlé, our largest consumer position, and DowDuPont.”
Summarized, this is how the fund’s Q2 and YTD performance was so far:
But enough about his performance, what is always of greater interest to investors is Loeb’s outlook on the future, and here he remains optimistic, if perhaps to the same extent as last year.
This is how he views the current investing climate:
While it is important to stay abreast of political events and shifts in economic policy, data, and forecasts, our performance is driven primarily by bottom-up, fundamental investing and only occasionally by our ability to read a macro crystal ball.
Still, we spend time studying global market dynamics because, every few years, doing so gives us a chance to decisively shift positioning or asset classes when we recognize a turning point in extremely volatile markets.
With this in mind, our view of the current economic backdrop is:
- US growth will remain buoyed at a high level due to the fiscal stimulus impulse from spending increases coming into the system. Barring an escalation of trade conflict, most of the deceleration in the global manufacturing cycle is likely behind us;
- inflation has remained stable in the first half of the year, with little sign of impending acceleration, despite a record low unemployment rate;
- the cycle can extend longer than many people think as companies are in good shape, particularly in the US, and the consumer is strong while carrying only modest debt levels; and,
- equities are not expensive at 16x forward earnings. We believe the risk of recession in the next year remains low and, without this concern weighing heavily on markets and with the tailwinds we have described, we believe equities should go higher but at a moderate pace.
As we said, optimistic to a fault. Or maybe not, because while he believes that the status quo provides for a backdrop of “moderate increase”, Loeb notes that the environment is “more fragile than it was a year ago” and everything could change on a dime. In this context, he notes the “single most important factor to follow” for the market which, not surprisingly, is “Fed action” to wit:
While our case for continued favorable conditions is sound, we recognize that the calculus is more fragile than it was a year ago. The single most important factor to follow is Fed action. If the Fed is determined to “kill the patient” through aggressive intervention in the form of rate hikes then the current health of the patient is irrelevant. If the Fed continues at its current pace, it will have tightened by ~3% (or even ~4% if one includes its roll-off of quantitative easing measures) by the end of 2019. Tightening of that magnitude has almost always resulted in recession.
And while Loeb believes this well-seasoned Fed “understands exactly the tightrope it is walking, the risk of destructive action is not zero.”
But wait, there’s more, because in addition to the risk of “destruction action” by the Fed, Loeb lists 3 additional factors that could upset the market, which are:
- an escalating trade war. At this point, we are not concerned about the impact on the economy from the current tariff tit-for-tat, but an out-of-control battle could inject fear and caution into markets. More important, and less well-understood, is that a trade war threatens the margin structure of the S&P 500. Since 2000, 100% of margin expansion has been driven by manufacturers (e.g. technology, capital goods, etc.). We estimate that global value chains have driven between one-quarter and one-third of this expansion. Thus, a trade war that results in substantial increases in labor costs or even disruption to the current system could meaningfully reduce a key element of corporate profitability;
- any growth acceleration will be less strong than in 2017 and is likely to be concentrated in the US, an unfavorable comparison to the previous year that may encourage pessimism; and,
- increasing signs of inflation, given the tight labor market.
Loeb concludes with some thoughts on his investing style as we approach the threshold of the longest economic expansion on record:
Growth Is Where the Value Is
Over time, we have generated returns by adjusting our exposure levels (sometimes adding decisively at market lows), by shifting our allocation to equity versus credit, and even by adding skills in new areas like sovereign and structured credit to take advantage of dislocations in those markets. Over the past five years, we have added adjacent styles to our equity investing tool kit, moving from purely an event-driven, value-based universe of stocks to include “compounders” and, increasingly, what are classically considered “growth” stocks.
The value-based argument for owning “growth” stocks (or those with high EPS growth) is that their P/E premium to the rest of the market is not especially large compared to what we have seen historically (for a dramatic illustration of this, see the 1999-2000 tech bubble). We have also discussed with investors the insight that stocks with unprecedented growth rates have defensible valuations when one extends earnings out two to three years. We are happy owning these stocks for longer periods at higher multiples and absorbing the inevitable volatility, particularly in this late cycle environment.
Of course, we have not shifted our entire portfolio to fast-growing, high-multiple securities but we see a place for the companies of tomorrow as investments alongside our classic special equity and credit situations. In a world of increasing disruption in virtually every industry, we recognize that we must continuously evolve our framework or risk being disrupted too.
Finally, as had been leaked several days earlier, Dan Loeb confirms that he is now long PaypPal, whose shares he believes will hit $125 in 18 months, representing 50% upside:
During the Second Quarter, we initiated a long position in PayPal, a $100 billion market cap online payments company that processes ~20-30% of all ecommerce transaction volume globally (ex-China), led by the excellent CEO Dan Schulman. With 237 million active accounts and 19 million merchants using the iconic PayPal checkout button online, PayPal enjoys a dominant competitive position with a 10x scale advantage relative to peers. Consumers love PayPal because it enables hassle-free, one-touch checkout across millions of online merchants; merchants love PayPal because it drives higher sales, with a checkout conversion rate of 89% – almost 2x that of credit/debit cards. We see parallels between PayPal and other best-in-class internet platforms like Netflix and Amazon: high and rising market share, untapped pricing power, and significant margin expansion potential. PayPal is in the process of evolving from a pure-play “checkout button” to a broader commerce solutions platform, expanding into adjacent verticals (e.g. in-store payments, B2B) organically and through M&A. We forecast above-consensus EPS growth driving shares to $125 within 18 months, for ~50% upside.
Much more in the full letter:
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