Vulture Capitalism

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Source: Wikipedia

Predictably, the Sears bankruptcy has attracted much wailing and gnashing of teeth around so-called “vulture capitalism” as practiced by hedge funds and private equity firms (here in the biz we use terms like “activism” or “distressed” investing). “Vulture” is of course used as a pejorative in these articles. Personally, though, I think practitioners should embrace the label.

In nature, vultures play an important role in ecosystems:

When vultures are unable to clean up the carrion in an area, other scavenger animals increase in population. The scavengers that tend to move in where vulture populations are low include: feral dogs, rats, and blowfly larvae. While these animals do help to remove carcasses from the landscape, they are also more likely to spread disease to human populations and other animals as well. In India, for example, the feral dog population increased significantly after vultures consumed cow carcasses poisoned with diclofenac, a painkiller. These feral dogs carried rabies and went on to infect other dogs and local people. Between 1993 and 2006, the government of India spent an additional $34 billion to fight the spread of rabies. India continues to have the highest rate of rabies in the world […]

[…] It is important to remember that even though the vulture species lacks the cute cuddly appearance of some endangered species, it is still a critical piece to a much larger, complex ecosystem. The world needs vultures to help control the spread of disease.

Likewise, vulture capitalists pick apart the corpses of dead and dying firms. Eventually that capital is recycled elsewhere in the market ecosystem.

Now, clearly this is not a pretty process. It is gruesome. It involves ruthlessly cutting costs; it involves firing good, hardworking people; it involves selling off assets and extracting cash instead of going through the “feel good” motions of reinvesting that cash into a dying enterprise. The firms that specialize in these activities are at the pointy end of Schumpeter’s “creative destruction.” It’s not exactly shocking that they’re unpopular with the general public.

But here’s the thing about “vulture capitalists.” They don’t feed on healthy companies. And there’s a good reason for this. Healthy companies are too expensive for distressed funds and buyout firms to get their claws into.

The popular notion that Sears, as a business, is dead money has been around since at least 1988. 1988! That’s thirty years. Three decades. Take a moment and think about that.

For thirty years now it’s been pretty clear the investment case for Sears rests largely on a sum-of-the-parts valuation of the real estate assets. There were very few possible worlds in which Sears would reinvent itself as a thriving retail business—particularly given brutal competition from Wal-Mart, Target, CostCo and others.

So when we talk about Sears we’re talking about the business equivalent of a sickly, dying wildebeest. Vulture capitalists consuming the carcass is simply the natural order of things. Even though hedge funds and private equity firms lack the cute, cuddly appearance of certain other market participants, they remain important pieces of a much larger, complex ecosystem.

Extinction

Dinosaur
Remains of a volatility short

Markets are ecosystems. And like any ecology, markets can come to favor organisms with certain traits over arbitrary time periods. In the natural world, dinosaurs flourished when the global climate favored their biology. Then, quite suddenly, that changed. National Geographic tells it like this:

Scientists tend to huddle around one of two hypotheses that may explain the Cretaceous extinction: an extraterrestrial impact, such as an asteroidor comet, or a massive bout of volcanism. Either scenario would have choked the skies with debris that starved the Earth of the sun’s energy, throwing a wrench in photosynthesis and sending destruction up and down the food chain. Once the dust settled, greenhouse gases locked in the atmosphere would have caused the temperature to soar, a swift climate swing to topple much of the life that survived the prolonged darkness.

This is not so much different from those who got wiped out holding large positions in XIV. Short volatility strategies thrived in a market environment that for years has favored long duration assets (long term bonds, high growth stocks, cryptocurrencies) and dip-buying any market decline. When the market environment changed, suddenly and violently, the short volatility trade blew up. Years of gains vaporized in a single day.

20180210_XIV_Chart

Over the past couple of years I have begun to believe there are tremendous benefits to viewing markets through an evolutionary and/or ecological lens. I think this helps you focus on a range of variables impacting the markets, versus wearing blinders that limit you to valuation, momentum, or whatever it is you consider your “thing.” So when a particular asset class catches a strong bid, here are some things I consider:

If this is a cash flow producing asset, what is the relationship between the intrinsic value of the cash flows and the market price? For stocks it is not especially difficult to use the market price and a simple DCF model to derive a market implied IRR. For bonds just check the yield to maturity, yield to call, yield to worst, etc. This gives you an idea of how investors are pricing risk.

Who is driving flows into or out of a sector or asset class? Mutual funds look at the world differently from hedge funds, which look at the world differently from banks and insurance companies. Each of these players has different objectives and constraints, which will impact their behavior as market conditions change.

Are the players driving flows into the asset weak or strong hands? Retail investors are the weakest hands in the markets. I consider many mutual funds weak hands also (depends on the fund family). Mutual fund flows are driven by retail investors and their financial advisors, who are notorious for chasing performance.

How highly levered are the players driving flows into the asset? Leverage can drive extraordinary returns, but it also creates fragility. When deleveraging events occur, prices can collapse suddenly. Many of the short volatility players who got blown up recently didn’t understand the magnitude of the leverage embedded in their positions.

What exogenous factors are driving flows into this asset class? Is an asset in demand due to expectations for low interest rates, low inflation, or other macroeconomic variables? Macro conditions are fickle, and human beings are notoriously poor forecasters.

The most fragile market ecology is one where weak hands are using leverage to play some exogenous variable with known unstable or mean-reverting properties. From this perspective, systematically shorting volatility was stupendously risky–a form of Russian roulette. A large number of retail investors were trading instruments (volatility linked ETPs) with significant embedded leverage, placing a massive directional bet on low rates, low inflation and market momentum.

A market ecology I believe is extremely fragile, but hasn’t blown up yet, is high yield debt. This is an asset class that is highly leveraged by definition, and has attracted massive flows from yield-starved investors. Strong flows have pushed prices up to the point where future expected returns are dismally low, and protective covenants are the weakest on record. Perhaps worst of all, there is a liquidity mismatch between the ETPs (HYG, JNK, etc.) providing investors with easy access to high yield debt and the underlying high yield bonds. For a preview of what happens when a liquidity mismatch meets a stampede for the exits, refer to Third Avenue Focused Credit.

Next stop: Adaptive Markets by Andrew Lo.

Life and Death in the Equity Market

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Deep value investors at work.
In my humble estimation most investors have a limited view of the market ecosystem. This is the fault of the financial advice industry (which emphasizes performance comparisons to sell products and services) and also the financial media (which emphasizes performance comparisons even more than the financial advice industry).

When you look at markets from that point of view, there are “winners” and “losers.” The “winners” are always doing so at someone else’s expense. Usually mom ‘n pop. Or mom ‘n pop’s ineptly managed pension plan.

Make no mistake. Markets are competitive. But they are also vibrant and nuanced. As with any ecosystem, most of the “organisms” in the market contribute to its health in some way.

David Merkel tackles the market ecosystem in two excellent pieces:

http://alephblog.com/2013/04/23/classic-get-to-know-the-holders-hands-part-1/

http://alephblog.com/2013/04/24/classic-get-to-know-the-holders-hands-part-2/

Broadly speaking, he writes about the differences between “balance sheet players” such as banks and insurance companies and “total return players” such as hedge funds and mutual funds. These entities have different investment objectives and constraints and so behave very differently in the markets.

I want to go through a similar exercise. Of course, what is written below involves simplification and generalization. I also focus specifically on equity markets for simplicity. The real world is more complex. But I hope this helps readers think about markets in a more nuanced way.

Traders vs. Investors

At a very high level you can separate the market ecosystem into traders and investors. Traders have short time horizons (sometimes as brief as a few seconds, in the case of high frequency, algorithmic trading). Investors have long time horizons (sometimes as long as decades, in the case of Warren Buffett). Perhaps more importantly, traders and investors make different contributions to the health of the market ecosystem.

Traders’ Contributions To The Market Ecosystem

Traders buy and sell based on anticipated changes in the supply and demand for securities. They contribute to the health of the investment ecosystem by making markets and keeping bid/offer spreads narrow, which reduces the cost of trading for other market participants.

Arbitrageurs are a subset of traders that enforce price relationships among various financial instruments. For example, arbitrageurs ensure that ETF share prices track closely to their net asset values. You can read more about this process at ETF.com.

Many traders are completely unconcerned with the direction of markets. Rather, they attempt to capture small pricing inefficiencies at relatively high frequencies. 

Some traders simply execute transactions for longer term investors and attempt to do so as efficiently as possible. For a large investor that is far from a trivial task. It is one thing to buy $10,000 worth of KO shares and quite another to buy $10,000,000 worth of shares. The latter will move the market.

Investors’ Contributions To The Market Ecosystem

Investors buy and sell securities based on market prices relative to their estimates of “intrinsic value.” Investors contribute to the health of the market ecosystem by ensuring security prices properly reflect underlying economic value. Broadly speaking, there are two subspecies of investors in equity markets: value investors and growth investors.

Some people mistakenly believe value investors seek to buy assets at a discount to intrinsic value while growth investors buy at a premium. This is not true.

Value investors typically demand a much greater “margin of safety” (extra discount from intrinsic value) to buy a security. They tend to gravitate toward businesses that generate profit and excess cash flow, but have modest growth potential. An example of a value stock would be Exxon Mobil or another large integrated oil company. Growth rates are less important to value investors than cash flow and profitability. Value investors tend to focus on what could go wrong in the future versus the potential reward if things go well.

Growth investors gravitate toward businesses where future profits and cash flows are potentially much greater than they are today. These are stocks such as Facebook, Amazon, Netflix and Tesla. Some growth stocks are profitable today (Facebook). Others are kind of profitable (Amazon). Others generate large losses (Netflix, Tesla). The level of profitability today is of less concern to a growth investor than the potential profitability in the future. Growth rates and addressable market size, on the other hand, are of paramount importance to growth investors. Growth investors would prefer to own businesses that will change the world and accept the risk and uncertainty that goes along with that stance.

Popular misconceptions regarding value and growth investors stem from the fact that growth investors tend to own stocks that trade at relatively higher valuations, as measured by ratios such as price to earnings. Regardless, growth investors are always buying at a discount to their estimate of a stock’s intrinsic value.

Life And Death In The Equity Market

When a stock is born (or, rather, goes public), it may start as a high-flying growth company. The business may not be profitable, but as long as it is growing revenue and can capture an increasing share of a large addressable market then growth investors will own the stock. These investors ensure the stock’s price properly reflects the growth potential of the business. The main risk for a growth investor is that a company’s growth rate slows much faster than anticipated.

As a business matures, its growth rate declines and its market share stabilizes. Ownership will transition to value investors who will want to see profitability, cash flow generation and the return of cash to shareholders through dividends and share buybacks. The main risk for a value investor is that growth rates and markets never stabilize, but instead continue to spiral downward. This is called a “value trap” and it is a value investor’s worst nightmare. Another, less prominent risk is that the management will do stupid things like divert free cash flow or take on debt to do silly acquisitions to “buy” growth. A major reason value investors want to see free cash returned to shareholders is to prevent management from doing stupid things with it.

Most businesses will eventually enter terminal decline. There are many reasons for this but the outward signs include falling profitability, sharply declining market share and increasing amounts of debt. Eventually, if a company does not make significant changes, it will become insolvent. When a company reaches this final stage of its life cycle the “deep value” or “distressed” investor steps in to own the stock. The distressed investor evaluates the various securities in the capital structure to identify their value in a restructuring or liquidation. Thus the distressed investor seeks to buy at a discount to liquidation value. The main risk for a distressed investor is an adverse event or legal decision involving the business that unexpectedly changes the liquidation value of the securities in the capital structure.

When a company finally liquidates, its capital may ultimately end up recycled into young companies in the public and private markets.

And so the cycle can begin again.