The Market Beat #40
The Market Beat #40
Backslidden value investors, and a U.S. Court says the quiet part out loud about public company audits.
The Prodigal Hedge Fund Managers
An article in the Wall Street Journal about value hedge fund managers gone astray caught my attention recently. It’s worth a read, you can check it out here.
Per the article:
In college, Benjamin Stein and Zachary Sternberg devoured Warren Buffett’s annual letters, embracing his value-driven approach to investing.
This guided the undergrads when they started a hedge fund, Spruce House Investment Management, in 2006. It would go on to mint profits and manage billions for clients like the Massachusetts Institute of Technology, the University of Notre Dame and wealthy individuals like hotelier Barry Sternlicht.
Around 2017, Stein and Sternberg began to change tack, going on to place what would become chunky wagers on highflying growth stocks and lengthening how long they were willing to wait for those companies to generate profits. The shift worked—for a while. By 2021, their fund’s assets had swelled to $4.7 billion, up from $2.2 billion in late 2017.
Then the Federal Reserve began hiking interest rates. Tech and growth stocks cratered. So did Spruce House: The New York hedge fund lost about two-thirds of its clients’ money in 2022, according to people familiar with the matter, one of the worst showings by a stock-picking fund that year.
It was a period of “psychological torture,” the two wrote in a letter to investors.
Now, Stein and Sternberg, both 38 years old, are trying to claw their way back. They have told investors they are holding more cash, holding less concentrated positions and hewing more closely to their investing roots.
So, a few things here.
It seems like the change was probably a net positive for the fund managers even despite the fund’s losses in the Great Tech Wreck of 2022. Adding $2.5 billion to your fund? Over four years? Excluding for the sake of argument the traditional 20% profit-taking that hedge funds engage in, that’s an increase of $50 million per year to the fund’s top line if the fund charged the traditional 2% fee.
This turn of investment philosophy seems… very odd for a professionally managed fund. More to the point, I wonder what the agreements with the LPs look like…? Typically, a fund has an investment philosophy that it more or less follows. You don’t want to get involved with a fund manager who says he buys exclusively U.S. stuff and then goes out unannounced in the next quarter overweight Eurozone debt, for example.
It’s interesting to look back at the ZIRP world and remember how mind-boggling (and frustrating!) it was to value investors to watch Carvana (which these two invested in!) go to the moon (even for a brief period).
Anyway, I think this draws out an interesting thread about investing, and illustrates the point made by Peter Lynch in his great One Up On Wall Street. In his seminal book, Lynch points out that (unlike the example illustrated above) most institutional fund managers are hemmed in on all sides by investment restrictions. You can’t just change your investment philosophy on your investors. You typically have to spell out exactly the kinds of situations you’re looking for (at least in broad terms). You are often restricted by market capitalization and share cost.
Can these guidelines be tossed out the window? Sure, of course. Unlike highly regulated mutual funds (Lynch’s world), hedge funds can strike whatever arrangement they like with their investors or LPs. However, no matter the arrangement, I think the fact remains that investors can stomach losses if they know what the investment is. Losses on a surprise are another matter. If I told you I was going to buy bananas with your money—even implicitly—you’d probably have some questions if I came back with a bag of oranges.
The mea culpa article also brings to mind a Warren Buffett quote about the money management business. To paraphrase, the oracle once remarked that in the hedge fund game managers can lose all their client’s money while creating generational wealth for themselves.
At any rate, the managers of Spruce House seem to have learned their lesson and are now only charging performance fees on new client money only after said money has been doubled. Still, doesn’t seem like the pair got (or are getting) the short end of the stick.1
Aside from being interesting, the article also raises the perennial question—should investors stick to their knitting when it comes to investment styles? Should growth and value investors stick to their respective camps? As Peter Lynch says, you aren’t required to as an individual investor, and that can be a strength. It can also be a massive hindrance, having virtually no check on one’s mind straying to newer, flashier investment themes.
Ultimately, I think the question has a flawed premise, and that there are situations where it makes sense for some people to travel down both roads, while others (due to temperament or some other factor) should probably stick with one or the other.
However, for these guys (even just for, you know, potential liability reasons!) it’s probably best to stick to the script.
They Said The Quiet Part Out Loud
Look, as public market investors we have to put up with a lot. We put our cash into a company, hoping the stock will rise while sleepy boards grant uninspired management teams massive comp packages in stock with low hurdles. Tale as old as time, right?
Anyway, it appears that investor’s lot in life just got a bit worse. As if the accounting scandals of the past 25 years or so weren’t enough to convince you that the perfunctory annual audit that public companies subject themselves to is of little to no value, then perhaps this bit from the Wall Street Journal will:
One of the country’s most influential courts has asked the nation’s top securities regulator for its views on an uncomfortable subject: whether audit reports by outside accounting firms actually matter.
The court already ruled that, at least in one case, they didn’t. That case, where an insurer overstated profits and an auditor signed off on its books, led to an investor lawsuit against the auditor that was dismissed. In its ruling, the court said the audit report was so general an investor wouldn’t have relied on it.
The decision could have broad ramifications for the Securities and Exchange Commission, which oversees corporate financial disclosures, and for the auditing industry, which charged about $17 billion last year for blessing the books of publicly listed companies in the U.S.
More particularly on the case:
The court ruling involved a lawsuit by investors over an audit gone wrong. AmTrust Financial Services, an insurance company, had overstated its profit, and BDO USA, its outside accounting firm, had blessed the numbers.
Investors sued BDO, and a court dismissed their claims. They appealed, and the Second Circuit this summer said the language of BDO’s audit report was so general that an investor wouldn’t have relied on it. Consequently, the court said the audit report wasn’t material— meaning it didn’t matter—and upheld the dismissal of the claims against BDO.
Ah, yes. Well.
Anyone who has perused a 10K with a hint of seriousness has almost certainly read the boilerplate language of an auditor’s certification. The certifications are so boilerplate that even a change of a single word from one year to the next can trigger a frenzy. Therefore, it’s kind of difficult to understand the court’s position (this, for the record, is more or less the SEC’s position on the case).
And yet, shouldn’t we all know by now that audit certifications should be taken with a grain of salt…? Perhaps a friendly reminder is in order that auditors, when going about the business of auditing, are doing so for their clients. You know, the people responsible for paying them and the people who, should they be unhappy with you, can all too easily go across the street to your competitor. You don’t have to go far to find examples of auditors getting too cozy with a company and dishing out bills of good financial health while the patient is slowly dying.
This is a drum short sellers have been beating for years (and, I guess you could say, a main reason why they continue to exist). At the end of the day I suppose this is just another bit of evidence to put on the pile of evidence that shows that investors should always, always, maintain skepticism when evaluating a company, because, hey, it’s not like you can count on the $17 billion audit industry to do it for you.
Stuff To Read
Here’s the latest from Conor Mac at the always-worthwhile Investment Talk. Conor gives a good bit of insight into the British luxury brand Burberry.
If you haven’t found Market Sentiment yet, then have I got a treat for you. The newsletter recently published this excellent piece without a paywall on the Lindy Effect. You won’t regret reading this one.
Final Thoughts…
Holiday shopping is not what it once was. Home prices are falling in Beijing (that’s not good). Don’t count Apple out of the AI game. Barron’s 2024 market predictions. The world’s best-performing stock in 2023 was a South Korean EV maker. You can get George Santos to send you a cameo (please, please don’t, I’m begging you),
Disclaimer: Nothing here is investment advice. This is a work of opinion only. Consult with a securities professional before investing in any security.
Depending on what the management fee for the fund is.