Category Archives: Vocabulary

the Sequoia Fund and redemption in kind

April 11, 2016 By in redemption in kind, Uncategorized Tags: , , , , , , 1 Comment

I read in the Wall Street Journal over the weekend that the Sequoia Fund (assets of around $5 billion) was experiencing heavy redemptions during 1Q16 and met them for some shareholders “in kind.”

Sequoia:  a first glance

I don’t know Sequoia at all.  A quick check of its December 2015 annual report shows the fund had what I judge to be a very unusual portfolio structure.  At that time Valeant Pharmaceuticals (VRX) made up 20% of assets (down from an even more whopping 28%+ in June of last year); Berkshire Hathaway, classes A and B, comprised another 13%.  That’s a third of the fund in two names.  Very concentrated, in my view.

Unfortunately for holders, VRX fell by 60% during the second half of 2015–during which time Sequoia boosted its position from 11.2 million shares to 12.8 million–before losing 2/3 of its remaining value since this January 1st. Hence the Sequoia redemptions …and the retirement of the fund’s senior portfolio manager.

The Journal reports that, in accordance with long-term fund policy, redemptions of $250,000 or more are being met substantially in kind, meaning that the seller is being paid mostly through a transfer of stock held in the fund portfolio, rather than in cash.  The WSJ cites one customer who received about 5% of his money in cash, the rest in shares of O’Reilly Automotive (ORLY).  That would probably mean less than 1,000 shares of a stock that trades 750,000+ shares a day.  So no liquidity problems.  Commission on the sale, other than benighted souls who patronize traditional high-cost brokers, isn’t a big deal, either.

How is this possible?

According to the WSJ (I haven’t checked, but I presume it’s a boilerplate feature of the prospectus), Sequoia discloses the policy of redemption in kind in its regulatory and marketing materials.

my thoughts:

I don’t ever recall hearing about redemptions in kind for retail investment products   before, although I suspect the provision is contained in every mutual fund and ETF prospectus.  The words “in kind” may not be there, but a general description of emergency measures likely is.

“In kind” strikes me as a draconian measure.  It certainly discourages/punishes redemptions.  And it’s not the sort of thing that encourages a customer to return at a later date.

It probably minimizes downward pressure on portfolio holdings from what would otherwise be forced selling by the fund.

It deals with tax issues in a way that doesn’t harm the redeeming customer and favors remaining shareholders.

How did the VRX position get so large?

 

More tomorrow.

 

 

 

 

 

the last bull standing

March 21, 2016 By in last bull standing, Uncategorized Tags: , , , Leave a comment

Being the last bull standing isn’t necessarily a good thing.  The Wall Street cliche is that the bear market doesn’t end until the last bull capitulates.  The complementary, equally hoary, standby is that the bull market isn’t over until the last bear capitulates.

To my mind, both are useful guidelines but not infallible ones.  On the one hand, markets are inherently cyclical.  So if an equity investor has a close to infinite capacity to endure pain–and if his clients don’t fire him in the meantime–persevering with a bad-performing portfolio can eventually pay dividends.

More qualifiers:

–that’s assuming the companies whose stocks the suffering-oriented manager holds are inherently sound, and not barreling down the road to bankruptcy.  They’re just poorly positioned for the current economic environment, which will sooner or later change for the better.

–a surprisingly large number of pension clients love to hire managers who have a recent hot hand and to jettison ones who are cold as ice, no matter what the long-term record.  So my “if his clients don’t fire him” qualification is a much greater risk than one might think.

On the other, there is something to the idea that until the most vociferous and publicity seeking defenders of a given position that’s going wrong give up, the situation rarely changes.  This may be as simple as that when, and only when, the buyers of what short-sellers want to offload disappear, so too does the short-selling–and hence the downward pressure on the stock in question.

…which brings me to Valeant Pharmaceuticals (VRX).

It has caught my eye that William Ackman, a long-time booster (and holder) of VRX, has joined the board of the beleaguered drug firm.  He’s also raised something like $800 million by selling shares of Mondelez, which was reportedly the largest position in his hedge fund.

To the extent that one believes in the last bull theory, and if Mr. Ackman is in fact the last bull, he’s in a no-win situation.

is “tenure voting” the answer?

March 15, 2016 By in activist investing, activist investors, tenure voting, Uncategorized Tags: , , , , , 2 Comments

tenure voting

The weapon institutions are currently discussing to combat the potentially negative influence of activists on company management plans is called “tenure voting.”

Under a tenure voting scheme, a shareholder accrues more voting power the longer he holds a given stock.  On day one, for example, the shareholder might have one vote to cast on proposals at a shareholder meeting.  This might rise to three votes after three years of continuous ownership and peak, say, at five after five years.

This heavier voting power given to long-term shareholders would, in theory at least, make it much more difficult for an activist investor with a hit-and-run strategy to coerce favorable action from a timid CEO.

the arithmetic of influence

An activist can have leverage over company management at present by buying, say, 3% of the outstanding shares to obtain 3% voting power.  If the typical institutional holder bought his core position five years ago and if institutions overall hold 60% of the outstanding stock, then with tenure voting in place the activist wouldn’t achieve the same amount of clout until he had accumulated at least 10% of the target firm’s stock.  Of course, the activist could also wait for a half-decade for his stake to achieve maximum voting power, but none strike me as having that much patience.

an effective deterrent

So tenure voting would likely insulate many of the large firms potentially under activist attack from such predation.

But…

–there’s a practical issue of implementation.  Instituting tenure voting at a firm would presumably require rewriting corporate bylaws.

–it doesn’t stop activist action.  It just changes the game.  Activists would have to adopt a two-step strategy, the first of which would be to court one or more big long-term institutional holders of a target firm’s stock.  Of course, this is arguably the intent of proponents of tenure voting–the presumption being that professional portfolio investors would rebuff the activists.  Maybe so.  But maybe not.  However, the obvious place to start would be index funds.  It’s not really clear what unintended consequences this might produce.

–tenure voting has been a traditional practice in places in Continental Europe like France.  In my view, it has been a disaster there, cementing in place an elitist old boy network of corporate managements that have had little regard for ordinary shareholders.  More than that, the French government’s move last year to make tenure voting mandatory for all publicly traded firms met with violent opposition from investors who know this system the best.

All in all, although I’m not necessarily a fan of activists, I think in this case the cure is worse than the disease.

institutional investors vs. “activists”

March 14, 2016 By in activist investors, Uncategorized Tags: , , , , 1 Comment

As I see it, today’s activist investors are the successors to the corporate raiders/ “greenmailers” of the 1980s.  In some cases–Carl Icahn is an example–they’re the same person.

Greenmailers (a takeoff on blackmailers) would typically attack small cash-rich companies by buying a 5% – 10% equity position and threatening to launch a hostile bid to take over the firm unless they were bought out at a high price.  That price would typically be all the cash in the corporate treasury.

The tactic often worked.  A CEO who had spent thirty years clawing to the top of the heap  so that he could exercise power and reap large cash/stock rewards during a five-year tenure as chief executive, knew he would be out the door if a change of control took place.  So he might be all for acquiescing to the greenmailer.  Sometimes, too, a company might have questionable accounting or other dirty secrets that could scarcely stand to see the light of day.

The issue for other shareholders:  while the greenmailer would make a financial killing, he would leave behind a firm drained of cash and typically worth considerably less than before the greenmailer showed up at the door.

Activists play a slightly different game.  They attack large companies (perhaps because smaller prey has long since been devoured).  They typically invest millions of dollars in buying a company’s shares, but because of the size of the target, may only hold 1% – 3% of the outstanding equity.  Activists typically demand seats on the board of directors and offer “advice,” which may be sound (or may not), and which usually consists in actions like dividend increases, stock buybacks and/or spinoffs of business lines.  These are all levers designed to get the stock price up quickly–so the activist can sell and be on his way.

The threat is the same:  the sitting CEO has run a grueling thirty-year corporate marathon only to see the prize snatched away as he’s crossing the finish line if the activist decides that he’s part of the problem.

The issue for other shareholders:  none of the actions activists recommend may be good for the long-term health of the company (look at what happened to J C Penney).  And unlike the greenmail case, where the attacker’s threat is to take over the firm–meaning a profit for other holders and resolution to the issue–the activist may well tie up management time and energy with proxy fights or other distractions that go on for years.

Tomorrow:  what to do.

 

 

closet indexing

March 9, 2016 By in closet indexing, Uncategorized, Vocabulary Tags: , , , 1 Comment

“Closet indexing” is the term used to describe the practice of portfolio managers who claim to be active managers–and charge correspondingly high fees–yet maintain holdings that replicate the structure of their benchmark indices extremely closely.

What’s wrong with this?

On the one hand, the empirical evidence is that the average active portfolio manager in the US consistently falls below the performance of his benchmark index, so indexing–even closet indexing–is a viable strategy for beating most of one’s competitors.

On the other, the justification the much higher fees active managers charge is to compensate for maintaining a research department of investment professionals and for skill in figuring out a portfolio structure that both differs from the index and provides superior performance.

The issue, then, is that the closet indexer offers the client a low-cost index product in a very expensive package.  This is socially acceptable, even desired, in some circumstances–like when a luxury car dealer charges $200 for an oil change that goes for $35 at the neighborhood Jiffy Lube.

I have some sympathy for closet indexing, although not a lot.  Unlike the luxury car dealership, where by paying six times the going rate for services the customer makes a status-building public display of having money to burn, investors of all stripes have a severe aversion to underperformance.  As one of my old bosses was fond of putting it, “The pain of undereperformance lasts long after the glow of outperformance has faded.”  Outperforming is also hard to do.  So I can see how an “active” manager can drift toward the index as a strategy.

Still, to justify collecting active management fees, one should at least make an effort.

 

More tomorrow.