Tag Archives: hedge funds

Sliding Stocks Carry Hedge Funds Downwards, Few Worry of Bubble

2014 has been a rough year for internet tech and biotech stocks. Despite their 2013 gains, recently Google has fallen around 10% since last month, and Valeant Pharmaceuticals Intl Inc. has fallen over 17% since February. While the recent dip in the stock market has impacted many investors over the past few months, according to the Wall Street Journal, many top hedge funds have been hit especially hard.

It sounds like many hedge funds, not wanting to be left behind, jumped into stocks in the beginning of the year after watching last year’s bull-market rally. However, those that increased their exposure to last year’s darling companies have often seen their lackluster returns drastically missing the S&P 500 average. For instance, while the S&P 500 has been down around 1.2% since the beginning of this year, the $28 billion large hedge fund Viking Global Investors LP has fallen more than 4% in both march and april. John Thaler, a former analyst at the tiger cub hedge fund Shumway Capital, saw his $2.2 billion JAT Capital Management fund take a 10% loss for the year (on a side note, the tiger cubs are hedge funds that spun off of Julian Robertson’s famed Tiger Management Corp hedge fund that, although incredibly successful in the later 1990s, eventually went bust when its largest holding in U.S. airways crashed in 2000).

The culprit behind the lackluster returns of these hedge funds, according to Brian Shapiro, founder of the hedge-fund analytics company Simplify LLC, is that duplication has become common among hedge fund managers. Many firms end up placing the same bets, either by independently coming to the same conclusions about stocks or, more likely, because they hope to ride a momentum wave by copying the strategies of other hedge fund managers. This inevitably pushes up the price of the asset that everyone is buying, and creates “wealth” on paper, but if a few of these managers get smart and decide to sell to lock in their winnings, the stock begins to sink all of their boats will capsize together.

To me, this kind of speculative behavior seems to be the kind that could form a bubble, since people are attempting to make a profit on the rising price of an asset by investing in places where others have already made money. However, according to Vikram Mansharamani, a lecturer at Yale University who has written extensively about how to detect a bubble, this may not be the case.

In an interview with the Wall Street Journal, Dr. Mansharamani outlines 3 red flags that may signal a potential bubble.

  1. Rapid Rise in Prices: In the beginning of a bubble, investors push up the price of an asset quickly. For instance, in the year before the dot-com bubble the Nasdaq rose 110%. Also, the price spike might also be interspersed with panicked selling, says Professor Didier Sornette, who holds the Chair of Entrepreneurial Risks at the Swiss Federal Institute of Technology Zurich (ETH Zurich).
  2. Prices Breaking from Asset’s Underlying Value: Using the Shiller P/E, which is the market price for an asset divided by the 10-year inflation adjusted average earnings, a high ratio may indicate a bubble. For instance, while the median P/E ratio of large U.S. stocks has been around 16 since the late 1800s, but during the dot-com bubble the Shiller P/E surpassed 44.
  3. “Exciting”  innovation as justification for the price increase: If, in an effort to justify their irrational exuberance, investors point to new technological innovations as a rational cause for the price increase, there’s reason to be skeptical. This can be seen in both the dot-com boom and in the housing crisis (with the popularity of innovations in mortgage-backed derivatives). Overall, it’s important to remember that irrational people will find a way to rationalize anything.

By these criteria, the overall S&P 500 may not be in a bubble. Although the S&P 500 returned 32% last year, it’s Shiller P/E is only around 25, which is somewhat worrisome but not yet alarmingly indicative of a bubble. Professor Sornette’s models did, however, identify internet retail stocks and healthcare and life-sciences stocks as bubbles before the recent sell-off. As evidence, the Nasdaq biotechnology index has fallen more than 18% since the beginning of the year after last year’s rapid ascent.

 

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On the other hand, the famous Bitcoin does meet the criteria for a bubble. The price has exploded in the past year, rising from a low of around $120 last April to a high of near $1126 last December. Investors have also justified its ascent due to its “innovation” and “potential to change the world” (just see the website bitcoinquotations.com for a list of quotes from hyped up entrepreneurs, economists, and politicians), while the fact remains that few retailers currently accept payment in Bitcoin and there are no underlying assets backing the currency. This is not to say that Bitcoin, or a similar technology, won’t be important to the future of finance, it just suggests that Bitcoins recent gains are likely the result of hype and popularity.

Overall, It’s important to remain level headed and rational when investing, as even institutional investors and hedge fund pros can and often do make poor bets.

Delaware: incorporate for the taxes, stay for the arbitrage

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A little known court ruling in Delaware from 2007 has had some big consequences.  While it has provided some benefits for investors, it also results in the inefficient use of resources, increased costs for mergers and acquisitions, and arbitrage.  After examining the source of these effects, it may be possible to reduce the costs while keeping the benefits.

The case, which found that a shareholder could vote on a proposed deal if they held stock on the date of the vote, as opposed to the date of record (when the offer was made). This has allowed hedge funds and activist investors to take positions in a target companies after a deal price has been announced, then vote stop the deal in order to determine a fair price through what is called an appraisal.  This has resulted in what is known as appraisal arbitrage. While this plan can backfire if the judgement decreases the price, professional investors are in as good a position as anyone to decide whether a price is too low, and there is an additional incentive that mediates the cost of the appraisal and the possibility off loos.  However this outcome is actually quite rare: 80% succeed in getting a higher price.

Hedge funds argue that investors can actually be made better off by these deals because it allows bad deals that would have otherwise gone through to be recognized by professionals and provides an avenue to rectify the situation (with interest!).  Recent examples in the news demonstrate this. The threat of appraisal by Carl Ichan didn’t prevent Dell from going private, but it did secure a higher price per share for investors. Currently, Dole is in court over its acquisition last year being too low, and Darden Restaurants is currently dealing with Starboard Value LP, a hedge fund who wants to stop the sale of its Red Lobster Chain of restaurants.

While such actions by activist investors and hedge funds have made investors better off in the past, it’s called arbitrage for a reason.  Once the case arrives in court, the price is arrived at via the discounted cash flow method.  According to David A. Katz, a partner at Wachtell, Lipton, Rosen, and Katz, “Discounted cash flow analyses, however, often produce values in excess of what a buyer would be willing to pay or the value of the company’s stock in the public trading markets.”  In addition to the inflated measure of value the company has to pay 5.75% interest on the judgment, even if the original price is found to be fair.  This amounts to a practically risk free profit if the deal was even close to fair to begin with.

Appraisal arbitrage can be seen as less an economic issue and more of a legal anomaly.  To fix this problem, while preserving the economic benefit for consumers, the court should allow for the use of whatever valuation method is most appropriate to the company in question.  Most importantly, it must reduce the interest rate that it pays on the judgments to be pegged to treasuries to end the arbitrage opportunity.  In this way, activists and funds will intercede only when investors need them most.

 

 

 

 

 

Hedge Funds’ “Appraisal Arbitrage”: Profiting from Buyouts

Dole Food Co., the relatively unexciting agricultural corporation and famous pineapple producer, became the center of an increasingly popular trend in hedge fund investing during its recent buyout. According to the Wall Street Journal, last year Dole Food Co. sold itself to its founder, in this case by purchasing all of the public shares in order to take a public company private. While most investors would have seen this as an average buyout, a few hedge fund managers took the opportunity to use an old legal strategy called “appraisal arbitrage” to grab a slice of the profits from the deal.

According to Latham and Watkins, one of the world’s most profitable law firms, appraisal rights have “historically been a back-water of the public company M&A process and practice, largely ignored and often thought irrelevant.” Well, not anymore. In a nutshell, appraisal arbitrage is a strategy in which a minority of investors purchase a large minority share of a public company just before the shareholders vote to decide whether to accept the terms of a buyout. Appraisal rights are the statutory rights of a minority shareholder to seek a fair stock price determined by a 3rd party appraiser and for the acquiring entity to repurchase the shares for the fair price. Basically, these hedge fund managers are purchasing shares of companies which have entered into undervalued buyout deals, forcing a fair appraisal of the company’s assets through judicial order, and then profiting from the presumably more generous valuation.

This supposedly previously obscure strategy has been gaining popularity in recent years. According to the Wall Street Journal:

Appraisal claims were brought on 17% of takeovers of Delaware companies in 2013, the most since at least 2004, according to a coming study from Brooklyn Law School and Case Western Reserve University. Based on deal prices, those claims were valued at $1.5 billion, an eightfold increase from 2012.

One potential risk to this strategy is a stipulation in the rule that states that the investors who wish to request a fair appraisal must either vote no or abstain in the decision to proceed with the buyout, and they must not make up the majority. This means that if the investors own more than 50% of the shares, then this rule doesn’t hold and the buyout simply doesn’t go through and nobody profits. The hedge funds investing in the Dole Foods Inc. buyout were lucky, as the buyout passed with just 50.9% of the vote. Overall, this is one strategy where it pays to know something that no one else knows.

While it appears to be based upon fair law and is therefore a legal strategy for investors, its abuse potential, just like high-frequency trading and hostile takeovers, could be grounds for a healthy dose of skepticism about whether it’s ethical for outside investors to meddle in others’ purchases. However, in many cases, it seems that this strategy is one in which the rest of the shareholders of a company may also enjoy the benefits of a more fair valuation of the share price. At the very least, it forces a second opinion in the determination of a company’s fair value. In the end, this is a zero-sum game, and therefore is an issue in which many economists and investors will likely disagree about the ethics.