Grey Owl Capital on the Role of Cash in a Portfolio

Jeff Erber and Grey Owl Capital are out with their fourth quarter letter to investors.  In it, they highlight how they started to move more cash into equities in Q4 and have continued to do so in 2013.  This led to an interesting discussion about how they view cash as a component of their portfolio which we wanted to draw attention to.

Cash as a 'Hedge'

Grey Owl outlines the tradeoffs between holding cash and being invested:

"We have chosen to 'hedge' our exposure to these individual equities by holding cash.  If the broad equity market was overvalued and the economy was on artificial support, we wanted the cash available in order to take advantage of likely dislocations.  Today, our analysis says that the value of holding this cash is lower than in the past few years."

While they use the term 'hedge,' what they really mean is that they view cash as an opportunistic tool to take advantage of market sell-offs that might be unwarranted.

After all, Passport Capital's John Burbank once said, "cash is most valuable when others don't have it."  We've also posted how DoubeLine Capital's Jeff Gundlach said investors should hold cash.


Cash as a 'Call Option'

Given this discussion, it's important to also highlight how Berkshire Hathaway's Warren Buffett views cash.  Alice Schroeder (his biographer) highlighted that,

"He thinks of cash differently than conventional investors.  This is one of the most important things I learned from him: the optionality of cash.  He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price."

The Downside of Holding Cash

Turning back to Grey Owl's letter, they touch on the downside of holding cash: 

"We can hold a large-than-typical cash position (which we have), waiting for the monetary manipulation and fiscal imbalances to cause market dislocations (as they eventually will).  Alternatively, we can increase our exposure to the common stocks of great businesses ... They will certainly experience more market volatility than cash and we would typically like to make purchases with a wider 'margin of safety,' but the alternative of negative real returns in cash is worse."

The interesting decision here is that they've essentially determined that the adverse effects of negative real returns in cash is doing more harm than the benefits offered by having cash on hand as a 'hedge'  and as an opportunistic tool.  As such, they've decided to allocate more of this cash into equities.

This is a phenomenon we're seeing gain steam among investors.  Bridgewater's Ray Dalio highlighted this very concept of the negative real return on cash and said that cash will move into 'stuff' in 2013.  Appaloosa Management's David Tepper is also bullish on equities.  Contrafund's Will Danoff is also bullish for 2013.


Risk/Return

Normally, the investment environment dictates how much cash an investor will hold, i.e. if things are overvalued, they will hold cash and wait for better opportunities.  What's intriguing here is how Grey Owl's decision is less about deploying cash due to low price opportunities (after all, this isn't the financial crisis).  Instead, their decision was more-so focused on the perceived lack of risk in equities.

Investors are always focused on the risk and return of a potential investment.  Most of the time, value investors will wait for risk to abate via share price declines (providing a larger margin of safety).  In this scenario, it seems many investors are investing not because of an improved risk profile due to lower security prices, but instead because of the perceived lower risk environment as a whole, led by the Fed's backstop. 

So there are obviously a few different ways to view cash as a component of the portfolio.  Monetary policy has altered the way Grey Owl views cash.  They end their missive by saying, "At this point, too large an allocation to cash might prove to be a bet on Fed failure.  More likely, the performance of the underlying businesses will determine our results."

It will be interesting to see if even more investors follow this framework and shift their views, but as illustrated above, many already have (but for a myriad of reasons).


Grey Owl's Q4 Letter

Embedded below is Grey Owl's latest letter:

Grey Owl Capital on Investing in a Low-Return Environment: Q1 Letter

Jeff Erber and Grey Owl Capital are out with their Q1 letter to investors and in it they highlight how they're approaching investing in a low-return environment.  They're employing a three-pronged attack as follows:


1. Look for undervalued securities:  They've been "high-grading" their portfolio by buying cheaper, high quality US names.  This is a concept long echoed in commentary from Oaktree's Howard Marks as well as GMO's Jeremy Grantham for the past few years as rates have remained low for a prolonged period.

Here's what individual names Grey Owl's been trading in:

New stakes: Pepsico (PEP), Blackrock (BLK), BMC Software (BMC), and Excelon (EXC)
Added to existing stakes: eBay (EBAY)
Exited: Apollo Residential Mortgage (AMTG) and Western Union (WU)
Trimmed: Apollo Group (APOL), Bridge Point Education (BPI), Market Vectors Gold Miners (GDX), Lexmark (LXK), and Transocean (RIG).


2. Invest in short dated high-yield fixed income:  Given that the Fed has in the past signaled potentially raising rates in 2013, this short-dated approach makes sense.  They've purchased the following bonds (with full write-ups on each stake in the below letter):

MGM Resorts 6.75% 9/2012 - purchased in December 2011
CSC 5.5% 3/2013 - purchased in January
Western Alliance Bancorp 10% 9/2015 - purchased in early April


3. Hold plenty of dry powder anticipating better opportunities: This might look counterintuitive at first glance given that holding cash earns you practically nothing, especially in a low yield environment.  However, consider that many hedge fund managers often hold cash as a hedge and as a utility to deploy when better investment opportunities arise. That's exactly what Grey Owl has done as they've deemed the current set of opportunities less desirable and they think better prices to buy at lie ahead.


Embedded below is Grey Owl Capital Managment's Q1 letter & you can download a .pdf here:




For more investor letters we've posted up Dan Loeb's Third Point Q1 letter as well as Passport Capital's letter.

Death of Stockpicking Claims Are a Good Sign for Value Investors

The following is a guest post from Grey Owl Capital. In the past, Market Folly has posted their second quarter letter that outlined how uncertainty can provide opportunity. Here is Grey Owl's recent commentary on the influx of claims that stockpicking is dead:

A recent Wall Street Journal article highlights the macro-driven nature of today’s stock market. In it, long-time value investors lament the current environment where stocks appear to trade in unison based on unemployment data or European bank stress test results. If stocks are driven by macro factors instead of individual company fundamentals, stock pickers can’t get an edge. Market strategist James Bianco of Bianco Research asserts “stock picking is a dead art form.” Macro hedge-funds are opening at a rate equivalent to that of traditional stock funds and the big asset management firms are even launching macro mutual funds.

We think stock-picking is very much alive. In fact, we recently wrote a 20-page investment guide that details a bottom-up approach for today’s environment. Call us contrarian, but we couldn’t think of a better sign than this article that fundamentally-driven, bottom-up stock-picking is likely to make a comeback sooner rather than later. Didn’t the commodity bubble burst right around the time that the asset management firms were rolling out a new commodity fund or ETF every week? Moreover, didn’t “the death of equities” cover stories in the early 1980s signal the start of a 20+ year bull market for stocks?

The Wall Street Journal article presents data that shows the correlation of stocks in the S&P 500 between 2000 and 2006 was 27% – quite a bit of disparity indicating undervalued stocks could appreciate and overvalued stocks could depreciate as opposed to trading up or down in unison. The article also points out that correlation spiked to 80% during the credit crisis and again more recently during the European sovereign debt scare. As these issues petered out, correlations never dipped below 40% and today hover around the mid 60s. However, the article does not point out the length of time over which the correlations were measured – days, weeks, months?

The time period over which the correlation is measured is critical. “Time arbitrage” has proven to be a very effective investment strategy. Who cares if individual stocks are correlated over days and weeks when your investment horizon is years? Glenn Tongue (one of the Ts in T2 Partners along with Whitney Tilson) highlights this fact in a recent appearance on Yahoo! Finance. Like us, the partners at T2 believe buy-and-hold stock picking is far from dead. Mr. Tongue also makes a critical point about matching the duration of the investment strategy and the investors. This is why we work very hard to ensure our investors understand our process before they become clients.

Don’t misunderstand our view. We agree the data shows a significant increase in correlation between individual stocks (and we witness this as we watch the market and our individual names on a daily basis). We also agree that the macro backdrop driving the market will remain for some time. The over-leveraged PIIGS, US federal and local governments, and the US consumer will likely take years to adjust to sustainable levels. In addition, the massive government intervention in fiscal and monetary policy does not appear to be subsiding with Bernanke and company preparing for QE2’s maiden cruise. (We have discussed these issues at length in several of our recent quarterly letters.) The market will certainly react to macro factors over short time periods, but that doesn’t mean significantly undervalued stocks or significantly overvalued stocks won’t gravitate toward fair value over a longer period of time.

In our recently published investment guide titled How to Prosper in Volatile and Range-Bound Markets we detail the strategy we are employing to deal with the current environment. We believe a concentrated portfolio will be more likely to outperform – a few deeply discounted names that are returning capital to investors (via share repurchases or dividends) and that also have a catalyst can outperform even if the majority of the market moves in unison. In addition, the flexibility of corporations to deal with macro shocks (be they slower growth, inflation, government regulation) means equities have a better chance of outperforming government bonds, currencies, or commodities (areas macro funds are more likely to play in).

Finally, we think valuation-based timing will be more important than it has been for traditional stock pickers. While Japan’s macro-driven market now trades at close to a quarter of its peak value 20 years ago the market experienced four rallies and five sell-offs of greater than 30% over that period. That type of volatility creates terrific opportunities for value investors to increase exposure as the macro shock of the day creates fear and to pare exposure as the fear fades away.

The above was a guest post from Grey Owl Capital. Be sure to check out our coverage of their second quarter letter as well where they outlined how uncertainty can provide opportunity.

Uncertainty Provides Opportunity in Transocean & Apollo Group: Grey Owl Capital's Q2 Letter

Grey Owl Capital Management is out with its second quarter letter and the focus of the commentary is devoted to opportunity in the markets. While as a whole they feel markets are overvalued, they highlight that near-term uncertainties have yielded potential opportunities in Transocean (RIG) and Apollo Group (APOL).

Firstly with Transocean (RIG), the thesis largely lies in a long-term play on rising oil demand (and prices). Grey Owl had previously owned shares of RIG but sold them back when oil prices neared sky-high prices of $120 per barrel. Late this February, they re-initiated a small position partially as an inflation hedge. Then, opportunity came-a-knocking: an oil spill emerged in the Gulf of Mexico under BP's watch and Transocean was the owner of the rig. The unfortunate environmental incident caused both stocks to tumble.

Yet from an investing standpoint, many investors are able to look beyond the near-term and focus on the long-term picture. Whitney Tilson's hedge fund T2 Partners has presented the bullish case for BP. Additionally, while not directly related to the oil spill, David Einhorn's Greenlight Capital has bought Ensco (ESV) as a result of the depressed stock prices in the oil drilling sector. And today we're presenting Grey Owl Capital's bullish case for RIG. The main concern for Transocean is the liability associated with the oil spill. Grey Owl quickly points out that it is a standard industry practice for the operator (BP) to indemnify the owner (RIG) from risks associated with blowouts, with the exception of gross negligence. As such, unless Transocean is proven grossly negligent, they are in much better shape than BP from a liability standpoint.

Overall, Grey Owl points to Transocean's huge contract backlog of almost $30 billion (a free cashflow backlog estimated just under $15 billion) as a means to weather this storm. Additionally, they highlight that any concerns over the Gulf of Mexico drilling moratorium should only have a modest impact as 75% of RIG's contract backlog resides in non-Gulf of Mexico waters. Grey Owl feels that this single event will not have a lasting effect on Transocean's business and that at $50 per share, RIG is trading just under 6.5x 2010 consensus EPS estimates. They fully expect the stock to be under pressure in the near term, but they're focused on the long-term and expect the stock to trade back to pre-spill levels in a year's time.

Secondly, Grey Owl outlines an opportunity derived from uncertainty in Apollo Group (APOL). This has been the definition of a battleground stock and Grey Owl have staked their claim. As we've detailed before, Steve Eisman of FrontPoint Partners laid out the short thesis on APOL in a presentation he called 'Subprime Goes to College.' This then caused the President of the Career College Association to pen a response to Eisman's thesis. Grey Owl points out that the for-profit education sector is subject to extreme headline risk. However, the biggest risk is the potential new regulations designed to limited student debt burdens. Grey Owl feels that even if these are implemented, Apollo Group trades around fair value. They write,

"APOL trades at a free cash flow yield of 11% and a P/E of 12.5 on a trailing twelve-month (TTM) earnings. This is for a business that has 28% operating margins, has grown revenue an average of 17% over the last three years with very little marginal capital required, and has zero debt. In this case, the extreme uncertainty around the regulatory changes has caused the market to over-discount."

In fact, APOL has appeared numerous times on valuation screens found in the Value Edge newsletter (15% discount here). So, the stock is obviously cheap. But the question then becomes, is it rightly so? Other investors believe that there will be long-term ramifications in the industry. After all, why else would hedge fund Conatus Capital sell out of APOL and then Andreas Halvorsen's Viking Global sell APOL as well after holding it as one of their larger positions.

We've detailed the progression as many prominent hedge funds took bullish positions in the for-profit education space last year. Yet somewhere along the line, something changed and that 'something' was increased uncertainty. Grey Owl viewed this uncertainty as an opportunity and dove right in. This dichotomy of viewpoint is what makes a market.

Embedded below is Grey Owl Capital Management's second quarter letter:



You can download a .pdf copy here.

One year from now we'll have to look back and see whether or not uncertainty yielded opportunity. We've posted a ton of hedge fund market commentary and recommend also checking out the latest thoughts from Perry Capital, David Gerstenhaber's macro outlook at Argonaut Capital, Corsair Capital's latest investment ideas, as well as David Einhorn's latest Greenlight Capital letter.

Grey Owl Capital Management: Investor Letter (Q4 2009)

In our quest to present you as many resources as we can, today we present you Grey Owl Capital Management's fourth quarter 2009 letter to investors. In the commentary, they address current market valuation and the possibility of range bound markets. It also delves into the concept of buying 80-cent dollars versus waiting for 50-cent dollars, a quandary often found in value investing.

Embedded below is Grey Owl's fourth quarter commentary:




You can download the .pdf here.


We've been posting a bunch of market commentary up as of late, so head to all our coverage of investor letters for more insight.