Bridgewater's Ray Dalio on Radical Transparency & Building a Culture

Ray Dalio of Bridgewater Associates sat down with Charles Duhigg at The New York Times New Work Summit to talk about building culture and how it relates to his hedge fund where he encourages radical transparency.
    
Dalio says: "I want an idea meritocracy.  I want independent thinkers who are gonna disagree.  The most important thing I want is meaningful work and meaningful relationships and the way to get that is through radical transparency."

Dalio also notes he gave everyone at Bridgewater a copy of Duhigg's book, The Power of Habit. 

The Bridgewater founder feels this transparency (once you get over the emotional reaction of the 'naked truth') develops much deeper, more meaningful conversations.

On markets, he went on to add: "The markets teach you humility and they teach you what works.  You have to be an independent thinker in markets to be successful because the consensus is built into the price.  You have to have a view that's different from the consensus.  When you have a view that's different from the consensus, you're gonna be wrong a certain number of times.  It teaches you humility.  The most important thing is to have humility and to think about 'how do I get the best decision?' It doesn't have to come from me, I just want to be right."

Dalio concluded:  "Decision making should be two steps: the first step is taking in information, particularly if there's disagreement, and then to make a decision ... it's so stupid not to take the time to take in and explore disagreement that might help you prevent yourself from being wrong."

Embedded below is video of Ray Dalio's interview:

Avoiding Mistakes in Hedge Funds: Lessons Learned From Blowups & Frauds

Greenwich Roundtable has published an interesting piece on Best Practices in Alternative Investing: Avoiding Mistakes.  In it, they dive into due diligence on fund manager selection in an effort to examine warning signs of potential trouble in funds.

They utilize case studies to showcase hedge funds that have failed and how investors could have identified these warning signs and minimized the impact. 

We thought this would be an excellent study for two groups of people: those invested in (or looking to invest in) hedge funds, as well as potential hedge fund managers looking to launch a fund.  Everyone can learn from others' mistakes here.


Warning Signs Learned From Hedge Fund Blowups

While there are numerous reasons for hedge fund blowups, two reasons at the forefront seemingly always are excessive leverage and liquidity (or lack thereof).

The document goes in-depth with various case studies, but for summary's sake, here are some of the warning signs they've highlighted:

- Fund was managed by one person with no risk manager

- Dangerous extent of portfolio concentration could have been revealed through conversations

- It's vital to conduct reference checks on key people

- Lack of clear measures of leverage or liquidity in monthly reports

- Manager had track record of less than one year

- Strategy drift

- Lack of transparency

- Assumption that a former analyst can all of a sudden perform as a portfolio manager at a new fund

- Lack of a key man clause

- Beware of a hard sell, especially with third-party marketers

- Manager full of hubris

- Fund grew assets way too quickly

- Fund grew but operating staff didn't grow to keep up

- Abrupt personnel changes/resignations


The end of the report essentially breaks down the categories where warning signs appear: risk management, illiquidity, transparency, complexity, operations, strategy drift, rapid growth, and hubris.

While there are many potential 'yellow flags' in blowups, the two glaring red flags always seem to be excessive leverage and/or illiquidity.

Embedded below is Greenwich Roundtable's comprehensive document on Best Practices in Alternative Investing: Avoiding Mistakes:

Global Hedge Fund Assets Hit $2.059 Trillion

Hedge Fund Intelligence is out with an interesting report on hedge fund assets. In it, they find that overall assets increased in 2011. Despite the fact that the median performance of hedge funds in 2011 was -2.01%, the industry still saw net inflows.

At $2.059 trillion in assets, hedge funds still have yet to re-conquer the peak in assets reached in 2007 of over $2.5 trillion.

According to the release, "The US market remains very much the top location for the world's biggest hedge fund firms. There are currently 230 firms that manage hedge fund assets of $1 billion or more from the US."

Embedded below is the global hedge fund assets report:



For more stats, see also the top 10 hedge funds by net gains since inception as well as the top 25 highest earning hedge fund managers of 2011.

Top 10 Hedge Funds By Net Gains Since Inception

Bloomberg is out with an interesting piece examining the top 10 hedge funds by net gains since inception. The list contains the who's who among the hedge fund elite and is pretty much who you'd expect to be on it.

The data was compiled by LCH Investments NV (part of the Edmond de Rothschild Group) and is based on audited reports from each investment firm, discussions with the funds, as well as confidential sources.


Top 10 Hedge Funds By Net Gains Since Inception

1. Ray Dalio's Bridgewater PureAlpha: $35.8 billion net gain since 1975
2. George Soros' Quantum Endowment: $31.2 bn net gain since 1973
3. John Paulson's Paulson & Co: $22.6 bn net gain since 1994
4. Seth Klarman's Baupost Group: $16 bn net gain since 1983
5. Brevan Howard: $15.7 bn net gain since 2003
6. David Tepper's Appaloosa Management: $13.7 bn net gain since 1993
7. Bruce Kovner's Caxton Associates: $13.1 bn net gain since 1983
8. Louis Bacon's Moore Capital: $12.7 bn net gain since 1990
9. Thomas Steyer's Farallon Capital: $12.2 bn net gain since 1987
10. Steve Cohen's SAC Capital: $12.2 bn net gain since 1992


One interesting tidbit here is that Louis Bacon's Moore Capital makes the top ten, but his mentor Paul Tudor Jones (Tudor Investment Corp) does not. Tudor was largely responsible for seeding Bacon's fund by sending him investors that Tudor had to turn away back when he was first getting started.

Compare the above to the top 10 biggest hedge funds in 2010 and it's no surprise that there's considerable overlap as some of the most successful hedge funds have become some of the largest. Also, the two funds that have been around the longest on the list (Bridgewater and Soros) are the two that occupy the top positions.

Five of the managers above are featured in our Hedge Fund Wisdom newsletter and you can see their latest investments in our brand new issue.

Howard Marks' New Book: The Most Important Thing

Oaktree Capital's Howard Marks just released his new book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. We wanted to highlight this because Marks' market commentary has been some of the most insightful around.

Often quoted for his wisdom, Marks' new book has received some impeccable recommendations:

Baupost Group's Seth Klarman says, "Regular recipients of Howard Marks's investment memos eagerly await their arrival for the essential truths and unique insights they contain. Now the wisdom and experience of this great investor are available to all. The Most Important Thing, Marks's insightful investment philosophy and time-tested approach, is a must read for every investor."

Berkshire Hathaway's Warren Buffett also offered praise by saying, "When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something, and that goes double for his book."

When two of the greatest investors of all time say something is a must-read, then you quite simply have to read it. We look forward to learning from Marks' book, The Most Important Thing and recommend our readers do the same.

Ira Sohn Investment Idea Contest

***Update: Be sure to check out our notes from the Ira Sohn Conference for 2011 where we're providing updates on the presentations from top hedge fund managers.


The legendary Ira Sohn Investment Conference in New York has a new twist this year. They are having an investment idea contest before the event to be judged by Seth Klarman, Michael Price, David Einhorn, Bill Ackman, and Joel Greenblatt. The winner gets to present their investment idea at the conference to 2,000 attendees later this month.

The judges are looking for the best investment idea with a one-year timeframe. You can learn more about the contest and submit your ideas here. Deadline for submissions is May 20th.

Here's the details of the conference:

Wednesday, May 25th, 2011
12:15 - 6pm
Rose Theater, 5th Floor, Frederick P. Rose Hall
Broadway at 60th Street, New York City

For more information on the contest and to submit your idea, visit http://www.irasohnconference.com/contest

Market Folly Contest Too

We're having a simultaneous contest for our readers too. Entry is free so simply email your submission to us: marketfolly@gmail.com.

We'll handpick our own winner (totally separate from the Ira Sohn). The winner of our independent contest will receive a free 1-year subscription to our Hedge Fund Wisdom newsletter (a $199 value). The runner-up of our contest will receive a copy of Bethany McLean & Joe Nocera's book, All The Devils Are Here. Good luck and get writing!

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Top 10 Biggest Hedge Funds in 2010

AbsoluteReturn+Alpha is out with its 2010 year-end survey of the top ten hedge funds in the Americas. Their findings show that American hedge funds manage a combined $1.297 trillion, up 10% from the year prior. However, this still falls short of the 2008 peak level of $1.675 trillion before the financial crisis.

The Top Ten Hedge Funds in the Americas

1. Bridgewater Associates: $58.9bn AUM
2. JPMorgan Asset Management: $45.5bn
3. Paulson & Co: $36bn
4. Soros Fund Management: $27.9bn
5. Och-Ziff Capital Management: $27.6bn
6. BlackRock: $26.6bn
7. Baupost Group: $23.4bn
8. Angelo, Gordon & Co: $22bn
9. Farallon Capital Management: $21.5bn
10. King Street Capital Management: $19.9bn


Possibly the most astonishing fact here is that in 2010 the big... got even bigger. Ray Dalio's Bridgewater Associates increased its AUM by $15.3 billion. Dalio gave a rare interview yesterday that's definitely worth listening to. His Pure Alpha Fund II gained 44.8% last year, quite the performance when you compare it to other 2010 hedge fund returns.

Of the hedge funds featured on the list, we provide updates on the portfolio activity of four of them:

- Seth Klarman's Baupost Group has been active in commercial real estate and we just posted up an excerpt from his year-end investor letter.

- Paulson & Co has been focusing on restructured equities as noted in their year-end letter.

- Farallon Capital focuses on risk arbitrage and their investments have been featured in our newsletter.

- You can also view the latest portfolio activity from Soros Fund Management here.

Bridgewater's Ray Dalio: Rare Interview

Ray Dalio of $58.9 billion hedge fund Bridgewater Associates gave a rare television interview yesterday on CNBC so we wanted to feature his comments on a myriad of topics. His Pure Alpha II fund returned 44.8% last year and is the largest hedge fund firm in America.

On the topic of US equities, Dalio said that they, "first are still comparatively cheap. But more importantly, the flows are beneficial to them because US equities benefit from currency depreciations. I think, as I say in 2012, the developed countries' currencies will devalue in relationship to the emerging countries' currencies."

So, it appears as though Dalio sees equities benefiting, at least in the near-term. The last time we saw Dalio's elongated comments on markets back in February 2009, he was claiming it would soon be the "buying opportunity of the century" and he was right.

His thoughts on weakening currencies are intriguing given that he also thinks gold is under-appreciated here. This is largely the thesis John Paulson's gold fund is predicated upon, so they share this viewpoint. Dalio thinks gold should garner at least a portion of your portfolio, at the very least for diversification and risk reduction purposes.

Dalio also had a good quote on the topic of thinking for yourself, saying, "in order to make money in the market you have to be an independent thinker. And I think also creative, you have to be willing to make mistakes. And so the process is that anybody in the company, if anything doesn't make sense to them, that they can bring up what doesn't make sense to them in a non-hierarchical way and look at whether it's true or not and what we should do about it. We particularly like looking at mistakes or weaknesses that we have in order to get stronger."

He raises a good point and many prudent investors have honed in on learning from mistakes over the years.


Embedded below is Dalio's interview (email readers will need to come to the site to view):



For thoughts from more great hedge fund investors, today we've also posted up an excerpt from Seth Klarman's 2010 year-end letter.

Hedge Fund Compensation Report

The pain of 2008 now seems like a distant memory for those working at hedge funds.

As the U.S. economy continues to recover at a slow pace, hedge fund managers are recording double- digit growth and outperforming the markets once again. According to Eureka Hedge, total assets in the industry are now on track to cross the historical high of US $1.95 trillion by end of 2011. The upside is showing in hedge fund pay.

The latest report on Hedge Fund Compensation revealed that hedge fund managers received double-digit increases in total compensation to match the fund's performance, primarily driven by big year-end bonuses. The annual industry report is based on data collected directly from hundreds of hedge fund managers and employees.

In contrast with 2009 compensation, that was essentially flat when compared to the year earlier, 2010 pay came in 10 percent higher. More than half expected a raise in total compensation with the average coming in at USD $326,000 and about one quarter expecting to earn between $300,000 and $500,000. The number of professionals expecting pay cuts decreased from 19 percent last year to 12 percent.

Investors have started asking more questions than in the past and the fund manager's track record is no longer enough to get them to part with their money. They want to know how the strategy is being executed and they want more transparency in the reporting and fee calculations as well.

Despite increased investor demands, hedge fund managers still have a business to run. Some are requiring limited liquidity (a more stable base of capital) and investors are seeing a reduced management fee structure in return. Performance fees, however, are still driving big bonuses.

The front page criticism of Wall Street bonuses has primarily discussed investment banks, but hedge funds are not immune to this criticism. Investors also want to see a bit more skin in the game; 12 percent of hedge fund professionals reported that they are now required to invest a portion of their bonus back into the fund.

The report reveals that the higher the overall earnings, the more bonus matters, especially for those in the highest pay ranges. The top earning hedge fund employees expect a full 80 percent of their cash compensation to come in the form of bonus payments, but these payouts are by no means in the bag. Fewer than one in five hedge fund employees reported having a guaranteed bonus.

(click to enlarge)

The 2011 Hedge Fund Compensation Report has grown to become the most comprehensive benchmark for hedge fund compensation practices in the industry. It is based on compensation data collected directly from fund professionals representing both large and small firms. Click here for the full Hedge Fund Compensation Report.


About the Author

David Kochanek is the publisher of HedgeFundCompensationReport.com and the hedge fund career site, Hedge Fund Jobs Digest, a web-based career service catering to investment professionals.

Follow A Hedge Fund Manager's Portfolio

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2010 Hedge Fund Returns: Performance Numbers From Top Managers

Data from Hedge Fund Research indicates that as a whole, hedge funds returned 10.5% for 2010, lagging the S&P 500 return of 15.06%. Below you'll find specific hedge fund performance from top managers for last year. We'll continually update this post as more numbers roll in.

In general, the month of May was brutal for hedgies, but the majority managed to turn things around by the end of the year. And if you're interested in a year-over-year comparison, head to our posts on 2009 hedge fund returns as well as 2008 returns.

Hedge Fund Returns: 2010

Paulson & Co: +11%. That number pertains to John Paulson's Advantage Fund. The firm saw varied performance last year as its Advantage Plus Fund returned 17%, its Recovery Fund soared 24%, its Gold Fund returned 35%, and its merger arbitrage fund returned 27%.

Also worth highlighting is the fact that the gold share classes of Paulson's funds performed markedly better. The gold share class of the Advantage Fund was up 31% in 2010 (compared to +11% for the normal class). As always, we've showcased an in-depth look at Paulson's gold fund.

Bridgewater Associates: +38%. Ray Dalio's 'zen' approach to an investment firm paid off as they returned one of the higher totals across the hedge fund industry last year.

Renaissance Technologies (Medallion Fund): +30%. Jim Simons' legendary hedge fund continued its epic run of performance in 2010. What's astonishing is that those numbers are net of a 5% management fee and a 44% performance fee (gross performance of the fund would have been around 60%). Back in 2008, Medallion returned an astonishing 80% while markets crumbled.

RenTec's RIFF finished up 22.7% and its RIEF was up 16.5%. We've posted up the Medallion Fund's historical returns before for those interested.

Millennium Management: +13.3%. Israel Englander's firm now manages around $9.1 billion.

Greenlight Capital: +12.5%. We've of course covered David Einhorn's portfolio in-depth on the site. Last year seems to be the first that he's lagged the major market indexes as he took a cautionary stance given economic uncertainty.

SAC Capital: +15%. Steven Cohen's firm was amongst a bevy of other hedge funds that saw returns in the mid-teens.

Pershing Square Capital: +29.7% net. Bill Ackman's hedge fund had a stellar year as a bet on General Growth Properties' (GGP) bankruptcy turnaround paid off. Ackman discusses his portfolio here.

Tudor Investment Corp: +7.5%. Paul Tudor Jones' flagship BVI Global fund was positive for the year but still lagged the markets in general.

Appaloosa Management: +22%. That number is for their Thoroughbred fund. We also posted Tepper's recent interview.

Harbinger Capital Partners: -12%. Phil Falcone's fund had a rough year as they transitioned from their normal strategy to a concentrated bet on 4G.

Glenview Capital: +15.3% net. Here is our coverage of Larry Robbins' portfolio activity.

Moore Capital: +3%. Louis Bacon's flagship Moore Global was up only single digits for 2010, but its macro managers fund returned 105%.

AQR Capital: +27.3%. Cliff Asness' firm saw solid returns last year in its macro strategy.

Third Point: +34%. Dan Loeb's Offshore hedge fund had an impressive year and we've detailed his portfolio throughout the year. He manages around $2 billion.

JANA Partners: +8.4%. Barry Rosenstein's activist and event-driven hedge fund has around $1.9 billion AUM.

Clarium Capital: -23%. Peter Thiel's hedge fund continues to struggle as its long-term predictions face near-term volatility. While Clarium was down single digits in 2008 (and thus beat the market that year), the fund has lost money for three straight years. At last tally, Clarium managed $681 million, way down from its peak of over $7 billion.

Citadel Investment Group: +10%. Ken Griffin's investment firm saw 10% returns in its main Kensington and Wellington funds.

Passport Capital: +18.3%. John Burbank's macro style of investing has been known for its volatile near-term swings but solid long-term performance. We previously posted Passport's market commentary.

Centaurus Energy: -3.8%. Famed energy trader John Arnold suffered his first yearly loss in 2010. Arnold makes large and concentrated bets and has been hampered by regulators imposing position limits.

Xerion Fund (Perella Weinberg Partners): +12.66% net. Dan Arbess' fund manages $2.3 billion and we posted Xerion's 2011 investment outlook.

BlueCrest Capital: +16%. This quant fund turned in better numbers than its multi-strategy fund, which was up 8% or so.

T2 Partners: +10.3% net. Whitney Tilson and Glenn Tongue's hedge fund had a great start to the year but then bled gains as their short positions rallied against them. Here are T2's long and short positions.

Och-Ziff: +8.44%. Performance is for their flagship Master Fund. Their Special Investments Fund was up 13.16% for 2010. The firm manages over $27 billion.

Perry Capital: +14.6%. We talked about one of Richard Perry's latest investments here.

HBK Capital Management: +11.62%. The firm manages $5 billion and is named after the initials of its founder, Harlan B. Korenvaes. He launched the fund back in 1991 with $30 million.



Possibly the most intriguing note about hedge fund returns for 2010 is that a number of big name investors lagged market indices. This includes Ken Griffin (Citadel), Paul Tudor Jones (Tudor Corp), and one of Louis Bacon's funds (Moore Capital). Heading into 2011, we've already seen that hedge funds have reduced equity exposure so it will be interesting to see how they zig and zag through markets this year.

For past returns, head to our posts on 2009 hedge fund performance numbers and 2008 hedge fund returns.


Sources: Anonymous investors/investor letters, Hedge Fund Research, Bloomberg, Institutional Investor, Dealbreaker, Reuters, & HSBC.

Pershing Square Gains 15% in November, Skeptics Emerge - A Lesson in Hedge Fund Tracking

Bill Ackman's hedge fund firm Pershing Square Capital Management returned 15% gross and 12.2% net for the month of November and has returned 35.5% gross and 27% net for 2010. Fantastic numbers, no? Given the somewhat outlandish results in one month, it's not necessarily a surprise that skeptics have emerged. It's perfectly acceptable to be skeptical/suspicious/curious given the cloud of secrecy that largely surrounds the hedge fund industry. However, when skeptics don't know how to track a hedge fund properly, their argument immediately loses credibility.

So, what's all the fuss about here? We hesitated even bringing this up for fear of drawing further attention to the article, but we couldn't bear it any longer. Earlier, Dealbreaker reported Pershing's performance numbers. Then, a site called Insider Monkey published an appalling article and the shit hit the fan. After "analyzing" the returns of Pershing Square's investments in November, Insider Monkey concludes that, "either Ackman made another secret investment which returned a gazillion percent or... Dealbreaker was duped."

First and foremost, any reader of Dealbreaker knows that the site posts performance updates directly from top hedge funds from time to time (i.e. printed on the hedge fund's letterhead). So, for Insider Monkey to insinuate that Dealbreaker posted up a 'duped' document is a bit asinine considering Bess Levin's pristine track record of posting authentic material. Bess is probably straight up laughing at Insider Monkey's insinuation. Next: onto the important stuff.

The crux of Insider Monkey's misstep is that they completely failed to assess Ackman's FULL portfolio. This highlights rule number one when tracking hedge funds: never rely solely on the 13F filing. If they had also read Ackman's various 13G's, 13D's and Form 4's filed with the SEC regarding Pershing's position in General Growth Properties (GGP), they would have realized where the bulk of the fund's performance came from and wouldn't have penned that nonsensical article.

A cursory look over the hedge fund's other SEC filings reveals that GGP emerged from bankruptcy on November 9th and obtained $6.8 billion in new equity capital and restructured $15 billion of debt. Pershing Square owned GGP equity and GGP unsecured debt. Additionally (and probably most importantly), Pershing Square purchased 46 million shares of new GGP at $10 per share and warrants as part of the restructuring (with shares now trading around $16).

So voilà, there's your answer. Insider Monkey was using a 13F filing that disclosed positions as of September 30th to determine a hedge fund's performance when one of the fund's main holdings saw a major corporate event a month after the 13F was filed, altering their position size. While Insider Monkey makes note of GGP's spin-off of the Howard Hughes Co (HHC), they completely fail to recognize the full extent of Ackman's position in the various securities of the company. Needless to say, Ackman owns much more GGP/HHC than what is reported on the latest 13F filing.

Not to mention, they completely omit the fact that Ackman holds other assets that SEC 13F filings don't require disclosure of. Assets falling into this category that Ackman owns include cash settled total return swaps and stock options, real estate hedges (via short sales and/or other non-disclosed positions), as well as a past position in BP (BP) credit default swaps. Lastly, Ackman could possibly hold various debt positions as well.

On their Seeking Alpha article, commenters have also pointed out Insider Monkey's misstep. What's comical is that after this revelation in the comments, Insider Monkey claims, "it looks like our conclusion is correct," referring to their conclusion that, "Ackman made another secret investment which returned a gazillion percent."

Umm, no. There was NOTHING secret about this investment (or any other investment that could have contributed to Pershing's performance). Within our article alone, we've already linked to Ackman's updated aggregate economic exposure to GGP, his various stock options plays, as well as updates on all of his portfolio holdings. Again, it just goes back to Insider Monkey's complete lack of attention to detail. Had they simply read the various SEC filings made by Pershing not titled 13F, they would have found their answer as Ackman disclosed the extent of his aggregate economic exposure (and reason for the bulk of his strong performance) long ago.

So, what has Insider Monkey's folly taught us? It reinforced the fact that when tracking hedge funds, you have to take 13F filings with a grain of salt. Additionally, you have to track the full gamut of information (all SEC filings, investor letters, presentations, manager comments etc). This is what Market Folly strives to do on a daily basis. We simply wanted to use this as an opportunity to present a lesson in hedge fund tracking and why it's important to track MUCH more than just a fund's SEC 13F filing.

Based on this, we'll be launching a series of educational articles on the various aspects of hedge fund tracking and how to do it, so stay tuned! In the mean time, scroll through all of our coverage of hedge fund portfolios here and remember that MarketFolly.com is your go-to source for the full spectrum of hedge fund analysis.

Send Us Hedge Fund Letters

Market Folly readers: Now that various hedge funds are sending out their third quarter letters, we need to ask you a huge favor. This site has become largely what it is today due to the generosity of readers willing to share resources. So, we have one simple request: send us hedge fund letters!

Rest assured that every contribution will be treated as anonymous and confidential. Your privacy is our top priority. If there are watermarks or other identifiers on the letter, we will remove them & summarize the letter instead. The more people that share, the more resources we can provide.

Thank you for sharing with the Market Folly community! Click here to send us an email.

Best Investments During Inflation

So, what is the best investment during inflation? The good news is that there are a multitude of securities and assets that can protect against inflationary pressure. The bad news is if such a scenario comes to fruition, your purchasing power is reduced. The main thing to keep an eye on is the money supply. Throughout the crisis, the monetary base has expanded, but has yet to materialize in the money supply. If/when this comes to fruition, you'll be prepared after learning how to invest for inflation below.

Interestingly enough, deflation has been the top concern amongst investors as of late and yesterday we detailed the best investments during deflation. But investors have quickly forgotten that inflation was the primary concern just a mere few months ago. This revisits a post we originally published in August 2008 examining investment scenarios for inflation versus deflation. Regardless of outcome, investors need to be prepared for either.

Why should you be worried about inflation? Well, how about because one of the greatest investors of this generation is concerned. Yup, Baupost Group's Seth Klarman is worried about inflation. Not to mention, Kyle Bass, the hedge fund manager who predicted the subprime crisis as well as sovereign defaults has voiced concern about inflation and significant currency devaluation around the globe. For every prominent investor worried about deflation, there is another concerned with the converse scenario.

Here are the best investments during inflation:

Avoid Cash/US Dollars: Inflation typically results in domestic currency devaluing. You can fight this by simply not holding it and allocating the capital into other assets and investments. Nowadays, cash is most certainly part of the asset allocation picture. During inflation, you want to have as little of it on hand if possible. Since it devalues during inflation, those of you wishing to press your bets against the US dollar can buy the PowerShares Bearish US dollar index fund (UDN).


Buy Gold & Precious Metals: If you'll think back toward the end of the crisis, gold was all the rage. As the Federal Reserve's printing presses worked overtime to churn out US dollars to resuscitate the economy, many became very worried about inflation. Their number one investment to protect against this? Gold. While precious metals in general are a solid bet, gold in particular is seen as a hedge against uncertainty and a store of value. For an in-depth thesis as to why you should buy gold during inflation, we turn you to out post on successful hedge fund manager John Paulson's gold fund. He launched this vehicle last year as a means of betting against the US dollar. Another option is the stocks of companies that mine the metal. One hedge fund recently opined that gold is good, but gold mining stocks are better.

We've detailed how countless other prominent investment managers favor yellow bricks. John Burbank's Passport Capital outlined the rationale for owning physical gold. David Einhorn's hedge fund Greenlight Capital also owns physical gold. Those of you who don't have access to physical bars can invest via the SPDR Gold Fund (GLD). Practically all of the hedge funds that are not investing in physical gold use this investment vehicle for their gold exposure. If gold doesn't tickle your fancy, legendary investor Jim Rogers sees opportunity in silver and palladium which can provide you with precious metals exposure. PALL is the ticker for playing palladium while SLV is a way to play silver.


Buy Crude Oil: Going long oil ties into the whole 'buy commodities' theme as protection. In a truly inflationary environment, oil is supply inelastic; any increase or decrease in price would not result in a corresponding increase or decrease in supply. In the past we've outlined how to invest in crude oil, as there are many investment vehicles out there, each with pros and cons. These funds include USO, DBO, & USL and are examined in-depth via the link above.


Short Fixed Income: Bonds should be avoided due to a weak domestic monetary system. In particular, avoid US Treasuries as they will underperform. As yields start to rise, bond prices will fall. A plethora of prominent investors have gone this route in order to gain inflationary protection. Seth Klarman has purchased out of the money puts on bonds. He's acquired tail risk insurance against a sharp rise in interest rates that protects him should rates skyrocket to 10%. Legendary hedge fund manager Julian Robertson had previously put on a curve steepener trade and then shifted to a constant maturity swap (CMS) trade. These are more advanced trades and typically are reserved for institutional investors. Retail investors can buy puts on or short the iShares 20+ Year Treasury (TLT).


Buy Emerging Markets: A weak domestic currency (US dollar) implies higher returns can be found abroad in other countries. A monetary system in trouble in the home land means your dollars should be invested abroad (especially consider commodity producing nations such as Australia and Brazil). You can invest in either emerging market currencies, equities abroad, or investment funds denominated in those foreign currencies. For broad emerging market equities exposure, one can purchase iShares Emerging Markets Index (EEM). For the Australian Dollar, consider FXA and for Brazilian exposure, consider EWZ.


Buy Technology: While this was also a suggestion for investing during deflationary times, it applies to inflation under the same rationale. Regardless of environment, technology is in demand and will continue to evolve.


Buy Treasury Inflation Protected Securities: These types of treasuries (known as TIPS for short) provide the safety of a government bond with the bonus of protection against inflation. You can buy these outright, or via the iShares Barclays TIPS fund (TIP).


While inflation was all the talk only a few months ago, it has since taken a back seat to deflationary chatter. Given the back and forth, it only makes sense to examine both scenarios. In the depths of the 2008 crisis we broadly examined investment scenarios for inflation versus deflation. At the time, it was unclear what type of environment we'd be entering. While still not entirely evident to this day, many have postulated that deflation in the near-term will then give way to inflation in the longer-term. A compromise of views, if you will. We've mapped out inflationary defenses above and for a look at the converse scenario, be sure to check out the best investments for deflation. Now you have a loose framework for either environment.

Best Investments During Deflation

Today we're laying a loose framework for the best investments during deflation. Why? Because deflationary signals have reared their ugly head as of late. Not to mention, many prominent investment managers have voiced their concern about the dreaded scenario. While inflation versus deflation has been the great debate over the past two years, the deflationistas have been boasting quite loudly as of late.

We've detailed how David Gerstenhaber's global macro hedge fund Argonaut Capital thinks deflation is the greater risk. Additionally, Broyhill's Affinity hedge fund has been betting on deflation as of late. PIMCO's bond king Bill Gross has been buying treasuries in order to combat these fears. And for more, The Reformed Broker has a quick summary of the New York Times' deflation round-up as well.

While investing during the dreaded 'D' word is not impossible, the options to preserve and grow capital are certainly limited. So, what is the best investment for deflation? Very broadly and in no particular order, here's some potential answers:


Cash/US Dollar: The phrase "cash is king" is often cliche. It's not cliche during deflation, it's rule number one. Assuredly, cash is one of the few 'safe' investments you can make in this scenario. Over the normal course of investing, most investors focus on their return on capital. This time around, the focus is simply on return *of* capital. While many wouldn't consider this an investment, having physical cash notes saved and on hand can be crucial during extreme situations including: bank failures, a collapse in credit, or the government defaulting on its debt. Not to mention, the US dollar has been a strong performer during deflationary times. Holding the physical currency is easy enough, but those wishing to further their wager can play the PowerShares US Dollar Bullish Index (UUP).


Pay Off Debt: Again while 'paying down debt' doesn't sound like an investment, it most definitely is during deflation. In a period where literally every single dollar matters, each dollar of debt can become crippling.


Buy Long-Term Bonds: Alternative to cash, fixed income is also seen as an option for those who seek protection. While fixed income yields decline due to Federal Reserve easing in an effort to combat deflation, the underlying bond should appreciate (or at the very least, depreciate much less than equities). US Treasuries are highly coveted here as they are the safest and most in-demand. If one were to go the corporate bond route, seeking high quality bonds is preferred. The thesis behind this play is laid out by Broyhill's Affinity hedge fund in their presentations: ten reasons to buy bonds as well as their bet on long-term treasuries. The most logical wager here would be the iShares Barclays 20+ year Treasury (TLT).


Short Equities: Traditional investments will start to suffer as underlying companies will see lower margins and losses. Not to mention, highly leveraged companies make ideal short selling targets and certain companies can face the risk of becoming insolvent. If your conviction is strong enough, you could simply short the S&P 500 index (SPY). There is, however, one potential safe haven in equities (keyword being 'potential'), which brings us to the next investment:


Buy High Quality Dividend Paying Stocks: Understand that during deflation, equities in general are one of the major investments to avoid. However, high quality stocks could be a potentially dim light in an otherwise dark scenario. While the majority of companies will lose pricing power and succumb to weak margins, large cap high quality companies that dominate their industries may be able to maintain pricing power. Not to mention, many of these stocks pay dividends which generate valuable cash during deflation. Seek companies with pristine balance sheets.

GMO's Jeremy Grantham recently voiced concern about deflation and one of his few investment recommendations was to buy high quality stocks. For ideas, hedge fund T2 Partners recently issued a presentation on 3 large cap stocks. Sectors to look toward include healthcare, technology, and telecom as those have outperformed in Japan during their deflationary lost decade. Microsoft (MSFT) is one name that has been repeatedly mentioned by strategists and managers. Keep in mind though that despite being high quality blue-chip companies, these are still equities. As such, there is obviously inherent risk in owning them during deflation.


Short Housing/Avoid Real Estate: In deflation, prices fall. As such, rent rather than own. Stand back and let the landlords watch the values of their properties plummet. You can short the iShares Dow Jones US Real Estate (IYR) for some exposure.


Short Leverage: Deleveraging should be a big theme playing out in the future, environment notwithstanding. As mentioned earlier, short the equity of companies that have poor balance sheets and are highly levered. In deflation, leverage begins to unwind and currency plays can be found. A massive leveraged carry trade in the Yen has taken place over the years and as such would be unwound in deflation, thus benefiting the Yen.


Long Technology: Regardless of environment, technology will advance and will be in demand. The technology sector was highlighted as one of the few areas to possible allocate capital in high quality equities. Companies that have strangleholds on their industry should have an advantage. A basket of technology stocks could be purchased via the technology exchange traded fund (XLK). However, that gives you exposure to a lot of companies and it's probably more preferable to single out high quality technology names with pristine balance sheets such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO).


Gold: Conventional wisdom says to avoid precious metals during deflation. During the Great Depression from 1929-1932, commodities in general crashed. However, in very extreme circumstances (emphasis on extreme), some have argued that gold can make sense when acting as currency. The majority of proponents for owning gold during deflation would cite its store of value or hedge against uncertainty. While gold can be played via the SPDR Gold Fund (GLD), many hedge funds advocate physical gold. That said, those doing so are mainly seeking inflationary protection.


Buy TIPS: Treasury Inflation Protected Securities, or TIPS, serve as long-term protection from inflation. Buying TIPS during deflation? What's the point? This is an option if investors believe that deflation will eventually lead to inflation two or three years later. As policy makers attempt to combat deflation, the natural antidote is inflationary medicine. As such, investors looking further down the road can fend off these inflationary pressures with TIPS. And even if deflation persists for an extended period of time, TIPS still produce income via yield and investors can regain their bond's face value at maturity. This can be played via iShares Barclays TIPS Bond Fund (TIP) for those looking for an easy solution.


That sums up some of the best ways to position a portfolio when confronted with deflation. Recent concern is duly warranted considering that deflation typically rears its ugly head after periods of prolonged globalization and global growth. Such growth leads to increased investment, a massive increase in production, and thus excess capacity all around the world. This excess capacity then brings forth lower prices. In deflation, companies suffer while the consumer is the real winner. The above present theoretical options of how to invest during such a scenario. Make no mistake though, investing during deflation can be quite difficult and painful.

Back in August 2008 when the crisis was heating up, we penned a very broad outline of investment scenarios for inflation versus deflation. During the pinnacle of the crisis, it wasn't quite clear which situation would play out so it made sense to lay a framework for each context. (And arguably, it's still not entirely clear. Many have hypothesized that we'll see a compromise of views: deflation in the near-term and inflation in the long-term). A few months ago, inflation was all the rage. Now, deflation is the primary concern. Investors have been flip-flopping more frequently than politicians as of late.

Regardless of outcome, it makes sense to be prepared for either environment. Check back tomorrow as we'll turn the tables and outline the best investments during inflation in order to present both sides of the argument. In the mean time, be sure to see what hedge funds are investing in these days with our daily coverage.

Send Us Your Hedge Fund Letters

Since second quarter hedge fund letters have been sent out, we're putting out a call to our readers to contribute. This site has become largely what it is today due to the generosity of readers willing to share resources. So today we have one simple request: send us hedge fund letters you have access to!

Large or small fund, it does not matter; we welcome all resources. Rest assured that every contribution is treated as anonymous and confidential. We respect your privacy and take it very seriously. Don't worry if the letters have watermarks or unique identifiers either, we can easily remove those. Remember, your confidentiality is our top priority. Thank you for sharing with the Market Folly community! Click here to send us an email.

Here's some examples of the great hedge fund commentary we've been able to share:

- Perry Capital's Q2 letter

- Argonaut Capital's global macro outlook

- Corsair Capital's latest investment ideas

- Oaktree Capital's letter from Howard Marks

- T2 Partners' investment presentation

- Greenlight Capital's Q2 letter

- East Coast Asset Management's latest thoughts

- Grey Owl Capital's Q2 letter

Oaktree Capital's Howard Marks on the Greek Tragedy

Oaktree Capital's Howard Marks is out with his latest Chairman's Letter and as always, it's a must read. When we last checked in with the prominent manager, we saw that Howard Marks was cautious. And he's certainly not alone in his concern as legendary investor Seth Klarman is worried about the markets as well. Needless to say, Marks is still concerned about many issues. His July missive, entitled 'It's Greek to Me' obviously outlines the recent problems in Greece.

Given that the country has been responsible for so many headlines in the Eurozone (and appropriately so), Marks outlines the ingredients that have contributed to the contagion across the ocean, notably:

- Slow-growing, unproductive & uncompetitive economies
- Low birthrates & aging populations
- Generous benefits & social services
- Extensive vacations & limits on work weeks
- Early retirement
- Artificially high debt ratings & resultant low interest rates

However, the Oaktree Capital Chairman also argues that debt is not the problem (or even the cause of the problem), but rather the facilitator. He writes, "without credit - I think back to my pre-credit card college days of 45 years ago, for example - you couldn't spend money you didn't have. Thus you couldn't buy things you couldn't afford. Then the miracle of credit came along and it became easy to get in over your head." He relates that analogy to government spending and wonders what would come to be if governments couldn't finance deficits by issuing debt.

Marks then compares the United States' situation to that of Greece. While he does not think the US will face the crisis Greece has, he acknowledges the basic problem is the same: both countries have a bigger government than they're paying for. To avoid such folly, he argues "the bottom line appears to be that the U.S. must anticipate austerity, higher taxes, and the sluggish growth that combination is likely to produce. Failing that, we may face devaluation, default and other unthinkable developments. We are not exempt from the problems besetting Greece."

Turning to Marks' thoughts on the current markets, he actually began his letter by touching on the tenets of successful investing. He writes, "risk control and consistency hold the keys to long-term investment success." He comes full circle and ends his commentary by lamenting that, "bottom line: anyone who invests today in a pro-risk fashion out of belief in the recovery must be confident he'll be agile enough to take profits before the long-term realities set in."

Embedded below is the latest market commentary from Oaktree Capital's Howard Marks:



You can download a .pdf copy here.

For more market commentary from Oaktree, head to our piece on Marks' cautionary stance. And for the rest of our 'market-strategist-Monday' pieces, you can head to the latest investment outlook from PIMCO's Bill Gross, as well as Jeremy Grantham's latest commentary from GMO.

Three Investment Ideas: Interview With Seth Hamot, Founder of Roark, Rearden, & Hamot Capital

Today we're pleased to present an interview with Seth Hamot, 48, founder and managing partner of Roark, Rearden, & Hamot Capital Management. His fund has over $150 Million under management, has performed well through 2-3 recessions, and returned an annualized 17% to investors net of fees. This interview comes as a guest contribution from Ankit Gupta of SelectedFinancials.com. We're always looking for rising managers here at Market Folly and Ankit has done an excellent job with the below discovery:

"The following is an interview to try and learn a little bit about Seth Hamot's experience. As you read this, do remember that he has spent 15+ years building this investment fund and this interview cannot capture that, but hopes to bring a small portion to the public surface. Dr. Sergio Magistri, who led a company through the dot-com bubble and exited with a large acquisition by GE also shares his thoughts on what happened. He led InVision Technologies, which turned out to be an amazing investment for Seth’s fund. Today, InVision’s products can be found in airports helping to prevent terrorism. With his input, we can analyze this amazing investment from the side of Seth and Sergio, both.

When did you launch your investment fund and what were you doing leading up to that?

RRH launched in the mid to late 90’s and prior to that, I was working with partners buying distressed and defaulted debt backed by real estate. I started doing that in 1989 and 1990. Prior to that, I was the President of College Pro Painters, a painting contracting company with a student labor force. I graduated college and since CPP was owned by a foreigner, and needed a local president and leadership, I was brought on board. It was going through financial distress, had no local leadership, and so I was brought in to turn it around. We went from $3 Million/year in revenue to $11 Million when I left. Shortly after, a real estate recession kicked and, and so I began looking for turnaround situations with distressed debt that could be bought. My partners from those ventures eventually retired and so I continued what I was doing into the public markets. We found poorly performing assets that were either too encumbered with too much debt or too little leadership, focusing on hard assets like real estate and mining assets.

What is your fund’s underlying approach? What wrong do you right in the markets?

I want to find companies going through a transition. Eventually, that transition will translate into others seeing that the company will be worth more than they originally thought. It might be divesting a cash burning division, or new credit facility, or maybe the company just did a merger or acquisition allowing the business model to be leveraged, etc. The objective is to NOT be an activist in these situations. There are a lot of great opportunities because really great companies make errors, but they can move on. We enjoy dealing with smart businessmen on a daily basis. Often times though, managers slowly become content to have a larger span of control and more remuneration. They change by rationalizing their business to make themselves better focused and more efficient and effective.

Where did you get your first 5 investors for your fund?

College roommates, families of college roommates, friends, my own money, etc.

What were the first 5 years of your fund like? How many employees did you have and what were some of the larger challenges?

It was a small fund and so picking investments was the main challenge. It was just myself initially. We took a very large position in a liquidating insurance company that lasted 2-3 years, but was very profitable because the markets misunderstood it entirely. It took a little bit of activism and at the end of it, I met someone, who introduced me to his own limited partners, and that’s where I brought in some fresh capital. One of the joys there was that I met some great people who were also doing small cap value investing.

Eventually I was introduced to a well-run fund of funds on the west coast. I was told that we made some great investments, but our documentation was on napkins and we used grid pads for calculations. We got a real lawyer, real documentation, put together information for investors, and then began to grow. From the original $2 Million that we started with, we had grown to somewhere around $15-20 Million, and then these guys came in. We’ve been successful in our performance with investors: Over the last decade, ended December 2009, we’ve returned 17% annualized, net of all fees.

The name of your fund has a very unique name – it has names of characters from the books of Ayn Rand. Can you tell us why you did this?

In general, we take a contrarian view. Doing it all the time is not contrarian and so this allows us to take investments from a unique vantage point.

What do you look for in an investment?

A perfect investment would be in a business that was once well covered by investors, analysts, raised a lot of money, etc. and then the company and industry went through a transformation and the stock trades very cheaply. Even after that, the underlying business itself makes sense and with some tough decisions, it can regain its value and it will right itself. A simplistic example is a REIT that for some reason no longer pays its dividend, driving the stock price very low. It’s a hard asset business that won’t just disappear. If you can foresee the dividend coming back, it will get bought again for its yield eventually. So if someone calls in and says, “I’ve got this REIT I want you to look at,” I’ll respond by asking, “Is it paying a dividend?” If the answer is yes, then I don’t care, but if the answer is no, then let’s talk!

How do you find your investments? Are they brought to you or do you screen for them?

We don’t use as many screens as our competitors – we look for situations of transition. We monitor a lot of announcements for spinoffs, acquisitions, divestitures, distributions and one-time dividends, etc. A good 1/3rd of our investments come from people who call about how they’ve lost a lot of money and they don’t understand why the equity is performing so poorly. They want information, but in another sense, they’re questioning whether an activist could help out. More often than not, present management and the board of directors will deal with the issues. We don’t want to be activists, generally, but to the extent that we’re wrong that the CEO isn’t good, we have to do it.

If it’s activism, it’s because the board or CEO is not reasonable. When we are activists, we always say to CEO’s and board members that we see this (something specific) as a problem and that any reasonable businessman would see this as a problem. Reasonable owners, your shareholders, see this as a problem. “Why don’t you get in front of this and solve it?” It’s only when they refuse to address the issue and completely ignore rational shareholders that we become activists. It’s not a case of them not being granted an opportunity to fix it. Furthermore, when they stick to their actions – often to feather their own actions, they refuse to accept that we are the shareholders and owners of the business. Instead, they try to publicize that we are a “lesser class” of shareholder, a hedge fund. One extreme example is a board that said they had a program in place to find new, more docile, shareholders. Instead of realizing value by spending time to follow suggestions, they were spending time on finding money and new bosses.

How long do you typically hold an investment for?

Our average investment period is well over a year, probably closer to a couple of years. I’m the chairman at TEAM, chairman at ORNG, both of which we have owned for over 4 years. Some of our other big positions are in the 3rd year of our ownership. We’re not traders and our investors see it by the tax bill – we’re not paying short-term taxes nearly as much as others.

Some of your investments are in pharmaceuticals or biotechs along with energy, mortgage processors, etc., how are you doing this?

We’re generalists and start digging into anything. If the problem is product based, we don’t dig into that. We’re focused on the business. If the company has successful products, but is spending too much on R&D, it’s a question of capital allocation. We avoid biotech companies without significant revenues because we don’t have a take on science. At the same time, we don’t have any problem in investing in a pharmaceutical spending a lot on biotech, but already has successful drugs in the marketplace. If there is a mismatch between capitalization and value of drugs that are already in the market, there will be a major discount to the market value of the company. A big discount points out that investors don’t value the R&D pipeline even though the drugs are kicking off a lot of cash.

How much do you care about where the overall markets are and where they are headed?

We used to not care at all, and through 2008, a lot of my competitors and I started to care very greatly. I don’t really pay all that much attention to it though, because I’m investing longer term than most, 2-4 years, and if they can turn a business around in 2 years, any 1 days headlines today won’t be the headlines 2 years from now.

Do you take long positions only or short positions as well? Is any of this as a hedge or do you look for companies with something that is fundamentally wrong when taking a short position?

We do take short positions, but we’re not nearly as good at them as our longs. We look for bad business models, too much leverage, and companies generally run for the benefit of senior management and board members. Shorts tend to go against us because whenever any activity continues, the investment community rates it highly. We’re not too good at anything other than when the debt comes due causing the company to reorganize or hand over ownership to the debt holders.

Your firm seems to be okay with small cap positions. Do you ever worry about a complete lack of liquidity that small caps will see whenever there’s a downturn?

Yes, we worry about liquidity. We think about it more today than 2 or 3 years ago because it is an issue and with many stocks that we used to get involved in, we will no long get involved in.

How do you manage and define risk?

We define risk as leverage – certainly not beta. Our only use of leverage will be used to trade around positions. That said, liquidity is the first coward and when liquidity dries up, you just have to put up with the bumpy road. There’s a desire to avoid volatility at all costs. The flip side is that you’re paying for it in liquidity. Our 17% annualized return partly comes due to an illiquidity premium. Neither the auditor nor the IRS makes us give back our excess return due to that though!

Your fund has lived through 2 or 3 economic downturns – which one were you most prepared for?

2000 Internet crackup. In 2002, when the S&P500 fell 22%, we were up almost 10%. These crises are very good for us, eventually. They’re not so good short term because we go through hell too. Just after it though, we tend to double and show over 100% returns. Leading up to the recent troubles, we were short on homebuilders and held CDS’s at one point, however gave those up on suspicions that the markets were rigged.

Do you ever notice that it’s easier to be right than it is to know when you’ll be proven right?

Yes, very much so. It happens in real estate quite a bit. You can buy a property one minute and then in the next minute, you can come up with a number for what it’s worth. Sometimes, it takes longer, and sometimes it’s shorter. This applies to stocks too – you know what it’s worth when you buy it, you have to wait though. We were investing 3-4 years ago and are still waiting for the investments to complete. We see how they will, but the markets have not recognized it yet.

Historically, do you have any investments that you remember as amazing? Maybe an investment where you were just so darn right that it was memorable?

Yes, two in specific:

1. Nursing Homes: In the early parts of the last decade, nursing homes were providing elderly housing and elderly care. They were expanding the elderly care to provide ancillary types of procedures, like occupational therapy, breath therapy, etc. and all these things made tons of money. The underlying business was great, and then they issued a ton of debt, raised capital, etc. Shortly after, congress cut back funding. With that, the top lines and margins went through the floor, leveraged ones went bankrupt, and the industry in itself went through a transition.

The markets priced that as if nursing homes would go away. In reality, there would only be more elderly people given enough time. We were buying healthcare REITS, preferred shares with 20% yields, dividend-paying instruments for 50% of pay, etc. Lo and behold, the Internet stocks went to hell and these nursing homes were going through a change too. Even while they went through a change, they had to keep paying rent, and so the REIT dividends kept coming in. It was priced like a junk bond, but the yields were better and actual ratings were better too!

2. InVision Technologies (from Seth Hamot’s point of view). During the internet bust, you would hear tons of ideas that all began, “This company has so much cash on hand and is only burning this much per quarter.” We found INVN, which was a collection of venture ideas that were being commercialized. The CEO of this company, though, was committed to being profitable. Same sort of upside, but without the cash burn, as the Internet investments. The CEO basically said this: “They (our investments) turn positive NOW, not later on.” Meanwhile, I’m getting a ton of calls from people to buy 1 of 6 online pet food supplier stocks, they have a ton of cash and little burn – they don’t need money for two years! I heard that all day long and then went to buy Invision. I paid less than the cash they had and saw some upside on a logger product that was going to make logging much more efficient. They weren’t burning cash either, and that’s what made it attractive.

I went over just 1% of the company by September 10th, 2001. On the next morning, terrorists attack the country and so the markets don’t open for a while. Invision actually had technology that sniffs for bomb threats in airports. At this time, it was in beta testing at a few regional airports. I hadn’t paid attention to this part of INVN at all, but now it was a lot more important than all the other activity at the company. I had been buying the stock for $3 per share, less than net cash. It was a “net net.” As you know, the markets remained closed until September 17th, when it opened around $7.50. By that afternoon, it traded around $9. This is when all the value investors got out right away. Around this time, I said, “You know, if it’s a real business, and it’s up to $9 today, because it was installed as a beta test, the government will want hundreds and thousands of these in the recent future, these will be hot.” Eventually, I got out between $17-20. If you travel now and look behind the check in counter, those machines that they put your luggage through are Invision machines. I have no idea what happened to the log cutting advancements or anything else, I was following a CEO who wanted profitability even when everyone else had different ideas.

2a. InVision Technologies (now from Sergio's point of view - CEO/President)

Dr. Sergio Magistri was the President the CEO of InVision Technologies, which developed technologies for Explosive Detection Systems (EDS) and other civil aviation security. He joined in 1992, raised $21M in 1997, and entered into a merger agreement for $900M, or $50 per share, on December 6th, 2004. Below are some of his thoughts:

1. Does the description that Seth gave of the situation sound adequate?

Yes, from a contrarian investor point of view looking at the overall high-tech space near the end of the dot-com bubble. At InVision (INVN) though, we never felt that we were part of the dot-com mania. We had a long-term strategy that was quite simple: (1) Security is an event driven market (2) The best marketing is the quality of our products (3) Keep developing the best technology in the industry without running out of money and maintaining at least a cash flow break even or better (4) At some point in time, the market demand will come. In retrospect, I wish we would have been wrong or at least the demand (as a consequence of a terrorist event) would have been lesser.

2. Why did you care about cash flow break even or positive at a time when most others did not?

At the valuation we had before September 11th and during the dot-com period, the company was not re-financeable almost at any valuation, because we were not “fashionable.” We had real products, revenues, and even some profit.

3. Did you get a hard time from anyone for pursuing cash flow breakeven and profitability before others?

Quite a lot of our investors (and our own people) were pushing for some kind of splash change in strategy to appease the dot-com believers, but at the level of management and board of directors, we decided to keep executing our security strategy. We had a clear understanding that we didn’t belong to the dot-com world.

4. Seth mentioned a logging enhancement that your firm was working on, but that might have been hidden by the success of the Explosive Detection Systems. Could you tell us what eventually happened?

After September 11th, we were management and resource limited. For a while, we tried to spin it off as an independent and financed entity to avoid defocusing our security effort. Once this failed, we decided to abort the development. Even today, while recognizing the need for the decision at the time, I believe that this was and will be a very interesting opportunity.

And now, back to some questions for Seth: When dealing with small caps, do you ever think about why some of them are publicly traded to begin with?

All the time. If you actually understand the classical theory of public markets, they exist for raising initial capital. No one would actually give capital unless there’s an exit strategy, and the public markets allow that exit strategy to be a reality for small holders of stock.

Looking at your current positions, can you offer any insight as to some of the more interesting ones?

Aeropostale (ARO) – Aeropostale is the premier teen retailer in my estimation. When you compare the company’s fundamentals to the other large players, AEO and ANF, you see the superiority clearly. Yet, ARO is relatively cheaper than its competitors. Let’s first look at the ability to drive same store sales. In 2009, arguably the worst year for retail in the last generation, ARO had year over year gains every month. Furthermore, if you consider the gains in total sales compared to the recent trimming of inventory – that’s right, the decline in inventory – you realize the increasing efficiencies that are driving huge cash flows at ARO. [Specifically, let’s take the summation of the last four quarters of “percentage yearly revenue gains” and subtract from that number the summation of the last four quarters of “percentage of yearly inventory gains,” the latest quarter being actually a reduction in inventory. ARO’s resulting number is 50.83 and accelerating. AEO’s is 21.88, and going in the wrong direction and ANF’s is 34.68 and also headed in the wrong direction.]

Analysts miss all this though. They are so wed to their bullish calls on ANF and AEO that they have conjured up a story that once the recession ends, all those customers who are moving to a lower price point by shopping at ARO are going to return to the competitors’ stores. Hence, ARO trades at 5.43x its LTM EBITDA, while ANF trades at 7.26x and AEO traded at 7.14x until it lost 35% of its value in the last quarter. Caught up in their past view of the world, they are missing one of the great retail stories around today, which continues to improve its business quarter over quarter.

Nabi (NABI) – this is a wonderful story. Nabi has a vaccine that helps with smoking sensations. Glaxo Smith Cline (GSK) actually put up $45 Million to partner with them on this drug. No one spends $45M on a drug that isn’t credible. That will probably move forward by the end of 2011. When I entered my position, I wasn’t paying more than cash and the NPV of royalties, probably lower and upper 3’s. GSK validated the vaccine and the ramifications of its approval are mind-boggling. You take 4-5 shots over 6-8 months and you can get over smoking. Our nation spends a lot of money on smoking and so there will be a lot of push behind this drug, you could make budgets balance if less people smoked. Even if you doubt it, the GSK guys have been looking at it for months and when they’re done with the next phase of development, GSK will pay NABI another $30 Million for the work they’re doing, and then the numbers get really crazy for royalty payments. When I was buying, I got in at prices where most of the story was for “free” because of where the stock price was trading.

(Market Folly note: There's an interesting tie-in here as readers will recall that Dan Loeb's hedge fund Third Point had been selling Nabi, though they still own a sizable position).

BreitBurn Energy Partners (BBEP) – This company found they were overleveraged at one point last year and so they cut the dividend distribution, causing the stock to go down to $6. Dividend money went to cut down debt and now it’s at $15. We went from $6 to $15. Baupost is there and the interesting thing is that they got involved with a proxy contest with the largest shareholder. Quicksilver, the largest shareholder, went on the board and removed 2 guys – the chairman and CEO, the two folks whose name is in the company name itself. They became management employees.

(Market Folly note: You can view the specifics of Seth Klarman's BBEP investment via Baupost's portfolio.)

Quicksilver (KWK) is overleveraged and owned 21 million shares of this company at one point, or about 40% of the company. They had a proxy contest and those 2 were removed. You have to take a step back and wonder what’s going on. If there is nothing going on, why would they bother to remove people from the board who will object and not be happy about the situation? There’s a possibility that managers were taken off the board of directors so that potential M&A activity could be kept segregated from the operations, which offers a potential exit strategy for Quicksilver. In the meantime, I got a 10% dividend and 37.5 cents per quarter per share, not too bad at all, and mostly tax-free.

How do you try and structure your portfolio? Your top holding is 15% of your invested portfolio and the top 5 make up 44% of your portfolio, even though you had 29 positions at the last 13F filing.

We tend to buy as much as 6-7% of the portfolio and will be pruning as it crosses the 10-15% threshold. We’re usually always pruning.

How do you deal with prices at which you are okay holding a stock, but not buying?

Opportunity cost would say that if you aren’t willing to buy it at the current price, you shouldn’t be holding it, because by not selling, you’re effectively buying at the current price. One of the pains is you buy stocks out of favor. Often times, they become in favor! Just because they’ve risen past fair value, and you saw that in InVision, where the fundamentals had markedly changed, you have to be patient and see it runs its course. By the same token, if I was buying for the log cutting machine software, and if it was done with the beta tests without much business activity, I would have found another investment to move onto. From my point of view, I can be patient.

Can you recommend a few books for investors that you found to be helpful?

Sure - Ben Graham's Security Analysis, The Intelligent Investor, and Seth Klarman's Margin of Safety. Additional reading includes Warren Buffett's annual letters and an understanding of topics of leveraged buyouts and stability of cash flows."


And that concludes the excellent interview. The above was a guest contribution courtesy of Ankit Gupta of SelectedFinancials.com. Those of you interested in a .pdf copy of the above interview can download a .pdf here.

If you or anyone you know is a fund manager open to being interviewed, please send us an email.

Odey European's Hedge Fund Market Commentary From Founder Crispin Odey

Today we present you the latest market commentary and current outlook from Crispin Odey, founding partner and portfolio manager at Odey Asset Management, one of the premier and widely regarded UK based hedge funds. Odey currently manages around $5 billion for institutions, endowments, private banks and individuals. Crispin founded the firm in 1991 with a focus on preserving capital and generating superior returns.

In terms of recent results, we saw in our May hedge fund performance update that Odey was down 10.96% in the month of May alone. Crispin addresses this and other topics in his most recent commentary:

"May was ugly. Markets did exactly the opposite of what I was expecting them to do. Government bonds rose by 8%, equities fell by 8%. In my hedge fund I was 100% short the bonds and 100% long these equities. Risk controls cut in and ensured that we lost only 1.5% on the bond book, but we also lost money on the currencies. We took the net equity book down to 40% at one stage and we reduced the bond short book to less than twenty percent. This was not one's finest moment.

However, do all those price moves change much? Are there lessons to be learnt? What are markets predicting?

Questions, questions, questions. Sure the ECB handled Greece badly. They should have investigated bankruptcy. Sure the Spanish Caixas need recapitalizing and some honesty needs to be brought to bear in property loans in evaluating Spain, but should this blow off course the natural reflationary policies being pursued by the authorities. The price action of May for all asset classes was only explicable on the grounds that Europe and indeed the world is going to follow Japan into deflation.

The line of argument goes. Firstly, credit cannot expand because there is a standoff between those who have the equity to buy assets and those selling the assets; over price. The equity participants are asking for a discount on the assets. The sellers, thanks to low interest rates, do not have to sell and are holding out. This presents an uneasy truce but it does not permit credit gains.

Secondly, governments are only too aware that this crisis has left government finances in an untenable position long-term. Tax revenue has rarely managed to get about 40% of GNP. Government expenditure is now universally running in excess of 50% of GNP. In Osborne's case, the need to bring expenditures into line with revenues is compounded by the fact that if he does not announce cuts immediately, he cannot blame the outgoing government.

Markets are worrying in many ways rightly, that with the corporate sitting on cash, a fall in government expenditure is not going to be met by a rise in private sector spending and employment. Thus the market in May is pricing in a double dip.

This has been compounded by the weakness in the corporate bond market of late. With the one year ECB repo of ?400 billion coming due on 1st July, every bank is nervous that the ECB may not renew it or will only renew it only quarterly. Here I remain more positive. For me the lucky thing for Europe is that Germany may have the strongest economy in Europe, but they also have the weakest banking system and that is some claim when you look at the competition in Europe. This means the 1st July is likely to bring news that the repo loan is extended and most likely for one year. Thus fear of deflation provokes further reflationary policies.

This brings me on to the future. It is highly unusual for a new bear market in equities to begin even as profit estimates are being upgraded as they are now. Equities are cheap against all other assets, pricing in a 30%-40% fall in profits.* They are also under-owned. That makes them vulnerable to changes in sentiment. That makes them volatile, but it also makes them attractive as investments.

As some stage the re-flation will result in inflation and all of these fire practices will help the fund to do well. But in the meantime it looks like returns will be allied to volatility. *Even in 2009, with the banks going bankrupt in the UK, profits only fell by 8%. Written the 28th of May 2010."

Certainly intriguing commentary from the Odey manager and for more from this hedge fund we've previously covered Odey's European Fund commentary from earlier in the year. Additionally, we often cover fund manager Hugh Hendry on the site and keep in mind that before founding his firm Eclectica, Hendry was previously a partner at Odey. As such, we recommend you also view Hendry's recent thoughts where we learned he has constructed an Asian bear portfolio.

For more market commentary from top investment managers, head to our compilation of various hedge fund investor letters.