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Dan Loeb: No Recession on the Immediate Horizon

Dan Loeb's Third Point strives to invest with an edge and to reduce market risk via lower net exposures and less beta in the portfolio. Loeb just released his second-quarter letter and although it contains few individual stock ideas, there is a lot of great insight into portfolio management and late-cycle positioning there. Third Point's Offshore Fund gained 3.8% in the second quarter and 13.1% year to date. That's with the fund positioned only as 40% net long. Here are the most interesting pieces of the letter and why (emphasis mine):

Current positioning

Loeb started by describing what he has been doing this year:

"During the first half of this year, we primarily focused on event-driven strategies, including activist investing. We also grew our concentrated book of single name shorts and increased some sector and market hedges to dampen volatility and market correlation. Our nets have averaged ~40% this year. We believe that this positioning, late in the economic cycle, allows us to take advantage of market corrections and be poised to shift into credit as opportunities emerge."

Event-driven strategies cover a wide spectrum of opportunities, from spin-offs, M&A, liquidations, bankruptcies and restructurings, as well as activist investing. The important characteristic of this strategy is in the name: It is event-driven. Because an "event" takes place at a certain time (in case of a merger for example) or during a set or at least limited time-frame (like with a liquidation). Straight-up equity investing can be likened to investing in long-maturity bonds (ie equities don't even mature) hence they share similar behavior. Event-driven investing can be thought of as investing in bonds with short maturities and low duration. The return in event-driven names primarily come from "the event" and drivers associated with that event. That means a portfolio of these names is less correlated compared to a straight-up portfolio of stocks. Those stocks share much more general market risk.

"Our equity book has the highest proportion of idiosyncratic to other types of risk (market, sector, factor, etc.) in over five years, and our nets are at the low to mid-level of our historical exposure ranges. With this portfolio composition, we believe we are well-positioned to generate alpha while navigating the growth slowdown versus fiscal easing paradigm that should drive markets again during Q3."

By referring to the idiosyncratic nature of the portfolio Loeb specifically refers to this characteristic of event-driven situations. These beat to their own drum. At the same time, they have also positioned the portfolio to have low net exposure. That should help in a tough market environment. A long/short portfolio can work extremely well if you generate Alpha on both sides.


Loeb also opined on what the future hold for markets and stocks:

Of course, it is impossible to predict when the credit cycle will turn. However, given current debt levels throughout the system and the potential for an economic slowdown in the next few years - although we see nothing on the immediate horizon - we believe flexible positioning is appropriate.

I think Loeb means they prefer liquid names or other liquid securities over gathering a lot of high Alpha illiquid securities which could be more beneficial in a different environment. He seems wary of a slowdown and debt levels and he's certainly not the only one among the value gurus I follow.

U.S. equity markets have been strong this year despite weak global growth and low overall earnings growth. The strength seems largely driven by the dovish pivot in Fed policy from targeting higher neutral rates to focusing on low inflation and trade war concerns to initiate a rate-cutting cycle. After some initial hiccups early in his tenure, the "Bernanke Put" baton that was handed to Janet Yellen seems now to have been passed to Fed Chair Powell.

It does seem like the market is mostly driven by Fed policy. Occasionally it is noticeable that some other driver influences markets at times but when the additional stimulus is provided after a period of falling prices markets have quickly rallied back. I think traders refer to this as a "buy the dip" environment where it has been effective to buy after every small or medium-sized dip. I don't believe this strategy will work forever but it may continue to work for some time.

In Europe, the ECB has initiated efforts this year to stimulate Eurozone growth by maintaining rates at sub-zero levels and renewing a program of cheap bank loans, rather than tightening as previously forecast.

Likely Brexit, zombie companies, trade tensions, and political change have influenced this decision. Maybe Draghi leaving office plays a role as well. He can still set the tone for this year.

In Asia, China has stimulated via credit and fiscal policy and may have room to stimulate further. We expect growth to stabilize for the rest of the year, partially because manufacturing activity - the main driver of global GDP swings - appears likely to be overshooting on the downside, driven by inventory liquidation.

If it were to stabilize it would run at around 6% per year. That's still high GDP growth compared to Europe or the U.S. but for China, it would be a record low since the '90s.

Financial conditions have eased meaningfully and there are few imbalances in the U.S. economy. Thus, while we may be "late-cycle", we do not see any evidence of an immediate economic downturn. We continue to closely monitor the health of the U.S. consumer, given its outsized contribution to GDP, and second-order effects from an inverted yield curve.

Likely a downturn will be very hard to detect unless it is already breathing in your neck. Instead, slowly more and more indicators will flag yellow or red. Very few people have called multiple recessions well. But it has to happen at some point and it surely can't hurt to park safe.

Our equity book has the highest proportion of idiosyncratic to other types of risk (market, sector, factor, etc.) in over five years, and our nets are at the low to mid-level of our historical exposure ranges. With this portfolio composition, we believe we are well-positioned to generate alpha while navigating the growth slowdown versus fiscal easing paradigm that should drive markets again during the third quarter.

Just like Loeb I've been concentrating on idiosyncratic risk with a lot of corporate risk mixed in. He has an excellent strategy to deal with the current market environment. To me that means including lots of M&A situations, (distressed) debt, spin-offs, liquations, etc.

Quality vs quantity in investing

There is no set formula to measure the quality of investment returns. Our multi-asset, multisector idea-driven approach, designed to pivot quickly to generate high risk-adjusted and uncorrelated returns over a cycle, makes the exercise more difficult. The S&P 500 is an insufficient benchmark for the task. Today, we evaluate our return, beta, correlation, and risk profile across several indices and over a long period of time. For an index comparison, we use the MSCI World Index, which is a broad-based global equity index across 23 developed market countries. It covers ~85% of the free float-adjusted market capitalization in each country and excludes emerging markets. Its market cap is roughly divided into approximately 65% North America, 23% Europe, and Asia/Other making up the rest. Since 2009, Third Point's global equity gross breakdown has been roughly 75% North America, 15% Europe, and 10% ROW so we believe this index better represents our typical portfolio composition.

Loeb makes an interesting point that I think is valuable for every individual as well. Sometimes we are buying a bit too much into the S&P 500 (SPY). Returns are easy to quantify and everyone understand this statistic. But returns are a very noisy statistic that doesn't provide a lot of valuable signals. This is especially true with an event-driven strategy that is also concentrated into its very best investment ideas.

Returns also don't capture the risk you've taken to acquire them. There are statistics that provide insight into the riskiness of an investment, like beta, current ratios and others. In aggregate I don't think these are very useful. Occasionally one of your portfolio companies will be flagged but should be extremely rare.

To summarize there's a quantitative aspect to returns that is easy to observe but very hard to obtain a signal through. On the other hand, there's also a quantitative aspect of investing. The largest or highest quantity investment fund is certainly not always the largest or easiest to get into.

Disclosure: no positions.

This article first appeared on GuruFocus.