Hedge fund manager letters are a great source of investing wisdom and market intelligence. In order to better understand the meta game of markets, we analyzed a sample of nearly 200 first and second quarter hedge fund letters using natural language processing (NLP) tools in Python. These funds covered a wide variety of strategies, but all had significant exposure to equity markets. In this piece I highlight the key themes of these letters, along with how sentiment has shifted as the pandemic has run its course, and the stock market reacted violently.

What were hedge fund managers writing about the most? this word cloud shows the most common words appearing in hedge fund letters during 2020Q2.

Hedge Fund Letters

Stock markets collapsed in March, but then recovered quickly and eventually exceeding prior highs.   The changes in sentiment between Q1 and Q2 were sharp.   Analyzing how the popularity of different words and phrases shifted between quarters is also revealing.  For example, words such as “mania” and logic” were common in Q2, but were virtually absent in Q1.  

Lets look closer at the key themes on which the buyside is currently focused.

Key Themes in 2020Q2 Hedge Fund Letters

We identified several key themes in the latest batch of hedge fund letters.  In this writeup we highlight three:

  • Profiting from uncertainty
  • The disconnect between stock prices and fundamentals
  • Great companies but expensive stocks

Profiting from uncertainty

An infectious virus, combined with geopolitical risk and an uncertain economic and logistical backdrop create an environment of heightened uncertainty. With such a wide range of potential outcomes, how should investors approach the valuation and portfolio management processes? Managers have continued to struggle with this conundrum throughout the year. Yet this very uncertainty about the macro situation creates a lot of opportunities for stock pickers.

According to Alta Fox Capital:

What was so unique about the first half of 2020 was that the market’s traditional mechanism for valuation began to fail for nearly the entire market because it was difficult to develop conviction in earnings forecasts even one year out due to the uncertainty introduced by COVID-19. This led to widespread panic and significant buying opportunities for the nimble and focused investors.

Uncertainty doesn’t necessarily equate to risk of permanent capital loss. Lightsail Capital also saw a lot of opportunity when companies with great long term prospects experienced temporary headwinds.

We like certainty too, but for us the next few years are far more important than the next few quarters. What we seek to avoid is not short-term uncertainty, but risk . Businesses facing temporary interruptions to demand from COVID-19 can also possess secure long-term futures, especially if they sell compelling products that benefit from positive multi-year demand trends, and have balance sheets that provide years of running room. Such businesses can present very low risks despite the short-term uncertainty that comes with owning them — and, when they are ignored by most investors, they can also offer very high rewards.

At some point, the companies facing headwinds will get past them, and those being discounted despite attractive long-term futures will get noticed. Until then, we can buy excellent businesses at prices ranging from attractive to outrageous.

Australian manager Forager Funds stated in their letter that the current environment is the most fertile backdrop for stockpicking they’ve seen since the financial crisis.

Company after company is showing that they can adapt and flex and still be profitable. And low long-term interest rates have to be taken into account. I’m highly confident that a broad equities index will do better than cash over the next decade…

…Many stocks have been left behind in the rally. Many of those don’t deserve to be. The gap between the popular and unpopular is as wide as I have ever seen it. And the reward for finding a stock that can jump the gap is immense.

Disconnect between stock prices and fundamentals

The market recovered quickly, even though the actual real economy remained in the doldrums. Furthermore, we aren’t anywhere close to conquering the virus.  Is the stock market just completely disconnected from the economy?  Many expressed concern that earnings would not recover nearly as quickly as the market seemed to expect. 

Desert Lion Capital, For example, argued that the sudden recovery was driven by liquidity, not fundamentals. Here is their summary of the situation:

On February 19 this year, the S&P 500 hit an all-time high of 3 386. Then the market posted one of the fastest crashes in history on the back of the coronavirus fears. Around the globe, severe lockdowns were imposed with the intention of flattening the curve and preparing medical facilities for worst case scenarios. Apart from essential services and in-demand technology services and products, whole economies and almost all trade were basically shut down. The lasting effects are likely to lead to the worst fundamental economic impairment since World War II, or even the Great Depression, including the worst unemployment rate.1 The economic impact is clearly more severe and more widespread than Dotcom or the GFC. Yet, top to bottom, the S&P 500 declined -34% through March 23rd and at date of writing the letter, the S&P is back at 3 185, only -6% from its all-time high.

The current recovery is fragile and could be temporary:

The rapid recovery of the U.S. stock market is somewhat understandable. Congress passed trillions of dollars in fiscal programs while the Fed added trillions of dollars in monetary stimulus. Unemployment may be at historic highs, but many individuals are not yet feeling poorer thanks to direct cash payments and unemployment benefits. In the short run, all that additional money must go somewhere. With near-zero interest rates it is obvious that a lot of that money is going to find its way to the stock market.

Here is the problem. The complex system driving this market higher is extremely fragile and can change rapidly, which could lead to massive drawdowns.

Howard Marks at Oaktree Capital notes that whatever the logic of current valuations relative to fundamentals, the odds aren’t in favor of equity investors:

Importantly Fundamentals and valuations appeared to be of limited relevance. The stock prices of beneficiaries of the virus- such as digital service providers and on-line merchants approached “no price too high” proportions. And the stocks of companies in negatively affected industries like travel, restaurants, time sharing and casinos saw massive recovery, even though their businesses remained shutdown or barely functioning. Investors were likely attracted to the former by their positive stories and to the latter by their huge percentage declines and the resulting low absolute dollar prices.

… the fundamental outlook may be positive on balance but with listed security prices where they are, the odds aren’t in investors favor.

Others argue that current valuations are actually justified if you consider the longer term. Markets ,are after all, forward looking. Losing one year of earnings doesn’t really matter that much if a stock is worth the discounted value of over a decade of cash flows. This idea was expressed by Bill Miller, at Miller Value:

Let’s go back to this idea that stocks at current levels are “disconnected” from the real economy and that presents a problem that stands in need of correcting. In order to say stocks are “disconnected,” one needs to have some idea of what the connection is between the market and the economy. The belief appears to be that stocks go up when earnings and the economy are going up and they go down when the economy is doing the same. So, in short, stocks and the economy are positively correlated. The problem with that view is that there is no evidence at all to support it, as a few minutes research demonstrates. The correlation coefficient of stocks to annual economic growth from 1930 through 2019 is .09, that is, no meaningful correlation at all. For rolling 10-year periods over the same time span, it is slightly negative. I am reminded of the quote of the now mostly forgotten British poet and classicist A.E. Housman, who likewise was confronted with a belief that had no basis. Housman said, “Three minutes’ thought would suffice to find this out; but thought is irksome and three minutes is a long time.”

The Miller Opportunity Fund Letter provides details on the math behind this view:

Over its entire history, the S&P 500’s price-to-earnings multiple has averaged 17.2, which means only roughly 5.8% (1/17.2) of the market value reflects current year prospects. Data on market earnings are most readily available, but you can guess from my former comments that cash flow numbers would be more useful. Regardless, the conclusion remains the same. The market places the greatest emphasis on the future prospects of businesses rather than what’s going on today.

Pop quiz: If some event were to wipe out one year of market earnings/cash flow, roughly how much would you expect the market to sell off? Ding, ding ding: The answer rounds to 6%. Guess how much the S&P 500 is off its highs as I write this?3 The answer rounds to 6%! So the market is telling us that the pandemic will cause a loss of roughly 12 months of earnings/cash flow. The National Bureau of Economic Research said a recession started in February 2020. The US Government’s “Operation Warp Speed” aims for 300M doses of vaccine (almost covers the US population) by January 2021. That might be too optimistic, but first half of 2021 seems reasonable. So that’s roughly 12 months (or a little more) of malaise before a normalization. Obviously, the pandemic hasn’t entirely wiped out earnings even during this period, and it will take additional time beyond a vaccine to heal. But overall, it still seems logical. You might hear pundits screaming about how unjustified current market prices are relative to the economy; the math suggests quite the opposite.

The market believes the pandemic’s impact will be similar to a natural disaster: severe but temporary, with nearly a full recovery once the risk has passed. Fiscal and monetary stimulus are big reasons why this is the case, but that doesn’t make it any less true or “real.” The market can always be wrong, and it will adapt to new information as it comes out. But whenever you hear commentators obsessing about how markets don’t make sense, it’s likely the commentator who’s missing something, not the market.

Regardless of whether the V shaped recovery in the broader stock market portends a V shaped economic recovery,  one issue that no one can avoid is record high valuations in certain high performing stocks.

Great companies with overpriced stocks

Several hedge funds expressed concern about how expensive FAANG stocks have become. They might be great businesses, but a great business doesn’t necessarily a great stock. (This is one of the reasons why we’ve created earnings derivatives)

It seems that the Covid-19 pandemic has accelerated many trends that were favorable to FAANG stocks. Their stock prices has surged. The problem is current prices already included embedded expectations of future growth.  As Harding Loevner pointed out:

The problem in trying to value these rapidly growing companies is that we can’t really know whether the crisis has merely brought forward their future growth (which was arguably embedded in investor expectations, and thus the stock price) or whether it has also expanded their addressable market, thereby extending the duration of their rapid growth. The market’s view is clear: it is apparent that one of the lesser known effects of Covid-19 is to supercharge the embedded growth expectation for the largest and fastest growing companies. Rising to new highs this quarter, the stock prices of these companies continue to stand near the extremes of valuation relative to all other stocks that we highlighted last quarter, even as the entire market has rebounded. So far into the future is the profit growth that some stock prices discount today that our tolerance of high prices begins to feel more like an embrace of fundamental uncertainty the uncertainty of whether we can even begin to properly analyze growth dynamics or competitive forces that result from the new technologies, new business models, or changes in government regulation or taxation not yet on our radar.

Since tech stocks were surging while the real economy was suffering, the tech bubble was on a lot of manager’s minds this quarter. Lessons from the prior tech bubble show the need for prudent equity investing(and the use of new tools). Many older investors have experienced this pernicious cycle, with earnings multiples reaching their peak years after the dot-com bubble crashed.

Yet perhaps there are even more salient examples further back in history. According to Pabrai Investment Funds:

Hardly anyone remembers the Nifty Fifty. This grouping of fifty stocks included such stalwarts as McDonald’s, Xerox, Disney, Coca-Cola, PepsiCo, 3M, Johnson & Johnson etc. These were wide-moat businesses. Many of them are still dominant after half a century. In 1972 Disney and McDonald’s both traded at a trailing P/E of over 70. The FAANGS are great businesses with very bright prospects. Quite similar to the Nifty Fifty. However, every business, regardless of quality, has a finite price. In auction driven markets, it is common for businesses to change hands significantly over or under their real value. That is how we make money.

Like the movie Back to the Future imagine if you could have parachuted forward from 1970 to 2020 and then back to 1970. You’d definitely want to go long Disney and McDonald’s in 1970. It would have been a wise move if you could have stomached the subsequent crash. They got crushed in the ’73 – ‘74 crash. The entire Nifty Fifty was taken out back and shot. One would have to have had a lot of intestinal fortitude to hold these names as their prices drifted lower daily. It was a very rough ride for 25 of the 50 years from 1973 – ‘81 and 2000 – ‘16.

See also:

Inflation and P/E Ratios: The Role of Rarnings Derivatives

Lessons From The First Tech Bubble Show The Need For New Strategies