A growing proportion of institutional investors are prioritising a track record on the short side, according to studies such as the 2019 Credit Suisse Hedge Fund Investor Survey. Yet after a ten-year bull market in US equities, many managers struggle to demonstrate consistent alpha on the short book – let alone the absolute profits that Cooper Creek Partners has delivered – and some have even given up trying to pick single stock shorts. Of course, some managers are content for their short book to simply underperform their long book, while helping to finance the longs, and reducing overall strategy volatility. If this is the aim then using broad market or sector indices for part or all of the short book might well be appropriate. Cooper Creek founder, Robert Schwartz, only trades single stocks on both sides, and every position is intended to be a profit centre. Cooper Creek’s performance attribution at first sight seems atypical and uncorrelated in that the manager has sometimes profited on the short book and lost on the long book, during years such as 2017 when US equities rose. Shorts have made absolute profits in four of the past five calendar years, and in 2015 short alpha was a stonking 21.5%. Upon closer examination, Schwartz is something of a maverick who clearly has a contrarian streak: analysis of 13F filings and prime brokers’ lists of crowded holdings shows not only a minimal overlap with typical “hedge fund hotel” stocks, but also reveals that Schwartz is sometimes on the opposite side of such consensus trades.
A short theme that has not been dominant over the past few years could come to the fore over the next few: debt maturities, and debt covenant issues.
Robert Schwartz, Founder, Cooper Creek
Cooper Creek’s investment universe of around 600 stocks is drawn mainly from Russell 2000 index constituents with market caps between $250 million and $10 billion, but financials and healthcare are excluded as the team has not specialised in them, and Schwartz views them as being too politically driven. A handful of Canadian-listed companies with US operations can be included. Schwartz is foraging for opportunity in what is relatively neglected territory – for the buy side and the sell side alike.
Few managers focus on US small caps in the first place; those that do tend to be long only or long-biased; even long/short players often pay less attention to their short books; many populate the short side with larger market cap stocks; and broadly market neutral managers will often look for pair trades within the same sector, rather than individual short ideas.
Sell side research coverage is patchy for Cooper Creek’s investment universe: “10% have no coverage, and 50% are only covered by three or so brokers – versus 20 or more for many US large caps”, says Schwartz. “We build our own valuation models from scratch, but do find several dozen selected sell side brokers useful for trading capabilities, to get a handle on consensus forecasts and to secure corporate access,” he adds. In Europe, MiFID II has reportedly reduced already limited coverage of small and mid-cap stocks. If a similar trend takes hold in the US, Schwartz would welcome it as increased inefficiencies would improve his opportunity set.
Cooper Creek’s investment team, including three investment professionals in addition to Schwartz (AJ Strasser, Matt Sherwood and Joe Roszkowski) each specialise in sectors. Schwartz focuses on retail, consumer products, leisure, media; Strasser on energy, food, commodities, government and defence; Sherwood on industrials and special situations, and Roszkowski on retail and restaurants. Strasser and Sherwood have been with the firm since 2009; Roszkowski joined in 2017, having formerly worked at Folger Hill and Citadel’s Surveyor Capital. The team meets companies; produces in house cash flow forecasts; attends industry and broker conferences; hustles for political, regulatory and legal intelligence; and monitors insider buying and selling.
10.2%
Cooper Creek’s net exposure – averaging 10.2% in a fairly tight range since 2008 – has actually been tighter than that of some funds categorised as “market neutral”.
The process has generated roughly four times as much short alpha as long alpha since inception. The short approach has been honed and refined over the years. Shorts come under six thematic categories. “Accounting shenanigans include companies with aggressive accounting; M&A accounting shenanigans can drag on for years after companies have over-stated earnings and firms with deceptively high dividend yields often prove vulnerable so cashflows are scrutinised to predict dividend cuts,” says Schwartz. “Beyond this peak margin stories are companies around the top of the cycle including some retail and industrial names in 2019. One hit wonders or one-time events such as regulatory and legislative issues or tariff exposures are another group.” Short themes will move around with the economic cycle: “Another short theme that has not been dominant over the past few years could come to the fore over the next few: debt maturities, and debt covenant issues,” he continues. “There are several ways to win on the short side.” Though Schwartz is confident in his shorting prowess, he is also humble enough to adhere to strict rules about reducing short positions that breach pre-defined loss thresholds.
While shorts typically have a three to six-month time frame, longs are more often held for nine to eighteen months – and are sized larger. “Value with a catalyst” is a phrase widely used for categorising a style of management that is not purely about buying cheap stocks, because it requires an identifiable catalyst that might lead to a recovery in earnings, or valuation multiples, or both. Cooper Creek seeks catalysts that can be hard events or softer processes. Turnarounds; restructurings; operational improvements; changes of business model; or changes of management are examples of soft catalysts. Regulatory or legal changes, such as gaming liberalisation or tariffs; litigation; emergence from bankruptcy; balance sheet optimisation or spin-offs are harder catalysts.
Plenty of event-driven managers are also looking at these situations. What really sets Cooper Creek apart is its contrarian mindset. “We seek out ‘icky’ sectors, of which retail in the US is currently the ickiest,” he says. “I started out as a retail analyst in investment banking, at Banc of America Securities, and at JL Advisors. In 2019 a number of consumer-facing stocks drawn from the restaurants, leisure and gaming sectors have made some of the best long book contributions.” Though Schwartz has identified some compelling longs in retail, the strategy is in fact net short the sector overall. The poor sentiment towards retail has also thrown up sum-of-the-parts valuation anomalies, where the negative perception of a retail division is overshadowing value elsewhere. Of the top five long positions disclosed in the first quarter 2019 report, Schwartz is most excited about Caleres, which is a classic conglomerate discount story. Caleres combines two divisions – footwear retailing and branded footwear manufacturing. Schwartz is of the opinion that the whole company is being valued on a lowest common denominator basis, at a multiple that is typical of retailing – but well below manufacturing. If the manufacturing unit was re-rated to a valuation matching its peers – which might eventuate in its being spun off – Schwartz could envisage 100% upside.
With only 25-35 longs, Schwartz is highly selective, and will not necessarily find value in all of the most out-of-favour sectors. For instance, coal and tobacco have been underperforming, partly due to them increasingly being excluded by ESG investors, but Schwartz has not identified interesting stocks in either of these sectors.
Once the market recognises the value that Schwartz has identified, he will tend to take profits and redeploy capital into fresh ideas. For instance, the 2019 rally means that some stocks have already hit Schwartz’s price targets. One example is The Children’s Place. “We were excited about the acquisition of Gymboree, but the stock appreciated faster than we expected. We often trade around names, and could re-enter on a pullback,” he says.
We seek out ‘icky’ sectors, of which retail in the US is currently the ickiest.
Robert Schwartz, Founder, Cooper Creek
Cooper Creek’s net exposure – averaging 10.2% in a fairly tight range since 2008 – has actually been tighter than that of some funds categorised as “market neutral” and Cooper Creek could reasonably be described as “broadly market neutral”. Schwartz chooses to classify the strategy as “long/short equity” because its style of management – a concentrated portfolio of single stock picks – is more typical of long/short. And unlike some market neutral funds, Cooper Creek is not sector neutral: the strategy can be net long or net short of the sectors it picks stocks from. Cooper Creek’s volatility is also a bit higher than that of some hyper-diversified market neutral funds. In common with many equity hedge funds, Cooper Creek can use call or put options, mainly for risk management.
Some market neutral funds (and alternative style/factor/risk premia strategies) are also explicitly trading styles or factors, such as value, growth, momentum, quality etc whereas Cooper Creek’s exposures are predominantly to idiosyncratic company risk. “Factor analysis does identify a small cap bias, because the strategy tends to be net long of small caps. There has also been a slight bias to value, and – unsurprisingly given the contrarian bent – a slightly short momentum tilt, which has sometimes contributed to performance setbacks. But overall no factor stands out and we analyse potential risks to make sure no exogenous risk factor could hamper the strategy,” confirms Schwartz.
Nonetheless, Schwartz does expect that if value investing returns to vogue, this would be good for his style of investing. The underperformance of value in 2017 and 2018 has, to some extent, been a headwind for his long book; though he also admits he was too patient with a couple of turnaround stories and the resurgence of performance is partly due to some tweaks in the process. Schwarz has noticed that, “investors are not rewarding turnarounds at the first inflexion point but are rather awaiting several quarters of evidence,” and has modified the timing of these trades accordingly.
The latest leg of the US bull market has arguably been driven at least partly by corporate tax cuts. Some hedge fund managers pride themselves on their political prognoses and analysis, but this is much less relevant for Cooper Creek. Granted, policy changes such as tariffs have sometimes contributed to the investment thesis for some of Schwartz’s single stock ideas. But being broadly market neutral means that Schwartz is not really worried about macro level issues such as US corporate tax. Arguably, small and mid-cap US companies that were actually paying 35% corporate tax have been the biggest beneficiaries of US corporate tax cuts, which some Democratic Presidential candidates, such as Joe Biden, would reverse if they came to power. But Schwartz, “does not envisage any large positive or negative impact from changes in corporate tax rates”. US politics is clearly polarised and if the pendulum does swing to the left, Cooper Creek will simply continue its tried and tested approach of searching for mispriced stocks.
The UCITS is an ideal way to expand the investor base because European investors have a strong appetite for lowly correlated, differentiated strategies that can diversify their portfolios. Day one assets of $110 million at launch on November 12, 2018 made this one of the largest alternative UCITS launches of 2018. An anchor investment came from Quilter Investors, the multi-asset investment management business. Firm assets are at currently c$200 million as of June 2019. Schwartz started the strategy in 2008 with his own capital (which came from his remuneration at previous employer JL Advisors) and remains the largest investor in the non-UCITS fund. He tentatively suggests that strategy capacity across all vehicles could be around $1 billion, but is quick to point out that he would close the fund to new investors if there was any sign of asset growth impairing returns.
Schwartz spent two years talking to platforms before deciding to partner with MontLake, which set up its Irish-domiciled, UCITS platform (which has received awards from The Hedge Fund Journal) in 2010. “We interviewed 12 platforms and chose MontLake, because we liked the team and people, the size of the platform, and their marketing capabilities. Reference checks were positive,” he explains.
The mandate of the UCITS differs from the existing offshore fund in two respects, due to the UCITS’ daily liquidity and the UCITS rules. Gross exposure is around 90% of the offshore fund and a small number of microcap positions do not fit into the UCITS. Over time Schwartz only expects a marginal divergence between the two.