Fundamental Investing in US Equities

Where to go long and who to short

MALCOM FAIRBAIRN, CIO & FOUNDING PARTNER, ASCEND CAPITAL LLC

My background is I have a bachelor’s and a master’s degree from MIT. I worked as an engineer for a while and then proceeded to work for a start-up company. I went back to school for my MBA at Harvard Business School. Once I graduated, I had an opportunity to work in Harvard Management, but ended up working at a firm called Strome Susskind.

If you ever want to start a fund, it is best to start it during a bad time. The environment that existed in 2000 was an environment in which John Templeton made $100 million personally by shorting every company on ipolockup.com. There were a lot of liquidity-based issues. Since stocks, first and foremost, follow liquidity, you had a ton of terrible companies where you had 10% of the float outstanding and 90% of the stock coming off their IPO lock up where people wanted to sell. It was a once in a lifetime opportunity on the short side. We didn’t cover a short for two years.

Ascend was founded in January of 2000. We’re a focused long/short equity strategy. We started with $3.3 million. Half the money was my own at the time and I still have the vast majority of my money in the fund. I think that has definitely changed my incentive structure. You want to make sure that you preserve capital but also make money which is very much in alignment with our investors. I definitely encourage all senior employees to put a large percentage of their own money in the fund as well.

Accounting matters
The first thing is accounting. When we started in 2000, accounting was a big opportunity because there was so much bad accounting. For the most part, if you follow the cash you get the answer right. Don’t look at the income statement; look at the cash flow statement. If you follow the cash flow and follow the balance sheet, you’ll get things right more times than not.

The companies with really bad accounting end up going bankrupt. Companies like Nortel, that self-funded their growth, got into an awful lot of problems. Currently there are certain countries that are self-funding their own growth. It’s an interesting situation if you look at those countries as if they were companies. Would you believe these countries would go bankrupt as well?

We then went through a period of time where the accounting was pretty clean. In the last three or four years, several companies have tried to fund their own growth and do the same thing that Enron did – use their balance sheet to obscure what the true earnings power is and fund their own growth. These are always great short candidates.

There are certain areas where people get accounting wrong. People usually get currency wrong, they get pensions wrong, and if you follow those through you can come up with what the right answers are. Even with a $200 billion consumer goods multinational stock earlier this year, it was very obvious that earnings estimates were 10% too high because of currency. When they finally got on their conference call and said earnings estimates are going to go down 10% because of currency, the stock still sold off. Don’t underestimate the obvious and take advantage of these types of situations.

Alpha, compounding and performance attribution
We measure our performance by Alpha. We have a sector-focused approach. Currently we have seven different people that manage money within their different sectors. We also believe in the power of compounding. I think Ben Franklin said that compound interest was the eighth wonder of the world. In 1790, he left in his will an investment of $4,500 to be placed in a trust for 100 years. After the first 100 years the trust had grown to $400,000 and by 1990 the remaining amounts grew to $4.5 million which in turn has helped fund the Boston Public Library. It’s just the power of compounding over a long period of time. The lack of drawdowns is key to that. We have set up our system not to fail.

Long/short equity was set up in 1949 by A.W. Jones and I think that long/short as a general category has worked pretty well. There are two different styles of long/short. One is the event driven where you’re taking advantage of capital arbitrage, you’re taking advantage of event-driven specific items. The other area is that it’s sector-specific focused work, so if you focus in on only your sector, you’re going to know your sector better than the competition.

If you’re looking at a long/short portfolio, there are three different drivers of performance. The first is stock selection and that’s the part that can’t be explained by anything else. The other ones are sector allocation and market exposure. These are your three big levers. What can’t be explained by markets and can’t be explained by sector, can be explained by stock selection.

Buy-backs versus issuance
It is a very impressive list of stocks that have shrunk their share count year in and year out. It’s like increasing the dividends every year because if you are buying back stock that means you have a good business, high ROE, and generally have a good discipline on allocation of capital. If you’re increasing your share count, it means that you probably have problems. The best shorts are ones that have capital structure issues where they’re over levered in a marginal business and in some way or another you’re going to have to issue dilutive equity. There are also certain businesses that through no fault of their own but are in the wrong space at the wrong time. I think these are a good source of short opportunities as well, but ideally it’s your spread between your longs and your shorts that matter the most. When you use your shorts to fund your longs, you can create non-correlated positive return streams which is the goal that everybody wants to achieve.

Company meetings and fundamentals
Good longs – we’re looking for improvements in revenues, better earnings growth, stable ROIC, competitive advantage, under-levered balance sheet, high barriers to entry. Shorts we’re looking for the opposite of that – deteriorating fundamentals and liquidity issues. Liquidity issues are actually my favourite on the short side. It’s over-levered companies, deteriorating cash flow, and also if there are large discrepancies in cash flow versus reported earnings.

Several companies have been caught recently with Brazilian exposure and their receivables were going up significantly. You can talk a lot about it but the issue is if your receivables are increasing a lot, you have to make up for that somehow. I think it’s a very good source of short ideas when you’re looking at this but doing balance sheet analysis.

Short criteria include increase in competition, product cycle, weak and unsustainable capital structure, and flawed business models.

Healthcare sector
What is interesting about the healthcare sector is that most drugs are set up like a toll bridge. The acquisitions actually work because you’re not going to lose share. For example, if a pulmonary company buys another pulmonary company, you literally get rid of one company’s entire sales force (S). You have one salesman selling two products instead of one calling on the same doctor – incredible productivity and efficiency. Next, G&A can be significantly reduced by eliminating redundancies and R&D can be stripped out.

By eliminating S, getting rid of G&A, and R&D, and reducing the tax rate, suddenly one can strip 20 to 30 points out of the operating model. It’s just gushing cash, so you can buy companies at 10 times the EV to EBITDA, and then you can almost get a 20% IRR on it because you take out costs from SG&A, R&D and save on taxes.

Longs and shorts
A US fertilizer company is an example of a recent winner. It is a low-cost producer of nitrogen-based fertilizers that uses natural gas as an input. The US is a net importer of nitrogen-based fertilizers so the US is going to be cost-plus relative to the other areas. If you are producing a commodity, you want to be low cost. When we bought this company, it was selling for eight times free-cash flow – four times the EV to EBITDA. They were buying back 10% of the company on a quarterly basis – it is fair to say nobody liked them.

A certain US E&P company has been one of my favourites on the short side lately. It’s the modern day Enron. However, unlike Enron, everything was laid out in its disclosure. The US E&P company basically told you that there’s no cash flow, there’s no real earnings, it’s over levered and cash flow is very dubious. I don’t think there was anything that was illegal. It is just a very bad business model that people didn’t understand.

Oil services shorts
One of our current shorts is a deep-water driller. The deep-water drilling is a terrible business. It makes the airline business look pretty good. One reason the airline industry is such a bad business, is that when one airline goes bankrupt the planes don’t go out of service, somebody buys the planes, spray paints their logo on it and it’s right back out flying ruining the business for everybody else. The reason that deep-water is worse is that it costs $50 million to stack a rig. From the rig owners perspective it is better to rent it for free than to stack it.

The market is oversupplied on the deep-water side and deep-water has become the high-cost producer of oil. Onshore shale oil is now lower cost than offshore meaning it will come back first. When we take this into account and put today’s rig prices into an income statement, we believe deep-water drillers are 8.5 times EBITDA to debt, meaning the equity has no value.

Again, this deep-water driller is a highly levered entity in a deteriorating environment. The company has good management, but it is just a bad business, and they’re over levered.

Macro view
To me the US looks like it’s okay. The GDP looks fine and hourly wages are starting to tick up.

This economic expansion is not going to be over until we have a housing cycle, a credit cycle and a capex cycle from a US centric standpoint.

I agree with Dornbusch that economic cycles generally don’t die of old age, they’re murdered by the Fed, and it’s usually to fight inflation.

To increase residential capex, it’s in everybody’s best interest to alleviate some of the very negative rules and regulations on the housing market. The housing market regulations are too tight when Bernanke can’t get a loan because he lost his job. Housing starts should go back up to a more normalized rate, which should increase GDP by a couple percent.

We are now in an industrial recession. Everything associated with the mining and materials sectors is very weak. Recently Parker Hannifin and Emerson confirmed this with their weak orders. Layoffs are happening in the energy patch, and on the industrial side. We’re going to see significantly more negative earnings revisions later in this third quarter. Much of the cause of this is by what is happening in China, Brazil, and the rest of the world.

US wage inflation
In a recession you have six people looking for one job and there is no wage inflation. Currently there are two people looking for one job, and because of this the US is experiencing 2.5% to 3% wage inflation. If you were taking your Economics 101 mid-term and somebody told you that unemployment is 5%, wage inflation is 2.5% to 3%, where should you set rates? You would answer 2.5% to 3% and that is where Yellen wants to set rates. She believes she’s behind the curve and wants to raise rates soon.

I don’t think raising rates will hurt the economy or the market. However, what could potentially derail the market is the unintended consequences of the stress that it puts on the rest of the world.

US small-cap valuations and liquidity
The area that is very overvalued right now is small-cap stocks. I think we could be entering a 1998 type of situation where small caps dramatically underperform. The underperformance will be based on illiquidity. It doesn’t take a lot for them to start underperforming. Recently, there has been a lot of money that has gone into smart Beta or smart Alpha strategies. These strategies are equally weighted indexes instead of market-cap weighted indexes. In effect, these funds sell Microsoft and buy a $100 million company. I’ve traded small caps before and can verify there are no bids in a down tape.

European wage inflation
I think Europe looks pretty good. Europe is benefitting from QE, weak energy and a weak euro and Germany has been one of the biggest beneficiaries of these trends.

Germany’s willingness to allow for some inflation has been very positive for the rest of Europe. It allows for the rest of Europe to heal without having prices go down due to inflation. And as John Maynard Keynes says this allows for the errors or stupidity and the optimism.

China overcapacity
China just looks horrific. If you start with China capex relative to GDP, there are only a few countries in the history of the modern world that have even come anywhere near 40%, 45% of capex relative to GDP. The most recent ones were Thailand, Indonesia and Singapore in 1998. When this bubble burst Thailand’s market went down 90%, its currency corrected by 50% and its GDP fell by a third.

Currently the IMF estimates China is running at 55% capacity utilization. It’s utter insanity to have almost half of your plant and equipment sitting idle and spending half of all GDP building stuff that’ll never be used. And China has been borrowing to pay for this. They’re using debt to build stuff that’ll never be used. Their goal is to transition from a durable to a non-durable economy without having any hiccoughs. There’s an awful lot of consternation right now. To make matters worse, China is the high cost producer of iron ore, met coal, urea, polyethylene, polypropylene, the aromatics chains, the fertilizers, and aluminium.

Japan’s demographic challenges
Japan is a fascinating study too. We had a demographer that came in two years ago and according to his numbers, he believes the last Japanese goes extinct in 2450. When running the numbers, we still had 200,000 to 300,000 Japanese around in 2450, but his point is well taken that there will be half the population by 2100.

Japan is in a very difficult situation. It’s debt to GDP is over 2.5 times. The BOJ’s debt to GDP is already at an alarmingly high level of 0.7. If interest rates go to 4%, all of Japanese tax revenues goes to paying interest. Japan wants to have 3% inflation with 1% interest on long-term debt. I don’t think that exists. I think it’ll be the first major country to have significant problems.

The above is a transcript of a presentation made at the 4th FERI Hedge Funds Investment Day, held in Bad Homburg, Germany on 10 September 2015.

Malcolm Fairbairn founded Ascend Capital in 1999. Prior to launching the fund, Mr. Fairbairn was Managing Director of Structured Equities for Citadel Investment Group, Inc. in Chicago, Illinois. Subsequently, he launched and was portfolio manager for Orchard Partners, L.P., for Citadel Investment Group in San Francisco. From 1994 to 1997, Mr. Fairbairn worked as senior analyst for Strome Susskind, L.P. and was a portfolio manager for Strome HedgeCap, L.P., in Santa Monica, California. In 1993, he served as an equity analyst for Capital Research and Management Group in Los Angeles. Mr. Fairbairn received his M.B.A. from Harvard Business School in 1994 and was awarded his B.S. and M.S. degrees in Chemical Engineering from Massachusetts Institute of Technology in 1985.