Being prepared to argue with markets (positions not paying off and adding to losers) and then receiving a big payoff in returns as the markets recognise the value, usually generates a lumpy pattern of return to value investors. Often a fund run by a deep value investor will have months of dull returns, then a spectacular phase of returns as the market comes into gear for their style. The downside of positions and the whole portfolio is typically limited by the value inherent, but the realisation of upside potential comes in discrete phases. Ahmet Okumus had few of these outcomes historically and ultimately defied the stereotypes completely through a rigorous investment process and learning lessons from his own experiences as a fund manager. The Hedge Fund Journal went to his offices on 3rd Avenue in New York to see how he applies those lessons now.
Okumus Capital invests predominantly in US equities using a deep-value investing methodology. The stock selection discipline is rigorously applied in each fund. The core of the investment process is the identification of long (short) stocks that are trading at a large discount (premium) to fair value. The metrics used are ones you see in other firms – P/E, Free C/F multiples, EV/Sales and Price/Book. Stocks will only be bought when they can be acquired for around 40% discount to the internally-generated fair value. Stocks can be considered for shorting when they trade at twice the estimate of fair value and with broken fundamentals.
These are tough bogies to attain. This is one of the key aspects of Okumus Capital. The firm is extremely selective about what goes in their funds. But after a stock/company is assessed to have the right characteristics the firm's only portfolio manager, Okumus, has great conviction about the positions. His experience of running money from a deep value bias over fifteen years is that once you have found the high potential stocks, believe in them and express that belief in position sizing. This conviction arises because of the rigorous research conducted and high margin of safety demanded in each investment. Psychologically the conviction also arises because the hit-rate has been so high historically.
Fig.1 shows that Okumus has a very high hit-rate of trades that are successful, and that the hit-rate is extremely high in bull market conditions. The net long bias of the funds works well against a bullish phase, but the returns during bear phases showed that the alpha generated is not a function of market beta.
Research at Okumus is of a type that is commonly seen at US-focused hedge funds. An analyst from Okumus Capital will take primary responsibility for a potential target company. They talk to senior level officersof the company's major suppliers regarding their sales to the target company. The analyst will talk to the major customers of the target company regarding their purchases from it. In addition an analyst will conduct an in-depth review of all available company documents and research reports and talk to senior management of the target company. The analyst will also talk to major competitors of the target. At the end of the research phase, which includes the analysts building their own independent models, it should be clear whether Street estimates for the company are too high or low, and whether there are potential catalysts visible to change perceptions of the company or earnings estimates. Analysts are given a minimum of five days to do their work if they are looking at a company from scratch. More usually, analysts are refreshing their understanding of a company they have looked at before. In either case a high level of productivity is expected of analysts at the firm.
The other element that shapes the research effort is the tiering of companies by their potential as investments. Research time is a scarce resource so it has to be allocated constructively. Okumus Capital maintains three levels of companies/stocks: the first cut of the 3000 name universe is a list termed the Focus 1 List which comprises of the names that are currently in the portfolio. The Focus 2 List comprises names being watched closely by Okumus Capital as they are near price and valuation levels that will trigger an investment and where research is being conducted today. The third level, the Focus 3 List, is the sole responsibility of Okumus, and that consists of industry leaders and names that are trading well away from the price target and where the manager is simply waiting for the stock to trade at the right price. These lists are very dynamic and are updated on a daily and weekly basis.
Another element of the research process that is important at Okumus Capital is company insider transactions. For longs, although it is not absolutely essential that senior company executives have been buyers of stock recently it can underline a case that is strong on valuation and balance sheet grounds. "It is not just any insider that is useful to track here," explains Okumus. "We give a lot of credibility to purchases by the Head of Sales, the CFO or Treasurer and obviously the CEO. We look at the extent that the transaction is meaningful to the company executive. If the consideration is big for the individual then that has more weighting. If there are stock options involved you have to look at the strike prices – it does not reflect much confidence in the company if stock acquired at $30 from an option is sold at $32 a share shortly afterwards. There are also a couple of companies we follow where there are some individual senior executives that have very good records of timing their stock purchases (and sales) over periods of years."
This is quite an intensive research effort, and most stocks do not reach the required stock price that gives Okumus both the potential for a good return (IRR per position) plus safety margin, which is 40% at the firm. This is where another tool is applied to leverage the research process. Okumus Capital uses options to potentially acquire stocks at the required 40% discount to fair value level, and potentially sell stocks at the desired level to short. Options are only sold: put options are sold to generate possible purchases at the strike price minus the premium received; and call options are sold to short stocks at the strike price plus premium received. Full fundamental analysis is done to determine the strike price at which the options are written: the options are a means to execute the fundamentally-driven value-based equity strategy. This tactic works best when traded option volatility is high. Both traded volatility and actual volatility have come down a lot as the bull market of the new century has evolved. This has changed the number of positions it is feasible to use options to acquire/sell.
So in 1999 it was possible to generate 20-25% of fund P&Ls from exposures to stocks taken through options. Three years ago that was down to 10-15%, and last year only 5% of fund profits came from exposures taken on through options. The use of options to affect stock purchase and sale disciplines at Okumus is not across the board. Where a catalyst has been identified to potentially cause a change in the stock price then options will not be used. To put it another way, options are used where the required IRR does not have a high probability of being generated in an appropriate time-frame because of the absence of a catalyst.
The criteria used at Okumus Capital to find short stocks are used elsewhere: bad businesses to be in, substantial debt with low or no return on equity, negative free cash flow, weak management, bad capital allocation, and warning signs in financial statements. One of the lessons that Okumus has learned is that on the short side over-valuation is not sufficient. "I suffered in the tech bubble as stocks I shorted with a valuation of 150 or even 170% of our fair value carried on going up. Now the overvaluation has to be more extreme for us to consider shorting (100% above fair value) and we absolutely require a clear catalyst." Catalysts could be a deteriorating balance sheet, a new product announcement, or expectation of disappointing earnings release. Major announcements can be catalysts for longs such as a spin-off or a stock buy-back.
Like all good hedge fund managers Okumus will review his activity periodically. Up to November 2002 he used three valuation criteria on top of deep fundamental analysis to select longs: 1. Multi-year low for Price/Free Cash Flow; 2. Lowest Price/Sales and Price/book since 1990; and 3. The Lowest Price/Sales ratio in 5 years. His review led him to conclude that using criteria 3 had led to selecting too many losing and volatile positions. In the period up to the time of the review the hit-rate of positions was 90%. Since eliminating the use of criteria 3 for selecting longs the hit-rate has increased to 98-99% and more importantly from a commercial perspective, the volatility of returns has come down substantially. A consequence of this change in selection criteria is that annual turnover of longs has gone from 5 times a year (average holding period 4 months) to 3-4 times a year with an average holding period of 6 months.
The average holding period of Okumus funds is short for a deep value manager, though the turnover as measured by the number of positions is not. This is because of the position sizing. Or to put it another way, the returns generated are high as the capital committed in the funds is highly productive. Put simply these are concentrated portfolios with a very low number of losing positions.
The Okumus Opportunity Fund was the first fund from Okumus Capital, and it truly expresses Okumus' way of addressing markets. Not all investors have been able to stomach the month-to-month volatility of returns of the core Okumus Opportunity Fund (see Figure 2), even after revisions to the risk framework in 2003. Okumus has recognised this by introducing the Okumus Diversified Fund which aims to limit downside deviation through the portfolio management rules given in Figure 4. Now the firm runs four strategies, each with an onshore and offshore version (see Figure 3). The funds other than the Opportunity Fund have return and downside volatility targets that fit with a broader investor base than the Opportunity Fund can appeal to.
The managing of position sizing (money management as it is called) is unusual for the Okumus Opportunity Fund and indeed the other funds of Okumus Capital. "If we like a stock and can acquire at the right price, then I buy a position," states Okumus baldly. There is no phasing in of positions. From his experience Okumus has developed great conviction if the stocks meet his very strict criteria. On the day of the interview the Opportunity Fund was 40% invested – 40% long and no shorts. There were four positions in the fund in addition to option positions. If there were five qualifying names there would be five stocks in the portfolio. If three names from the same industry qualified they would all be in the Opportunity Fund, but may be sized differently in the other funds where there are exposure limits.
This combination of deep research and concentrated portfolios is a latter-day take on the investment style of Warren Buffett, a man who ran a hedge fund in the 1960s. One of Buffet's baseball analogies is that of a baseball slugger, investors should wait patiently for the ball delivery that suits their style. This is exactly what Okumus does. Asked, what does he do when there are no opportunities at the right price, Okumus replies "Keep waiting." For most of the time that Buffett has run Berkshire Hathaway he has run concentrated equity portfolios and famously cares about the last nickel on the entry price.
Clearly there are differences in turnover: Buffett has had more or less permanent positions, Okumus Capital has a holding period measured in months. This requires a productive research process as well as stock selection discipline. Often Okumus Capital captures the large-scale moves of the early stages of long-term stock price turnarounds. Unlike some top-tier hedge fund managers Okumus claims no special skill in the timing of the closing of positions. "I know we leave a lot of money on the table," confesses the studious Okumus. "We close out when longs are at a 10-20% discount to our estimate of fair value."
In order to help deliver the downside volatility characteristics given in the objectives of the Diversified and Technology Funds the manager has had a portfolio stop-loss policy for the last four years. For a month-to-date fall of 2 12% for either fund the net exposures will be cut by 25%. For a 5% MTD fall exposures are cut a total 50%. A danger of this sort of policy is that funds can be forced out of markets when they start to recover. At Okumus Capital a 1% recovery from where the stop-loss was triggered will cause all the positions to be put back on in the two lower-risk profile funds.
Okumus Capital has 14 employees – 9 investment professionals and 5 staff with operational and risk control duties. The key staff members to the investment process, other than the CIO himself, are the analysts. The analysts at the firm may have buy-side or sell-side experience: either can be valid for the deep-value approach. "I don't have the time to train analysts for the basics," says the 37 year-old money maestro. "So the analysts come here time-served with some good companies, but the key is they must have good accounting knowledge and understanding, combined with excellent financial analysis skills. I have CPAs and CFAs working here and they must all be able to read and interpret financial statements. They have to be able to identify a build up of inventory, and understand the significance of it. What I really want is for the analysts to be able to connect the dots in a particular company and industry. You can't really do that fresh out of college, so experience counts for a lot."
The CIO of Okumus Capital sets the tone for the firm's work ethic, and he expects his leadership in this regard to be followed. "What I want to see when screening for new analysts is passion. You have to have passion for the markets to put the hours in. If you don't love what you are doing it is never going to work."
One of the areas that investors in hedge funds investigate when considering investing in a hedge fund is whether the manager is financially committed to the business of managing the fund. The ownership of the management company/advisor is typically checked, as is the extent of the manager's investment in his own fund. In both regards Okumus harks back to a bygone era. One of the keys to the accumulation of wealth by the likes of Soros, Steinhardt and Buffett is that they had their capital tied up in tax-advantaged pools, and the capital was allowed to compound over a long time. Whilst the tax benefits of offshore fund structures are readily appreciated, Buffett used the tax advantages of an insurance company balance sheet to great effect in a similar way. Okumus has applied the lessons of the past masters and through the reinvestment of performance fees has built up his ownership position to account for most of the 25% of firm capital that is sourced from employees and principals of the firm.
Parenthetically, a good chunk of the capital in the Okumus range of funds comes from HNW individuals and family offices. Funds of funds contribute a mere 12% of the capital. A typical attitude from the naysayers is that the volatility of the funds is too high, and "isn't he the guy that had that massive drawdown?" This illustrates that databases do not tell the whole story, and that improvements in process and risk management are not necessarily allowed for. Some investors in hedge funds can have narrow understanding of what truly is the risk in an equity hedge fund, a cause of frustration to Okumus himself at times.
"Risk for me is not the volatility of the fund. With our portfolio constituents we have an in-built value floor to the stock prices,"explains Okumus. "We know the intrinsic value of our holdings. Without that knowledge, investors are making investment decisions without full understanding. To me, the risk in portfolio management is characterised by the proportion of trades that are losers and how big the losses are on a realised percentage basis when you get a position wrong."
Some great track records amongst hedge fund managers are built on added-value from stock selection and market timing magnified by the judicious application of leverage. So in stating that his long-term ambition is to build the best long-term track record amongst managers of equity funds, quite rightly Okumus qualifies the goal with "adjusted for leverage/gross exposures." Where does he stand against this lofty goal? Looking at the track record of the Opportunity Fund – the one that is truest to his own instincts as an investor – then he is nearly there. In five months time the Opportunity Fund will have a ten-year record, which is long-term by anyone's measure, and with a billion dollars under management we are not talking niche strategies here.
Okumus invests in markets with iron discipline, and applies a great determination to achieve his goals. Who would doubt that he will be the best performing equity specialist among hedge fund managers? And you know, the improbable thing is, he seems to be getting better as he has refined his process.
In the medium-to-long-term future it would not be a surprise to see the Okumus Capital CIO apply his investment principles to markets outside the United States. Although the academics of the hedge fund world claim that there is not the persistence of performance amongst managers, who would bet against the driven Okumus being atthe top of the rankings when he has completed the second decade of his track record?