Swimming Against The Tide

Stock picking underlies Farringdon performance

Originally published in the February 2009 issue

Not every fund in the long/short equity sector is hurting. Farringdon Alpha One, launched in December 2006 by Geneva-based Farringdon Capital Management, has posted two straight years of modest, albeit impressive, gains given the turbulent backdrop to global stock markets. What’s more, it managed to increase assets under management in 2008 during a time when the overwhelming majority of funds suffered from redemptions.

The firm’s three portfolio managers – Andreas Tholstrup, Bram Cornelisse and Dennis van Wees – are practicing low-key stock picking based on bottom-up research into companies’ financial and operating data. With the managers devoting their full attention to picking long and short stock positions, both the use of leverage as well as the net market exposure is minimal – with the latter generally veering between 30% and -30%. Consequently, the impact of market volatility is dampened although the wild swings during some trading sessions in recent months meant that no fund could entirely escape the fallout.

“The whole idea behind Farringdon came from the time when Bram and I worked extremely well together at Merrill Lynch on the Scandinavian equity research sell- side team in London,” says Tholstrup. “We found we complimented each other well by bouncing ideas off each other and working to hone our valuation skills.” The partners met at the investment bank in 1996. In 2002, Tholstrup joined Carnegie Asset Management, the Swedish investment bank and fund manager, in Copenhagen, where he founded and co-managed its WorldWide Long/Short Fund, which grew to 700 million during his four years in charge. Bram remained at Merrill until both managers joined forces in the spring of 2006 to set up Farringdon. Van Wees who previously worked with Bram at Merrill Lynch subsequently also joined from Aegon.

Geneva is far from being a magnet for single manager hedge funds, though the city’s profile has certainly received a boost from the launch of Jabre Capital Partners in 2007. Farringdon set up there since the city, while not as established as Zurich or Frankfurt as a financial centre, is on the circuit for public companies doing road shows to meet investors, thus ensuring access to vital information. The partners’ growing, young families also featured in the relocation decision.


Minimal funds of funds allocation

In a movethat is scarcely imaginable now, the new managers didn’t bother to approach seed capital investors. Nor did they seek early allocations from funds of hedge funds – a key part of the investment landscape in Switzerland. “From seeing potential investors, we knew nine months prior to launch that we had enough money to start with,” Tholstrup says, noting that the fund’s main backers are institutions and family offices. Even now, fund of fund money is less than 10% of AUM. “It has been a good thing in a year like 2008,” he says. “The investors we have in the fund tend to be much more stable.”

The fund, which gained 4.9% over 2008, grew to 135 million from 120 million during the year. Most of the money came from existing investors but some came from new backers. The laudable 2008 performance built on a 15.6% return achieved in the fund’s inaugural year during 2007.

A revealing thing about the firm is that the three managers only have one other in-house staff member, an office manager. Farringdon is able to operate this way because it outsources virtually all its non-investment functions including administration, middle and back office, information technology and parts of marketing. The result is the investment managers are free to concentrate on the portfolio. Asked about the firm’s svelte shape, Tholstrup says the biggest manpower saving comes from not having a back-office and marketing team. “We made a conscious decision not to market the fund to investors,” he says. “We have spent very little time on marketing and we have travelled only three or four days each year for marketing purposes. What we wanted to do was run money and not do a lot of marketing. Our philosophy is that if the track record is there, the money will follow.”

Farringdon’s fundamental research focuses on Europe and covers a wide range of industries and market capitalisations. Just as market exposure is low, the fund also abjures taking high volatility, single factor risks with heavy geographical or sector concentration. Sector exposure typically will not exceed 10% of the portfolio, either long or short. The partners expect this will produce low correlation to other asset classes. To maintain the integrity of the investment process, the fund is to soft close at 250 million and hard close at 400 to 500 million.

The fund’s limited net exposure and cap on gross exposure at 180% is spread among 15 to 30 positions on the long side and 15 to 30 positions on the short side. The limited leverage is financed through the short positions. The fund carries a minimum of 30 positions in order to ensure sufficient diversification. Conversely, having a limit of 60 positions enables the managers to maintain a deep understanding of each individual position and a qualitative overview of risk levels.

Some positions held for years
The portfolio is structured around pair trades as well as single long and single short positions. Tholstrup sees the pair trades as lower risk, shorter duration investments of up to several months. In contrast, the fund’s holding periods for structural long or short positions can be years.

Like a number of managers, Farringdon got caught in the cross fire surrounding Volkswagen. The short position the fund entered into saw its net exposure plunge to -20% – its lowest level throughout 2008 and a consequence of the stock soaring in response to Porsche’s undisclosed creeping control of VW via options trading.

“Normally we do not engage in crowded trades,” Tholstrup says, discussing the VW trade. “However, we thought because it was so over valued it was worth it,” a position that the managers laid out in some detail in their end-of-September investor letter. That cost the fund about 7% even though it didn’t exit the trade at the worst possible time.
The structure of the trade offered some protection for the fund. Farringdon took out a term loan on the VW stock with March maturity. “With a term loan you can protect yourself,” Tholstrup says. “It gives you a different time perspective.” Index changes in Germany have improved liquidity in VW shares and the fund’s position has now fallen to about 1% of AUM. On the dubious German regulatory framework allowing Porsche’s options strategy, he observes: “Options can confer control so there should be provisions requiring disclosure.”

The fund has bounced back with a 4% gain in January amid some early year buoyancy in equity markets. But the fund still expects to make money on its short book even when markets are rising. Tholstrup says it made “good money” on its shorts in 2007. “From a short perspective, the first half of 2007 was very difficult but we still made money on our short book,” he says.

Now, however, the investment backdrop is throwing up a variety of buying opportunities. “What has happened through the last couple of months of 2008 is that we have found lots of cheap stocks,” he says, while being careful to stress that the new environment hasn’t led to changes in risk management or the portfolio structure.

“We are not very thematic in what we do,” Tholstrup says. “It is pretty much dependent on single stocks. We are happy to operate in themes, both on the long side and on the short side. For us what matters is the value of individual companies. We wouldn’t describe ourselves as value investors, but we have a valuation bias,” he adds. “The difference is that we don’t mind buying things on a price/earnings rating of 20 if it makes sense and it often does.”

Low portfolio turnover
Running a fundamental portfolio means that each position is based on an investment case and modelled using spread sheets. Since Tholstrup and Cornelisse are bottom up stock pickers, not traders, the portfolio, on an averaged basis, is turned over only about twice annually.

The spread of geographic exposure is 70% Europe, 25% North America and 5% in the rest of the world, but mainly Hong Kong. On a sector basis, the fund tends to eschew biotech and mining plays. “They are binary outcomes,” says Tholstrup. “We don’t like that. We can’t add anything.” Since the credit crunch began in mid-2007, the fund has stayed away from financials. Tholstrup attributes this to companies’ not disclosing the relevant data the firm uses in its modelling, though he notes that this is starting to change. “We are fairly active in the market with pretty much everything but financials, biotech and mining,” he says. “With everything else we are pretty active.” Among the managers’ favoured areas for both long and short positions are gaming, software, medical technology, food processing and pharmaceuticals.

An interesting case study of a profitable shorting strategy saw the fund target the gambling market. Tholstrup explains: “In 2007 we started to short US casinos. Bram found that they traded at a very high book value. For some companies there are good reasons for that if they make high and sustainable profits. But in this case there was no reason.” Despite casinos at the high end of the market making good returns early in 2007, Cornelisse’s research uncovered a massive increase in high end casino building permits, thus upping capacity. As this filtered into the market prices plummeted. One operator, Vegas Sands, which topped out at $140, now fetches just $6.

Just over two years into the partnership, Farringdon has established a track record. that should ensure a solid base for future growth. “We would hope to work together for a very long time,” says Tholstrup. “It is something Bram and I talked about for years before setting up. It is something we would hope to do for many more years.”