Tony Dye

Phillip Coggan
Originally published in the February 2005 issue

Tony Dye has had the last laugh. Five years ago, he departed from Phillips & Drew (‘P&D’), one of the UK’s top fund management firms, after his warnings of stock market apocalypse had proved premature. Within a month, the man dubbed “Doctor Doom” in the press was proved right; the dotcom bubble started to burst.

Now Dye sits in offices at the heart of the City, testing his judgment against the markets through two long-short equity hedge funds, Contra and Contra Temps. And after a slow start, he has built up more than E400 million (euros) in assets. Running a smaller business may suit him – he says it is liberating not dealing with all the meetings that he used to face at P&D – but it has not softened his bearish views. He still thinks that bad times could be “just around the corner”.

Dye has been working in the financial markets for more than 30 years. Having studied economics at the LSE, he briefly became a graduate trainee at an engineering company. The experience was not a success. “I think I was the first and last graduate trainee the company had” he recalls.

He ended up in the City by walking into an employment agency run by an old major, who pointed him in the direction of London Life. He joined a tiny investment team in a fascinating period – the early 1970s. “I instinctively thought the market was too cheap, although I was much too early” he says. “But the great advantage of such a small operation was that if I could convince the boss, I could try my hand at other things. While I was part of the bond team, I was always interested in equities and convertibles.”

He eventually joined Colonial Mutual Life, before moving to P&D as a fund manager in 1983. Within two years, he became chairman of the investment committee and eventually was appointed chief investment officer. Back then, P&D (along with Schroders, Gartmore and Mercury) was one of the “big four” asset managers that dominated the pension fund market.

P&D was known for its value style that worked well over long periods, but could go out of fashion for years at a time. Dye was thus naturally not an enthusiast for the technology boom of the late 1990s. He also became convinced that the market as a whole was becoming overvalued.

“I think the bubble probably started in 1995, in the sense that was when the strong positive feedback began” he recalls. “Equities started to have an impact on the economy over and above what they normally do. By 1998 and 1999, I knew it was a historic bubble.”

His public statements on the likelihood of a crash made Dye London’s highest profile bear. On a couple of occasions, during the Asian crisis of 1997 and the collapse of Long-Term Capital Management in 1998, it looked as if he was going to be proved right. But in both instances, the world’s central banks stepped in to cut interest rates and avert a crisis.

“I remember what the chairman of trustees of a pension fund client said to me at the time. ‘They will fight you every step of the way’. The Fed has gone out of its way to stop anything unpleasant from happening” he argues.

With the apocalypse postponed, P&D’s performance started to deteriorate relative to the competition. The fund management group faced a real dilemma. By taking such a vigorous bearish and value-based stance, they could not switch to buying growth and technology stocks without losing all credibility. But clients were drifting away.

When the crunch came, Dye says the departure was “partly voluntary, and partly I was pushed out. A new man wanted new and younger people in charge.” In retrospect, it turned out to be a great sell signal for the market.

It was a year before Dye set up his own fund management company, Dye Asset Management, with Ed Knox, who formerly worked at Foreign & Colonial. Without any marketing resources, it was slow going at first. “Early investors were largely people that knew us, although we did attract one million from a hedge fund manager I’d never met” he recalls.

Staff numbers have now reached seven, of whom five work on the fund management side. Apart from the founding two, there is Nigel Gliksten who came from Flemings, Manraj Ahluwalia from UBS and Dye’s son, John, who joined from Newton. Dye says the individuals on the team have some broad areas of specialisation. His son Jon is the strongest economist in the group, while Manraj was an actuary who worked as a consultant at Bacon & Woodrow. There is also some sector specialisation among the fund managers; Tony Dye covers the banks for example, but the aim is not to be too exclusive, so there is a broad exchange of views.

In addition, the group has a risk manager who analyses the correlations with the portfolio, comparing it with 60 different factors. “Last year, we found we had a strong negative correlation with software stocks for example” Dye says. “We have risk limits which we don’t go beyond. The r squared on any factor cannot be more than 40 per cent.” (In other words, the factor cannot account for more than 40 per cent of the portfolio’s movement.) At the time of the interview, the group’s biggest short position was in cyclical stocks.

Much of the staff’s time is spent at their Number 1, Poultry offices which may be expensive but offer plenty of light and a view of a Wren church. Dye sees little point in company visits. “We find access to companies of no real value” he says. When he was an institutional manager, Dye says he “never learned very much from visits to big companies. Largely it was a marketing exercise. And you could end up being influenced by whether or not you liked the management; it was better not to meet them.”

By not visiting companies, Dye says his team has “much more time to concentrate on looking at the accounts and trying to think about how things will develop within a company, sector or economy.”

How has Dye adapted to the hedge fund world? “Alpha is not a word that trips easily off my tongue” he admits. “It is clearly very variable over time. Interest in hedge funds is high because people think they can generate very high gains in financial wealth.”

Dye thinks that “the trouble with hedge funds is that people are comparing apples with potatoes. A lot of the high returning funds are achieving their results with leverage. We operate at 100 per cent gross exposure and we have never borrowed money. Our funds are very plain vanilla; we buy stocks and shares on one side and sell on the other.”

As a former long-only manager, Dye admits that short-selling is tricky. “The timing is more difficult. You’ve got to see people who are convinced that the stock is a good idea, change their mind. There is also an asymmetry of risk. It is very rare for stocks to fall to below half their intrinsic value. But stocks priced at three times their intrinsic value can get to four times. Warren Buffett (the legendary investor behind Berkshire Hathaway) has said that he and Charlie Munger have thought about shorting. But while they might get it right on a five year view, they could get killed over the short term.”

But Dye seems to have had some success on the short side. “In terms of our Contra fund returns, the contribution of longs and shorts has been about the same” he says. Contra, which is a long-short European equity fund, began operating in March 2001, with the aim of producing returns 5-10 per cent above the risk-free rate. By the end of last year, it showed a return of 32.8 per cent in euro terms, with low volatility. Assets under management are E360m (euros).

“Our fund doesn’t mirror what the average long/short fund does” says Dye. Indeed, performance suffered in the last two months of 2004, when most hedge funds were doing well, because of the group’s bearish stance.

“We have been what we call ‘dirty market neutral’, effectively about 15 per cent short. That was a bit of a headwind for us last year” Dye admits. As a result of last year’s struggles, Dye has reviewed the running of the fund and has introduced two new measures. Any stock that has moved more than 20 per cent against the fund’s position (on a relative basis) will be formally reviewed, as will all positions that have not performed within six months.

Dye’s second fund, Contra Temps, was set up as a global equity long-short fund, using overlay positions allowing the group to take macro views. Up to a third of the risk of the fund comes from these bets. As a result, the fund is a bigger play on a falling market, with a net 35 per cent short position.

“It will have quite a lot higher volatility than Contra Fund” Dye says. “Some people liked what we did and wanted us to have higher volatility, by which they meant higher returns.” Contra Temps now has some $90m in assets. Both funds charge fees of 1 per cent annually and 20 per cent of total return.

According to Dye, a lot of the group’s return has come from a few stocks situated on both sides of the fence. “We did very well from long positions in United Utilities and from EMI, which we have since sold.” (EMI issued a profit warning on the day of the interview.) On principle, Dye says he does not commenton individual short positions.

Dye says that mid cap and small cap stocks have done very well, “so over the last 18 months we have been moving towards the large cap, where we think valuations are quite attractive. When I was at UBS, Manraj and I produced a paper on the effect of indexation on large cap stocks; the top 50 stocks in the US traded on a 60-70 per cent premium. Back then, it was thought you had to be big to take advantage of all the global opportunities. Since then opinions have swung round 180 degrees and people think big caps are boring. Investors are now paying a 25 per cent valuation premium for the FTSE Mid 250.”

As befits his style, Dye is taking some unfashionable positions. “A lot of people talk about the fabulous cash generation from the market but that cash is coming from stocks that people don’t want to buy, like oils and pharmaceuticals” he says. Dye has been long the oil sector. “Oil companies are priced as if the crude price is $25 a barrel; analysts seem to have left their earnings forecasts at that level.” Dye thinks those out-of-date oil forecasts are an indication that people tend to believe what they are told. As another example, he says that companies have very high margin expectations and investors assume that the corporate sector can move from here to a very high margin environment.

Such optimism does not fit in with Dye’s world view, which is still pretty bearish. “We have witnessed the attempts by the Fed to escape the effects of the dotcom and stock market bust” he says, “but those efforts have created manifest bubbles, particularly in housing, both domestically and globally. Indeed, part of the Chinese investment boom can be attributed to the Fed.”

By creating more credit, Dye believes the world has borrowed even more growth from the future. “I don’t think there’s an easy way out. I’m a bit Austrian school.” (The Austrian economists such as Ludwig von Mises believe that recessions are a healthy part of the economic system. They eliminate capital in inefficient businesses and allow it to be re-allocated to the growth businesses of the future. By cutting interest rates in a downturn, central banks are preventing this clearout from happening, and thus creating a worse outcome for the economy in the long run.)

Dye feels many investors are too complacent about the dangers. “A lot of people have been quite relaxed because they haven’t seen any negative consequences. The economy has been given a fantastic injection by Greenspan and the Bush tax cuts. The Fed has given profits to the banking sector through low rates and there has been a certain amount of corporate zaitech” (the habit, prevalent in Japan in the 1980s, of boosting profits through market investment).

Dye is also worried about the derivatives market, which he says has reached some $200 trillion in nominal terms. “The big question is whether that can ever stop growing.” “We have seen the biggest dose of moral hazard” he adds. “The asymmetric response of the Fed is well-known. At the first sign of crisis, they will twitch the monetary knob to create the carry trade. Theway in which the US public is borrowing is very rational, given the incentive to save is zero.”

But this cannot go on forever. “We have had a massive interference in what would probably be the market interest rate. Can a central bank keep interest rates at such low levels forever while creating such manifest distortions?” he asks. “Can you have credit continuing to grow at twice or three times the rate of gross domestic product?”

The one thing that is slightly baffling Dye is the bond market. If there had been an explosion in credit, one would have expected yields to move higher to reflect the risks.

Dye says there are a number of reasons why the bond market could be confusing people. “The first, is that the market, in its infinite wisdom has decided there is no threat of inflation and economic growth will be quite poor. The second may be a technical reason; that investors need to buy bonds for regulatory purposes” (insurance companies meeting solvency requirements, for example). The third, says Dye, is that the market has been rigged by central banks, such as the Asians who are recycling their foreign exchange reserves into T-bonds to prevent their currencies from gaining ground against the dollar. The fourth is that the bond market vigilantes are dead and they have been replaced by people who are indulging in the carry trade. That seems to be backed up by the low level of spreads on corporate bonds and emerging market debt; people have chased risk.

But what would be the trigger for an eventual downturn? Dye does not think this is a useful question. “What caused the 1987 crash? Even afterwards, people didn’t know.” Dye thinks it is more pertinent to ask “who would have thought five years ago that the Fed funds rate would fall to 1 per cent and the budget deficit would grow to 5 per cent of GDP?”

“There has been a phenomenal Kremlinesque effort by the Fed to tell investors that they are going to raise rates, to avoid blowing a hole in the financial system. If Greenspan is really trying to move US monetary policy to a neutral interest rate, then the game would be over.”

What about timing? “As always, I think the crash is just round the corner” he says. “We have had a colossal housing boom. In the States, there are signs that it has become intensely speculative, with people putting down multiple deposits, and selling the place the same morning. The longer it goes on, the more likely that it crashes.” “If you look at US sectoral balances over the last five years, essentially what has happened is that the government has given money to the corporate sector. As the government deficit has widened, the corporate sector has been the beneficiary. But if Bush really does cut the deficit, that will put pressure on the other sectors of the economy.” “In the UK, it looks as if the housing market is moribund and consumer spending is definitely edging down. The whole growth in the banking sector has come from personal finance – mortgages and related loans.”

Those who share Dye’s gloom about the amount of debt in the global economy tend to fall into two camps. One group believes that the central banks, who have unlimited power to print money, will simply inflate away the problem. The other believes that the burden of debts will lead to widespread defaults and a depression.

“I’ve always thought it’s much more likely to end in depression” Dye says. “Look what happened after 1929 in the US and 1989 in Japan. Quite bright people believe that central banks can create inflation. I’m not sure they can but they are having a bloody good go at it. Inflation is certainly showing up in asset prices.”

If Dye is right about a depression, then bond yields will be justified in retrospect, he says, “regardless of whether investors were buying them for the right reasons.” The outlook for equities, by contrast, will be “pretty grim. Profits are likely to be much lower and ratings may be lower as well. House prices would also be going lower and we might get an overshoot.”

There could be an omen, Dye thinks, at the recent low level of market volatility. “If one looks at the long history of the market, there have been periods where it has been very low. But there have been booms and busts in volatility as there have been in the market. There has not been a downturn in the market since shares bottomed in March 2003. That is nearly two years in which markets have not had a setback. That is highly unusual.”

But it would be wrong to think that Dye is betting the farm on market crash. After 30 years in the business, and almost a decade as a prominent bear, he has learned to be patient.

Philip Coggan is Investment Editor of the Financial Times.