| Lee Ainslie III, Maverick Capital (Bloomberg) |
Tiger Cub Lee Ainslie III’s Maverick Fund is suffering through its worst year in five years. If not for the firm’s short bets, its performance would be even worse. The fund’s manager, Dallas-based Maverick Capital, tells investors in its most recent letter that it thinks the environment for shorting stocks is getting better by the day.
The long-short Maverick Fund was profitable in each of the four previous years, posting double-digit gains in three of them. This year, however, the fund has hit a big bump, losing about 5.3 percent through August.
In its second-quarter letter, dated July 30, Maverick tells clients that its short bets have been doing well for some time, and it expects this trend to continue. Specifically, Maverick says the stocks it shorts have underperformed the Standard & Poor’s 500 stock index by nearly 5 percent in the second quarter, which it asserts was the best showing since the second quarter of 2012. It was also the fifth straight quarter of gains for the short portfolio, Maverick adds, noting this kind of streak has not happened since the 2007–2008 period.
It is not clear what specific impact these gains had on the long-short fund’s overall performance. However, in the second quarter Maverick Fund gained 2.9 percent, cutting its loss for the year at the time to just 0.8 percent. The Maverick Long Fund returned 1.5 percent in the second quarter and was down 0.2 percent in the first half of the year, suggesting the short positions helped to further boost the hedge fund’s second-quarter profits.
Maverick Long Enhanced — a long fund that uses leverage — returned 0.3 percent in the first half of the year. Maverick Select, on the other hand, lost 0.6 percent in the second quarter and 5.7 percent in the first half. It is a concentrated long-short fund launched with internal money in 2012 and opened to external money at the beginning of 2013.
There is no way of knowing how Maverick Fund’s shorts have fared in the first two months of the third quarter or why the fund has experienced a rough period otherwise. However, the investor letter provides interesting insight into Maverick’s short strategy and why it is confident it will be successful in the future.
For one thing, Maverick points out that generating alpha from shorting is historically cyclical. And the firm thinks this cycle has further to go for a few reasons, not least because the environment for shorting “is arguably just starting to improve,” the firm writes.
Maverick has found several common conditions under which short-selling is especially lucrative: a tightening monetary policy, widening credit spreads, widening valuation spreads and elevated valuations.
“In our judgment, each of these preconditions exists today,” Maverick tells clients in the letter.
We have chronicled several times in recent years that many long-short managers have had a tough time shorting. A major reason for this has been the worldwide quantitative easing policies instituted by major central banks, which have inflated most financial assets without much discrimination between quality and lousy companies, and an accompanying reduction in volatility.
“In this era of cheap, abundant capital, fundamentally-weak companies have been able to: acquire businesses, which help mask underlying issues; be acquired themselves by companies taking advantage of this financing environment; or access debt and/or equity capital markets to dampen the impact of disappointing results or extend their life cycle,” Maverick explains.
However, the tide seems to be turning. For one thing, the U.S. has begun the tightening cycle, i.e., raising rates, although at a very slow pace. This tightening is expected to resume, possibly as early as next week.
“While other important central banks still have the money printing presses running full-steam ahead, evidence is mounting that the impact of incremental quantitative easing is rapidly diminishing,” Maverick states.
Meanwhile, credit spreads are starting to widen. Maverick points to the growing disparity in yields since last year between corporate bonds with a Baa rating, the lowest investment grade rating, and ten-year Treasury securities.
“Investors are increasingly not marching in lock-step but rather are demanding greater premium for lower quality than they were three years ago,” Maverick stresses.
Maverick also points out that the difference in the valuations of the most expensive and least expensive stocks has been widening for the past three years. Yet this differential is still way down from earlier periods over the past 20 years.
“Again, investors are clearly becoming more discerning, which is reflected in rising valuation spreads, as fundamentals are beginning to play a more important role in determining valuations,” Maverick explains.
To the hedge fund firm, these trends support its case that the “short alpha cycle” should continue to improve.
“As central bank policy has diminishing influence on equity markets allowing fundamentals to play a growing role in determining equity values, the environment for short-selling should continue to improve,” Maverick explains.
Meanwhile, Maverick points out that the fees it pays to borrow the stocks it shorts have been steadily declining since April 2014. The rate is currently the lowest it has paid since October 2007. It cites two factors for this trend.
For one thing, a growing number of hedge funds are moving away from shorting individual stocks and are instead shorting exchange-traded funds (ETFs) and futures or are buying put options. Maverick acknowledges this strategy requires less effort and reduces the odds of losing money. However, it asserts that using these instruments “virtually eliminates the ability to generate positive short alpha.” Secondly, Maverick also insists it avoids the crowded short investments.
The firm does not identify the specific stocks it’s shorting or its net exposure, which it says has been less than half its historical average since August 2015.
States the letter: “For years we have carefully tracked the expected returns of our long and short investments in comparison to risk scenarios for each security and to other measures of risk. Recently, these measures indicate that our current short portfolio is significantly more attractive than usual.”
