Portfolio manager John Boich clearly knows his way around the institutional investment scene, having navigated quite successfully from the Boston Co. to San Francisco's late, lamented Montgomery Asset Management, where he steered several of that group's large international funds into the ranks of top performers. Now John has taken aim at the alternative investment arena with Avera Global Partners,
a dollar-neutral long-short hedge fund firm he founded in July 2001. But John's also sticking to what he knows. Avera has been structured, from day one to meet the special requirements of institutional plan sponsors as they venture into the wilds of hedge fund land. So far, all its $40-plus million in assets have come from the institutional set, and John and his team have delivered as promised. Not by hitting the cover off of the ball. But by staying in the game, without swinging for the fences, he explained to me last week. -KMW
Why not start by explaining how you're trying to set Avera Global Partners apart from the hordes of other hedge funds in the universe?
The one thing that is demonstrably different is that our global long-short equity fund's return stream is negatively correlated to those of your average long-short manager, based on surveys by consultants like HFR or Tremont or any of those guys. By design. It's what validates our approach to creating an institutional fund characterized by consistent returns, low annual variability and a low correlation to the major indexes.
You put real emphasis then, on attracting institutions as clients?
Absolutely. Total. Unlike most hedge funds, Avera Global Partners has been built specifically to serve institutional clients. The first thing we did coming into this business was get registered as an investment adviser with the SEC. We've also assumed a lot of backoffice operational expenses to make sure that things like the daily reconciliation of our positions and trades and such are top-quality. We just want to be triple-sure that nothing ever goes wrong there.
You mean it takes more effort to hold institutions' hands than it does to pamper the rich?
That's not as pejorative as you make it sound. When a public pension plan sponsor looks into investing in our fund, his first job is not to blow up his plan's capital. So their first concerns are risk control, operations, business risk, infrastructure. We don't have any money from the traditional investors in hedge funds, either high net worth individuals or funds of funds. Now, if one wanted to give us $100 million tomorrow, I might have to think twice about this, but we have intentionally organized our marketing around institutions, only 25 percent of the hedge fund market.
Yes, but that 25 percent is up from practically nothing just a few years back.
What has been amazing to me, in making the move from traditional long-only institutional asset management as we practiced it at Montgomery Asset Management, to alternative institutional asset management, at a time when the institutional side of the alternatives world is really still an infant, is that there is a whole new breed of consultants emerging.
Because being able to talk the talk is at least as important as actual performance when hedge fund managers compete in institutional beauty contests?
That's not how we'd put it. But you do need to have an organization chart, a real operating infrastructure. You need to have an investment process that is transparent, as well as one that is supported by a robust research infrastructure. All of that is second nature to me, because this is the third institutional investment team I have built just in the last 13 years. The first two at large firms and now this one for myself and my team.
Everything is harder today than it was when Wall was a one-way Street. But aren't you just a little worried that the imposition of consultants, and layers of infrastructure, sectorization etc. on the once-swashbuckling hedge fund sector will kill the goose everyone's expecting to continue laying golden eggs?
The answer is no. I don't think the consultants, for example, are going to have an opportunity to categorize hedge fund managers and to constrain them in style boxes the way they did the long-only universe.
What is to stop them? It seems that process is already underway.
Well, they can try all they want. But one thing I've noticed in getting this business up and running is that the big, traditional long-only pension consultants – the Frank Russells etc. of the world – are still way behind the curve in the alternative asset management category.
The question is, how many institutions really know what they're getting when they dabble in now-trendy alternative vehicles?
We tell potential clients that one of the mainstays of our investment philosophy is that things just aren't what they seem. People make mistakes all the time-and we prey on those errors. The same thing is going to happen to institutional investors in alternative investments that happened to them in the international arena. Remember, in the late 1980s and early 1990s, when Japan was flying and all of a sudden it was like, "Hey, why don't you put some international assets in your plan? They're a good diversifier and reduce risk."
Until they don't.
Yes. But it was such an easy sell. We grew a business from zero to $4 billion in the 1990s with international and global mandates.
What does that say about Avera's own long-term prospects?
Well, that is not to say that alternative investment vehicles, just like international investment portfolios, aren't a robust profitable business opportunity, if you're any good. But for everybody else at the margin, you are right. There is no long-term business plan for mediocrity. And that is the way it should be. During the 1990s there was just so much mediocre product entering the market, it was unbelievable. So for the last three plus years, we've been going through the painful process of weeding all that stuff out. The same cycle will probably happen in alternatives. But you know, I really feel for these people trying to run pension funds and these public plans. They are in a horrible bind.
Because their assets don't come close to matching their liabilities, you mean?
Think about it. If you were okay in 1995 and the market then went up 300 percent and then fell back down, you'd think you'd be more or less back where you started. But somehow something got messed up on the way down, right?
Big time.
While companies feasted on "earnings" that should have been poured into the pension plans. Which, of course, had a negative impact on the net present value of the pension plans.
Anyway, institutional investors are stampeding into funds, like yours, that promise things like low volatility and non-correlation with the indices. Yet isn't volatility what most often creates opportunities in the markets?
It depends on how you define volatility. We define it as the annual standard deviation of returns. But there are clearly other ways of looking at it. That's why funds of funds are popular, isn't it? Maybe, if you have a little of everything, you get the best of all of it.
Or the worst.
That is true.
What's that line about lies, damned lies and statistics? The irony is most hedgies's returns lately have been uninspiring.
True, the median return last year was negative for the hedge funds tracked by Tremont and HFR, which are universes that include long-short, market-neutral, commodities, just about every style.
Not exactly a strong selling point.
You're right. We use HFR's indexes for comparison. We are biased towards them but they do a pretty good job of keeping the index clean and they do have a long history. Part of the trouble is that the really terrific hedge funds don't report results anymore. They just don't want to hassle with it. They have enough money.
Even so, what numbers are available suggest that many of the investors who've poured into hedge funds in the last couple of years must be disappointed.
Yes, people have been disappointed for the last two years. But you have to put that into context. Last year, Avera Global Partners was down about two percent. It was our first year. And a two percent decline was pretty much the average for all of the managers in our category. But meanwhile, the market was down 19-20 percent.
Admit it, haven't you looked at your own results sometimes and wished you'd had the nerve to jettison the losing short side of your portfolio? Without it, you'd be up something like 25 percent year-to-date.
Great question. Think about it this way: If you are really a stock picker, why not just create a 10-stock portfolio, five longs, five shorts? That is extreme, I admit, and I don't know anyone who does it. But with that portfolio, I really wouldn't care what the market was doing. I'd just want to find the stocks that were blowing up in a bull market and the ones that were beating the numbers in a bear market. In a sense, that is what we do.
How so?
Well, we have 1,100 stocks in our North American universe and the market is up 20 percent year to date, even more off of the bottom. Yet I could give you the names of 200 of our stocks that are down, probably by more, during that same timeframe. My point is that those are the stocks a stock picker should focus on. Why they are down is what we are supposed to unearth and figure out. We basically believe that companies with improving earnings momentum that trade at a discount to their region and sector tend to outperform, while companies with deteriorating earnings momentum that trade at a premium to their region or sector tend to underperform. Our expectation is that by blending cheap stocks with improving earnings momentum with expensive stocks with deteriorating earnings momentum in a balanced global/long/short portfolio, we should be able to capture the performance spread between those two types of companies – while at the same time controlling the amount of risk we're assuming. And without having to make a directional bet on the market. That's why I come down on the side of being directionally neutral.
If it's a close call, maybe, fine. But if your research leads you to believe the market's heading one way or the other, why not try to enhance your returns?
It comes down to a question of risk. Of course, I have my own biases and my judgments – and I actually act on those in my personal account – but for an institutional product I think the answer is minimal directional bias, which translates into zero correlation with the S&P 500 and the MSCI world. And that's what we have: Zero correlation.
Zero – under normal circumstances, you mean? The market has a way of making a mess of the best-made plans-
You are absolutely right. There are always the exogenous forces at work. It's just that you have to use what tools you have.
At any rate, except that you now balance your longs with shorts, Avera's approach doesn't differ a whole lot from what you did for 10 years at Montgomery Asset?
Not much at all. I've got multiple analysts at Avera gathering lots of data points and communicating what they find efficiently among one another. That is how we start to generate conviction and ideas; how we start to see trends that aren't reflected in stock prices yet.
And this data is essentially about earnings expectations? Even though analysts' forecasts have been pretty thoroughly discredited since the bubble popped?
Well, our Web site [www.averagp.com] explains our methodology very quantitatively and explicitly for the sake of transparency to our clients. But what it all comes down to philosophically is the recognition that analysts make errors. So we try to use the consensus numbers, along with lots of others, to identify where analyst error may be taking place. We are absolute return managers, but any valuation is going to be relative to stocks in its region and in its sector. So when looking, for example, at a retail stock in Japan valuation-wise, like Yamada Denki Co., I don't care what its absolute multiples are. I do care what its multiples are versus its peers, though. Its sector is out of favor, so the whole thing is cheap. But this stock is cheap even versus its sector. So we like it as a long. Our thinking is, if Yamada Denki is trading at a discount to its regional peers, which it is, and if they report a positive earnings surprise, which we are hoping they do, won't analysts say, "Hey, these guys are delivering yet trade at a discount, so a re-rating is in order?" So it's not like we just pick stocks trading at P/Es of less than 10 times. What matters to us at any point is how a stock is trading versus its regional peers.
Nor do you do a lot of after-hours trading in mutual funds, I trust.
No. We focus on the fun stuff. Finding ideas before other people and exploiting them. That's why I'll be in Japan soon, looking at all these retail trade companies. There are a couple of dozen. I am just going to visit all of them. The retail traders, department stores, apparel stores, mail order stores, catalog companies. Their poor industry has been in the tank for eight years.
So what macro signs are you seeing?
What we are seeing in a few charts are early signs – nothing conclusive yet – that the trend is changing in terms of household income, retail sales, and home consumption expenditures in Japan. It's no surprise at this juncture that Japan's macroeconomic position is improving. Everybody loves Japan's macroeconomics here. And analysts on balance earnings revisions tend to closely track trends in macro forecasts. But what may be happening below the surface hasn't gotten much attention.
You think this recovery in Japan is for real? Not another head fake?
We do. I have been involved in the Japanese market for the last 13 years. But it's only in the last six-seven weeks that we have really increased our net exposure in Japan as well as our exposure in Japan's retail trade space, based on information we've gotten from the companies we have talked to. We will be topping off that research effort in the next four weeks with a trip there. Still, whether this will be a one-month thing, a six-month thing, or a two-year thing, we just don't know yet.
Japan's retail stocks weren't the first to catch investors' eyes
The really high-quality restructuring stories like Nissan, we've had in the portfolio since we started Avera. And in those stocks, a lot of U.S.-based investors have kept us company. Where we are going now, though, is definitely a road less traveled in Japan. The thing that has encouraged me the most – there's a monthly data series, going back to 1971, that we pull called "average monthly total cash earnings, all industries," whose name doesn't do it justice. What it represents is Japan's household earnings from all sources, including wages and bonuses. The last data point we have is June, but the line on one chart has not only turned up, it has risen to its highest level since 1997, which puts year-over-year growth back into positive territory for the first time since 2000. In fact, it has reached pre-Asia crisis levels. If incomes are a precursor to spending, this is a good sign. For now, we only have a small position in the retailers. But when we get back from Japan in a month, it may turn out to be a very big position.
Which Japanese retailers tempt you most?
At the company level, we would like to see earnings beating expectations. On that score, a few stocks look to be in the very early stages of a recovery. You can already see analysts' consensus expectations starting to rise a little bit. So we are looking for information that says business is good, we are on track to meet our numbers, and here is why. In one case, the upturn is going to be all about digital electronics, flat panel TVs, as well as competitors going out of business in what has been a very tough environment.
Which company is that?
Yamada Denki. It's sort of the Best Buy of Japan. Yamada Denki is benefiting from market share increases. In August many of their competitors had negative same-stores sales growth, year-over-year. But Yamada Denki miraculously pulled out a positive same stores sales growth number. All the more impressive because the weather was lousy.
How does Yamada Denki's valuation stack up?
Here's a stock that trades at 15 times earning when the whole group is at around 21. It is trading at a big 0.4 enterprise value to sales ratio, which could double from here and just get back to its five-year average. This company has great margins. It's a real company with double-digit sales and EPS growth. It sells real things, all over Japan. Its five-year average return on capital, at 16 percent, is higher than the North American average. And when you consider the cost of capital is 1.5 percent in Japan, that makes for very strong economic value-added.
How about another example?
Another we like is Shimachu. It is Japan's leading furniture chain, enormously liquid. Its enterprise value to sales is 0.3, and that is adjusted for cash. It had fantastic sales growth last year in a difficult environment, and its sales are growing this year, producing double-digit earnings per share growth. These guys have double-digit operating margins, so it's not as if it's a troubled company. It has a double-digit return on capital, all the metrics are there. But it has been overlooked. In part, because it's not an enormous cap. It's a mid cap. But mostly because when people don't like things in Japan, they really don't like them. Conversely, when they love them, they can't get enough.
So tell me about another.
Just one. Aoyama Trading. They sell discounted men's suits. Kind of like Men's Warehouse. They've been doing very well at moving up the pricing chain. I think their average suit price has gone up from roughly the equivalent of $185 to $225 over the last two years. In other words, they've managed to increase their price point amid probably one of the worst economic environments in post-war history in Japan. So they've increased their margins. Yet this stock trades at 0.6 EVA to sales. It is at 21 times earnings, but that is cheap versus its history.
Okay, but does nothing appeal to you on these shores?
Well, HMOs in North America – like Aetna (AET), Mid Atlantic Medical Services (MME), Coventry Healthcare (CVH). There are fantastic margin dynamics at play in that business now. Premiums, as we all know, go up every year. But their costs have actually been going down. And they're continuing to go down as big drugs go generic, as more people with insurance have to accept higher deductibles or pay larger portions of their premiums because companies are cutting back. There are all sorts of reasons HMO costs have been heading down for at least the last 24 months now.
This trend hasn't exactly gone unnoticed in the market.
The stocks have been fantastic. But we think there is a lot more upside. And the stocks just had a really nice dip. AET, for instance, is down to around 57 after topping 70. MME is about 10 points off its peak of 60 or so, and CVH has roughly followed that same track. So if you think there's another leg coming, now is definitely the time to buy.
Thanks, John.
Kathryn M.Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co., L.P. Greenwich, Conn. http://welling.weedenco.com
