– February & March 2003 –

Confessions V: Massacre of the Beloved

This is Hugh Hendry, and this is the fifth in my podcast series of confessions; confessions being an examination of the early part of my career when I didn’t properly understand risk. I didn’t understand hedge funds that much either, but I had just been handed the keys to this very fast sports car at the end of 2002 and I was determined that I was going to endure. This is my story.

This time around we’re going to discuss the month, or rather plural, the months of February and March 2003, because at the end of January, I had been given a foretaste of the damage that was to come. But if you remember, January had initially been my salvation, I had made 4% for the Fund and the stock market had plummeted 11%.

I owned government bond futures. I owned commodity futures. And I owned a whole set of stocks, commodity producers and gold stocks which were a huge component, well over 60% of my total risk portfolio, but which were insignificant in size and import to this benchmark that I kept measuring myself against. But using this very, very dirty benchmark, and from the Fund’s inception 4 months earlier, I was now up almost 1% whoopee doo! And the FTSE All Share index was down 11%. But there was no jubilation; I was about to suffer a stinging pullback.

So, this edition of the podcast is all about that pullback. It’s all about getting a bit too excited and driving my sports car too quickly. Last time we went under the bonnet and reflected on whether January’s 4% return was really a big deal? Why not +8% or 10% or 12% given the huge amount of risk that I had on the book? Shamefully, I can’t even tell you what our VaR was…I had yet to develop an appetite for clever scrutiny and I had very little idea of our probable loss. We may have had a sports car but we didn’t have any mechanics standing buy to perform risk analysis; I was driving blind.

This time we are going to deal with the consequences of such ignorance because for the month of February, the Fund, my fund, for February I smashed this glorious red Ferrari into a wall, and the Fund was down eight percentage points. I had been prescient in not crowing about my “splendid” returns in my January newsletter. By March I’m starting to enact my emergency plan, which is a lot like a hot air balloon, and it found me desperately jettisoning weight. I said that I had been 170% of nav long in January. But that was more like 140 if we exclude the German Bund futures that I alluded to last month. By the end of February this equity proportion had shrunken to 89% of the portfolio. I still had the bond future but I’d taken a chainsaw to the shorts which had fallen from 35% of the nav to 15%.

If you look at the long-term chart of gold it had rallied strongly for the last three years, from lows of c. $250 and we were kind of within touching distance of $400. Relative to the world’s stock markets the rally was even more profound. But for the next several years the gold futures didn’t do a huge amount; all the price action was in the mining stocks. And at the turn of the year, the voices inside my head, or rather the chart patterns, were literally screaming at me to go for it and take more risk.

Today I am more circumspect, more cautious, about these head fakes. But back then? We did push higher initially and that’s why December and January’s performance sparkled. But then we slammed back. This was all new to me. The market was going to grapple with gold being $400 until 2005, it takes a long, long time for markets to overcome their prejudice. And the very good institutional investors that I had cut my teeth with, in Edinburgh, they didn’t start buying commodity miners until 2005/06. So, we’re very early in the price discovery process, and accordingly it’s volatile.

I did an Instagram video, shame on you if you haven’t subscribed to my Instagram channel, Hugh Hendry Official. But I did make a little video which was inspired by the caption from this month, which was “no one’s allowed to make money, the market uses volatility to separate profits from the majority”. And that’s what’s clearly happening here. There is an oncoming freight train, I can feel the vibrations on the rail-track, you can’t see the damn thing, but I can sense it, and it’s getting closer and closer. Change is coming.

The same principle applies to the stock market. Despite hitting a wall fast in February, the Fund was still up since inception four months previously. But stocks are down 8.5%! We’re at the bottom of the TMT Smash, a historic low for shares, and it’s proving impossibly difficult to own securities! You would think it would have been easy to just load up on stocks but that’s a myth.

I think that Crispin Odey penned the letter for March entitled A bear market for bears?  Cyclical stocks were priced not to last the winter and the growth stocks as though they would never grow again. A market for bears…except we know that that’s not the natural state for stocks and so opportunities must be presenting themselves. It’s logical? No? He was buying and he’d raised his long exposure. Me? I was having none of it. My spot of gold trouble meant that I was still putting out my own pit-lane fires…

March was another tough month. I was down another 4.6%, and was now down 12, since I started the fund. I had essentially eaten into and destroyed two quarters of performance. And I’m thinking it’s lights out for me. So I think it’s very relevant this notion that bull markets or the profits from participating in them, especially in the treacherous environment of nascent bull markets, that this volatility is treacherous, and low betide you if you try and be super smart and have stop losses…

Let’s consider stop losses with high volatility. Back then there was high volatility from the emerging bull market in gold. And high volatility in this back and forward thrashing around that you see at the bottom of profoundly deep bear markets; the TMT crash of 1999. And if you were to impose a stop-loss regime into that, I assure you, you would end up buying high and selling low every time.

So, what is the solution? Again, I alluded to it, that I did instinctively learn, and I’m sure Crispin Odey helped me with this, but I recognised early on that survivors dig shallower graves. I had not foreseen the magnitude nor damage that would be brought on from what was really a very modest pullback in the gold price. It had revealed the naivety of my risk positions.

But I did know something: you know I was a bad loser. I hated losing money. I was not courageous. I was not the type of person to say, bring it on! I was more the type of person to say I’m funded with short term capital and they’re going to want their money made whole again and I’ve got to get out of this draw-down. I’ve got to get back to positive and it gets easier to do this the less your losses end up being. So, message to self, mitigate losses; don’t subject the Fund to further extreme losses.

And that’s a pattern you’ll see time and time again. I was good at rejecting or cutting it all off, like the guy I’ve alluded to, the free climber with his arm trapped, I could take the pen knife and start cutting. I’ve revealed my modus operandi, that I tried to have 100 legs, 100 feet, lots of arms, lots of feet, in the game, and I tried to accustom myself to change. My life was dedicated to change. Yes, I had a narrative, but the narrative had to survive the day, the week and the month. And back then, all I knew was that it was my damn narrative that was killing me.

The one thing I wanted to be, more than anything else in the world, was a hedge fund manager and so the shallow grave analogy meant that the longs, and all these precious metals stocks that I loved so dearly, that they had to be cut. To repeat, I was not courageous: losses made me physically ill and yet, writing this investment report so many years ago, I can recall sitting there with Crispin Odey by my side and this weird bunch of scrotum scratching English eccentrics and I’ve heard it said that bad things happen in bear markets. But, no, that’s wrong! I wrote that somewhere. But is preposterous. Bad things happen in bull markets, truth be told. Bad things happen to your portfolio in bull markets, and if you’re not careful your decisions can haunt you for a long time.

I related at the start of my March letter to the Hollywood starlet J-Lo. I had to look her up – it stands for Jennifer Lopez. She was born a few months after me, we share the same birth year – big deal! She has had a very good 20 years; I think much better than me. Her films have grossed over $3 billion at the box-office and she’s sold over 70 million albums, a lot of albums.

I’ve always been curious about culture, and its newly emerging icons. Back then, there was this new television program. J-Lo’s former boyfriend had just won the American edition of I’m a Celebrity, Get me Out of Here. And he won because he was full of remorse, with tears welling up, emotional because he still had this great, deep seated, unrequited love for his former belle. And that was me. I was like, “Hey, I’m a hedge fund manager! Can you get me outta here because I’m still in love with these stocks? But I’m? Truth be told it’s a massacre of love. I’m just killing my beloveds like that gruesome scene from Star Wars when Anakin kills all his young Jedi siblings because I HAD to survive, I just had to…

Make of that what you will…

And then during all this personal psychological carnage inside my head, I’m still trying to offer stock insights. And the stock insight for February. Can you believe that I start talking about this micro small cap Scottish company?  It’s called Devro. I think it had IPO’d out of Johnson and Johnson or one of the large US pharmaceutical companies. It was a food ingredients stock. And it effectively made condoms for sausages – that film that covers the meat – sorry for these unintentional double-entendres – doing away with the traditional practice – if you go to a delicatessen and you order a fancy sausage you find it is covered in the gut of the animal to keep it compressed.

Devro had devised of a yield management process where they could deliver something very cheaply, but which was also very safety stringent and could overcome all the rigorous health concerns for something that is being ingested. So, there was an obvious healthcare angle, and they were very clinical and successful so much so that they had 76% global market share. And from my time spent back in Edinburgh, an experience that was still resonating at the forefront of my mind, my former employers had been the biggest shareholders in this stock with huge profit margins.

Customers were not hugely incentivised to negotiate the price of each sausage condom – the cost was insignificant, and the greater concern was to ensure that nothing bad would arise from its human consumption or delay production. And so, there was scope for an invisible layer of margin protection, and you could slowly but steadily attempt to massage prices higher. The market share being globally high and formidable, huge returns on capital, a hugely profitable business…what wasn’t there to love?

But then it became beset with problems – biblical plagues!  That’s just bad luck. There are sometimes glitches which take down fantastic businesses, and they are the opportunities that you are always looking for, to make lots of money. This was the biblical plague of British mad cow disease. And they had become implicated because they were putting these sausage condoms, onto British produced meat, and therefore they found themselves banned from foreign export markets.

And we discovered oddities – that life is never as transparent nor binary as we wish for, and so we found out unexpectedly that South Korea was a very profitable niche and that they had closed all imports of UK meat leading to an unexpected profit warning. And with bad things arriving in droves, a Spanish competitor had emerged as a destabilising threat. Devro’s 76% global market share was evidence of a great moat but as it had proven several years earlier, with Marlboro Friday, and the tobacco giant’s decision to slash its prices to squeeze out the price discounting competition, which was destroying the profitability of the US domestic cigarette market. Philip Morris had this great brand, had this great market share position. And yet they decided to sacrifice about three years’ worth of profits to re-establish pricing discipline.

We are constantly taught that duopolies are these stable and formidable things, but they’re inherently vulnerable. It just takes one member to not show the discipline and it can have a profoundly negative impact on the market. And that’s what happened here. So biblical plague plus the presence of a significant price discounter, and profit warnings…not good…. I think on one day Devro’s shares fell 24%, placing it 90% below its price peak.

Despite the profit warnings it was still fantastically cash generative and fantastically cheap. And indeed, the following month in March, despite everything else that was happening, or maybe because of everything else, it had become the second largest holding in the Fund. Big deal! I had been full of bravado, with these huge risk positions in these individual gold stock names. And now my second largest risk position was a 1% NAV holding in a sausage condom maker – how the mighty had fallen.

Odey had written the March paper introduction. He alluded to modern historic trends in world trade, and it’s a theme that antagonizes the majority, when I say that this benevolent hegemon, which had stepped into the fray, I’m talking of course about the USA.  That after the Second World War, and facilitated with the Marshall Plan, and with a whole host of institutional and monetary agreements, had instigated the ability to finance the rebuilding of former opponents. So, the rebuilding of Europe, principally Germany, and the rebuilding of Japan had seen international trade rise from 5% of global GDP to 20% at the time of writing.

But 17 years ago, there was a conjecture about International disharmony. You know, the pain and the scars of the Iraqi conflict were still fresh in the mind and the way that had separated former friends and allies from around the diplomatic table; that alliances seemed to be shifting. And Odey was suggesting that perhaps we have to consider and let me pause there because this form of investment is about curiosity. You are obliged to ask questions.

Would we see a return to national champions? That the strategic need for resources like, perhaps, steal and coal, would come to the fore. Now, this is conjecture. It was made more powerful because it was coinciding with the rise of China. And so, having supported and facilitated the re-emergence of Japan, Germany, etc. and now very much with China on the rise and again, being endorsed and  being allowed admittance to the World Trade Organization by the US.

I think the subsequent success we enjoyed on these curious investments had nothing to do with the thesis that we would see governments champion once more their national champions. I think it was more about very low valuations for cyclical stocks coinciding with China’s admittance to the global stage and its insatiable appetite for commodities.

Now I don’t for one minute like the idea or the term cheap. Typically, something’s cheap for good reason, which to see is lowly rated. Saying something is cheap is self-serving. At the time, domestic UK, coal and steel assets were lowly rated and deservedly so. Odey called them cheap. They were known as fallen angels; they were certainly not in heaven anymore. But with this HUGE Chinese economy bearing down on the global economy like an enormous spaceship docking with the international space station, plugging in and consuming. What were they consuming? They were consuming steel and every other commodity you can think of. And so, back then, if you think of some of my previous admonitions, to buy the best in case you’re wrong and buy the worst in case you’re right, these fallen angels had a lot of one-off rerating potential.

UK Coal the only listed, and the former government controlled, coal miner in the north of England was listed on the market, it had no place being listed on a public market. But there it was. It had a £110m market capitalization, which seemed very, very small. And apparently no debt. Odey was always making stuff up or exaggerating the lack of risk factors – it gave him the strength to misbehave and take on these fallen angels. Because further examination must surely have revealed that the pension liabilities would have been enormous. But conveniently we brushed over this analytical matter. So, we were a bit naughty. We maintained that we were buying for just 15% of sales.

Enterprise value, the market capitalisation plus the company’s net indebtedness, was one of our things. And Ken Fisher, the son of Phil Fisher and the scuttlebutt theory of bottom-up analysis. People always ask me for book recommendations. Ken Fisher’s book, Super Stocks which outlines the discipline of using an EV-to-sales methodology was one that captivated me.

So, 15% of sales, hmm…very interesting. £110m market cap, and because they were not reinvesting in the business, why would you? this was like, the last blacksmith and the return that accrues to the last man standing when the tide retreats. No need for growth investment because none was likely forthcoming; which is to say that the business was immensely cash flow generative to the tune of £50m. So, superficially, it was on two times cash flow and paying out a 12% dividend yield. And you could argue that the market cap was accounted for by some property assets.

But again, all of that is to ignore the pension liability, which would have been extreme, but we made a substantial investment and it fared well. It was like a Catherine Wheel – like a firework – you light it, you step well back, and you watch it fizz, fizz, fizz fizz…fizz out! And so, you must be acutely aware of your exit.

It was a similar story of bravado, an ounce of investment genius, good fortune and conveniently side stepping some significant risk factors that explained another successful fallen angel investment – British steel. The former national steel company had become a penny stock, trading for eight British pennies, which is to say nothing. Odey, calculated that it had 24 pennies of working capital that could be realized if the business were to cease trading. Liquidation could generate three times that of the present market capitalization, sometimes things are better left to the grim reaper. A cute statistic, a cute moment for speculation and some exciting and explosive turns of the Catherine wheel.

So, that’s me at 25 minutes. I do talk too long. I covered two momentous months. As I say we end in March, I’ve endured 2 really sobering months. I’ve tried to deal with it by closing as much risk down – the slaughtering of the innocents – which I guess was a triumph because my narrative was still that the future is gold but the present dictated that I had to let go of gold and the ability to do so meant that I didn’t go into this enormous black hole. And we’re about to see that that was a good thing. And the next challenge was what to do as gold seemed to be stabilizing. So, I hope to share with you that sooner rather than later. So, thank you very much for joining me. It’s Hugh Hendry. I’m in St. Barts and I’m saying goodbye, goodbye.