Glenview Institutional Partners has had some pretty fancy returns since inception in February 2001 with gross returns of 17.47% CAGR. Here is the narrative from Larry’s Q3 2010 investor letter.
As of September 30th, our top ten long positions listed alphabetically were Aon Corporation, CVS, DaVita, Express Scripts, FIS, Life Technologies, McKesson, Medco, Thermo Fisher Scientific and Xerox. Our top ten positions collectively represented 51% of our capital.
Our top ten short positions represented 7% of our capital. Our short positions included two medical/HMO companies, an insurance company, two semiconductor companies, a REIT, a multimedia company, an enterprise software/services company, a computer/printing company, and a human resources company. In addition, throughout the quarter, we held short positions in various indices as hedges and, as initially outlined in our Q2 2009 letter, in the sovereign debt of six primarily European countries as a hedge against a second global liquidity crisis.
Executive Summary
i) The fund produced positive returns of approximately 4% during the quarter, driven by strength in our equity long book.
ii) Reflective of the healthy performance of our underlying companies combined with lower security prices, our long equity investments remain quite similar to our composition during the prior quarter.
iii) We remain constructive on the investment environment over the medium term and expect overall valuations to begin to recover in the coming quarters.
iv) We continue to withdraw capital from long fixed income strategies and redeploy capital in long equity strategies with superior risk / reward characteristics.
v) We harvested a portion of our sovereign and European CDS hedges but, as discussed at our November 8th Investor Conference, we are currently building a book of hedges based on the mortgage putback exposure we have identified.
Market outlook (discussion taken from 11/8/10 Investor Conference)
We think the market has bent knees and is ready to leap forward. The investing environment is constructive. We’ll talk about our four legged stool. We think liquidity is ample. Security selection will likely remain defensive.
Regarding the macro environment, we’ll go through our “fake Goldilocks” analogy.
What do we mean when we say that the market is returning from fully extended to bended knee? When we began operations in 2001, the market was trading at 21x forward earnings. I think all of you know by now that we like to buy mid-teens or greater growth businesses at mid-teens or lower valuations. If the whole market is trading at 21x, it’s awfully hard to find high quality businesses that trade at 13x earnings. It’s not a coincidence that while earnings have grown over the last decade, valuations have compressed, and we’ve seen the market generate zero returns. Valuations were simply too high, and there was no place to go in terms of valuations. The legs might have been moving, but the knees weren’t bent, and therefore you didn’t get anywhere.
Today, the market is more of a coiled spring. There is a potential that we can spring forward from where we are today, not in Treasury rates but certainly in equity markets.
Earlier this year in one of our investor letters, we shared with you the market P/Es over the last 250 quarters in the equity market. We talked about the fact that when Treasury rates are between 3% and 7%, there seems to be a sweet spot in the market – some combination where deflation is off the table but inflation is also equally off the table, and in general the market trades at around 18x earnings. Today (November 8th), the market is trading at approximately 12.5x forward earnings.
There is significant room for valuation appreciation if central banks around the world are successful in what they’re trying to engineer – e.g. modest growth through fiscal stimulus, which gets us away from deflation.
Bond rates may back up a little bit but, as a result, that should be somewhat of a healthy combination of growth and interest rates for the equity market. In fact, should interest rates rise back to where the 10 year is between 3-7% and equity multiples return to their historical averages relative to this interest rate environment, the market’s multiple expansion from 12.5x to 18x over a three year period would add 45% to equity returns above and beyond earnings growth.
You could get earnings growth plus 15% per year. To be clear, that outcome is not our core forecast, but that is just how far the knees are bent.
As we entered 2010, we talked about four key factors, or legs, to the investing stool: low valuation, excess corporate liquidity, a growing economy and ample overall liquidity at the investor level. We’ve discussed valuation. Regarding the strong and excessive corporate liquidity, corporate cash balances were and are at an all time high of $1.5 trillion. (That is non-financial companies only, and therefore ignores the fact that banks are also holding onto a lot of cash.)
What is that $1.5 trillion earning today? If it’s sitting in cash, it’s earning 30 basis points. It’s earning zero. Why would you be sitting on an asset earning zero when there are wonderful opportunities to deploy it and earn something real?
So that pendulum has to swing, and we’ll talk about that later. Regarding the growing economy, consensus estimates have the US economy growing 2-3% percent annually. We are not smart enough to argue whether it’s going to be 1%, 2%, 3% or 4%. All I know is that, in general, I think the consensus is that we’re likely to move forward.
Regarding liquidity, on a global basis, liquidity has moved from totally dysfunctional two years ago back to highly functional today. In fact, on an absolute basis, when you take out the spread to Treasuries and just look at absolute yields, this is about as cheap as noninvestment grade companies have ever been able to borrow and very close to as cheap as investment grade companies have ever been able to borrow.
So then the question becomes, “If the Fed has had the spigots on for the last year and a half, and equities have gone up a little bit, aren’t equities going to start to be desensitized to all this liquidity being pumped in?” In other words, if you keep hammering the same nail and it’s not really going anywhere, at some point in time aren’t you being counterproductive?
We actually don’t think so. We think that it’s a cumulative process that is going to have a cumulative
effect. In other words, if you look at the total investing landscape and assume that it is a football field of 100 yards, we think that many different asset classes – Treasuries, investment grade bonds, non-investment grade bonds, CMBS, actual real assets, real estate, gold, etc. – have gone from potentially and then wildly undervalued to now being at least fairly valued, or, in some cases, overvalued.
Certainly on the debt side, if you are an absolute return investor, things are quite sparse there. So where’s the only place for the liquidity to go? The only place left for the liquidity to go, which can
absorb that liquidity, is high quality US equities.
That is where the undervaluation is. If you think of the market as a giant football field, then if 80% of the field is saturated but the liquidity sprinklers are still on all around the field, then that means that 5x as much water is going to find the remaining 20% which is still dry. Thus, that liquidity is going to have an ever-increasing effect, and so while we are not predicting that the equity market is suddenly going to leap forward at a massive rate, we do think the conditions are setting up for significant equity appreciation over the next few years.
We have a different analogy to say the same thing – we are folding the bottom of the toothpaste tube. If you take a toothpaste tube that is half empty and you smack the bottom of it, nothing really happens, right? It moves a little bit to the right or left. But, if you fold that tube of toothpaste 8x, you’ve built pressure. Now, if you hit the bottom of that tube, all of a sudden things go far. Those are the analogies we think about as we think about what the Fed is doing.
There is of course the “buy the Treasuries on the quantitative easing, and front the Fed” trade. But beyond that, what investor, for example a pension fund trying to earn 8% to pay for its retiree obligations, would decide “I’m going to be fine earning 2.5% per year over the next 10 years. Let’s flood into Treasuries.” The Fed is trying to take those opportunities away such that all the new capital to be invested moves to the area of the football field not yet watered, e.g. US equities.
What types of companies are we investing in? We think the economic forecast is too unpredictable to have a cyclical sailboat and so we think you need a motorboat. Again, I use an analogy, in this case, in the movie “Tommy Boy”, Chris Farley in his comedic wisdom is sitting in a sailboat waiting for the wind to blow and, of course, the wind never comes and his sailboat never moves.
If you invested in cyclical companies and consumer related companies in the 1990s, you looked like a genius. Why did you look like a genius? Well, because you had a 4% GDP growth tailwind in the US.
Most anybody can move forward in a sailboat if there is wind. The problem is when the wind dies down.
So we’re trying to find companies which have cyclical growth drivers that don’t necessarily need an economic tailwind in order to move the boat forward. We’re not saying that there is definitely going to be no wind in the next five to ten years. What we’re saying is that it’s highly uncertain, and therefore we do not want to be dependent on economic wind power in order to power your capital forward.
Another analogy: bowling. My kids bowl with gutter guards and think they are great. However, with gutter guards, anybody can bowl 120. You can’t possibly miss the pins. This is the same thing that’s going on with the economy right now. The Fed is basically saying “If things get too cold, we’re just going to keep easing.” The Fed went to $2 billion of quantitative easing and then, in March, the Fed said they were going to start to withdraw that. As bond payments came due, the Fed was going to sell Treasuries because they would mature, and the Fed would start to shrink the balance sheet naturally. And what did it take, six weeks for the market to implode? It imploded on the news from Greece and Europe.
So then, the Fed decided three or four months later “You know what? We are going to reinvest our coupon.” Well that’s only $60 or $70 billion on $2 trillion holdings, and it’s kind of a “Who cares? That’s not enough.” So the Fed thought “I know. Why don’t we do another $600 billion? We’ll take it from $2 to $2.6 trillion?” What happens after that? We don’t know. What we do know is that the Fed is trying to shout from the hilltops that they are going to take their bazooka out.
The Fed is going to drop cash from a helicopter. The Fed is going to do whatever it takes to try to keep the ball in play. The Fed thinks that inflation is below target, and therefore they can do whatever it takes to try to stimulate growth. Will it work? I don’t know if it will work, but I think the odds that we veer toward the “left bowling gutter” of a double dip recession are diminished by the fact that the Fed is standing there, and every time the ball gets close to the gutter, they’re trying to kick it the other way.
What would happen if we got runaway inflation and runaway economic growth? We might get inflation because the dollar devalues, but are we going to get real inflation? We have 9.5% unemployment and if you talk to people on the other side of the George Washington Bridge rather than all of us in Manhattan, it feels more like 15%. There is excess capacity everywhere. There is no wage inflation. None of the companies we’re talking to are planning on building new factories or new equipment in the US because of all this excess overcapacity. And so, we don’t see the case for normal inflation or wage inflation or finished goods inflation, etc. Is it possible you get commodity inflation because of mixed
math, because of the BRIC countries coming in? Yes, that’s possible, but it’s offset by the other forces we mentioned.
Thus, as a result, I think the economic ball stays in play, and therefore I think we’re looking at a couple percent GDP growth which is uninspiring, but as long as the ball doesn’t go into one of the two gutters and you eliminate tail risks, then you should be fine. For these reasons, we find the investing backdrop constructive, and we feel that we can confidently execute our strategies in long short investing, event-driven situations and in stressed or distressed fixed income opportunities.
As of September 30th, our top ten long positions listed alphabetically were Aon Corporation, CVS, DaVita, Express Scripts, FIS, Life Technologies, McKesson, Medco, Thermo Fisher Scientific and Xerox. Our top ten positions collectively represented 51% of our capital.
Our top ten short positions represented 7% of our capital. Our short positions included two medical/HMO companies, an insurance company, two semiconductor companies, a REIT, a multimedia company, an enterprise software/services company, a computer/printing company, and a human resources company. In addition, throughout the quarter, we held short positions in various indices as hedges and, as initially outlined in our Q2 2009 letter, in the sovereign debt of six primarily European countries as a hedge against a second global liquidity crisis.
Executive Summary
i) The fund produced positive returns of approximately 4% during the quarter, driven by strength in our equity long book.
ii) Reflective of the healthy performance of our underlying companies combined with lower security prices, our long equity investments remain quite similar to our composition during the prior quarter.
iii) We remain constructive on the investment environment over the medium term and expect overall valuations to begin to recover in the coming quarters.
iv) We continue to withdraw capital from long fixed income strategies and redeploy capital in long equity strategies with superior risk / reward characteristics.
v) We harvested a portion of our sovereign and European CDS hedges but, as discussed at our November 8th Investor Conference, we are currently building a book of hedges based on the mortgage putback exposure we have identified.
Market outlook (discussion taken from 11/8/10 Investor Conference)
We think the market has bent knees and is ready to leap forward. The investing environment is constructive. We’ll talk about our four legged stool. We think liquidity is ample. Security selection will likely remain defensive.
Regarding the macro environment, we’ll go through our “fake Goldilocks” analogy.
What do we mean when we say that the market is returning from fully extended to bended knee? When we began operations in 2001, the market was trading at 21x forward earnings. I think all of you know by now that we like to buy mid-teens or greater growth businesses at mid-teens or lower valuations. If the whole market is trading at 21x, it’s awfully hard to find high quality businesses that trade at 13x earnings. It’s not a coincidence that while earnings have grown over the last decade, valuations have compressed, and we’ve seen the market generate zero returns. Valuations were simply too high, and there was no place to go in terms of valuations. The legs might have been moving, but the knees weren’t bent, and therefore you didn’t get anywhere.
Today, the market is more of a coiled spring. There is a potential that we can spring forward from where we are today, not in Treasury rates but certainly in equity markets.
Earlier this year in one of our investor letters, we shared with you the market P/Es over the last 250 quarters in the equity market. We talked about the fact that when Treasury rates are between 3% and 7%, there seems to be a sweet spot in the market – some combination where deflation is off the table but inflation is also equally off the table, and in general the market trades at around 18x earnings. Today (November 8th), the market is trading at approximately 12.5x forward earnings.
There is significant room for valuation appreciation if central banks around the world are successful in what they’re trying to engineer – e.g. modest growth through fiscal stimulus, which gets us away from deflation.
Bond rates may back up a little bit but, as a result, that should be somewhat of a healthy combination of growth and interest rates for the equity market. In fact, should interest rates rise back to where the 10 year is between 3-7% and equity multiples return to their historical averages relative to this interest rate environment, the market’s multiple expansion from 12.5x to 18x over a three year period would add 45% to equity returns above and beyond earnings growth.
You could get earnings growth plus 15% per year. To be clear, that outcome is not our core forecast, but that is just how far the knees are bent.
As we entered 2010, we talked about four key factors, or legs, to the investing stool: low valuation, excess corporate liquidity, a growing economy and ample overall liquidity at the investor level. We’ve discussed valuation. Regarding the strong and excessive corporate liquidity, corporate cash balances were and are at an all time high of $1.5 trillion. (That is non-financial companies only, and therefore ignores the fact that banks are also holding onto a lot of cash.)
What is that $1.5 trillion earning today? If it’s sitting in cash, it’s earning 30 basis points. It’s earning zero. Why would you be sitting on an asset earning zero when there are wonderful opportunities to deploy it and earn something real?
So that pendulum has to swing, and we’ll talk about that later. Regarding the growing economy, consensus estimates have the US economy growing 2-3% percent annually. We are not smart enough to argue whether it’s going to be 1%, 2%, 3% or 4%. All I know is that, in general, I think the consensus is that we’re likely to move forward.
Regarding liquidity, on a global basis, liquidity has moved from totally dysfunctional two years ago back to highly functional today. In fact, on an absolute basis, when you take out the spread to Treasuries and just look at absolute yields, this is about as cheap as noninvestment grade companies have ever been able to borrow and very close to as cheap as investment grade companies have ever been able to borrow.
So then the question becomes, “If the Fed has had the spigots on for the last year and a half, and equities have gone up a little bit, aren’t equities going to start to be desensitized to all this liquidity being pumped in?” In other words, if you keep hammering the same nail and it’s not really going anywhere, at some point in time aren’t you being counterproductive?
We actually don’t think so. We think that it’s a cumulative process that is going to have a cumulative
effect. In other words, if you look at the total investing landscape and assume that it is a football field of 100 yards, we think that many different asset classes – Treasuries, investment grade bonds, non-investment grade bonds, CMBS, actual real assets, real estate, gold, etc. – have gone from potentially and then wildly undervalued to now being at least fairly valued, or, in some cases, overvalued.
Certainly on the debt side, if you are an absolute return investor, things are quite sparse there. So where’s the only place for the liquidity to go? The only place left for the liquidity to go, which can
absorb that liquidity, is high quality US equities.
That is where the undervaluation is. If you think of the market as a giant football field, then if 80% of the field is saturated but the liquidity sprinklers are still on all around the field, then that means that 5x as much water is going to find the remaining 20% which is still dry. Thus, that liquidity is going to have an ever-increasing effect, and so while we are not predicting that the equity market is suddenly going to leap forward at a massive rate, we do think the conditions are setting up for significant equity appreciation over the next few years.
We have a different analogy to say the same thing – we are folding the bottom of the toothpaste tube. If you take a toothpaste tube that is half empty and you smack the bottom of it, nothing really happens, right? It moves a little bit to the right or left. But, if you fold that tube of toothpaste 8x, you’ve built pressure. Now, if you hit the bottom of that tube, all of a sudden things go far. Those are the analogies we think about as we think about what the Fed is doing.
There is of course the “buy the Treasuries on the quantitative easing, and front the Fed” trade. But beyond that, what investor, for example a pension fund trying to earn 8% to pay for its retiree obligations, would decide “I’m going to be fine earning 2.5% per year over the next 10 years. Let’s flood into Treasuries.” The Fed is trying to take those opportunities away such that all the new capital to be invested moves to the area of the football field not yet watered, e.g. US equities.
What types of companies are we investing in? We think the economic forecast is too unpredictable to have a cyclical sailboat and so we think you need a motorboat. Again, I use an analogy, in this case, in the movie “Tommy Boy”, Chris Farley in his comedic wisdom is sitting in a sailboat waiting for the wind to blow and, of course, the wind never comes and his sailboat never moves.
If you invested in cyclical companies and consumer related companies in the 1990s, you looked like a genius. Why did you look like a genius? Well, because you had a 4% GDP growth tailwind in the US.
Most anybody can move forward in a sailboat if there is wind. The problem is when the wind dies down.
So we’re trying to find companies which have cyclical growth drivers that don’t necessarily need an economic tailwind in order to move the boat forward. We’re not saying that there is definitely going to be no wind in the next five to ten years. What we’re saying is that it’s highly uncertain, and therefore we do not want to be dependent on economic wind power in order to power your capital forward.
Another analogy: bowling. My kids bowl with gutter guards and think they are great. However, with gutter guards, anybody can bowl 120. You can’t possibly miss the pins. This is the same thing that’s going on with the economy right now. The Fed is basically saying “If things get too cold, we’re just going to keep easing.” The Fed went to $2 billion of quantitative easing and then, in March, the Fed said they were going to start to withdraw that. As bond payments came due, the Fed was going to sell Treasuries because they would mature, and the Fed would start to shrink the balance sheet naturally. And what did it take, six weeks for the market to implode? It imploded on the news from Greece and Europe.
So then, the Fed decided three or four months later “You know what? We are going to reinvest our coupon.” Well that’s only $60 or $70 billion on $2 trillion holdings, and it’s kind of a “Who cares? That’s not enough.” So the Fed thought “I know. Why don’t we do another $600 billion? We’ll take it from $2 to $2.6 trillion?” What happens after that? We don’t know. What we do know is that the Fed is trying to shout from the hilltops that they are going to take their bazooka out.
The Fed is going to drop cash from a helicopter. The Fed is going to do whatever it takes to try to keep the ball in play. The Fed thinks that inflation is below target, and therefore they can do whatever it takes to try to stimulate growth. Will it work? I don’t know if it will work, but I think the odds that we veer toward the “left bowling gutter” of a double dip recession are diminished by the fact that the Fed is standing there, and every time the ball gets close to the gutter, they’re trying to kick it the other way.
What would happen if we got runaway inflation and runaway economic growth? We might get inflation because the dollar devalues, but are we going to get real inflation? We have 9.5% unemployment and if you talk to people on the other side of the George Washington Bridge rather than all of us in Manhattan, it feels more like 15%. There is excess capacity everywhere. There is no wage inflation. None of the companies we’re talking to are planning on building new factories or new equipment in the US because of all this excess overcapacity. And so, we don’t see the case for normal inflation or wage inflation or finished goods inflation, etc. Is it possible you get commodity inflation because of mixed
math, because of the BRIC countries coming in? Yes, that’s possible, but it’s offset by the other forces we mentioned.
Thus, as a result, I think the economic ball stays in play, and therefore I think we’re looking at a couple percent GDP growth which is uninspiring, but as long as the ball doesn’t go into one of the two gutters and you eliminate tail risks, then you should be fine. For these reasons, we find the investing backdrop constructive, and we feel that we can confidently execute our strategies in long short investing, event-driven situations and in stressed or distressed fixed income opportunities.
