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Rupert Hargreaves
Rupert Hargreaves
Articles (1448)  | Author's Website |

John Hempton's Strategy for Finding Shorts and Longs

Some insight into the Australian fund manager's investment process

June 25, 2019 | About:

I recently read an interview with Australian hedge fund manager John Hempton in the spring issue of Graham & Doddsville, the magazine compiled, edited and published by students at Columbia Business School.

I highly recommend going and having a look at the interview if you have time as Hempton provides a great discussion about what he looks for when searching for potential investments and why he is looking for companies that are a "small part of a big thing."

A skilled manager

Hempton has a unique take on finding longs, but he's perhaps better known for his shorts. One short he is particularly known for is his position against pharmaceutical company Valeant (now known as Bausch Health Companies Inc. (NYSE:BHC), which saw Hempton pitted against Wall Street legend Bill Ackman (Trades, Portfolio).

The Australian fund manager's skill for finding shorts is apparent in Bronte Capital's -- the investment management firm he founded in 2009 -- results for 2018. The firm achieved a double-digit return for its investors last year, putting it in an elite club of hedge funds that managed to achieve a positive performance for their investors during one of the worst years for actively managed fund returns since the financial crisis. Bronte's Amalthea fund returned 20.2% in 2018.

According to its end-of-year investor update, Bronte's performance benefited from several successful shorts on "over-hyped and over-levered" stocks. The firm's overriding goal is to generate outperformance for its investors by "shorting the trashier end of the market -- and converting the gains into high-quality assets purchased at attractive prices."

Inverting the problem

In the spirit of Charlie Munger (Trades, Portfolio), who believes that to understand why so many businesses fail, we need to invert the problem; I'm going to turn this statement on its head.

Bronte has achieved outperformance by shorting "over-hyped and over-levered" stocks. This seems to suggest investors who are trying to make money on the long side should avoid these businesses. Of course, this is easier said than done. For example, it is difficult to tell if a stock is particularly overhyped. You could argue that an overhyped stock has a higher valuation, but how would you determine between an overhyped stock and a high-quality business that deserves a higher multiple?

There is, however, much more to the idea of overhyped than just valuation.

Unique companies

Hempton has a strong preference for companies that fill a unique niche, one that cannot be replicated by competitors or companies that distribute their benefits of scale to customers, such as Amazon (NASDAQ:AMZN) or Costco (NASDAQ:COST). These companies with substantial competitive advantages are difficult to overhype. On the other hand, businesses with no competitive advantage, moat or niche product can be overhyped. The point I'm trying to make here is about the quality of businesses.

Low-quality businesses without a niche product or competitive advantage do not deserve high valuations. It is only likely to be a matter of time before a competitor with a better business model takes market share. The combination of a lack of quality and high levels of leverage can be toxic.

So if we invert Hempton's shorting strategy, the takeaway seems to be to avoid highly rated, low-quality companies with lots of borrowing. This doesn't necessarily mean investors should avoid all low-quality companies. If the asset is cheap enough, it is always worth a closer look. If the business is low quality and overhyped, though, it might be best to stay away, at least until the hype dies down.

Disclosure: The author owns no stocks mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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