Investors, Hedge Funds, and Market Timing

My partner and I were discussing private equity takeovers last week over lunch. It was a continuation of an earlier discussion involving timeframes of various investors.

I was relating some business reporting on these private equity groups looking to clean up and "unlock value," as the pundits were saying of Goldman Sachs last week, in regard to the rumored AMR-BA merger.

It occurs to me that there are basically two kinds of investing: betting on continued excellence, or betting on someone bailing out and fixing a loser.

The latter approach requires at least three assumptions:

1. Someone else will view the poorly-performing asset of which you own a share as fixable
2. The right person/group will come along to fix that asset
3. You will be allowed to realize increased value from the fixing of the asset, or the act of buying it from you (and other shareholders) in order to privately fix it

To me, these seem very problematic and risky assumptions to make, and they must all come true if the investment is to be worthwhile.

It's at least a timing issue, and more. That is, this type of investment is a variation of market timing. The white knight which comes along to 'save' or fix the asset in which you have invested is looking to 'unlock' value and sell, not necessarily reorganize the company for long-term, consistently superior total return performance.

Along these lines, my partner sent me a New York Times article from this past Sunday by Mark Hulbert entitled "A Good Word for Hedge Fund Activism."

Herewith is some of the text of his article,

"WHEN hedge funds buy shares of a company and start agitating for changes in the way it is being managed, they may seem to be gunning for a quick killing at the expense of longer-term shareholders.

But, in fact, the evidence shows that for the most part, buy-and-hold investors ought to cheer when hedge funds jump aggressively into a stock, according to a new study. Titled “Hedge Fund Activism, Corporate Governance and Firm Performance,” it was written by Alon Brav, a finance professor at Duke; Wei Jiang, an associate professor of finance and economics at Columbia; Frank Partnoy, a law professor at the University of San Diego; and Randall S. Thomas, a professor of law and business at Vanderbilt. The study has been circulating in academic circles since the fall.

The authors examined nearly 900 instances from 2001 through 2005 of what they call hedge fund activism. The professors compiled their database in large part from the reports that hedge funds must file with the Securities and Exchange Commission whenever they acquire at least 5 percent of a company’s outstanding shares and intend to get involved in running the company.

Though the professors concede that they have no way to know whether their sample included every instance over this five-year period of hedge funds trying to change a company’s behavior, they write that they believe the sample “includes all the important events.” Included in the professors’ database are not only aggressively hostile actions like threats of lawsuits, proxy fights and takeovers, but also offers to help management enact policies intended to bolster the company’s stock price. Inherent in such cases, Professor Brav said, is an implied threat of hostile actions if management rebuffs those offers.

The professors found that the stock of the average company singled out by a hedge fund outperformed the overall market by 7 percentage points over a four-week period: the two weeks before and the two weeks after the hedge fund’s public acknowledgment that it was aiming at the company. ........If hedge funds did nothing to improve the target company’s profitability, this short-term boost to its stock price would be temporary, and the stock would fall back. But that is not what the professors found. In the year after that initial month of market-beating performance, the average target company’s stock kept pace with the overall market. And over the subsequent two years, the professors also found, the operating performance of the target companies improved markedly.

In finding that the market’s reaction to this type of activism was the rule, not the exception, the professors concluded that the average long-term investor in companies singled out by hedge funds has benefited significantly."

I found this article to be very interesting for two reasons.

First, that the best that could be found for hedge-fund activism, which, for an existing shareholder, is probably better than private equity activism, in which the shareholder loses his shares and all future gains in the company, is a month's worth of outperformance. That's it. One month.

Clearly, these hedge funds are out to "unlock value," meaning, get a quick pop and unload most of the position, a la the Goldman Sachs activity in the airline sector.

Apparently, in the best case, as in the bolded passage, there's a one month outperformance, followed by a year of average performance. The comment about "operating performance of the target companies improved markedly," is code for, 'darn, no more total return effects after that month, but, hey, at least the fundamentals seem to have improved, although without any corresponding stock price gain.'

Second, the authors of the paper, and the NYTimes piece, Hulbert, all consider timeframes longer than a month to be "long term." Even as little as that extra year of average returns is ostensibly good for "long term" shareholders.

Yet, my own research has demonstrated that even for periods as long as three years, there are incredibly large volatilities associated with total returns, such that they are neither predictable, nor reliable.

Further, even I am not a "long term" shareholder. I look for long term patterns of consistency, but I only hold for a period sufficient to suggest I will reliably earn another increment of superior total returns. Holding an equity for years, on the hopes of some sort of magical uplifting of the stock price above the market, is a mug's game.

The paper to which Hulbert refers reinforces my point. One has to be extremely fortunate to already be in an equity which is sufficiently depressed to attract the right sort of attention. Timing has to be down to the month, to really optimize one's gains. Who among us, not managing a hedge fund, is that good at market timing?

I'd much rather identify patterns of consistently excellent fundamental and technical performance, and buy, in the expectation that such above-average performance is causally based, and likely to last just a little longer. That way, I don't need to rely on a somewhat complicated, loose transmission system of poorly-performing equities, white knights, and timing.

It takes discipline to use my approach, rather than simply hoping for good luck and a white knight.