JP Morgan, James Grant & Hedging

Years ago James Grant of theĀ Interest Rate Observer astutely pointed out how how deep and complex the JP Morgan “book” had become thanks to their leading position in derivatives. His account of just the main contours of their positions and operations was mind numbing. The nuances and “emergent factors” of these myriad positions are simply unknowable.

So JP Morgan announced a surprise $2B loss from “failed hedging” and joins the ranks of numerous failed trading strategies implemented by all the “smartest and best equipped teams in the world.” To channel Donald Rumsfeld for a moment we all know that the risks from the massive and complex derivative market are unknowable.

Warren Buffett famously warned that derivatives were like hidden nuclear weapons lurking in our financial system. Despite knowing all this we’ve seen bigger and bigger failures – culminating in the collapse of 2008. It’s a bad thing for our markets. As can be seen by the chart here (from PitchBook) the capital markets haven’t been the same for some time. Volumes have not come back into the markets. This isn’t good.

We’ve seen quite a few friends loose money in their self-directed investment accounts and also massively in funds like the “can’t miss” Goldman quantitative return funds where their few million dollars (minimums were high on those) literally went to zero. Friends shouldn’t let friends invest in quant funds!

Bringing this back around to the SoundView TechFund we continue to shine the light on how hedging and the penchant for smooth monthly returns is insane and impossible. It’s very old school but the modern practice of doing your work and buying low and selling high works very well when you invest for a year or more.

We are not a hedge fund in the sense that we try and remain market neutral. It’s likely that we will have some short positions from time to time but they are for fundamental reasons. That means that we will have bad months and good months. Having down months means that most institutional money won’t be interested because they are looking for funds “that only have good months.” (I’ll pause here so to enjoy the absurdity of it which never gets old for me.)

Sometimes our friends see the news about collapsing markets and kindly ask “are you doing okay in this horrible market?” To this we point out that if you have a plan then volatility is your best friend. We’re not going to lie and say it’s sometimes nice to see your portfolio have a great day, it is. But unless you are withdrawing your money the next day it’s just another point on the curve. The mission is to make sure the curve has a positive slope!

For example we had a rough April. Several of our positions were hit by heavy selling due mostly to “risk off” behavior and sector rotation into things like consumer staples and healthcare. During this time we are adjusting and increasing positions where there is the greatest potential return. LinkedIn (LNKD) has moved up substantially and while it still has more room we reduced our position from 7% to 3%. Qualcomm (QCOM) however has pulled back from $68 to $63 so we upped our 3% position to 6%. (Our LTIV on QCOM is $100.)

To love volatility you can’t be sleeping with leverage on the side. Using leverage blows up this strategy. We’ve seen this recently with Green Mountain Coffee (GMCR) which is not something we would ever own but we weren’t short either. There are multiple problems with this story but one that surfaced recently is that senior management borrowed against their stock positions. In other words they were on margin. When the stock started going down they were forced to start selling at lower and lower prices. When the smoke cleared the shares collapsed from $50 to $25 in a hurry. Being forced to sell low cannot be a possibility for your strategy to work.

Lastly we can hardly say enough about sticking to our intrinsic value (IV) process. It can be hard to do in the face of “great companies” that you “have to own” but that trade at very high valuations. This happens often in the IPO market as enthusiasm trumps analysis. One company we watch is Cornerstone OnDemand (CSOD). It’s a very good company but came public and began trading with a value of 21x sales. A multiple like that is so high we don’t even need a model to say that it’s way too expensive. A year later the shares are where they were then, $18/share, and the company is “growing into” that stock price. Today the price to sales ratio is 12-13x. That’s still high but getting reasonable. We have to build our model to know if this is a good investment now but we won’t own it if it’s not.

Right now truly safe investments like US Treasuries ensure that you will lose value due to inflation. There are some pretty safe yield bets out there that should generate 3-5% annual returns and if you have a one year or longer investment horizon you can exploit the market to get higher, growth-driven returns; not without volatility. But as we said… if you can learn to love it the benefits will last a lifetime.

 

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