2015 Oil & RTY Correlation

Advice from Hedge Fund Manager – Michael Thompson

Last week I had the pleasure of interviewing Michael Thompson from BHR Capital. Michael has been managing the firm since its inception in 2010.

I think Michael is a great investor and strategic thinker, and as usual I was impressed with what Michael had to say. We discussed his views on the world, the hedge fund industry, how it’s changing, how to get recruited and what he thinks you should read.

 

Breaking Point:

When I look at the world I see a lot of breaking points. The cracks are showing everywhere.

In the hedge fund world, the big issue is the mismatch between the tenor of investment horizon and time frame of your capital. This mismatch is unsustainable. Due to this and recent performance of the industry, it is going through structural change.

 

What is very concerning from a hedge fund industry perspective is electronic and algorithmic (algo) trading, because it significantly increases the path dependency of a Hedge Fund investment thesis

 

For example:  you might have a three to four year investment thesis – where you estimate intrinsic value of the business, why it’s cheap, how the discount will close, what are the catalysts. But the problem is that you can still have so much volatility in the medium term from the algo trading noise, that it can itself destroy the investment thesis.

 

Correlations:

Sometime the market can take on new correlations – such that the stock price has nothing to do with its fundamentals – all the price action is being driven by algos pushing prices around based on the correlations or relationships they have found.

For example last year many things became correlated to oil prices to extremes that are difficult to justify based on pure fundamentals. In the short-term, oil price appeared to provide a proxy for deflation and thus most levered stocks declined in lock-step with oil while any mitigating factors were essentially ignored by equity markets. For example look at the price chart of the Russell 2000 versus Brent last year, and compare that to the last five years.

2015 Oil & RTY Correlation

Longterm Oil & RTY Correlation

Specific stock fundamentals didn’t matter – what mattered is the risk factors / risk premium that the algos wanted to focus on.

 

Views on the Future:

Michael envisions the following changes in the industry:

  1. Quant strategies will become more pervasive
  2. Fee structures will be under pressure
  3. Permanent capital will be more valuable
  4. AI (artificial intelligence) will be significant and will make investing for humans harder

See related FT article

 

When he thinks about solutions and how he wants to adapt, his focus is on investment strategies, where the risk from technology is harder – for example:

  1. The deal element – M&A related, where a business is driven by acquisition, or buying real assets
  2. Less liquid markets – fixed income and distressed
  3. More intelligent systematic overlay

 

Lessons from Buffett:

One of the greatest things Warren Buffett ever did was to switch to permanent capital early. Most of you know that Buffett used to run a hedge fund / partnership and he closed those down and began using Berkshire which was at that point a broken textile mills business as is entity for permanent capital.

The 70’s happened soon after – and the market declined by over 50%. Some partnerships were down 60-80%, with a large number closing down.

The fact that Buffet’s capital was permanent meant that he survived that crash and subsequent large market draw downs

 

Three great reads on Warren Buffett’s early years:

The Snowball by Alice Schroder

Buffett Partnership Letters

History of Warren Buffett

 

Getting Hired:

It’s getting harder given the number of funds closing and people leaving banks, but here’s what you need to do, to be noticed:

Creativity – a different point of view, and different approach to a stock.

Ideas – you should have good ideas, they don’t have to be regular, but they should be thought through. The best way to get them out there is to share on VIC (Value Investing Club) or even send him ideas directly. He always looks at them.

Network – get referred. It’s easier to get noticed if you are coming well recommended.

 

Books to read for people looking to get hired:

The Prize and The Quest by Daniel Yergin are very relevant given their focus on the energy markets and a must read for historical perspective.

The Outsiders by William Thorndike discusses the best CEOs & capital allocators in history,

Reminisces of a Stock Operator by Edwin Lefevere is one of the best books on market psychology, and is something that should be re-read regularly.

Alchemy of Finance by George Soros offer an approach to a unified theory of the world and introduces you to Reflexivity.

Thank you Michael

 

Go ahead, see what you’ve been missing. 

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