Hedge Funds and How Fund Managers Think

And Sage PLC

The Worship of Mammon by Evelyn de Morgan, courtesy Wikipedia

The hedge fund is the most lucrative new product invented by the financial community since the Assyrians and Babylonians founded the business of banking 3,000 years ago. The promise to make money every year regardless of the business cycle has lured investors big-time. Today, hedge funds manage $2.4 trillion. Along with the big promise go big commissions - a 2% annual charge on assets plus 20% of any profit over a defined benchmark is the standard. And secrecy. Hedge funds keep the detail of what they do secret, on the grounds that to inform the public would give an advantage to their competitors. And other than their investors, no one has access to their investment performance. Managers do trumpet the dollar value of their hedge funds, for it is volume where they make their money.

According to Simon Slack (The Hedge Fund Mirage, 2011), between 1998 and 2010 hedge fund managers made $9 billion for investors and took $441 billion in fees for themselves. One hedge fund manager, John Paulson, earned $4.9 billion in 2011. Between 2003 and 2012, the S&P 500 outperformed hedge funds every year except for 2008 when both fell sharply. Hedge funds have not even kept pace with inflation (The Economist 22 December 2012). 800 hedge funds in the UK manage 80% of the hedge fund business in Europe. The disconnect between what hedge fund managers earn and what they achieve is, unfortunately, not unusual in the fund management business.

Seth Klarman (Margin of Safety, 1991), manager of Baupost, the 4th biggest US hedge fund, wrote of fund managers in general:

   "Most money managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management. The incentive is to expand managed assets in order to generate more fees. Yet while a money management business typically becomes more profitable as assets under management increase, good investment performance becomes increasingly difficult. The conflict between the best interests of the money manager and that of the client is typically resolved in the manager's favor." 

Mr Klarman's own hedge fund, Baupost, started off with $30 million in 1982 and now manages $23 billion. According to press reports and Mr Karman's letters to investors that have made their way to the internet, Baupost has underperformed the S&P 500 in 1990-2000 and 2009-12. In 2008 his fund lost 12% compared to the 37% loss in the S&P 500. I cannot find Baupost performance figures for the period between 2001 and 2007. One reason for the underperformance must be his large holdings of cash, which sometimes reaches 50% of the fund. I say 'must be' as no detail of Baupost results is available. 

The lesson for the individual investor is to take care with any offering from the City on the assumption that it will be loaded in favour of the vendor and not the investor: the candid Mr Klarman explains (we can substitute 'the City' for 'Wall Street'): 

1. "Wall Street is in many ways just a gigantic casino. The recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of economic activity than its economic utility".

2. Beware of Initial Public Offerings (IPO). "A significant conflict of interest also arises in securities underwriting. This function involves raising money for corporate clients by selling newly issued securities to customers. Needless to say, large fees may motivate a firm to underwrite either over-priced or highly risky securities and to favor the limited number of underwriting clients over the many small buyers of those securities." The Facebook IPO, where the stock fell 32% in a matter of weeks, is but the latest example.

3. Beware of new investment trusts. "Sometimes the lust for underwriting fees drives Wall Street to create underwriting clients for the sole purpose of having securities to sell. Most [investment trusts], for example, are formed exclusively to generate commissions for stockbrokers and fees for investment managers. . . 8% commission is paid to the underwriter, leaving 92% to invest. Within months of issuance, [investment trusts] typically decline in price below the initial per share net assets value. This means that the purchasers . . . on the IPO frequently incur a loss of 10 to 15 percent of their investment."

4. Fund managers' interests do not coincide with investors. "A great many of those who work on Wall Street view the good will or financial success of clients as a secondary consideration; short-term maximization of their own income is the primary goal." Their business is to maximise fees and commissions.

5. Beware of broker recommendations. "Investors must never forget that Wall Street has a strong bullish bias, which coincides with its self-interest . .  there is more brokerage business to be done by issuing an optimistic research report than by writing a pessimistic one. . .  In addition, analysts are unlikely to issue sell recommendations due to an understandable reluctance to say negative things, however truthful they may be, about the companies they follow." This is especially the case when the broker also works for the company. Also, in order to generate commissions, brokers will advise selling one stock to buy another (a practice known as 'churning').

6. Beware of new types of securities. "Investment bankers . . . are constantly creating new types of securities to offer to customers. Occasionally such offerings both solve the financial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, that is, the generation of fees and commissions." Klarman notes that the early success of an innovation is not a reliable indicator of its merit. "It takes longer for problems to surface." Think CDOs (collaterised debt obligations) and, in the retail banking sector, PPI. The current rage for structured products is another examples of a security that may well go wrong. Of course Klarman, writing in 1991, does not mention hedge funds, but they should surely be included as the biggest self-serving creation of Wall Street and the City to date.

However, Fund managers are as an essential part of an individual's investment process as the stock market. They have introduced low cost trackers and exchange traded funds. UK investors have access to all the markets in the world thanks to fund managers. And, of course, they are essential for savers who do not have the time or interest to select their own investments. But it helps to understand how they think.

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Sage PLC

Clay accounting tokens from Susa, Mesopotamia 3500 BC courtesy of Wikipedia

Sage has established a large, profitable, cash generating business providing accounting software and services to small and medium sized businesses primarily in North America and Europe. 69% of its revenue is derived from subscriptions, up from 61% in 2008, and they provide a regular income stream. The remaining revenue comes from the sale of software licenses.

The company has a market cap of 3.9 billion pounds and it is a component of the FTSE 100. In the past 5 years, Sage shares (blue) have comfortably outperformed the FTSE 100 (green):

Graph courtesy of Yahoo, click to enlarge

Sage's finances are in excellent health: 

1. Earnings per share have increased at an annual rate of 12% between 2001-3 and 2010-12, slowing to 9% in the last 6 years, and the net operating margin is a substantial 25% 

2.  Operating cash flow of 1.5 billion pounds in the past 5 years has comfortably covered the 0.7 billion capital expenditure requirements and the dividend. The surplus has enabled Sage to acquire businesses. 

3. Net debt is down from 497 million pounds in 2007 to 186 million now. Net debt to equity has declined from 47% to 13% in this same period. 

4. Neither derivative exposure nor pension liabilities (the only defined benefit pension scheme is in Switzerland) are significant balance sheet items. 

5. Return on equity is 13% on both capital and retained earnings. 

29% of Sage's revenues come from North America, 20% from France, 19% from the UK and Ireland, and it has substantial businesses in Spain, South Africa, Germany and Australia. Revenue growth has declined and 2012 earnings per share were down 2% on 2011. The company has the objective of reaching 6% organic revenue growth by 2015 by implementing a new plan: 

1. Sage is focussing the business on its bookkeeping and business management software and it is exiting other businesses that account for 10% of revenue. It has entered the Brazilian market by purchasing a local business. 

2. Sage is diversifying its technical offer by increasing its online bookkeeping service to small businesses (5 to 25 employees), launching in 2013 a hybrid cloud service for small to medium businesses and integrating its payment services with its accounting software. The company has employed a new Marketing Director, who formerly worked at Cisco. 

3. The company is concentrating on the subscription business, which is much less volatile than license sales. 

Other than the new Marketing Director, Sage's senior management have all been with the company for several years or longer. One director has sold 450,000 shares at 310p in January 2013. There are no other significant sales or purchases in the last year. 

At the present price of 341p, Sage shares are on a PE of 22 and yield 2.9%.  

Using a discount rate of 10.5% (Sage pays 4.5% on its loans), my valuation model values Sage shares at 270p. This is the average of discounting earnings (331p), return on equity (235p) and equity per share (243p) projections for 2013-17. 

The current share price of 341p is 26% above the 270p price of my valuation model. 

Cautious investors will note: 

1. Sage's share price has jumped from a low of 245p in May 2012 to a 12-month high of 356p in March 2013. And it is not far off that high now. 

2. Sage is stuck in low growth markets with little exposure to Asia or other emerging markets. 

3. Sage's future growth is predicated on its new plan. Plans are full of promise when they are born, but like children they can disappoint when they get older.