Dear friends,
About 40 of us gathered on Tuesday evening to talk with Bernie Horn. It was an interesting talk, one which covered some of the same ground that he went over in private with Ed and me but one which also highlighted a couple new points.
Highlights:
- The genesis of the fund was in his days as a student at the Sloan School of Management at MIT at the end of the 1970s. It was a terrible decade for stocks in the US but he was struck by the number of foreign markets that had done just fine. One of his professors, Fischer Black, an economist whose work with Myron Scholes on options led to a Nobel Prize, generally preached the virtues of the efficient market theory but carries "a handy list of exceptions to EMT." The most prominent exception was value investing. The emerging research on the investment effects of international diversification and on value as a loophole to EMT led him to launch his first global portfolios.
- His goal is, over the long-term, to generate 2% greater returns than the market with lower volatility.
- He began running separately-managed accounts but those became an administrative headache and so he talked his investors into joining a limited partnership which later morphed into Polaris Global Value.
- The central disciplined are calculating the "Polaris global cost of capital" (which he thinks separates him from most of his peers) and the desire to add stocks which have low correlations to his existing portfolio.
- The Polaris global cost of capital starts with the market's likely rate of return, about 6% real. He believes that the top tier of managers can add about 2% or 200 bps of alpha. So far that implies an 8% cost of capital. He argues that fixed income markets are really pretty good at arbitraging currency risks, so he looks at the difference between the interest rates on a country's bonds and its inflation rate to find the last component of his cost of capital. The example was Argentina: 24% interest rate minus a 10% inflation rate means that bond investors are demanding a 14% real return on their investments. The 14% reflects the bond market's judgment of the cost of currency; that is, the bond market is pricing-in a really high risk of a peso devaluation. In order for an Argentine company to be attractive to him, he has to believe that it can overcome a 22% cost of capital (6 + 2 + 14). The hurdle rate for the same company domiciled elsewhere might be substantially lower.
- He does not hedge his currency exposure because the value calculation above implicitly accounts for currency risk. Currency fluctuations accounted for most of the fund's negative returns last year, about 2/3s as of the third quarter. To be clear: the fund made money in 2014 and finished in the top third of its peer group. 2/3s of the drag on the portfolio came from currency and 1/3 from stock selections.
- He tries to target new investments which are not correlated with his existing ones; that is, ones that do not all expose his investors to a single, potentially catastrophic risk factor. It might well be that the 100 more attractively priced stocks in the world are all financials but he would not overload the portfolio with them because that overexposes his investors to interest rate risks. Heightened vigilance here is one of the lessons of the 2007-08 crash.
- An interesting analogy on the correlation and portfolio construction piece: he tries to imagine what would happen if all of the companies in his portfolio merged to form a single conglomerate. In the conglomerate, he'd want different divisions whose cash generation was complementary: if interest rates rose, some divisions would generate less cash but some divisions would generate more and the net result would be that rising interest rates would not impair the conglomerates overall free cash flow. By way of example, he owns energy exploration and production companies whose earnings are down because of low oil prices but also refineries whose earnings on up.
- He instituted more vigorous stress tests for portfolio companies in the wake of 07/08. 25 of 70 companies were "cyclically exposed". Some of those firms had high fixed costs of operations which would not allow them to reduce costs as revenues fell. Five companies got "bumped off" as a result of that stress-testing.
Interesting Q&A:
Timothy Garr:
why not just a concentrated, "best ideas" portfolio. BH: we've tried modeling concentrated portfolios of our holdings, but we haven't been able to find a way of constructing a focused portfolio that has a consistently better risk-return profile than global value's.
Timothy Garr:
why charge a transaction fee? BH: our Pear Tree and PNC funds don't. For Polaris itself and for most of its investors, it makes little economic sense to impose the extra fees required to create the NTF illusion. You can buy PGV direct from Polaris to dodge those fees.
Neil Burns: how do you handle "consolidated
risk" factors, such as how much emerging markets exposure to have? BH: it's a combination of our cost of capital discipline (if your economy and government are shaky, you end up with a high cost of capital and very few of your firms will be able to earn their cost of capital) and qualitative screens (he and all of his staff are heavily invested in the fund and he
hates to lose money, so he ends up doing a "gut check" that sometimes lead him to say "no mas").
Ken Norman: how would you
allocate between your foreign value and foreign value small cap funds? BH: a conservative foreign investor might look at 75% Value/25% SCV. They try to "manage down" the small cap fund's beta but it's more of a challenge now than it used to be. Small cap investors used to be reasonably patient and long-term because they knew that's what it took to unlock the small cap premium, which tended to dampen volatility. Now with so much money invested through sliced-and-diced ETFs, the markets seem jumpier.
Ken Norman: are you the
lead manager on both the foreign funds? BH: Yes, but ... Here Bernie made a particularly interesting point, that he gives his associates a lot of leeway on the foreign funds both in stock selection and portfolio construction. That has two effects. (1) It represents a form of transition planning. His younger associates are learning how to operate the Polaris system using real money and making decisions that carry real consequences. He thinks that will make them much better stewards of Polaris Global Value when it becomes their turn to lead the fund. (2) It represents a recruitment and retention strategy. It lets bright young analysts know that they are a real role to play and a real future with the firm.
Shostakovich: you've used
options to manage volatility. Is that still part of the plan? BH: Yes, but rarely now. Three reasons. (1) There are no options on many of the portfolio firms. (2) Post-08, options positions are becoming much more expensive, hence less rewarding. (3) Options trade away "excess" upside in exchange for limiting downside; he's reluctant to surrender much alpha since some of the firms in the portfolio have really substantial potential.
Shostakovich: how did you manage to r
educe your e.r. at a time when assets were not rising sharply? BH: we decided to absorb some of the expenses ourselves in order to reduce our e.r. below 1.0%, which is a threshold for consideration by many institutional investors. We're hoping that going below 1.0% makes them willing to take us seriously.
For what that's worth,
David
Comments
http://www.mutualfundobserver.com/wp-content/uploads/audio/PGVFX_20150113.mp3
Thanks for this. Very informative, and many thoughtful comments and insights offered by Mr. Horn.
Kudos all the way around.
D.S.