Hedge fund managers who blew up
Let’s look at the issues faced by each of the hedge fund luminaries during their anni horribiles!
Mr Paulson was thrust into the limelight from relative obscurity in 2008, having run a small hedge fund out of New York that had concentrated on so called “Event/ Merger Arbitrage” since the late 90’s, and where his firm churned out steady, if not spectacular, returns. There is some contention over who was the real architect of the so called “trade of the century”, with Paolo Pellegrini seen by many as the real catalyser of the us subprime bond trade that made Paulson’s name and his multi-billion fortune. Controversy also surrounded the aftermath of the trade with Goldman Sachs being at the centre of allegations that jp and the Vampire Squid had ‘rigged’ the so called Subprime cds tranches that Paulson bought options/insurance on to other investors detriment. Nonetheless, jp managed to keep his haul intact — a haul that summed $3.5Bn personally. Until 2011 that is…
Poor old “jp”, as he is known, suffered one of the biggest drawdowns (profit give back) in hedge fund history during 2011 — a year to forget for many. His flagship fund, the “Advantage Plus” fund, fell by an amazing 52.5% In 2011 — a year when the S&P 500 essentially finished flat. That measure of underperformance against his benchmark is almost unheard of for a fund manager of his calibre. What makes it doubly hurtful for him is that the majority of the monies in his funds are his and his employees! If you’re wondering how much in cash terms the funds lost, the answer is around $15bn — give or take a billion! That’s gotta hurt, no matter how much you have.
So why did jp stumble so much in 2011? The answer is essentially simple — firstly his big macro call — that the us economy would resurge, was wrong. Get your primary asset allocation call wrong and you are basically going to swim against a tsunami. Secondly, not only did he get it wrong, but he bet too big — he made the same elementary mistake most novice traders do and that is he position sized too large. Makes you feel better eh? That even the “Pro’s” succumb to human nature! Finally, he quite simply failed to reduce his positions quickly enough.
His 2012 has not gone much better either with Paulson down at the time of writing another 18%. Again, this is in contrast to an S&P 500 year to date return of almost 13%.
John Meriwether learnt his craft at the venerable us investment bank Salomon Bros where he was an exceptional bond trader and ultimately rose to become Vice Chairman of the bank. He went on to start the infamous and rather inappropriately named Long Term Capital Management (ltcm) hedge fund in 1994 with the creators of option modelling and pricing — Myron Scholes and Robert Merton — both of whom shared the Nobel prize for Economic Sciences in 1997 (1 year before ltcm’s collapse!).
Ltcm was engaged in exploiting tiny pricing anomalies in bonds, so called statistical arbitrage, and for its first few years it produced cracking returns — in excess of 40% after fees. When the Russian Financial Crisis hit in 1998, a year after the Asian one, ltcm came a cropper and in fact needed Fed intervention to avoid a collapse of the financial system. The reason? Again, leverage. So small were the individual returns on each of the positions that the fund needed to borrow to the hilt to amplify these. At the time of the collapse the fund was levered 25 times!
Alan Greenspan rounded up his buddies on Wall Street as the unwinding of the positions threatened to create a cascade of selling in S&P futures and a consortium of investment banks took the positions on their books with Fed help and rode the storm through. At its heart, the underlying positions were fundamentally sound. Where they went wrong was again the twin evils that seem to befall many a successful trader — hubris and greed.
What lessons can we learn from the experiences of the hedge fund managers above? To me, the glaring thing that stands out is that your luck never lasts forever. You have a winning streak? Take the money out of the market — spend it, put it in “safe investments”, do anything with it, but take some out.
Secondly, the vast majority of returns on accounts that appear spectacularly successful pretty much without fail come from asset allocation — get this right and then run with the position and you shorten your odds of success — this ties in with the best trend following systems modus operandi. Of course, choosing the right asset class is easier said than done — major technical dislocations, glaring fundamentals that support the investment case and en masse disgust with the asset class are all ingredients you want to see on the buy side — Spanish equities anyone? And, of course, vice versa on the short side.
Thirdly, the word “crisis” seems to crop up quite a bit in this article — that’s because people continue to make the same mistakes. Always have, always will. If the markets have been going great for a few years, this leads to complacency and excessive risk taking and, it seems, a new crisis. If you’ve been sailing on the calm waters of a conducive market environment for some time, and feeling good about your trading, then this is precisely the point you should be dialling back leverage and reducing risk.
Zak Mir Interviews
Alpesh Patel- The Mind of a Trader
Alpesh Patel is, to my mind, one of a kind. An independent and somewhat maverick figure in both the City and the business world. His list of activities over the past decade is breathtaking simply by virtue of the sheer variety of roles — trader, author, trained barrister, asset manager and adviser to companies and Governments. In this article, it is his “Mind of A Trader” that we explore…
Zak: Alpesh, at the beginning of the 2000’s you were somewhat the “People’s Champion” in terms of being a commentator / educational force and, most importantly, an objective figure in the financial markets as compared to the banks / fund managers and their legion salesmen. In those days, most of us could probably not even guess the number of sharp practices and scandals that were waiting to be uncovered… 10 Years later, the retail customer / investor seems to be in no better a position than back then even with your efforts, the media and the role of the internet to inform us. Being cynical, has your influence for good made any difference whatsoever?
Alpesh: I am sorry to say that it has probably made no difference to the vast majority of people even though I was writing for the ft or being a guest presenter on Bloomberg. My position put me somewhere between being an investigative journalist and a Member of Parliament, rather than a trader. Individuals were helped on a case by case basis, but in a broad sense, no, my crusade probably fell on deaf ears. The big institutions seem to have more and more resources at their disposal and have become ever more adept at hiding and, in some instances, cheating. Perhaps this has been a symptom of our times where City individuals are solely focused on cash based incentives, or perhaps it is indicative of a more general moral decline. Either ways, it would appear that individuals are tempted to cheat to get their hands on money.
The vast majority of private equity investors end up being merely index trackers through a ‘managed’ fund or etf, or they are attracted by the glitter of what is exciting, interesting or innovative — in most cases omitting to analyse just how much cash a company is throwing off — free cashflow. We like predictability in cash flows — similar to the venerable Mr Buffet’s approach and which also explains why he would never be involved with a company like Facebook as there is no track record of consistency or, equally importantly, when you project forward their revenue figures, no net present value that came close to their flotation market capitalisation.
Zak: On the basis that I am interviewing you for Spreadbet Magazine, I would put it to you that investing for the long term is not rocket science, find a boring blue chip like Diageo — people always need to get drunk(!) — buy the shares and wait a few years. It is not rocket science, even an old fool like Warren Buffett can do it. We do not want to wait until we are 80 to be rich. But the real challenge and excitement is in short term / day-trading even though it may be the North face of the Eiger for many. The $64,000 question is what should the first steps in this area be?
Alpesh: First point is that you can still spreadbet for the longer term. The second is that whether it is the long or short term, you still apply the same principles, such as money management, thorough analysis and discipline. Money management is number one — don’t bet or leverage yourself too much where you get into a bind and can’t emotionally take the loss.
Here’s an interesting comment for you — David Kyte, now a fully paid up member of the the uk’s Rich List said that when he was on the Liffe floor (futures trading exchange) they used to consult Page 3 of The Sun when deciding what to buy! True! This may be sexist, but what he was really saying was that he did not care in which direction the market went as long as there was momentum he could follow as well as not allowing his downside to exceed his upside expectation.
Another approach the private punter can take is technical analysis. Of course we all know nothing is 100% in trading, if it were you would be God. 7/8 Times out of 10, then you are son of God.
But I am happy with a 6 out of 10 strike rate. I do not search in vain for the Holy Grail in the markets — it doesn’t exist. Find a system that works for your personality profile and stick with it — applying money management rigidly and if it works, get on with it. If it doesn’t, analyse why and change.
Zak: I think what you are missing out on is the emotional side, the common sense side. Unlike you, most people do not have the analytical abilities of a barrister, two degrees, and an iq north of 150! They also do not have nerves of steel. Most people cannot help buying at the top and selling at the bottom — in the manner of the Bell Distribution Curve, and do not know whether the strategy they employed will work, especially after a few consecutive stop loss hits.
Alpesh: Actually it is 3 degrees and an iq of 178! As for the ‘balls’ — I won’t comment! In actual fact, I believe that over-analysing and having an excessive belief in one’s own intelligence can actually get in the way of trading. You tend to overthink these things. Some of the most successful people in business I know just get on with the job, they are not thinking about the meaning of life, they are just getting on with the task. You should be removing the emotion out of trading, as the moment you get emotional you are not following the process. This should be a detached process. Certain research done on this subject has found that the best traders are actually slightly psychotic or emotionally detached. As well as three degrees I also have two ex-wives, and at least one of them will vouch for my emotional detachment, something which proves helpful in terms of writing the alimony cheques via trading!
Zak: Isn’t short term trading for most people the equivalent of smoking, it would have been better if they had never started. There is no upside, unless you know you have the right aptitude or strategy?
Alpesh: It is not like smoking; it is like Facebook. For most people it will be absolutely pointless, but it will give you joy and pleasure. How does losing money do this? I will tell you how. What you do, you start small. The common sense thing to do is that while you are determining whether you have the aptitude you start small, say £5 bets for a few minutes a day. Be patient, and start with small amounts.
AIM, Oil and Gas Update
We provide an update overleaf on those stocks included within our Dream Oil Explorers Portfolio list and which is playing out nicely — the only real disappointment so far being Xcite Energy. Before we get into the individual stocks, I want to share the chart below with you which is a depiction of the aim Oil & Gas index and which I personally found very interesting.
To look at the bulletin boards of late (and which are always great contrary sentiment indicators, or so I find), you would be mistaken for thinking that the aim O & G sector was plumbing new lows what with many stocks languishing at valuation troughs comparable to those seen at the nadir of the 2009 bear market. However, as you can see from the chart below, the index is actually up around 100% from those lows. Yes, it is down over 30% ytd, but the level of pessimism around the sector is unjustified.
Aim Oil & Gas Index
Even more interesting, to us, is the technical picture of the index when viewed in the context of the current strong bearish sentiment.
We count 5 clear waves (if you are an Elliot Wave theorist) numbered in the chart below, and that per Elliot wave theory, such a pattern usually concludes a particular move. Our arrow indicates that we expect a rally back towards the upper resistance line of the flag formation over subsequent months and a break back towards and beyond the old highs.
We can also see that the index is perched bang on the support line from early 2009 and that we have retraced around 50% of the gains made from March 2009 to early January 2011. In short, coupled with the negativity around the sector and the many technical factors pointing to an important bottom being carved out, the chart picture emboldens us further with our stock picks.
Before we get into the individual stocks overleaf, take a look at the most recent ev:2P (Enterprise Value relative to Proven & Probable reserves) table to the right and you will see that our picks (with the exception of Ithaca Energy) are still very firmly in the lower half and more particularly around the $2-3 price range — a level that has set off takeovers in other companies (red squares).
The real outlier is Gulfsands Petroleum whose reserves are valued at less than a dollar a barrel due to the sanctions currently imposed on the company as a consequence of the ongoing issues in Syria.
Plenty of recent news flow from Heritage Oil which was 130p at the time of the original article (we called a Conviction Buy at 142p in April). In early July, the company announced it had formed a joint venture, Shoreline Natural Resources, with a local Nigerian partner, Shoreline Power, to acquire a 45% participating interest in oml 30, in Nigeria. It subsequently announced a $370 million rights issue to fund the $850 million acquisition with the remainder coming from a $550 bridging loan. The terms of the Rights Issue are expected to be announced by the 28th August 2012.
The oml 30 assets were acquired from Shell, Total and eni and will increase Heritage’s production significantly to around 11,500 barrels per day. The fields will be 45% owned by Heritage with the remainder being in the hands of the Nigerian government. The company expects oml 30 production to increase from 35,000 to 145,000 barrels per day by 2018. Heritage estimates that oml 30 has gross proved and probable reserves of 707m barrels of oil and 2.5Trn cubic feet gross reserves of gas.
The shares were suspended at 123p in early July at the time of the announcement. The shares returned from suspension on August 7th and have since rallied to 173p (time of writing). The cash flow from the Nigerian deal will enable Heritage to develop its other assets such as the Miran field in Kurdistan. In our opinion this is a smart deal to allow funding of more speculative parts of the company’s portfolio, and more importantly bridge the cash flow of the company through to monetisation of their key Miran field in Kurdistan. It also avoids some of the financial pitfalls that many smaller oil and gas companies are presently experiencing.
When Gulfsands Petroleum was first featured in the “Oil Explorers Dream Portfolio List” in July this year, its share price was 90p having plummeted from over £4 in 2011 to a low of 77p in June due to concerns about its exploration and production assets in Syria. Since then, the shares have rallied to 125p (time of writing), and still valuing the company at just £148 million.
In July, the company said that its Chorbane permit in which Gulfsands has a 40% interest and is operated by adx Energy (located onshore Tunisia) has been renewed for a further period of three years. The minimum work obligation for this further three year period consists of the drilling of one exploration well to a depth of at least 2,500 metres, and if the well is successful, Gulfsands will have the right to become its operator. In June, the Sidi Dhaher exploration well on the permit was plugged and abandoned since, despite good flow rates from the two reservoir zones, the fluids did not contain any oil.
Clearly despite the rerating from the lows, the value of Gulfsands’ Syrian operations has been pretty much discounted in its entirety by the market. Any potential resolution to the Syrian crisis and a resumption of activity could have a significant impact on the share price — probably starting with a 2 — and if not, then triggering a bid for the Group. For now the situation remains uncertain, but for patient investors it continues to be worth the wait and the shares should be added-to on any weakness.
At 60p in July and now at 64p, investors are waiting for key pieces of news from the company which is due to begin drilling in mid-August, and agree a farm out deal for its offshore Cameroon assets as well as the onshore Bomono acreage by the end of the year. Recent broker reports estimate a valuation of 189p a share based on the $4.7 Per barrel achieved in the recent farm out by Rockhopper to Premier Oil. Keep adding.
Xcite Energy shares have remained in a tight range around 77p despite positive news flow from its North Sea Bentley field over the last few weeks. The Rowan Norway rig drilling the 9/03b-7 well was producing at a stabilised rate of approximately 3,200 barrels per day with no associated basic sediments or water as of the beginning of August after an initial 2,900 barrels a day rate with 47,000 barrels of dry oil being collected by the Scott Spirit tanker.
Investors are waiting for further news from Bentley on the reservoir performance and potentially maximised flow rates as well as a potential farm in deal to allow phase 1b of field development to begin in 2013. Patience required for now, but everything remains on track with a highly attractive asset in the North Sea.
Falkland Oil and Gas
Falkland Oil and Gas sits at 92p compared with 97p in July, but plenty of news flow since then.
Fogl has struck a deal with Noble Energy Falklands Ltd, an affiliate of Noble Energy, with a farm-in to the northern area licences of the South Falklands basin for a 35% interest except for two excluded areas. Fogl will secure total investment over the next three years between $180 million and $230 million leaving the company with around $200 million at the end of the current drilling campaign to continue exploration work or appraisals later in 2014 (equivalent to just under 50p per share). Fogl will continue as operator of the entire Northern Area Licences until early 2013 when operatorship of the farm-in area will be transferred to Noble. In June this year, fogl announced a farm out deal with Edison International.
The Loligo exploration well 42/07-01 was spudded on Friday 3rd August 2012 using the Leiv Eiriksson rig. Following Loligo, the rig will move to the Scotia prospect in Q4 2012.
To sum up, investors looking for a bit of action from the Falklands Islands have plenty to keep them excited in fogl given the potential size of Loligo and Scotia in coming months. Plenty of risk, of course, but significant upside at 92p.
Northern Petroleum was 60p in July and is now at 67p following some positive drilling announcements.
In mid-July, Northpet Investment, which has a 2.5% Interest offshore Guyane (Northern owns a 50% equity interest in Northpet), commenced operations on the gm-es-2, the second well on the Guyane Maritime permit on Friday 6th July. Gm-es-2 follows up on the Zaedyus oil discovery in late 2011 which encountered 72 metres of net oil pay. Results are expected in October from the well.
In early August, Northern Petroleum announced that it had commenced drilling operations on the La Tosca-1 well in Italy, targeting a 43 billion cubic feet of gross mean prospective resource gas prospect with results expected in October.
To conclude, with a freshly buoyant oil price, a supportive technical picture, cracking valuations relative to the sector for our stock picks (on a ev:2P basis) and also relative to recent corporate takeover benchmarks, we sit expectantly awaiting material gains from this area of the market over the next 12 months.
You won’t win any prizes for guessing that the euro is the most popular currency to trade at the moment, and it has held onto its popularity crown for a considerable amount of time. The single currency has been a topic of conversation ever since the banking crisis of 2008 morphed into the sovereign debt crisis of 2010 and now, two years on, we are still talking about the eurozone every day with seemingly no end in sight to the woes of the Eurozone region…
Most recently the President of the ecb, Mario Draghi, said that he would do “whatever it takes” to save the euro which triggered a prolonged rise in risk assets and in particular a recovery by the single currency. This was an exceptionally bold statement for any central banker to make, especially since it was during a speech that was outside of any official policy meeting and regular press conference.
It certainly got investors pressing the buy-button faster than you can say “bid” and took eur/usd up towards the 1.2400 Level which many had not expected to happen since only a few weeks ago the calls were growing for a return to 1.1800 And even 1.1500. A short squeeze, many might say, but at least those clients who had been trying to pick the bottom of the bearish euro-move were happy to see the bounce. So now we’ve seen this bounce within a clearly bearish medium to long term trend, is there room for more upside or will the calls of sub 1.2000 Be right?
The concern is that Mr Draghi’s comments were carefully planned and designed to prevent a catastrophe. We know that in the past he’s done that with his Securities Markets Program (smp) and Long Term Refinancing Operation (ltro) which meant another banking crisis had narrowly been avoided, so what was he so scared of this time? Was Spain about to go kaput? Was Greece about to exit, or was Italy’s Prime Minister about to pick up the telephone to request a bailout? We are unlikely to ever know, but it is very possible that something was amiss otherwise he wouldn’t have said it and, to date, so spectacularly misled the markets as he hasn’t backed his words with actions.
The general consensus is that the euro is well supported over the near term and any other talk of protecting it from Mr Draghi could put more pressure on the mass of shorts that are still expectant of a complete euro collapse. But over the longer term the view is that the trend still has a southward tinge to it and the sticky plasters will not prevent the inevitable. Whatever happens in the coming months, I am sure we will still be talking about the euro for a long time to come…
Next up for our clients is gbp/usd or more commonly referred to as “cable”. Sterling has been impressive in recent months in its resilience and, in general, it is still perceived as a safe haven currency. But many argue that with the uk’s growth prospects continually being downgraded and record low interest rates of 0.5% — Which could even be slashed further later this year — the days of sterling strength are numbered. Let’s face it; the debt mountain that the coalition government have been at pains to reduce has barely had a dent put in it over 2 years into this exercise.
Against the euro, the Great British pound also seems to be defying gravity and, in this instance, there are few punters who would bet against the euro making back much ground against gbp due to the continual woes affecting the eurozone and single currency. But, where our clients are expecting the real action when it comes to sterling is in gbp/usd as sellers of cable have been creeping in. There are quite a few bears of sterling against the dollar, but the greatest challenge to their view is that no matter how poor the uk’s fiscal position looks, if the us starts ramping up the stimulus measures again this could easily send the dollar tumbling once more…
Last but not least, the Aussie dollar is another favourite for clients.
“Down under”, the Australian economy continues to boom and the Reserve Bank of Australia had raised interest rates way above those of Western central banks.
Whilst they have gradually been bringing that base rate down in the past year, their currency remains strong against the us greenback. The parity level remains a force to be reckoned with and, for now, those commodity bulls remain in the ascendancy. As with cable above, if the Federal Reserve does get qe3 underway, then this could precipitate another sudden move higher for aud/usd.
It would seem that whatever happens in the currency markets that for the rest of this year there are two major events that could impact them — the euro and the Fed. We will watch and wait to see how things unfold.