Thoughts of an Investment Advisor - 2nd Quarter 2015 - Part 3

As I discussed in my last post, I am considering what to do with one of our positions that is underperforming so far this year – Gotham Market Neutral fund.  I have now participated in the Second Quarter update call on the Gotham funds as well as a roundtable conference call with the fund managers.  I have to say I came away very impressed by the managers’ knowledge, methodology, ability to explain complex issues, and willingness to answer some pretty tough questions.  The most surprising thing I heard was that all of their funds are still experiencing net inflows.  In other words, their investors are not bailing. 

Gotham has 13 analysts who review 3,000 stocks.  The methodology of the Gotham Market Neutral fund is based on valuing those 3,000 stocks and buying the 300 most undervalued and selling short the 300 most overvalued.  They make money or lose money based on “the spread” which is the difference between what the longs and shorts earn.  Their valuation process consists of three metrics as follows:


1.       Free Cash Flow
They view a stock as a business and consider the “free cash flow” that a business earns as the most important metric.  Free cash flow (FCF) is the cash left over after paying for operations, asset purchases, loan payments, and dividends.  They measure FCF as a percentage of the stock price.  On average, their long stocks have a positive 8.5% FCF and their shorts have a negative 0.51% FCF.  In other words, the shorts are losing money and will have to replenish their capital through loans or stock issuance. 

2.       Relative Value
A high FCF amount is only a positive factor if the price paid for the cash flows is low.  For example, if stock A and B each have FCF of $5.00 per share, and stock A sells for $60 per share while stock B sells for $150 per share, stock A would be undervalued compared to stock B. 

3.       Historic Relative Value
If two stocks have the same “value”, one stock may still have a valuation edge on the other.  Let’s say stock C has traditionally had a premium valuation and now has an average valuation and stock D has an average valuation but in the past had a low valuation. Gotham would consider stock C to be the more undervalued stock.   


The Market Neutral fund is underperforming this year because the short positions, which are overvalued per Gotham’s calculations, are going up in value faster than their long positions.  The managers view this as a situation which cannot last indefinitely.  Most of their short positions are small-cap stocks in the Russell 2000 Index.  That index, per Gotham, is very overvalued.  In the past 25 years, 95% of the time the index has had a lower valuation than it does today.  They were asked how long this imbalance might continue and could not, of course, give a definite date.  Instead, they said that in past periods of an index this overvalued (1999, 2007), when a reversal begins, the correction happens very quickly – one or two months in duration.  In a reversal, the overvalued stocks tend to decline in value much more than the undervalued stocks.  Therefore, the spread is very positive in a market decline and the fund value increases as the broad market is decreasing.  

I hold this fund as a partial substitute for the protection that bonds can provide to a portfolio.  It is part of the risk control of my portfolio allocation, along with balanced funds, bond funds and general diversification.  In my opinion, in order for an investment to provide effective protection, it has to meet two objectives:


1.      In a stock market downturn it has to decline less than the market, or preferably increase in value during the downturn.

2.      In normal stock market periods, it should have either a very low cost or contribute to overall returns.   


Holding cash meets the first objective, but in the current interest rate environment does not meet the second objective.  Likewise, buying puts on the market might help in a downturn, but would cost too much to hold the rest of the time.  As I mentioned before, I was impressed with the Gotham management and their methodology.  Does their approach meet my requirements for protection?  I have monthly return numbers for the strategy from mid-2009.  There were several market downturns in the years from 2010 to 2013 while the strategy was a hedge fund.  Here is a table that compares the S&P 500 returns during the downturn periods with several “insurance” type investments including gold, bonds, a Goldman Sachs hedge fund, and Gotham Market Neutral. 

Note that the Gotham periods are full months because I did not have daily return data.  All the insurance investments met the first objective by declining less than the market in total for the loss periods.  Bonds and Gotham performed better than gold and the hedge fund.  While all the investments had positive returns over the entire four year period, the hedge fund and Gotham performed appreciably better than bonds and gold.  Based on this comparison, I would have to say that Gotham met my requirements for effective portfolio protection in the past.  

The stock market has not had a 10% correction in 3 ½ years.  The likelihood of a meaningful correction increases by the day.  The Gotham Market Neutral fund should provide significant protection during a pullback notwithstanding the recent weakness in its returns.  My decision is to continue to hold the fund based on its past history, sound methodology, and excellent managers.  As always, feel free to call or email me with your comments and concerns.