Institutional investors have become sceptical of hedge funds, particularly since so many have proved to be no more than expensive purveyors of beta. SIMON MUMME profiles one domestic marketneutral manager, TechInvest, which argues it has lived up to the sales pitch.
“Valuation itself is the treasure and jewel of the valued things,” writes Friedrich Nietzsche, the existentialist philosopher. He spent much of his time fighting to unlock life’s vitalities. “Through valuation only is there value; and without valuation, the nut of existence would be hollow.” People familiar with Sydney-based hedge fund, TechInvest, will recognise the quote since it accompanies the signature of its founder and head of research, Paul Davis, in each email correspondence. He says it encapsulates the importance of backing a worthy conviction. For an active manager, this means identifying the fundamentals and future profitability of businesses and how accurately they are reflected in the sharemarket.
“Someone has to be active. If everybody indexes, how do you know who’s wrong? If people invest solely on the basis of market capitalisation, you never get capital reallocation, and you get no growth,” Davis says. “Only through people going against this wisdom do you get value creation.” So far, the manager’s market-neutral global equities fund, the Intercept Capital Fund, which notched up its first fiveyear return last month, outperformed relative to its cash benchmark while all markets went to hell. For the 12 months to February 2009, it returned 7.34 per cent. Since inception, it has generated 9.84 per cent each year after fees, against the UBS Australia Bank Bills Index return of 6.3 per cent each year.
Concentrating on the knowledge industries of technology, telecommunications and health care, the Intercept fund aims to identify companies that will benefit or be harmed by impending structural change in those industries, and builds long and short portfolios accordingly. The manager, which formed amid the irrational tech-frenzy of the late 1990s, has always viewed technology as a growth sector. Davis has worked in California’s Silicon Valley, and later ran his own venture capital firm, which spawned E*TRADE in Australia, prior to starting TechInvest. “He’s a software nut,” says Ashley Young, portfolio manager with the boutique. “Paul has been there through the entire life cycle of companies, from start-up to mature businesses.”
But this focus on technology was relaxed to encompass global equities as it became clear that technology was being integrated in businesses across many sectors, Rick Steele, the boutique’s CEO and former head of BT Asset Management, says. “Now technology impacts almost every listed company. The aerospace, medicine, retail and health care sectors are now mostly driven by technology,” Steele says. “The new global giants in the index are IBM, Google, Cisco.” Within the IT sector, the area of innovation has changed to prioritise ideas over scale, Davis says. New concepts for products and software are most profitable, because the requirements for capital and infrastructure are trivial compared to hardware and distribution. “Look at Facebook, Twitter, Skype: they were created by a handful of people with assets in the tens of thousands,” he says.
“All the conventional stuff – the cheap distribution, storage – is now at a scale where the rate of innovation has slowed, and it’s now a question of refinement.” Identifying these types of industrywide changes drives the Intercept fund’s investment decisions. To arrive at these views, the team prefers not to use mediated information from brokers, company representatives or management – who have an incentive to please – but from information gathered first-hand. To gather inside information, Davis attends industry trade shows, and networks among business leaders and entrepreneurs at high-profile corporate events. The emphasis on change led Davis to concentrate on pharmaceuticals in the late 1990s: “It was clear to us that it was going to be a 20-year story, and be as productive an area as IT.”
Now TechInvest is pursuing an additional theme, not in the growth of a new industry, but of two massively populated countries. “It’s the same deal with China and India. There is a slump, they will stagger for a number of years, but they will be huge in the next five-to-20 years,” Davis says. The basis of his view can be traced to the early 1980s. Working in California’s Silicon Valley, Davis thought that in coming decades, the Asia-Pacific region would produce better investment opportunities than the US. Now he is planning to spend 2010 in India and China to gain an insight into how local corporations and entrepreneurs think about capital, risk and business decisions.
At some point beyond the global downturn, Davis says, India and China will generate their own breed of consumers and learn to not depend on export sales to the West. This will require domestic technological innovation, independent of Silicon Valley. “The consumer economies in these countries are still in nascent stages,” he says. “They will have to create their own internal demand, produced by their economies specifically for their consumption. In this, California won’t be that useful. “They have the capital to do it, but they’ve been living off exporting surplus production to the West and haven’t yet resigned themselves to the fact that those days are over.” Davis will draw on contacts in business, academia and the media to find innovative companies and detect research themes, and maintain contacts for the years ahead.
He expects the experience to yield insights, but few conclusions. “These are huge countries with millennia-old cultures. The idea that I’ll come to grips with them is preposterous,” he says.Going short, for the long run Steele says technology is permeating its way through society, and if companies don’t exploit the opportunities made possible by technology, they will suffer as the rest of the market evolves. Entertainment industry juggernauts, for instance, are being threatened by new waves of music distribution vehicles, such as the iPod and iTunes, and the ease with which content can be ripped. “Warner Music has been a great short over time,” he says.
“It holds up a barrier to entry and has content for sale, but they’re pushing water uphill because it has over-valued that content. The people who deliver now are those that disseminate content in different ways.” Big pharmaceutical companies have similarly been undermined by their smaller, more adaptive rivals, who use computers to empower drug research and development, says Young. “Biological research is different today than what it was a decade ago,” he says. “Today you need a degree in computer science to do research in that area.” He points to a celebrated achievement in modern science – the decoding of the human DNA sequence – to illustrate the advancements made possible by technology.
The super-computer enabled Dr Craig Venter, of Celera Genomics, to crack the human genome sequence ahead of a US Governmentfunded project with the same aim. “It was a match between a super computer and people with PhDs in white coats and test tubes,” in which technology delivered the unmatched edge, Young says. Five years ago, TechInvest itself reacted to the state of play in the broad market by adopting short-selling as a risk management and return-seeking technique. Dealing with the dotcom boom and fallout as a long-only manager “was so frustrating,” Davis says. “We would see crappy valuations all the time, but we didn’t have the tools, skills, or experience to go to the short side.
“Companies were selling at around 100-times sales. There is no world in which 100-times sales will make you money.” The performance of Intercept’s short portfolio indicates that the technique has positively influenced returns. Steele predicts that marketneutral managers, who in recent times accounted for about 5 per cent of the hedge fund market, will soon comprise between 15 and 20 per cent of it. Hedge fund survivors of the financial crisis – those that can retain investors and earn some performance fee – are positioned well to grow their businesses. “The world will drift to brand, transparency, simplicity,” he says.