The Paper Trail: Market Champions

And there goes July!

I hope everyone is having a great summer. It's been a busy month in the Huber house - my daughter and I share July birthdays a week apart from one another. I blinked and all of the sudden she is 5 (going on 15) years old. As for me, the final countdown of my 30's has begun with less than a year to go til the big 4-0. We were also blessed to celebrate the baptism of my son this month. Life is good. 

Before I get too sappy, I'd be remiss if I didn't shamelessly plug my recent appearance on the Making Markets podcast with my buddy Eric Golden. We talked private credit and a host of other investment topics. I don't usually enjoy the sound of my own voice, but I had fun listening back to this one...

And now, please enjoy the July 2024 edition of The Paper Trail. This month's research roundup features:

• Data science applied to LP-led secondaries
• Trend following and long/short quality as an alternative to bonds
• Life cycles of market champions
• The difficulty of being a patient investor
• Building a hedge fund portfolio
• The case for small buyouts in PE
• Equity issuance vs. buybacks
• Holding companies
• Endowment performance
• And much more!

Why is it so difficult for market leaders to stay on top for long?

"While the timeline of each cycle is highly uncertain, the vast majority have eventually succumbed to new entrants. Some have gone to zero; some are still relevant today but have underperformed the broader market. Every company is slightly different and today’s champions might be here to stay for the time being (especially given their strong competitive moats and strong balance sheets, allowing them the opportunity to both invest in new innovation and to buy up potential competitors), but the same could be said about others of the past. What we can say with a high degree of certainty is that the forces of creative destruction, whose effects are captured in the chart above, will make staying on top very difficult, and over a long enough period, very few will succeed."

The Life Cycle of Market Champions (Bridgewater)

Is there a better way to add "defense" to a portfolio than traditional fixed income?

"We investigate the value of the yieldy put by combining it with the ubiquitous ‘traditional’ global 60/40 portfolio in Figure 2. Note how the risk-adjusted returns of both our traditional portfolio and yieldy put strategy are about the same, but the properties of the 50/50 blend are significantly better. Relative to the traditional portfolio alone, the Sharpe ratio more than doubles, driven by both an increase in return and reduction in volatility, all while the drawdown is reduced by a factor of five – from 32% to 6%."

The Yieldy Put: To Infinity and Beyond Bonds (Man Group)

Are secondary buyers in PE not spending enough time on the "small" exposures in the portfolios they are underwriting?

"We find that these underperforming assets are statistically more likely to fall within the bottom 20-30% of the net asset value (NAV) of the mature private equity fund portfolios that secondary players tend to price. We examine the differences between these “Small” exposures compared to “Large” exposures, which account for the top 70-80% of NAV."

All or Nothing – The Importance of Data in Secondaries (Clipway)

Why is it so hard to be a diversified investor?

"Many investors suffer from behavioral biases that may result in performance chasing behavior. They are often fearful when the market declines and hence get more conservative at an inopportune time. Conversely, they may also chase good returns by investing in risky assets after a period of strong investment gains. Succumbing to these mistakes may lead to poor decisions, and hence poor portfolio outcomes. This is partly because return-chasing behavior often leads to buying high and selling low."

The art of patient investing (Meketa)

Why are so many venture-backed unicorns continuing to stay private for longer?

"Several of the largest private companies today have been in existence for decades: SpaceX is 22 years old, Stripe is 15, Databricks is 11. In 2024, Reddit went public after remaining private for 19 years."

Private companies disrupting the world (Fidelity)

Which hedge fund strategies have offered the most diversification during equity market drawdowns?

"We find that around 34% of hedge funds delivered positive returns during two or more of the five worst equity drawdowns. Almost all Managed Futures funds were positive in two or more drawdowns. In contrast, this was true for only 20% of Equity strategies over the same period. For many of the other strategies, the results were more mixed."

Building a Hedge Fund Allocation: Integrating Top-down and Bottom-up Perspectives (GIC/J.P. Morgan Asset Management))

Does the lower middle market offer structural advantages for private equity investors?

"The size of the potential investment opportunity set compared to the amount of capital chasing those opportunities has historically been mismatched in the small buyout market. Large market funds dominate the amount of capital raised in the private equity industry and fight over a limited set of target investments. The lower middle market is fragmented and, while there are more private equity firms, the number of potential deals is exponentially larger and continually growing"

The Case for Small Buyouts (RCP Advisors)

Are stock buybacks and stock-based compensation at odds with one another for capital allocation purposes?

"From an investor’s point of view, the returns for the stocks of companies issuing stock have been substandard, and the returns have been attractive for those that retire stock, on average. Those signals cross for companies that issue and retire stock at the same time. Presuming that executives can distinguish between stock price and value because they have better information than investors do, either issuing or retiring fails to meet the central goal of capital allocation."

Which One Is It? Equity Issuance and Retirement (Counterpoint Global)

Is endowment portfolio relative performance merely a function of how much equity-like risk is being taken?

"Total portfolio absolute returns are primarily driven by the overall risk budget of the portfolio including large allocations to illiquid asset classes – primarily comprising private equity."

Analysis of Large US University Endowment Outperformance (True North Institute)

Has the rising level of passive investing had an outsized impact on stock market returns?

"Passive has unquestionably changed the landscape of investing. But it hasn’t changed the math of investing, and at the end of the day it is the math that matters most."

FAQ: Passive Investing (GMO)

Why are aspiring entrepreneurs and post-MBA graduates gravitating towards the holding company model versus private equity or traditional search funds?

"The biggest difference between a holding company and a traditional search fund or a private equity platform is the anticipated duration of the project. Private equity and search funds think in years, and holding companies deliberate in decades. This allows for continual capital compounding, tax deferrals, avoiding idle time between investment projects, and bypassing redeployment risk."

Exploring Holding Companies in the Search Fund Ecosystem (Yale School of Management)

Do private funds offer diversification benefits to public markets investors?

"Nonetheless, we find a considerable fraction of their return variation remains unexplained post-2007 in all asset classes. Since unlisted assets expand the opportunity set for public investors, this suggests private funds have continued to offer considerable diversification benefits. Our results are based on a comprehensive data set of 6,000 North American private funds from 1980 to 2022 from the MSCI Private Capital Universe (PCU)."

Understanding Private Fund Performance (Dimensional Fund Advisors)