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Bigger Is Better? For Investment Managers, Maybe Not

It’s no secret that America has long operated under an obsession with size. Over the last couple of decades, the average house size has continually increased (even as lots are shrinking ), cars have become supersized , food portions have grown, retail stores continue to sprawl, and even our waistlines have gradually expanded. Everything, it seems, is increasing in mass or breadth , as our national focus on size-above-all becomes ever more pathological with each passing year. This “bigger is better” mentality bleeds over into our financial lives, as well. Even as we rail against the “Too Big To Fail” banks for destabilizing our economy and extracting rents from working-class Americans, we continue to bank with them en masse, lured by the convenience and security of working with a known brand name. As a result, the big banks continue to get larger still, to the point that they’re now bigger than ever (and, coincidentally or not, failing some government-led stress tests). Click to enlarge Unsurprisingly, this same mentality holds true when it comes to our investments, and the advisors we choose to work with. Most individuals simply default to working with the big wirehouse brokerages (Morgan Stanley, Merrill Lynch, Wells Fargo, etc.), even when they could be obtaining better service (and true fiduciary advice ) by working with a smaller, independent Registered Investment Adviser firm. And yet, there’s a growing body of evidence that smaller (and not bigger) might actually be better for many things, including our investment returns. In early 2013, a study released by Beachhead Capital found that among approximately 3,000 long/short hedge funds, the funds managed by firms with total assets under management (AUM) between $50 million and $500 million outperformed those run by larger firms over essentially every time period studied. And the amount of outperformance was significant — 2.54% per year over five years, and 2.20% per year over ten years, with the outperformance concentrated in the years immediately preceding and following the financial crisis of 2009. Risk measures were roughly the same for the different types of firms, so the outperformance can’t be explained by greater risk-taking. And while “dispersion” measures were greater among the smaller advisors — meaning that returns varied more for smaller firms than for larger ones — the overall difference in performance is too large to be ignored. These findings run counter to what much industry research might predict. Whether at hedge funds or at investment advisory firms, scale is generally expected to improve purchasing power, and to allow for access to a broader range of investment vehicles (like certain swaps and derivatives or other over-the-counter products that smaller firms simply can’t access via their existing custodial channels). If nothing else, size is supposed to improve the terms that managers are able to negotiate, whether via lower commissions or fees or via improved investor protections in potential bankruptcies or other corporate restructurings. And yet, intuition aside, these benefits of scale simply don’t seem to be flowing through to the bottom line, for the firms or their investors. Beachhead presented a number of potential explanations for the disparity, a few of which I’ll paraphrase here. Some investments don’t benefit from scale Contrary to conventional wisdom, bigger isn’t always better in the markets; sometimes, size can be a limiting factor, constricting the types of investments that a firm can realistically add to its portfolio. Take the case of the Harvard Management Company, the group tasked with managing Harvard University’s sizeable endowment . For years, HMC’s investment performance was top-notch, consistently beating its peers as its talented managers consistently generated high double-digit annual returns. But as HMC’s portfolio continued to grow, it found itself running out of viable places to put all of its money. In many markets, they had already become the single largest owner of available shares, and to increase the size of their stakes in those investments would impede their ability to exit (or trim) those positions in the future. In some markets, HMC had effectively become the market, simply by virtue of its size. Funds (or managers) in that position are left with two basic options: either begin to branch out into ever more esoteric investments and asset classes, or else pile into the so-called “hedge fund hotels” , those few investment vehicles that have the opportunity for outsized gains, but are also large and liquid enough to accept massive inflows of capital without enduring wild market-moving price shifts. Neither option is particularly attractive, from the investment manager’s point of view. Choosing the “esoteric investments” route often means accepting significantly less liquidity (and an attendant increase in volatility), which tends to limit flexibility while also exacerbating the impact of downturns on fund returns. Indeed, this is exactly what happened to HMC during the 2009 financial crisis, a dynamic that led to a reconsideration of overall investment strategy. But the “hedge fund hotel” route is similarly problematic: for one, how can a fund distinguish itself from its peers when all funds own the same investments? Wouldn’t larger firms then, by definition, simply trend toward standard “average” market performance over time? And, perhaps more concerningly, what happens when a majority of the large funds all run for the “hotel” exits at the same time? At best, the fund is, again, forced to endure greater portfolio volatility, and at worst, the managers are trampled like so many young men in Pamplona . The fact is some investment opportunities are small enough that only a small advisor can really avail itself of the benefits — the market for the investment could be so limited that the large manager’s entrance would simply overwhelm the market and thus eliminate any mispricing opportunity. Even if the large fund were successful in its trade, the gross size of the gain might be so small as to barely impact total fund returns. Think of the old parable of Bill Gates stooping down to pick up a 100 dollar bill (or a mythical 45,000 dollar bill ) — reaching down to pick up that $100 would have little to no impact on his net worth, and it might even be a complete waste of his time to bother with picking it up. For a panhandler, though (or a poor college student, or me or you), that $100 would make a meaningful impact on our bottom line. The same holds true in the markets: sometimes, the available opportunity in a specific investment is limited to a set dollar amount, an amount that will certainly help improve small manager returns, but that would have little to no measurable impact on the returns of the larger fund. Beachhead refers to this dynamic as the “broader opportunity set” dynamic, and it is very real. If it weren’t, then “hedge fund hotels” would never have existed in the first place. As it stands, the larger you get, the fewer markets (or opportunities) you can find that are large and liquid enough to accommodate your increased size. Hence, in some markets, smaller advisors are at an inherent advantage in terms of percentage performance. The “talent” gap It’s generally assumed that the most talented managers will be enticed to work at the largest firms, since those firms have the greatest resources and opportunities, enabling young and talented advisors to thrive and become rich. However, there’s a counter-narrative in play that makes at least as much sense. If you’re truly talented, and capable of generating outsized returns, why would you want to sell that skill off, enabling a large corporation to profit from your work? Wouldn’t you be better off launching your own firm, so as to profit off of your own work, rather than counting on your boss (or a board of directors) to determine your ultimate compensation? Indeed, there’s an argument to be made that smaller advisors represent a specific type of self-selection: only those advisors who are very confident in their ability to survive on their own will even bother to break away and start their own operation. Yes, they’ll be smaller by definition, but their talent and ability to generate returns for investors will be unaffected by a switch in the logo on their business card. As demonstrated above, the advisors might even be able to open up their investment opportunity set by doing so. Arguably, those who choose to work at the largest firms (and stay there for the long run) are simply those who crave the stability and comfort that those firms provide or promise. Particularly for the millennial generation, there seems to be a trend toward entrepreneurship and betting on oneself , and that trend impacts the investment advisory industry as well. If you’re an investor, do you want to hire the manager who needs (or who thinks he needs) a big brand name in order to succeed, or one who trusts in his ability to swim on his own, even without the resources and advantages that the larger firm provides? That remains an open question, but the evidence is beginning to mount in favor of the smaller firm. The importance of each individual client One dynamic that Beachhead does not mention, but that may be particularly important for those looking to choose an investment manager, is what I will call the “burning platform” issue. At a large firm, complacency can often be a very powerful force. For the big wirehouse brokerages, a sudden loss of 1 or 2 or clients (or even, say, 5-10% of clients) may not be meaningful enough to really impact the bottom line over the long run. Sure, a few layoffs and restructurings might result, but the viability of the business is rarely threatened. At smaller firms, though, the experience and importance of each individual client is amplified. A period of sustained underperformance that leads to client attrition could , in fact, threaten the long-term viability of the firm, as well as the paychecks of the managers in question. The closer a manager is to the end user — and the greater the importance of each individual client — the less room for complacency and apathy there will be. At smaller firms, there’s simply less room for ignorance of client needs — you either perform or you’re history, generally speaking. At the end of the day, while we all might derive some comfort from size, research shows that betting on smaller managers can often be a savvy move. Ultimately, brand names are little more than a signalling mechanism — “we’re safe, we’ve been vetted,” say the big brands. You can trust them, they’d argue, because their size indicates that many others have (presumably) done their research and chosen to work with them already. 50 million Elvis fans can’t be wrong , right? Thus, when we blindly choose to work with the big brand name, what we’re effectively doing is outsourcing our due diligence to others. Instead of choosing to learn about the firms or managers in question, we simply rely on the brand name to protect us, because it’s the seemingly “safe” play. Increasingly, that approach doesn’t hold water. As an investor, take it upon yourself to learn more about the actual services that are offered, the actual philosophies that guide different offerings, and really get to know the diversity of service offerings. All of the various industry players have different strengths and weaknesses, the relative merits of which may or may not be important to you; don’t assume that the big guy has exactly what you want and need just because they’re big. In reality, it’s rarely the case. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.

Lessons From The Fall Of SunEdison

“The boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.” – George Soros, Alchemy of Finance There was a very interesting article in The Wall Street Journal a few days ago on the story of “the swift rise and calamitous fall” of SunEdison (NYSE: SUNE ). Like a number of other promotional, Wall Street-fueled rise and falls, SunEdison became a victim of its own financial engineering, among other things. SUNE saw rapid growth, thanks in large part to easy money provided by banks and shareholders. Low interest rates and deal-hungry Wall Street investment banks helped encourage rapid expansion plans at companies like SunEdison and provided the debt financing. Yield-hungry retail investors suffering from those same low interest rates on traditional (i.e., prudent) fixed-income securities helped provide the equity financing. Just like MLPs and a number of similar structures popping up in related industries, SunEdison provided itself with an unlimited source of growth funding by creating a separate business (actually, a couple of separate businesses) that are commonly referred to as yield companies, or “yieldcos”. These yield companies are, in effect, nothing but revolving credit facilities for their “parent” business, and the credit line is always expanding (and the yield company is the one on the hook). The scheme works as follows: a company (the “parent”) decides to grow rapidly. To finance its growth, it creates a separate company (the “yieldco”) that exists for the sole purpose of buying assets from the parent (usually at a hefty premium to the parent’s cost). To source the cash needed to buy the parent’s assets, the yieldco raises capital by selling stock to the public, by promising a stable dividend yield. The yieldco uses the cash raised from the public to buy more assets from the parent, and the parent, in turn, uses these cash proceeds to buy more assets to sell (“drop down”) to the yieldco, and the cycle continues. Thanks to a yield-deprived public, these yieldco entities often have an unlimited source of funds that they can tap whenever they want (SUNE’s yieldco, TERP, had an IPO in 2014 that was more than 20 times oversubscribed). As long as the yieldco is paying a stable dividend, it can raise fresh capital. As long as it raises capital, it can buy assets from the parent, who gets improved asset turnover and faster revenue growth. In SunEdison’s case, the yieldco is Terraform Power (NASDAQ: TERP ). (There is TerraForm Global (NASDAQ: GLBL ) as well). I made a very oversimplified chart to try and demonstrate the crux of this relationship: It Tends to Work, Until it Doesn’t Buffett said this recently regarding the conglomerate boom of the 1960s, whose business models also relied on a high stock price and heavy doses of stock issuances and debt: If the assets that the yieldco is buying are good quality assets that do, in fact, produce distributable cash flow (i.e., cash that actually can be paid out to shareholders without skimping on capital expenditures that are required to maintain the assets), then the chain letter can continue indefinitely. The problem I’ve noticed with many MLPs is that the company’s definition of distributable cash flow (DCF) is much different than what the actual underlying economics of the business would suggest (i.e., a company can easily choose to not repair or properly maintain a natural gas pipeline. This gives it the ability to save cash now [and add to the DCF, which supports the dividend], while not worrying about the inadequately maintained pipe that probably won’t break for another few quarters anyhow). Another thing I’ve noticed with businesses that try to grow rapidly through acquisitions is that the financial engineering can work well when the asset base is small. When Valeant (NYSE: VRX ) was a $1 billion company, it had plenty of acquisition targets that might have created value for the company. When VRX became a $30 billion company, it is not only harder to move the needle, but every potential acquiree knows the acquirer’s game plan by then. It’s hard to get a bargain at that point, but it’s also hard to abandon the lucrative and prestigious business of growth. ( Note : Lucrative depending on which stakeholder we’re talking about.) In SunEdison’s case, the Wall Street Journal piece sums it up: “As SunEdison’s acquisition fever grew, standards slipped, former and current employees, advisers, and counterparties said. Deals were sometimes done with little planning or at prices observers deemed overly rich… Some acquisitions proceeded over objections from the senior executives who would manage them, said current and former employees.” So, the game continues even when growth begins destroying value. Once growth begins to destroy value, the game has ended – although it can take time before the reality of the situation catches up to the market price. Basically, it’s a financial engineering scheme that gives management the ability (and the incentives, especially when revenue growth or EBITDA influences their bonus) to push the envelope in terms of what would be considered acceptable accounting practices. In some recent yieldco structures, I’ve observed that when operating cash flow from the assets isn’t enough to pay for the dividend, cash from debt or equity issuances can make up the difference – something akin to a Ponzi. Incoming cash from one shareholder is paid out to another shareholder as a dividend. Even when fraud isn’t involved, this system can still collapse very quickly if the assets just aren’t providing enough cash flow to support the dividend. Incentives The incentives of this structure are out of whack. The parent company wants growth, and since it can “sell” assets to a captive buyer (the yieldco) at just about any price, it doesn’t have to worry too much about overpaying for these assets. It knows the captive buyer will be ready with cash in hand to buy these assets at a premium. In SunEdison’s case, management’s incentive was certainly to get the stock price higher because, like many companies, a large amount of compensation was stock-based. But their bonuses also depended on two main categories: profitability and megawatts completed. Both categories incentivize growth at any cost – value per share is irrelevant in this compensation structure. You might say that profitability sounds nice, until you read how management decided to measure it : “the sum of SunEdison EBITDA and foregone margin (a measure which tracks margin foregone due to the strategic decision to hold projects on the balance sheet vs. selling them).” Hmmm… that is one creative definition of profitability. Not surprisingly, all the executives easily met the “profitability” threshold, and bonuses were paid – this is despite a company that had a GAAP loss of $1.2 billion and a $770 million cash flow loss from operations. Growth at Any Cost At the root of these structures is often a very ambitious (sometimes overzealous) management team. The Wall Street Journal mentioned that Ahmad Chatila, SUNE’s CEO, said that SunEdison ” would one day manage 100 gigawatts worth of electricity, enough to power 20 million homes .” Just last summer, Chatila predicted the company would be worth $350 billion in 6 years , and one day would be worth as much as Apple (NASDAQ: AAPL ). These aggressive goals are often accompanied by a very aggressive, growth-oriented business model, which can sometimes lead to very aggressive accounting practices. I haven’t researched SunEdison or claim to know much about the business or the renewable energy industry. I’ve followed the story in the paper, mostly because of my interest in David Einhorn, an investor I admire and have great respect for. Einhorn had a big chunk of capital invested in SUNE. David Einhorn is a great investor. He will (and maybe already has) made up for the loss he sustained with SUNE. This is not meant to be critical of an investor, but to learn from a situation that has obviously gone awry. Parallels Between SUNE and VRX The SUNE story is very different from VRX, but there are some similarities. For one, well-respected investors with great track records have invested in both. But from a very general viewpoint, one thing that ties the two stories together is their focus on growth at any cost. To finance this growth, both VRX and SUNE used huge amounts of debt to pay for assets. Essentially, neither company existed a decade ago, but today, the two companies together have $40 billion of debt. Wall Street was happy to provide this debt, as the banks collected sizable fees on all of the deals that the debt helped finance for both firms. Investing is a Negative Art A friend of mine – I’ll call him my own “west coast philosopher” (even though he doesn’t live on the west coast) – once said that investing is a negative art. I interpret this as follows: choosing what not to invest in is as important as the stocks that you actually buy. Limiting mistakes is crucial, as I’ve talked about many times . While mistakes are inevitable, it’s always productive to study your own mistakes as well as the mistakes of others to try and glean lessons that might help you become a little closer to mastering this negative art. One general lesson from the SUNE (and VRX) saga is that business models built on the foundation of aggressive growth can be very susceptible to problems. It always looks obvious in hindsight, but a strategy that hinges on using huge amounts of debt and new stock to pay for acquisitions is probably better left alone. Sometimes, profits will be missed, but avoiding a SUNE or a VRX is usually worth it. General takeaways: Be wary of overly aggressive growth plans, especially when a high stock price (and access to the capital markets) is a necessary condition for growth. Be skeptical of management teams that make outlandish promises of growth, and be mindful of their incentives. Be careful with debt. Try to avoid companies whose only positive cash flow consistently comes from the “financing” section of the cash flow statement (and makes up for the negative cash flow from both operating and investing activities). Simple investments (and simple businesses) are often better than complex ones with lots of financial engineering involved. Here is the full article on SUNE , which is a great story to read. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Quarterly Update: Portfolio Rebalancing – A Potentially Golden Opportunity

For a variety of reasons, gold is a widely held asset class within investment portfolios. Many investors include gold in their asset allocation mix for its perceived ability to act as both a diversifier and as a potential store of value in times of uncertainty; these perceptions contribute to the concept of gold as a “core holding” in many diversified portfolios. Indeed, with the notable exception of Warren Buffett, 1 some of the investment community’s most distinguished names currently maintain investments in gold 2 . Like any investment, gold is subject to rebalancing or reallocation when its value relative to other portfolio components shifts significantly. Examining quarterly data from the beginning of 1976 (the year that gold started trading freely in the United States) through the quarter ended March 31, 2016, suggests that gold is overvalued relative to historical price relationships with the major agricultural crops of corn, wheat, soybeans and sugar. 3 In fact, the gold/soybean ratio is nearly at its all-time high. At quarter end March 31, 2016, the gold/corn ratio, defined herein as the number of bushels of corn an investor could buy with the proceeds from selling one troy ounce of gold, was 351 bushels, versus a 39-year average value of 170 bushels. Gold investors attempting to maximize portfolio performance through disciplined quarterly or annual rebalancing, may want to consider adjusting their gold holdings in tandem with their existing or anticipated agricultural sector portfolio investment mix. For example, the historical data for the gold/corn ratio suggests that a mean reversion 4 from March 31, 2016 levels of 351 bushels to the 39-year mean value of approximately 170 bushels of corn for each ounce of gold (bu/oz), could benefit an investor rebalancing gold for corn within their portfolio. Click to enlarge As illustrated in the chart on page 1, at 351 bu/oz the gold/corn ratio is approximately 107% above its nearly four-decade average of 170 bu/oz. Hypothetically, if an investor sold gold and purchased corn at the current 351 bu/oz level, and the ratio subsequently retraced to its historical mean value of approximately 170 bu/oz, the investor would then be able to sell the corn and buy back 107% more gold than was originally sold, to make the temporary reallocation from gold into corn. The gold/corn ratio may have been within 6% of its all-time high at the end of Q1 2016, but both the gold/wheat and gold/soybean related ratios were also very near historic highs over the same time period. The gold/wheat ratio was within 3% of its all-time highest value, and the gold/soybean ratio was within 1%, or virtually at, its all-time high value. The gold/sugar ratio is 41% below its all-time high. Charts for the gold/wheat, gold/soybean, and gold/sugar ratios are shown below. Click to enlarge Click to enlarge The current availability of both futures contracts and futures-based exchange traded products for gold, corn, wheat, soybeans, and sugar make rebalancing the gold and agricultural components within a portfolio easier than ever before. Investors and advisors need to make an assessment of the relative value of gold versus their other portfolio constituents, including agriculture, and appropriately adjust their allocations to suit their individual investment needs and objectives. 1 “Why Warren Buffet t Hates Gold.” NASDAQ 15 Aug. 2013: Web. October 9th, 2014. 2 Based on the 13-F filings for holders of GLD, the SPDR Gold Trust, as of 3/31/16 and found using Bloomberg Professional, April 12th, 2016. 3 Analysis & corresponding charts were prepared by Teucrium Trading, LLC, using Bloomberg Professional, April 12th, 2016. All supporting detail available upon request. 4 Mean Reversion: A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry. Disclosure: I am/we are long I AM/WE ARE LONG CORN, WEAT, SOYB, CANE, TAGS. Business relationship disclosure: Sal Gilbertie is the Founder, President, and CIO of Teucrium Trading, LLC, the Sponsor of the Teucrium CORN Fund ETP (NYSE Ticker “CORN”) and other agricultural ETPs listed on the NYSE under the ticker symbols “WEAT” “SOYB” “CANE” and “TAGS.” Additional disclosure: I have held in the near past, and may purchase in the near future, shares of DGZ as a proxy for short gold against my long agricultural holdings of corn, wheat, soybeans and sugar.