Reflections on Hedge Fund AltaRock’s Investment Process – Part 2

Today, I continue my commentary on hedge fund AltaRock’s investment criteria as laid out in their first half 2010 letter. As I explained in yesterday’s post, I have structured my remarks using my investing blueprint as the framework.

6.  Buy the Cheapest Business Available. AltaRock looks to buy businesses that are cheap. You can infer from their letter that, in general, they are looking for businesses that will deliver more present value dollars of cash than an investment of equal value in a market index, such as the S&P 500. They know that if they do this consistently, over the long term, they create a real mathematical expectancy of beating the market. Similarly, you want to put together a portfolio of investments that ideally is both cheaper than the market and that has an intrinsic value that is growing faster than that of the market.

7.  Focus on Your Best Ideas. AltaRock has 84% of its capital in its top five holdings and 94% of its “look through” earnings. Here they follow Buffett who tracks his share of the earnings of his equity holdings. The idea here is that even though these earnings are not reported in Berkshire’s financials because of GAAP, the earnings still accrue to the economic benefit of Berkshire.

8.  Practice Patience. The letter opens by saying that AltaRock underperformed the S&P 500 in the first half of 2010. They don’t put undo emphasis on short-term results, nor should you. He goes on to say that their strategy tends to generate short periods of superior performance and underperformance. They look to outperform over the long-term.

You should adopt a similar approach. No one can produce positive or superior results every quarter unless they are fudging (Madoff). Plus it’s the long-term that matters. Focus on total returns not getting a smooth ride. Volatility is not a good proxy for risk.

9.  Avoid Stupid Mistakes. In the letter, AltaRock apologizes for holding too much cash – they averaged 30% – over the past decade, characterizing it as a mistake. I’m not so sure. They beat the market by a substantial margin with arguably less risk.

There may be times to be 100% long, but, more often than not, it is prudent to have a portion of your capital in liquid short-term assets. You never know when Mr. Market will become manically depressed; not holding cash can have a high opportunity cost. In his October 16, 2008 “Buy American” op-ed in the New York Times, Buffett wrote that he was previously 100% in U.S. government bonds prior to starting to buy equities.

AltaRock manages macro-economic risk by consciously building a portfolio that is exposed to faster growing emerging markets. They simultaneously hedge their exposure to currency and inflation risks in highly indebted developed countries.

Of note, although the letter does not mention it, is that AltaRock’s portfolio also appears well positioned for a deflationary period. The types of large caps stocks they invest in typically pay a relatively high dividend, particularly if purchased at their current depressed multiples. In addition, sales in AltaRock’s portfolio companies should hold up relatively well since they sell tend to sell necessities.

An important point regarding their discussion of cash holdings is that they have taken the time to go back and review their past performance in order to learn from it. Nobody, of course, can avoid making mistakes. Hopefully, you can learn from them by doing post mortems.

10.  Be a Learning Machine. AltaRock’s document does not directly address how they seek to continually learn. We can deduce that, like many investors, they are grappling with the lessons learned from the most recent recession and market shocks and that they are trying to position their portfolio in a way that puts them in a position to succeed if the macro environment continues to be a major headwind.

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