Mathews Capital – Are they really skilled or just lucky risk takers?

How do you assess whether a money manager is truly skilled or just lucky?

There is only one answer to this question – time. Lucky money managers will eventually fall by the wayside, just give them enough time and their initially impressive returns will revert to the mean or worse.

Money mangers with long track records of impressive returns are truly skilled. Think of Warren Buffett, Seth Klarman, Ed Thorpe, Ken Griffin, Paul Tudor Jones, Jim Simons and so on. Money managers with short track records of impressive returns are either skilled or lucky but you won’t know which until sufficient time has passed.

As I have previously written here, I once thought that Kerr Neilson was a truly skilled investor. I no longer believe that. I believe Kerr simply got lucky early on (with the help of one of the longest bull markets in financial history) and has been able to “dine out” on those earlier returns for a long time. As soon as 2008 came along, Platinum Asset Management’s funds started to struggle – they are still struggling.

Which brings me to Mathews Capital. A Sydney based outfit founded by Phil Mathews in 2001.

Phil Mathews, like so many others who have started funds management businesses in this country had a menagerie of former employers before going into business for himself (County Natwest, Ord Minnett, SPAL, Armstrong Jones, Jardine Fleming and Bell Potter).

Until 2010, Mathews Capital enjoyed spectacular success. Most of which was based on investing in smaller to medium sized resource companies. However, the wheels fell off in 2011 and 2012 is shaping up as another very poor year for the firm (between March and July of 2012 approximately 60% of the value of the Velocity Fund has been wiped out - it’s hard to understand how this could have happened).

One of the things that stands out you when you look at the monthly returns of Mathews Capital’s Velocity Fund is the volatility of those returns. Wild swings from month to month are the norm. This in turn indicates to me that the firm has taken significant risks to achieve their returns and their risk management techniques are not particularly effective.

It is known that Mathews Capital hedges equity positions with short positions over indexes. However, as any novice student of quantitative finance would know, the correlation (or indeed the cointegration) between the types of equities that fill the Mathews Capital fund portfolios and the indexes are very low, indicating that short positions in those indexes are not at all effective hedges for those long positions in equities.

My concerns with the Mathews Capital funds are as follows:

1. The firm attempts to pick the “winners” amongst hundreds of smaller resources companies, this provides spectacular returns if you get it right and appalling returns if you get it wrong. Mathews Capital got it right between 2002-2010 and is now getting it wrong;
2. The portfolios are highly concentrated – there is no room for error with such a strategy;
3. The firm seems comfortable with this level of risk – I don’t believe that they should feel comfortable;
4. The firm’s fees (while normal for most hedge funds) are high for a firm that at present only has funds with very short-term records open for investment and a history of very high volatility;
5. The inability to hang on to most of the spectacular returns achieved between 2006-2010 in the Velocity Fund are very worrying;
6. The firm’s practice of visiting vast numbers of companies is dangerous – most chief executives are optimistic, ego-maniac sales people. Plenty of them will lead you astray;
7. The firm’s investment in Elders a few years ago may be an example of point 5. It has been well known for a long time that Elders is experiencing significant financial problems and yet Mathews Capital were buying the shares;
8. The firm is still clinging tightly to the resources boom theme – but the boom seems to be over for now.

I would expect that the return from Mathews Capital’s funds will continue to decline towards index returns and if they do not get their risk management under control, returns may well eventually go below the index.

Please note that as always, none of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

The US Masters Residential Property Fund – Fees Galore

I was intrigued by the float a few weeks ago of the US Masters Residential Property Fund by Dixon Advisory & Superannuation Services Ltd.

This fund was created to invest in properties in Hudson County New Jersey. According to the fund’s balance sheet (as at 31 December 2011) it has $A18.7m invested in properties in Hudson County and another $A77m in cash, total assets were $A96.7m.

The directors of this entity (none of whom have any experience in the management of property) believe that residential property prices in Hudson County are very low and this was the premise on which they created this fund.

What I was taken aback by was the fees that the fund will pay to the responsible entity (which is controlled by directors of the fund). The responsible entity has the right to charge the fund 2.5% of the value of gross assets (including cash!). The responsible entity is “only” charging 1.59% currently. In addition there is also a “leasing fee”. Oh and I forgot to mention that the responsible entity also received up to 4% of the value of funds initially raised as “structuring and handling” fees.

But let me put that in perspective. If you owned a rental property that was valued at $400,000, would you be prepared to pay someone $6,360 per year to “manage” it for you? You wouldn’t? Well 1.59% of $400,000 is $6,360 and 2.5% is $10,000! And that’s what anyone who has invested in the US Masters residential Property Fund is paying and it’s even worse because they will pay that fee on any cash and other non-property assets the fund holds!

Would you also be prepared to hand over $16,000 if they bought that $400,000 property on your behalf (with your money) as a structuring and handling fee? Of course not, you would have to be mad to do that.

I’m really sick of seeing these sorts of fee structures. The fact that the fee is charged on gross assets rather than net assets also allows the fund to increase debt at some point in the future and take a higher dollar fee. It’s a totally wrong incentive.

It’s also not the type of fee structure that should engender confidence in investors. If the responsible entity took its fees as a percentage of the increase in net asset value and income that it can generate for the fund, I would have far more confidence. But they are effectively saying to investors we have no confidence in our ability to increase net asset value or generate high income from the fund, therefore we will just sit back and take a percentage of gross asset value.

I can rule out this investment for me (at the current price) on six grounds:

1. In my opinion, the directors do not have sufficient property experience;
2. The directors live in Australia, not the US (let alone New Jersey);
3. The fund is not adequately diversified in terms of geography;
4. The fees are excessive;
5. Fees on gross assets incentivize managers of the fund to use debt in order to increase gross assets and generate higher fees;
6. Fees on gross assets get paid on non-property assets like cash. Who pays fees on their own cash?

Please note that as always, none of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Alan Kohler takes advantage of Newscorp’s stupidity

The news on Wednesday that Newscorp had paid just under $30 million for Australian Independent Business Media (AIBM), a company majority controlled by Alan Kohler, Mark Carnegie, John Wylie and Eric Beecher was nothing short of astonishing.

AIBM’s only properties are the Business Spectator web site and the investment newsletter The Eureka Report. AIBM made only $237,000 last year (and no, I didn’t leave a zero out). In its five year existence, AIBM has only been marginally profitable. Realistically the company is probably worth $1 to $2 million. Stephen Mayne’s higher profile crikey.com sold for about $1 million a few years back.

There has been talk that Newscorp will use Business Spectator stories in The Australian and also put the site behind a pay wall. I will tell Newscorp’s Kim Williams right now that you cannot successfully put marginal “brands” behind pay walls, because when you do, 90% of your readership will evaporate. Or put another way, nothing you can find on the Business Spectator site is 1) worth paying for (or) 2) can’t be found elsewhere for free.

Alan Kohler has used his profile on the ABC television network (a public broadcaster) to create a business venture that largely exists only because of that ABC profile. Perhaps he should now be sharing some of his spoils with the ABC?

This year Kohler also changed the format of his Inside Business program on the ABC in order to give some of his co-investors in AIBM (like Stephen Bartholomeusz) a media profile which they previously didn’t have. It was all building up to a sale of AIBM.

The Business Spectator site itself is of mediocre quality. For starters, many of the stories that appear on the site are lifted straight out of the Australian Financial Review (i.e. they are not original stories). The opinion pieces written by Kohler, Gottliebsen and Bartholomeusz are of very limited value because the “spectators” are just that – spectators, not real financial market players.

As for The Eureka Report, what sort of people take financial advice from journalists (and money managers with dubious track records)? Answer: People who are very inexperienced and naïve.

If you want to see what kind of advice Kohler was giving in a December 2007 ASX publication (just prior to the full-blown effects of the GFC), read my 2008 article on this site: Old lessons to be learned from the Panic of 2008. Although I didn’t name him in that article, the respected business commentator I referred to in that article was in fact Alan Kohler. The advice he gave and opinions he expressed couldn’t have been more wrong.

As for Newscorp, Kohler had been a strident critic of both Rupert Murdoch and Newscorp. However, when enough cash was dangled in front of his face, he was willing to immediately jump into bed with the most disreputable media organization in the world. The Leveson Inquiry has clearly shown us just how unethical Newscorp has been. Enough said.

Newscorp doesn’t understand the online world and has lost vast amounts of money on previous investments such as MySpace. They will watch most of their $30 million for AIBM disappear too.

Caledonia Investments: The Legacy of John Darling

It was revealed this week that Caledonia Investments intends to short sell stocks for the first time in their history. A definite sign that buy and hold strategies are no longer generating sufficient returns (as I mentioned in my article on algorithmic trading).

Caledonia Investments was formed in 1992 as a vehicle to manage the inherited wealth of 20 or so members of the Darling family. These family members own 28% of Caledonia Investments (which manages approximately $A2 billion). In 1998, Caledonia was opened to outside investors.

The Darling family fortune was created by John Darling, a 19th century Scottish immigrant to Australia who founded a wheat and flour milling business. Apparently, by the 1880s, this business was Australia’s largest wheat exporter.

Current members of the Darling family that have taken prominent roles at Caledonia Investments include Michael Darling, his cousin Ian Darling and Ian’s father David. Like Rupert Murdoch, Michael Darling attended Geelong Grammer School and Oxford University. A privileged upbringing to say the least.

Ian Darling is also a documentary maker. Hhe produced the excellent Woodstock for Capitalists, a documentary made at the time of the Berkshire Hathaway AGM in 2000. If you haven’t seen it, go and get a copy.

Caledonia has tried to emulate Warren Buffett’s investing philosophies, which is why their announcement of their intention to short sell stocks is so interesting.

Caledonia does not disclose on their web site what the returns have been for each of their funds. Obviously, the move to short sell indicates to me that recent returns have not been sufficient. Media reports always refer to “excellent returns” achieved by Caledonia, but where do outsiders find the proof of this?

One rather indirect method of determining how successful Caledonia has been is to look at the wealth of the Darling family over time.

In 1990 the Darling family were worth approximately $A330m and are now worth in the vicinity of $A600m – that’s a compound return of about 3% per annum over that time period. This obviously compares unfavourably to many other rich Australians.

For example, over the same period of time, Kerry Stokes went from approximately $A150m to $A2.5 billion (14.3% compound), Lindsay Fox went from $A50m to $A2 billion (19.2% compound), Frank Lowy went from $A550m to $A5 billion (11.1% compound) and Stan Perron went from $A260m to $A1.9 billion (9.9% compound). I could quote many more.

If the Darling family had compounded their wealth at 10% per annum over the period 1990-2011, their fortune would now be approaching $A2.5 billion, the fact that it’s nowhere near that is revealing for a family that now manages money for outside investors.

The Darling family’s investment prowess also doesn’t compare favourably to two of the great investing families of Australia – the Hains family and the Millner family.

The Millner family also inherited great wealth but seem to have made many astute investments, one of the best being New Hope. You can actually invest alongside the Millners in one of their listed companies such as Milton Corporation (and the management expenses are miniscule compared to fund managers like Caledonia).

Senior figures at Caledonia Investments seem to have a wide variety of extra-curricular interests such as acting as trustees for various non-investment related bodies. I don’t like to see this, if you are managing my money, I want you absolutely focused on that without outside distractions.

Individuals will need at least $A250,000 to invest with Caledonia, with some funds requiring a minimum investment of $A500,000 and individually managed accounts requiring $A10 million(!).

The Secret World of Algorithmic Trading

In recent times I have been doing a fair amount of algorithmic trading based on a system that I designed a few years ago (which I rather unimaginatively named “Black Box”).

Black Box is just a piece of software that uses statistics to determine long and short entry points for a group of large highly liquid stocks. Each trade will typically result in a profit of between 1.5% to 4% (over an average holding period of 14 days - an annualized return of 39% to 104%). All trades are given up to 39 days to reach their targeted return before being time stopped.

I will normally have 1% to 2% of my portfolio invested in each trade. Black Box bases the trade size on the volatility of the underlying stock combined with the maximum allowable loss.

Black Box is seldom wrong in its signals, but of course it will be wrong on occasions. One of the main features of Black Box is its ability to largely filter out noise in price movements which is the bane of most traders. Of course I’m not going to tell you how Black Box does this, or indeed how Black Box works at all. The only systems you can see for free are the ones that don’t work.

While I still hold a long portfolio of great stocks like Berkshire Hathaway, Coca-Cola Amatil (CCL.AX) and Woolworths (WOW.AX), there are very few companies post GFC that can just be bought and held on to. However, there are far more than can be successfully traded using algorithms.

The primary criteria I use for algorithmic trading candidates are:

1. Large companies;
2. Highly liquid;
3. Fundamentally sound;
4. Relatively high price volatility.

Once I’ve selected the companies, it’s then a matter of feeding the required data into the computer which uses my algorithms to spit out entry signals on both the long and short sides. Ex dividend dates and important announcements also come into play here.

It’s always exciting to see what signals the computer is going to give. Of course, sometimes it won’t give any signals at all, which is fine.

Algorithmic trading is not for everyone, it requires a good knowledge of the relevant mathematics and statistics (that’s why all those huge algorithmic hedge funds employ mathematicians, in fact mathematicians like Ed Thorpe and Jim Simons were pioneers in this industry). But all this doesn’t mean that you have to be a mathematical genius. Algorithms vary in their complexity and complexity doesn’t automatically equate to larger profits.

It’s not much use buying books on the subject of algorithmic trading. As always, no one is going to give you the algorithms and strategies that will make your fortune in a book! Successful strategies and algorithms are normally being used by a few enough people to be effective. Once a strategy is widely known it will cease to work and that is the basic problem with any valid strategy that has been published in a book (or for that matter on the internet).

I may publish some of Black Box’s past trades here in coming months, so stay tuned.

Happy New Year to all.