A Primer on Public Equity Investment Styles
Long-only vs. Long/short, Value vs. Growth
I help you understand the variety of investment styles across two dimensions: 1) Direction (long only vs. long/short) 2) Flavor (value vs. growth).
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There are infinite ways to make money in the public market: Some trade, some buy and hold, and some do something between the two. One thing is for sure: you cannot influence how your future employer invests.
When you join the buy-side, you will either struggle to conform because of a lack of belief in the investment style, or you will excel because of strong alignment. Therefore, it’s absolutely paramount that you assess your personal investment philosophy, which should help you narrow down your job search targets. Yes, your opportunity set will be smaller than if you want to be everything for everyone, but you can tell a more convincing story, have more tailored stock pitches and most importantly, have a better chance of landing the job.
Conceptually, when you buy a stock, you get paid in three ways: dividend / stock buyback, earnings growth, and valuation multiple expansion.
Every fund claims they invest just slightly differently from the other funds out there, because an investment fund, as a business, needs to differentiate. In reality and my opinion, all stock-picking funds generally fall into one of the genres:
Deep Value
Deep value investors generally invest in non-growing or declining businesses operating in secularly challenged or heavily cyclical industries. The hard assets (equipment, manufacturing plants, oil rigs, etc.) for these companies can be utilized unproductively. Or, a free cash flow generating company in a mature industry with no growth or revenue decline. A deep-value investor could make money by agitating for the sale of the company or for an aggressive return of capital via dividends or share buybacks.
Traditional Value
Traditional value investing centers around the idea of mean reversion. Businesses can have short-term issues and the bet is by owning them during their troubled times and gaining conviction on the business’s ability to revert to normality. Traditional value investors usually get paid on reversion to normalized earnings power and the subsequent multiple expansion.
Activism
They are perceived to be glamorous because of all the publicity and the success the high-profile activists have achieved (think Bill Ackman of Pershing Square, Dan Loeb of Third Point, Paul Singer of Elliott Management, and Jeff Ubben of ValueAct.) It’s really just another form of value investing.
Activists take stakes in public companies to become one of their top shareholders in an attempt to influence the strategic direction or capital allocation because they disagree with how the company’s board of directors and the CEO are running the company.
I view activism to be the true “private equity approach to the public market”, which explains why activist funds favor candidates with elite private equity work experiences.
Activist funds typically invest concentrated (Pershing Square for example, currently owns 8 stocks) and take a long time to analyze a business – Many activism presentations are 100+ pages long, think about the amount of work that goes into that.
Activism can get paid across all three dimensions: dividend/buyback, earnings growth, multiple expansion.
Select famous value investors: Seth Klarman (Baupost), Leon Cooperman (Omega), Michael Price (MFP)
Select famous activist investors: Bill Ackman, Dan Loeb, Paul Singer, Jeff Ubben, Carl Icahn
GARP, Growth at a Reasonable Price
GARP investing is a blend of value investing and growth investing. GARP investors buy businesses that can grow consistently above market growth without overpaying.
A variant style under this genre is wide moat investing. They invest in consistently growing businesses that exhibit sustainable competitive advantage. Similar to GARP, wide moat investors will not pay a crazy price, but they are willing to pay a slightly higher multiple than what GARP investors would, knowing the quality of the businesses provides the qualitative margin of safety.
GARP investors mostly get paid on earnings growth without needing multiple expansions.
Hypergrowth
Well, they invest in high-growth companies, no confusion there. The companies in this category are growing very quickly because of their enormous addressable market. Hypergrowth companies tend to be unprofitable when they become public because of the need to spend on marketing to grow aggressively to achieve dominance as soon as possible due to the typically winner-take-all nature of their industries.
The stock market is mostly efficient, so hypergrowth companies often have high valuation multiples. Ultimately, sensible hypergrowth investors need to have valuation discipline (sadly even the successful practitioners in this genre clearly have forgotten that rule in recent years).
The bet is that by applying a reasonable multiple on the long-term earnings power of these businesses, the price paid today to own them can generate an attractive IRR or internal rate of return (for example, $10 to $100 over 10 years would be a 26% IRR).
Of course, the math is the easy part. The hard part is the deep work it takes to gain conviction in a hyper grower’s long-term earnings power.
The hypergrowth investors ultimately are paid on earnings growth, but they could be well compensated by multiple expansions if one bought a company at a reasonable multiple and the business is just on the cusp of entering the hypergrowth phase of their industry’s S-curve (shown below).
At such entry point multiple, the market was underestimating the earnings growth acceleration, which also underestimated the multiple the business can fetch during its hyper-growth phase.
To learn more about hypergrowth investing: Read Alex Sacerdote of Whale Rock Capital
Select famous GARP / wide moat investors: Warren Buffett, Charlie Munger, Peter Lynch, Chuck Akre, Terry Smith.
Select successful hypergrowth investors (yes, some of them are blowing up as we speak): Tiger Global, Coatue, Whale Rock, Altimeter, Aterides, Shawspring.
Special Situation / Event-driven
Special situation investing relies on company-specific events to drive investment return. Aside from quarterly earnings releases, many events can have a material impact on the value of a business and therefore its stock price.
One example would be a spin-off of a division within a conglomerate, where the market will appreciate the spun-off segment more with a higher valuation multiple when its economics are no longer masked by being within a sleepy conglomerate consisting of other inferior businesses. Examples of other events include debt paydown, asset sale, rights offerings, etc.
Special situation investors get paid primarily through multiple expansions. This investing style has the advantage of generating near-term to medium-term returns that are uncorrelated to the broader market performance due to the dependence on company-specific events (also known as catalysts.)
Another sub-genre of special situation investing is Merger Arbitrage: Merger arbitrageurs aim to make money by buying (and/or shorting) the acquirer and acquiree company based on an assessment of the probability of a merger transpiring.
The most famous special situation investor is Joel Greenblatt, whose book You Can Be a Stock Market Genius is a must-read on special situation investing.
Long only ("LO") vs. Long/Short ("L/S")
The biggest difference between long only and long/short investing is the involvement of shorting stocks (duh), where a fund borrows stocks, sells them at what the fund believes to be overvalued price, expecting them to decline and then buys the stocks back at a lower price.
At first glance, the mechanics of shorting is the mirror image of buying (or long) a stock. In reality, shorting is not just directionally opposite because of its infinite loss potential (a long position has 100% loss potential), liquidity and market flow consideration. All of these characteristics manifested themselves during the r/WallStreetBets fiasco. Therefore, shorting warrants its own discussion in a future article, but it's worth mentioning these issues which make long/short a very different beast compared to long only.
Long only (“LO”)
Long only (“LO”) funds spend 100% of their effort on identifying undervalued stocks, buying them, and selling them when the rest of the market realizes the fund is right and the stock goes up. When the overall market is expensive, LO funds have the discretion to stay in cash (evident in Berkshire Hathaway building a giant cash pile).
Most mutual fund companies and a small number of hedge funds offer long-only products (though mutual fund companies start to offer long/short products as well). Typically, the LOs have longer-term investment horizons with stable investor bases and significant scale, which translate to relatively better lifestyles and career stability.
Examples of LO investment firms:
Boston is the headquarter for many mega-LOs: Fidelity, Wellington, Putnam, MFS, Eaton Vance, Columbia Threadneedle, etc.
California: Capital Group, Franklin Templeton, Dodge and Cox
Baltimore: T. Rowe Price
New York: Bernstein, Clearbridge, First Eagle
Midwest: Harris Associates, Artisan Partners
Long short (L/S)
A long/short fund effectively has two portfolios running at the same time:
a long “book”, which is a portfolio of stocks similar to a LO in that the fund is buying low and selling high.
a short “book”, where the fund is borrowing stocks, selling them at an overvalued price expecting them to decline, and then buying them back (known as “closing the short”) at a lower price to generate a return.
Majority of hedge funds are long/short funds.
To understand long/short funds, you need to be familiar with two terms: gross exposure and net exposure.
Gross exposure: A hedge fund’s long positions + short positions, expressed in dollar or percentage terms.
If a hedge fund has $500 million in capital, and it deploys $250 million in long positions and $250 million in short positions, the gross exposure is $500 million. On percentage basis, 50% exposure in long, 50% exposure in short, and gross exposure is 100%.
If the gross exposure exceeds $500 million or 100%, the hedge fund is using leverage, meaning it is borrowing money to amplify returns (but increasing risk.). Conversely, if gross exposure is below 100%, a portion of the portfolio is sitting in cash.
Gross exposure measures a fund’s total exposure to financial markets, giving investors insights into amount of risk taken.
Net exposure: Calculated as the difference between a hedge fund’s long positions and short positions. For the aforementioned hedge fund with $250 million in long positions and $250 million in short positions, its net exposure is zero (which is market neutral, a style that I will explain to you below). A hedge fund can adjust net exposure up (to be net long) or down (to be net short). A net long fund will do better in an overall up market and net short fund will do better in an overall down market.
Within the long/short world, there are two types: market neutral and directional.
“MM” / “Pod Shop” - Market Neutral L/S
A market-neutral fund, if constructed properly, has zero correlation with the daily overall market movement. For example, if a portfolio manager (“PM”) runs a portfolio that is neutral to S&P 500 index, the PM can take a 50% long position in some S&P 500 stocks that they believe to be winners, and take a 50% short position in ones believed to be losers. Hypothetically, if the S&P 500 is down 5% on a trading day and there is no company-specific news on the stocks in the fund, the long positions will have a 5% unrealized loss and the short positions will have 5% unrealized gain, thus the overall portfolio has no gain or loss on that day, neutral against S&P 500 movement that day.
The return generated by a market-neutral fund should then be completely dependent on company-specific events (such as companies exceeding or missing quarterly consensus) for stocks within the portfolio.
Over the years, market-neutral strategy has enjoyed a tremendous amount of success because they deliver uncorrelated outperformance to their investors.
Perhaps you have never heard of the term “market neutral funds,” but many of you must have heard of the term “multi-manager (MM)” or “pod shops.” Before I explain what they are, let me introduce the firm names and their billionaire founders who frequently engage in pissing contests to see who can buy the next Manhattan / Miami penthouse or Greenwich / Hampton mansion. They are:
Citadel: Ken Griffin
Millennium Management: Izzy Englander
Point72 (previously SAC Capital): Steve Cohen
Why are these shops called multi-managers (MM) or pod shops? It’s because these firms are not run by a single portfolio manager. The MM provides a platform for hundreds of portfolio managers to run their portfolios autonomously. And each portfolio is a “pod”.
For example, when a PM joins Millennium Management, they contractually agree to some sort of risk limits (eg. that their portfolio will not have a more than x% decline over a defined period). If the PM breaches the risk limit, the PM and junior analysts supporting the PM are dismissed from the firm. It’s not personal, just how the system is designed and the contractual agreement.
You might wonder: Why does a pod shop impose risk limits on each PM? The reason: Pod shop / multi-manager platforms employ leverage. For an individual PM with (already levered) allocated capital, losing 3% on the portfolio level magnifies loss (ie. multiple of 3%) on the platform level. In such a model, risk control is paramount.
As you can see, if you are not a believer in constantly worrying about every stock movement, especially if the movement is not driven by a change in fundamental thesis, MM investing is very stressful. In return, MM investors are compensated handsomely and the PM truly eats what they kill instead of being at the mercy of the generosity of a single-manager hedge fund founder (discussed in the next section).
You just need to know that under the hood, MM investing provides the lowest relative quality of life and no career stability on the buy-side, in exchange for the most attractive financial reward and fastest path for becoming a PM if an analyst is successful under this model.
Directional Single Manager L/S
Most of single manager hedge funds are directional long/short funds, which means one person – the Chief Investment Officer or the PM – is responsible for sizing positions and deciding what to buy or sell on the long side and what to short or "close short" (ie. buying it back at a lower price.) on the short side.
The biggest distinction versus the multi-manager / pod shop is the ability to decide how the portfolio should be exposed to the overall market movement. If the PM believes overall market is going up, they can increase the net exposure. Conversely, if the portfolio manager overall market is going down, the PM can reduce net exposure.
Examples of single manager directional L/S hedge funds:
Tiger Cubs are mostly single-manager long/short: Tiger Global, Lone Pine, Coatue, Maverick
Eminence, D1, Soroban, Third Point, Appaloosa
What strategy should I work under?
No right answer, but I strongly suggest you introspect rigorously on the aspects of a job that matter to you. I completely understand that it’s hard enough to just land an interview in this profession, but picking a paradigm that suits you ensures longevity in this profession. The decision comes down to the tradeoff between lifestyle, stability, compensation, and speed to a risk-taking role (the time it takes to become a PM).
Your ability to add value
I am not a hypocrite – we are all in this business to make big money. I want to remind you:
Without the ability to add value, the million-dollar bonus is just a mirage. Make sure you find a philosophically aligned firm even if it pays less than another shop. Just to be clear, most don't make million-dollar bonuses as a junior analyst anyways.
Many on forums start their question thread telling others their ultimate goal is to start a hedge fund. To those types: please understand the back office cost and the legal complexity of setting up a hedge fund (or any fund). Also, have fun explaining to your investors after your first fund drawdown, as you sure will have one. Again, everyone wants to heaven but no one wants to die.
I will try my best to list the pros and cons of each path without mixing in my personal view on trading vs. investing (and that my long-time audience knows that market neutral / multi-manager is my no-go zone for career choice). There are always exceptions in this profession so understand everything below is a generalization – investment firms are small businesses where culture / style is heavily influenced by the founder’s decisions.
Multi-manager / Pod Shops
Pros
The only true meritocracy – you eat what you kill
It’s pure alpha because beta neutral (S&P up 20% or down 20%, pod shop should make money)
Tailwind: capital is flowing into this style
The abundance of resources (ie. alternative data, sell-side access, etc.)
The fastest path to wealth and responsibility (managing a book) for the skilled (think pre-2020 Gabe Plotkin)
Relatively most job openings (well, there is a reason)
Cons
Highest stress (in a relative sense, as all investing is stressful)
Poorest work-life balance (65 hour per week, IB hour, 80-100 hour? during earnings seasons)
Poorest job security (risk limit breach, the entire portfolio team is let go. No es personal, it’s contractual)
The stock price is always going to be more random than what the company is worth over time, so this style is very prone to short-term randomness such as macro
Single Manager Hedge Fund
Pros
Better (relative) stability than pod shops
At the right lineage (eg. Tiger Cub), a great launch pad to start your own fund after a strong track record
Still very good money (because better bonus than long only at the same experience level)
Can be longer term than pod shops, especially on the long side
Cons
Fewer openings than pod shops
Slim chance to managing a book (the PM runs the show, hence “single manager”)
Not truly long-term investing as they claim because the LP capital is not that long duration
Lifestyle dependent on the fund, cannot generalize – can be a 35-40 hour work week or pod shop lifestyle, depends on the founder and his / her lineage (think a Citadel cub like Melvin / Candlestick vs. a pseudo-long only hedge fund)
Long Only
Pros
Best stability
Best lifestyle
Very long-term focused on the business
Lowest relative stress
Cons
Lowest relative compensation
Stagnant or declining asset growth because many firms don’t add any value through the cycle
Longest time to becoming a portfolio manager (if one aspires to manage a book)
So few job openings because of asset decline and people don’t leave
To sum up, everything in life has its pros and cons. Please think hard about fit before obsessing over pay (and even worse prestige which means nothing to nobody.) When you find a good fit, I can guarantee you will get paid as long as you add value.
Like the stock market, price is what the labor market pays, and the value of the talent is what they get. Always focus on increasing your value, which is very much in your control.
Thanks for reading. I will talk to you next time.
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Wonder if you have any insight on Polen Capital? Is it considered a reputable growth-oriented fund? Thanks
what kind of a fund is Marshall Wace?