George Michelakis – Chess Master’s Approach to Long-Short Equity at Gladstone (EP.362)

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2:31Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

3:11Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast. My guest on today's show is George Mikulakis, the chief investment officer of Gladstone Management, a $2 billion long short equity hedge fund based in London. George founded Gladstone in 2006 with C Capital from, well, me, Protégé Partners, and six years later bought back the stake when still managing less than $100 million. In the dozen years since, Gladstone has won awards for European Hedge Fund of the Year and the top -performing five -year fund for three years in a row. Long before that, George became an international chess master and took third in the 1992 World Under -20 Chess Championships.

3:56We discussed George's path from chess to investing, alongside his college friend Roloff Bertha of Sequoia, the challenges of the fundamental long -short equity model, the culture required to make it work, and how he does it at Gladstone. Before we get going, 2024 is shaping up to be a great betting year. On the first episode of the year, I discussed a bet I made with Morgan Housel that same as ever would sell more than 100 ,000 copies. Morgan let me know just last week that his new book already has sold 150 ,000 copies. Sales are accelerating week over week, and it wouldn't surprise me if it sells a million copies ten times our over -under.

4:40Second, my son Eric touted his focus going into our family fantasy football league final. He sounded persuasive and perhaps ready to take over the show on the Spread the Word clip, but I edged him out and took home this year's trophy. Two bets in two weeks with two wins has me wondering if I should go to Vegas. If you want another winning bet, I'll share one here. I'll bet that if you share your love of capital allocators at the next opportunity, you'll look good, feel good, and be good. I'll also bet that if you're listening to this, you already agree. So go ahead and spread the love. Thanks for spreading the word about my betting prowess.

5:22Just don't tell Warren Buffett I said so. Please enjoy my conversation with George Mikulakis. George, wonderful to see you. Thank you for having me, Ted. Why don't you take me back to what you were most passionate about when you were a kid? Probably solving problems. And I became passionate about chess. That carried me intellectually when I was younger. And competing, I think, actually, in hindsight. I enjoy competition. So if you put together the competition with chess, where did you take that? Became this African champion. That happened relatively quickly. Came third in the world under 20. Played internationally.

6:05Very reminiscent of Queen's Gambit. I don't know if people watch that series on Netflix, but that history tour for me, clearly I'm not her and she's not me. But when I watch that, there's a lot of reminiscing. That was my misspent youth is the way I like to think about it. When you think back to those times, are there any particular stories from your chess playing years that stand out? It's all about characters, but like the series on Netflix, it's not specific events. But I think the characters involved, they're so unusual in many cases. I just enjoyed the travel, going to places. I went to Armenia in 1996, found myself in the middle of a coup d 'etat, was walking around with whatever hard cash and my passport in my pocket for three days.

6:50We had no idea what was going on. And I think the coup was repelled. And then the next thing we saw was the tanks, the army marching in the square and I go, it's over. What was your path from going through university into finance? Met somebody in my university time that we discussed a lot. What do we want to do with our lives, where do you want to go? That person is Rulof Boyter, who runs Sequoia globally. He went on his path and I went the London private equity, long short equity path. But I think we were motivating each other or at least discussing what's interesting, what's challenging, where's the opportunity set.

7:30Coming full circle back to chess, by the time I was in my late teens, it was obvious that there was some limit to how far I could progress in the chess world. Maybe you can get to the top 50 if you live and breathe it. But that's as good as I would have been able to achieve. Whereas I'd gone to private equity in the late 90s. It was a cottage industry. It's hard to imagine today, 25 years later, that private equity was literally teams of five or 10 people doing handcrafted deals. And the fund sizes were all one to five. And the firms were nascent in terms of just where they were in their development.

8:07And I think long -short equity, it's similar. At least in Europe, it's still somewhat unproven. Fundamental long -short single manager. There's just not many of us left in a way. A lot more opportunity to not be number 50 at best, but rather excel and get to the top. What was it that led you to go from private equity to public equity? Private equity, it's a patience game. You do a lot of work, three months potentially on a single company. You learn a lot, but often things don't happen. There's a lot of binary outcomes at the end of three months of work. As soon as I was in public markets, I think the fact that you get multiple opportunities to use your knowledge, either long or short, and that steady flow of opportunity set in a sense.

8:56And your ability to monetize your thinking both ways was extremely appealing. And really, you're pitting yourself against other minds, similar to chess. I think there was something more like chess about it that appealed, whereas in private equity, you have to create it, which is fine. It's entrepreneurial, much more process -driven, but hopefully you do a deal a year. What was your early training like in the public markets? It was a nascent industry back in 2003. So most of how I was learning was reading books and talking to people who were involved in the business. I'd say the best training I got at Lansdowne was risk management portfolio construction, which is totally not what you experience or see in private equity.

9:44There's risk management in underwriting the securities and the diligence and the efforts there, but you don't think of things in a portfolio sense. And you try and steer away from macro debates or macro risks and try and underwrite dull assets, predictable assets that should prove secure over long periods of time. Going to the public markets, I think the most informative was really learning about how to think about portfolios. What are the risks from a portfolio construction point of view? And what are the themes that the market's trying to capture slightly top -down ideas. And I'm actually grateful for that because a lot of the emphasis, be it private equity or hedge funds, in the initial five years of one's career is bottom -up.

10:27And that's a bit commoditized. People now know how to use a spreadsheet. People know how to read 10Ks. And you're not going to make better assumptions on a two -year view than most other people. So you have to differentiate in different ways. And I think top -down thinking, thematic thinking, understanding maybe even, an ambitious word, with that bottom -up analysis and looking for where those two coincide. Before we dive into how you do that, I'd love to chat about fundamental long -short equity, which over the last decade, maybe longer now, hasn't really delivered en masse what investors had expected.

11:06You've seen fund flows, index funds, all this kind of stuff. What's your sense of how the long -sert equity model should work? I think there are different models that can work and that platforms have clearly exhibited success in one type of model. I think on the flip side, when you look at the single manager construct, I think there's been hidden flaws in what most single managers gravitate to that isn't entirely obvious. And over time, the lack of success there, It's been relatively consistent. It comes down to portfolio construction and short alpha. And I think a little bit, the simple way to do the math is if you're running a 150 gross long short fund and you've got good long alpha, but no short alpha, and you end up with 150 50, what I mean is 150 gross, 50 net exposure.

12:02That means you're 100 long. So you're a long manager on that side of the balance sheet. And on the short side, you're running a 50 short book, which produces no alpha, which means you're basically short an index. So you're running a 150 gross product, which is effectively a long product with a short 50 index. Over time, why is that worth anything? And that very elementary math is at the heart of the problem. Too little gross, too little short alpha, and you end up being a diluted good long manager. Again, I think when markets are healthy, your longs are working, that product seems okay, but have some flat years in the markets and some challenging years where you're just short the index and the product doesn't work.

12:49And so over time, that construction, it's timid. It's almost too safe to begin with. And it's probably a reflection of the challenge of running long short makes people want to keep it safe and simple in terms of the portfolio construction. But that's like trying to build a Formula One racing team and not making the car fast. It doesn't make sense because you really have to be pushing the envelope intellectually, risk management, portfolio construction, seeking out alpha on the short side in a very persistent, methodical way. You can't really just have this diluted long -only product with skillful stock selection on the long side and safe shorts that make the product look like a long -short product.

13:36But the math is showing you is that it's just a diluted good long product. You mentioned the challenges of running a long -short fund. So let's say stripping out the Timed As You Say portfolio construction. What are some of those challenges? it's a high performance industry so you need to set yourself up for that environment that means people aligning yourself with your organization sourcing talent incentivizing the talent training the talent it's a lot about how do you find people that are aligned with that performance culture and have that persistent search for incremental performance bred into them they don't think that it's just going to happen because it may have happened.

14:21It doesn't mean it's going to happen again. So you have to keep pushing as with every competitive industry. You have to keep pushing for what's the next idea, what's the next improvement, et cetera. I think ultimately it comes down to, can you create that culture of performance, intellectual integrity, pursuit of excellence? And when you canvas randomly people, is that what you want to do? Many of them will say yes. what it takes to actually do it, that's a different matter. Everybody wants to be a world -class tennis player or golf player or something that's extremely competitive and difficult.

14:57When you get down to what it takes to actually get to that level of performance, I think most people just have other things on their mind. It's as simple as that. And differentiating between, can I build a culture where people are aligned and motivated to win, to perform. It's not easy, actually. What's an example of, in the investment realm, what it takes to be able to excel in that way that you feel sometimes people don't get to? Changing your mind, being intellectually flexible. I think a lot of people get into, I'm right. And the idea that just toggling other potential outcomes, possibilities, approaches.

15:38There's an inertia, there's a stubbornness. I think that's quite hard for people to navigate. If you think about it, in any professional sport, there are times when the individual, the team are not performing and they probably need to change something. And somebody needs to drive that change. Just because they worked before, it doesn't mean they're going to work in the future. So being able to be dynamic enough and open enough, intellectually open enough, emotionally open enough, maybe this has just changed. Let's just look at the facts anew. I think data is something that people struggle with.

16:16Embracing data seems to be a challenge, at least in the long short equity space. I'm sure I'll hear a lot of people say, no, that's not true because they scrape data. But it's as simple as, okay, you keep trying to short this sector and there's no alpha doing that. And you've been good idea. And it's like money ball. And if you can actually dissect performance into pieces and really analyze not just your longs and your shorts, but let's disaggregate that down into sectors. Have you managed to prove that you can generate alpha in this sector repeatedly or in that sector? And then that's where the platforms, again, just the entire construct is imposing that measurement discipline.

16:55I find in the single manager construct, many people are resisting that measurement. So in addition to the ability to be flexible intellectually and that use and embracing of data, what are some of the other challenges you've seen in people that can't get from maybe they're good to being great? Again, let's compare to professional sports. There's 10 ,000 guys with a great first serve, top 1 % type of great serve. Of those 10 ,000, what percent have a great forehand? Maybe 20%. And then of those 2 ,000, how many have a great backhand? Maybe 20%. And then how many can play grass and clay? Maybe 20%.

17:36So one of the challenges is that you're having to keep adding new skills and not only refresh the old ones because things are changing, but having to actually add new strengths. So you have to keep getting better. and that personal drive to keep wanting to improve and find areas that you can improve and then working hard at them to improve. People underestimate just how many thousands of hours a tennis player might spend just looking at his backhand. And the idea that you're going to spend 50 hours getting a bit better at your short side. People under egg just how hard it is to get better unless they're very determined.

18:20So I'd love to circle back in time to your founding of Gladstone as you come out of Lansdowne. If you look back, what are the things that you've learned both about building a business and about the investment process that you may not have known even if you thought you did when you launched Gladstone? On the investing side, I think probably the most valuable lesson I wish I knew back then that took me probably the first five years to figure out is have a very clear idea in your mind how you're going to construct the portfolio. And somehow committing to that structure really informs how you build the team, how many longs you need, how many shorts you need.

19:05It sounds simple and most people think they have the answers to those because their presentation deck has an answer to that. And I wonder how many people it changes every three or five years. But really committing to a portfolio construction system ideology that you've thought through. And if you have something that works, and it might be 180 gross, 30 net, or whatever it is, stick to it. And really build from there, because that will inform that you need 50 shorts, or you need 30 longs, or whatever the number is, and how many people you need to do that, and how you're going to go about doing that.

19:46I think managers who haven't thought through those things, they're often doing what their resources allow them to do. And they end up with the product that their resources allow them to have, which may again, not be a product that actually works. The comparison would be in tech land. If what I need to do is build this type of AI and have this size R &D team and invest $20 million to build it, because that's the only way to compete. I'm not going to be able to do it with $5 million. It's just an insufficient budget. Well, you'd never start that tech company if you only had $5 million. I think this business is the same.

20:22What you need is eight people. You need to generate a short idea a week. You need to generate one long idea every three weeks that makes it into the portfolio. It requires this many man hours, but you need to start with a really clear idea of what your portfolio actually is going to look like. And it's a tough exercise because when you're starting, you're not quite clear enough about all these variables. But spending the time to work that out and then asking yourself what resource that takes and how am I going to set my team up to execute on it is such a worthwhile investment because all the noise that can happen if you haven't done that.

21:02And I've seen managers on the single manager side, one day they're trying to be very long, the whole team's working on longs. The next moment they want to be neutral and the whole teams working in shorts. That's not possible. You can't manage an organization to go from serving Italian food one week and Chinese food the next week. It just doesn't work. Being very clear in your mind how to set yourself up from a portfolio side, I think is probably the number one lesson I had to learn pretty quickly. And then on the business side, and this is a recurring theme that I've experienced with entrepreneurs that I've engaged with, is I I should have brought in a chief people's office or an HR person very early on.

21:44This business is about people. And having somebody full -time focused on that flywheel is super important. When it comes to building the culture of the organization, there are a couple of buzzwords you threw in. Culture is one. Alignment, incentives. How do you go about creating, let's just say, the alignment and incentives in the model that's worked? One of the most important learnings is having that contract with people up front so that, okay, here, to do research and help produce alpha, the alpha will be measured. So having that contract with your investment team, what precisely I expect them to do, and how you're going to remunerate them for it.

22:29And I think, again, the platforms, they got that right because the contract gets set very clearly on day one. Whereas in the single manager contract, I think it's often quite fluid. And people are just expected to do more as they stay with the firm. And it's not always clear whether they are doing more. The measurement of what they are doing and what they're not doing isn't clear. So a lot of effort from our side to get better at that contract with the investment team, the incentives, how we measure, sitting with them on a biweekly basis to go through what they are and aren't doing and really helping develop them.

23:08any ambiguity in that relationship tends to not work over time. As you've set up those contracts with the people on your team, how do you bring that down into practice of what the alignment is? There's different compensation structures that people use as one portfolio. Is it individual ideas, a contribution to the portfolio? What have you actually done that's worked? Alpha measurement, recognizing when it's their idea versus somebody else's idea, or the firm's idea. Measuring. Just measure as much as you possibly can. And alpha being that North Star. Back to all good and well, these were money -making ideas, but there was no alpha.

23:49Or it was an okay short, but not a great short. Or it was a decent short, but we actually added at the wrong times and therefore there was no alpha. And so a little bit getting people to be more precise about how much alpha they're measuring and really measure themselves. Build the habits internally and also with the team to want to be measured, to enjoy being measured, to check their own performance. It's a performance industry. I'd love to turn to how you take all of these philosophies about people and portfolio and put it into practice at Gladstone. Let's walk through some of that investment process.

24:25So first, how did you decide what your investment universe would be? My background is financials and TMT. So those have tended to be the big areas where we focused on. We've extended that to consumer, which is touching TMT. So those today are the biggest three areas. And then over time, you can do smatterings of things as add -ons, some industrials, some healthcare, but really deciding what your core areas of expertise are and getting better at those and building the organization around those, building a culture of excellence around of those. So that takes an awareness of what am I going to do and what am I not going to do?

25:03What sectors, what market caps I'm willing to invest in? My background's always geographically been London. So European equities has always been an obvious investment place for us. The US is such a big, deep market. And we try and use what we see in Europe or our understanding of the world and apply that to the US. And then I grew up in South Africa. So that tends to be a market I play and I lived in Australia. So that tends to be a country where we do things. And beyond those, it's de minimis. So stick geographically to what you understand and stick from a sectoral perspective to what you understand.

25:38And that's led to a risk framework where we've, much like the platforms, we're measuring exposures by country aggregations of certain countries, by sectors, by subsectors, by factors. So there's very much a risk system framework that we use that dovetails the expertise. As you looked across those geographies, South Africa, Australia, Europe, US, I would love to get your sense of where you see relative inefficiencies and if they exist at all. Everything's an experiment. And the market is a snapshot of its estimate of what that experiment means in terms of the value of companies traded on an exchange.

26:28The fact that next year, out of the S &P 500, 50 companies will be up X percent and 200 companies will be down Y percent, and that estimation is perpetually changing. And it's not just the company said X and therefore the stock went up or down. It's an estimation of how the macro is affecting the company and what impactful AI have on these companies. We're always trying to gauge future prospects with current stock prices. That is inefficient. So the idea that the market is efficient is true of what is known. But as regards the future, it tends to be a very inefficient mechanism. So I think we're all trying to estimate where is the future likely to be different to what current information is telling you is true.

27:13that could be on this management team is promotional, obfuscating, so the information looks better than it really is. And that's going to unravel in the future. So that's a shorter. And human nature, the human condition, it's prevalent in everything and how companies get built and how communication happens with the stock market in whether management wants to be promotional because they want to feel like they're good guys because the share price is wrong, or you're a tech company and you have to keep being promotional because so much of your comp is in SPC. There's a lot of understanding incentives.