[REPLAY] André Perold – Pockets of Inefficiency at HighVista Strategies (EP.169)

25:01Often things are not obvious. You get a clinical trial where they had the dose wrong and the trial works out badly. And some people don't quite see that. So they sell as soon as it comes out thinking it's bad. And the smart money says, hey, wait a minute. It was just the wrong dose. We know when you put the right dose, it's going to work. Others dumped it. It's a bargain. But if you owned it before and it fell, if you're not a good investor, you may be tempted just to run as well. And the good investors understand when to double up and when not to. So it's a combination of someone who's a good investor who has a deep understanding of the fundamentals and who can do both sides of that.

25:41André Perold:We think a lot about stock pickers, that someone who has a 55 or even 60 % success rate can be pretty heroic. And I'm curious in In a sector like this, where, as you mentioned, the ultimate outcomes can be so binary, do the hit rates or the success rates of the good stock pickers, are they similar to those levels or do they have to be higher? I think that's an interesting area because you have such big winners over time. You can have a little company at$50 million that has a drug that can replace an incumbent that has a market cap of$10 billion. And so the upside is just absolutely monstrous. It's not going to happen overnight.

26:21It might happen over 10 years, but there is huge upside. So if you can hold on long enough, you're going to get phenomenal returns. And that's more of a slugging percentage idea. Certain strategies are based in the very short term, where you're looking at the results of clinical trials. You have a view on the market says this one's going to be great. The results are coming out next week. They're going to be great. and you think otherwise, and you can bet on that for a week, long or short. And so depending on your strategy, it could be much more of a hit rate approach where you're just doing very much a wash, rinse, repeat all the time, or it could be a much longer buy and hold strategy for the most part, which becomes more of a slugging percentage.

27:07So both things are very much present in this area.

27:09André Perold:And do you have a bias with the individual managers about the level of concentration in their portfolios? Yes. So what happens in the space, it's inefficient. If you really do your homework, you can figure that out. So the managers who, as I said, it's small, smart money, they love what they see. And so they just love the idea of having 10, 15 stocks in a portfolio. So imagine you have 10, 15 stocks in a portfolio, each of which is risky. Obviously, they hold it because they think they're going to do well. But the fact is, it's risky. So what we love about it it means that they have high conviction.

27:44So these are specialists that we work with. They have high conviction. We love it, but it's still risky. So for us, if we can find a range of such experts who do it differently, one of the nice things in the space is there are many ways to do it that don't really overlap. So you're not giving up much return by spreading your money among different strategies, but you are spreading your money among each of which is a very high conviction approach in the space. And then we get the diversification. we get the benefit of their concentration and their conviction, but yet we're not bearing nearly as much risk because we are diversified.

28:19André Perold:So how have you thought about risk and return on your portfolio of these managers? If you look at biotech stocks, they're extremely wild. If you look at biotech indices, they have at least twice the volatility or typically twice the volatility of equities. A typical manager, because they're so concentrated, also is not quite as high as twice the vol of equities, but pretty high. By being diversified, and we also do a little bit of hedging, we can get that vol down to mid-teams, 15 or so percent, which is very similar to equities. But you get all of the alpha, much higher return, and the correlations are very low.

28:59The correlation with equities of the strategies is something like between 0.5 and 0.6, which is a pretty low correlation. So now if you asked earlier about how do you create a diversified portfolio, if you were going to own equities and you have a chance to put some of your equity exposure into this strategy that has similar vol to equities, but a low correlation and a higher return, it's a wonderful diversifier.

29:24André Perold:So if that's your favorite example, what's your second favorite? I think the second favorite would be corners of the private credit market. Credit is as vast a space as any asset class in the world economy. It's huge. A lot of credit is safe or on the safer end. There's high yield and stuff. But at the level of private credit, a lot of folks, a lot of firms don't have easy access to credit. There's a reason why there's something that isn't easily figured out. And the big lenders have machines. The big lenders, in particular banks, they have a sausage machine of wanting to have loans conform to certain criteria where they can score them.

30:09And they don't want to do too much work for each loan. And so when something fits their criteria, they can make the loan and it'll be at relatively low rates. But what if it doesn't fit? Then that's where private credit steps in and says, okay, we can configure a loan. We're finding there's all sorts of things to do in niche corners of the credit markets. There are corners of the litigation finance market. There are corners of the catastrophe risk markets, corners within energy distress, corners within small ticket European distress, some MES lending in certain cases. There's stuff in aviation finance.

30:47There's just a very wide range. If you just look at the credit space, it's vast. And within it, there are corners that are just not that efficient because credit is really hard work. Credit isn't about being a genius investor that has epiphanies all the time. It's really about finding borrowers that need help, finding borrowers that have very high cost of money, and then finding ways to create a loan that's going to give you a very nice return. But a lot of that return is payment for the work you're doing. That work means you have to perfect collateral. You have to perfect title. You have to set up the loan in a way that protects you in a range of scenarios.

31:29And that's just hard work. And so you're being paid for work as opposed to being paid for epiphanies and genius. We love that. The more you can reduce investing to just hard work, it's awesome.

31:40André Perold:So if you picked out one of those corners of the market, you could take your pick, litigation finance, aircraft leasing, whatever it is. I'd love to hear the story of how you came about it and how you went through and did your work and partnered with managers in the space. Yeah. So let me talk about litigation finance as an example. This is where you're lending to folks who were awarded judgments that are being appealed. So let's say someone's awarded a judgment of$50 million. It's being appealed and you need to defend the appeal because if the appeal succeeds, you're not going to get your money.

32:17You need money to defend it. And so through a specialist partner, we will fund the loan. And then that partner has to make the judgment that this is a good bet. And so we, you know, fortunately through our network, we found a firm of folks who were lawyers before who were doing this, who realized they can turn it into an asset management business. We help put them in business and we have certain rights. We have a share of their investment capacity comes to us. And they do, as I said, it's hard work. They do one loan at a time. They have to source the loans. They have a network. They're making judgments.

32:55These loans are out for a year to three years. You can, in some cases, double your money if it succeeds. You can lose it all. So it comes down to hit rate, and they're just really good at doing it. And it's a tiny corner of the space, zero correlation. What makes a lawsuit succeed or lose has nothing to do with whether the markets were up or down in that moment. And so you can get these returns because it is off the beaten track. They are capacity constrained. And so there's a limit to what we can do. But for that little piece, that's just terrific. So as you take a step back and think about your business implications of these strategies,

33:38André Perold:how do you figure out whether one of these niches has a long enough duration that you turn it into a product as opposed to something that is a great investment opportunity, but maybe more ephemeral in nature? I would say on the latter type, the ephemeral ones, they come and go all the time. There are opportunities there. These are more where you need to, again, it's under the heading of you want to find a phenomenon that exists out there. It's a certain sector of the world where capital is scarce. The big money can't play. It requires great specialization. It's got to be inefficient. You need to understand the inefficiency.

34:20And then you need to find players, specialists who can actually succeed for you. And it's that combination. So when you see an inefficient market and you see that and you find these specialists, you can make a judgment. It's okay. This is going to go on for a while. And if we can find more than one specialist, maybe a range of them, we can bet that will be there. Our job is to keep reaffirming that the inefficiency is there and that the specialists are still available and they're not being swamped with capital. And so I think that's what it takes to form a product. So in the case of biotech, it is one area, but in credit, it's actually a wide range of areas that are all put together.

35:02So we're sort of betting that we can find a range of these inefficient markets and take advantage of them. And that there's enough out there to make it worth our while and that we can give our clients a really good investment that is spread across of those.

35:16André Perold:Before you started diving deeper into these niches, you were, like many people, out looking at great managers in, let's just call it more traditional markets, even if you want to say a long-shrift equity hedge fund is a traditional market. Curious what you think of active management in public equities and credit, let's just say, that aren't in these niche corners of the world. In active management more broadly, let's just take equities, even large cap equities. I do think it always surprises me how short term the markets are. And the managers will say this, and you sort of shrug it off, but it's true that the markets don't look very far out.

36:02The markets are focused on this quarter, next quarter. They don't look out five years. The markets have a great problem looking out five years for some reason. Three to five years is very difficult for people to want to bet on. And they'd like to see near-term confirming evidence. And because of that, especially in a world where the future is brand new, so if you look in the area of tech, for example, and right now we're at a moment of extraordinary innovation, And partly COVID has accelerated all of that. But the digital transformation is enormous. And so things are going to be happening three to five years out that are remarkably different from today.

36:42But it's hard for people to see it. And when they see it, do they get really high conviction? And if you see the future a certain way and it goes against you, how do you persuade your sources of capital that it's still good? So there is absolutely a sense of time arbitrage in the markets. I think you see it in all markets. And as long as that's the case, I think longer-dated, concentrated active management will always have a place. I don't see it going. Even in the largest cap stocks, I think it's there, which is nice and it's very healthy. And it means that those who have the patience and can have the staying power to live through these ups and downs,

37:22André Perold:they're very nice returns to be had. Probably alongside of that, we've seen a huge flood of capital going into, say, private equity and private markets, probably for the same reasons. What's your take on what's happening in private equity land? The great thing about private markets is that they become so big. And they become big, I think, for two reasons. One is that being public is expensive. SOX 404, for companies to conform just to that, but many other things, the regulatory costs of being public are pretty high. in certain areas. Being public is cheap, like biotech. The markets love these little things.

37:59But for the most part, being small and public is pretty expensive. And so, a lot of firms go private. And ones that are private, delay going public. And so, there's a supply of privates there. At the same time, there's just huge amounts of capital that has grown over time, trillions of dollars now seeking private equity returns. Some of it is because private doesn't mark nearly like equity. It's not as volatile based on marks. So that's attractive. But the fact is, there's a lot of sophisticated capital. So there's a lot of supply of privates and demand for privates at the same time. And what's exciting about that is I just think like any other place, there's inefficiencies of many kinds.

38:42We are seeing there's an inefficiency, it very much feels like, in private firms, pre-IPO privates, for example. You see that in many areas where If you can get in at the round before they go public, and certainly in biotech, but other areas as well, that's very nice. Taking companies private is a very interesting area. I think there's huge amounts of money tied up in private equity funds. At the end of life of those private equity funds, you know, a private equity fund will say we have a stated life of 12 years or 10 years, but we have the option to extend. and then very often they will extend a few years.

39:19And then they'll come back and say, well, we need even more extension. And as you get to near the end of life of these funds, stuff happens where people get impatient. They want to wind up the fund. They have some interesting assets in the fund they want to sell. The existing LPs want out. And there are opportunities to pick up some phenomenal assets that are being sold, but they're not public, so they're not traded. And you need to be in the loop and in the network able to take advantage of these. In venture capital, you'll see early in the life of these private companies, there are pro rata rights that you can get, rights to invest in the next round, rights to do all sorts of things.

40:00Often, the original investors, they want to exercise those rights and you can get the rights to do that. There's a very wide range of things you can do in the space. You need to be set up for it, but there's a wide range of places to pick your spots in the private markets, private credit similarly, but certainly in private equity. And that's also pretty interesting.

40:22André Perold:One of the things you haven't expressed is a broad concern over pricing of capital markets. I'm curious what your thoughts are about risk today. I was just looking at it recently. It's very interesting. The last 15 years that we've been in business, if you look at the return on the S &P, it's 9 % a year since late 2005. Of the nine, 3 % a year has come from multiple expansion. And that 3 % a year is entirely consistent with the 3 % decline in bond yields over the same period. So equity, you know, PE multiples have gone up by roughly 30 % from something like 15 and change to about 20 today. Those are forward multiples on the S &P.

41:06It's true. And the 3 % multiple expansion is true in other markets. It's true worldwide almost. So it really feels like we've had multiple expansion, which is the wind in your back as rates have come down. Going forward, what's tough is that you think of a 60-40 portfolio, 40 of the 60 is earning zero, okay? Zero real or maybe even negative real. And if your PE is 20, that's an earnings yield of five. Now, an earnings yield of five, if bond yields are zero, is kind of a risk premium of five. So, okay, there's a risk of five, but that's like a five real on equities maybe times 0.6 is three, and I get zero on the 40.

41:52So, I'm getting three real on a 60-40 portfolio. That's pretty tough. At the same time, that rates don't have much further to come down, if anything. So, you don't have the wind in your back of multiple expansion that you can look forward to. And if anything, there's maybe a risk of multiple contraction. That's not a forecast. you will see multiple contraction, but it says that the current levels of PEs are aided by low rates. And so going forward, returns, it's hard to see how you can say in the aggregate returns will be very high. They're not. Which is for us, we sort of view that as that's our business, is to help our clients who would otherwise be getting three real, help them find opportunities to do a lot better than that in a diversified portfolio of these niche opportunities that's our task because the three rail is low and it maybe is a risky three rail and you've got to worry about inflation you've got to worry about those things at the same time i would say that i think it's also pretty exciting if you look at the marketplace today i think like two-thirds of market cap is really in growth areas today of the of the s &p and it's there for a good reason it's there because the future is going to be different our tastes are different our buying habits of different technologies, allowing us to do things differently because of COVID.

43:13We may not all go back in the office. Just the future is different. And in a way, it's very exciting because it means that there are firms and businesses that'll be very exciting to be with. There'll be a lot of innovation. And so I would say within the growth areas, again, you need to know what you're doing, but if you can pick your spots, that's exciting. The non-growth areas, I like to call them mature areas as opposed to value. I think values are misnomer, but mature businesses are like financials and energy and real estate and consumer staples and things like that. Within those, they've been really hard hit by COVID.

43:53And the forward-looking earnings there, they're not expected to catch up to pre-COVID until at least two years from now, if at all. And so they're pretty beaten up, but there's a lot of bottom fishing opportunities there. And at the same time, those are also more inflation sensitive areas. And so I think if you look at financials, if we get high inflation, bond yields will go up probably. That's good for financials. It's good for credit. If you have inflation, the assets go up relative to liability. So credit's improved. So if you're looking for inflation sensitive assets, the mature ones are better places to look.

44:32Anyway, it's actually a really interesting... So while top down, the returns don't seem high, the opportunity set looks pretty interesting from a bottom-up perspective.

44:42André Perold:So if you're looking out five or 10 years from now, what does High Vista look like? I think for us as a business, what's exciting is leaving aside the excitement of trying to find opportunities. It's that clients, we all have the same problem. We're all trying to not be in the 60-43 realm. bucket if we can avoid it. And we find our clients want to know what to do about it. What do you do for bond substitutes? How do you get returns? How do we do it? And so I would say the opportunity set for us to work with clients pretty closely and help them see the world the way we see it through a bottom-up that becomes a top-down perspective, aided by all these specialists that we work with, is a very valuable thing.

45:29So I would say working much more closely with clients. We see the world quite broadly and interestingly and in a differentiated way. And that means the opportunities to work with clients are that much better. And so I think that interface of us being a strategic partner with clients is just going to grow and grow and grow. And I think that's a very exciting part of the business. And that will be, over time, that has grown for us and is changing the character of the firm as we go down this path.

45:58André Perold:So historically, you always had a balance of extracting, let's call it betas that were easy to do internally, some of these alternative betas, and then mixing it with some external managers. As you do more specialists, does it get harder to do internal implementation? I would say internal implementation for its own sake is something we're doing a little less of, and we do much more of the internal is simply a way of expressing what a specialist is doing. And so if they have great ideas, we can buy more of those on our own balance sheet. We can do SMAs. We can co-invest. We can work with them to see other opportunities and sometimes do those on our balance sheet.

46:44A great example was in March when the market was a massive dislocation. You had mutual funds being redeemed. they were dumping AAA bonds, especially AAA munis were being dumped at crazy prices. AAA bonds that were trading at 140 were selling in the 80s. And credits like the best IVs, for example, were among those that you know they weren't going to be impaired. And by having a muni specialist, we could figure that out and we could trade on a spark with them. And if we didn't have the direct capability, it would have been much harder to do. but it was still working with a specialist to be able to execute that.

47:23André Perold:How do you see HyVista evolving over the next five or 10 years? I think we're a firm that like every other investment firm, you always have to keep developing your edge and you always have to be able to evolve and innovate in a very competitive world. And I think in our case, working with smaller specialized firms in niche areas is a very big piece of our future by working alongside them and doing direct investing, in many cases with their help, so that as we execute, we can be that much more efficient, bring costs out of the system, have more liquidity, not do everything in an extremely illiquid way, have much more flexibility.

48:09I think that is our future. There is a bit of a convergence. I think if you look at most firms that are deep in the active space, they all have networks. They all have people they talk to. They all have ways to develop expertise on the fly when there's an opportunity. We have our particular way of doing it, but every firm does that. And I think I just see us going more and more in that direction.

48:34André Perold:All right, Andre, I want to turn to some closing questions and we'll do it in two sets as always. We'll do the first set and then we'll have a few extra ones for our premium members afterwards. So what's your favorite hobby or activity outside of work and family? I love the outdoors. I love nature. There's something about being out in nature that it's very tranquil. It just takes your mind off of the day-to-day stuff you're doing. So for me, golf and skiing, particularly skiing out, you know, high up in the mountains with stunning views or playing golf in a beautiful environment. I just love it.

49:10So those sorts of things to me are very special.

49:12André Perold:What's your most important daily habit? I had to think about that one because I guess we get so bound by what we do every day, we don't even notice. But I realized, you know, every day I get up, I walk the dog. Later in the day, I walk the dog. I taste my espressos. I have espressos at certain times of day. It's a set of habits that gives the sort of structure to the day that I just love it. What's your biggest pet peeve? There's a lot of those. I don't know if it's a peeve or an observation, but I just think people don't like to think for themselves. People love safety in numbers. They seek safety in numbers.

49:49And you see it in places where you shouldn't be seeing it. In the investment space, so many people like to do things that others do. They like to be in a herd. There are actually very few original thinkers. Everybody copies everybody else, but they all pretend to be doing their own thing. So the peeve is that people claim to be doing original work, but you know they're just copying other people's stuff. And you see that in research. You see that in ideas. You see that in almost every aspect of investing, but obviously you see it in every aspect of life as well.

50:21André Perold:What teaching from your parents has most stayed with you? I think my parents taught us as kids to figure stuff out and do things ourselves. And so the lasting effect has been to have the confidence to figure things out and then do it. So a lot of self-reliance and the confidence to be self-reliant, I think it's just a very powerful thing. All right, last one. What life lesson have you learned that you wish you knew a lot earlier in life? over time, the more you're experienced in dealing with people and firms and the real world, you realize that there's always a game being played of some kind. And understanding the game that's being played is a very big deal.

51:07And yeah, just don't take things at face value. It's so easy growing up. You believe in things, you trust everything. And I think it's easy to be naive on these things. And I for sure had my share of being naive, but you've just come to realize it's a pretty important skill to have. And the sooner you get it, the better. Andre, so much fun.

51:29André Perold:Thanks as always. Thank you, Ted. It's great to be here. All right. Now, normally I say we're going to let our hair down and finish these last questions, but you and I both know there's not a whole lot of that going on with either one of us. I'm going to ask you a couple more. And before we let you go here, What advice do you give to early career professionals? I think people need to appreciate that the real world is a very tough place to compete. What I say to people is the only way you're going to succeed is if you're hugely motivated. So don't do anything where you're not motivated. If you're going to pick stocks, you have to love picking stocks.

52:06It's not enough to just do it as a job. You won't be very good at it. So motivation is really important. I think you need to realize your most valuable asset is your human capital. And so if that's your most valuable asset, what are you doing to invest in it and grow your human capital and sort of consciously having a roadmap for doing so? For example, in our space of investing, having a network is critical. Developing, growing the network is a very big deal. and learning to do so takes skill and it takes practice and it takes determination. I already talked about, you know, understand the game people are playing, but I think people need to realize that not only must you understand the game you're playing, but learn also as needed.

52:54If you can, sometimes you can change the game and just be very aware of what you can do and what game is being played against you at the same time. People are afraid to take risks, especially when you're young, you absolutely have to keep taking risk, a lot of risk, but just be smart about it. But not taking risk is just a terrible idea. If you're going to fail, that's fine. We're in a very forgiving world where failure is not a terrible thing. If you're going to fail, fail often, and you'll end up doing really well. And that sort of relates to making your luck. I think you need to put yourself in positions where you sort of make your luck, where good things can happen, and you can take advantage of them.

53:38You know, it's a version of you can't win the lottery if you don't buy a lottery ticket. It's sort of that very basic idea. So those are some of the things that I love to tell people.

53:48André Perold:What are the kinds of conversations you're having now with your peers where they're seeking your advice? I think everyone's trying to build a business. It depends which peers we're talking about. If it's others in businesses similar to ours, it's what's going on in markets, what's going on with clients. I still think that in the investment business, it gets to the issue of the end clients need somebody they can trust. And they value the ability to be able to trust and work with you more than almost anything. So being super close to your clients. If your clients can trust you, then you can do wonders with them.

54:24Their ability to be better investors themselves goes way up. and your ability to do better for them and for yourself and for your firm also goes way up. So if you build your firm around this notion of trust in a very explicit way, I think the worst is you'll be okay. And the best is it could be an extraordinary business.

54:44André Perold:What's your favorite piece of writing? Could be favorite book or maybe something online. So I'm going to mention in COVID, I've been doing a lot of reading. We've been watching stuff. And so if I can talk about something I've watched. Recently, we watched a documentary called My Octopus Teacher. It's set off of Cape Town. And it's a story of a snorkeler who spends a year with an octopus and actually befriends the octopus. And it's just a very touching story of how a human being can get something like an octopus to trust them. and you learn about how this octopus lives and protects herself and the life cycle of that species.

55:30But it's just such a wonderful metaphor for life. And so as I was watching it, I was just so struck by the parallels to what you need to do just working with people instead of an octopus. It's fantastic. So it's one of the funnest things I've done in quite some time. What's been your biggest mistake and what do you learn from it? I think this is going to sound platitudinal, but Einstein, I think, is the one who said the definition of insanity is doing the same thing over and over again, but expecting different results. The mistake I've made is not to realize how often I was doing the same thing and expecting something different.

56:09So the issue is how long do you do the same thing before you realize that's what you're doing? and the mistake was doing it too long, too often, and being very sensitive to it. It makes a difference when you sort of think that way. As we conduct our business, as you have relationships with people, realizing that you're not always as sensitive to what might really be going on and you keep pretending it's something else and then you realize, oh my goodness, it isn't what I thought, but why did it take me so long? And there are many versions of that and iterations of that where we all have patterns of behavior where we do things for good reason, the same thing all the time.

56:51And then some of those, you're just perpetuating something that isn't so good.

56:55André Perold:Andre, thanks again. Really enjoyed it. All right. Thank you, Ted. Very much enjoyed. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you'd like what you heard, please tell a friend and maybe even write a review on iTunes. You'll help others discover the show, and I thank you for it. Have a good one, and see you next time.