Andreas Halvorsen's first quarter letter ("we are disappointed with the investment performance") and the departure speech of David Ott (AH's "closest partner, trusted-friend and Viking co-founder").
To: Viking Investors
From: O. Andreas Halvorsen
Date: April 13, 2010
David Ott, my closest partner, trusted friend and co-founder of Viking, has recently decided to step down as CIO and from active management of the firm in order to spend more time with his family (attached to this letter are notes from David’s talk this morning with all Vikings). As a result, most CIO portfolio positions have been transferred to other portfolios and a few have been liquidated effective today with minimal impact on gross exposure. David will become an Advisory Director and expects the time he will spend on Viking activities to be about half his previous level. He will continue to mentor the analyst staff and contribute to idea-generation, valuation judgment and analyst development as well as work on a variety of performance analysis projects.
I have met scores of impressive business executives in my investing career, but only very few are in David's league. His perceptive interpretation of facts and complex business relationships; his awesome processing power; his powerful ability to reach insights and conclusions in difficult situations; his willingness to rally behind others' good ideas; his quiet yet unwavering leadership; and his enthusiastic and unselfish encouragement of others, have left permanent marks on Viking's bedrock. With his continued involvement, it is unlikely that these marks will fade. His very successful management of the CIO portfolio has benefited all of us as investors in the fund. Since David assumed CIO responsibility in June 2005, VGE is up 119% net of all fees through March 31 of this year, compared to an increase of 11% for the MSCI World Index. While we recognize that David's reduced schedule represents a loss to Viking, we respect his decision and are very happy that he will remain involved; we expect that he will continue to have a meaningful impact on the firm.
The resulting reorganization of job descriptions provides great opportunities for a number of extraordinary Vikings who have been given increased responsibility to contribute even more to the firm. Each of these Vikings is eager and able to step up. David’s portfolio-related responsibilities have been passed on to portfolio managers Tom Purcell, Dan Sundheim, Jim Parsons and Dris Upitis who will now collectively manage 85% of capital. They are all outstanding investors who have made significant and consistent contributions to the firm during a combined total of 30 years and previously managed 55% of the capital. I will continue to serve as Viking’s CEO and risk manager and will now also serve as CIO through my involvement in the firm’s largest positions. I will not actively manage capital. My direct reports on the non-investment side, Rose Shabet (Chief Operating Officer), Eric Komitee (General Counsel), Ian Brock (Treasurer and Manager of Prime-Broker Relationships) and David Vaccaro (Acting Head Trader), will take on greater responsibility for the day-to-day management of the firm such that I can spend more time on investment-related activities. Dris will join the Management Committee, which already includes Tom, Dan, Jim, Rose and me; Eric serves as Counsel to the committee.
In response to these events, we have restructured the firm’s investment organization to optimally align our talented personnel with firm goals. Our job is to achieve maximum capital appreciation commensurate with reasonable risk. Every Viking identifies with this objective. There were three important tenets of our past structure that we will retain in our new model. One, the firm will be able to establish large positions and introduce concentration in the very best ideas; two, at least two senior portfolio managers will be involved when large positions are taken; and three, there will be a complete separation between portfolio and risk management.
Performance and Portfolio
Our first quarter performance for VGE was -0.1% and for VLF was 4.5%, net of all fees on a composite basis. This compared to a gain of 4.7% for the MSCI World Index and a gain of 5.4% for the S&P 500 Index.
We are disappointed with this investment performance. Two factors contributed to the poor results: The largest individual losses came from a few large long positions and the short portfolio in VGE outperformed the market indices. In contrast to the concentrated losses in our long portfolio, our short losses were broad-based as no single short position cost VGE more than 30 basis points in the quarter. On an unlevered basis, VGE’s long portfolio was up 5.1% and the short portfolio was up 7.2%, yielding a long-short spread of negative 2.2% (see the attached Base Case Analysis).
Having a negative long-short spread is no way to run a hedge fund. Our aspiration is quite the contrary: It is our goal to construct a diversified portfolio of longs that significantly outperforms a partly offsetting selection of shorts over time. During the first quarter, some of the companies in our long portfolio reported results that were worse than we had expected. Concern over the global economy, government stimuli, and regulatory initiatives combined with increased market volatility resulted in large price declines for companies that missed earnings. In VGE, Financials was the worst performing sector with Banks representing the only industry group with losses exceeding 100 basis points of capital. Bank longs contributed 0.2% while Bank shorts cost us 1.3%. The longs represented large, well-capitalized banks that, in our opinion, have adequately provided for losses in their loan portfolios. We were short a collection of smaller, regional banks with significant commercial real-estate related loan exposures that we believe have not yet been fully marked-to-market leading to a need for additional capital over time.
Following the underperformance in both longs and shorts, we investigated our assumptions and analysis on all of these positions and in most cases confirmed our prior findings and retained the bulk of our bank exposures. While the Financials sector was our worst performing for VGE, the Information Technology sector was our worst performing for VLF. The Health Care sector was the largest profit contributor for both VGE and VLF. Attached to this letter, you will find a breakdown of VGE and VLF exposures by sector and industry group as defined by the Global Industry Classification Standard (“GICS”).
At the end of the first quarter, Visa Inc. was our largest position in both VGE and VLF at 7.0% and 8.1% of capital, respectively. The largest individual short position in VGE represented 2.2% of capital. VGE’s ten largest longs comprised 35.8% of capital and the ten largest single name shorts accounted for 15.9% of capital on March 31. VLF’s ten largest positions comprised 41.5% of capital. The following were our positions on March 31 in order of size for both VGE and VLF:
Visa Inc. (V.N)
Invesco Limited (IVZ.N)
Unilever NV (UNc.AS)
Express Scripts Inc. (ESRX.O)
Tyco International Limited (TYC.N)
Bank of America Corp. (BAC.N)
Metlife Inc. (MET.N)
News Corp. (NWSA.O)
JP Morgan Chase & Co. (JPM.N)
Barclays PLC (BARC.L)
Four of the top ten long positions in both VGE and VLF were new to, or reentered, the list this quarter: Tyco, Metlife, News Corp and Barclays.
Express Scripts was our largest winner for the first quarter, contributing 0.5% to VGE’s performance and 0.6% to VLF’s performance. Express Scripts is one of the big three pharmacy benefit managers (PBM) in the United States. PBMs manage pharmaceutical drug benefits in an efficient and cost effective manner by aggregating the buying clout of their enrollees, enabling them to work with manufacturers for reduced pricing. Express Scripts’s business model aligns the company’s interests with its clients by incentivizing increased use of mail pharmacies and generic drugs, providing high margin to the company and cost efficient treatment for its clients. Over the next three years there will be a significant increase in the number of branded drugs going generic (approximately $28 billion in 2012 alone), and we believe Express Scripts will benefit from this brand-to-generic conversion. In addition, in late 2009, Express Scripts purchased WellPoint's less efficient PBM business which gave them a significant boost in scale. Express Scripts’s ability to take advantage of the generics wave and to optimize synergies from the acquisition of WellPoint’s PBM business is core to our thesis. We think there is significant upside to the stock as our earnings estimates are higher than consensus and we believe that the business deserves a minimum multiple of 20x earnings versus the current multiple of 16.5x 2011 consensus. As of March 31, Express Scripts was our fourth largest long position at 3.2% of VGE capital and 3.7% of VLF capital.
Our largest loss in the quarter was in Mastercard (MA.N) which cost us 0.7% in VGE and 0.9% in VLF. We have owned Mastercard at various points since its IPO and continue to believe in the long-term strength of its business model. Mastercard was our largest profit contributor in 2007, second-largest in 2008 and third-largest in 2009. Although we continue to believe in strong secular revenue growth for transaction processors, Mastercard relies heavily on credit card spending (which offers slower secular growth than debit cards) and has suffered a few key customer losses that will weigh on results in
the short-to-medium term. Visa, which was our largest position as of March 31, was the beneficiary of this share shift. We did not own Mastercard at the end of the quarter, but continue to follow the company closely and monitor the stock for potential re-entry points.
Our gross exposure remained relatively flat during the quarter, ending at 144%, after having trended up for over a year. We continue to believe that improved clarity around government regulatory actions around the world and a healthier financial market warrant higher gross exposure on the margin. However, increased dependence on central banks as a backstop for the financial system, leads, in turn, to questions about the health of sovereign states’ balance sheets. As you may recall, we started increasing our gross exposure from its nadir in November 2008, when central banks effectively socialized the risk of large bank defaults. Since then, an enormous amount of debt has made its way onto national balance sheets as a result of unprecedented fiscal stimuli with the effect that implicit and explicit government guarantees are less sound. While we do not believe there is cause for imminent concern, we remain cautious until there is more clarity as to how governments intend to reduce their debt burden and the effects this may have on the global economy and opportunities for corporate revenue growth and margins. In the meantime, we continue our search for winners and losers across a variety of industry
groups regardless of the economic environment.
At the end of the quarter, developed Asian markets ex-Japan represented less than 1% of gross exposure in VGE and VLF, while the U.S. and Canada represented 73% of VGE’s and 75% of VLF’s gross exposure. In Asia ex-Japan, there are 190 equities that trade over $30 million a day excluding Chinese A shares; including A shares, there are 520. While we make investments based on fundamental company research and do not allocate capital to a particular region based on top-down macro analysis, we believe the Asian markets represent an attractive investable universe that will grow over time. Accordingly, we plan to allocate more analyst resources to this region and are evaluating opening an office in Hong Kong.
We are often asked by investors how we think about owning stocks that are widely held by other hedge funds. There is no categorical answer to this question, but I would like to discuss some of the factors we consider when establishing and maintaining positions in companies known to be popular with our peers. First and foremost, the critical issue is whether we are ultimately proven right in our analysis. Every single position we take has been independently researched by a Viking analyst and each investment decision has been thoughtfully deliberated by one or more of our portfolio managers. We do not borrow conviction from another firm or individual, although we frequently find it informative to talk to other investors to understand the attributes they value. These conversations can help us better assess what has already been reflected in the prevailing stock price. Incidentally, we often find the greatest success in investments where we have a differentiated view from the Street, but we do not shy away from high conviction ideas just because other hedge funds are involved. Although we thrive on standing alone, we do not take positions opposite other firms just to be contrarian. We recognize that all the shares of a given company must be owned by someone and it can be comforting to know that the other shareholders represent firms that we respect rather than not. There is obviously some risk associated with being in an investment alongside likeminded investors who may have been trained in the stock-picking trade in similar ways in that we may decide to sell at the same time. To limit the consequences of crowded exits, we pay attention to the liquidity of the stocks we trade and take large positions only in the most liquid stocks in the world. The problem of crowding is most acute in our shorts due to the risk of unlimited loss and the potential for cancelled borrow arrangements. Here we do tread carefully. As you are aware, we are guarded in disclosing our shorts to anyone and we do on occasion limit the size of our positions, or eliminate them altogether, when we perceive a position to be tight in the borrow market or crowded by equity long-short investors. Ultimately, we live and die by our analysis, portfolio management skills and efforts to contain risk – managing crowded trades is merely another challenge we face in delivering attractive returns at reasonable risk.