Investment Strategies: Hedge Funds and Equity Valuation
The Genesis of Hedge Funds: Market Neutrality & Innovation
The concept of the hedged fund (not simply ‘hedge’ fund) was pioneered by Alfred Winslow Jones in 1949. Jones introduced the revolutionary idea of market neutrality, where a fund’s performance is not dictated by the overall market direction but by the relative performance of its individual investments.
- Jones also innovated the leveraged capital model and performance fee remuneration.
- Remarkably, over 34 years of managing his fund, Jones experienced only three losing years.
- By the late 1960s, many imitators emerged, including notable figures like George Soros and Michael Steinhardt.
Today’s hedge funds employ diverse strategies, yet their underlying model remains remarkably similar. They offer unparalleled wealth generation opportunities for partners within the financial markets.
Hedge Fund Reputation and Societal Impact
Despite their financial success, hedge funds often face a “clouded” reputation. Their private nature leads to a lack of transparency, and they are frequently portrayed as speculators or “vultures.” For instance, George Soros is often remembered for “breaking the Bank of England” through his attack on Sterling within the Exchange Rate Mechanism (ERM).
Is this negative perception entirely justified? Hedge funds contribute significantly to market efficiency by:
- Providing essential market liquidity.
- Engaging in shareholder activism.
- Enforcing price discipline.
- Exposing corporate fraud and preventing abuse.
Ultimately, hedge funds represent a vital capitalist vehicle, essential for the functioning of a dynamic capitalist system.
Equity Analysis: Defining Company Value
Equity Research: Fundamental Analysis & Future Returns
Equity research involves the fundamental analysis of a company to predict its future stock market returns. Its primary aims include:
- Defining the fair value of companies, towards which share prices should naturally tend. It is not a market timing indicator.
- Identifying a company’s intrinsic value for comparison against its current market value.
- Adopting a medium- to long-term perspective, based on future expectations for the company.
- Formulating insights through deep industry knowledge, a thorough understanding of the company’s financials, and the ability to model its potential performance over a 3 to 5-year horizon.
“Share Price is the Net Present Value of Future Expectations”
Why Value and Price May Differ
Value and price do not always coincide, as there is no single, universally agreed-upon definition of value. This divergence can be attributed to several factors:
- Investors may hold different expectations for a company’s future.
- Investors may assign varying importance to different company characteristics.
- Investors may have diverse interests regarding the company’s future trajectory.
- Investors operate with different time horizons.
Valuation Methods: Tools for Future Performance Analysis
Effective company valuation relies on various tools, all requiring accurate analysis of a company’s future performance. Key factors to consider include:
- Future Sales: Influenced by new products, large contracts, competitor activity, consumer demand, and broader economic conditions affecting product or service demand.
- Future Profit: Dependent on cost control, workforce adjustments (increases/decreases), and the need for investment and expansion.
- Management Expertise: The ability to react to market changes, innovate, control business operations, and avoid errors.
- Future Dividends: The proportion of future earnings that will be distributed to investors.
Static Valuation Methods
Static methods estimate the stand-alone value of a business at a specific point in time. These include:
- Accounting Value
- Asset Value
- Liquidation Value
Static methods are generally not forward-looking and do not account for the time value of money.
Dynamic Valuation Methods
Dynamic methods focus on future value, assessing a business based on its capacity to generate earnings in the future. Common dynamic approaches include:
- Discounted Dividends
- Discounted Cash Flows (DCF)
- Economic Value Added (EVA), which measures return against the cost of capital employed.
Multiples: Comparative Valuation Techniques
Multiples require an analysis of a company’s future prospects, using this information to compare the company against similar businesses or its own past performance cycles. This approach is based on the theory that markets tend towards efficiency.
Common Valuation Multiples
- P/E (Price/Earnings) Ratio: Measures how much profit is generated for each share divided by its value. It is widely used but has limitations.
- EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization): A more technically robust metric, as it accounts for debt.
- Dividend Yield: The annual return paid by the company to shareholders, expressed as a percentage of the share price.