Where Risk Isn`t a Factor

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THE DOW JONES BUSINESS AND FINANCIAL WEEKLY
www.barrons.com
DECEMBER 25, 2006
Profile:
Curtis Macnguyen
Founder
Ivory Investment Management
Where Risk
Isn’t a Factor
Hedge funds are the places investors go
with their risk capital. But in a year of
high-profile losses—Amaranth Advisors
and Global Alpha, to name two—investors
are reminded that risk has a downside.
That’s why Curtis Macnguyen is proud
of the risk-management practiced by his
Los Angeles firm, Ivory Investment Management. In its eight years, his Ivory
Flagship Strategy fund’s annualized returns have averaged 14%, a respectable if
unremarkable showing.
But Macnguyen has earned those
gains in a remarkably steady fashion:
Since 1998, his returns have deviated less
than 6 percentage points, on average,
compared with 15 to 20 percentage points
for the S&P 500 over time. In its worst
month ever, the fund was down just 2.6%.
“From a risk-adjusted perspective,
we’re one of the best performers out
there,” says the 38-year-old money manager.
The low volatility is no accident. At
Ivory, he’s created a system that reports
his portfolio’s exposure to more than 30
different risk factors, ranging from stockmarket capitalization to the price of commodities. The system allows Macnguyen
(pronounced ’Mac-win’) to ensure that his
portfolio isn’t biased by a market mania
that might unwind badly. Earlier this
year, for example, he avoided the heavy
bet on commodity prices that had become
fashionable. As a result, he underperformed many hedge funds in January, but
Mark-Robert Halper for Barron’s
By Bill Alpert
outperformed them in May when oil
prices fell.
By foregoing bets on trends that he
feels he can’t predict, Macnguyen expects
to win or lose on the merits of his stockpicking.
“We not only want to be great at pick-
ing stocks; we want to make sure that our
portfolio doesn’t have a lot of unintended
bets,” Macnguyen says.
He learned about unintended portfolio
bets at a prior firm, Siegler, Collery &
Co. Macnguyen’s partners there were
skilled at fundamental stock picking: they
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went long undervalued good companies
and shorted overvalued ones. But in Macnguyen’s last year at the firm—1998—the
fund was net long small-capitalization
deep-value stocks and net short large-cap
telecom and Internet stocks. He left that
summer, but many value-tilted portfolios
got creamed over the next couple of
years...especially if they’d bet against the
high-multiple Internet darlings.
So when Macnguyen started Ivory in
1998, he scrutinized his portfolio’s overall
exposure to four factors: industry concentration, market capitalization, debt level
and trading liquidity. He didn’t want his
portfolio to be net long or short any of
them.
Over time, Ivory’s list has grown to
more than 30. In 2003, for example,
stocks with a high short interest level ran
up so short that interest became an important factor.
Focus on Ivory Investment
Management
Investment Style: Long and short positions
mostly in publicly held equities.
Specialty: A proprietary risk-management strategy seeks to offset “long/short spread risk” and
other market factors, to generate returns primarily
from individual stock selection–or “alpha”–instead
of from market exposure–or “beta.”
Assets Under Management: $2.8 billion.
Investment Themes: Seeks to deliver attractive
risk-adjusted absolute returns by taking long and
short positions, while trying to neutralize risk by
balancing its portfolio’s long and short positions
to avoid unintended exposure to such factors as
market cap, earnings momentum and concentrated hedge-fund ownership.
Website: www.ivorycapital.com
Annualized Return*
Ivory Flagship Strategy
S&P 500
*From 12/1/98
14.0%
3.8
Source: Bloomberg
Hedge funds face three of their own
kinds of risk, he says. There’s the risk of
bad stock selection and the risk from the
market’s overall moves. To cope with the
latter, Macnguyen likes to maintain a low
net exposure: with his portfolio only 20%
to 25% net long, he won’t get killed in a
market swoon. Then there’s the risk from
the portfolio’s being overall long or short
an influential factor—constituting an implicit bet on something the money manager never intended.
Macnguyen says that Ivory picks individual stocks through a traditional bottom-up process, where he and his colleagues rip apart a firm’s financials and
call around its industry to gather information. Ivory’s comfortable investing in
most businesses except, perhaps, bleed-
Macnguyen’s Picks
Company/Ticker
Recent
Price
CVS/CVS
$30.97
Comments
If drug chain wins battle for pharmacy-benefits firm Caremark,
combination will have cost savings and tremendous buying power.
VeriSign/VRSN
24.38
Renewed contract as registrar for Internet’s “.com” and “.net” domains,
with built-in price increases.
Yahoo!/YHOO
25.52
If it gives up expensive search-engine challenge to Google, Yahoo!’s
cash flow will jump.
Hillenbrand Ind/HB
57.70
Could lever up overcapitalized casket business to reward stockholders.
Source: Bloomberg
ing-edge technology and pure commodity
outfits.
But Macnguyen then steps back and
examines his entire portfolio, to see if it
represents an aggregate bet on one or
another of his watchlist factors. If so, he’ll
adjust his holdings to neutralize them.
Worrisome factors shift with the market. To determine which ones are driving
share prices at a particular moment, Macnguyen assembles a custom index for
tracking each element. For example, he’s
got an index of companies with varied
amounts of debt leverage. In 2002, highlyleveraged companies underperformed the
market significantly; in 2003, they outperformed.
A staff of four updates Ivory’s indexes
continuously. The changes in them give
Macnguyen an empirical reading on
which characteristics have captured the
sentiment of the market. Not every attribute matters, at a point in time. “We
identify three or four key factors in any
given market,” says Macnguyen, “and
hopefully we can mitigate those.”
Once Macnguyen and his colleagues
decide which elements have the most current clout, they turn to a second proprietary system that lets them examine
Ivory’s exposure to them. The fund might
have 23% of its money long highly-leveraged stocks, say, but only 15% short
stocks that are leveraged. That would
leave Ivory net-long leverage, which
might not be a bet Macnguyen wants to
make. He’d then adjust his holdings, or
urge his analysts to keep their eyes out
for new stocks that might compensate.
Of course, some of Ivory’s 33 factors
are things that investors deliberately bet
their fund on. For example, the oil bet
that was so popular this year. Macnguyen
says he’d rather try to neutralize such influences and focus on picking the right individual stocks.
In 2003, Macnguyen threw in his lot
with FrontPoint Partners—a kind of family of hedge funds created by veterans of
Morgan Stanley and Julian Robertson’s
legendary hedge-fund shop Tiger Management. The idea was that FrontPoint
would provide accounting, legal and marketing services to managers like Macnguyen, who would pursue a variety of investment strategies under the FrontPoint
umbrella. But this year, Morgan Stanley
acquired FrontPoint, and Macnguyen decided to take Ivory independent again, a
separation that Ivory recently completed.
What factors matter now? Ivory’s indexes show that shares of companies with
high earnings-growth momentum are up
48% this year, while those with low momentum are down 7%. The high earnings
multiples accorded this year to stocks like
Google (ticker: GOOG), Apple Computer
(APPL) or Research-in-Motion (RIMM)
may have tempted some contrarian-minded value investors into shorting those
high-flying names, which would’ve been
disastrous. Macnguyen’s glad his riskmanagement discipline got him to resist
that temptation.
The latest risk item added to Ivory’s
system is hedge-fund concentration. It’s
become fashionable for hedge funds to
ape the positions of other well-regarded
managers (See “Tracking the Smartest
Money,” Dec. 4). Macnguyen therefore
has constructed an index of stocks with
the highest levels of hedge-fund ownership, so that he can avoid that fad. “There
are too many people copying other people’s portfolios,” he says. “A day of reckoning is going to come and it’s going to
end very badly.”
Macnguyen doesn’t like to talk about
his short positions...not in a national publication, anyway. But he’ll explain why
Ivory is long stocks like VeriSign (VRSN),
Hillenbrand (HB) and CVS (CVS).
VeriSign keeps the Internet’s largest
registry of domain names, those addresses that end in “.com” and “.net.” The U.S.
Commerce Department just approved a
renewal of VeriSign’s contract, which allows it to raise prices in four of the next
six years. Running the registry is a highmargin endeavor that’s growing 25% to
30% annually. Put a 25-to-30-times multiple on just this business’ after-tax contribution, says Macnguyen, and you’ve already justified the stock’s $24.50 price.
The company also has a certification
business, which reassures shoppers that a
retailer’s Website asking for their credit
card is valid. The latest Internet browser
from Microsoft has an address bar that
glows green when visiting sites that have
a VeriSign “extended validation” certificate—which costs the retailer extra.
Amazon and PayPal have already
signed on for this VeriSign seal of approval. Put an 18-times multiple on VeriSign’s profits from this enterprise, says
Macnguyen, and it brings another $7 of
value to the shares.
VeriSign has several other units that
provide services to telephone and cellular
companies—each worth perhaps $1 a
share. It’s got real estate worth almost $1
a share, as well as $2 a share in cash. Add
it all up, Macnguyen figures, and VeriSign stock should be worth 40 bucks or
more.
The Mountain View, Calif. company
has authorized a substantial stock-buyback program that’s on hold while it investigates some errant options backdating. When that self-exam is done,
Macnguyen expects VeriSign to start the
buyback.
Hillenbrand is the Batesville, Ind.,
maker of caskets and hospital beds. Trad-
ing recently at 58, the shares could get to
90, in Macnguyen’s view. If the company
can lift the operating margins of the hospital-bed business—say, up to 17% from
roughly 12% now—that unit could be
worth 18 times its earnings, or $50 a
share.
The casket business is overcapitalized,
he says, and could be levered up to yield
a 5% dividend. Hillenbrand has already
attracted the attention of buyout firms.
Shares of the drug-store chain CVS
sold off after it announced a deal to acquire pharmacy-benefit manager Caremark last month, falling from about 36 to
27, before recovering to a recent 30.
Express Scripts has announced a rival
bid for Caremark, but the Ivory crew
likes the CVS deal. Macnguyen thinks the
combined companies could earn $2.40 a
share in 2008—which would mean that
CVS stock is trading for just 12.5 times
that forecast.
Together, CVS and Caremark would
have $44 billion worth of annual drug purchases. That would give it about 1.5 times
the purchasing power of Walgreen’s,
twice that of Rite Aid and triple that of
Wal-Mart. Every 1% savings in drug
costs would yield 14 cents a share in
earnings for CVS. If the merged business
can grow its per-share earnings 20% annually for the next five years, it could
command a 20-times multiple and a $50
stock price.
Macnguyen also likes Yahoo! (YHOO).
He estimates that the Internet firm has
been spending $400 million-$500 million a
year on its search-advertising business.
The Sunnyvale, Calif. company is enmeshed in a project it calls Panama, to
make its search technology more competitive with Google’s. If Panama works,
Yahoo could improve its cash flow by
50%-to-100%. If it doesn’t pan out, the
downside will be cushioned. Yahoo could
cut out hundreds of millions of dollars in
annual spending and get paid to send its
search traffic to Google. While Yahoo’s
earnings may encounter near-term bumps,
Macnguyen thinks Google-smitten investors are overlooking the better risk/reward offered by Yahoo.
Now, the Ivory Capital boss wouldn’t
mind if stock picks like these lifted his
firm’s average returns to something more
breathtaking than 14%. But with the
memory of hedge-fund meltdowns like
Amaranth still fresh, Macnguyen’s “nosurprises” approach lets his investors
breath a little easier in the interim. n