Animal Spirits Podcast - Talk Your Book: Matching Longs with Shorts

Starting point is 00:00:00 Today's Animal Spirits Talk Your Book is brought to you by Wasatch Global. Go to wasatchglobal.com to learn more about their Wasatch Long Short Alpha Fund, ticker WALSX, which we're talking about on the show today. That's wasatchglobal.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion. and do not reflect the opinion of Ridholt's wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

Starting point is 00:00:38 Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Michael, I've always been really interested in the psychology behind people who were able to run long short books and funds and strategies because I feel like you have to be able to separate the two parts of your brain, right? Because long-only people, they have this certain mindset. I think even, like, you know, long-term, optimistic, glass-safull.

Starting point is 00:01:13 I feel like a lot of fixed-income people are glasses half-empty because bonds are there as the anchor. But long-short, you have to have both of those abilities. You have to, like, be able to fight through the cognitive dissonance. long short was a huge category of hedge funds back in the day right like this is what everybody wanted to be this was the sexiest strategy out there and they went through a really rough period as uh i would say like valuations got disconnected but whatever the case was it went through a really tough environment the 2010 was not easy to be a long short manager yeah um because typically long

Starting point is 00:01:47 you know uh value oriented names and short expensive that just blew up that was not a sustainable strategy in 2010s for reasons that are obvious in hindsight. Right. The higher valuation stocks did better than the low valuation stocks. So that was typically the strategy, right? You go along the low valuation stocks. You go short the high valuation stocks and hope that they come back and meet the middle through your version. And look, I made money on both of them. That didn't work anymore. So on today's show, we talked to Mick Rasmussen, who's a portfolio. One, one, an addendum to the intro. Is they use that word right, addendum? This is not a 50-50. This is not a market-neutral strategy, right, where the

Starting point is 00:02:28 shorts offset the longs and therefore all you're left with is the residual alpha to the extent that there is any? Yeah, well, that was a new will comment by you because everyone who knows what a long short fund is knows that. I don't think so. Yeah, there's long short funds, which are usually long. Oh, and then market neutral. Okay, fair enough. Well, listen, not everybody's a hedge fund professional on this show, okay? That's true. So we talked to Mick Rasmussen today who works at Wasatch global, and they are known for investing in small and midcaps, mostly small caps. They run like $30 billion in small cap investing, and then this is their first long short fund.

Starting point is 00:03:00 And so it sounds like they typically go long 90% to 140% or so, and then short between 0% and 60% or negative 60%, I guess it would be. But I think they kind of try to match it out, it sounds like. But actually, having a short book in the small cap exposure in the small cap universe is That makes way more sense to me than trying to short large-cap stocks, right? Because we've talked about it. There's a lot of junky small-cap stocks that don't make any money. So if you're going to do it, this would seem to be the place to do it.

Starting point is 00:03:31 Mm-hmm. Right? Okay. So we get into all this with Mick and how they work their strategy, the way small-cap stocks work, how they're sort of under-followed. So here's our conversation with Mick Rasmussen from Wasatch Global. All right, Mick, welcome to the show. Thank you.

Starting point is 00:03:50 So I have a question for you about long short fund. I have some hedge fund investing experience in my past. And the thing that I always thought was the hardest question to answer for a manager of a long short fund was not necessarily on stock selection. Obviously, stock selection is important, but it's the gross and net exposure that you have. And I think that's the hardest question to answer because you could have great stock selection, but if your gross and net exposure is not correct in terms of the direction of the market, for the direction of your stock picks, it could throw you off.

Starting point is 00:04:21 So how do you determine that? Do you, is it a static level for you? Do you change how that exposure works? Because it's obviously not going to be just 100% invested, like a typical long-only stock fund. Yeah, so, I mean, I think the main thing with all long-short investing is knowing your strengths and being really intentional about the risks you want to be taking.

Starting point is 00:04:40 So for us here at Wasatch, we are fundamental bottom-up small-cat managers. So we're quality growth investing in the small and mid-cap markets. And for us, it's really, you know, we think we can find really differentiated companies and excellent businesses within this space. But it comes with this source of risk that we're not, that's undiversifiable in a long-only portfolio. So you end up with whether or not small-cap growth is what's in favor at the time. That's your biggest source of risk in return, not whether or not we're able to find awesome.

Starting point is 00:05:17 businesses and compound over long periods of time. So with this strategy, it's all about taking that source of risk we want in the long side and hedging away the piece we don't want, which is that small cap factor, the growth factor, the sectors and industries we don't want the interest rate risk we don't want. So we're left with much more of what we're really good at and much less of that associated risk that comes with our style of investing. And the only way to really do that is in a long, short strategy. So they have, I mean, there's some one 30-30 funds that are relatively static, right? They go long, 130% long and 30% short, so effectively your net is netting out at 100. Do you try to get into that range or does your net exposure

Starting point is 00:05:58 move up and down? So we're a directional long, short fund. So we're always going to be somewhere between market neutral and fully long-only invested. So through a full market cycle called a 0.5 beta is exactly what we're looking for. That's going to fluctuate through time. Really what we're solving for is a sharp ratio. The best thing we want is that risk-adjusted return. So for every basis point of return we're getting, how much risk are we taking for that? But with our style of investing in small caps, with this inefficient high alpha space of the market, it tends to be about half the risk or half the exposure you'd get in our long-only strategies. So I want to talk about the the inefficiency that you just mentioned, how confident are you that the prices of the stocks

Starting point is 00:06:45 aligns with the fundamentals of the business? Because there's been a lot of debate over this. Einhorn has been out recently saying like a lot of the stuff that he used to do, like you could find a great business at a wonderful price, but if there's nobody else to realize the price with you, that it could just stay underpriced or overpriced for that matter forever. And being that you're in the arena doing this, I would imagine that you're still confident that actual stock selection does still work.

Starting point is 00:07:08 So talk to that dynamic. You know, it absolutely does. It just can take many, many years for that to play out sometimes. So, you know, if you hold a compounding business long enough, eventually those fundamentals are going to be what drives the price and you will get paid for that from the market at some point. The difficulty is, you know, yes, we have seen huge dislocations at specific points in time. And you have to be able to manage and live through those short-term risks and big inefficiencies

Starting point is 00:07:38 in the market so that ultimately you end up getting paid a much more fair price for the companies you're investing in. If one of the stocks that you're involved in somehow becomes a target of one of the squeezes that makes no sense, but they exist, right? Like it's a dynamic in the marketplace that you didn't have to deal with 15 years ago. If one of your companies is embroiled in that, would you be like, all right, we're out or would you be more likely to add to your position or how would you deal with such a situation? 100% we're out in that environment.

Starting point is 00:08:06 And, you know, we actually tend to try to. That's the right answer. You're not trying to step in front of GameStop? That's the right answer. Ultimately, hopefully we can avoid those in the first place. You know, we have some pretty tight restrictions on our short book. A typical holding is call it 50 basis points, maybe 70 basis points, or anything that has a high borrow cost, high short interest, we're going to avoid those.

Starting point is 00:08:26 And if a short's going against us, you know, we're in a, there's thousands of small cap companies and mid-cap companies we're looking at. So if something starts to show those types of behaviors, we're going to replace it with another company that we think gives the same hedging characteristics and the same negative alpha profile, but without the embedded risk of, hey, this is going to have those market dynamics really go against you. One of the stats, Michael and I have talked about the last couple of years, is it's something like 40% of all Russell 2000 stocks make no profit, right?

Starting point is 00:08:55 People have been beating this drum for a while. Is it easier for you to find short candidates in the small and midcap space because of this? I would imagine there's more short candidates in that bucket than there is in the large cap space. Absolutely. Yeah. I think that's what drew us so much to the strategy is, you know, within small caps, the breadth of great companies and terrible companies is massive. So there's a ton of differentiation between if you can find these really awesome businesses. There's still hundreds of these every year that are growing 20 plus percent compounding earnings, great management teams. And that's,

Starting point is 00:09:29 that's really our source of alpha. But, you know, on the short side, you're seeing the exact opposite, that were those tons of businesses that frankly shouldn't even be public right now, unsustainable business models, you know, companies that worked in a zero interest rate environment, but now definitely don't work with the cost of capital increasing to where it is today. So, you know, we think there's tons of opportunities to find great shorts that work best when they're paired with our high alpha long. So naked short selling some of these companies doesn't make much sense because you still have a positive expected return on a lot of them with a lot of

Starting point is 00:10:04 risk that comes with that. And that's why having this directional long short is, you know, we think a really, really nice way. So you're more playing the dispersion spread, basically, right? Like these ones are going to underperform these ones by a lot. Yeah, no, that's exactly right. I mean, the primary goal of our shorts is to hedge away the risks that come with our style of long investing. So, you know, it's, if we have a lot of software companies and a lot of healthcare companies, we have an insight on this management team and their ability to deploy capital and grow over long periods of time, but we don't have a take on whether the market's going to, you know, put this industry in favor over the next six months and have a lot of flows

Starting point is 00:10:40 and see large market moves. So it's protecting from those market dynamics is the primary goal of our shorts. So you mentioned that you would avoid high short interest stocks. It's funny because, again, back in the day, a high short interest, Tesla aside and obviously a few others aside, generally indicated lousy businesses. All the short sellers in the world is you know better than anyone can't put a good business out of business because these are businesses and ultimately a good business will thrive. You just said business like 12 times there. I did. I'm sorry. I'm kidding. That's what's important. I love it. Yeah, these are businesses, Ben. But it's funny. So, so you will avoid these stocks that have a high short interest because as I alluded to earlier,

Starting point is 00:11:22 they can be the targets of these coordinated attacks. Yeah, I think that's exactly right. Like, all I'll sequel, I would tend to, you know, be less interested in owning long something that has a high short interest because, you know, the market's not dumb and they're usually picking up on something. I think within our universe, there's just, there's enough opportunities out there that, you know, that there's plenty of unattractive small and mid-cap companies that aren't going potentially be caught up in those same dynamics. So if it's crowded short, yeah, no thanks. I have to imagine that the short interest cost has to be relative to like large caps. Is there enough liquidity where you can find enough candidates where it's not too cumbersome from a cost

Starting point is 00:11:59 perspective? Like, what is your line in the sand of, no, we're not paying short interest as high. That's ridiculous. It, like, the hurdle rate is too big. Yeah, it tends to be about 5% is the borrow cost where we're not going to initiate or maintain a position. You know, the dynamics of short selling, you know, you're borrowing stock at actually a much cheaper rate than you would be borrowing dollars for us. So it's a really nice, cheap source of leverage for us. And that's why we're able to go more than 100% long as well. So, you know, for every time we're, let's say a typical borrow cost is 50 basis points, we get to take that stock, sell it in the open market,

Starting point is 00:12:38 and then take that cash and reinvest it in our best long ideas as well. So, I mean, that's what allows us to be, you know, to actually get more of our stock picking in this portfolio. And we end up with even higher weights in our top ideas. And because we're hedging some of that risk as well, It's, you know, it allows for a lot of optimization there. Can you talk about the idea of you mentioned like where the shorts come from? How does, how does interest rates impact this?

Starting point is 00:13:06 Because this is like a double whammy for a lot of the error where interest rates were at zero. So you were getting nothing on the cash. Talk about how that works and how that might be a tailwind for what for your strategy. Yeah, you know, it's mostly just reflected in the equity prices themselves right now. So it's, it's the fact that the market's not willing to pay nearly as much for. a company when you can get 5% on your cash balance, as they were when you could get 0% on your cash balance. So it's for small cap growth investing, that's going to be especially exposed.

Starting point is 00:13:36 You know, we're long duration and there's a lot of businesses in the space that need external financing, which is going to be really sensitive to that and tied to what overall rates are. But in terms of the ability for us to short and the structural dynamics of the portfolio, it doesn't change much. do you have like bands where you won't either get too long or too short like how does how does that how the sizing of those positions were and not the positions themselves but how long you are and how short you are yeah so um our our maximum long exposure is going to be 100 so you know in a really extreme environment we could actually cover all of our shorts let's say that you know the borrow cost

Starting point is 00:14:18 goes through the roof on all small caps and we've had a major sell off market and we want to be 100% long. We have the capability of doing that. I doubt we ever would. On the short side, it's 50%. So we could never be more than 200% gross exposure, which would mean 150 long and 50 short would be. That's kind of the structural limits within a mutual fund for us. When was the time where you were max short? Call it the late 2020, early 21, kind of that peak of the post-COVID mania. That was actually really difficult environment for us coming out of that peak. period because risk on was the most important thing.

Starting point is 00:14:57 And a lot of these really speculative, high, multiple, low quality businesses that we were short were doing extremely well through that period. But we were able to maintain, you know, that high, short overall portfolio throughout that period and then got paid very well for that as the tide went out in the markets. That's when you tell your clients, this is a junk stock rally, right? No, but for real, I was going to ask. But it was. I'm curious if your clients, because I would imagine that this is mostly an institutional

Starting point is 00:15:23 product. I would imagine, despite the fact that you were getting your face ripped off by the shorts, I would imagine that they were like, this is going to turn. This doesn't make sense. Or am I giving people too much credit? Were they like, this sucks? What are you doing? You idiot? You know, I think our, we actually, we just launched this mutual fund in about three years ago. So we throughout that period, we were managing this internally at Wasatch. You know, we're very long-term focus. We managed the strategy for five years with just our, our own partner capital before we went public to the markets with us. So we didn't have external clients through that period. But certainly it was... All right. So what were you saying to yourself in the mirror?

Starting point is 00:16:02 You idiot. No, it didn't make any sense. And it was trying to stick to what our predefined game plan was and our discipline, which, you know, fortunately, our net long bias allowed us to be up in absolute terms a healthy amount in that period. And I would expect that going forward. But we certainly weren't keeping up with the euphoria of the markets. And, you know, I'd say we're seeing this. same thing to a much smaller degree today. You know, since the, there's clarity on rates being cut from here, post-election, we've seen, you know, a much smaller degree of those same things playing out where there's a renewed risk appetite in the markets.

Starting point is 00:16:38 And with that, we've seen our short start to outperform our longs just in the past, you know, call it a month or two. I'm curious how the dual process works. So you have these specific variables you look for in your process when you're going along a stock. Whatever it is, you can tell me, a certain level of earning. growth or a certain level of ROE or whatever it is, you're looking for those stocks. Is the short book just the opposite of that?

Starting point is 00:16:59 You're looking for companies that aren't growing. Is that how the long, short aspect of it works? Or there are different variables you're looking for between the different buckets? No, it's so, you know, I think it's really helpful to ground this in who we are at Wasatch. And, you know, we've been managing the same types of long-only portfolios for 50 years now, doing, you know, this very specific, like deep due diligence, getting to know management teams. getting no business drivers, getting no industries, in this portfolio and across our entire $30 billion platform, it's the same insight and the same, you know, every name that we own in

Starting point is 00:17:34 this strategy is owned across our U.S. franchise in other portfolios. So that really is the heart of how we win. And, you know, we have a process that's been proven to add alpha in this space for many, many years doing exactly that. On the short side, it's the first thing is, is that, you know, risk management piece is number one. So all those equally want our shorts to look a lot like our longs. If we have specific exposures, it's a matching exercise first and foremost. Does that mean like sector-based? Like if you're long, your biggest holding is in the healthcare sector, you want to have a short that kind of offsets it. Exactly. So we have risk models, which is the primary thing. So that's groupings of country risks and sector risks. It's factors.

Starting point is 00:18:18 So how fast is the overall portfolio growing and what's the leverage and cyclicality? It's also return correlations. So we're looking at when interest rates are up, when GLP1 drugs are doing well, when the AI infrastructure group basket of stocks is doing well, how's our portfolio be performing? Because that's not our insight. Our insight at Wasatch is always company specific. We, you know, it's very bottom up. We're not particularly great at the, hey, let's make a big macro call.

Starting point is 00:18:46 We want to own a lot of this sector. We want to own a lot of this macro theme right now. So if we have that as an output of our long portfolio, the first thing we do is let's get rid of that. So it's back to that intentional about risks. We don't want to have a call there. And a long only portfolio, we would have to have a call there. Let's go find a risk that are short that can offset that and go hedge that away. I want to talk about your fundamental, the stock picking, how that works.

Starting point is 00:19:13 But before, I just don't want to forget, I'm curious, was your worst drawdown in 21 or like, is it weird where like you had the worst? right on in a ball market or would it be in a bear market? Bear market for sure. So, you know, we have that 0.5 data roughly in this strategy. So, you know, 2020 was a really tough year for us. We were down about 8% that year with the small cap. So that's not so bad. Small cap growth was down, call it 25%.

Starting point is 00:19:38 Yeah, so that doesn't sound bad. And 8% down, you're in a really bad market. What would you have expected and they say, I don't know, a different bear market? That's what we're hoping for. Like we were, we were pleased with that. Oh, okay. Absolutely. But that's going to be in an absolute basis. Our worst periods are going to be when the market's down. But we should provide some downside protection. I was wondering if that was like a humble break because down 8% to 22 is pretty damn good. We're proud of it for sure. Okay. So are you guys, is there a quantitative screen and then you get working on the businesses or how does it work?

Starting point is 00:20:12 So a little background on myself, I was actually our first full-time quantitative analyst that was hired here at Wasatch. So, you know, we've been in business, as I said, 50. years and 40-person research team, 39 of them before me were doing stock-specific research, and I was brought in to come in and say, hey, what can we learn about our specific data, our style investing, our process to add value? And, you know, the key insights we had there were what I've mentioned of its company-specific insights are how we add value. Our stock picking is actually great. We're really good at knowing which companies to own. What we need some help with is when we own those businesses, how to put weight behind our best ideas and how to manage the portfolio level risk. So a lot of what I'm working on and not just this long,

Starting point is 00:21:00 short strategy, but across the firm is exactly that. So, you know, we'll have certain ideas. And when they hit characteristics that historically we've done really well. And that's when we'll add a lot of weight to those ideas and, you know, kind of double down when our thesis starts playing out. So as a quant, you go back and you look at the 30-year track record of your firm, and you figure out these are the attributes we picked that made sense, or this is the attribution and this is where we made our living, basically, and because we hit these specific variables, more or less? That's exactly right.

Starting point is 00:21:32 Yep. So it's saying, you know, we've done a really good job of documenting our, you know, company modeling. We'll say, what are our five-year earnings estimates for every business we own? One thing that I think is incredibly unique to Wasatch is we actually rank our management teams. You know, in small and mid-cap investing, there's a ton of. variance in management quality. There's some people behind these businesses that have no right being there. And there's some really top tier teams that we've known for many, many years. So we actually

Starting point is 00:22:02 survey everyone on our team every 18 months and say, here's our portfolio, rank the best management team to the worst management team. We measure that. We turn it into a quantitative output. And it's been by far our best source of outperformance of everything we've measured internally. So So the fact that we are getting to know these management teams and that we have experience meeting with so many, we now use that as an input in our portfolios. When we have a top scoring management team, we put a lot of weight behind those names and vice versa, if it's one of our lower quality management teams, we're going to limit our exposure there, which, you know, that's certainly not a screen you could run on Bloomberg or facts up, but it's something that we've built a decades-long process of measuring and now have a systematic way to harness that insight. So the short position, it's not necessarily to generate alpha. I mean, obviously that's the idea, but it sounds like it's more for risk management. I'm curious what like the turnover looks like on that side of the book.

Starting point is 00:22:59 Yeah. So on the long side, it's we like to hold things for, you know, three plus years as a typical investment horizon. So call it 20 to 30 percent turnover there outside of flows. And on the short side, it's going to be maybe three times that. So about 100 percent annualized turnover on our shorts is what we're going for. A lot of that's because we don't want to take that stock-specific risk on the short side. We want to hedge away a profile.

Starting point is 00:23:23 We want to protect from a certain risk. So we run much smaller names at a much flatter list. So as the shorts going against us, we're covering it. As your shorts working for us, we're likely going to add to that position. So it requires a lot more trading there and being a lot more nimble as we're adding in and out of positions, specifically because the volatility in some of these small cap shorts is huge. and we want to make sure to keep our overall exposure small. I'm curious to hear what your process is for picking small cap growth companies.

Starting point is 00:23:53 Is it growth at a reasonable price? You're looking for the best, highest growing companies that the market hasn't identified yet? What are those variables that you guys try to take off? Yeah, you know, I'd say the center of the plate for us is, you know, companies that can compound their earnings growth for 10 plus years, and the market is underappreciating that duration to their compounding. So it tends to be excellent businesses at premium multiples that we think deserve even higher multiples. So we always are going to skew a little bit more expensive than the market because it really is, you know,

Starting point is 00:24:28 if you can find a company that's able to compound for that amount of time, you're able to pay some pretty insane multiples for them and still have the stock price workout. So our insights very rarely on the stock price alone and the insights much more frequently on the same. is a business that we want to own for 10 plus years. So you've got 50, this is as of the end of September, 56 longs and 58 shorts. Is that about what it normally looks like? Yeah. So we'll typically have a few more shorts than longs because the typical position size is so much different. You know, on the long side, we're comfortable owning a 5% weight there if it's a company that we really like and know a ton about. On the short side, anything above about 1% we're going to start covering. So we do need a longer list to

Starting point is 00:25:16 offset that for us. So the one thing that I've always been told is that active management works better in places like small cap because there's not enough analysts covering them and it's easier to find a hidden gem. Is that still true? Do you find that happens in that space? Yeah, so we definitely seek out the inefficient parts of the market here where we're small and mid-cap specialists, but we actually invest globally. This strategy is is U.S. only, but firm-wide, you know, we've found that it's the small and microcaps in the U.S. And then international markets where we've tended to find those biggest dislocations in price. I think the double-edged sword piece of that is with those less efficient markets,

Starting point is 00:25:56 your risk management also needs to be stepped up a tier because you might have to live through those periods of extreme volatility and extreme mispricing. Can you do this inside of an ETF? Yes, you can. I think for us, the reason we haven't gone that route is the needing to show your hand, the transparency piece of ETFs today. In these relatively illiquid companies, we don't want to be showing our trading every day. And frankly, the semi-transparent ETFs haven't shown that much success yet. I think that creation and redemption mechanism, if you aren't showing exactly what you're holding, there just hasn't been the same liquidity there. And so you end up with a bigger bit. ask spread. But we do want to be as vehicle agnostic as we can. So right now we have two shares of a mutual fund in this strategy, but about half our business is in separate accounts. We have limited partnerships that we can offer. So that's the least important part of how we're building a strategy for us. But the ETFs and small caps, active small caps, just really isn't a great fit

Starting point is 00:27:06 yet. Do you have to have operational controls in place when you're building a position or getting out of it? You have to like leg in and leg out because of liquidity provisions at times? Yeah, absolutely. So, I mean, firm-wide, you know, our U.S. small and mid-cap franchise is about $20 billion right now. Are those mostly long-only or long-short or what exactly? Mostly long-only, yeah. So this is our first long-short offering. And our product roadmap here at Wasatch, it's research driven as opposed to marketing driven. So we've never sought out and said, hey, long, short, quantitative, fundamental is this big market need that we think we're going to raise a bunch of assets in? Because frankly, like, I don't know that there's many other products

Starting point is 00:27:48 that exist like this. It's much more, we see an opportunity. We want to put our own capital in this. We think it's a really interesting way to harness our investment insights. Let's go find a product and make that work. So this was very much an organic development from our research findings. But yes, the majority of our firm is long-only small-cap growth. All right, Mick, if people want to learn more about the Wasatch strategy that you guys run, where can we send them? Yeah, Wasatchglobal.com is going to be the best place to reach us. And you should see an advisor services email there as well if you'd like to reach out.

Starting point is 00:28:24 we've got lots of resources on that website, recent white papers about how we use quantitative and fundamental research together that we think are very relevant for this audience. So I'm happy to set something up as well. All right, we will link to that in the show notes. Mick, great job. Appreciate the time.

Starting point is 00:28:40 Thank you for coming on. Hey, thank you guys. Love what you do. Okay, thank you to Mick. Remember, check out wasash global.com at WAS, ATCH,CH. And check out the Wasatch Long Short Alpha Fund. email us animal spirits at the compound news.com. We'll see you next time.

Your Ad Here

Animal Spirits Podcast - Talk Your Book: Matching Longs with Shorts

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.