Jonathan Burton and Birinyi Associates Are Wrong About Sohn Conference Returns

DUQUESNE CAPITALYesterday Jonathan Burton published an article about the Sohn Conference returns based on a note from Birinyi Associates. “Last year’s stock picks , in aggregate, underperformed the S&P 500 by 19.1%, Birinyi noted” says Burton. Birinyi’s calculations had one major flaw whereas Burton’s article’s premise was wrong. Let’s first go over Birinyi’s fundamental mistake. Can you add apples and oranges? That’s just what Birinyi did. You can’t simply add the returns of short and long recommendations, and compare the overall average return to the S&P 500 index. A short recommendation is considered a successful recommendation if it underperforms the market on a risk adjusted basis. For the sake of simplicity we will assume that all stocks have the same risk. Let’s say Bill Ackman shorts a stock at $50 and the stock increases 20% in one year. Was this a good or a bad transaction? The answer is it depends. If the market went up by more than 20%, then Bill Ackman’s short was a good bet. If the market returned less than 20%, then Ackman’s bet was a bad one. Here is why.

Hedge funds don’t just short a stock and keep the proceeds from the short sale in cash (they would be net short in this case). Hedge funds receive cash when they short sell a stock and they use that cash to initiate long positions. They generate alpha on the short side of their trade if the shorted stock underperforms the market. They generate alpha on the long side of their trade if their long position outperforms the market. You can’t add the returns of a short recommendation and a long recommendation but you can add the alphas of a short recommendation and a long recommendation. Let’s do the calculations the right way:

Last year the Ira Sohn Conference was on May 8th. We will calculate the returns between May 7th, 2013 (closing prices) and May 2nd, 2014 (closing prices). Last year the following US stocks are recommended at the Ira Sohn Conference (based on Josh Brown’s and Zerohedge’s notes):

1. Kyle Bass recommended a long Dex Media (DXM) position. The stock lost 43.5%. S&P 500 ETF (SPY) gained 18%. DXM’s ”alpha” was -61.5 percentage points. Birinyi had different return numbers for some reason. We believe the dates we are using are more appropriate.

2. Keith Meister recommended TW Telecom (TWTC) and Level 3 (LVLT). TWTC returned 14.4% and LVLT returned 85.3%. TWTC’s alpha was -3.6 and LVLT’s alpha was 67.3 percentage points. Birinyi didn’t even have LVLT in his table.

3. Bill Ackman recommended Procter&Gamble (PG). PG returned 8.4% and had an alpha of -9.6 percentage points.

4. Stan Druckenmiller recommended Google (GOOG). Google returned 89.1% and had an alpha of 71.1 percentage points. Birinyi didn’t have Druckenmiller’s pick in his list either.

5. Mitchell Julis recommended Clear Channel Outdoor (CCO). CCO returned 18.4% and an alpha of 0.4 percentage points. Birinyi didn’t have Julis in his list either.

6. Steve Eisman recommended several housing stocks but he stressed a long position in Ocwen (OCN). OCN lost 11.7% and had a negative alpha of 29.7 percentage points. The other stocks he mentioned more or less in line with OCN’s performance.

7. Jim Chanos recommended short positions in WDC and STX. WDC and STX gained 44.4% and 25.1% respectively. Their alphas were -26.4 and -7.1 percentage points. Birinyi didn’t have WDC in his list.

8. Tor Olav Troim recommended Golar LNG (GLNG) which returned 28.4%. Its alpha was 10.4 percentage points. Birinyi didn’t have GLNG in his list.

9. Jon Jacobson recommended a short position in Digital Realty (DLR). DLR lost 16.7% and its alpha was 34.7 percentage points.

10. Clifton Robbins recommended Akamai (AKAM) and CACI International (CACI). Akamai returned 17.8 and CACI gained 21.4%. Their alphas were -0.2 and 3.4 percentage points respectively.

11. Jeff Gundlach recommended a short position in Chipotle (CMG). CMG gained 39% and its alpha was -21 percentage points. Birinyi didn’t have CMG in his list.

12. David Einhorn recommended a long position in Oil States Intl (OIS). The stock returned 0.3% and its alpha was -17.7 percentage points.

If we allocate equal dollar amounts to each of the hedge fund managers, then the average alpha of these 12 hedge fund managers would be 0.23 percentage points. If we allocate equal dollar amounts to each idea (the hedge fund managers with two ideas will be over-represented in this case), then the average alpha would be 1.8 percentage points.

So, hedge fund managers from 2013 Ira Sohn Conference, as a group, managed to generate a small amount of alpha over the past year. Unfortunately, Birinyi’s exclusion of GOOG and LVLT -which had huge gains- painted a much darker image. Adding apples and oranges was wrong too.

Jonathan Burton made a bigger mistake though. His article implies that hedge fund stars underperform in general (his title is “Ira Sohn heavy hitters keep missing”). You can calculate one year’s returns and get a number. That’s just a number though. In order to arrive at statistically sound conclusions, you need multiple data points. We, at Insider Monkey, analyzed ALL hedge funds’ 13F filings and the returns of their stock positions between 1999 and 2009. Our calculations showed that the 15 most popular small-cap stocks among hedge funds outperformed the market by an average of 18 percentage points per year between 1999 and 2009. This is a mind-blowing number. You may argue that that is old data and there was much less competition in the old days. That’s a valid point. We were really careful with our analysis and tried to avoid data mining or other sorts of biases, but you never know. So, we started forward testing this strategy since the end of August 2012. This strategy performed even better in forward tests. The 15 most popular small-cap stocks among hedge funds returned 84% since then, vs. 38% gain for SPY (see the details here).

Here is the main take-away from this article. Hedge fund managers (or any investor) may or may not outperform the market in any given year. However, on average over long periods of time, hedge fund managers’ small-cap best ideas have been outperforming the market by a gigantic margin. The two key phrases in the last sentence are “on average” and “best ideas”. Do yourself a favor and keep this fact the next time you read an article about hedge funds.

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