It has been a challenging period for the listed hedge fund sector with BH Macro (LON: BHMG) sliding to an unusual discount after some lacklustre performance and Boussard and Gavaudan (LON: BGHS) moving into a managed wind down, yet Pershing Square Holdings (LON: PSH) continues to march higher.
According to the accounts for the six months to the end of June, Bill Ackman’s £10bn fund achieved a 10% NAV total return and is up by an annualised 22.6% over five years. Normally with this kind of record you would expect the shares to be trading at a premium, but they are actually available at a 37% discount despite an active buyback programme.
PSH has a highly concentrated portfolio that typically consists of eight to twelve large, liquid US stocks that make up its core holdings. There is also a hedging strategy that is overlaid on top, which aims to protect against “black swan” and other global macro risks.
The Underlying Stocks
The manager invests in high-quality businesses that he believes have limited downside and generate predictable, recurring cash flows. These currently include the likes of: Universal Music Group, a dominant player in an oligopolistic industry that is trading at an attractive valuation; Restaurant Brands, which has a quality, capital light business with strong margins; and Lowe’s, a potential beneficiary of the home improvement drive as a result of the interest rate uncertainty.
Universal Music Group was the weakest performer during the reporting period due to the threat of generative AI on the music industry, although it has bounced back strongly since the end of June. Ackman believes that the company has tackled the risk well and that AI represents more of an opportunity for the business than a danger.
The most significant change in the period was the addition of a new position in Alphabet (formerly known as Google) whose shares are now up 40% since the initial investment. PSH says that the company benefits from deep barriers to entry, has a significant opportunity to expand its margins and enjoys a strong balance sheet with an attractive capital return program.
Perhaps the most significant event on the horizon is the new special purpose acquisition rights company (SPARC) that will be used to enable a private company to go public. The capital for this will partly be funded by PSH, along with other affiliates of the fund manager.
Hedging Strategy
PSH is currently short (through put options) 30-year treasury bonds because Ackman believes that long-term rates will increase, as inflation will remain persistently high due to elevated wage growth. He thinks inflation might stabilise at three percent, which could lead to treasury yields exceeding 5.5%.
During the six months to the end of June the put options fell in value due to long-term rates declining on recessionary fears and the regional banking crisis. The hedge has been retained though because of the risk of higher long-term rates on equity valuations.
PSH has a highly successful track record in getting these macro bets correct, including during the pandemic. The hedges are opened when it is cheap to do so, thereby minimising the impact on the fund if the negative event doesn’t happen in the expected timeframe.
When they get it right it can have a huge impact and generate significant cash for re-investment at a time when equity valuations are low. For example, during 2020 the manager positioned for an increase in short-term rates that produced $2.7bn of proceeds from an outlay of $384m.
Discount, Buybacks And Outlook
The broker Numis says that Pershing Square Holdings has generated outstanding performance over a number of years and that the manager has an impressive record of producing strong returns and protecting against market weakness using portfolio hedges with asymmetric payoffs.
Despite this the fund consistently trades at a significant discount to NAV, which is even more surprising once you factor in the active share buyback programme. Since this was first initiated in May 2017, the company has repurchased $1.19bn of shares at an average discount of 28.7%.
Numis describe the current 37% discount as excessively wide and believe that it offers significant value, although they can’t identify a near term catalyst for it to narrow. One possible explanation is the lack of transparency and expensive fees that you get with all hedge funds.
My own personal view is that the high discount and successful track record of protecting against the biggest macro threats make this a decent option if you want to increase your exposure to the US. Without these safeguards the main North American indices look expensive and vulnerable to a correction.