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Hedge Fund Industry: The Darwinian Implication of Capacity Declines

“In the long history of humankind (and animal kind, too) those who learned to collaborate and improvise most effectively have prevailed.” –Charles Darwin

We wanted to write a quick note to highlight a number of recent media stories about capacity declines in the hedge fund industry. No surprise, negative absolute performance has led to the closing of funds due to an inability to pay employees and an increase in investor withdrawals that have led to a cost structure that is no longer manageable for many general partners.

Specifically, the Options Group estimates that “hedge funds may cut 20,000 workers worldwide this year.” This is on top of the estimated 10,000 job losses in 2008. The primary driver of this is hedge fund closures, which hit roughly 920 funds last year, or almost 12% of the industry.

An article on Bloomberg by Kathy Burton yesterday discusses the implications of the industry decline when it comes to hiring. She quoted our good friend, Hank Higdon from Higdon Partners, the preeminent investment management search firm in the world, who said: “Hiring activity is much reduced and it’s going to get worse.” For anyone in the industry, this isn’t totally surprising. We are hearing stories of people working for free for periods of a quarter or more as a trial employment period. This idea of actually having to prove yourself was unheard of less than a year ago.

The upshot of these capacity declines is that hedge funds will once again become the bastions of entrepreneurism they once were. Some of the best and largest money managers in the world, started as very small shops with limited assets under managements, sometimes in the single digit millions, firms like SAC, Third Point, Atticus, Bridger, Harbinger, Citadel and others come to mind. These firms are now some of the most prominent and durable in the industry, and manage assets in the billions, but have shown the wherewithal to grow and thrive at a much lower asset base.

The benefit of building your business from such a small base, and by the sweat of your own labor, is that you fully understand all parts of the business and investment process, and you can very easily adjust to changes in the market. While 2008 was an incredibly challenging year for hedge funds, undoubtedly 2009 will be a year in which Darwinian rules take hold. Those funds that have been able to prosper through the cycles will continue their dominance. The upstarts will no longer be blessed with multi hundred million, or in some cases billion, dollar launches, but will have to make due with $25 - $50MM at launch. Ultimately, overtime, this will make them stronger managers and the hedge fund class of 2009 will likely be a strong one indeed.

Daryl G. Jones
Managing Director

Ox Blood: Chinese Trade Data Is Nasty, But Help Is On The Way

Overnight we received more insight on the extent to which global contraction is compressing Chinese economic activity and the degree in which the 4 trillion yuan stimulus package is compensating for the implosion of export-driven growth so far. Although the trade data is ugly, Investment and credit figures show that, without a doubt, that stimulus is now coursing through the Ox’s veins

TRADE

The General Administration of Customs’ statistics revealed that the February trade gap narrowed to $4.8 billion, following January’s $39.1 billion surplus, as exports contracted 25.7%, a record, and imports fell 24.1%, reaffirming the severity and the synchronized nature of the global economic contraction.

As the collapse in exports has intensified, forcing businesses to close and increase unemployment, the government has continued to announce measures to support the export sector. This week Commerce Minister Chen Deming announced plans to gradually eliminate export taxes and to subsidize exporters in an attempt to sustain growth. Further, faced with the weakening currencies of competitors and the resultant disadvantage, the central bank governor, Zhou Xianchuan, did not rule out a devaluation of RMB, more confirmation that the Chinese government will use any and all measures to increase exports.

INVESTMENT

According to the National Bureau of Statistics, urban fixed asset investment totaled 1.027 trillion yuan ($150.35 billion), during January and February, a 25.5% increase over 2008. Investment in the primary sector increased 100.3%, while the secondary sector and the tertiary sector experienced increases in investment of 24.8% and 26.9%, respectively. Central government project investment increased 40.3% while local government projects increased 25.1%. During the first two months of 2009 real estate investment was 239.8 billion yuan, a 1% increase, down from 32.9% over the same period in 2008.

Clearly that he 4 trillion yuan stimulus announced in November is driving the increase in fixed investment, which now accounts for 40% of GDP. Infrastructure projects increased 28% y-o-y, as the government invested in railroads, agriculture and mining, including $35 billion in energy projects. The National Development and Reform Commission announced that the central government will invest 908 billion yuan in infrastructure projects in 2009, a 20% increase in fixed asset investment over 2008.

According to Su Ning, a deputy central bank governor, total lending by China’s financial institutions will exceed 5 trillion yuan ($731 billion) in 2009. The most recent People’s Bank of China release stated that domestic banks issued a record 1.6 trillion yuan in new loans in January, with February estimates in the vicinity of 1.1 trillion yuan. The Bank of China reported extending 100.45 billion yuan in new loans to small- and medium-sized enterprises (SMEs) YTD, with total outstanding loans for SMEs reaching 860 billion yuan by the end of February.

Forward

With the stimulus impact starting to trickle through the financial system, the waiting game begins as we digest any data that may provide clues to the trajectory of economic activity. We have been bullish on China consistently since December of 2009 and remain so – we are long China via the CAF closed end fund.

Andrew Barber
Director

EAT – Bullish about margins

EAT’s CFO Chuck Sonsteby presented this morning at an investor meeting and said that relative to when the company reported its 2Q09 earnings in January that he is feeling bullish about margins. During the second quarter, EAT reported better than expected earnings as a result of better cost control and better than expected margins. At that time, however, Mr. Sonsteby said he was pessimistic about the company’s ability to maintain that level of margins with sales slowing. Today, he commented that he is optimistic about margins because EAT is benefiting from slower unit growth, which takes costs out of the business. In the past, EAT’s business model, particularly as it relates to margin growth, was built around growing the top-line through new unit growth. This growth led, inevitably, to increased costs and inefficiencies within the system. With slowed growth, management is more focused on eliminating these inefficiencies and better managing costs. As a result, Mr. Sonsteby said that EAT is experiencing improved labor productivity, lower employee turnover and better food cost control. Management is also working to take fixed costs down by renegotiating with its landlords. At the same time, commodity costs are coming down.

Although Mr. Sonsteby did not say that sales trends are improving, the fact that he is more comfortable with margins shows that the company is managing the things it can currently control. And, when sales do finally pick up, EAT will be well positioned to outperform! That being said, EAT, particularly Chili’s, has consistently outperformed the casual dining industry’s same-store sales growth as measured by Malcolm Knapp, and the monthly Knapp Track numbers improved sequentially in January. If Chili’s has been successful in maintaining its gap to Knapp, that might be one reason for Mr. Sonsteby’s optimism.

Controlling what it can, management is focused on using its free cash flow to pay down debt and increase the company’s financial flexibility in this difficult environment. In fiscal 2009, the company is expecting to spend $115 million in capital expenditures, which is down $155 million from fiscal 2008. Based on this lower capital spending, EAT said it should generate over $180 million in free cash flow in 2009, up from $48 million in 2008, and this is with an expected year-over-year slowdown in same-store sales growth.

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PSS: Keeping the Faith vs. Throwing in The Flag

OK. So do you go all-in, or throw in the towel? That’s the question that most holders of PSS will be thinking today. Though it’s not in our portfolio, this is definitely a name I’ve liked, and have been warming towards recently, so I am definitely in the same camp. Here’s a few notables…
Reasons to consider throwing in the towel
1) PSS missed both the Street’s and my estimate (-$0.44, and -$0.36, respectively) by a mile. Losing $0.54 with such negative momentum is not exactly indicative of being one of the ‘winners’ in this climate.

2) It’s been over a year since the Stride Rite acquisition, and over 2-years since this management team hit stride in its strategy to regain control of the consumer and grow the business. At some point sooner than later, we need to draw a line in the sand and expect results.

3) ‘Consumer connection’ has never been higher per Payless’ internal scoring system, but what good is that if we’re not seeing it in numbers?

4) Costs out of China are higher than the company guided, though this is not a big surprise to us.

5) Due to promotional environment & inventory levels at competitors, higher cost shoes were discounted so heavily that they impacted sales at PSS’s “primary” brands.

Reasons to keep the faith
1) Price point is up, transactions are up, product mix is improving, customer scores are reportedly getting better. Weak traffic is the problem. If there was ever an environment to give a zero-square-footage-growth retailer the free pass on traffic, then this is probably it.

2) Very interesting to hear Rubell say that he’s never seen inventory more healthy. Inventory in dollars ended the quarter up mid single digits, but in units it was down single digits. Setting the stage for better gross margins in 2Q onward?

3) SG&A cost reductions better than expected ~$30mm of identified reductions in 2009 with more possible. We’re modeling SG&A down 3-4% in absolute dollars in 2009.

4) Sperry and Saucony continued double digit growth rates with category growth for Sperry and channel expansion for Saucony (Europe) promising.

5) Significant CapEx reduction (from $130 to $85) will boost FCF. Even with operating cash flow down by a third, FCF growth should still be positive for the year.

6) THIS COMPANY IS NOT GOING BANKRUPT, AND WE DON’T EVEN THINK THEY’LL COME REMOTELY CLOSE TO BREACHING A COVENANT.

7) How I’m doing the math, the cash flow here should get total net debt down by 80% over the next three years. What does that mean? It means that today the EV/EBITDA multiple of 3.8x is nothing to write home about on the long side. But with debt coming down, we’re at 1.5-2.0x EBITDA 2-3 years out. At that point, we’re also looking at about 4x EPS. I’ll take that.

8) Timing considerations… In 2H, we see costs from China come down, duplicative DC costs come off, SG&A cuts, lower interest expense and tax rate, all at the same time we cycle very easy top line compares. When I put this in context of my view that cash flow for the group overall will begin to turn in 2Q/3Q (see my 3/5 note I’m Getting Fundamentally Bullish), and it starts to paint a nice multiple-expanding picture for PSS.

I’m definitely not throwing in the towel here. In fact, expect me to synch more with Keith on this one as it relates to his timing and sizing models for a potentially powerful long-term call.

Casey Flavin
Brian McGough

Dancing With The Shorts

"May you live to be 100 and may the last voice you hear be mine."
-Frank Sinatra

Yesterday was the most fun we've had in a while. As the market ramped higher in full percentage point increments, it developed a wonderful rhythm ... one, two, three... one, two three... and all of a sudden we were Dancing With The Shorts...

To understand how to Dance With The Shorts, one should have some experience in short selling. You learn how your partner breathes and moves. You learn where her confidence lies. You try to avoid her fears...

By now, we all know that this daily performance dance bounces to higher levels of volume during bear markets than in bull ones. But does the amateur short seller really understand the complexity behind what's happening underneath her feet? Let's consider the internals of the US market's foundation using a simple 3 factor model: price momentum, volume, and volatility:


1.      Price Momentum - never mind the silly guy in the cheap seats who is still trying to convince you that Dancing With Real Investors requires an exercise in valuation. The US stock market doesn't trade on valuation right now. It trades on price. As soon as price penetrated what we have modeled as an immediate term resistance barrier (706 on the SP500), the market really found its footing, and did what American Idol's Randy Jackson would call "blowing it out of the box!"... price momentum is critical to examine, because there are a lot of one factor model traders out there who chase price... once we shot through the 706 line, we immediately put the 755 line of the SP500 in play.


2.      Volume - on the NYSE yesterday, volume ran +33% higher versus the volume you heard out there on the dance floor on the evening prior (with the SP500 down -57% from her 2007 peak at 676, it got eerily quiet). When volume is decelerating in the face of price declines, and accelerating alongside on the UP moves, the short seller better beware. This is new, and doesn't signal another Great Depression.


3.      Volatility - as price momentum accelerated alongside positive volume, volatility (as measure by the VIX) broke her ankle. Yes, when Dancing With The Shorts, this is bad... if you are short, that is... Intermediate Trend line resistance in the VIX remains at 51.24, while the immediate term Trade support of 46.50 (shorter duration momentum) was penetrated to the downside yesterday, closing out the song with a final number of 44.37, which is -44% lower than the freak-out VIX levels of Oct/Nov 2008.


A lot of short sellers are new to being on the dance floor. Yes, the market having gone straight up from 2003 to 2007 had a stylistic impact. For whatever reason, I was fortunate enough to start my career on the buy side in 2000. Fortunate? Right, not so much if I was a levered long investor (the years 2000, 2001, and 2002 were all down years for the US market)... but very fortunate in having learned how NOT to get squeezed during bear market bounces.

I am a firm believer that one has to make a ton of mistakes in this business, using a live audience and marking oneself to market, before they should ever be so foolish to try to make a global macro "call" on the market every day like I have to... ask Jimmy Cramer how being in the fishbowl is treating him these days now that one of this country's finest entertainers (Jon Stewart) is taking him to task on what exactly it is that Jimmy does out there on the dance floor...

In Stewart's case, we have a credible entertainer who is reasonably transparent and accountable going after another entertainer who has issues with the same. It's sort of like Dancing With The Bears - to really pick them off, you have to have been one...

Back to the global macro playbook, I'm going to stay with the program rather than reiterate buying low beta Consumer Staples (Cramer's best idea was buying Hershey last night), and remind you of the BETA shift dance move that my Partner, Howard Penney, made a call on intraday to our Macro clients yesterday. As the music picks up its pace, and the volume accelerates, what you really should be doing is BETA shifting UP.  In effect, do the opposite of what Cramer The Entertainer recommends - buy higher BETA groups like Energy, Tech, and Basic Materials; short Consumer Staples.

I basically covered ALL of my shorts other than 3 positions by Monday's close. I have NEVER done that in my career. We can chalk it up to my being lucky again, and I am very cool with that. Being lucky these days is a lot better than being depressed.

The shorts that I had on yesterday acted great, on a relative basis to the Dancing that was going on out there with the shorts. I ended up with 5 virtual short positions, and they were as follows: short the US Dollar  (UUP), short Bonds (SHY and LQD), short Coke (KO), and short WMS.

WMS tagged me pretty good, and I deserved that. Unlike Coke and Hershey who miserably underperformed, WMS is high BETA, and charged higher with the ultra high BETA Gaming Sector. Good thing we were long names like WYNN, which more than offset that terrible timing decision I made to short WMS early this week.

No matter how good your investment ideas, everything has a time and a price. Ostensibly, all of the dancers on this floor are intelligent market participants. What will differentiate investors in this live Darwinian dance exercise from here will be the same thing that's always governed free marked-to-market performance. There will be winners, and losers. This is America, afterall... and as our Great American friend Frank Sinatra reminds us "You gotta love livin', baby, 'cause dyin' is a pain in the ass. 

May we all live and trade markets until we are 100!



LONG ETFS

EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.25% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.

USO - Oil Fund- We bought oil on Friday (3/6) with the US dollar breaking down and the S&P500 rallying to the upside. With declining contango in the futures curve and evidence that OPEC cuts are beginning to work, we believe the oil trade may have fundamental legs from this level.


QQQQ - PowerShares NASDAQ 100 - We bought QQQQ on a down day on 3/2 and again on Friday of last week.


SPY - SPDR S&P500- We bought the etf a smidgen early, yet the market indicated close to three standard deviation oversold.


CAF - Morgan Stanley China fund - The Shanghai Stock Exchange is up +17.4% for 2009 to-date. We're long China as a growth story, especially relative to other large economies. We believe the country's domestic appetite for raw materials will continue throughout 2009 as the country re-flates. From the initial stimulus package to cutting taxes, the Chinese have shown leadership and a proactive response to the credit crisis.


GLD - SPDR Gold- We bought gold on a down day. We believe gold will re-find its bullish trend.


TIP - iShares TIPS- The U.S. government will have to continue to sell Treasuries at record levels to fund domestic stimulus programs. The Chinese will continue to be the largest buyer of U.S. Treasuries, albeit at a price.  The implication being that terms will have to be more compelling for foreign funders of U.S. debt, which is why long term rates are trending upwards. This is negative for both Treasuries and corporate bonds.


DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.


VYM - Vanguard High Dividend Yield -VYM yields a healthy 4.31%, and tracks the FTSE/High Dividend Yield Index which is a benchmark of stocks issued by US companies that pay dividends that are higher than average.



SHORT ETFS

LQD -iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

SHY -iShares 1-3 Year Treasury Bonds- On 2/26 we witnessed 2-Year Treasuries climb 10 bps to 1.09%. Anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate "Trend." If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.2691. The USD is down versus the Yen at 98.4950 and up versus the Pound at $1.3742 as of 6am today.


Eye on Commodities: Leading Indicators?

We wanted to highlight two commodity related charts here today. The first is the percent change of price levels of the SP500 versus copper and oil over the last three weeks. The second is the longer trend line for oil.

On the first chart, the last three weeks have seen an important signal from commodities as they outperformed domestic equities, even as the US dollar index has strengthened. This to us is an important early signal--just like semiconductor companies saying that “things are less bad”--that global demand is set to pick up from the lows of Q4 2008 / early Q1 2009. There is likely no better leading indicator than basic commodities like oil and copper, and their clear divergence versus domestic equities over the past three weeks is to be noted.

On the second chart, the point is to highlight that there is serious upside to oil on a breakout. Our quantitative model has oil’s trend resistance at $89.84 per barrel for West Texas Intermediate, which is more than 100% upside from the current price. Obviously oil testing that line is far from a foregone conclusion, but we would highlight a number of incrementally positive fundamental data points:

· OPEC – While this is very difficult to measure, media reports suggest that OPEC compliance with the 4.2MM in production cuts announced since September are now near 80% with the potential to reach 90% by the March 15th OPEC meeting. There are also some rumors that OPEC may cut an additional 500K – 1MM barrels per day at this meeting. According to BP’s most recent statistical abstract, world oil production is at ~81.5 million barrels per day, so a 4 – 5 million barrel cut is very significant.

· U.S. inventory building at a lesser rate – Days supply in the United States has increased for 9 straight weeks from December 19th to the week ending February 20th from 21.8 says supply to 24.9 days supply. In the week ending February 27th, we saw the first abatement of this trend as days supply declined sequentially to 24.8.

· China – On March 9th, Zhang Guobao (head of the Chinese National Energy Administration) said in published reports that China should use part of its nearly $2 trillion in foreign exchange reserves to buy more gold, oil, uranium and other strategic materials. Obviously the Chinese have a lot of buying power. If they were to allocate ~4% of their foreign exchange reserves into buying oil, they could buy 500K barrels, at the current price, every day for the next year. As Tim Russert says, that is BIG!

Modeling the projected supply / demand for the global oil balance is a complex endeavor, but focusing on changes on the margin and major shifts in the model (China buying, OPEC cutting production) are important and can impact the supply / demand balance meaningfully. And as we see in the chart below, there is a serious upside if demand begins outstripping supply, even in the short term.

Daryl G. Jones
Managing Director

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