FA Alpha Daily

One of the biggest hedge funds is following its plan of locking up client capital for longer

2022 has been a year to forget for many hedge funds with many underperformers in this terrible market. But one fund has managed to significantly outperform the market despite the volatility. In today’s FA Alpha, we will look into Citadel Wellington’s top holdings through the lens of Uniform Accounting and discover what made their strategy so successful.

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Hedge funds might have some problems retaining client capital due to their performance, the overall market volatility, or some other factors like the personal preferences of investors.

If these withdrawals are significant, they might have a bad impact on the funds’ portfolios and performance.

As one of the smartest fund managers on Wall Street, Izzy Englander has been implementing a strategy to prevent this situation at Millennium Management.

This more stable capital structure enables the hedge fund to make some internal investments like technology upgrades or retaining and attracting high-quality investment professionals.

As a result, it gives the fund a better opportunity to deliver higher returns for its investors.

Following this strategy, Millennium Management will return $15 billion to its investors at the end of this year.

The amount being returned by Millennium is incredibly huge. Most hedge funds in the world do not even have that many assets under management.

However, it seems like the fund has the trust of its investors as they did not experience significant outflows since the fund started implementing this strategy.

In addition, Millennium Management has managed to deliver approximately 10% return this year as of September.

Considering that we are in such a year with high volatility and uncertainty in the financial markets due to global supply-chain issues, the Ukraine-Russia war, and the energy crisis in Europe, it’s a big accomplishment.

This success gives confidence to investors to stay at Millennium and ride the waves of the markets with them.

Let’s see Millennium Management’s top holdings and evaluate what makes them so special that investors are willing to lock up their capital for a long period of time.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Using as-reported accounting, investors would think that Millennium Management is even below average and their returns are not really rewarding.

On an as-reported basis, many of the companies in the fund are bad performers. The average as-reported ROA for the top 15 holdings of the fund is only 9%, which is less than the U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate earning power, we can see that the average return in Millennium Management’s top 15 holdings is 28%. That is thrice what the as-reported metrics suggest.

As the distortions from as-reported accounting are removed, we can see that McKesson Corporation’s (MCK) isn’t a 2% return business. In fact, its Uniform ROA is 32%.

Meanwhile, Gartner (IT) looks like an 8% return business but this technological research and consulting firm actually has a staggering return of 193% Uniform ROA.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Millennium Management’s top 15 holdings is actually 28% which is more than double the corporate average of 12%.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Millennium Management paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to stay flat in profitability while the market expects an improvement in profitability for the companies in the fund’s portfolio.

Analysts forecast the portfolio holdings on average to see Uniform ROA remain at 30% over the next two years. At current valuations, the market expects the profitability to rise to 32% Uniform ROA for these companies.

For instance, the giant pharmaceutical firm Eli Lilly and Company (LLY) returned 13% this year. Analysts think its returns will stay flat at around 12%. And at a 41.7x Uniform P/E, the market is already pricing Uniform ROA to keep rising to 28%.

Similarly, Humana’s (HUM) Uniform ROA is 14%. Wall Street analysts expect the profitability to remain around the same levels at 13%, but at the current valuations of 25.8x Uniform P/E, the market expects an improvement in profitability to 19%.

Overall, Millennium Management led by Izzy Englander offers a strong portfolio of high-quality names but the market’s high profitability expectations from these names could disappoint investors. Before jumping on any investment opportunities, investors should make a detailed analysis considering the current valuations.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Millennium Management’s largest holdings.

SUMMARY and Oracle Corporation Tearsheet

As one of Millennium Management’s largest individual stock holdings, we’re highlighting Oracle Corporation’s (ORCL:USA) tearsheet today.

As the Uniform Accounting tearsheet for Oracle Corporation highlights, its Uniform P/E trades at 20.0x, which is above the global corporate average of 17.8x, and its historical average of 17.4x.

High P/Es require high EPS growth to sustain them. That said, in the case of Oracle Corporation, the company has recently shown 11% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Oracle Corporation’s Wall Street analyst-driven forecast is for EPS to shrink by 16% in 2022 and grow by 16% in 2023.

Furthermore, the company’s return on assets was 33% in 2022, which is 5x the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 60bps above the risk-free rate. Together, these signal low credit risks.

Lastly, Oracle Corporation’s Uniform earnings growth is above peer averages, and below peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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