The active manager world is one of haves and have-nots. Those with a good track record get cash inflows. When you haven’t had a good performance, no one will invest in you.

If you’ve proven your fund can beat the market, pretty much no matter what you charge in fees, people will pay for getting to ride on your coattails.

The common charging structure in the actively managed funds is changing 2% management fees and 20% performance fees, called 2 and 20. Some are trying to win investors by shrinking down to 1% and 10%.

However, some of the big titans, like Renaissance, Point72, Bridgewater, and others in rarified air, go the opposite direction, charging 30% or more.

D.E. Shaw was right in that same area. 3 of its flagship funds always charged between 25%-35% from performance fees.

Its investment approach and successful track record make it stand out.

The fund uses various systematic strategies based on quantitative and computational techniques developed over 30 years of research and trading.

Thanks to these strategies, one of its flagship funds, the D.E Shaw Composite Fund, has generated an annualized net return of around 12% since its inception in 2001.

The fund also managed to deliver impressive returns last year and as returns are making its investors happy, the firm raised its fees.

Now, D.E. Shaw charges as much as a 40% performance fee. And investors are still desperate to pile into its funds.

Let’s take a look at D.E. Shaw & Co. through the Uniform Accounting perspective to see what they’re invested in that has made people so excited.

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 the D.E. Shaw & Co. is just average and their returns are not really rewarding considering the management and performance fees.

On an as-reported basis, many of the companies in the fund are average performers. The average as-reported ROA for the top 15 holdings of the fund is 11%, which is around the U.S. corporate average. This shows that investors are paying loads of fees for a portfolio of average companies.

However, once we make Uniform Accounting adjustments to accurately calculate earning power, we can see that most companies in D.E. Shaw & Co. are stronger than investors might think.

As the distortions from as-reported accounting are removed, we see that Apple (AAPL) doesn’t have 20% returns. It actually has a 45% Uniform ROA.

Similarly, Microsoft’s (MSFT) Uniform ROA is 40%, not the 15% figure as-reported metrics would suggest.

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 D.E. Shaw & Co.’s top 15 holdings is actually 24% which is twice the corporate average.
• 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 D.E. Shaw & Co paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to slightly improve in profitability, while the market expects profitability to slightly decline.

Analysts forecast the portfolio holdings on average to see Uniform ROA rise to 26% over the next two years, while the market is pricing to see returns fall to 24%.

Once again, Apple’s Uniform ROA is 45%. Analysts think it’ll stay strong, around 42%. That said, the market is pricing Apple’s Uniform ROA to fade to just 27%.

Qualcomm is another good example. It’s already a high-quality company with 30% returns, and analysts think Uniform ROA will rise to 35%. On the other hand, the market is pricing Qualcomm to see Uniform ROA fall to just 18%.

Overall, the portfolio consists of high-quality names that can help D.E. Shaw continue its successful track record. Given that a lot of these companies are trading inexpensively, it makes sense that many of them will beat market expectations.

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 D.E. Shaw & Co’s largest holdings.

SUMMARY and Microsoft Corporation Tearsheet

As one of D.E. Shaw & Co.’s largest individual stock holdings, we’re highlighting Microsoft Corporation’s (MSFT:USA) tearsheet today.

As the Uniform Accounting tearsheet for Microsoft Corporation highlights, its Uniform P/E trades at 21.1x, which is above the global corporate average of 18.9x, but below its historical average of 23.9x.

High P/Es require high EPS growth to sustain them. That said, in the case of Microsoft Corporation, the company has recently shown 1% 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, Microsoft Corporation’s Wall Street analyst-driven forecast is for EPS to grow by 3% and 16% in 2023 and 2024, respectively.

Furthermore, the company’s return on assets was 40% in 2022, which is 7x 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 30bps above the risk-free rate. Together, these signal low credit risks.

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