Sometimes, names can be misleading. Consider hedge funds, for example.
The “hedging” in hedge funds’ day-to day-operations sometimes generates more risk, not less. How much more?
Well, Long-Term Capital Management L.P. (LTCM), which had a great name that implied longevity and long-term thinking, had a fantastic team that counted not one but two Nobel Laureates in economics. Long-Term Capital Management ended up being relatively short-lived during the 1990s, lasting only about six years.
Fast forward two decades. The hedge fund industry is alive and well, having survived not only LTCM, but also the Great Recession, during which many funds closed. The industry has also weathered outright frauds such as the Bernie Madoff scandal.
The modern hedge fund world is diverse. Some hedge funds (defined as private investment pools available to qualified, or “accredited,” investors) are similar, by composition, to mutual funds, albeit with more concentrated portfolios. Some invest in everything from stocks to bonds to real estate to gold and other commodities, and many continue using derivative strategies and hedging techniques. Leverage is not uncommon.
These days, many hedge funds invest (and trade) in equities, and it’s normal to see a hedge fund or two among the top holders of many small-cap stocks.
The funds that we often see holding a top position in a stock could either be of a long-short type, or they could be activist funds.
Activist hedge funds are the ones of the most interest to me in my premium newsletter, Game-Changing Stocks. These funds typically have the longest time horizons among hedge funds: When they see value in shares of a public company, value that cannot be realized until some of the current conditions change, these investors take matters into their own hands.
They build a position, and then try to implement the desired changes. Activist investors could target management changes, company breakups, spinoffs, dividend initiations or increases, or even liquidations.
Often, these changes can lead to big-time gains for investors. Thus, when investing alongside an activist hedge fund, you are advantaged in a few important ways, to which you can also add strong research capabilities.
Hedge funds employ some of the best analysts in the industry.
In a nutshell, if an investor simply wants to copy what a hedge fund does, he or she should be ready to act quickly or risk getting caught in an exit stampede.
To reduce this risk, just as with any other investment, it helps to do your own research.
These Two Hedge Funds Might Affect My Best-Performing Stock
Case in point: Our best-performing position in Game-Changing Stocks to date: MINDBODY (MB), the undisputed leader in management software for the wellness industry.
Since our addition of MB to the portfolio, the market has been taking notice. At the time I issued my “sell” recommendation (I’ll explain why in a moment), my readers and I were sitting on a 47.6% gain in five months.
Several hedge funds have been paying attention, too, as they built substantial positions in the stock. It has been a great stock not just for us, but also for a few hedge funds, such as Luxor Capital Group, LP, and Abdiel Capital Advisors LP.
The largest holder of MB is Luxor, with the ownership of more than 15% of shares outstanding — making MB Luxor’s fouth-largest position. And here’s more evidence that Luxor really likes the stock: Filings show that the hedge fund has recently been reducing the size of each of its top seven positions, except for MB.
Luxor isn’t the only institutional investor with significant interest in MB. The No. 2 holder, with a position just a tad smaller than Luxor’s, is Abdiel. This young hedge fund holds a concentrated stock portfolio of which MB is the second-largest holding.
To a certain extent, this kind of institutional interest is great news — the buying from Luxor, Abdiel and the like had worked to our advantage. But I don’t think it’s safe when a position is strongly concentrated in just a few institutional hands. If MB’s growth, profit, or some other metrics disappoint, we can fully expect shares to see an exaggerated selloff because these overly concentrated owners might not have a few quarters’ worth of patience.
For Luxor, it’s not difficult to imagine. Either one of these hedge funds might be forced to sell if faced with redemptions from investors. If so, MB might be disproportionately impacted.
Luxor Capital used to be a sizeable fund, with about $10 billion under management just four years or so ago. In 2016, however, the fund shrunk to only $3.8 billion in assets, and, because of such losses, it had to restrict redemptions. In March 2016, Luxor said in a letter to clients that it would keep 12% of its assets until it sells some illiquid investments.
Here’s why this matters…
On the surface, this has nothing to do with MB. On the other hand, the market has been doing well this past year, and this must have helped assuage investors’ fears. If there is a downturn — hypothetically — a call for further redemptions could make it impossible to hold even the most promising long-term investments.
It just goes to show how simply researching the company itself is sometimes not enough when picking a stock. This is especially true of stocks with a small market cap. It helps to look at who the top holders of the stock are, and examine the circumstances that might force them to sell shares and put your own stake at risk. That’s why I told my Game-Changing Stocks readers that the best course of action was to sell MB to preserve our strong profits on the stock.
We’ll be on the lookout for a reentry point if its growth story continues. But a 47% gain in five months is exactly what we’re looking for in my newsletter. In the meantime, we’ll continue our search for more opportunities in growth stocks that most investors have completely ignored. If you’d like to learn more about our plan to do this, go here.
StreetAuthority’s mission is to help individual investors earn above-average profits by providing a source of independent, unbiased — and most of all, profitable — investing ideas. Unlike traditional publishers, StreetAuthority doesn’t simply regurgitate the latest stock market news. Instead, we provide in-depth research, plus specific investment ideas and immediate action to take based on the latest market events. Visit us at StreetAuthority.com.