Dark Clouds around Crowded Stocks

Herding and crowding. Crowding and herding. These terms have become synonymous with hedge funds, and somewhat deservedly. In 2014, we launched this blog to point out some of the risks creeping into the ecosystem of equity oriented hedge funds. Crowding is now covered across every financial news source, usually with a negative tone. Our intention was never to be explicitly negative about crowding, but rather to provide candid and useful observations. Our view is that a crowding phenomenon across hedge funds can be positive (a lot of smart people seeing similar opportunities). But the wisdom of crowds can turn into the madness of crowds, as we saw in 2015. So what do the tea leaves say today?

To begin with, a mixed story. The headline is ugly, and the undercurrent is worrisome. The headline is crowded stocks have badly underperformed in 2019. We expected this in the second half of 2018 (as we wrote in our last 4Cs update), when funds were deleveraging their risk into year-end. For this underperformance to continue into a rising stockpicking environment such as the first half of the year is more surprising. Looking at this through the Novus Crowdedness Index, we see that 2019 has been consistently woeful, with underperformance in first half of the year extending into significant underperformance towards the end of August (the time of this writing). The index has returned a paltry 1.15% compared to ~16% for domestic equity benchmarks:

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What has been the driver of that underperformance? Bad stockpicking misses. Take Roan Resources (ROAN), a constituent of the Crowdedness Index in the second quarter. This post-bankruptcy entity IPO’d in September 2018. Hedge funds owned nearly 60% of shares outstanding post IPO, and the stock has summarily dived from a first-day trading value of ~$17.50 to $1.15 less than a year later! This has yielded an estimated $650mm of losses in 2019. Another loser was Herbalife (HLF), a contentious stock that we have written about in the past for its salacious headlines. Over 70% of shares outstanding are owned by a few dozen hedge funds, and this stock is down over 40% YTD.

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While the Index has outperformed the S&P 500 going back 15 years, the last 5 years have been far less constructive. What might have been a wisdom of the crowds signal has turned into madness of the crowds! We’ve seen a consistent level of underperformance across our Crowdedness Index since 2014 that contradicts the historical behavior of the Index:

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So what is going on?  Potentially a few important things:

1. With hedge fund assets growing, the liquidity impact on these crowded names has become more important and simply put, riskier.
2. The successful names that hedge funds herd into (e.g., “FAANG”) generally do not merit inclusion into our Crowdedness Index, because we measure liquidity impact as a key input into the Index’s construction. These “headline” names that funds herd into have ample liquidity to support that level of ownership and thus the Novus Crowdedness Index is more biased to special situations and smaller cap situations that have more disproportionate ownership.  These names have suffered, relatively.
3. Perhaps an ominous warning sign? The last time we saw similar negative behavior for our Crowdedness Index was during the precursor to the financial crisis, the period leading into the debt ceiling debacle of 2011, and the end of 2015 (“the Valeant meltdown”). The first was one of the worst financial crises of the last 100 years, the second was a moment of financial system disbelief, and the third may have been a mini-recession (it depends which economist you ask).

The question we have now is which of these three symptoms is most indicative of sickness going forward: the liquidity impact of hedge funds, the recent difficulties with special situations, or the warning signs toward the global economy?