Manager Monday: ValueAct Capital

Introduction to ValueAct Capital

“Developers! Developers! Developers!” The memorable sight of a sweating, red-faced billionaire CEO chanting to a room of highly educated engineers was nothing new for watchers of Steve Ballmer, who somehow managed to hold on to his post at Microsoft for more than a decade. Under his tenure the firm lost 40% of its stock value, missed numerous opportunities – smartphones, music players and tablets to name a few – and released a series of poorly-received products. However, ultimately it took the behind-the-scenes intervention of ValueAct Capital, an activist hedge fund, to oust Ballmer – an action for which they have been rewarded (Microsoft’s stock price has rebounded nearly 34% since Ballmer’s resignation as CEO was announced). Just this week, the Fund has been in the news after making a substantial investment in Rolls-Royce and immediately pushing for changes at the firm to improve margins. In this blog post, I will focus on what makes ValueAct so successful.

Keep in mind that everything mentioned in this post is sourced exclusively from public data, including the manager’s profile, simulated performance and all other analysis and commentary. The data used here omits the short side, non-equity securities, many non-US securities and all non-public information such as actual fund performance. Still, with a manager like ValueAct, this data can be incredibly insightful if viewed through the right lens.

ValueAct was founded in 2000 by Jeffrey Ubben, a former private equity executive, and portfolio manager at the Fidelity Value Fund. The combination of a focus on undervalued companies (a hallmark of the value investing philosophy espoused in the FVF) and a PE-style, hands-on collaborative approach are key components of ValueAct’s investment style. Unlike many famous activists (Icahn, Ackman, Loeb), ValueAct under the stewardship of Ubben and his partner Mason Morfit (an ex equity analyst at CSFB who rose through the ranks at ValueAct after joining in 2001) invests in a quieter, more under-the-radar fashion. Instead of brash public letters (a la Herbalife, Yahoo!, Apple), ValueAct tends to work in collaboration with boards and management to enact measures to increase the stock price of their investee companies. The Fund’s close relationship with big institutional investors such as T. Rowe Price and Fidelity means that it can push for meaningful change with smaller investments.

ValueAct’s long-term, predominantly equity strategy makes it an ideal candidate to analyse through the Novus Public Ownership platform. We integrate global, historical filings into our powerful portfolio analytics platform, allowing us to dig into the Fund’s portfolio, and simulate P&L based on pricing movements and quantity changes between quarterly public filings to understand what’s worked and what hasn’t.

ValueAct Capital’s Performance

Since 2001, based on simulated returns, the fund has significantly outperformed the S&P 500 (BM1) as well as the MSCI World (BM2) – particularly since 2010.

ValueAct Capital’s Fund Analysis

Based on reported market value, ValueAct has experienced spectacular growth – from the $200mm portfolio value reported in its first filing in Q3 2001, the Fund has grown to $17B+ as of the Q1 2015 filings (an increase of 5.2x since Q1 2010).

Typically, an increase in assets in an equity portfolio translates in one of three ways (each with its own potential disadvantages):

1. The manager increases the number of issuers it’s invested in (potentially increasing the number of lower conviction names)
2. The manager invests in larger market capitalisation names (potentially resulting in style drift)
3. The manager stays in the same number of names in the same market capitalisation, but the fund’s liquidity deteriorates

The number of names in ValueAct’s portfolio has stayed roughly stable while assets have risen…

…while liquidity, which was never particular high given ValueAct’s concentrated activist style of investing, has also stayed roughly stable:

It is unsurprising that ValueAct has responded to growing capital by investing in larger market capitalisation names (as measured by median market cap). Later, we’ll dig a little deeper to see if this shift is beneficial for ValueAct investors.

Since January 2010 (the point at which ValueAct’s filed market value began to steadily rise), ValueAct has held 62 names, 77% of which have been winners, with 92% of capital deployed to those winners. The average winner has contributed roughly 783bps, whereas the average detractor has cost roughly 44bps, generating a win-loss ratio of 17.8x. ValueAct’s exceptional capital deployment and win/loss ratios illustrate their ability to scale up their winners and cut their losses early—and helps explain their annualized return of 32.5% since 2010.

While these numbers are impressive, ValueAct’s stellar track record coincides with one of the longest bull markets of the last century. It is thus useful to dig into ValueAct’s returns to see what has come from their market and sector exposures (beta), and what has come from their ability to pick stocks (alpha). To do this, we can compare every single security to its relevant sector level benchmark to try and isolate the alpha component.

Let’s look at ValueAct’s biggest winner over this time period: Valeant Pharma (VRX). Based on ValueAct’s public filings over the last five years, along with VRX’s total return, we simulate total PnL of 13,710bps. Had ValueAct taken the capital they had invested in VRX, and put it into a broad market index (the S&P 1500), they would have made 2,856bps. By choosing to invest in a healthcare company (VRX’s sector), they would have made another 1,985bps. Summing these two figures up gives us the portion of VRX’s PnL that we can explain away by “beta”. In other words, ValueAct generated 8,868bps of alpha by choosing to invest in VRX. Doing this calculation across ValueAct’s portfolio shows us that of the 36,982bps they generated, roughly 40% (15,058bps) came from alpha. Other significant winners over this time period include ADBE, MSFT, CBG, and MSI.

Note: ValueAct’s investment in VRX is deserving of an entire blog post of its own. Our simulations show returns nearing 44,000bps since their initial investment in 2006. The fund was instrumental in Valeant’s superlative performance over the past 9 years, helping to put together an innovative pay package to recruit CEO Mike Pearson in 2008.

ValueAct Capital’s Market Cap

As we remarked earlier, ValueAct’s increase in AUM has been accompanied by a shift up the market cap spectrum. ValueAct has shifted focus from small and mid cap names to large and mega cap names. While part of this rise has been driven by the market-cap growth of VRX, investments in names such as MSFT, FOX, MSI, HSH, CBG have also contributed.

While a change in market cap exposure can often indicate value-destroying strategy shifts, that hasn’t been the case for ValueAct. Large and Mega Cap names have actually been among the best performers for ValueAct in ROIC terms:

When we compare each position to its relevant market-cap benchmark, it becomes even more clear that ValueAct’s rise up the market cap spectrum has been additive to portfolio alpha (“Relative Contribution” below is what’s coming from the market and market cap picks, whereas “Selection” is the securities’ outperformance):

Again, many of these numbers are skewed due to VRX’s spectacular success, but at minimum, we can confidently say that moving out of small caps and into larger names has been a good thing.

ValueAct Capital’s Sector Allocation

Tech names have been a consistent—and growing, fraction of the fund’s portfolio (historically IT, VRSN, Misys, more recently ADBE, MSI, MSFT), with a recent fall-off in healthcare (as the Valeant position has been trimmed) and financials. ValueAct has seen a spike in energy this year as ValueAct has bought big stakes in Halliburton and Baker Hughes while pressing for a merger between the two firms. This jump in exposure appears to have been a good move, as energy has already generated the third largest share of alpha across sectors.

Given the underperformance of energy stocks over this time range, ValueAct’s outperformance in this sector can be attributed to security selection, along with the effects of their activism on the share prices of HAL, BHI and DRC (the latter sold itself to Siemens, generating 300bps for ValueAct).

ValueAct Capital’s Position Sizing Skill

We’ve previously discussed how position sizing can effect manager returns.. Whether via under-sizing their winners, or failing to cut their losers fast enough, poor portfolio management decisions can negate all the good work done by superior stock picking. As evidenced by the chart above, as well as by ValueAct’s superlative win/loss ratio, the fund has not experienced this issue. Simulated returns cumulatively outperformed an equally weighted portfolio by over 120% since Jan 2010.

Additionally, when we assign each name to a dynamic position sizing bucket (e.g. 0-0.50%, 0.5-1.0%, etc.), we see a correlation between conviction and performance:

Intuitively, this makes sense: a manager is more likely to keep tabs on a higher conviction name that a lower conviction one. This trend is even more exaggerated in the case of ValueAct; they often serve on the boards of their biggest investments, and thus can proactively unlock value in their highest conviction portfolio companies in a way they cannot for some of their smaller investments.

Conclusion to Our Analysis On ValueAct Capital

Studying portfolio attribution helps frame ValueAct’s success as dependant on both the market’s direction and, to a larger extent, skill. Even though the manager has experienced massive AUM growth and resulting sector shift, the data points to skill still being a large driver of returns for the manager. If the managers continues to exhibit the same stock picking and position sizing skill as they have in the past, investors are going to be rewarded yet again.

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