Many years ago, Joyce Meng asked herself: how would someone design a hedge fund if they had no pre-conceived idea how a hedge fund was supposed to look?
Her FACT Capital is both the product of that curiosity, and the proof that the existing Wall Street model could be wildly improved upon.
FACT (fairness, alignment, compounding, transparency) marked the two-year anniversary of its long-short strategy in September, meaning it catapulted almost straight from inception into the COVID-19 crisis. Having returned 61.4 per cent after fees since September 2019 to the end of October 2021, Meng does not dispute it was hard work to earn her numbers.
This year, while Wall Street has broken records, about 40 per cent of FACT’s book is in China, where a policy push for common prosperity has dissuaded some foreign investors of a more skittish nature. Another 40 per cent is in US stocks and the rest of the world represents about 20 per cent.
All up, it only carries about 20 long exposures, which is how it managed to outperform with not just a preference for high conviction ideas, but hyper-specificity on every level in its preferred areas of technology, consumer and health care.
“Our approach to investing is very micro thematic in nature,” says Meng, speaking from New York ahead of her first appearance at the Sohn Hearts & Minds investment conference on Friday.
There is not a lot of value, she argues, in themes, when everything is a theme: disruption, ageing, luxury. A rising tide may lift all boats, as the saying goes, but micro themes will thrive even in low tide.
“You want to find the best house in the best neighbourhood,” she says. A theme is “useless”.
A FACT micro theme could be venture capital-backed biopharma companies that drive more outsourcing to contract research organisations and contract development and manufacturing organisations. Another is growth in Chinese cybersecurity investment. About 10 micro themes are represented in the 20 longs.
A micro theme may only capture five to 15 companies. One of her largest positions is the Nasdaq-traded ICON plc, an Irish drug and medical device development outsourcer which is up 42 per cent this year.
FACT bought in around February when it acquired PRA Health Sciences for $US12 billion when there were some doubts about the merits of the deal.
It previously owned clinical research outsourcer PPD, which was acquired by Thermo Fisher Scientific in April for $US17.4 billion in cash. From there it rotated into ICON, having already done its homework on the business. And in China, it owns the Hong Kong-listed WuXi Biologics (at least a three-bagger for the fund having backed it since inception).
With transparency in mind, her investors can log-in to FACT and see not just performance and positions, but the entire research library behind every idea, including the 100 channel checks that might sit behind a stock.
Team profit share is 20 to 25 per cent a person, made possible because of FACT’s small size.
“Our number one most important cultural value is intellectual honesty. And intellectual honesty is very specific,” Meng says.
That extends to how FACT allocates its time, by defining the scope of the stocks that it follows, enabling Meng and FACT’s analysts to make fewer but higher quality decisions and eliminate the risk of loss.
Nobody pitches internally, and the long-short strategy cannot claim a performance fee unless it generates 33 per cent over three years (meaning 10 per cent a year for three successive periods).
When it comes to arriving at a potential idea, it must first survive an exhaustive checklist that keeps the size of the portfolio necessarily tight.
“You really can focus on your time, which is your most precious resource, on areas where the hit rate on individual stock goes up because the broader neighbourhood is just seeing such strong, strong opportunities,” she says.
Growth, a favourable market structure, and strong capital allocation are the fundamentals of a good business in Meng’s mind.
FACT has about 210 companies that meet its quality growth, market structure and capital allocation criteria on file. From there, it will need a 10-year cash flow profile, “just to really understand the runway” and ensure the valuation stacks up.
Next, it needs positive earnings revisions because “stocks don’t work if earnings estimates are getting cut, if people are lowering expectations – even if it’s a good business”.
Exceptional companies can keep growing into their earnings, getting cheaper every year. She cites how WuXi added a vaccine platform to its capabilities. “Maybe TAM (total addressable market) goes up, maybe revenues go up, maybe they enter new business lines, maybe they’ve done very smart M&A.”
Those are the fruits of smart capital allocation.
On the other hand, if a stock is in a downgrade cycle it simply means the stock is more expensive than it appears at face value. Finally, when it comes to sizing, the manager evaluates forecast stability and cyclicality.
“I call models moodles. Sometimes, you could change the outcome so much, depending on your mood. So, if you have a company where there’s an incredibly wide distribution around your point estimate, it becomes very hard to have conviction.”
Meng believes that a good business is a forecastable business, so FACT does not expend much energy or capital in commodity producers. “How am I supposed to know what commodity prices, interest rates, look like three years from now? Exactly. So, no, we like forecastable businesses.”
Meng’s short portfolio might examine where FACT’s revenue estimates differ to consensus, the presence of insider selling, competitive intensity, and always, potential catalysts. She will never short on valuation grounds.
“This is a tough business, it’s incredibly humbling. We’re so grateful for this opportunity to invest. And I love this job. I feel so privileged to be able to do it. But ... we have to earn the privilege to run our LPs’ capital.”
On the topic of regulatory risk, FACT has been particularly sensitive to the political climate in China. "For investing in China, paying attention to regulation is incredibly important. One of our team members is based in Asia, all three of us are Mandarin speakers, we care very much on trying to find aligned areas of interest with the government, and we’ve lived through many regulatory cycles.
“Our view is that China is never as good as people think it is, and then it’s also never as bad as people think it is.”
With her investor’s instinct, China is too large to ignore on account of size, market depth, research and innovation, and it tends to be a helpful macroeconomic counterpoint to the US cycle. Next year, the US Federal Reserve will be tightening, while China could see looser policy and moderate stimulus.
Another micro theme the strategy has pursued is the onshoring of Chinese luxury consumption. Hainan for example, an island in southernmost China, is often compared to Hawaii for its marriage of coastline with luxury shopping. FACT owns China Tourism Duty Free, which has a monopolistic grip on the Chinese market, but whose share price has been beholden to the health of the travel industry.
Returning to the concept of intellectual honesty, when a position goes wrong, Meng says the outcome should be, “I made a mistake, let’s cut risk”. But that’s not always possible in an environment where investments are made by committee, or egos rule, she says.
“We only care about what the portfolio does, we’re only going to grow and be successful if every single one of our ideas is top notch.”
Meng is also the co-founder of Givology; as a Rhodes scholar, she wanted to “give back” in college, but didn’t have deep pockets. The platform has been innovative in its own right and similar to FACT in its selection of deliberate and purposeful causes.
FACT is based near Rockefeller Centre, home of New York City’s best Christmas tree. “We love it during the season.” She agrees, New York is back.
This article was originally posted by The AFR here.
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