Know Your Enemy

One of my favorite investors that I love reading and following, Harris Kupperman, has offered up his latest thoughts on the market this week.

Harris is the founder of Praetorian Capital, a hedge fund focused on using macro trends to guide stock selection.

Harris is one of my favorite follows and I find his opinions - especially on macro and commodities - to be extremely resourceful. I’m certain my readers will find the same. I was excited when he offered up his latest thoughts, published below (slightly edited for grammar, bold emphasis is QTR’s).

Whenever someone takes the other side of my trade, I want to put myself in their shoes. Is this a worthwhile opponent with a differentiated view? Am I stepping into a trap? Or are they doing something for totally uneconomic reasons? I need to know my enemy.

“Yes, I know my enemies
They’re the teachers who taught me to fight me
Compromise, conformity, assimilation, submission
Ignorance, hypocrisy, brutality, the elite
All of which are American dreams…”
– Rage Against the Machine

Naturally, I prefer the situations where my opponents are being absolute complete fuckwits—totally disengaged from valuation-based decision-making. Those are the opportunities where I want to wave it in with both hands.

Think back to peak ESG idiocy; I’m a hired mercenary, my only mission is to make my investors as much money as possible. Meanwhile, a surprisingly large number of institutional firms are run by their marketing departments—incredulously, those guys decided that their ESG score was far more important than performance. Suddenly, the guys with the big capital didn’t even seem to care if they lost money. I was still playing chess and they were playing dominos. Many allocators simply hit the sell button on non-ESG positions—smashing equity prices to obscene levels. Millions of retirees were looted by their fiduciaries, while being told that their sacrifice would improve the weather. Meanwhile, I was there buying as much as my balance sheet could bear. It was one of the silliest wealth transfers of my career. I still look back at that moment and giggle like a little kid. It’s not supposed to be that easy in finance. Your opponents aren’t supposed to be hateful of performance. Disdain, sure, that happens, but hateful was a whole new experience for me. Ever since, I’ve spent my free time trying to find the next moment when investors fixate on the wrong thing.

Of course, it’s rarely that easy. Often, I see the opportunities, but also wonder what I’m missing. Equities are usually approximately fairly-valued. If something is sort of mispriced, I assume there’s a divergence of views around an accepted framework, and when something is a few standard deviations off the mark, I genuinely wonder if I’m the one who’s lost the narrative. However, I frequently find that there are occasions where investors trade with different rulebooks than my own. These are the situations where opportunities are rife for structural reasons, often for extended periods of time. Let’s look at two prior occurrences so that you’ll understand the opportunity at play here.

Think back over the last decade and look at value stocks. At first, it was a slow drip, then an undertow, followed by a complete torrent of selling—that selling has never really subsided. As value-based funds have underperformed, they’ve gotten redemptions, forcing more selling and more underperformance. This underperformance then leads to market cap weighted index funds selling additional shares, leading to more underperformance and more redemptions. The vicious cycle has continued for a decade now, and still seems to be ongoing in many ways. Amazing opportunities have been created in its wake.

As a side note, my brain literally hurts to think about how many shares have been bought back in the various value sectors like coal companies, often at less than three times cash flow. Who could still be selling these shares this cheaply? Yet, the Venn Diagram of value investor outflows has a strong intersection of ESG idiocy and performance chasing. At some point, this will resolve itself, likely in a positive way for value names, but I’m amazed that it continues even today.

Trust me, value investors don’t want to sell things at 3 times cash flow. I know these guys, they are my friends, and it hurts them deeply in their souls when they’re forced to make sales. However, they show up in the morning, look at their redemptions, and are required to sell something. It’s been ongoing for a decade now. Despite tens of billions in buybacks amongst value names, the buybacks cannot seem to overcome the forced selling by value investors. While we may be nearing the end of this process, it’s only because the companies involved have retired so many shares that they’re starting to run out of free-float to buy. Honestly, I think there’s substantial opportunity here.

Let’s look at another instance when valuation-irrational investors created opportunity. Remember when an army of meme bros showed up in 2020 and 2021? These guys also didn’t care about valuations, except instead of selling cheap assets, they bought the most insanely expensive ones. They gravitated to frauds and Ponzi Schemes, lifting whole sectors to insane prices, often by chasing call options at already silly implied volatilities. This wave of valuation agnostic investors caught many formerly staid investors unaware, particularly as short selling had previously been a core component of most strategies. Look, the individual retail meme investor is undercapitalized and positively braindead, but millions of them are sentient in the way that a cloud of locusts is sentient. They probed at vulnerable situations and stampeded the shorts. This created innumerable opportunities, as the rules had once again changed.

At my fund, I bought highly liquid Ponzi Schemes like Bitcoin, while joining into almost every short squeeze I could find. In particular I realized that if the locusts were chasing call options, the corollary was that deeply OTM put option premiums would also inflate to crazy IV levels, and I sold those, even if they were on a well-diversified basket of Ponzi Schemes and outright frauds. Unfortunately, that wave of mispricing was short-lived, but for over a year, it really was too easy to take money out of the markets, whole sectors went wonky with mispriced opportunity.

Finance is rarely static. If something has worked for a few years, it usually stops working for the next few years. With all the meme bros forced to get jobs again, I’ve once again wondered who’s the sucker at the table. Who’s in the arena trying stuff, yet totally valuation agnostic? Who literally doesn’t care what price he buys or sells securities at? These are the guys that I want to fade. They’re my enemy.

I’m going to generalize a bit and probably offend a bunch of you; but I’ve never been scared of that around here. Simply put, I think we’ve hit peak pod-shop. The idea that you can run a highly levered, yet fully hedged portfolio, with negligible volatility seems illogical. Pod-shops have grown massive and have completely distorted the market—often as multiple pod bros tend to have the same trades on, bullying a stock in the direction that they favor, stampeding everyone in their way. These guys live and die on rate of change. They use almost real-time data, data that I mostly ignore as a longer-term investor. If this week’s credit card runs are inflecting up, they buy more, if they’re inflecting down, they short more of it. They frequently play quarters, often playing intra-quarter. Pods seek momentum and trend; they don’t seek fair value. Maybe that works in an aggregate sense, and maybe it doesn’t. However, I feel confident in saying that many of these guys are valuation agnostic. Instead, they use pair trades, explicitly so that they can ignore valuation, and focus their books on rate of change. Meanwhile, given their size, and the cohesive group-think amongst supposedly competing funds, they tend to overwhelm markets and have optimized their strategies to take advantage of the self-fulfilling nature of the momentum that they generate. Of course, strategies like this work, unless someone takes the other side.

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In my realm of value investing, I’m genuinely amazed at how these pods will short high-quality, rapidly growing businesses at under five times cash flow—just because the next quarter will be weak. I don’t understand how that strategy makes money, except during highly truncated bear-raids, yet the pods keep playing at it as they fixate on short-term rates of change. Then right after the negative print, they often accelerate their short selling, pressuring the stock in the pre-market and further spooking the longs. They want to take a bad quarter and stampede things, so that they can cover. Even then, sometimes they don’t cover until the data stops inflecting negatively. Then they cover en masse.

I see this group as the newest and greatest source of Alpha in the markets. While I figure that most of these pod-shops will eventually liquidate in a cataclysm of margin calls, I intend to harness them for as long as possible before then. They’re the new meme bros, and they’re the new ESG mandates. They’re the idiots in the room, the pinata that we’re all supposed to swing the bat at. They’ve had it too easy, as too many traders focus on price action, and then get bullied by the pods as they paint the tape. Too many long-side traders still believe that mainstream media is actually reporting, as opposed to reading a script that’s paid for by pods. Not enough guys are willing to trust their research and stand in there, absorbing cheap stock from the pod bros who are shorting it.

NEW YORK, NEW YORK – AUGUST 12: Tim Commerford, Brad Wilk, and Zack de la Rocha of Rage Against the Machine perform at Madison Square Garden on August 12, 2022 in New York City. (Photo by Astrida Valigorsky/Getty Images)

These pods came of age during a time when value investors were getting liquidated—all the pods had to do was push a bit and the liquidations would intensify. No one had fresh capital to buy and defend their names. I now think that the tide is finally turning. I’ve seen the pods get stuffed over and over during the past few quarters as the buybacks are intensifying, the free-floats are consolidating, and the redemptions are slowing. I think this is finally the pivot. As for me, I’m willing to stand my ground, hold my levels and absorb incredibly cheap paper, knowing that I may need to suffer through a bad quarter or two. That’s the very essence of value investing. These pods aren’t used to that, they’re used to using violence to shake someone’s convictions. I feel that as other traders realize that these pods are inch-deep aggression, they’ll also be more willing to stand and fight. If they cannot penetrate your levels, they’ll abandon the mission. Their strict risk-control, with tight stop losses, is their undoing. It really is an idiotic model. They’re my new enemy.

“’Cause I’ll rip the mic, rip the stage, rip the system
I was born to rage against ’em
Now action must be taken
We don’t need the key, we’ll break in”
– Rage Against the Machine

If someone is laying into your company at less than five times earnings, then it’s probably a pod. They’re going to bully you, that’s what they do. I’m not scared, as I know the trick now. I’ll let them short into me. I trust my research. I don’t live on rate of change; I live on valuation. I can suffer through a bad quarter or two and use their vigorous sales to buy more. Like all great surges in valuation-agnostic investing, this one too will wane. Until then, I believe that this is the clearest opportunity out there—though, I fear that it will be fleeting. Until then, I intend to rack up skins.

Happy hunting friends…

Please read QTR and Harris' full disclaimers here.

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