FA Alpha Daily

Millenium may be trying to save one of its biggest competitors

Schonfeld Strategic Advisers began as a formidable fund manager, rivaling industry giants like Citadel and Millennium. However, its recent performance suggests a less optimistic outlook, raising concerns about the possibility of a bailout. But is this narrative entirely accurate? In today’s FA Alpha Daily, we delve into Schonfeld’s current performance and analyze its top 15 holdings using Uniform Accounting.

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What started as an obsession with numbers and probabilities has evolved into something massive for Steven Schonfeld. After working as a stockbroker up until 1988, Schonfeld finally built up enough experience and capital to begin to run his company, a short-term trading business.

At its roots, the firm found success trading on market volatility. It made $200 million during the peak of the dot-com bubble.

As quantitative strategies took off around 2006, Schonfeld saw his firm heavily investing in new technology. Despite early troubles, he lured in quants to Schonfeld Strategic Advisors through promises of capital to start their own firm and rights to intellectual property.

Quantitative strategies now lay the foundation for much of the firm’s investment framework, assisting in the generation of a 13% annualized return since inception.

The fund has seen rapid growth over the last few years, although, the same cannot be said for its performance. After large funds closed off money to new investors, Schonfeld stepped in and accepted inflows. This move would allow the firm to grow from $6 billion to $12 billion in AUM in only two years.

Multi-manager funds like Schonfeld operate wide and at large scale which inherently leads to higher expenses, especially growth in its workforce. With promises of profits exceeding fees, most of these costs are pushed onto end investors.

Problems arise when performance does not exceed operating costs. Costs don’t drop in line when assets do, so a gap is created.

Assets doubling has led to higher costs, however, performance is not there to match it. This idea is what caused the firm to run into trouble during the pandemic when it dropped about 16%. Prime brokers requested collateral be put up, and investors were withdrawing money.

Considering all options, the firm turned to Millenium as a potential capital source. Nothing came out of that discussion as the firm was able to derive capital from investors. Though, Schonfeld’s recent underperformance has sparked up a chat with Millenium again.

With its two flagship funds down during the first 8 months of the year and a 4.5% return last year, Schonfeld may need a bailout. More recently, the fund has also begun offering fee discounts to investors who agree not to withdraw capital for the next two years. Not something you want to hear as an investor.

In light of this news, let’s take a look at Schonfeld’s top 15 holdings and assess if its holdings have played a role in the fund’s recent performance.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, and flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Looking at as-reported accounting numbers, investors would see that Schonfeld Strategic Advisors invests in relatively low-quality companies.

On an as-reported basis, many of the companies in the fund are below-average performers. The average as-reported ROA for the top holdings of the fund is 9%, which is notably lower than the 12% U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return of Schonfeld Strategic Advisors’s top holdings is quite profitable compared to what as-reported metrics show, coming in at 22%.

As the distortions from as-reported accounting are removed, we can see that Amazon (AMZN) isn’t a 2% return business. Its Uniform ROA is 11%.

Meanwhile, NVIDIA Corporation (NVDA) seems like an 8% return business, but this large chipmaker actually drives a 26% Uniform ROA.

That being said, to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Schonfeld Strategic Advisors’s top holdings is actually 22%, which is way above the corporate average in the United States.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Schonfeld Strategic Advisors paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to increase profitability. Similarly, the market has expectations for these companies to exceed current valuations.

Analysts forecast the portfolio holdings on average to see Uniform ROA rise to 31% over the next two years. At current valuations, the market has slightly higher expectations than analysts and it expects a 34% Uniform ROA for the companies in the portfolio.

For instance, Walmart (WMT) returned 9% this year. Analysts anticipate its returns to increase to 10%. Similarly, the market seems to think optimistically about the company’s future and its pricing in an increase in profitability to reach a Uniform ROA of 18%.

The majority of Schonfeld’s holdings are profitable, reputable stocks. At current valuations, the company is heavily outperforming the corporate average ROA, and it appears that it will over the next couple of years.

Investing in high-quality companies can allow for stability and resilience, especially in market downturns. However, there are cons in the form of limited upside. Looking at the overall portfolio, the market expects about a 12% increase in ROA over the next five years. This suggests that most growth prospects and potential tailwinds are already being priced in, which limits the upside potential for an investor.

Although, there are cases where the market may underestimate a company’s potential in the future. For instance, the market is pricing in for Microsoft (MSFT) to slightly decline to a 31% Uniform ROA in the next five years. In this case, the market may be overlooking the AI and cloud tailwinds that Microsoft could face in the future.

Microsoft has been open about its partnership with OpenAI and the growth prospects that could develop from its new tools. Additionally, cloud computing is a frontrunner in technology as it helps manage the increasing amount of data that innovations have created. There are other factors to consider but this is a general way to look at the holdings in the portfolio.

However, funds are different from individual stocks. There is always more to the story, and this is what appears to be happening with Schonfeld. While its holdings appear sound, performance has not been there which is taking a hit on an operational level.

Assets are being withdrawn and the firm faces capital issues. Historically, the fund has proved to be a top player in the space, but it hasn’t been showing.

The story hinges on whether the fund will be able to dig itself out of a hole as it did in 2020, otherwise, Schonfeld may have to accept help from one of its biggest rivals.

SUMMARY and The Sherwin-Williams Company Tearsheet

As one of Schonfeld Strategic Advisors’ largest individual stock holdings, we’re highlighting The Sherwin-Williams Company (SHW:USA) tearsheet today.

As the Uniform Accounting tearsheet for The Sherwin-Williams Company highlights, its Uniform P/E trades at 24.9x, which is above the global corporate average of 18.4x, but below its historical average of 29.6x.

High P/Es require high EPS growth to sustain them. In the case of The Sherwin-Williams Company, the company has recently shown 9% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, The Sherwin-Williams Company’s Wall Street analyst-driven forecast is for EPS to grow by 13% and 4% in 2023 and 2024, respectively.

Furthermore, the company’s return on assets was 24% in 2022, which is 4x the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. These signal low dividend risk and low credit risk.

Lastly, The Sherwin-Williams Company’s Uniform earnings growth is in line with peer averages, and above peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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