FA Alpha Daily

This famous arbitrager is celebrating 50 years of success

Arbitrage investing is a popular strategy among investors and hedge funds. It involves looking for mispricings between similar assets. Davidson Kempner Capital Management is a pioneer of this strategy. In today’s FA Alpha Daily, we’ll use Uniform Accounting to assess Davidson Kempner’s top holdings and see its performance amidst the current market environment.

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Arbitrage strategies are one of the oldest but one of the most powerful strategies in the investment industry.

Nowadays, computer-based models are identifying arbitrage opportunities in a matter of seconds or even in sub-second time periods in the market.

While quant funds seem like they’re leading the way with their emphasis on technology, there are lots of different strategies to be employed when it comes to arbitrage.

Davidson Kempner has been one of the pioneers of these strategies. Let’s remember the tactics and strategies they employ from the original article we wrote back in September 2020.

Arbitrage is just a fancy way to say an investor is finding two assets that are mispriced relative to each other, and then holding until the values converge.

If the same asset has different values in different markets, you can place a trade benefiting if the more expensive asset slips or the cheaper asset rises. It is essentially a way to take advantage of inefficient markets by betting on the price differences between similar assets.

Hedge funds have popularized many different forms of arbitrage. An example is convertible arbitrage, where investors can trade convertible bonds against the equity of the company.

Typically an investor will buy a convertible, and short the underlying stock to capitalize on the mispricing between the convertible and stock. The bet is at some point the convertible note can convert to equity, so eventually the two assets will converge on pricing.

There is also classic relative value arbitrage. This is when you find a company trading very cheaply relative to a peer in the same industry, and you go long the cheap stock and short the other.

The bet is that two companies in the same industry with similar macro trends should trade at similar valuations. Thus, over time the stocks should converge in value towards historical means with the cheap stock appreciating and more expensive stock reverting to averages.

Finally, merger arbitrage is another popular form of investing. It is built off of academic research that shows acquisitions tend to destroy value. In fact, it is estimated that more than 60% of mergers and acquisitions (M&A) actually hurt value.

If acquisitions destroy value for the acquirer, it is likely the acquirer’s stock will thus drop as an acquisition approaches.

At the same time, the acquired company’s stock, assuming the deal will close, has little downside if it is an all-cash bid. Equity bids have the downside of having the stock drop being captured in the acquirers’ stock.

Therefore, an investor can go long the stock of the company being acquired, and short the company acquiring, and just wait to take on the spread between them.

Like other forms of arbitrage, it seeks to take advantage of market inefficiencies, this time related to M&A. Our director of research Rob used to work at a hedge fund called The Abernathy Group, who were successful as innovators of this strategy in the 1980s and 1990s.

Davidson Kempner, one of the world’s largest hedge funds, focuses on these types of arbitrage strategies as well.

Along with the arbitrage strategies, the firm is also focused on distressed asset investing and more traditional long/short strategies.

Davidson Kempner currently has $36 billion in assets under management and has been in business for over 40 years.

Additionally, Marvin H. Davidson who initially founded the firm in 1983 is celebrating 50 years of investment history this year.

In light of this, let’s take a look at the firm’s top holdings based on its most recent 13-F filing.

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, as well as 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, it would appear Davidson Kempner is buying sub-par companies under distress. While that might make sense for the fund’s distressed asset strategy, it doesn’t make sense for other strategies. This might make investors wonder if Davidson Kempner Capital is arbitrarily picking stocks with low returns.

On an as-reported basis, many of the companies in the fund are poor performers. The average as-reported ROA for the top 15 holdings of the fund is 5%, which is significantly below the U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return in Davidson Kempner Capital Management’s top 15 holdings is actually 24%.

As the distortions from as-reported accounting are removed, we can see that Horizon Therapeutics (HZNP) isn’t a 6% return business. Its Uniform ROA is 63%.

Meanwhile, Qiagen (QGEN) seems like a 6% return business, but this life sciences company actually powers a 21% 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 Davidson Kempner Capital Management’s top 15 holdings is actually 24% which is better than 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 Davidson Kempner Capital Management paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to slightly decline in profitability. The market agrees with analysts but has an even more pessimistic view.

Analysts forecast the portfolio holdings on average to see Uniform ROA decline to 19% over the next two years. At current valuations, the market’s expectations are lower than analysts and it expects a 16% Uniform ROA for the companies in the portfolio.

For instance, Meta (META) returned 28% this year. Analysts think its returns will fall slightly to 21%. And at a 16.7x Uniform P/E, the market expects profitability to fall even further and is pricing Uniform ROA to be around 8%.

Similarly, Keurig Dr Pepper’s (KDP) Uniform ROA is 49%. Analysts expect its returns will increase to 60%, but the market is highly pessimistic about the company’s future and pricing its returns to be around 34%.

Overall, we can see that Davidson Kempner has high-quality names in its portfolio and is well-positioned for high returns with the market’s low expectations on these names.

This situation creates a significant upside opportunity for the fund, just as you would expect from an investing pioneer.

However, it’s important to note that the fund is highly concentrated on various strategies and the performance of these strategies has a huge impact on the fund’s consolidated returns.

Therefore, investors should carefully analyze these strategies and see if they are aligned with their own views of the market and investing. Additionally, the current valuations are another important factor investors should consider before jumping on an investment opportunity.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Davidson Kempner Capital Management’s largest holdings.

SUMMARY and Arko Corp. Tearsheet

As one of Davidson Kempner Capital Management’s largest individual stock holdings, we’re highlighting Arko Corp. (ARKO:USA) tearsheet today.

As the Uniform Accounting tearsheet for Arko Corp. highlights, its Uniform P/E trades at 23.9x, which is above the global corporate average of 18.4x, but below its historical average of 21.7x.

High P/Es require high EPS growth to sustain them. In the case of Arko Corp., the company has recently shown 27% 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, Arko Corp.’s Wall Street analyst-driven forecast is for EPS to shrink by 21% in 2023 and grow by 12% in 2024.

Furthermore, the company’s return on assets was 7% in 2022, which is 1x 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.

Lastly, Arko Corp.’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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