Large Wall Street firms have a significant advantage over smaller players due to their scale and market power. This is especially evident in the hedge fund industry, where the top 5% of firms are expected to capture the majority of new investment money in 2023. However, one European hedge fund, Marshall Wace, is bucking the trend. The London-based firm has grown its AUM to over $63 billion, thanks to its unique partnership structure and innovative investment strategies. In today’s FA Alpha Daily, we’ll take a closer look at Marshall Wace’s top holdings under Uniform Accounting to better understand how the fund has achieved this success.
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The hedge market is heavily saturated and highly concentrated in the U.S.
Of about 30,000 hedge funds that are operating globally, the U.S. dominates the market with about 65% market share.
Citadel and Millennium Management, both having AUMs of above $50 billion, are prime examples of how these large industry giants have carved themselves into the center of the market.
In such a competitive industry, hedge funds have seen the need to develop some edge to be on par with these huge money managers.
One fund has done exactly that and defied the odds of industry standards.
Marshall Wace, a European-based hedge fund manager, has used its unique fund structure and strategy to grow itself to the size of some of the largest funds in the world.
It all started with Paul Marshall and Ian Wace who came together to create Marshall Wace, a hedge fund that was heavily supported by industry legend George Soros.
Upon startup, the duo kept to the basics.
Marshall and Wace continued to develop and adapt its strategy, investing in different business processes, systems, and controls until something finally stuck, and it did.
The most pivotal point in the firm’s history was the development of Trade Optimized Portfolio Systems (“TOPS”) which ran analysis on buy and sell recommendations from thousands of external analysts.
The system synthesizes all those recommendations algorithmically to try to beat the market. This is the first “alpha capture” system ever created.
Having that as a baseline for the development of the funds, Marshall Wace utilized TOPS as the bridge towards the advancements of its quantitative business. Currently, two-thirds of the fund’s assets are allocated through computer algorithms, with the firm now advertising technology as the basis of its business.
In addition to this innovative and unique way of investing, Marshall Wace has also developed a competitive edge through its partnership structure.
With 33 partners, the fund has seen success through the distribution of ownership in the company.
In a way, this type of diversification among ownership created stability in the business. This led financial giant KRR to buy 40% of the business in 2015.
As the fund continues to grow and hone its market-beating tools, let’s take a look at the fund’s top holdings and see how these different techniques have played a role in the growth of the fund.
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, investors would think that Marshall Wace invests in below-average 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 15 holdings of the fund is 9%, which is notably below 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 in Marshall Wace’s top 15 holdings is actually 28%.
As the distortions from as-reported accounting are removed, we can see that Adobe (ADBE) isn’t a 14% return business. Its Uniform ROA is 69%.
Meanwhile, MercadoLibre, Inc. (MELI) seems like a 5% return business, but this large online commerce business actually drives a 40% 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 Marshall Wace’s top 15 holdings is actually 28%, 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 Marshall Wace paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to maintain the same levels of profitability. On the other hand, the market has a more optimistic view of the companies in the portfolio.
Analysts forecast the portfolio holdings on average to see Uniform ROA stay at the same levels around 28% over the next two years. At current valuations, the market’s expectations are higher than analysts and it expects a 34% Uniform ROA for the companies in the portfolio.
For instance, Walmart (WMT) returned 9% this year. Analysts think its returns will remain at these levels around 10%. However, the market has a more optimistic viewpoint on the company’s profitability and pricing its Uniform ROA to reach 18%.
Similarly, McDonald’s (MCD) has a Uniform ROA of 17%. Analysts expect its returns to stay around these levels at 19%, but the market is much more optimistic about the company’s future and pricing its returns to be around 33%.
Overall, the fund is composed of well-established companies with relatively strong financial records. This makes sense when considering that a large number of its portfolios are constructed through TOPS, which uses analyst recommendation algorithms for portfolios.
The market clearly understands the strength of its holdings as well. Hence, why it’s anticipating Uniform ROA to exceed the expectations of analysts moving forward.
Moreover, the fund’s ability to reach its current capacity, in such a competitive industry, is a promising indication that its strategy and structure are well thought out.
For generating returns in this fund, you are banking on the fact that right now, the best place for investors to be is in quality stocks regardless of price.
Though, when considering the size of its asset base, it appears that investors surely have trust in Marshall Wace’s future.
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 Marshall Wace’s largest holdings.
SUMMARY and Microsoft Corporation Tearsheet
As one of Marshall Wace’s largest individual stock holdings, we’re highlighting Microsoft Corporation (MSFT:USA) tearsheet today.
As the Uniform Accounting tearsheet for Microsoft Corporation highlights, its Uniform P/E trades at 26.7x, which is above the global corporate average of 18.4x, but around its historical average of 25.8x.
High P/Es require high EPS growth to sustain them. In the case of Microsoft Corporation, the company has recently shown 4% 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, Microsoft Corporation’s Wall Street analyst-driven forecast is for EPS to grow by 13% and 14% in 2024 and 2025, respectively.
Furthermore, the company’s return on assets was 33% in 2023, which is 5x 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, Microsoft Corporation’s Uniform earnings growth is in line with peer averages, and in line with peer valuations.
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.