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Transcript: Raj Moorthy – Advantage Alpha Capital Length: 1 hour 3 min Web page: capitalallocatorspodcast.com/advantage-alpha

Raj Moorthy is the Managing Partner of Advantage Alpha Capital, where he oversees a small cap, market neutral hedge fund focused on extraordinary businesses with a beautiful hedge.

Our conversation covers Raj’s early interest in business and his professional path across stops in investment banking, private equity, and entrepreneurship before landing in small cap public equities fifteen years ago at Pivot Point Capital. We discuss lessons learned over a twenty-five year investing career, discovering extraordinary small cap businesses, structural inefficiencies in the Russell 2000, the role of valuation in portfolio construction, managing emotions in volatile markets, and an unconventional approach to generating material and consistent alpha. We then work through the portfolio construction process at Advantage Alpha, beautiful hedge, leverage, correlation, and fund capacity. We wrap up with a discussion of Covid-19 and how Raj managed through the pandemic.

Edited by: Rev.com

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Ted: 00:00:06 Hello, I'm Ted Seides, and this is First Meeting. This show is an exploration of leading investment managers across asset classes. We'll replicate a first meeting an allocator might have with the manager and reveal who they are, what they do, and how they do it?

Ted: 00:00:27 My guest on today's First Meeting is raj Moorthy, the managing partner of Advantage Alpha Capital, where he oversees a small cap market neutral hedge fund focused on extraordinary businesses with the beautiful hinge. Our conversation covers raj's early interest in business and his professional path across stops and investment banking, private equity, and entrepreneurship before landing in small cap public equities, 15 years ago at Pivot Point Capital. We discuss lessons learned over a 25 year investing career, discovering extraordinary small cap businesses, structural inefficiencies in the Russell 2000, the role of valuation in portfolio construction, managing emotions in volatile markets, and an unconventional approach to generating material and consistent alpha. We then work through the portfolio construction process at Advantage Alpha, beautiful hedge, leverage, correlation, and fund capacity. We wrap up with the discussion of COVID-19 and how raj managed through the pandemic. Please enjoy my first meeting with raj Moorthy from Advantage Alpha. raj good to see you.

Raj: 00:01:39 Good to see you Ted.

Ted: 00:01:41 Well, why don't we start with your initial interest in investing?

Raj: 00:01:46 My initial interest is actually different in that my initial interest was in business. My dad had always worked at large corporations first, Caltex, then IBM for a long time, Bank of Montreal, and then Ontario Hydro. And so my introduction to ultimately investing started from the business world. And from my dad coming home and talking about what was going on at work and thinking about these large businesses. And this is going to be incredibly nerdy. But when I was in junior high, I read a book called On a Clear Day You Can See General Motors, and written by John DeLorean of DeLorean Fame. Back then he was a rising star, senior executive at GM, and left and wrote this book. And it was really exciting here was this swashbuckling executive. Shot through the ranks at GM, and one of the most powerful companies in the world at the time, dating models and actresses.

Raj: 00:02:49 And I thought to myself you know what? It's kind of like my dad, but I want to be that guy. And that's really where it started between dad and thinking about these large businesses. And my

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dad saw me reading that book and he's like, why don't you read a little bit about Alfred Sloan, if you really want to understand GM. And that was pretty cool. Okay. Here's Alfred Sloan, Forward was the dominant company at the time. He had by really strong management and many of the principles that people use today, he was able to overtake and make GM this dominant business. And that sort of started me on this path. And I always thought I would be in business.

Ted: 00:03:30 How did you take that through kind of your education or early work experiences?

Raj: 00:03:35 I'm the son of Indian immigrants. And I don't know if much about Indian immigrants, but they want their daughters to become doctors and they want their sons to become engineers.

Raj: 00:03:47 And even though my dad was in business, that's what my parents wanted. Long story short, they failed miserably. My sister's an attorney and I'm an investment manager. But when I applied to school they made me apply to engineering schools and I desperately did not want to go to be an engineer.

Raj: 00:04:05 So I applied to what was my first choice school back in Canada called University of Western Ontario, where I could satisfy their interests the first couple of years by doing sciences and then apply to the undergrad business school at Western, which is sort of a really well regarded business school within Canada. And I surreptitiously followed in my father's footsteps, frankly, and went to the business school there. Had a great experience at school and was fortunate enough to get recruited by strap consulting firms and investment banks.

Raj: 00:04:42 What appealed to me and I think it appeals to a lot of people is get to see a lot of different companies, a lot of different industries. You're dealing with really smart, motivated people. You are also dealing on the client side with fairly senior executives. And all of that was very appealing, and I was really struggling between what to choose. And the clincher for me was that the investment banking offer was in New York as opposed to going back to Toronto. And I had grown up all over the world, India, Hong Kong, Indonesia, Montreal, Toronto. And so my parents put that bug in us to move around and going to New York was exciting. And I thought if I was going to do something, I want it to be in the center of the store. I was fortunate enough to join CSFB, did mergers and acquisitions as a generalist there. And I hit the ground at the time when there was an M&A boom, just saw a ton of transactions, learn a lot of professional skills.

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Raj: 00:05:48 And it was there while I worked on large corporate mergers dealing with often the most strategic decision management teams make I was put on a project to sell a business spinning out of union carbide at the time. And I was the lead analyst. In my second year I ran the model. I was in every meeting. They have to have me because I knew the business from a financial perspective, certain way, better than most. And so I attended all the meetings and we were selling the business to private equity firms. And that was pretty interesting. I ran the LBO model from an advisor perspective and a sell side perspective. And here were these people who are putting their money where their mouth is having skin in the game. And that seemed really exciting to me that you're not just advising, but you're actually a principal in the transaction.

Raj: 00:06:44 That's really the moment where investing became a really exciting thing for me. The end of my second year, I had a couple of opportunities and there was this one entrepreneurial firm. It was a young private equity firm called Advanta Partners where I could have gotten into a more mature firm, but this young firm really appealed to me. I really liked the three partners there. I was going to be the first junior person. And that was exciting. I knew if I could join and prove myself that I could do every role from the analyst role up to sort of a VP type role. And these three partners really took me under the wing. And so I joined Advanta partners. We did growth capital and buyouts, and I learned just so many lessons. I mean, one how to think like an owner, how to interact with management teams.

Raj: 00:07:38 I would work with CEOs on compensation schemes, really every end of the transaction. And I got to see both ends of growth and buyouts, which is also great learning for me. And we performed really well. And it was just a great experience. And I also met the managing partner at the time was Tony Brenner. Tony has been sort of virtually a mentor my entire career and my business partner for the last almost 17 years. So that was a pretty pivotal event. And then from there, I went to business school where we were classmates.

Ted: 00:08:11 How'd you decide to leave to go to business school?

Raj: 00:08:14 I had no intention of leaving. And what happened at Advanta Partners, we perform really well, right? Ours were, I think, hard to replicate now. It was a different world in private equity back then, but we had one LP at the time.

Raj: 00:08:29 And then with the goal of raising our second fund with a broader swath, and it became a real political issue between the

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LPs and the partners and Advanta Partners actually ended up, you could see it on the horizon breaking up because of this.

Raj: 00:08:47 And it's one of these unfortunate conflicts you see in business that has nothing to do with the underlying events that are going on, but egos get involved and things happen. And so for me, going to business school was a natural segue at that point. And my business partners, my recs, they really supported that. And going to Harvard didn't seem like such a bad second prize.

Ted: 00:09:11 So did you go with the intent of joining another private equity shop when you left?

Raj: 00:09:15 I did. I did. First of all, HBS was just an incredible experience. I mean, I think what HBS did more than anything for me, it wasn't as much the classes that I joined. Certainly some of the other classes. I have friends who are brothers to me and I met my wife there. The biggest thing HBS did was really opened my eyes that anything's possible.

Raj: 00:09:41 You can do extraordinary things. You can create things on your own in a way that perhaps I hadn't fully dreamt as big as when I was at HBS. So what happened at HBS is fully expected to go back into private equity. Had a couple of opportunities again, and my friends and I, as you recall, we were class of 99, the internet boom. We wrote a business plan, we presented it to three VCs. And the next thing you knew we were closing up all our stuff, putting it in storage. And within two weeks we were funded and we launched our business.

Ted: 00:10:27 What was the business?

Raj: 00:10:29 It was called Elabs Europe. And it was really a marketplace for life science products in Europe. Life sciences is a highly fragmented industry on the supply chain side. A little bit more concentrated on the customer side, but there's a real opportunity to create exchange where sellers could meet buyers.

Raj: 00:10:51 And we went about executing that business for two years. I learnt a lot about entrepreneurship, how difficult it is. And I gained an enormous amount of respect for operators. I was in Munich, my then girlfriend/fiancé had started a company in Boston. And we also got married while I was in Munich and she was in Boston. So the natural step was moving back to Boston. I knew I wanted to get back to investing. That was my natural wheelhouse. It's what cited me. It's what I thought about. And

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so I joined the Audax Group in Boston. Audax was founded by Geoff and Marc Wolpow.

Raj: 00:11:34 They had just bought out maybe a year earlier from B.I.G. Capital and was happily ensconced doing middle-market buyouts in Boston. Audax was pretty unique in that. Marc and Geoff were precluded from hiring anybody from B.I.G. Capital. So what they did, and it was pretty prescient of them. They hired a bunch of really smart, talented professionals. 50% of them came from a consulting background, a lot of bank consultants, as you can imagine. And 50% of them came from investment banking, experience backgrounds like myself. And it was a real melding of the two. And for me, it was a great education in strap consulting in real time. And it gave me frameworks and how to think about companies. It advanced my thinking about strategy. It advanced my thinking about how to evaluate businesses. Advanced my thinking on beyond sort of financials. How can you look at a company and think about where the value is created. And all of that sort of built on my prior experiences to really evolve my thinking as an investor.

Ted: 00:12:43 Where are the biggest differences in the kind of academic lessons you learned in business school about businesses, and then what you learned at Audax?

Raj: 00:12:51 What I would say is, first of all, if I thought about my favorite classes in business school. Those weren't finance, it wasn't marketing. It really was strategy classes. That was my favorite class first year. That was my favorite classes in second year, I loved the game theory class. I think my nephew just asked me what books to read, because he has an interest in investing. He started buying stock. I said, let's start with competitive strategy. That is foundational for me. If you want to be an investor and start thinking about companies.

Raj: 00:13:25 So I don't dismiss the academic stuff. For me that was foundational. What I would say about Audax and sort of what I learned there. And being as a consulting firm, as I learned, it was more practical. So you look at a company, let's just see where the profit's made. Let's line up all their products and services, and let's look at revenue and operating margin fully allocated, and let's really understand where you make money and where you lose some money. And let's align them up in a row and say, what are we going to do to either optimize this?

Raj: 00:14:00 Did we cut this out? Can we raise pricing? Can we cut costs? What do we have to do to compete? And you make very tangible decisions. That to me was sort of the practice of what

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we do all the way today in Advantage Alpha. Really understanding if you look at a company and it operates within an industry, well, where does it fit in that industry?

Raj: 00:14:22 So you can do a market map, you say, what does it share? What is the other player share? What are the adjacencies? So it can really inform your acquisition strategy that these are the pockets that you really want to go after. It's these tools that may not see profound, but they really are profound. And once they're shown to you, they're like big aha moments. And I had a series of those aha moments at Audax. It really fostered this cross pollination between sort of the two sides that eventually you just became an Audax investor.

Ted: 00:14:57 Yeah. Where along the way did you end up shifting from the private markets to the public markets?

Raj: 00:15:03 Audax today has an incredible culture, but back then any time you bring that many people in together, the culture takes time to evolve. And I really wanted to create my own culture. That was a burning ambition. And around that time, Tony Brenner, who is my managing partner at that private equity firm came to me with the idea for a hedge fund, that would become Pivot Point Capital. It was really appealing to me on a number of fronts.

Raj: 00:15:33 One, it fit this need to create my own culture. This entrepreneurial spirit I had. Two, I really liked the strategy. And I thought the strategy could create a lot of value. And three Tony had been a mentor, sort of my best professional experience working with Tony seemed really exciting again. And sort of when I looked at all those three, it made all the sense of the world. And the strategy was very private equity like, so it was a natural transition to go from private equity to this model.

Raj: 00:16:07 And our model was to focus on small cap equities and to be highly concentrated within small cap equity. So very private equity, like in terms of our diligence, our modeling, writing thesis statements need to believe in doing really extensive diligence on these companies.

Raj: 00:16:24 And the way we executed the strategy was informed by all this work, thinking about companies throughout my career, and an idea that Tony had. When you invest in small cap equities the opportunity is that you have more companies, fewer investors and less investor coverage, that creates an alpha opportunity. And I think most people recognize that, but most people don't pursue small cap equities because of two constraints, illiquidity

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and volatility. Tony's thought was, hey, illiquidity is a reality. We're just going to have to live with that. Volatility, let's try to make that our friend. So our model was to invest when others panicked. Stocks down 25%, 30% because they report poor earnings to really look at those moments where there's panic and the stock to see whether the market's overreacted.

Raj: 00:17:20 And if you do that correctly, what happens is multiples compress, you do your work. You think the issues are transitory and the multiple is going to go expand back to its natural state. And if you think of a slope of a curve, you now have a much steeper slope where you have multiple expansion plus earnings growth, and we can underwrite to quite high IRR. And I think the overlay that I brought to Tony's thoughts was that if we're going to do this, we're going to accept illiquidity of small caps. We're going to have to live with the volatility of small caps. It can be our friend, but it can also be our enemy. In order to mute risk where we concluded was that we only want to invest in extraordinary businesses. And what we found interestingly enough is that extraordinary businesses when we analyze it prior to launch dislocate as often as lousy businesses.

Raj: 00:18:19 And the reason is everything in Wall Street is an expectations game. So it's all about meeting or exceeding or not expectations. And so we went through a three to four month process prior to our launch where we distilled the Russell 2000 down to what we felt were the most extraordinary businesses. We would get to know these companies, we'd listened to a hundred earnings calls each quarter, we'd visit with the management teams, and then we'd be poised to act, to take advantage of those dislocation opportunities because we know the businesses fairly well. And that model worked wonderfully for a long time.

Ted: 00:18:56 How do you define what these wonderful businesses are?

Raj: 00:19:01 I'm going to describe that Ted, nothing I'm going to say is extraordinary. It's really in the application. So let me describe how we do it. And it really hasn't changed. We've definitely gotten better over time, but our definition really hasn't changed from way back yet.

Raj: 00:19:15 When in 2004, 2005, how we apply it to different industries may have evolved and definitely has evolved. We've looked at business characteristics, governance characteristics, and financial characteristics. But we would not even spend any time on governance and financial characteristics until a business met our business criteria.

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Raj: 00:19:38 So when we went through the Russell 2000, we went through it company by company. We didn't apply any screens. There's no financial metrics. And the business criteria at its highest level is the following three. We only want it to invest in secular growth markets. So we weren't interested in investing in the buggy whip industry or the newspaper business for instance. We wanted secular growth. It doesn't mean it necessarily is high growth. It could be GDP plus type businesses, but growth. Second and most important criteria is we wanted the competitively advantage business. The businesses we invest in had to have a structural advantage that we could identify.

Raj: 00:20:21 I'll come back to that. And the third is we wanted market share gainers. Our thought on an operating basis was that look over any duration peak to peak trough to trough five years, that if you have companies that are in secular growth markets that are the competitively advantaged player, that are market share gainers, we're in a good fishing pole from an operating basis. So that we could get a lot of things wrong. At Pivot Point, when we went to invest, we could have invested right when Fidelity decided to sell, or we could have made a mistake in our diligence, or we could have called the macro wrong. But if the underlying asset was as sound as we thought, then we'd be okay. And that was our biggest way of muting risk at Pivot Point was to only invest in these extraordinary businesses. We can spend a lot of time on what does advantage mean, but let me give you an example.

Raj: 00:21:20 A simple example, people will talk about market share as a stat. This company has 20% market share. Market share is a individual stat, for instance, is not all that meaningful. A company that has 70% share then that's a meaningful stat. 20% in and of itself doesn't tell us a lot. But if we learned a company had 10% share, and then there are nine other players that have 10% share, we're not going to spend any time on that industry. We can quickly sort of discard that business because when you have 10 players with 10% share, they have equal access to resources, equal access to purchasing. They're likely beating each other up pretty aggressively. However, if you have an industry structure where you have a player that has 10% share and the next largest player has 1% share, I mean, without knowing anything about the business, what product it has, what service it's performing, whether it's a product or service company, what end market is, we would sit up in our chair.

Raj: 00:22:30 That is an incredibly attractive industry structure to us. Because just with those two data points we already know a lot. That 10% player likely has significant structural advantages over the 1%

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player. They may be able to purchase better. They may be able to invest in technology in a way the 1% player they can. It also tells you, they have a long runway for growth, either through acquisitions or taking market share. Those are the kinds of things that we would think about constantly.

Ted: 00:23:01 Were there other rules of thumb that you use to help filter 2000 companies into something you can screen through in a relatively short period of time?

Raj: 00:23:10 We shied away generally from commodity based businesses where the company didn't have pricing freedom. We shied away from hits based businesses. So biotech, video games, movies, where we didn't feel we could diligence or analyze the business. Oftentimes in the hit space business that's a challenge. We would shy away from those types of businesses. Outside of that, our watch lists really cut across the US economy and was very diverse. Now, within that there's sectors, there's types of businesses that we just didn't like within that criteria, so we could quickly disregard them.

Ted: 00:23:54 And so, as you worked through that and created this kind of list of potentially attractive companies, how many were there in that mix?

Raj: 00:24:02 In our initial list, we distilled the Russell 2000 down to 100 companies. It's about a 5% hit great, and 95% didn't make it. And this watch list was living, breathing, meaning it was designed to be durable through cycles. We wanted businesses. We were thinking in sort of five, 10 year horizons for these companies. So really the criteria we applied wasn't that, hey, we're in an expansionary phase of the economic cycle. Let's look for those companies that would do well. It was irrespective of economic cycle we just wanted the best of the best. And the other criteria we didn't apply at the time or ever is valuation. We were also valuation agnostic when we built this watch list, because remember the purpose really was to form a fishing pool for our concentrated set of 10 companies that we'd invest in. When we went to invest in Pivot Point, we were very valuation sensitive.

Raj: 00:25:02 We were looking for that panic to occur in these 100 companies so that multiple to compress, we were very evaluation sensitive. But to form the watches, we were valuation agnostic. Now, we live in small cap world. So the turnover on this watch list, it's sort of a garden that needs to be tended. It's going to surprise you because I've told you we have 10 year outlook. It's about a 20% turnover, each year. And why is that? Well, about four to

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eight get acquired each year because they're well positioned, smaller businesses. Companies can grow out of the market range ultimately because they're so successful. Three, the world changes. Amazon was a threat in '05. Yes, but a very different threat today in 2020. So the world can change. And we went through that Russell 2000 process every year. So I've gone through the Russell 2000 for 16 years, no problem. I probably shouldn't say that.

Raj: 00:26:03 We can do it fairly quickly, we're efficient, we know a lot of the companies. But we're constantly looking to optimize and print. And the watch has vacillated between 100 and 115 names over time.

Ted: 00:26:15 What are the causes of a company that you didn't have on your list before that then sort of gets added to it at some subsequent year in the future?

Raj: 00:26:26 There are a lot of very good businesses. I'll give you an example. Security software, security software in the mid-2005 to 2010 was a very hot area and continues to be a hot area. Security hasn't abated, but it was very hard for us to differentiate between the businesses. They were all growing like a weed, but we couldn't find structural advantages. And strategy is as much what you don't do as what you do do. And we were very disciplined and it was very important to maintain that discipline.

Raj: 00:27:03 And what happens is companies evolve and industry structures evolve and change. And as those companies evolve and industry structures evolve, structural advantages may become more apparent. So typically that's what's happened when we pass on a very good business, is that very good business with a very good management team creates a structural advantage. If you think about Amazon, Amazon had various competitors. Amazon, first of all, it's the most competitive. We abandoned business in my lifetime, but their competitive advantages have evolved over time. And that's why they continued sort of their dominance. And that happens in younger businesses as well, where competitive advantages evolve over time.

Ted: 00:27:48 Now, when you're both coming from private equity and not just going to public equity in engendering all the kind of common behavioral biases that come up. But you're doing it as you said in this strategy that it's just going to exacerbate all of those behavioral challenges. What did you learn along the way for kind of how you made that work?

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Raj: 00:28:08 One, a very much help that Tony had actually been a public market investor before he went into private equity and really is a seasoned investor. In fact, on our 10 year anniversary, we wrote our lessons learned and there was obviously a ton of them. But let me tell you perhaps one that was most meaningful for me. When we started Pivot Point, we sort of knocked the cover off the ball and we just had very strong years. '05, '06 '07 and then '08 happened. And ultimately we did very well in '08. In fact was our largest year of our performance. But you can imagine the emotions going through a manager, especially a concentrated manager during those times, if I contrast it with private equity. In private equity you care about valuation twice when you buy the asset and when you sell the asset. Ostensibly you may mark to market, but probably the deal teams don't even know what they're marked at.

Raj: 00:29:09 All you care about in private equity is within those two sort of points is growing EBITDA. How do I grow EBITDA? I can invest in a sales-force depressing EBITDA for the next year and believe that coming out of that, I'll have a larger EBITDA. That same decision in a small cap business by a management team perfectly sound decision can cost a 35% reduction in its share price in a day in the financial crisis where markets were plummeting at times 8% in a day it really showed you the impact of emotions. And I always thought of myself as this incredibly rational person and come to realize I'm actually like everybody is an incredibly emotional person. And I learned a lot about emotions. I learned about that emotions are, there's not a value judgment associated with them. You're angry, you are angry. It's not a right or wrong you just are angry. You're scared, you're panicked, or you're feeling greedy. Emotions are and you need to recognize those emotions before making decisions.

Raj: 00:30:25 You almost need to say to yourself, I'm feeling panicked right now. I'm feeling fear. And then you can make a much better decision on whether you want to sell, hold or buy. And it really took the financial crisis for me to learn about that. And it was a real-time lesson and it's a lesson that sort of stood me well in investing. And it's a lesson that stood me well in all sorts of relationships that I have. If my son is really getting me angry recognizing, and not that I'm perfect at this, don't get me wrong. Well, recognizing that I'm angry is helpful on whether I want to engage with them now, but I want to make a joke whether I want to walk away. So applying that, that was a very powerful lesson for me.

Ted: 00:31:17 So you're doing this for years and somewhere along the way things change a few years ago?

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Raj: 00:31:24 Two things happened. One, if I go back to this watch list of 100 to 215 companies, we would track the data and see how these companies performed. Even after five years in business, we saw in this was just extraordinary performance and significant health regeneration. And we sort of looked at ourselves and said, wow, that's interesting. And really on our 10 year anniversary, I was sitting with Tony and we're looking, we would have our quarterly offsite where we would look at this data. And what we saw with the watch list, this 100 to 115 company choice was that not only had it materially outperformed in generate material alpha, it did so consistently. We're taught in business school that, hey, once you're past about 40 companies in a portfolio, that's well-diversified, you're diversifying a way to syncretic risk, but also idiosyncratic returns so that your return should start mimicking the market.

Raj: 00:32:30 Yet here's this 100 company watch list, that's market cap weighted generating material alpha. Sort of we looked at each other, looked at the data. And I just said to Tony, we need to do something about this. And we both agreed. The first thing we needed to do was vet the data, make sure it's all cleaned up and make sure it's accurate. Two, is understand why is it happening? And we spent time along those scores. And that work is really what led to the foundation for our Advantage Alpha our current fund. And we can go into more on that Ted. With Pivot Point, Pivot Point was very much a value oriented manager. We liked the margin of safety, right? Valuation compression, issues get answered, multiple expands back to the mean, in fact, often expands past that because of momentum. We really ride that benefit and that worked wonderfully really for the first 12 years of Pivot Point's existence. Fast forward to sort of the late 2015, 16, 17 timeframe.

Raj: 00:33:38 What we found is the strategy didn't work as well in an extended high valuation market. Our pace of investment historically at Pivot Point was about one and a half new investments, a quarter, which if you work that out, it's about an 18 month hold period. Which is the right amount of time to have an issue, have it worked out, and then weed the benefits and then you turn it over.

Raj: 00:34:02 What we found is our pace of new investments start plummeting to one to two per year instead of one and a half per quarter, because we just weren't getting attractive opportunities. Companies were still dislocating, don't get me wrong, but it's normal multiple was 10 times EBITDA. Perhaps it dislocated from 18 times to 14 times and we were having to underwrite going back to 18 in order to meet our return

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thresholds. We thought about, hey, maybe we compromise our return thresholds or compromise our criteria.

Raj: 00:34:34 What we learned over time, again, going back to strategies every time we did that, we sort of got our fingers burned. And that didn't seem appealing. Tony and I were also significant investors in the fund. Our first rule was always treat our investors' money like our own. And as we thought about it, we became increasingly concerned in '17 about a market correction of eventually an economic cycle. And at Pivot Point, we had a few degrees of freedom. We already averaged about 20% cash back to 18% cash over our history. And if we felt this way, you would really want to go 50% cash. As you know that's sort of a perilous decision for any fund to make, because unless you call the market right, our investors who felt very good about us probably wouldn't feel very good after a year or so. Or we could just hold our noses and keep investing.

Raj: 00:35:27 And that, again, isn't something that we were willing to do. And the third was returned capital. We elected door number three, sort of very independent decision. In the intron we had continued doing a significant amount of work on the watch list. We developed an understanding why this was happening.

Ted: 00:35:46 And why was it happening?

Raj: 00:35:48 First of all most financial analysis are done on the S&P. It's a longer data series than the Russell. It's what people think of as the market. It's the line share of market value clearly. The entire Russell is worth two S&P companies today, Amazon and Microsoft are worth more than the entire Russell. Here's what I think people miss, the S&P is an aspirational index. It's a club you want to join, and then you want to climb within it. The Russell is a very different index and we call it an index of the mediocre.

Raj: 00:36:23 And here's why? If you're a young company, you want to join this club, you want to join the Russell, but then you want to graduate out of it. You want to grow to become a mid-cap company, and then eventually an S&P company. You don't want to be a fallen angel. You don't want to be a midcap company that falls into the Russell 2000. So I use the example always of bed bath and beyond. A couple of years ago fell into the Russell 2000. Well, that's a broken business model. That's going to be hard to change that tide. And then you have a bunch of companies that sort of just hang out in the Russell. I use this analogy probably inappropriate, but it's like a dirty old man hanging out in the club. It's there, but it really shouldn't be. And

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what you see when you analyze the Russell is that there is a significant differentiation in quality, significant, it's massive.

Raj: 00:37:16 The second thing we've talked about is that the dispersion of returns in the Russell is also very wide because of this volatility. And the opportunity becomes, does quality correlate to returns. And quants would say absolutely. And it's true, quality absolutely correlates to returns.

Raj: 00:37:37 What we found was by focusing on extraordinary and using our criteria you're generating material alpha, material alpha. And not only are you doing that, and I think, let me just stop there for a second, because if you had asked Tony and I, what do you think your watch-list is going to do way back in 2005, 10 years later? We would have told you, we absolutely think it's going to generate alpha. Maybe 100, 200 basis points because these are great businesses.

Raj: 00:38:06 The reason it's not more is that they're priced at great company prices and the market's efficient. So therefore we wouldn't expect the alpha to be as material, but we expect some alpha. Yet here we saw this extraordinary level. The second thing we saw was the consistency, not only two great companies outperform the mediocre over time because I think people could buy that. It's doing it over shorter durations and medium term duration and long-term durations. And that was the giant. It was sort of a double, giant aha moment for us. When we saw the data and then when we understood why it's happening and the fact that it's happening over shorter duration really opened up sort of the realm of possibilities of what we could do with this.

Ted: 00:38:56 So why don't we step into sort of Advantage Alpha and how you took that insight about the success and consistency of the watch list and kind of turned it into how you're managing portfolios today?

Raj: 00:39:09 We analyze this data, just saw this material alpha generation. And to give you a sense it's about, if all you did was invest in the watch list, it generated about 590 basis points of alpha going back to 2005. And as you know Ted alpha generation and hedge fund industry has really materially declined.

Raj: 00:39:31 The strategy is sort of consistently generating just substantial wealth. That's sort of what we were looking at. And it became a question, well, okay, what do we do with this? How do we optimize it and understanding the defensibility of it? There's a reason advantages in the name. It's both the underlying asset.

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And we think about our own structural advantages. And then how do we productize it? We found ways to optimize that alpha. So it's still a market cap way to portfolio, but we asked ourselves what if we didn't invest in all of the companies, but in 70% of the companies. This would still be a liquid portfolio.

Raj: 00:40:09 Can we enhance the alpha generation and still minimize the volatility? And what we found is doing a few basic things like introducing valuation for the first time. So going from valuation agnostic to introducing valuation and a few other factors. A simple one would be, if you think about a two by two matrix, you want low value, high earnings growth. Introducing basic factors that any sensible investor would introduce we found we could take that 590 basis points to 700 basis points of alpha now. And then we looked at and said, okay, what's the best way to optimize this. If you thought about the twin characteristics here of both material alpha generation and consistency, it's sort of lent itself to a market neutral product where we could isolate for this alpha generation, remove beta, and generate a very attractive risk reward stream for investors. We centered on that pretty quickly as a very attractive structure.

Ted: 00:41:16 Let's talk a little more about that portfolio construction for Advantage Alpha today. So if it's 70% of say 100 names that say 70 names, how are you waiting those names in the long book?

Raj: 00:41:28 Again, we're in small cap. The first natural inclination would be to say, hey, we should do an equal weight portfolio. An equal weight portfolio would generate a little bit more alpha, but the reality of investing is we could only grow to a very small size that wouldn't be economically sustainable.

Raj: 00:41:46 And if we went to a market cap weighted portfolio, we don't sacrifice much in alpha, but it can be an economically stable model where we're able to invest with a lot of liquidity. And so we quickly went to a market cap weighted portfolio and then what we do is for the first time, as we said, we introduced valuation. We are looking at every company and looking at what we believe is sort of the intrinsic value of that business. And then indexing all 100 companies, but companies trade at different multiples. So a financial services company is going to trade on a P multiple, the SAS company we talked about, we do these DCS, but we bring that back to an intrinsic multiple of revenue because that's what SAS companies trade at. An industrial business can trade at EBITDA. A business services company is going to trade it adjusted EBITDA. We have to accommodate all of that.

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Raj: 00:42:41 So we're looking at the valuation on that intrinsic basis. And if a company trades, a simple example, 12 times today on whatever metric and it's 10 times, we think is the intrinsic value we're going to put that factor. And then by lining them up, we're able to say, hey, these are the 70 most attractively valued. And then we build our portfolio. And we should say, we're fundamental in the security selection. We are systematic in portfolio construction. So we have a model and the model will take market cap. It'll take valuation to arrive at the 70 companies that should be in the portfolio.

Raj: 00:43:22 Then it waits based on again, market cap, value, and a few other factors to weight that portfolio. And we do that on sort of a monthly basis, every 33 days. We found when we looked at the historical data that that sort of optimize returns. And that's how we do it. Now, we apply some judgment to the model weightings, but any judgment we apply, we evaluate it the next month, which can be sometimes sobering. But what it gives us is a very good yard stick. And what we've learned over time is that the model really works very well in terms of portfolio waiting.

Ted: 00:44:04 A couple of things you mentioned, you just mentioned rebalancing every 33 days?

Raj: 00:44:09 Yeah.

Ted: 00:44:10 Where did you come up with that number?

Raj: 00:44:13 The way it worked out is that we found monthly was about the right rebalance period, because you want, again, there's a lot of volatility in small caps as you know. Over a month you allow things to play out and that generates returns for you. But if you wait too long with that much volatility, valuations change dramatically. So you can't wait a quarter. And we found 30 days was the right metric. The reason for 33 days is our strategy happens to be very tax efficient. We think the lion's share of our gains will be over 90% long-term with nights periods of deferrals. And by going to 33 days, we simply avoid wash sale rules without again changing any of the return profile of the business.

Ted: 00:44:59 How do you factor in sector exposures?

Raj: 00:45:02 So again, sectors for us is an outcome. We don't go in saying, hey you know what? We want the Russell for instance, has a certain allocation to financial services. We want to mimic that allocation. That's really oftentimes a mutual fund sort of

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mindset. For us it's an outcome. So we have sector profiles that are very different than the Russell. We're just looking for the most extraordinary businesses. It turns out it's still develops a well-diversified portfolio.

Raj: 00:45:33 But then we asked ourselves, well, okay, clearly we have sector imbalances with the Russell. Are we again in a good fishing pool? So we actually went back and analyzed Russell sector returns. We sort of lined them up and said, what if on every rebalance the Russell adopted our sector weightings going all the way back to 2005. And what we found is sector weightings are a tailwind for us and a significant tailwind. So the Russell itself would have generated 170 basis points of extra IRR with that 16 year period if they adopted our sector weightings. So what it tells us that, hey, we have a tailwind behind us. Any one quarter can vary, but it's a long-term tailwind.

Raj: 00:46:18 And why is that happening? And it's happening for two reasons. One is this ROIC factor where we tend to be in higher ROIC businesses so that gives us a natural tailwind. The other thing is because of valuation, our model is naturally self-correcting. People are really bullish on the industrial as well we're sort of slowly reducing our weighting on industrials. And if technology is overweight, we're doing that valuation correction. And that is also additive. There's two things. One, it's a fair question. And so what we do every quarter is we report to our investors, how much did sector tilt, contribute or detract from our performance? And it feels good that it is a long-term tailwind for us. The other is that we want to make sure we think a lot about our hedge and then the hedge being the Russel. And we have this notion of the perfect hedge.

Raj: 00:47:10 The perfect hedge is something that if you have your portfolio returns is perfectly correlated with your portfolio returns, but there's a big gap, right? And that gap is alpha. And if you had that perfect hedge of was just perfectly correlated every step of the way with that sort of fixed alpha in between. If you had that, you could infinitely hedge that and make a lot of money. We don't have a perfect hedge. We sort of use the term we have a beautiful hedge. Our correlation with the Russell is sort of 0.9, incredibly correlated. So that is very important to us. So sector tilts may vary, but that correlation is incredibly important to us. And we generate a high alpha very consistently. So while we don't have that perfect hedge, we have a beautiful hedge.

Ted: 00:48:02 You have this beautiful hedge, you've had this portfolio that's shown consistency and outperforming over time. And I imagine you want to emphasize that stock selection as much as you can.

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How do you figure out the size of your balance sheet or the amount of leverage to use?

Raj: 00:48:17 We really looked and said, hey, let's look at drawdowns. What do we think is a reasonable drawdown sort of triangling in between drawdown, return, volatility, and saying what is the most attractive risk reward profile? In every down market you have this strategies returned to positive return and performed quite well. In '08 the markets were down 38%, the strategy returned positively.

Raj: 00:48:43 But what you found in '08 during the financial crisis was that there was a fair amount of volatility, that was like the ducks swimming across the pond with the legs turning underneath. And what we saw with the drawdown in '08 that really governed. We said, okay, for us to generate alpha, the market needs to be discriminating, meaning they should be thinking about what business are performing well? What business aren't? What's the valuation? What's earnings growth?

Raj: 00:49:09 In a market like '08 and to a degree this year when panic hits and the premium is on liquidity, I'm going to sell, what's not nailed down and I can't sell. In an undiscriminating market we can experience more volatility. And what we saw in '08 for that unfortunate investor to invest it in the worst possible moment, they would have been down about 15%. If we thought about the worst environment we could think of that was about the worst environment. That seemed a manageable drawdown. The interesting thing is, as soon as the market's discerning, what happens in our drawdowns is you see rapid recovery. That investor who invested in the worst possible moment is back to their high water mark in 11 months, and then made a lot of money. So that's really how we arrived at the leverage.

Ted: 00:49:54 And where did that end up the magnitude of leverage that you're using?

Raj: 00:49:58 So if you give us $100, we'll leverage that once. So we'll build a $200 loan portfolio and then pay to hedge fund, so that we're completely beta neutral.

Ted: 00:50:07 So as you've been running this out of sample, what has the beta or the correlation, whatever the right metric is played out to be relative to say that Russell or something like their SMP?

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Raj: 00:50:20 So our correlation is 0.95, our beta over our history is 0.9, but it's not static. It can be as high as one and as low as I think it's gone as low as sort of below 0.8.

Ted: 00:50:37 And that's of the long book, right?

Raj: 00:50:40 That's of a long book.

Ted: 00:50:41 How about the fund as a whole?

Raj: 00:50:42 We're simply not correlated. So over long durations and short durations we have a virtually a zero correlation to the market to the S&P to the Russell. And frankly, we correlate it to other Russell classes and we don't see any correlation across the board.

Ted: 00:50:59 Balance, you've got something special here. How did you figure out sort of what the capacity of the strategy is and balance that against the liquidity of the underlying names?

Raj: 00:51:09 The way we think about it is we're looking at liquidity number of days to liquidate in the portfolio. We have actual obviously, say we've been around a while now. We periodically check our actual portfolios and the liquidity in them. And what we found is that if we grow to a billion dollars, we're likely to close it at that point, had a billion dollars of AUM we build a $2 billion long portfolio. And when you work through the math, that portfolio still has strong liquidity at a reasonable trading volume. I think we use 15% of daily trading volume. What that tells us is at a billion dollars of AUM and a $2 billion long portfolio we can grow with our investor base at that time.

Ted: 00:51:53 And what does that translate to in kind of call it average market cap of the names in the portfolio?

Raj: 00:52:00 Today, we have an average market cap of call it two and a half to 3 billion. And that is higher than the Russell. What we want to maintain is correlation to the Russell. And the reason we're higher is because if you thought about the ideal scenario, Ted, if we're talking five years from now, our ideal scenario is our watch list, all become mid-cap companies. And if we did that, that's not going to happen by the way, a significant portion hopefully will, but not all of them.

Raj: 00:52:31 If it did, we will have done really well for our investors. And that's our goal. We don't want the companies that just hang out in the Russell. So we want these companies that are going to

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become midcap companies. So what happens is even though to join our watch list, we want companies that are in the market cap range of the Russell. But what happens is these businesses do well so we end up skewing higher.

Ted: 00:52:54 I want to turn to some closing questions, but before we do that we're in this period of time with the pandemic of COVID-19. And I'm curious how you're thinking about the challenges that some of the companies on your watch list might be facing in this unusual time?

Raj: 00:53:13 When COBID hit we were fortunate in that we have a large well diversified portfolio. And the first thing we did was in a crisis everything's a liquidity question. We analyzed our companies and looked at leverage levels, compared it to the Russell and the S&P. And it turns out were companies on average, much lower lever than the indexes. So really well-positioned companies.

Raj: 00:53:36 And so we didn't have to do a lot, we performed well through the crisis. When you look at individual companies, there are companies that are impacted. So classic example would be, let's say a retail business. We have retail business that normally in most economic cycles would do well because they happen to sell something that's very resilient. But in COVID, which was a unique situation where their retail operations are shut down we not only have to look at their leverage levels we had to run extreme scenarios in terms of models on what their liquidity situation would look like in a protected COVID, shelter in place situation, and the economic recession that would fall.

Raj: 00:54:18 And we did that and we found most of our companies are well positioned. But if I give you an example of a company that maybe the future is a little bit more uncertain than it was, we have Planet Fitness. Planet Fitness for instance, I could first of all wax poetic on its competitive advantages. I love this business and what they've brought to the fitness center market and the innovations that they brought are absolutely unique. And like pre-COVID, like Amazon they're competitive advantage they're growing. They're not stable or decreasing, they were growing. Here we a situation where their competitors oftentimes are leveraged, they're struggling. So it's not a question of, is Planet going to take share from other fitness centers.

Raj: 00:55:03 It's really what is consumer behavior going to look like post-COVID. There's uncertainty there and then you have a health question pre-vaccine, post-vaccine that you also have to look at. Is everybody going to be doing Peloton at home? And the reality

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is the Planet consumer is not going to be buying a Peloton. But are they now going to exercise at home? How do we analyze that?

Raj: 00:55:28 So with Planet, it's a wonderful model. It's a franchise or franchisee model. We've done the extreme economic modeling, but there's a long-term question. So we're looking at consumer service. We think there's a pre-vaccine answer and a post-vaccine answer. And we think the notion that everybody is going to stay at home forever is just to me too big a societal change. It may take time. We're going to get a vaccine at some point and post that I think planet goes back eventually to it's sort of normal course.

Raj: 00:56:03 In the implants Planet's doing smart things. They're doing work from home videos, this huge audience that they have can they have the best of both worlds. And those are the kinds of questions we're posing to management. So let's put that in context of our portfolio.

Raj: 00:56:19 Planet isn't one of 10 names or one of 20 names. Planet is one of 70 names. And for every Planet we have another company. So let me give you the other side of the coin. We added Teladoc a year ago to our watch list. Teladoc is the leading provider for both telemedicine on both the service and tech basis for providers and payers. In less than a year what was a certain trajectory for telemedicine adoption has obviously gone through the roof and that stock has benefited. There are puts and takes that we need to manage through and we need to be very thoughtful about, but as a whole what I would say about our portfolio and it's particularly in COVID is that great company that we saw that this in the GFC, they take advantage of their competitive advantages, their balance sheet, their competitive position.

Raj: 00:57:13 So in crises, they're able to do really smart things. They can acquire salespeople from their competitors. They can continue to invest in R&D. They can acquire competitors. They can take the opportunity to move through adjacencies. What happens in recessions typically is the strong get stronger than we get weaker. And COVID has only exacerbated. I mean, you see it in the large cap world, and it's only exacerbated that. And we think in this case, we'll get stronger. And we're in the companies that are strong.

Ted: 00:57:47 All right, raj, let's turn to a couple of closing questions. What's your favorite hobby or activity outside of work and family?

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Raj: 00:57:54 This is going to sound pretty basic, but golf in the summer and skiing in the winter. The only thing I'd say is I came to him later in life. I started skiing the same time as my daughter when she was three. And yes, she is a better skier than me. But what I like about both is I'm outside. I'm away from my cellphone and it's a constant evolution of discovery, constantly thinking about it. How do I get better? And I just love it. And it's something that we can do together as a family.

Ted: 00:58:23 That's great. If you started your career over today and money's no object and you couldn't be an investor what do you think you'd like to do?

Raj: 00:58:33 It's hard to picture myself doing anything, but I'll tell you an area I've been passionate about. And it's perhaps living in San Francisco education policy. If you just take COVID as an example, the quality of opportunity notion here, and Warren Buffett's winning the genetic lottery. It's just not creating an even playing field. My kids go to a private school. They had Spring break, Easter break, and then the week coming out, they had full days at school, complete virtual learning conversion. My understanding is the public schools in Sacramento. Even now you're lucky to get a one or two hours of school a day. I mean, we are creating a have not society. And even well-meaning places like San Francisco, you think liberal policy, there's just flawed policy creating a real issue in America. I think I'd like to spend some time there.

Ted: 00:59:30 How about your biggest investment pet peeve?

Raj: 00:59:33 I'm probably going to get in trouble for saying this, but I'd say my current biggest pet peeve is I find investors are really focused on source of alpha. Where do you generate the source of your alpha? And I think the real question is how much alpha are you generating? How consistent is it and how sustainable or defensible is it? That's really the question. And if you feel comfortable with that, the source of alpha shouldn't matter as much.

Ted: 01:00:05 What teaching from your parents is most stayed with you?

Raj: 01:00:08 I think it's probably one of my dad's sayings that he would always hammer home to me and everyone. He's an internal optimist. And he always said, don't look back, look forward. What he really meant by that is learn from your mistakes, but you can't dwell on the past. You can't change the past, really look forward. And it's a really good actual way to live your life. And he lives his life that way. And it's really quite remarkable.

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And it's great. You don't have regrets. You don't live constantly with regrets.

Ted: 01:00:41 Great. raj. Last one, what life lesson have you learned that you wish you knew a lot earlier in life?

Raj: 01:00:47 This is going to sound trite, Ted, but, and it's taken me a while to get to this point. And not that I'm perfectly there anyway. I spent so much of my life striving and thinking about tomorrow. And when you're doing that, you don't enjoy the moment. And you can apply that to your family, to your kids, are you really enjoying the moment with your kids? And I do find myself really making a conscious effort to enjoy the moment more. So even with advantage of, for the building process, to me isn't when... It's always ups and downs and there's always tribulations, you need to go through. But enjoying the moment.

Ted: 01:01:22 Great, raj, thanks so much for taking time.

Raj: 01:01:26 Thank you Ted.

Speaker 1: 01:01:32 This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. All opinions expressed by guests on the show are solely their own opinion and do not necessarily reflect those at their firm. Managers appearance on the show does not constitute an endorsement or investment recommendation by Ted or Capital Allocators.