Strategically Speaking Grandmaster Capital Management
“Under no circumstances should you play fast if you have a winning position,” advised Hungarian chess Grandmaster Pal Benko. “Use all your time and make good moves.”
Chess can be a long, strategic game. It can also be brutally short if you lose control of the board. Patrick Wolff, founder and managing member of long/short equity fund Grandmaster Capital Management, knows all about that: a Grandmaster and two-time US chess champion, as a junior he crushed world champ Garry Kasparov in a blistering 25-move simultaneous exhibition match. But his investment style is also about taking the very long view while limiting exposure to catastrophes. The influence of Peter Thiel, his mentor at Clarium Capital, is evident, but also Warren Buffett – Wolff has been known to take on all comers (blindfolded!) at Berkshire Hathaway shareholder meetings.
“Getting caught up in the game of trying to figure out what somebody else will pay for your stock a year from now is a fool’s errand,” he says. “You are a minority owner of the businesses you hold. It’s much easier to make a good return over time by compounding in a business that’s growing rather than trying to generate a new idea every six months. It is also a much better use of your resources because it gives you a much longer time horizon in any given position.”
Do not play fast if you have a winning position, as Benko said. So what is a winning position for Grandmaster? In Wolff’s words: “A good business at a reasonable price where something interesting is happening.”
A good business has a defensible competitive position and is well-managed. The catalyst element is important but Wolff ultimately balks at the ‘GARP’ label. You do not generally get growth at a reasonable price, he argues, whereas you often can buy quality at a discount.
“What really matters is whether a company will enjoy as good or better prospects for earning money five or 10 years down the road,” he says.
• 2011: Founder, Grandmaster Capital Management
• 2005-10: Clarium Capital Management, ultimately managing director and member of the investment committee
• 1997-2005: Various roles in strategy consulting, internet start-ups and banking
• 1989-1995: Professional chess player, a Grandmaster and two-times US champion
There tends to be 15-20 of these stocks on the long side of the book. The short side is more diversified to deal with the fatter left tails of short selling, an example of how Grandmaster protects its core five to 10-year investment views with downside risk management. But it is not about hedging risks on the long side. Every position has to make sense based on its own fundamentals, so the last thing Wolff wants is to take that risk out again.
There are inevitably risk overlaps: while the strategy is bottom-up fundamental, top-down themes do run through it and characterise holdings both long and short.
“If I’m wrong on these things I will get hit on both sides,” Wolff concedes. “So I need to be right about the risks I am explicitly trying to take, and manage the risk that I’m wrong by taking appropriate exposure – leverage magnifies returns in both directions and in this business if you go too far down you don’t get to come back up again.”
A top-down view is important because, as Wolff observes, when things go very, systemically wrong, bottom-up is rarely the right way to think about what is going on. But the top-down ideas running through the portfolio today are more evident in what is absent than what is present. Look at the portfolio, and you see a tilt to quality companies in the US. But that only hints at Grandmaster’s strongest-held convictions, which concern the past 20 years’ big themes of commodities and emerging markets.
“The boom in emerging markets of the last decade has come to be regarded as ‘the way things are’,” says Wolff. “But I regard it as a cyclical aberration still waiting to be corrected.”
For those persuaded by the new fiscal strength in many emerging economies, Wolff’s contention that “the fundamental difference between First World and Third World countries” is that capital runs to the former and away from the latter in a crisis will look hopelessly outdated. He simply points to 2007-11 as yet another case in point.
He identifies China as the likely source of the next big crisis. While acknowledging that its reserves make it unlikely to suffer a 1997-style balance-of-payments crunch, he feels its gross misallocation of resources set-up a solvency crisis that will make the liquidity crunches of 2007-08 look minor.
“We have never before seen an economy generate half of its output from fixed-asset investment,” he observes. “If you believe much of that is not required, it is the worst kind of economic activity – the more you do, the poorer you are. And more and more is being underwritten by debt. This massive credit expansion has led to very little gain in production, which suggests credit is funding current operations – which in turn tells you something about how profitable those operations are. We know what happens when investment booms come to and end. It’s ugly.”
Wolff paints a picture of a loss of confidence in the Chinese state itself and a resulting capital flight as the wealthiest Chinese head for the developed world. “Can China institute reforms quickly enough to re-build the aircraft while it’s still flying?” he asks. “Maybe, and I hope so – but I’m not optimistic.”
Grandmaster Capital Management
• Established: 2011
• Assets under management: $250m (€200m)
• Strategy: Long-term, bottom-up long/short global equity
One position explicitly expresses this view – Grandmaster spends about 40bps a year on USD/CNY calls – but you’ll only find a handful of China stocks in the short book, all there for bottom-up reasons.
“Just because something is a bubble that doesn’t mean the best risk-reward comes from trying to short it,” Wolff explains. Because he claims no better idea of when the crash will come than anyone else, the view is expressed in the lack of China longs, a bias away from Europe (where companies have more China exposure) and a continuing focus on US quality. Eight years ago Grandmaster might have cited the bubble in US housing as a reason to hold McDonald’s.
“What has McDonald’s got to do with US housing?” Wolff asks. “Exactly – nothing. The stock is up three-times since 2006 so who cares about the volatility during 2007-08? Earnings were barely affected.”
When your very long-term strategy agrees with your view on how to handle shorter-term risks, that helps you stay the course – including, and perhaps especially, when things seem to be going so well. US quality has hugely outperformed China, emerging markets and commodities over recent years, but Wolff expects much more yet from these trends.
“If I’m right, we need to get to a point where almost no-one regards commodities as a respectable asset class, and where everyone recognises China has a long, long way to go to converge on the developed economies,” he says.
The focus on cash flows rather than price action helps to maintain that discipline. The steely nerves of the Grandmaster, always looking 10 moves ahead, cannot do any harm, either.
“Knowing the King’s Indian Defence doesn’t teach you how to read a balance sheet,” as Wolff puts it. “But high-level chess does teach you about how you react under the pressures of both success and failure. I think it would be valuable to take that self-knowledge into future endeavours – whether investment management or anything else.