This fund’s insights are as coveted as the Ark of the Covenant
With deep knowledge in the world of mathematics and quantitative investing, this gentleman’s fund has had the strongest sustained returns of any investing great in the recent past.
The manager of this fund spent most of his time in the classroom, teaching. And as the saying goes, the best way to learn is by teaching.
In addition to examining what made this professor’s portfolio so great, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.
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Note from Valens: We originally published about Renaissance Technologies in February of 2020, just before the coronavirus market sell-off. With big changes to both the market, and this portfolio, we wanted to revisit and refresh our analysis of this legendary fund with an updated portfolio analysis.
Much like Indiana Jones, this hedge fund titan has spent his fair share of time in the classroom, but what has really made him famous is his success in applying his knowledge in the field.
Thanks to his team’s research, at the forefront of quantitative investing, his fund has had the strongest sustained returns of any investment great in the recent past.
In Raiders of the Lost Ark, Indiana Jones is teaching an Archaeology 101 class before Marcus Brody comes to him to send him on his quest to find the Ark of the Covenant.
His students hung on to his every word, not just because they wanted to excel in the class, but they wanted him to grade their exams. They even tried to break down his door to get him to do that after the lecture was over.
While they viewed Indy as a teacher—and a hard one to pin down at that—little did they know where Indy had been before, or where he’d go after.
They didn’t know that Indiana Jones had been an adventure-driven archaeologist for years, from his youth when he found the Cross of Coronado, to having recently survived a temple run at the Temple of the Chachapoyan Warriors.
They also didn’t know where Indy would be heading when he snuck out the window of his office, off to find the Ark. In a future adventure during World War II, he would successfully discover and identify the Holy Grail in a race against time against the Nazis.
In much the same way, one wonders if the students at Jim Simons’ class at Stony Brook University in Long Island knew who they were studying under.
After Simons graduated MIT and Berkeley with a PhD in mathematics, he contributed to develop a great deal of research on manifolds and characteristic classification work. These are complex areas of geometric studies.
This work lent itself to cryptography, and so his work caught the attention of the National Security Agency (NSA). They wanted Simons to work as a code breaker, which he did, for the NSA and Institute for Defense Analyses (IDA) until 1968, when he joined Stony Brook’s faculty, eventually becoming the chairman of the math department.
But it is what Simons did after he left his students at Stony Brook full time that is impressive.
Much like Indiana Jones, Simons set off to find the holy grail…and found it.
Simons found the holy grail of investing, an investment strategy that could generate returns so massive that even after steep fees, it would trounce the market and rarely have negative returns.
Simons founded Renaissance Technologies, one of the most respected quantitative hedge funds in the world, in 1978. It was originally called Monemetrics, before it changed its name in 1982.
Renaissance’s flagship Medallion Fund, which has been closed to outside investors since 1993, and has not had any outside money at all since 2005, did 98.2% in 2008 when the S&P was down 38.5%.
It has produced an annualized 66% gross return since 1988, and a 39% net annualized return even after the fund’s significant fees. Over the 12 years from 1993 to 2005, the fund only posted 3 down quarters.
It is arguably the most impressive track record in the entire investing industry.
Simons built Renaissance on a few key principles.
The first was a deep focus on pattern recognition analysis, similar to the type of work his thesis was on, and that he worked on in the realm of cryptography.
The second principle was to stay as far away from MBAs and those with a Wall Street background. Instead, Renaissance is sometimes stated as having one of the best math and physics departments of any institution, academic or corporate, in the world.
Simon’s view is that the group thinks across Wall Street on how the market should work, the relationships assets should have, and the type of education and information that is useful are part of the reason the market is sometimes as inefficient as it is.
Instead, bringing knowledge from its physics and math PhDs, Renaissance has been analyzing correlations and relationships between markets, corporate fundamentals, and various datasets for decades. Renaissance was working with petabyte-sized databases long before big data was a term used in business and in investing.
Even as other quantitative investors have attempted to catch up to Renaissance, the company’s strategies and research continues to unlock significant value.
Much like Bridgewater, Renaissance’s focus is not having analysts actively picking stocks. The firm’s quantitative strategies identify stocks and other assets to buy and sell operating off the company’s research.
But even without active stock pickers, looking at the stocks Renaissance’s process identifies to generate alpha is instructive.
It is an interesting exercise to see if Uniform Accounting lines up with the quantitative strategies Renaissance is using.
We’ve conducted a portfolio audit of Renaissance’s top holdings, based on their most recent 13-F.
We’re showing a summarized and abbreviated analysis of how we work with institutional investors to analyze their portfolios.
Unsurprisingly, for the most part, Renaissance’s analytics appear to be steering the portfolio to companies that Uniform Accounting metrics highlight are much higher quality, and have higher potential, than the market and as-reported metrics imply.
Because Uniform Accounting metrics do a better job of identifying real corporate performance than as-reported distorted metrics do, UAFRS is more likely to identify candidates to generate alpha.
Even though Renaissance is coming at identifying those companies from a very different direction, their process is unsurprisingly identifying the same signals UAFRS does.
See for yourself below.
Using as-reported accounting, investors would be scratching their heads at some of the companies that Renaissance owns.
On an as-reported basis, many of these companies are poor performers with returns below 5%-6%, and the average as-reported ROA is only 9%. The average company in the portfolio displays an impressive average Uniform return on assets (ROA) at 40%. That’s well above the current corporate average returns.
On an as-reported financial metric basis, it would appear that Renaissance was identifying companies that were primed for an inflection in returns based on Renaissance’s other data, not that they were identifying strong companies.
However, once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see that the returns of the companies in Renaissance’s portfolio are much more robust.
In fact, looking at the companies that Renaissance is buying on a Uniform basis, it’s clear Renaissance is buying companies with strong economic moats that will keep on performing well in this mid-to-late cycle environment.
Once the distortions from as-reported accounting are removed, we can realize that VeriSign (VRSN) doesn’t have a 29% ROA, it is actually at 110%. VeriSign is a strongly-positioned software security company that is both growing and producing impressive profitability for shareholders.
Similarly, Monster Beverage (MNST) ROA is really 143%, not 18%. Renaissance’s quantitative strategy sees its strong profitability and visibility of earning power.
Bristol-Myers Squibb (BMY) is another great example of as-reported metrics mis-representing the company’s profitability. If Renaissance’s model was powered by that data, it wouldn’t be identifying the company’s strong fundamentals.
Bristol-Myers doesn’t have a 4% ROA, it’s actually at 34%. Renaissance’s system appears to understand that the market pessimism for the company is overblown and that the company’s real fundamentals are strong enough to warrant upside.
The list goes on from there, for names ranging from Palo Alto Networks (PANW) and Biogen (BIIB) to Fortinet (FTNT), Zoom (ZM), and Baidu (BIDU).
If as-reported metrics tracked the economic reality that Renaissance is identifying using their models, these companies wouldn’t show up in its portfolio, because they look like bad companies and poor investments.
But to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics mis-represent 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.
Renaissance is also investing in companies that the market has low expectations for—low expectations the companies can exceed.
This chart shows three interesting data points:
– The first datapoint is what Uniform earnings growth is forecast to be over the next two years, when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework. This represents the Uniform earnings growth the company is likely to have, the next two years.
– The second datapoint is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we are showing how much the company needs to grow Uniform earnings in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily and our reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for Uniform earnings growth.
– The final datapoint is the spread between how much the company’s Uniform earnings could grow if the Uniform Accounting adjusted earnings estimates are right, and what the market expects Uniform earnings growth to be.
The average company in the U.S. is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. Renaissance’s holdings are forecast by analysts to outpace that, growing at a healthy 16% a year the next 2 years, on average.
Renaissance’s system is not just finding high quality companies; it is finding mispriced companies.
On average, the market is pricing these companies to shrink earnings by 13% a year, below market averages. These companies are intrinsically undervalued, as the market is mispricing their growth by 29% on average.
These are the kinds of companies that are likely to see their stocks rally when the market realizes how wrong it is. Without Uniform numbers, the GAAP numbers would leave everyone confused.
One example of a company in the Renaissance portfolio that has growth potential that the market is mispricing is Bristol-Myers Squibb (BMY). Bristol-Myers’s analyst forecasts have 22% annual Uniform earnings growth built in the next two years, but the market is pricing the company to have earnings shrink by 18% each year for the next two years.
Another company with similar dislocations is Zoom (ZM). Market expectations are for 90% growth in earnings. However, the company is actually forecast for Uniform EPS to grow by a robust 204% a year. If it can deliver on this growth, there’s more upside, even after how far the company’s stock has rallied the past few years.
Yet another of the fund’s largest holdings, Baidu (BIDU), which is priced for a 14% decline in Uniform earnings, when they are forecast to grow earnings by 1% a year.
Unsurprisingly, considering the quantitative nature of the strategy, there are very few companies in the portfolio that look misplaced in this strategy. Only one name appears to have a significantly negative dislocation between what the market is pricing in and what is forecast.
But for the most part, Renaissance’s quantitative portfolio looks like a high quality, undervalued set of stocks with businesses displaying strong earning power. It wouldn’t be clear under GAAP, but unsurprisingly, Uniform Accounting and a system built to deliver alpha see the same signals.
SUMMARY and Baidu, Inc. Tearsheet
As the Uniform Accounting tearsheet for Baidu, Inc. (BIDU) highlights, Baidu’s Uniform P/E trades at 9.3x, which is below the corporate average valuation of 23.7x, but around its own historical valuation of 9.2x.
Low P/Es require low, and even negative, EPS growth to sustain them. In the case of Baidu, the company has recently shown a 37% 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, Baidu’s Wall Street analyst-driven forecasts are 10% EPS shrinkage in 2021 and 14% EPS growth in 2022.
Based on current stock market valuations, we can back into the required earnings growth rate that would justify Baidu’s stock price of $191.55 per share. These are often referred to as market embedded expectations.
The company can have Uniform earnings shrink by 17% each year over the next three years and still justify current price levels. What Wall Street analysts expect for Baidu’s earnings is above what the current stock market valuation requires in 2021 and 2022.
Furthermore, the company’s earning power is 6x the corporate average. Also, cash flows and cash on hand are 5x its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals a low credit and dividend risk.
To conclude, Baidu’s Uniform earnings growth is below its peer averages, while their valuations are traded well below its average peers.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research