Investor Essentials Daily

This hedge fund legend has emerged with a new identity after overcoming previous scandals

March 19, 2021

It’s never a good sign when a company needs to change its name because of a scandal. But sometimes the company that emerges keeps what made it great, and can now leave behind the legacy of its prior poor decisions.

This investment manager used to be one of the most successful firms in the industry, but poor decisions laid it low. It’s kept its smart analyst team, but moved away from its founder to try to get past its prior scandals.

In addition to examining the portfolio, 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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It has been nearly a year since we took a look at Sculptor Capital Management.

The firm, originally called Och Ziff, was founded in 1994 by Daniel Saul Och. After a few scandal-filled years, Och rebranded the fund to align it with a new era.

Since the rebrand, Sculptor Capital has maintained the same great performance investors expected from Och Ziff. A lot has changed in the last year, and we feature an updated portfolio analysis below.

Industry-leading firms don’t generally change their names.

There are plenty of examples of companies that have changed their name, although generally early in their lives. Any simple internet search will tell you that Google used to be called “BackRub,” or Best Buy used to be called “Sound of Music,” Nike used to be called “Blue Ribbon Sports,” and Pepsi…Pepsi was “Brad’s Drink.”

But generally, those name changes occurred early in a company’s life. The company rebranded before it took off, to better reflect the company’s offering.

Sometimes though, a company needs to rebrand for entirely different reasons.

Two of the most famous scandals of the past 20 years were Enron and Valeant Pharmaceuticals, and both led to companies changing their names to distance themselves from the bad press and history of prior decisions.

Enron’s accounting fraud didn’t just bring down the company, it brought down one of the “Big Five.”

Its accounting firm, Arthur Andersen, was one of the five global accounting firms, along with Deloitte, Ernst & Young, KPMG, and PwC. But Arthur Andersen’s size wasn’t enough to protect it. Its contribution to the scandal brought the accounting firm down in the midst of the controversy.

While the scandal brought down the accounting firm, it didn’t bring down its prior subsidiary, a very successful consulting and outsourcing business, Andersen Worldwide. That business had spun out from Arthur Andersen just before the crisis, and was quick to rebrand in the midst of the crisis to distance itself.

You may have heard of the firm, one of the largest consulting firms in the world: Accenture.

Similarly, Valeant’s crisis almost brought down the firm. There were real concerns for investors about how real the company’s revenues were, and if the company could handle the mountain of debt it had built in its roll-up.

After stabilizing the business, the new management team understood they could never rebuild the Valeant brand. It was better just to walk away from it.

Hence, why you probably might have heard the name Bausch Health, after Bausch + Lomb, Valeant’s largest business segment. That’s the name Valeant rebranded itself as.

That need to rebrand after a crisis to move on from the past isn’t something that is exclusive to the public companies you can invest in. Investment firms sometimes need to do the same.

Daniel Och is a legend in the hedge fund world. He founded Och Ziff in 1994 after 11 years at Goldman Sachs, and he left having run the firm’s prop trading desk.

He built Och Ziff into a $50 billion assets under management (AUM) behemoth and took the company public. He was one of the first to see the opportunity of bringing institutional money to the land of hedge funds, such as pensions, and endowments.

He revolutionized the industry in many ways and had an impressive track record in his day job running a hedge fund.

But after the late 2010 scandals from the company’s African government bribes, the company faced an issue: continuing on with the name and founder, now tarnished with a scandal that its institutional investors would not be comfortable signing off on, or starting anew.

The firm’s decision was the latter. Och was transitioned out of the firm and the company was rebranded as Sculptor Capital. But the investment team, the people who had made the company one of the “smartest groups in the room” even in the world of hedge funds, was kept.

These were the young analysts and portfolio managers that had helped Och Ziff, now Sculptor, become a powerhouse in not just equity investing, but also credit and real estate. The investors that had understood how to identify mispriced investments and successfully profit from them, even with a bulls-eye on their backs as one of the biggest players in the space.

But considering the challenging last few years of the company, one can’t help but wonder if the team might have lost its focus and if Sculptor has lost its edge.

We’ve conducted a portfolio audit of Sculptor’s top equity holdings, based on their most recent 13-F, focusing on their non-financial company holdings.

We’re showing a summarized and abbreviated analysis of how we work with institutional investors to analyze their portfolios.

Unsurprisingly, for the most part, Sculptor’s research appears to line up with Uniform Accounting.

Uniform Accounting metrics highlight the company’s equity investments are much higher quality, and have higher potential, than the market and as-reported metrics imply.

See for yourself below.

Sculptor sees through the accounting noise to pick up names markets are completely misunderstanding, often because of accounting issues.

On an as-reported basis, many of these companies are poor performers with returns around 5%, roughly 2x below the corporate average ROA of around 12%.

However, once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see that the returns of the companies in Sculptor’s portfolio are much more robust.

The average company in the portfolio displays an impressive average Uniform return on assets (ROA) at 32%. This is well above corporate average returns.

Once the distortions from as-reported accounting are removed, we can realize Booking Holdings (BKNG) doesn’t have an ROA of 2%, but returns of 106%. Booking Holdings isn’t a low-return business, it is a company with robust cash flows that Sculptor thinks is misunderstood by both equity investors.

Similarly, Alibaba’s (BABA) ROA is really 119%, not 5%. Sculptor’s focus on better accounting and credit analytics recognizes a high return business with cash flows to handle obligations.

UnitedHealth Group (UNH) is another great example of as-reported metrics mis-representing the company’s profitability.

UnitedHealth’s ROA isn’t 8%, it’s actually 32%. Uniform Accounting lines up with Sculptor’s decision making, showing the company is really a high return business.

The list goes on from there, for names ranging from Apple (AAPL) and Salesforce (CRM), to Spirit AeroSystems (SPR) and Facebook (FB).

If Sculptor’s investment strategy was powered by as-reported metrics, it would never pick most of these companies, because they look like bad companies and poor investments.

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 generate real alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

Sculptor 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:

  1. The 2-year Uniform EPS growth represents what Uniform earnings growth is forecast to be over the next two years. The EPS number used is the value of when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  2. The market expected Uniform EPS growth is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we show by 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 analyses and reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for Uniform earnings growth.
  3. The Uniform EPS growth spread is the spread between how much the company’s Uniform earnings could grow if the Uniform 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. Sculptor’s holdings are forecast by analysts to grow by 6%, only slightly above the average.

Despite this, the market is pricing these companies to grow earnings by 12% a year on average. While these companies are growing faster than the market, they are intrinsically undervalued, as the market is mispricing their shrinkage at 6%.

These are the kinds of companies that are likely to see their stocks rally when the market realizes growth potential. This may be the market pricing some of these companies for massive declines in profitability in distressed credit situations. Without Uniform numbers, investors cannot see the strength of these names.

One example of a company in the Sculptor portfolio that has growth potential that the market is mispricing is Alibaba Group Holding Limited (BABA). BABA’s analyst forecasts have 22% Uniform earnings growth built in, but the market is pricing the company to have earnings growth by 30% earnings each year for the next two years.

Another company with dislocations is Alphabet Inc. (GOOGL). This might look like a company Sculptor is misunderstanding initially, with low market expectations.

Market expectations call for a 3% growth in earnings. However, the company is actually forecast for Uniform EPS to grow by 4% a year. GOOGL only has to overcome these sluggish expectations to see upside.

Yet another is UnitedHealth Group Incorporated (UNH). The firm is priced for a 2% expansion in uniform earnings, when they are forecasted to grow earnings by 11% a year.

For the most part, Sculptor’s holdings are high quality, undervalued portfolios with businesses displaying strong earning power. This wouldn’t be clear under GAAP, but unsurprisingly Uniform Accounting and a system built to deliver alpha see the same signals.

SUMMARY and Alphabet Inc. Tearsheet

As Sculptor’s largest individual stock holding, we’re highlighting Alphabet’s tearsheet today.

As the Uniform Accounting tearsheet for Alphabet Inc. (GOOGL) highlights, Alphabet’s Uniform P/E trades at 23.3x, which is around the corporate average valuation of 25.2x, but around its own historical valuation of 19.5x.

Average P/Es require average EPS growth to sustain them. In the case of Alphabet, the company has recently shown a 6% 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, Alphabet’s Wall Street analyst-driven forecasts are 22% EPS growth in 2021 and 11% EPS shrinkage in 2022.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify $2,021 per share. These are often referred to as market embedded expectations.

The company can have Uniform earnings shrink by 7% each year over the next three years and still justify current price levels. What Wall Street analysts expect for Alphabet’s earnings is below what the current stock market valuation requires in 2021 and 2022.

Furthermore, the company’s earning power is 3x the corporate average. Also, cash flows and cash on hand are consistently exceeding its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals a low credit and dividend risk.

To conclude, Alphabet’s Uniform earnings growth is well above its peer averages, while their valuations are traded below its peers.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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