Universa article

March 2020 was a rough month for hedge funds, with a dismal industry performance of negative eight point one two percent returns across thousands of funds of varying sizes and strategies. Yet not everyone was caught wrong‑footed in the market turmoil. Mark Spitznagel, protégé of Nassim Taleb, hedge fund manager, and part‑time gentleman farmer slash goat cheese producer, booked a staggering return of three thousand six hundred twelve percent in the month of March amid one of the most severe crashes in market history.

The question is: how did he do it? An investor's strategy is, like Spitznagel’s strategy, a magician's tricks or a chef's prized recipes — proprietary secrets to be protected at all costs. Spitznagel even admonishes against trying to emulate his strategy, stating: “This is a dangerous place for amateurs and professionals alike to play, so I'm doing people a favor when I'm not telling them what we do.”

I find this staunch warning to be somewhat puzzling. After all, he devotes two full chapters in his book The Dao of Capital to the practical application of his theory of roundabout investing. And while the strategies outlined therein are admittedly simplifications, the data indicates someone following those principles would have outperformed the market over the past 100 years.

Past performance is not indicative of future success, however, and Mark Spitznagel is a truly gifted individual who, by the age of 20, had already made over four hundred eighty thousand dollars writing a program for Hewlett‑Packard in the early 1990s. He also has a cadre of other mathematically inclined PhDs at his disposal, so undoubtedly the strategies discussed in this video only scratch the surface when it comes to the level of sophistication seen at his fund.

I am also not an investment advisor, and these videos are for educational purposes only. With that out of the way, let's go over the two core ideas behind Spitznagel’s investment strategy: number one, tail hedging; and number two, value investing in businesses with a knack for the value‑creating, efficient allocation of resources — businesses he refers to as “Siegfrieds,” after the dragonslayer in Richard Wagner's Ring Cycle.

Tobin’s Equity Q Ratio The first strategy is closely related to Tobin's equity Q, which is the ratio between an asset’s market value and its replacement value. Take the McDonald's Corporation, for example. It is a publicly traded company with a market capitalization of around 135 billion dollars. We can plug this number into the numerator. Now, they hold a number of assets: land and improvements, buildings and improvements, machinery, furniture, equipment, goodwill, and other tangible assets like the iconic golden arches logo and the intellectual property on Ronald McDonald and a slew of other characters. For some of these, the replacement value associated with McDonald's — the cost of essentially trying to replicate the company's business operations — goes into the denominator.

The Federal Reserve aggregates this data for all non‑financial corporate businesses, allowing us to calculate Tobin's equity Q ratio for the U.S. stock market as a whole. Broadly speaking, an excursion into deep fractional territory — like in Q1 of 2009, when Tobin's equity Q ratio bottomed out at 0.66 — signals corporate assets are severely undervalued and likely primed for a nice leg up. Similarly, a soaring ratio like the all‑time high of 2.14 reached in Q1 of the year 2000 portends a momentous market correction.

The data in Spitznagel’s book is more complete than the time series found on the Federal Reserve Bank of St. Louis’s website and goes back to 1901. He also scales the chart by applying a running geometric average to the data series, revealing the sobering nature of the boom‑and‑bust cycle. After the first cycle from 1901 to around 1925, a simple strategy of buying near the lows and selling — and going into one‑month Treasuries near the top — would have consistently beaten the market and outperformed the overwhelming majority of hedge funds.

Tail Hedging Strategy Spitznagel further refines this strategy through the introduction of out‑of‑the‑money put options. When Tobin's equity Q ratio shows a reading in the third and fourth quartiles, a simple tail‑hedging strategy with a 0.5% monthly allocation to two‑month, 30% out‑of‑the‑money puts on the S&P outperforms the index and allows the holder to remain invested in quality stocks on the long side throughout periods of market turbulence.

Now, admittedly, while one could argue the nature of the business cycle was already apparent in the 1920s, the 1940s, and the 1960s, it would have taken a great deal of foresight and courage to implement such a strategy. Plus, we have been seeing higher peaks and higher valleys, to such an extent that someone hoping for a retrace back to the 1980 lows would have missed both the post‑dot‑com bubble rally and the stock market boom that started on March 10th, 2009.

That notwithstanding, I believe there is both deductive and empirical validity to this simple strategy because of the numerous and not‑at‑all‑infrequent opportunities for extreme returns in recent years: the August 24th, 2015 flash crash; the early 2016 downturn; the June 2016 referendum; the 2016 elections; the day the VIX doubled in February 2018; the Christmas crash of 2018; and the recent 2020 stock market crash.

Unsurprisingly, as of March 26th, 2018, Spitznagel’s Universa hedge fund had delivered a compound annual growth rate of 12.3% between March 2008 and February 2018. After the March 2020 payday, Universa's flagship Black Swan fund has produced a mean annual return on invested capital of 76%. As you can see, tail hedging has been a rewarding strategy in recent years and is likely to remain so for as long as equity prices continue trading at levels greatly detached from the historical average.

Value Investing and the Faustmann Ratio This is the tail‑hedging aspect, but ideally one would apply this protective strategy to a portfolio consisting of names capable of delivering excess returns over the S&P 500. Spitznagel hones in on productive companies with extreme returns of over 100% on invested capital. This makes intuitive sense, as you'd probably want to stay away from capital‑intensive businesses with low profit margins, like those in the automotive sector. Ideally, you'd want to find a company capable of delivering the most profit with the least amount of capital outlay. Moreover, a higher return on capital virtually guarantees companies will want to reinvest in the business, and it is this compounding over the years that leads to explosive exponential growth later on.

But return on invested capital alone isn't enough. Any individual title worthy of inclusion in our portfolio should also have a low Faustmann ratio. Originally developed in the field of forestry studies, the Faustmann ratio compares the expected value of developing a given parcel of land — the land expectation value (LEV) — to the land replacement value (LRV).

The price of a stock, and by extension its market cap, is determined by discounting the sum of future cash flows — its expected value. So the Faustmann ratio is just as applicable to forestry rotation as to the capital markets. If you estimate a company will generate half a million dollars in profits over the next five years and another million over the rest of its active lifespan, how much should you be willing to invest in the present? This calculus is the stock market in a nutshell: find out what something is worth and try to pay less than fair market value.

Ideally, we want a growth stock that is so severely undervalued that the market thinks it's worth less than the cost to replace its machinery, intellectual property, etc. So what we're really looking for is a Faustmann ratio at or below 1.

As applied to the valuation of companies, the Faustmann ratio is equal to market capitalization of equity divided by net worth. This calculation is somewhat tedious but can be performed through diligent digging in the balance sheet. This is to be expected because, after all, the path of least resistance is hardly ever profitable.

Spitznagel's strategy isn't for everyone, as you can look rather foolish paying insurance while waiting for a market crash that may never come. Most people would prefer a steadier, less volatile ride. But I believe Mark Spitznagel’s results speak for themselves and make Universa's hedging strategy worth looking into.

Alternative article

March 2020 was a tough month for most investors – amateur and professional alike; the operating keyword being “most,” because for Mark Spitznagel’s hedge fund Universa Investments L.P. the 2020 stock market crash was a moment of vindication; and a very profitable one at that.

To wit, the fund returned 3,612% in the month of March alone, after Spitznagel’s long-standing tail hedging strategy paid off spectacularly.

Now, Mark Spitznagel is a highly sophisticated investor managing his own and other people’s money; he runs a business, not a charity, so he won’t exactly be holding us by the hand and walking us over the fine minutiae of his strategy.

Still, he has shared his investment philosophy, even going as far as offering a couple of fairly actionable pieces of advice in his book ‘The Dao of Capital.’

First, he uses Tobin’s Equity Q as a barometer of market exuberance: when a stock’s market valuation far eclipses the replacement cost of the equipment, intellectual property, etc. – the cost of replicating the business – that means the market’s about to undergo a steep correction.

Corollary to this is the use of strategic put options – insurance if you will – to protect one’s portfolio against these inevitable draw-downs, while at the same time benefiting from a basket of stocks on the long side.

Moreover, if we’re going to hedge against portfolio losses, we want to be invested only in the best, most profitable stocks the market has to offer.

According to Mark Spitznagel, the two criteria for what makes a stock worthy of inclusion in our hypothetical portfolio is a high Return On Invested Capital (ROIC), ideally above 100%.

This makes intuitive sense: a high ROIC indicates extreme efficiency and the correct allocation of resources.

It also means the company is likely to reinvest those profits back into the business: after all, why invest in bonds or leave the money in the bank, or invest in other companies when those funds could be put to work in a business the owners know like the back of their hand?

A high ROIC is only half the story, however, because stocks should also have a low Faustmann Ratio – the ratio between the market capitalization of a company and its net worth.

Now, this Faustmann Ratio is somewhat tedious to calculate, but the operating principle here is similar to Tobin’s Equity Q: it only makes sense to invest in a company when it is being undervalued by market participants.

In other words, a company is thought to be undervalued when the market capitalization is equal or lower to the net worth, which is the sum of a company’s invested capital and its cash balance minus the debt and preferred equity.

During boom times, the cost of protecting the portfolio means Mark Spitznagel’s returns will likely lag the S&P 500, making him look like a bit of an underachiever.

Yet, when a black swan comes along (every one or two years now, it would seem…) the strategy is vindicated, further solidifying Universa’s investment track record.