The Interview – Pedro Noronha, Noster Capital: “The two most important assets a manager can have are a stable capital base and patience – like Warren Buffett”

Pedro Noronha, managing partner of Noster Capital, says the firm’s proprietary indicators currently say that the green shoots crowd is too early in pricing a V-shaped recovery into the market, and that credit spreads, which have tightened to levels that are in some instances similar to the top of the market bubble, are set again to widen considerably once new problems with European bank lending start to surface.

GFM: What is the background to your company and fund?

PN: Noster Capital was formed in September 2007 following my resignation from JP Morgan. Since 2003 I had managed the European Special Situations portfolio for the proprietary positioning business, an independent division within JP Morgan that reported directly to the board of directors.

The Noster Capital fund, currently the firm’s only one, was launched in March 2008 and follows a global long/short value investing strategy with a macro overlay. The fund has currently around USD40m in assets, which mostly came from the managing team. Only now, after 15 months of operations, is the fund opening itself to outside investors.

GFM: Who are your key service providers?

PN: Noster Capital’s auditor is Deloitte, its law firm is Simmons & Simmons, its fund administrator is UBS and its prime broker is Goldman Sachs.

GFM: Have there been any recent key events such as changes to the management team?

PN: We have been building up the team slowly as we have been focusing on creating a solid platform for a high performing operation. Noster currently has three full time employees and is currently adding a partner as director of research.

GFM: What is the profile of your client base?

PN: Noster is different from most other hedge fund managers in that we tend to concentrate in medium- to long-term trades. We view most of the hedge fund arena as very short-term focused and often too catalyst-driven. When more than 90 per cent of managers are looking for short term trades, a number of appealing medium- to long-term investments open up, where mispricing is much more frequent.

In our view the two most important assets a manager can have are a stable capital base and patience. Having both places a manager ahead of the game by a significant margin. (Interestingly, Warren Buffett has exactly this characteristic). The current investment universe mainly comprises managers who don’t possess either, and that’s why many people have become disenchanted with returns in the industry.

Patience is something that one is either born with or not – there’s not much one can do to become more patient and less trigger-happy. A stable capital base, however, is under almost complete control of a manager, unless they are too greedy and accept pretty much anybody into their funds.

That’s where we believe we are different. To begin with, we don’t tend to accept money from funds of funds, which we view as too short-term driven and unlikely to accept any kind of volatility. These funds are all looking for the T-bond plus 400 basis points manager with low volatility. We are looking for almost exclusively ultra high net worth individuals, and only those who we think understand our model of investing for the medium to long term. Our assets are currently 100 per cent from private clients and we don’t intend to change this focus.

GFM: What is your investment process?

PN: Our investment process is another differentiating factor. We are fundamental value investors at heart and employ a very thorough investment process. On any given position in the portfolio we have an extensive and highly detailed report that includes detailed forensic analysis and investigation – no stone is left unturned.

We read and analyse all annual and quarterly reports to understand better the capital structure and operations of the company. We speak with the management, competitors, suppliers and clients. It’s very important in our view to assess whether the company has a competitive advantage (a moat), and if so, whether it is a durable one.

Lastly we value the company using different sensitivities and various valuation methodologies (free cash flow multiples, M&A comparables, trading comparables, leveraged buyout models and discounted cash flow models) in order to get a better idea of the intrinsic value of the business and the sensitivity of valuation to ever-changing variables. These are proprietary models; we do not rely on the sell-side for this.

We believe this detailed and unconflicted analysis allows us to understand each of our investments better than most of our competitors, and in time will allow us to transform this competitive advantage into higher performance figures.

GFM: How do you generate ideas for your fund?

PN: We run a proprietary screen that has been developed and improved over the past six years. We are looking for listed companies anywhere in the world that are trading at metrics that would qualify them for full due-diligence, including low price-earnings ration, low price to book, high return on investment, low net debt/Ebitda and high free cash flow generation. The important thing is to find companies with businesses that are simple to understand and to operate, and that we believe have a durable competitive advantage in their field, on top of being cheap.

Given that most of the money we currently manage is our own and that we intend to manage most of our liquid net wealth in the fund, we like the concepts of value and of margin of safety. Some of the best investors of all time have made their name following a similar value approach. There has never been a better time to buy dollar bills for 20 or 30 cents than there will be in the next couple of years. We believe this once in a lifetime opportunity will be around for some time, and for that reason we are still not fully invested.

GFM: What is your approach to managing risk?

PN: We have a very disciplined approach to risk. The core of our investment philosophy is to minimise capital losses. In order to compound our investors’ wealth at higher rates, the most important thing is to avoid bad investments and to let the good ones work extra hard for us.

Given the medium- to longer-term nature of our investments, we tend to look for significant returns, often in the 200-300 per cent range for the ensuing three to five years. As a result, we don’t need to jump ‘all in’ at any time and can approach each trade with a lot of discipline. Normally we invest following a unit of risk philosophy (three per cent of portfolio) and only add to the trade when we are profitable. We don’t usually average down. Trades that are moving against us mean that a variable out there is telling us our thesis is wrong.

Price is the biggest fundamental and when the market tells us we are wrong we take a small loss on the one unit of risk we had - given that we avoided adding to the initial position because of the price move against us.

As positions move our way we add to them and use running stop losses adjusted on a weekly basis, insulating us from market noise while we let the fundamentals do the work.

GFM: How has your recent performance compared with your expectations and track record? Do you expect your performance or style to change going forward?

PN: Recent performance was frustrating as we had two down months in a row in June and July following a very good start to 2009. Our macro thesis had proven right since launch in early 2008 and it started gaining a lot of traction in the first five months of 2009, leaving us up 18 per cent at the end of May.

Since then the bear market rally persisted and the name of the game was ‘risk on’ trades. We were premature in positioning ourselves bearishly again. We are astute students of history and we always watch proprietary indicators very closely. These currently tell us that the green shoots crowd is too early in pricing a V-shaped recovery into the market.

A quick recovery is not entirely impossible, as there are several elephants in the room (central banks) whose only interest is to reflate the economy at any cost. But the probability of immediate success is very slim, in our opinion. Market players have driven equity markets to the point where it is pricing a 40 per cent pick-up in earnings and four per cent GDP growth in the US. Reality will, in our opinion, be very different, and even if it has cost us a significant amount of our positive performance this year, we have positioned the portfolio according to our more realistic beliefs.

GFM: What opportunities are you looking at right now?

PN: Right now two sets of opportunities are very compelling. First, many deep value stocks, with good business models that generate substantial cash flow and are undervalued, have failed to rally significantly in the past months. The reason is that most of these stocks are not only under-followed but also had small short interests, and so did not benefit from the rally to the same extent as some lower-quality names. This is a very compelling opportunity and we are working flat out on some of these names.

Secondly, credit spreads have tightened to levels that are in some instances very similar to the top of the credit market bubble and in some cases even tighter. This is one of the best risk-reward trades we have ever seen, as one can buy a basket of a diversified group of issuers at a spread of 40 bps over government securities or even lower.

Europe has many difficulties ahead – not only did European banks lend more than EUR4trn to Eastern Europe but in many countries where bank loans multiples of the country’s own GDP. The system was stressed late last year but government intervention saved us from the worst. The question remains whether Germany will be willing to bail out countries such as Austria, Greece, Italy, Ireland, Spain and Portugal. As soon as new issues start arising here, credit spreads will once again widen considerably, making our low cost/low carry positions extremely profitable.

One of the unique characteristics of Noster is that we will invest in the instruments that are more compelling from a risk-reward and from a risk management perspective. We do not run a pure long/short equity fund. We invest in most asset classes, as we want to be in the tranche of the capital structure that we find most attractive and where the margin of safety is the highest. It is our own money we are investing, after all.

GFM: Are investors’ expectations moving towards capital preservation? If so, how do you deal with this?

PN: In early 2009 there was a huge increase in the popularity of capital preservation as investors ran for the exits after the terrible performance of 2008. Sadly, most investors seem to have forgotten what happened in the past 12 months and we are back with a ‘risk on/let’s speculate’ attitude.

At Noster, capital preservation is at the heart of our business. We believe strongly that one does not need to be an aggressive risk-taker all the time; we aim to preserve capital and only take risk when we are being well remunerated for it.

As a result, there will be times like 2007, 2008 and 2009 where we will be holding substantial cash balances as we do not deem the payback appropriate for the risk we would be taking, or in many instances because we believe we will be able to scale in at even better levels. The important thing is not to lose money and to preserve mental and physical capital for when the home runs present themselves – as they always do.

GFM: What differentiates you from other managers in your sector?

PN: It is pretty difficult to find a sector that we consider ourselves to be associated with. Is Noster a hedge fund? In many senses yes, as we take both long and short positions in several asset classes and we can (but don’t always) employ leverage.

Are we a value fund? Absolutely, but we look at all asset classes in our search for value and not purely at equities. But unlike plain vanilla value funds, we also try to hedge some of the risks we take when we deem the economic cycle to be extended.

What differentiates us from most asset managers is first the thoroughness of our analysis. Secondly, we have an extremely stable capital base and patience to wait for the right opportunity at the right time; we are not forced by funds of funds - who need to justify their one-and-10 fees - to chase the crowded short-term catalyst trades. Lastly, the fact that we can focus our analysis in three- to five-year opportunities with no imminent catalyst means we are operating in a niche with fewer players and where it is much easier to find mispriced securities.

We don’t think we are cleverer than our competitors; we are very humble in the way we work. We just try to make the odds of success as high as possible, and by having secured stable and long term capital we are already one step ahead. The traditional fund management industry created its own difficulties by getting seeded by investors who don’t feel comfortable with bold action, who are too trigger-happy, who do not do their homework properly and who constantly need to hedge career risk.

We were one of the first funds to come out with a lower fee structure. We have a yearly hurdle rate of 5 per cent, as we don’t think it’s fair to charge a performance fee on what – under normal market conditions – is essentially the risk-free rate. We have also banned certain practices such as soft dollar (paying a higher fee to a broker who will then pay for certain services that one ought to pay from the management fee) that are common in the industry, as we do not feel it is right to do so.

GFM: Do you foresee problems in raising mandates from investors through 2009?

PN: The Madoff and Stanford events woke up many investors to perform more due diligence, and that’s a good thing. However, the larger, more established funds have been the major beneficiaries of the post-Madoff era as they can more easily pass investors’ more stringent due diligence tests.

The problem that we envisage is that a few funds are getting the majority of new capital and have been taking in more cash than they should. To this day no hedge fund has been very successful after hitting the USD20bn mark, and it is easy to understand why – the same reason that an oil tanker is not as agile as a speedboat: it is very difficult to beat the markets when you become the market.

A manager with USD20bn under management that invests in 50 securities (most managers are more concentrated than this) would need to invest USD400m per position. Assuming they don’t want to be more than 5 per cent of the free float of any given security, that means they can only look at companies with a market cap higher than USD8bn.

Their investible universe is much smaller than that of a USD200m manager whose average position is USD4m. As a speedboat one has a much larger investible universe, more liquidity to get in and out, and can look at securities that are not as widely followed as USD8bn-plus companies, which are more likely to be correctly priced.

We clearly understand the economics of being an asset gatherer rather than a speedboat. It all depends what makes you tick – in our case superior long-term performance. We love what we do and we won’t change our business model. Noster will close once we get to USD300m.

We are only now opening the fund to outside investors. We did very well at preserving our capital by not losing money since the beginning of the crisis while at the same time making good number of investments that could generate returns of 300 to 500 per cent returns over the next cycle. We are focused on performance and our clients will eventually find us. There is nothing better than word of mouth.



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