Pennant Capital Management

Alan Fournier founded Pennant Capital Management in 2001 in Chatham, NJ. Today the hedge fund manages around 4 billion dollars. The only publicly disclosed returns are for a decent range since its inception and a short quarterly result (1) Starting in 2001 through early 2007, the fund averaged an annual compounded rate of return of over 19%, in comparison to a 3% return for the S&P 500, and (2) At the end of first quarter of 2012, the fund was up 14% year-to-date, outperforming the S&P 500 by 2000 basis points. While it would be nice to know the returns through the financial crisis and the ensuing Great Recession, the change in assets under management from 2007 to now indicate that the fund managed to avoid drastic losses: In early 2007 the assets were 1.4 billion dollars, in early 2008 they were 2.3 billion dollars, and today are reported to be around 4 billion dollars. Since the pounding of the markets in 2008 was nearby when the fund was at 2.8 billion, it is unlikely that the fund mushroomed in two quarters to a size where it could have taken a bad beating in the market (along with customary client redemptions) and from that shrunken size come back to 4 billion dollars. It is more likely, considering the hedge fund’s long-short equity strategy, that the fund fared relatively well through a combination of client stickiness, asset addition, and positive returns resulting in today’s assets under management quantum.

Prior to founding Pennant Capital Management, Mr. Fournier honed his investment skills under the tutelage of a few very impressive and stalwart investors. But before joining the world of investing, in 1983 he graduated in engineering (without ever taking a class in finance) from Wentworth Institute of Technology in Boston and for the following five years he was involved in technology sales as a National Sales Manager for Digital Equipment Corporation that was founded by an MIT alum and eventually sold to Compaq in 1988. The same year he joined the research training program of Sanford C. Bernstein Inc and after two years went on to become a partner in institutional sales. By 1993, he was running Bernstein’s Institutional Middle Market research sales group that had its niche in providing research to hedge funds and institutional money managers with less than 1 billion dollars in assets under management.

While at Bernstein, Mr. Fournier came under the guidance of Rich Pzena who was at that time the Head of Research. Mr. Pzena was an enthusiastic advocate of Bernstein’s long-term value orientation and deep research, and his relentless pursuit of uncovering undervalued businesses experiencing temporary setbacks with a roadmap to recovery and prior valuation left an indelible mark on Mr. Fournier. Actually, Mr. Pzena went on to found his own hedge fund Pzena Investment Management in 1996 (that manages 16 billion dollars now and focuses on long-only undervalued stocks that it holds for a long period of time) and Mr. Fournier worked there as a portfolio manager. As expected, Mr. Fournier’s research skills for long plays were taken to a different level here as he had to engage in the execution of trades rather than pure theoretical research. As any value investor knows, the real returns come from controlling fear and greed when executing the trades, and this skill set is only gained through real experience in the markets.

Also while at Bernstein, he regularly interacted with two of their prominent value investor clients John Neff of Windsor and Michael Price of Mutual Shares (now he manages MFP Investments). While Mr. Fournier was interacting with these big name in the value world,  on the flip side, he also dealt with successful momentum investors who would buy the stocks that Bernstein research was recommending to sell. This view of the whole spectrum of investing styles allowed Mr. Fournier to understand that it is possible to progressively make money on stocks as they morph from value securities to recovered securities to growth securities. This understanding  combined with the banking crisis of the early nineties that was going on then, further gave Mr. Fournier the insight that it is not necessary to bottom fish since there usually is quite a bit of room to make money between the time a security rebounds and achieve close to full valuation.

Akin to most of the noticeable investors that influenced him, Mr. Fournier met David Tepper as a client of Bernstein. Before forming Pennant Capital Management, Mr. Fournier worked as a partner at Mr. Tepper’s macro, event-driven and distressed opportunities hedge fund Appaloosa Management.  Mr. Fournier handled global equity investments there, and although he was deploying his value investment skills the orientation was more around the balance sheet of special situation such as distress or bankruptcies. This was in sharp contrast to the focus on income statement and the recovery of earnings at Bernstein’s. Here he got into the nitty gritty of shorting also and saw the value of doing both bottom-up and top-down analysis.

(On a side note, it was Mr. Tepper who encouraged Mr. Fournier to leave Appaloosa Management and form his own hedge fund. While Mr. Fournier took his advice, he did not go too far away not only he remained in Chatham, NJ, but in the same unassuming building on the prosaically named Main Street surrounded by residential suburbia. Since then Appaloosa Management has relocated to Short Hills, NJ, and Mr. Tepper’s new office is now the home to a statue of brass balls symbolizing his investment style that were gifted to him by Mr. Fournier. To read more about the investment philosophy and style of the illustrious Mr. Tepper go to Appaloosa Management .)

At Pennant Capital, Mr. Fournier’s investment philosophy is to combine the best of all the strategies he learned at Bernstein, Pneza Investment and Appaloosa Management (and that for sure makes up for lack of finance classes).

As an overall investment philosophy, emphasis is focused on deep and continuous research both on the micro and macro side, and not being in a hurry to execute a trade but seeking a rebound first (on a long idea) and seeking a deterioration first (on a short idea). Special emphasis is paid to risk mitigation and constantly monitoring and evaluating the changing probabilities of success of their long and short positions. The idea is to construct a long-short portfolio of investments where the risk-return spectrum is so majorly skewed that if the investment works out the potential percentage gain is about three times more than the potential percentage loss if the investment backfires (no interest in 50/50 coin tosses). In real terms, that means they seek a 1.5x return on most of their investments. They are careful not to let their portfolio deviate to pair-trades so special attention is paid to keep the investments asymmetrical. Although their holding period varies they normally look at a time horizon of 12 to 18 months, yet they are quick to cut losses and letting the long winners run further than 1.5x as they revalue the stock at each and every escalating price.

Below we outline some of Pennant Capital’s differentiating investment tenets that have resulted in their outperformance of markets.

Idea Generation:

Pennant Capital proactively uses various screens for finding investment opportunities. On the long side, a company’s balance sheet and EBITDA are some of the factors that determine whether a stock is undergoing revaluation (read multiple expansion) as it emerges from struggling earnings to margin recovery and improving revenues. On the short side, the screens are oriented towards finding deteriorating earnings and brewing troubles within the company.

Pennant Capital’s research is also reactive and event-driven in that Mr. Fournier often finds an investment opportunity when the market is over-reacting to bad news. For instance, back in 2007 when the scandal of backdating of options by United Health Care came to light, the stock suffered a 30% loss. Mr. Fournier and his team astutely analyzed the situation to find out that although this was a PR problem in reality the financials of the business were not affected at all by this but the market reacted as if the company had cooked its books.

In general, Pennant Capital does not make concentrated investments on any particular sector. Yet, often one investment idea leads to another and they are not averse to having many individual securities in one sector or related sectors. For example, when they participated in investment opportunities when the steel industry was under duress, they correlated it to the coal industry as steel production relies heavily on coal and hence on the price of coal.

Lastly, they continuously communicate and network with the top management of the industries they invest in so as to stay abreast of any new products or trends in order to isolate investment opportunities early.

Leverage:

Unlike many traditional investors, Mr. Fournier seeks opportunities in businesses that are levered to the hilt. The logic behind that is that the equity of a company is the final residual in the capital structure and thereby taking a long or short position in the equity will magnify the upside or downside. Naturally, when a company is performing well, the best place to be invested in is that residual equity as all the surplus returns emanating out of the leverage go to this small sleeve of the overall capitalization of the company. On the other hand, when a company’s performance is highly challenged, then the residual equity is hurt the most because of the leverage.

Being a long-short fund, Pennant Capital attempts to benefit from this leverage regardless whether the levered company is doing well or not. On the short side, the screen for companies with balance sheets levered to the eyeballs and dismal earnings which are going from bad to worse.  On the long side, as long as they deem a company to be in initial stages of recovery, they invest in levered balance sheets despite the fact that other investors have lost faith in normalization of earnings.  Actually, in the second year of the fund’s existence (2002), they had as much as half of their investments in the special situations such as re-orgs and post-bankruptcies. (This is in line with their guiding principle that different environments require different strategies and expectations.)

Managing Risk and Probabilities:

The first layer of their risk management is good old diversification. At any given moment their portfolio usually has thirty to sixty long positions and none of the individual securities constitutes more than 5% of the entire portfolio.

The second layer of protection is to sizing the positions: they tend to start with a relatively small position and then gradually build it. Mr. Fournier learned the importance of sizing positions early – the same year he founded it. In 2001 the fund had a position in the stock of a travel-related business, and in the aftermath of the 9/11 tragedy the stock lost half of its value.

Further to the tactic of sizing positions, Pennant Capital does not shy away from buying more of a stock as it share price goes up. The logic is that if their analysis is working out, they constantly revalue the opportunity as a fresh one (of course within the limits of 5%). While many value investors are often comfortable cost averaging down, they are not typically enthused of cost averaging up.  But for Mr. Fournier if the probability of the company recovering has increased then so has the probability of return being higher even though the equity is valued at higher multiples. On the other hand, if one of their investments is actually not working out, then they acknowledge that the probability factor has changed and they freshly revalue the company to determine whether it is worth holding or not.

The third layer of mitigating portfolio risk is that the fund always maintains short positions. Depending on the environment, that can be a range of 60 to 100 positions.  That way they usually only have a 20% to 40% net long exposure.

On the short side, they also mitigate their risk by keeping their individual position sizes smaller than their long position sizes.  This is not due to a lack of commitment (on the contrary their shorts are driven by a fundamental belief that the stock will fare very badly in a year to almost two years), but because that way they can avoid being forced to trade out of the short position if the company announces some good news that is temporary.  So while other investors and traders close their positions immediately as they fear a short squeeze, Pennant Capital has already accounted for the probability of such fluctuations. Of course, if the good news somehow points to fundamental changes, they re-evaluate the investment for its risk-reward probabilities.

Further on the short side, they do not open a position on a stock that they have analyzed will deteriorate soon. Instead they are somewhat conservative as they only initiate a position when the deterioration of the company has become an open secret and is already partially reflected in the stock price. This is in accordance with their conservative investment philosophy on their long positions which they normally only initiate when the stock is rebounding from its lows rather than bottom fishing. Again, this is because of their fundamental tenet being that money can be made on a stock even if you are “late”.

A fourth layer of differentiation in Pennant Capital’s risk mitigation is that they carefully scrutinize the whole long-short portfolio to ensure they are not accidentally deviating into a paired portfolio. Essentially, the portfolio needs to comprise asymmetric positions with assigned probabilities of success. On the long side, this normally results in having huge gains in a few stocks and small losses on many stocks as they are quick to cut them through re-evaluating the probabilities of success. Similarly, on the short side they earn a lot if the markets are down generally, but lose less when the markets are up.

A Note on the Name:

Mr. Fournier’s naming the fund Pennant Capital harks back to his days of racing sailboats. The wind is a major contributing factor to how the sailing team races on any given day – they can practice and plan ahead but they have to deal with the vagaries of the wind on the day of the race. In order to understand how to navigate with current wind conditions, sailboats have pennant flags which help the racers determine the direction of the wind. Also, during a race as wind conditions change, they have to accordingly change their racing strategy, often back and forth. While this is an apt analogy for Mr. Fournier and his team’s investment style, it also points to his differentiation as a value investor who pays attention to the macro picture.