Dan Loeb’s Investment Process

You’re in for a treat.

It’s not every day that one of the most successful and consistent investors in the game talks process. Mostly when you hear from hedge fund managers it’s in the context of doling out stock picks for a charitable conference. That’s cool too even though it’s very much a “give a man a fish” affair.

But in Dan Loeb’s Q1 investor letter, we get a glimpse into how the Third Point manager came across the Japanese macro trade that’s been such a home run, how he knew when to hold back and then when to press. Think of his commentary here as an investing master course in miniature.

Before sharing any quotes from the note, the firm’s disclaimer:

Third Point’s Quarterly Letters are designed to inform our investors about recent portfolio developments and provide our views of the market environment. Our letters are not investment recommendations for the general public. The legal disclaimer makes clear that we may trade in and out of positions discussed at any time and undertake no duty to update anyone, except to the extent we are required to make filings with the SEC. Investors who choose to take action based on our investment ideas do so at their own risk.

In other words, take away lessons from this, not an exhortation to buy or sell.

So how did the fund know they had a winner on their hands? It’s not like Japan hadn’t pursued easy monetary policy before, mostly to little effect…

First there’s the trip to Japan. Third Point doesn’t just pull the trigger because, what the hell, they flew all the way there and have a sunk cost. No, they take what they’ve learned and file it away, biding their time. Patience is the mark of a mature investor and lots of research and legwork goes nowhere sometimes.

We visited Japan last April following the Bank of Japan’s (“BOJ”) announcement of a new policy of targeting a 1% annual inflation rate. We recognized from past experience that meaningful quantitative easing in Japan could provide opportunities like our “don’t fight the Fed” investments in 2009‐10 and European sovereign debt trades in 2012. Meetings with academics and government officials last April convinced us that the articulated “changes” were more rhetorical than practical at the time, but also revealed that many Japanese realized wholesale shifts would be necessary to pull the country out of the deep doldrums it had entered after the tsunami and subsequent nuclear catastrophe of 2011. Despite returning disappointed that this time wasn’t different (yet), we had developed an understanding of the signals that would indicate the start of a paradigm shift if the time came.

Finally, the signal arrives and the firm is ready, with their background knowledge from prior research underpinning a reaction to new developments:

In the fall of 2012, we recognized as a critical catalyst the increasing likelihood of a transition to leadership by the Liberal Democratic Party, led by Shinzō Abe. In statements leading up to his election as Prime Minister, Abe had articulated reflationary policies dramatically different than the BOJ’s recent initiatives. Accordingly, we established a position speculating that the Japanese currency would be devalued aggressively and equities would rise once Abe took office. We sized the position decisively after concluding the investment had highly asymmetric outcomes.

The “Abe‐nomics” catalysts have played out essentially as we anticipated, and his approach has been met with unusual public support from the Japanese. Our optimism was reinforced by the appointment of Haruhiko Kuroda as the Governor of the BOJ on February 27. By analyzing Governor Kuroda’s speeches and papers over the past two decades, we recognized him as a proponent of radical change, structural reform, and “dovish” monetary policy. Another important catalyst was the (grumbling) acquiescence by Western powers throughout Q1 as Japan began asserting its case for devaluing its currency.

Recognizing when you’re right – and for the right reasons – is a harder thing for investors than you would probably think. But knowing you’re right is the key to knowing when to increase your bet. After all, what good is nailing the thesis but blowing the execution with too little at stake to move the needle? Watch Dan press his bet:

Despite massive market speculation and an already significant move in the Yen, potential QE measures were simply speculative until last week’s first Kuroda‐led BOJ meeting. We increased our position ahead of the meeting, rejecting the market consensus that the upside was already baked into any policy moves that might be announced. As we had hoped, the Governors managed to exceed even the highest of expectations with their initial actions, ticking all of the boxes we anticipated and adding others. The steps amounted to a complete reboot of the Japanese monetary experiment. The impact of this bold plan should be far‐reaching, not only for Japanese companies but also for Japan’s trading partners.

Finally, once you’ve already been right, there comes the age-old struggle with knowing when to stay with the trend versus taking the gain and moving on. Everyone struggles with this and I don’t know which is more painful to one’s psyche: Scalping a quick profit only to watch an investment soar or hanging on too long and watching a winner become a breakeven or a loser. Third Point has made a decision on their already-successful Japan Macro trade:

Perhaps most importantly, from a Third Point process and framework perspective, we have learned that in environments where QE and government intervention are critical engines, our catalyst‐driven approach allows us to find compelling “macro” opportunities. We believe there is still value in our initial currency/index trade reflecting this important structural inflection point and also have taken selected positions in single name stocks that we believe will benefit from this policy shift.

This was a great letter and proof that a rational, methodical approach with lots of homework and planning can lead to a winning trade. For those of us who are process-oriented, it’s always nice to read about and experience real-life examples of process leading directly to positive outcomes.