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Third Point 4Q16 Letter: Review/Outlook, Financials Equities, Credit Cycle

Third Point Fourth Quarter 2016 Investor Letter, February 1, 2017

“We often decide that an outcome is extremely likely or impossible because we are unable to imagine any chain of events that could cause it to occur. The defect is our imagination.” – Michael Lewis

“While America may or may not be made great again, there is no question that the rules are literally being rewritten and there is likewise no question that this process will be carried out in a flamboyant fashion. We do not plan to trade the tweets but we expect an increasing number of real and, even better, fake dislocations to create some extremely rewarding investing opportunities.” – Third Point LLC

2016 Review and Portfolio Positioning

  • Early in 2016, a number of funds crowded into a trade based on the consensus view that Chinese policy makers would be forced to choose only two options among ensuring a stable Renminbi, stressing economic growth, or restructuring vast amounts of impaired private debt
    • Following the popular conclusion, many hedge funds shorted the RMB and further pressed this view by going long defensive names and short materials companies
    • Turned out that Chinese government had another trick up its sleeve, avoiding a trilemma choice by engaging in stealthy policies to gradually implement devaluation while continuing expansionary fiscal policy and kicking debt issues down the road
    • We avoided most of the ensuing mayhem by covering shorts and dramatically increased credit and energy bets
  • Brexit was the next “unanticipated” event and most investors were caught flat footed; some of those who were actually positioned properly misinterpreted the likely consequences and saw huge two day gains on their shorts evaporate just as quickly when markets rallied back
    • We responded by using the sell-off as an opportunity to increase exposure and turned in a good post-Brexit performance
  • US presidential election was the most significant event of the year; we did not anticipate Trump’s win although his election served to crystalize trends that had been taking place for some time
  • Despite being properly positioned for two of the three significant macro turns last year, overall performance was a disappointing +6.1% – corporate and sovereign credit outperformed meaningfully but equity portfolio underperformed primarily due to Allergan and Amgen
    • Since inception, 15.7% annualized return versus 7.5% S&P 500
  • Generated positive returns in corporate credit via long energy trade, Argentine sovereign credit investments, risk arbitrage, and constructive positions in Baxter, Dow, and Sotheby’s
  • Added data science to our toolkit for identifying interesting, uncorrelated opportunities

Outlook

  • Trump’s election has accelerated the end of QE; baton is now passing from the Fed to the Treasury which will provide fiscal stimulus via tax reform and infrastructure spending
  • Expect a significant reduction of corporate and individual taxes, elimination of interest rate deduction, and removal of the deductibility of state and local income taxes from federal returns
  • We see an immediate deduction for capital spending and dramatic pullback in government bureaucracy, red tape, and regulation; most controversial and complex is the Border Adjusted Tax to help pay for these measures
  • Significant infrastructure plan would also stimulate the economy – would be partially paid by an 8% tax on repatriated funds held offshore by US corporations
  • Economic growth will come at the same time as inflation is starting to inflect upwards and domestic economy is close to full employment
  • Combination of higher nominal growth and lower tax rates could cause earnings to rise in the high single digits this year
  • Some draw parallels to the 1980s but starting levels are very different: then, both interest rates and unemployment were high; debt as a function of GDP was 30% and now it’s 80%; median age in the US was 30 and now 38
  • Regime shift to fiscal spending will create a very different investing backdrop – cross-asset class correlations should fall and even within equities, there will be greater dispersion of results; this is a better environment for active investing; higher rates will create opportunities, reversing the one-way trade in yields that dampened the past few years
  • While the markets have move since the election, do not believe that investors have digested how different things will be
  • Move from deflation to inflation is good for active investing; reflationary environment creates favorable conditions for value and event-driven investing, risk arbitrage, and activism
  • Credit will be a mini-cycle story like last year
  • Recognize that trade wars and/or escalating inflation could result in a policy mistake that could result in a sharp sell-off; our hedges are structured to guard against negative impact from those events

Financials Equities

  • On November 8th, financials portfolio was 4.4% of the fund; one day later, it was 6%; one week later, 10.5%; one month later, 11.8%; reallocated half of initial holdings from high-multiple, FCF businesses in payments, ratings, and P&C (which traditionally outperform during periods of deflation), to more traditional reflationary exposures in banks, brokers, and geographically, in Japan
  • Some believe rally in financials has been driven by expectations of tax cuts, or potential repeal of Volcker Rule, or reduced compliance costs, or more relaxed capital regulations
    • These would bring material additional upside to bank stocks but our focus is different: pendulum in monetary policy has begun to shift away from austerity and its limiting factors; bullish for rate-sensitive financials
  • Rising rates have the obvious benefit of boosting net interest margins but this is particularly true today because banks are sitting on more excess cash and liquidity than ever; rising rates also unlock activity across fixed income trading
  • As relative policies between countries diverge, currency trading and hedging accelerates
  • Most will underestimate the significant operating leverage inherent in financials: expanding interest income or more velocity in trading does not require additional technology or more personnel

Credit Update

  • Structured credit:
    • Last year, cut exposure in US RMBS and other areas of the structured credit market; exposure was once over a quarter and is now less than 10%
    • As focus shifted away from RMBS, have been finding opportunities in new or different parts of the structured products universe; half of current exposure is Re-Performing Loan securitizations where we took a medium-term view that the borrowers would continue to make mortgage payments and become clean-pay borrowers
    • Other key component is in the marketplace lending sector; as origination and securitization of assets have become more difficult for larger financial institutions, smaller technology-driven platforms have filled the void
  • Corporate/Sovereign Credit:
    • High yield spreads are back to historical averages; spread compression drove a 13.4% return in high yield for 2016 with depressed energy and materials segments doubling the performance of the overall high-yield market
    • Credit, like equities, is starting from a relatively high point in valuation this year and expect the rising rate backdrop to provide a headwind
    • Distressed class of 2016 did not produce a stellar crop of post-reorg equities and we expect some freshly minted energy equities to turn out to be value traps
    • Retail is the only credit sector with relatively widespread distress but we have not seen a solution to address the increasing secular challenges in the brick and mortar retail world and so the distress is probably warranted
    • In the sovereign space, reduced exposure to Argentina but continues to be a big position in our portfolio; Argentina remains a major outlier when we look across the globe at sovereign yields relative to leverage and economic trajectory and governance
    • Greece is once again approaching a pinch point between populist promises and political-economic realities; expect a volatile reconciliation and are positioned to capitalize on the confusion surrounding that political process

Third Point is a New York-based long/short, event-driven, and activist hedge fund founded in 1995 by Dan Loeb. As of 2014, Third Point had an estimated AUM of $17.5 billion.

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