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Hedge Fund Report: Activists Don't Always Shout

Emma Trincal

Shares of Zoltek(ZOLT Quote), the St. Louis-based carbon-fiber manufacturer, declined sharply Friday after the company filed an S-1 registration form announcing that it would issue 7 million additional shares for the conversion of its convertible debt.

Investors reacted strongly even though the registration filing was expected. The 5.6% decline was "a sign that the market is weak in general," says David Edwards, an analyst at ThinkEquity Partners, a research and investment boutique firm, who has a buy rating on the stock. "I'm not concerned with the registration statement."

Hedge fund activist Dan Loeb, who runs Third Point and who is the largest shareholder in Zoltek, seems to believe in the long-term prospects of the stock in spite of the slide. Two weeks ago, he disclosed a 7% stake in the company in a 13-G filing. The filing was unusually quiet, with no letter attached. That's in contrast to the typical missives to management Loeb publicizes in his filings, which have earned him the reputation of being a bully.

In his most recent campaign, for instance, he lashed out at the "extravagant" compensation of Massey Energy's(MEE Quote) CEO. This time, the hedge fund had no comments.

"Loeb seems happy with the company. It's a long-term investment. It's not an activist play," says one sell-side analyst who requested anonymity.

Here's why: Zoltek enjoys a quasi-monopoly position in the commercial carbon-fiber market. The market for those synthetic materials is divided between commercial goods (such as wind turbines) and aerospace applications (fibers for airplane brakes). Zoltek produces nothing but commercial carbon-fiber products and it dominates this market.

"The aerospace sector is growing so fast that Zoltek's biggest competitors, such as Toho Tenax and Toray Industries, haven't had a chance to focus on the commercial applications," says William Gregozeski, analyst at CapStone Investments, who has a buy rating on the stock with a $42 price target. It would take a company entering the commercial carbon-fiber market today at least two years to compete with Zoltek, he adds.

As a result, the stock is in growth mode, despite Friday's slide. Since the beginning of the year, share prices are up by almost 260%. Loeb himself pocketed 21% in profits since he purchased his shares at the end of April.

Valuation is rich -- the stock trades 29.5 times next year's earnings estimate of $1.05 cents a share. Yet some say it's justified by the company's outlook. "The stock is growing really fast and it deserves a higher multiple," Gregozeski says. On May 11, shares moved up 24% after the company posted its first operating profit in seven years.

Zoltek is seemingly one of those stories in which even activist investors can be quiet and patient.

No More Regulation

Hedge funds have been on the radar screen of the Securities and Exchange Commission. But last week, it was time for the Senate and Federal Reserve to pay a closer look.

Fortunately for managers, the conclusion of hours of discussion was that hedge funds do not need to be further regulated. Whether this is a good or bad thing for individual investors remains to be seen.

"Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking, but in the case of hedge funds, the reasonable presumption is that market discipline can work," said Fed Chairman Ben Bernanke, speaking about hedge funds and risk at a Federal Reserve Bank of Atlanta's conference in Sea Island, Ga.

Bernanke followed in the footsteps of his predecessor Alan Greenspan, who was never in favor of regulation during his tenure. Speaking last week at the Bond Market Association's 30th anniversary reception, Greenspan reiterated that he opposed the regulation of hedge funds because it would hamper market efficiency.

Separately, regulators and industry experts met last Tuesday at a U.S. Senate Subcommittee hearing and talked about the role of hedge funds in capital markets. The consensus was that the best regulator for hedge funds is the marketplace.

Adam Lerrick, professor of finance at Carnegie Mellon University, said at the hearing that the overall level of leverage in the market should be made public. Randal Quarles of the Department of Treasury stressed that leverage, concentrated positions, and valuation pose the greatest risks in hedge fund investing. But overall, the credo was: Live and let live.

Those talks demonstrate the growing role of hedge funds in the financial markets. In 1969, hedge funds represented 200 shops managing $1.5 billion, according to HedgeFund Intelligence. There are now nearly 9,000 hedge funds with a global asset size of $1.5 trillion. Such growth, plus hedge funds increasingly catering to retail investors, is what led the SEC to impose its recent hedge fund registration rule. But apparently, that's as far as we get.

The Sincerest Form of Flattery

It pays to imitate hedge funds. In a research report released last week, Morgan Stanley(MS Quote) describes one of its investment models based on the concept of investing in stocks that are highly popular among hedge funds. This strategy of buying "high-conviction hedge fund ideas" would have realized a 486% cumulative return since 1999 vs. the S&P 500 return of 12% or the Russell 2000 return of 89% during that same period, the report says.

Analyst Henry McVey, co-author of the research, writes that using the SEC 13-F filings, his group first ranked the 25 stocks within the S&P 500 with the highest percentage of hedge fund ownership.

The second step of the methodology consisted of screening those stocks to determine those with the smallest number of hedge fund owners. The idea is to narrow down the stocks to 10 names that have a few number of hedge fund investors with high percentage ownership.

Investing with hedge funds is one thing. But the model stresses the importance of investing in stocks that are not too crowded with too many hedge funds. In other words: One hedge fund with a strong conviction is better than several piggy-backers.

For those who want to invest in hedge fund-like vehicles but with the ease and relative safety of mutual funds, a solution exists.

A new generation of open-end mutual funds called hedgelike mutual funds combine alternative investment strategies, such as leverage and short-selling, with the low minimum investments and accessibility of a mutual fund. While a hedge fund typically requires a minimum investment of $1 million and is open only to qualified investors, those hedgelike mutual funds are available to all with as little as $1,000 or $2,500. Due to their growing popularity, Morningstar created a long/short category of mutual funds, as previously reported here.

Franklin Templeton(FTF Quote), for instance, has such a product with (TLSAX Quote)Templeton Global Long-Short, and Janus is readying its Advisor Long/Short fund. The latest in the series is the (BETAX Quote)Beta Hedged Strategy fund launched last week by AIP Alternative Strategies, a White Plains, N.Y.-based money manager specializing in alternative mutual funds. It's a more aggressive version of AIP's first hedgelike mutual fund, the (ALPHX Quote)Alpha Hedged Strategies fund launched in 2002.

Casualty Report

The convertible arbitrage market is recovering, but there are still some casualties.

The latest is Saranac Capital Management, a hedge fund run by Ross Margolies, a former Citigroup(C Quote) trader. The fund is closing down due to a loss of 80% of its assets, according to a Bloomberg report published on Friday. Saranac opened at the end of 2004 with $2.9 billion and is left today with only $600 million, according to the report.

The loss of assets, which generate fees for the fund, is what prompted Margolies to close down his shop. Two-third of the firm's assets were in arbitrage strategies, with 60% of that amount invested in convertible arbitrage. The convertible arbitrage funds lost 2% last year, sending investors to the exit door. Margolies expects to return money to his investors by June 30.