Manager Monday: Palo Alto Investors
Every Monday we break down a manager's portfolio to find where they're creating alpha, how they mitigating risk, and where they're invested.
About our Data
Everything mentioned in this post is sourced exclusively from public data, including the manager’s profile, simulated performance and all other analysis and commentary. The data used here omits the short side, non-equity securities and all other non-public information such as actual net performance.
Led by a Wall Street veteran William Edwards, Palo Alto Investors focuses on investing in the Healthcare sector and was recently featured in our report of the most unique hedge funds with high performance, Which Hedge Funds are Worth the High Fees. The simulated performance of the manager on the long side has been nothing short of extraordinary.
According to our data the fund’s long investments annualized over 15% since April 2000 compared to 4.3% for the S&P 500 and 9.1% for the S&P 1500 Healthcare sector with dividends. This is an extraordinary feat and the results are not simply driven by the manger’s preferred sector, healthcare.
Analyzing the performance further we can see the presence of “chunky” outperformance throughout the manager’s history. This is something we usually see with managers focused on long-term performance. In a rolling 12-month view of returns we see relatively few but extended periods of outperformance over the markets. The green circled areas are those of outperformance on a rolling 12-month basis. The most recent 12-month period has been impressive as the fund returned 94% compared to 12% for the S&P and 28% for the Healthcare sector with dividends. One area of underperformance (red circle) occurred in late 2002 and was followed by an extreme spike of out-performance the following year. Again, we see this trend with long term investors that may get the timing wrong on initial investment but have the conviction to stick with it and are rewarded down the road.
How They Do It
The reason the fund was featured in our report was not performance alone, it was also due to the manager’s unique portfolio relative to the most common names in hedge funds. Given that the manager invests in a specific sector and in smaller capitalization stocks, this is somewhat expected. But it’s the reason for their returns that made us do a deeper dive into Palo Alto. Most of the returns have been generated through stock selection skill. Let’s take a look at their portfolio attribution when run through the Novus Attribution framework. The Novus framework is used by investors to segregate a manager’s return into four components; returns sourced from market volatility, sector volatility, security selection and trading.
Security Selection Skill
As mentioned before, the fund invests in Healthcare now, but that has not always been the case. Prior to 2006 the portfolio resembled one of a manager with a generalist approach.
The dominant majority of the fund’s contribution to P&L, however, did indeed come from Healthcare.
Furthermore, the lion’s share of the contribution from the Healthcare sector was attributable to security selection, or picking the right stocks within the sector. The numbers are striking:
While the market and sector allocation certainly helped the manager, an incredible 368 percentage points of return was attributable to choosing the right stocks within the Healthcare sector. These kinds of numbers are very difficult to come by in our universe of 1,000+ hedge fund managers.
Market Capitalization and Uniqueness
We mentioned that Palo Alto made it into our report for two distinct reasons. One was high performance on the long side and the other being a unique portfolio among hedge funds. Only 2.7% of the manager’s portfolio overlaps with the most common hedge fund stocks.
This is partially due to their market capitalization breakdown: the manager invests in smaller capitalization stocks, probably hoping to find thinly covered stocks with more upside opportunity. Analyzing the manger’s exposures by market cap reveals a trend from Micro-Caps into more small and (recently) increasingly mid cap securities.
This makes sense when analyzed vis-à-vis their AUM growth:
But investors need not be concerned with the manager’s move up the market cap spectrum into mid and small capitalization stocks. In fact, those two buckets are the sources of most of the security selection alpha historically. It is probably for the best the manager has moved away from Micro Caps- as that capitalization has not served them well in through their entire history. Here is security selection contribution by Market-Cap buckets:
So, given the increased AUM and the move up the market cap spectrum, how has the manager’s liquidity changed? An analysis of the portfolio’s 30-day liquidity profile (percentage of assets that can be sold in the market over 30 consecutive trading days, without accounting for more than 20% of the trailing 90-day average daily trading value) shows a consistently liquid portfolio with a marginal improvement of liquidity in the recent quarters.
So what does this skilled Healthcare manager think is best positioned to outperform? Here are Palo Alto’s largest positions and latest trades based off of the Q1 13F public ownership release.
Learn how investors and managers are using the Novus Platform to track their own skill sets, risks, and liquidity by requesting a demo today.www.novus.com.