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Today on the deep dive, we are uh taking a privileged look inside the thinking of one of the world's most high conviction investors. We're talking about Persing Square Holdings, PSH, right? They're famous for running this incredibly concentrated portfolio and for making these massive, really timely macro bets.
So, we're dissecting their recent financial reports to understand not just what they own, but how they think about risk in such a complex world. Exactly. We've been through the 2023 interim and annual reports, and they, you know, they offer a kind of masterclass and long-term strategy and this deep dive is necessary because their structure is so different.
It is, it allows them to just ignore the kind of volatility that paralyzes most other investors. So, we're tracking their core philosophy, the major portfolio shifts of 2023, and there were some big ones. Oh, yeah. a huge tech entry and a very profitable exit. And we have to get into their predictions about where inflation and long-term interest rates are headed.
They are very very specific. Our mission then is to really understand what makes their approach tick. And the proof I mean it's certainly in the results. Well, yeah. The investment manager founded back in 2004 has delivered a 16.1% annualized net return. 16.1%. I mean that just blows the S&P 500's return of 9.4%.
4% out of the water over that same period. That level of outperformance over two decades. It really highlights the power of their approach. It does. And it's all fundamentally enabled by one thing, their permanent capital structure. Okay, let's unpack that right away. That structure, that philosophy, it drives everything they do,
right? Most hedge funds live in constant fear of redemptions. PSH does not. And they define their investment policy so clearly. preserve capital and seek maximum long-term capital appreciation. But the key part, the part you have to get is their definition of risk. Yes, for them, risk is not daily price swings.
It's not volatility. It's the permanent loss of capital. And that distinction changes everything. It completely changes how you behave during a market panic. It's why they can run a portfolio that is so incredibly concentrated, just 8 to 12 core holdings, typically all liquid, large cap North American companies.
They look for businesses with high downside protection and predictable recurring cash flows. And they're not passive. They call themselves active and engaged with their management teams. And the results, even recently, speak for themselves. In a year of enormous uncertainty with rising rates, PSH's net asset value, its NAV, grew 13.1% through mid August 2023.
And that's not a one-off. Their compound annual return over just the last six years is 25.3%. It's extraordinary. A huge part of that success comes down to what they call asymmetric hedging. Uh yes, these are cheap targeted bets that basically act as catastrophe insurance. We have to talk about the famous COVID hedge from March 2020.
It's a perfect example. It is. It's legendary. In early 2020, the firm spent what they call an immaterial investment. Just $27 million on CDS premiums. All right. Default swap. So like an insurance policy against corporate default. Exactly. They bought insurance on a basket of debt, betting that well that things were about to get very bad very quickly.
And when the pandemic hit and credit markets froze up, that $27 million insurance policy generated $2.6 billion in cash. Just take a second on that. That's a 100 to1 return. And it provided that liquidity, that 2.6 billion, at the exact moment the market was collapsing, which allowed them to go on a shopping spree, reinvesting in their favorite companies at rock bottom prices.
So they use hedges not just to protect themselves, but to turn systemic risk into a massive opportunistic cash reserve. It's the definition of turning risk into opportunity. And that brings us to their current playbook. All right. So let's connect that to their 2023 portfolio. The biggest new position they took in the first half of the year was Alphabet,
Google's parent company. Yeah. Which is, you know, not a typical move for a deep value investor to buy a mature tech giant. What was the thinking there? The firm saw classic value emerging. They felt Alphabet was trading at a really attractive valuation around 16 times forward earnings. Okay, so a big discount compared to its historical average.
A huge discount. It usually trades in the mid20s. And they figured this discount was all because of in their words misplaced concerns over the impact of AI on Google's search business. Right? So the market was pricing in this like existential threat from new generative AI tools. Why did PS think Google was safe?
They pointed to three key modes. First, just Google's vast distribution network. We're talking 15 products, six of which have over two billion users each. A huge moat. Then second, they have the best training data in the world just from their history of indexing human behavior. And third, they're not new to this.
They've been investing in AI for a decade, deep mind, their own custom chips, the PPUs. And this was all backed up by signs of operational improvement, too. Right. Absolutely. The thesis also highlighted a big margin expansion opportunity. Digital ad revenue was starting to accelerate again and management was finally getting serious about costs.
Very serious. A 6% workforce reduction and the cloud segment was finally getting to break even profitability. That was huge. So a powerful thesis. You've got mispriced risk and a real operational turnaround story. Exactly. On the flip side, they made a major exit. Lowe's. Yeah, that was a big one. Was it just about taking profits or was there more to it?
It was pure discipline. I mean, Lowe's had been an incredibly successful holding for them, nearly six years. What was the gain on that? 175% gain from their average cost to their average sale price. A huge win. But they exited because the industry was getting volatile. The near-term earnings were looking uncertain
and valuation and the valuation. They concluded that the stock price already largely reflected the company's future financial prospects. So, easy money was made. That's the idea. In a concentrated portfolio of only 8 to 12 names, you have to be ruthless. If all the future good news is already priced in, you rotate that capital into the next big mispriced opportunity
like Alphabet. Like Alphabet. Okay, so let's shift focus now. They had other winners like Chipotle and restaurant brands, but let's springboard into their big macro bet. Where are they putting their hedging resources today? They are hedging the risk of a substantial rise in 30-year Treasury rates. Higher for longer.
much higher for much longer. They're betting big on this and not just for a year or two. They see it as a structural shift. So, they're challenging that whole consensus that rates have to come back down. They are fundamentally challenging the idea that a 4.3% Treasury yield is historically high. They think long-term rates can go up substantially.
This goes against decades of thinking about the so-called neutral rate being near zero. What forces do they see driving inflation higher for the long term? They lay out four big ones. First, higher defense spending globally. Second, energy scarcity and the enormous cost of the green transition. Both inflationary,
highly inflationary. Third, deglobalization. Bringing supply chains home is just less efficient. And fourth, the growing bargaining power of labor, which keeps wage growth high. These aren't cycles. These are structural shifts. Precisely. And this is the core of their macro thesis. They don't just say rates will be high.
They put a number on it. This is the aha moment in the report. They think the 30-year Treasury yield should settle at 5.5% or even higher. Yes. So, how do they get to that very specific number? It's a surprisingly simple model based on three parts. They start with their estimate for long-term inflation.
They model that at 3.0%. Okay, a full point above the Fed's target. Then they add the equilibrium real short-term rate which they estimate at 0.5%. So that's three and a half% so far. What's the last piece? The historical average term premium. They add another 2.0% for that. And the term premium is basically the extra return you demand for locking your money up for 30 years.
Exactly. And for decades, the market has treated that premium as if it's zero. PSH is saying, "No, that was an anomaly. The historical average is 2% and it's coming back." 3% inflation plus a half% real rate plus a 2% term premium. That's 5.5%. That's the target. And they see the supply and demand for Treasury supporting this too,
right? Huge new issuance from the Treasury. A flood of it. $1.9 trillion of new issuance in just the second half of 2023. At the same time, the Fed is a seller through quantitative tightening and foreign buyers are backing away. Major foreign holders, Japan, China, Saudi Arabia, they're all showing signs of reducing their holdings.
So, more supply, fewer buyers. It points to higher rates. Let's bring it back to PSH itself because the structure is what lets them actually make these bets. It is their single biggest edge. The permanent capital from the closed end fund. It means they can't get a margin call. They never have to sell assets at fire sale prices to meet redemptions.
It's a fortress and it lets them issue really cheap long-term debt. Their weighted average cost of debt is only 3.1% with an 8-year term. And crucially, no mark-to-market covenants on those bonds. They are insulated from that volatility. That insulation is great, but they still have that classic closed end fund problem.
The share price trades at a discount to the net asset value, the NAV. It's a huge focus for them and a source of intense frustration for their shareholders. The discount was nearly 29% at the end of 2023, but they are taking steps to fight it. Oh, yes. They're aggressively returning capital. They've bought back $1.3 billion dollar worth of shares since 2017,
which is a great use of capital when your shares is that cheap. Absolutely. And they've put in this formulaic increasing quarterly dividend that's tied directly to the NAV. They also looked at getting a US stock exchange listing, right, to get more investors in. They did, but after a thorough review, they concluded the plan was uh not viable,
a non-starter. Why? It came down to US regulations, the Investment Company Act of 1940, and a bunch of complex tax issues. So for the foreseeable future, PSH has to stay a closedend fund listed outside the US. So the structural advantage remains, but so does the structural discount, it seems. So let's touch on the software advantages.
The firm is tiny, only about 40 employees, which is only possible because of that permanent capital. It actually helps them recruit and retain talent. Analysts would rather have that stability than the short-term pressure of a typical hedge fund. We also have to mention their longestterm holding. Fanny May and Freddy Mack.
This feels like the ultimate test of their patience. It really does. They see it as a perpetual option on the company's eventually exiting government conservatorship. Still waiting. Still waiting. They see the 2024 US election as a potential catalyst for reprivatization. And in the meantime, the companies are building capital like crazy.
Okay, finally let's talk about the future and this Spark initiative. Yeah. What is a special purpose acquisition rights company? It's designed to be a much much better version of the spa by fixing the biggest flaw of the old spa model which was the opportunity cost. A classic spa made you lock up your capital in a trust account earning almost nothing for maybe years while the sponsor looked for a deal.
So your money was just sitting there dead. Exactly. The spark fixes that. If the SEC approves it, the firm can go look for a merger deal without taking any upfront capital from you. Okay? So, the clock isn't ticking on your money, right? Only when a deal is announced do the rights holders, the spars, decide if they want to exercise their right and buy shares at a fixed price.
And PSH commits to anchoring the deal with up to 3.5 billion of its own capital. It's just a cleaner, more shareholder friendly structure. Massively, it's another example of them leveraging structure to create an advantage. So if we zoom out, the whole strategy is this powerful duality, isn't it? It is
deep value, high conviction investing in great businesses like Alphabet and Chipotle. On one hand, paired with these strategic asymmetric hedges against the biggest macro risks out there right now, that's rising long-term interest rates. And the connective tissue, the thing holding it all together is that permanent capital.
Yes, they say it themselves. Volatility is the friend of the long-term investor with permanent capital. That structure lets them be patient and then pounce on the very uncertainty they're hedging against. So, let's leave you with a provocative thought based on their interest rate thesis. If PSH is correct and a 5.5% long-term Treasury yield materializes, the risk-free return needed to fight off structural inflation, how drastically would valuations for high growth tech stocks have to change, or really any company that relies on cheap debt?
The math is brutal. Those valuations are incredibly sensitive to that discount rate. But then you have to ask the other question. If they're wrong and rates fall back to historic lows, what does that imply about our expectations for global growth? It forces you to think about what other traditional economic assumptions like geopolitical calm or global supply chain efficiency might still be completely underpriced by the market.
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