Hedge Fund Betting on Years of Low Rates Puts 99% Cash in Stocks

(Bloomberg) -- A hedge fund that’s delivered almost double the returns of the S&P 500 Index this year is going all-in on stocks -- at least the safe and stodgy ones.

Valley Forge Capital Management, whose $460 million of assets is invested in just nine stocks, has cut its cash holdings to 1%, the lowest in seven years and compared with an average 20% in the fund’s history, according to founder Dev Kantesaria.

In a paradox characteristic of the late-cycle rally, Kantesaria is bullish on equities but bearish on the economic outlook. While he reckons a sustained low-rate environment makes stocks look “exceedingly cheap” now, he’s betting big on companies so entrenched and conservative that they’re insulated from economic swings.

“It is possible that we have here in the U.S. a 10- or 20-year period where interest rates could remain quite low as the Fed tries to spur growth and employment,” he said from Wayne, Pennsylvania. “The ideal type of company that you want to own is a company that has strong organic growth and predictable earnings -- essentially a high-quality bond that’s yielding a good amount today and will continue increasing its yield going forward.”

Owning quality stocks is a popular strategy at this point in the economic cycle -- beloved for its supposed ability to ride on buoyant equity markets even through slower growth. While investors have come to count on global central banks almost as downside insurance, it’s clear global economic expansion is not accelerating. And beyond the near term, structural changes in the economy, including an aging population, are fueling fears of a secular slowdown.

Valley Forge Capital is up 34% this year through June, nearly double the S&P 500’s total return, and has gained 400% since its 2007 inception, according to a person familiar with the matter who asked not to be identified because the information is private.

Chasing the stock rally while fretting about the economy is especially in vogue now. A Bank of America Corp. survey of fund managers overseeing a total of nearly $500 billion showed investors are adding equities and cutting cash this month. At the same time, the percentage that saw the business cycle as a risk to market stability reached nearly 73%, the highest in eight years.

The S&P 500 dropped for a third day on concern profit growth is slowing and the U.S.-China trade conflict has come no closer to a resolution.

That environment dovetails with Valley Forge Capital’s conservatism. The fund favors large companies with strong pricing power, growing earnings, a reliable outlook and little need for capital re-investment. In Kantesaria’s books, the stocks that fit the bill include Visa Inc., Intuit Inc., Autodesk Inc., Fair Isaac Corp. and Moody’s Corp.

With a concentrated portfolio, he has a lot riding on that handful of stocks. It’s a strategy more active investors are adopting to prove their mettle against passive funds coasting on high-flying equity benchmarks. To some, that promises better odds of beating indexes -- though the loss of diversification might also mean wilder swings.

“It is the only way to invest and have any chance of outperforming the broader market,” he said. “By the time you own 25 or 30 stocks or more, you’re not investing in wonderful businesses anymore.”

That selectivity means even the tech giants -- revered for their dominance and profit growth -- are too aggressive in re-investing cash for the 46-year-old, who studied to be a doctor at Harvard and worked in venture capital before he founded the hedge fund in 2007. (His fund has a 0.4% position in Amazon.com Inc.)

The common gripe is stocks with such prized qualities are already richly valued. U.S. companies with fast earnings growth have been extending a record high versus the overall market almost every day of late, according to MSCI indexes. Ditto for a Goldman Sachs Group Inc. basket of high-quality shares.

Kantesaria’s trick is to go for the dullest names. Being in the suburbs of Philadelphia rather than a few blocks away from Wall Street helps, he reckons.

“Telling someone about the business model of Moody’s is like watching paint dry,” he quipped. “No one is talking about these companies.”

To contact the reporter on this story: Justina Lee in London at jlee1489@bloomberg.net

To contact the editors responsible for this story: Blaise Robinson at brobinson58@bloomberg.net, Namitha Jagadeesh, John Viljoen

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