Why Hempton likes big tobacco and value stocks

John Hempton, the eccentric hedge fund manager who retired at 39, then founded Bronte Capital after receiving threats of divorce from his wife, has revealed some of his key investments in a recent podcast with David Clark from Koda Capital.

Hempton is perhaps best known for his public stoush with Bill Ackman (who recently presented at this year's Sohn Hearts & Minds Conference). Ackman shorted Herbalife, claiming the company was an illegal pyramid scheme. Hempton disagreed, purchasing a large position in the company. With Ackman having covered his short position, and the stock having rallied a long way since the positions were opened, I think it's safe to say Hempton won this one.

In this article, I summarize some of the key points from the podcast, and provide a link to access the full podcast at the bottom for those who want to hear more.

2020 - a year of extremes

Like many investors, 2020 has been a rollercoaster ride for Hempton. It started well when his Amalthea global long/short fund bet against markets in the early days of the Covid-19 pandemic, making “a crap load of money”. But then he got two things wrong: misunderstanding virus epidemiology in humans; and underestimating just how hostile monetary policy would become to the fund’s strategy.

“People adjust up and down the amount of risk that they are prepared to take such that it matches the benefit that they get. And that’s individual for everybody,” he said. “I was projecting that the virus would get worse and worse and worse. And hence the economy would get worse and worse and worse. And I was wrong … we got some things spectacularly right this year and some things spectacularly wrong!”

The experience has left Hempton reflective, owning British American Tobacco and investing in Value stocks. He also has strong views on how various economies have handled their pandemic lockdown strategies.

“Partial lockdown does much less than you would think. It doesn’t change mortality very much. And it doesn’t even have predictable effects on economic activity (that could go either way). But it is expensive,” he explained.

“Strangely we agree with both our libertarian friends here (who hate all lockdowns) and our public health orientated friends here (that think the lockdown is not harsh enough). Both are rational positions. It is hard for an instinctive centrist to say this, but in this case the middle ground is plain stupid.”

While wishing he had realised this earlier, Hempton said he overestimated the economic effects of the virus because there was no clear behavioural model of how society would respond to the virus. This left the fund way too bearish at the end of March. This reversal of fortunes is reflected in the Amalthea fund, which was up 11% in March but lost 5.1% in April and a further 4.8% in June. However, it did generate a 16.5% return for FY 2020.

Rip van Winkel portfolio

Asked to reflect on Bronte's latest investments, Hempton said it was currently a “Rip van Winkel portfolio” where you “could go to sleep, come back in a year and it will look roughly the same”.

“Our longs are still by and large high-quality stocks that we buy and intend to hold for years,” he said. “Our shorts are by and large the widest range of crap we’ve ever done. Partly in response to the mistake of not keeping our beta constant, we’ve put an enormous amount of effort into measuring our beta so we can roughly keep it constant and get some kind of rebalancing effect.”

Hempton added that most incremental longs added to the portfolio fell into the Value bucket, despite acknowledging that these have been a consistent way to lose money over the past decade.

“Every now and again I tweet out something like ‘Help I’m looking at value stocks!’ And I get about 500 responses, with most wanting to send me to a rehabilitation clinic,” he said. “If you were a naïve value stock investor then you did fantastically well from 2000 to 2006. After that you got smashed!”

Hempton puts the doom and gloom surrounding Value stock performance down to the rapid rate of change in the world over the past ten years, especially with the internet finally delivering on its promise. Value investors who bought Myers or media companies have had plenty of time to reflect on how these sectors have been disrupted. So why does he like these companies now?

“The only question we really want to ask is why is this (company) going to be an important business in ten years’ time?” he said. “We don’t need it to be bigger and better if it’s 7 or 8 PE … we just need to make sure we’re not owning the Sydney Morning Herald as it implodes.”

Custody and cigarettes

This philosophy has led Bronte Capital to looking closely at the custodian banks, which run the back office of large mutual funds, and “the big old dirty tobacco companies”.

Hempton argues that tobacco companies have prospered because regulators have essentially created formidable barriers to entry and allowed the market to consolidate down to a small number of players with outsized market power. Whilst not shying away from the potential risks, the contrarian investor makes the case for the opportunities he believes it presents.

“We have a position in British American Tobacco. Cigarettes margins have gone up and up and up and these margins are supported by the tax regime,” he said. “For years taxes have gone up and this has been surprisingly good for cigarette companies. The reason is that it’s completely supported their margin.”

Further, because regulators want to reduce tobacco consumption, they are actually more than happy for tobacco companies to acquire each other and keep raising prices. Unlike most industries, antitrust concerns are therefore almost non-existent.

And the undervaluation of tobacco stocks over most of the past 30 years has allowed tobacco companies to buy back a lot of their own stock at cheap prices, or pay high dividend yields which investors have been able to reinvest. As Hempton puts it, the industry is dying … but dying slowly and generating bucketloads of cash as it does so.

Listen to the full interview with David Clark on Inside the Rope below.