All bets are on hedges

Hedge funds, with an estimated £646bn under management, are bringing a little excitement to an otherwise dull media sector. By David Forster

The media sector’s April performance demonstrated the industry’s diversity yet again. Ostensibly, it was a dull month, with fully listed media shares falling 0.6% on average and AIM-listed media stocks rising 0.2%. Yet, underlying this seeming stasis was volatility, with radio/outdoor bouncing 10.7%, and at the other end of the spectrum, free-to-air television falling 3.2%.

The recovery in radio/outdoor, with a 10.9% recovery in GCap’s share price the principal driver, reflected renewed bid speculation and something of a dead cat bounce, with GCap’s shares still down 12.7% in the year to date. Free-to-air’s fall was attributable to disappointment about advertising prospects, with little evidence of a World Cup bonanza, and evaporating bid premium after the failure of the Apax/Greg Dyke offer.

In prior months, we highlighted the growing influence of private equity on the public media sector. For instance, in addition to the lapsed Apax offer for ITV, the list of bidders for EMAP France includes a number of private equity firms, while a private equity consortium has raised its offer for Dutch-based publisher VNU.

However, less obvious is the significant presence of hedge funds as media investors, whose growing influence is probably underestimated and certainly often misunderstood.

The Sunday Times’ Rich List highlights the fabulous rewards generated by an elite and growing group of hedge-fund managers. The nature of the hedge business is such that no one really knows how much the industry has under management, but it is estimated to be around $1.2tr. Of that, maybe 75% is invested in the US, 15% in Europe and 10% in Asia, with nearly all of the European money managed out of London – the hedge fund capital of Europe.

Weight to throw

The actual weight of money that hedge funds can bring to bear is in reality far greater than the $1.2tr (£646bn) figure, given the financing structures that are often in place, including the use of leverage (debt). However, to put the $1.2tr (£646bn) figure in context, it is worth noting that there are a small number of global investment institutions that have that level of assets under management on an individual basis. In other words, although the hedge fund industry has been experiencing phenomenal growth, it is still relatively small and immature.

Much coverage of the hedge fund industry creates the impression that it is about taking large, risky bets, which, if they come off, create phenomenal returns but simultaneously have scope for huge losses if a bet goes awry. In fact, this is at odds with the strategy of most hedge funds.

Absolute returns

A key feature of the hedge fund industry is its focus on absolute returns. Whereas a traditional fund manager typically makes money by investing in a company that increases in value, hedge fund managers make money out of companies that both increase and decrease in value. In a falling market, the measure of a traditional fund manager is whether he or she has outperformed the market. By contrast, the hedge fund manager has the ability to make money out of a falling market by a process known as “selling short”.

Put simply, “selling short” means borrowing stock from an investor (at a cost), then selling it with a view to buying it back at a lower valuation and pocketing the difference. This ability to make money out of rising and falling markets adds a different dimension to the strategy of hedge funds, because it means they may be as interested in a poorly performing sub-sector as one that is rising strongly. This is not the case for traditional fund managers, who will simply want to be “underweight” in those areas that are underperforming.

Ripe with opportunities

So why would hedge funds be interested in media when at face value the sector has underperformed the broader market for the past three years and has been virtually flat much of that time, which sounds as if it must have been difficult to make money using either a long or short strategy?

In fact, the media sector has been ripe with fantastic opportunities for hedge funds to make money. This is because hedge fund management is about more than simply the ability to sell short; it is about the ability to hedge, or put simply de-risking an investment. The characteristics a hedge fund manager will look for include sub-sectors within an industry where there is scope for divergence in performance, or ostensibly similar companies where there appears to be a valuation anomaly.

Backwards glance

If we were to rewind the clock five years and take the view that the ability to freely download music was bad news for the music industry and, furthermore, that while we were unsure of the outlook for the rest of the media sector we were confident that it was not as bad as the prospects for music sales, then a smart strategy would have been to sell EMI shares and to buy a basket of other media shares.

Provided EMI did worse than the media sector average, we would have made money and, in the event that we were caught out by a bid for EMI, we would have had some protection through our basket of other media shares which would have probably received some halo-effect benefit from the EMI bid. In reality, a number of hedge funds made a lot of money by adopting just this strategy.

Similarly, if we felt that WPP Group was undervalued relative to Omnicom, we could buy WPP and sell Omnicom. Whether WPP subsequently rose or fell, we would make money so long as WPP did not become even more undervalued relative to Omnicom (or our original analysis was wrong).

Another sector characteristic beloved of hedge funds is high levels of corporate activity, especially when it involves larger companies where it may be possible to trade in ordinary shares, convertible shares and corporate bonds/debt instruments. This provides a variety of often highly complex trading opportunities for hedge fund managers and can put them at an advantage to a traditional fund manager who only invests in ordinary shares.

In summary, from a traditional fund manager’s point of view, the media sector has been something of a dog for a number of years; for hedge fund managers it has been a target-rich environment.

The IBIS Capital Media Indices

IBIS Capital is a corporate finance advisory and investment business focused on the media sector. The IBIS Capital Media Indices are a set of proprietary analytical tools developed to monitor the UK media industry from the perspective of the share price performance of publicly listed companies.

The indices group companies with similar business models into sub-indices. Over time, significant variations in sub-sectors’ performances can be seen. The indices also include a split b¡etween media companies fully listed on the London Stock Exchange and those listed on the Alternative Investment Market (AIM).

The junior market, with its less stringent listing requirements, has been enjoying a relative boom in investor interest, and many media companies have listed on it. However, fashions change, and when the AIM does suffer a setback, its lack of liquidity relative to the LSE means it is likely to underperform the senior market.

The IBIS indices will highlight the relative performance of the two markets and may give an early indication of a change of direction.

As well as being of interest to those concerned with the performance of the UK’s media industry and its sub-sectors, the indices are useful to directors considering a flotation of their own company, or for anyone else considering the purchase or sale of a media company or shares.

Methodology

The indices monitor all UK media companies listed on the London Stock Exchange and on the Alternative Investment Market with a market capitalisation over £10m. Some companies are included that are listed overseas or have split listings.

The indices are based on the market capitalisation of each constituent company but, in common with the practices of other recognised stock market indices, they make various adjustments.

Factors taken into consideration in the compilation of the indices include: changes in the share prices and number of issued shares of the constituent companies and the number of shares in free float. The effect of initial public offerings, bringing new companies into the indices, and of mergers and acquisitions, which may take companies out of the indices or create new companies, are also considered.