Why one Canadian hedge fund manager is shorting Bill Gross’s firm

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U.S. bond king Bill Gross started his latest investment outlook letter by warning that when 2015 ends, "there will be minus signs in front of returns for many asset classes." One Canadian hedge fund manager is betting that Mr. Gross's warning applies equally to the stock of his new employer, Janus Capital Group.

Mr. Gross is the billionaire 70-year-old fixed income money manager who abruptly departed the firm he co-founded, Pacific Investment Management Co. (PIMCO) last fall for much smaller Janus. When the move was announced last Sept. 26. Janus stock jumped by 43 per cent to close at $15.89 (U.S.). Janus shares have recently edged higher, trading in the mid-to-high $16 range for much of the past week. With more than 180 million shares outstanding and no other significant news of note from Janus, it's fair to say that Mr. Gross's arrival has added about $1.1-billion to the value of the Denver-based fund manager.

But share prices can't rely star power alone. Mr. Gross has to bring in some client assets to boost fees and earnings to justify the inflated share price. Our hedge fund manager, a well-regarded investor who asked not to be identified, got to work on the numbers, then decided to short Janus stock, placing what he calls a "material" bet that the share price will fall. "This is a classic case of retail investors getting carried away with a story," the hedge fund manager says.

Here's what he's been telling clients. Money management firms typically trade at around 15 times forward earnings. At that multiple, Janus would need to boost annual net earnings by $73-million (U.S.) to justify the $1.1-billion increase in its market cap, by our hedge fund manager's calculation, or $117-million in earnings before interest, tax, depreciation and amortization (EBITDA), and, working back one more step, $234-million in revenues. Assuming the company earns 0.5 per cent in fees for every dollar in funds under management, Mr. Gross would therefor have to bring $47-billion in new funds to Janus in the next year or two to justify the lofty share price, all other things being equal. (The fund actually lists a 0.65 per cent management fee, which would translate into a need for $36-billion in new funds)

How much money has followed Mr. Gross to his Janus Unconstrained Bond Fund? Just $1.4-billion so far, and some of that is his own. How much is uncertain: a recent Wall Street Journal story revealed much of the total flowed into the fund through the same California brokerage office where one of Mr. Gross's personal financial advisors works.

Janus did not respond to a request for comment.

The fund saw just $176-million in net inflows in December, $770-million in November and $364-million in October. That's a long way from $47-billion, and a fraction of the $87-billion investors pulled from out of PIMCO funds during those months. The amount that left PIMCO "was the loose money," our hedge fund manager says, and notes that the vast majority of it didn't follow Mr. Gross. The bond king "still has an awful long way to go. It will get harder – and his performance has not been good."

Indeed, Mr. Gross's initial performance has trailed most of his peers as of earlier this month. And consider the fund-raising efforts of another star bond manager, Jefrey Gundlach, who started his own fund manager, DoubleLine Capial LP in 2009. DoubleLine posted some of the best returns in the business, and still it took close to five years to raise the kind of money Mr. Gross needs to bring to Janus to justify its current share price.

Our hedge fund manager is convinced Mr. Gross will fall short of baked-in assumptions, and Janus' stock will tumble. And what if he's wrong and Gross delivers? "Then he would just meet what's priced into the stock. The market has paid for something that hasn't occurred yet and what it has paid for is an outlier."

Then again, many would argue betting against Mr. Gross would make anyone an outlier. It will be fascinating to watch this play out.