Third Point LLC’s flagship fund underperformed the broader US market in the second quarter, gaining just 1.1% after holding “undersized” positions in the handful of tech behemoths that drove the S&P 500’s returns.

Now Third Point is pivoting toward holding more of the potential winners in any artificial intelligence revolution, fund head Daniel Loeb wrote in a letter to investors. The firm’s too-small stakes in the likes of Microsoft Corp. and Alphabet Inc., which can benefit from the growth of AI, contributed to its lagging performance.

Those two companies gained at least 15% in the quarter, helping to pull up the S&P 500 by more than 8.7%, including dividends and price gains. Third Point Offshore Fund Ltd.’s performance underscores the difficulty active managers have faced in a market where a half dozen stocks have accounted for the majority of index returns.

Loeb said his team correctly called the market bottom last October, forecasting the economy would begin to stabilize and inflation would ease. But instead of betting on growth stocks, the firm remained cautious and focused on value stocks, reflecting the pervasiveness of bearish sentiment that gripped professional investors late last year and earlier in 2023.

“Unfortunately, rather than expressing this constructive view by investing heavily in high-quality tech companies with earnings growth (an obvious choice in hindsight), we primarily committed capital to value situations which have since underperformed,” Loeb wrote in his letter.

The Russell 1000 Value Index returned about 4% in the second quarter, on a total return basis. While Third Point’s performance lagged US equities, the fund did outperform a Credit Suisse hedge-fund event driven index, which gained about 1%.

Third Point believes AI will have far reaching effects on the economy, stocks, and society. About 45% of the fund’s net long exposure includes direct and indirect AI beneficiaries, such as Microsoft and semiconductor companies.

“We are mindful of the ‘hype cycle’ that surrounds AI as well as the attendant regulatory risks,” Loeb wrote. “And while the AI investment opportunity remains in its infancy and will take time to mature, we see clear evidence that it is already leading to the creation and destruction of large profit pools, and many stocks will be beneficiaries.”

Trimming Shorts

Loeb has been cutting back on selling individual stocks short. It’s more challenging to bet against particular companies’ shares because of factors like Reddit discussions that can push meme stock prices higher, according to Loeb.

“Fundamental analysis is increasingly taking a back seat to monitoring daily option expiries and Reddit message boards, as evidenced by the numerous short squeezes and manipulations of heavily shorted stocks such as AMC and Gamestop in 2021 and others this year,” Loeb wrote, adding that he hasn’t abandoned the practice but is reducing single-name shorts in favor of market hedges.

The company’s corporate credit holdings returned 8.7% in the first half of the year. Third Point believes high-yield risk premiums, or spreads, will widen because of a weaker economy, or as higher interest rates make refinancing harder.

--With assistance from Jeremy Herron.