In college, Benjamin Stein and Zachary Sternberg devoured Warren Buffett’s annual letters, embracing his value-driven approach to investing.
This guided the undergrads when they started a hedge fund, Spruce House Investment Management, in 2006. It would go on to mint profits and manage billions for clients like the Massachusetts Institute of Technology, the University of Notre Dame and wealthy individuals like hotelier Barry Sternlicht.
Around 2017, Stein and Sternberg began to change tack, going on to place what would become chunky wagers on highflying growth stocks and lengthening how long they were willing to wait for those companies to generate profits. The shift worked—for a while. By 2021, their fund’s assets had swelled to $4.7 billion, up from $2.2 billion in late 2017.
Then the Federal Reserve began hiking interest rates. Tech and growth stocks cratered. So did Spruce House: The New York hedge fund lost about two-thirds of its clients’ money in 2022, according to people familiar with the matter, one of the worst showings by a stock-picking fund that year.
It was a period of “psychological torture,” the two wrote in a letter to investors.
Now, Stein and Sternberg, both 38 years old, are trying to claw their way back. They have told investors they are holding more cash, holding less concentrated positions and hewing more closely to their investing roots.
“It’s important to remember we are 36, and even though it doesn’t feel this way today, we are just getting started—and this too will be an unfortunate blip on a very long-term chart of our returns,” they wrote to investors last year.
They have high hurdles to clear. Spruce House for the year through mid-December has gained about 65%, according to people familiar with the matter, fueled by a recent rally in tech and growth stocks. (That includes a gain of about 145% in its publicly traded stocks.) But it is still in the red, cutting into the lucrative fees it can make and raising the risk of employee turnover. Numerous hedge-fund firms over the years have thrown in the towel when caught in a similar bind.
Many a fund has been drawn to the huge returns promised by growth stocks, especially in the years just before the pandemic. Sustained near-zero interest rates made many investors willing to take on more risk. A flood of money into fast-growing public and private companies supercharged corporate valuations and juiced their investors’ returns. Covid-19 seemed only to cement the new regime.
But in markets, venturing afield is often risky. And for value investors in particular, chasing a sparkly new trend runs counter to the Buffett principle of sticking to what one knows. Other managers who bet big on growth are digging out from their losses.
Stein and Sternberg don’t see themselves as having changed strategies, a person close to them said—a view some of their clients take issue with. They have told people they are partnering with founders they believe in for the long haul, regardless of whether the companies are public or private.
The two became friends their freshman year while living in the Spruce House dorm at the University of Pennsylvania.
Stein’s father, Andrew Stein, once served as president of the New York City Council. His mother, telecom veteran Lynn Forester de Rothschild, married billionaire Evelyn de Rothschild of the European banking dynasty.
Sternberg grew up in a Philadelphia suburb with his father, a real-estate developer, and his mother, a lawyer.
In college, Stein studied international relations. Sternberg studied accounting. The two were enamored with Berkshire Hathaway’s Buffett, who espouses cheap stocks in companies that generate consistent profits as opposed to riskier growth stocks that promise big future returns. They worked summers with a New York value investor, Robert Robotti.
The two also discovered the importance of compounding, a principle often lauded by Buffett. Running the math as 20-year-olds, Stein and Sternberg realized that $1 compounding annually at 15%—a lofty return—would be $1,084 by the time they were 70. At 20%, $1 would turn into $9,100.
Figuring they didn’t have time to waste, they opened an E*Trade account and started investing from their dorm rooms. A year later, they formed Spruce House and went out to raise money.
The pair gained their own bona fides in the value-investing world. They were asked to contribute to the newest edition of Benjamin Graham and David Dodd’s “Security Analysis,” a bible for value investors first published in 1934. Seth Klarman, who runs the Boston hedge fund Baupost Group and became a mentor to Stein and Sternberg, edited the book.
As Spruce House grew, Stein and Sternberg described it not as a hedge fund but “a friends-and-family investment partnership” with some institutional clients. Even as they were managing billions of dollars, the firm didn’t have an investor-relations department, they wrote.
Various family members, friends and others took a chance on the duo. One was Sternlicht, the real-estate investor, who for years has served with Forester de Rothschild on Estée Lauder’s board. MIT’s endowment was an important early institutional client.
A foundation tied to Klarman, and others tied to prominent biotech investors Julian Baker and Felix Baker, also cast in with Spruce House.
Stein and Sternberg liked founder-led companies, had a concentrated, typically long-only portfolio and often held on to positions for years. They sometimes took board seats, and for years focused on buying big stakes in cheap, unglamorous companies like logistics provider XPO and real-estate services provider FirstService.
One notable win came from doubling down on XPO in 2018 after a short seller’s report caused the stock to nosedive. Already a top shareholder, Spruce House reported owning tens of millions of dollars in additional shares at year-end. By the time Spruce House sold the last of its shares a few years later, XPO’s stock was worth multiples of its 2018 low.
It was around 2017, after years of near-zero interest rates, that Stein and Sternberg began to buy into more expensive companies where big potential profits were years out.
They had reason to be confident. Spruce House’s average annual return from its start through 2016 was 18% after fees, compared with about 8% for the S&P 500, including dividends.
The fund took stakes in two buzzy online companies, furniture seller Wayfair and car dealer Carvana. It traded out of profitable wagers in non-tech companies like construction-materials supplier Builders FirstSource. It added bets in newly public companies like mobile developer tool provider AppLovin and keyless lockmaker Latch.
Shares of online car dealer Carvana have soared this year, but are still down sharply from their pandemic highs. Ted Shaffrey/Associated Press
Stein and Sternberg later would write that Graham, the famed value investor, would view their wagers on Carvana and Wayfair as speculation. They described the companies as logistics networks, and wrote that it was worth the risk to bet on companies trying to improve markets that are fragmented and offline.
Stein and Sternberg also made a late-cycle push into venture investing. Spruce House put money into 14 private companies in 2021, up from one in 2020, according to data from PitchBook.
In a letter to clients in July 2021, the two wrote: “In very short order we have been able to put Spruce House in the flow of some of the highest quality venture and growth equity opportunities.”
Markets rewarded Spruce House’s shift, enabling it to keep posting outsize returns as it got bigger. By mid-2021, it was compounding at about 20% a year since inception, nearly twice as fast as the S&P 500, including dividends. Later that year, they sold nearly $900 million worth of shares in Carvana and Wayfair, reaping some pandemic gains.
The two 30-somethings had started to take on some of the trappings of success. Sternberg bought a $17 million home in Aspen, Colo., in 2019. Stein paid $11 million for an apartment in Manhattan’s Tribeca neighborhood in 2021.
By 2022, tech and growth at times made up more than 70% of Spruce House’s portfolio of disclosed public holdings globally, up from less than 20% as of early 2017, according to Old Well Labs, a data platform that analyzes investors and their holdings. The analysis categorized Wayfair and Carvana as tech.
But when the Fed started hiking rates, tech and growth stocks plunged. Spruce House’s public-stock holdings were hit particularly hard. Shares of Carvana ended 2022 down 98%. Wayfair and AppLovin lost more than 80% of their value.
In a letter to clients, Stein and Sternberg wrote they were re-examining their portfolio and trying to stay focused and unemotional. They used much of the money from sales of Carvana and Wayfair stock to reinvest in the companies in early 2022 at lower prices.
“If we are close to right about each company’s value in five years, little else really matters,” they wrote in July 2022, adding they were taking care of themselves by sleeping, exercising, meditating and reading Winston Churchill.
They also said they had invested more of their own money into the fund and offered to begin collecting incentive fees on any new money clients put in only after that money had doubled.
The pair later vowed to return to prioritizing companies that were consistently profitable and carried little debt.
Candace Taylor contributed to this article.
Write to Juliet Chung at Juliet.Chung@wsj.com and Peter Rudegeair at peter.rudegeair@wsj.com
