VIEWPOINT – JANUARY 2016 A TIME FOR ‘LONG-SHORT’ EQUITY · 2015-12-31 · 7 Viewpoint –...

VIEWPOINT – JANUARY 2016 A TIME FOR ‘LONG-SHORT’ EQUITY

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Viewpoint – January 2016 | A time for ‘long-short’ equity

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n Lower market returns will increase the importance of alpha in portfolios

n Long-short funds can generate greater alpha as individual stock returns diverge

n Long-short funds can protect capital and profit as market volatility rises

A TIME FOR ‘LONG-SHORT’ EQUITY

As the post-crisis easy monetary policy period in the US comes to an end and volatility in equity markets increases, some investors are looking to long-short equity funds, designed to navigate the volatile markets.

Volatility is returning to financial markets, making some investors rethink the kind of exposure they want to equities. Stock markets have rallied almost without interruption since the 2007-2008 financial crisis, richly rewarding investors with broad exposure to the asset class. But China’s slowing economy, the Eurozone’s prolonged weakness, Britain’s vote on exiting EU, and US preparations for interest rate rises are stoking uncertainty, ending this benign financing environment.

For the past seven years, central bank monetary easing has helped economic recovery and boosted equity prices, with the S&P 500 Index more than tripling in value since March 2009. S&P 500 companies’ operating earnings have doubled to ~$1 trillion, with more than two thirds of them beating estimates during this period. The percentage of companies exceeding earnings estimates peaked in the third quarter of 2014, and more and more companies have started to miss estimates especially in Industrial, Retail and Financial sectors. As corporate profits falter, a nervous market is penalising companies that don’t meet earnings expectations by severely marking down their share prices.

This is the environment in which equity long-short funds are designed to perform better, as their managers navigate the markets’ volatility by dynamically altering the exposure to markets. Long-short funds can benefit more from the diverging fortunes of companies, which present greater opportunities for fundamental stock picking. They can invest not only in stocks they believe are poised to rise but also ‘short’ those likely to fall (see mechanics of short selling box).

We believe that turning these opportunities into solid returns takes highly skilled stock picking driven by a fundamental research framework. As Warren Buffett, the legendary investor, has said: “It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it’s not.”

Amit Kumar Portfolio Manager, US Equities, Investments, Equities.

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MARKETS BECOME SELECTIVE

Since the financial crisis, central banks across the globe have maintained accommodative policies to help economies and inflate asset prices through low interest rates and quantitative easing. Dovish and stimulative policies in the US, UK, Europe and Japan have helped to heal the financial system and prevent contagion spreading to the real economy.

As a consequence, equities have made gains in many cases regardless of the quality of the company that underlies them (as measured by important fundamentals such as its return on equity, cashflow, balance sheet strength, etc). Such market conditions have made stock picking difficult, especially for short positions, and they have proved frustrating for managers that rely on simple quantitative frameworks.

The benign interest rate environment has also fuelled merger and acquisitions activity that has peaked this year with ~$2.7 trillion of transactions in the US. Short selling of poor quality overvalued companies has been more difficult in this backdrop. As John Maynard Keynes, the noted English 20th Century economist and investor, said: “Markets can stay irrational longer than you can stay solvent.”

We believe we are now at a turning point for the equity markets and the operating metrics that drive stock prices. With the US and UK signalling early steps to remove some of the monetary accommodation in light of improving economic prospects, lofty stock valuations may prove unsustainable as interest rates rise and quantitative easing tails off. At the same time, Europe and Japan have signalled they will continue with quantitative easing, which will accentuate foreign exchange impact on export driven companies in the US and UK.

Quantitative Easing vs. S&P500 performance

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Total Securities purchased in Fed Balance Sheet ($b) since Lehman Bankruptcy

S&P 500

Fed B/S ($265b) S&P500 (-45%) = ~($3T) marketcap

Fed B/S ($211b) S&P500 (-16%) = >($1.5T) marketcap

Fed B/S ~($100b) S&P500 (-18%) = >($1.5T) marketcap

Fed B/S ~($180b) S&P500 (-8%) = >($1T) marketcap



Bloomberg 2016.

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It is not only monetary conditions that are beginning to diverge; so is economic growth. While growth prospects have weakened in China and other emerging markets during 2015, they have improved slightly in developed markets. Global economic (GDP) growth for 2015 is projected at 3.1% by the IMF in its latest economic outlook, 0.3% below 2014 and 0.2% below its forecasts in July 2015.1 It expects the recovery in advanced economies to pick up slightly, while emerging markets slow for a fifth year in a row, primarily reflecting weaker prospects for large emerging market economies and oil-exporting countries. 1IMF World Economic Outlook, October 2015.

AMPLIFYING STOCK PICKING SKILL

Rising volatility – VVIX Index December 2011 to December 2015

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VVIX Index 200 day moving average

Source: Bloomberg as at 31 December 2015.

Against this backdrop, financial market volatility is rising. These are ideal conditions for long-short equity funds, which depend for their returns far more on their managers’ skills than long-only funds. They are designed to amplify the effects of stock picking skills, or alpha, rather than the movements of the overall equity market, which is known as beta. At the same time, they may also manage their net exposures based on their market outlook.

For example, our US long-short equity funds avoided the worst of the late summer’s equity market falls by cutting market exposure after we spotted early signs of distress arising in China. The country’s GDP outlook was weakening, questions were being asked about elevated levels of debt and companies with large Chinese businesses were reporting subdued trading conditions. The Chinese equity market had fallen by 40% from its peaks, yet even though China is the world’s largest exporter, equity markets elsewhere hardly reacted.

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From a stock selection perspective, the economic environment is also leading to clear opportunities. For example, many large US companies are exporters and international revenues account for more than one-third of S&P 500 revenues. As the US dollar rises because of the likelihood of higher US interest rates, so they are becoming less competitive. This is likely to depress revenues. With the markets punishing earnings shortfalls severely, short positions in stocks with unrealistic expectations could be richly rewarded.

At Columbia Threadneedle, we have two types of long-short strategy. Our Extended Alpha strategy’s net exposure may range from 80-120%, depending on the manager’s optimism about stocks and the market. Our Absolute Alpha strategy’s market exposure is typically far less, ranging from -35% net short of the market to 50% net long.

The Extended Alpha concept – how it works. Greater opportunity to generate alpha

Fund exposure

Long-onlyportfolio

Extended alphaportfolio

100% 100% 100%

30%

30%

Leverage

Shorting

Net exposure -40%

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Extended alpha funds combine a traditional long-only portfolio with a short portfolio. Short sales generate cash, which is used to increase long positions. In this example, the resulting portfolio is 130% long in favoured stocks and 30% short in stocks that are expected to underperform. The net exposure is typically 100% just like plain long only funds. Example only. In this example there is 130% long and 30% short.

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Threadneedle American Extended Alpha Fund Performance against benchmark and peer group

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Threadneedle American Extended Alpha Z USD Accumulation Morningstar GIFS Offshore - US Large Cap Growth Equity

UK IMA - North America S&P 500 Total Return

Source: Columbia Threadneedle Investments, as at 31 December 2015.

The Absolute Alpha concept – how it works. Greater opportunity to generate alpha

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Absolute alphaportfolio

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Emphasis on absolute returns (alpha), not market returns (beta).

Absolute returns are derived from picking stocks. Both long and short

In this example, the portfolio is 80% long in favoured stocks 70% short in stocks expected to underperform.

The net exposure is typically low.

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We combine intensive company research with a structured portfolio approach, splitting our holdings into four groups: core holdings, cyclical growth, special situations and catalyst-driven. In our short book, we also use a style known as relative value; short positions may be paired against longs, aiming to take advantage of the contrasting fortunes of companies in the same industry.

Amazon is an example of a long core holding. Looking back to 2012, it was criticised by well-known and respected hedge fund managers for its high valuation and poor profit margins. We initially examined the stock as a short but the striking similarity of Amazon’s growth model to Walmart, its prime franchise, hyper growth cloud business, and hidden options to unlock value in video and advertising led us to believe that Amazon’s growth model was sustainable. Jeff Bezos, the CEO, had been advocating investing for the long-term and focus on cash flow since 1997, and the company’s growth had clearly delivered on his vision. Amazon’s heavy investments in Prime, AWS, Kindle, digital media and customer experience were weighing on profits and were the basis of most bearish calls. However, Amazon’s investments have started to pay off in the last few quarters, driving a substantial rise in sales and its share price.

When it comes to selling stocks short, what all of our holdings have in common is that they are likely to disappoint the market. Mark Roberts, the analyst who publishes Off Wall Street short position research, says: “The main thing short ideas have in common is that their business model is not going to produce the sales and earnings that are expected by the market.”

THE MECHANICS OF SHORT SELLING

Shorting a stock involves borrowing shares and selling them in the market. By selling stocks they do not own, investment managers aim to profit from falls in their prices. In general, the holding period for a short trade is briefer than that of a long trade.

Compared to simply buying stock, borrowing it introduces additional considerations. These include borrowing fees, the possibility of the lender calling back its shares, dividend payouts, short squeezes, voting rights and regulatory restrictions.

Most importantly, borrowing stock adds the margin and callable features to the short trade - the most critical risks that make shorting different from simply selling a stock that you own.

To use an analogy, buying a stock is like running a marathon where the finish line is the only important milestone. By contrast, shorting a stock is like a hurdle race, where short-term hurdles (getting called on the stock, merger and acquisitions rumours, short-sale restrictions etc.) are as important as the finish line.

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REMINDER

n Lower market returns will increase the importance of alpha in portfolios

n Long-short funds can generate greater alpha as individual stock returns diverge

n Long-short funds can protect capital and profit as market volatility rises

TAKING ADVANTAGE OF VOLATILITY

As we enter a less certain period in equity markets, it’s likely that more companies will fail to deliver the sales and earnings that the market is expecting. This will reward short positions that are the result of skilled fundamental research.

At the same time, volatile markets may also produce compelling opportunities for investing in long positions. For example, broad market sell-offs often leave some high quality companies trading cheap and offer a chance to buy them at low valuations. After the long post-crisis period when equities rose together as an asset class, the return of volatility in equity markets is creating a host of new opportunities for stock pickers and makes a strong case for long-short equity.

Amit Kumar is Portfolio Manager for the American Absolute Alpha Fund and the American Extended Alpha Fund. He is also responsible for researching US companies across the consumer discretionary and technology sectors. Amit holds an MBA in Finance from Columbia Business School and a BSc in Technology from the Indian Institute of Technology. He also holds the Chartered Financial Analyst designationAmit Kumar is also the author of “Short Selling: Finding Uncommon Short Ideas” (Columbia Business School Publishing) Hardcover – December 8, 2015.

Important information: For Investment Professionals use only, not to be relied upon by private investors. Past performance is not a guide to the future. The value of investments and any income from them can go down as well as up. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Issued by Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: Cannon Place, 78 Cannon Street London EC4N 6AG. Authorised and regulated in the UK by the Financial Conduct Authority. Issued in Hong Kong by Threadneedle Portfolio Services Hong Kong Limited (“TPSHKL”). Registered Office: Unit 3004, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Registered in Hong Kong under the Companies Ordinance (Chapter 32), No. 173058. Authorised and regulated in Hong Kong by the Securities and Futures Commission. Please note that TPSHKL can only deal with professional investors in Hong Kong within the meaning of the Securities and Futures Ordinance. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document you should obtain independent professional advice. Issued in Singapore by Threadneedle Investments Singapore (Pte) Limited, 07-07 Winsland House 1, 3 Killiney Road, Singapore 239519. Any Fund mentioned in this document is a restricted scheme in Singapore, and is available only to residents of Singapore who are Institutional Investors under Section 304 of the SFA, relevant persons pursuant to Section 305(1), or any person pursuant to Section 305(2) in accordance with the conditions of, any other applicable provision of the SFA. Threadneedle funds are not authorised or recognised by the Monetary Authority of Singapore (the “MAS”) and Shares are not allowed to be offered to the retail public. This document is not a prospectus as defined in the SFA. Accordingly, statutory liability under the SFA in relation to the content of prospectuses would not apply. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. This material includes forward-looking statements, including projections of future economic and financial conditions. None of Threadneedle, its directors, officers or employees make any representation, warranty, guaranty, or other assurance that any of these forward looking statements will prove to be accurate. Issued in the US by Threadneedle International Limited (“TINTL”), a UK.-based investment management firm provides financial services to individual and institutional investors. TINTL is registered as an investment adviser with the U.S. Securities and Exchange Commission and is authorised and regulated in the conduct of its investment business in the UK by the UK Financial Conduct Authority. columbiathreadneedle.com Issued 01.16 | Valid to 04.16 | J24699

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VIEWPOINT – JANUARY 2016 A TIME FOR ‘LONG-SHORT’ EQUITY · 2015-12-31 · 7 Viewpoint –...

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