Adding value on both sides of the trade
Investor sentiment in the time of COVID has propelled some stocks and disrupted others, in the process creating some once-in-a-lifetime opportunities, says Paradice portfolio manager David Moberley.
With so much going on in the world – the race for a vaccine, the approach of a monumental US election, a global recession – many investors are rushing to exit stocks tipped for terminal decline. Moberley concedes many cyclical companies face medium-term structural headwinds, but suggests many investors are overreacting.
The retail sector is one he believes has fallen too hard, too quickly and which could instead proffer some upside surprises. He suggests parts of the energy, travel and leisure sectors may also offer medium-term opportunities.
In addition, Moberley explains how the manager’s short-selling strategy brings renewed alpha opportunities, producing over 350 basis points of alpha for the fund in the first 15 months of existence.
In the following wire, Moberley discusses whether a COVID cure is priced-in; how a short strategy can add value; and why he isn’t betting on the Biden-Trump showdown. He also singles out a "rare opportunity" to pick up a monopoly asset a discount.
As you look across the Australian market, what are some of the dynamics that stand out to you?
The market's trading at quite lofty multiples of around 22-times forward earnings. Obviously, the market will be forward-looking and not want to capitalise a potential trough in that earning cycle, but even when you forecast two years forward, the market's still trading at quite expensive levels.
I think one of the interesting things at the moment is the dichotomy in the market. That headline multiple may look expensive, but the bottom quartile of cheap or lower multiple stocks are very cheap. And that top quartile of expensive or high multiple stocks is very expensive.
Where in the market are you finding opportunity at the moment?
There are both risks and opportunities over the next four to six weeks. There is obviously a lot of speculation in the market around what sort of data is going to come out with these upcoming trials of a potential coronavirus vaccine. We are becoming increasingly of the view that you are likely to get some positive data around that.
There are so many shots on goal, so much money invested in this, that one of these phase three trials is likely to show some positive data. And we think that is potentially going to create some quite good opportunities in the market.
Why has Paradice added a long/short strategy to its suite of products?
Australia is quite unique in that it is one of the most concentrated markets. And what I mean by that is you have got a huge number of very big stocks at the top end of the market, and then a very long tail of small positions.
There are some unique challenges that come along with investing in a market like that. It is very difficult to express a negative view on that long tail of small weights. So, if you want to be negative on one of the big ones and you do not own it, you are taking quite a big bet against the benchmark. However, for a lot of those smaller weights, if you do not own it, it becomes an irrelevant bet. So that is the first problem.
The second problem is when you combine a lot of core Australian equity managers together, because of those huge stocks and sectors at the top end of the benchmark, they end up looking quite similar at the end of the day.
When you relax the shorting constraint and you enable managers to take a negative view, a lot of those smaller weights can be dialed up. For example, if you are negative on some of the casino stocks, they are a very small part of the benchmark, only 50 basis points. It is not going to mean anything if you don't own it. You can dial that weight up or express a negative view by shorting. And then obviously if those stocks go down, you're getting a benefit out of it.
The other benefit is that once you relax that shorting constraint, you are skewing your portfolio further and further away from the benchmark. So, from a portfolio construction perspective at, at the asset allocation level, there are blending benefits.
Can you tell us about the process you’ve developed and how you use this to identify short positions?
There are lots of different ways to make money on the positive or the negative side. And rather than going through all of them today, it's probably just good to put them into 'buckets'. We are finding most of our shorts fall into really four categories:
- An earnings downgrade, or an expectation mismatch where our fundamental process has highlighted that expectations are too high.
- Cash flow or balance sheet stress. We know over-geared companies tend to underperform.
- Fraud. This is not really a lot of what we do. Australia's a high-quality market, but we have managed to find a few.
- Pair trades, which involves really dialing up risk in between a couple of highly correlated stocks or sectors. Basically, you're looking to take out some of that the top down or macro risk in the trade. Again, it is not a huge amount of what we do, but it’s an approach we might use if we wanted to take a view on a certain commodity stock and wanted to remove the risk around movement in that commodity.
What are some of the less technical nuances or subtleties of the shorting process that you might employ to save yourself getting hung out to dry?
Firstly, we are never trying to pick a top. It is fraught with danger, and markets can be irrational for a lot longer than we can be solvent. If we were looking to take something like that on, it would only be if we saw a catalyst or an event.
When you are investing on the short side versus the long, your problems actually get bigger instead of smaller. So, when you are long a stock and you get it wrong and the stock goes down, it becomes a smaller part of your portfolio – less of a problem. But when you're short a stock and you get it wrong, it gets bigger in your portfolio. So, risk management is a key part of what we do. And we make sure that if we're getting something wrong, we're managing that position size. And if we're getting it wrong, we need to move on.
Being an independent thinker, but also having an open mind, is really important.
How much value has the short side of the portfolio added overall? What role does it play?
It has added alpha, but it's also helped with capital protection. So, a bit over half of the alpha of the product has been delivered on the short side.
Since inception of the product, we've been able to deliver over 700 basis points of alpha with roughly half of that coming from the short side.
What sort of ranges are you talking about here, in terms of long versus short net exposures?
There's a couple of different products in the mix when people talk about long/short, and it's probably important to highlight that what we've launched is called an alpha extension, or a 130/30, that's actually an equity product. It has a maximum cash limit of 20%, and so really it is benchmarked towards an index and you would expect it to have equity-like returns. There are other types of products in the market that are pure hedge or market neutral, benchmarked against cash. That's not what we're doing.
What are some of the sectors you think may be short-term beneficiaries, but more importantly might offer reasonable value on short notice?
Coming into COVID, obviously the sectors that were impacted the most have been those cyclical sectors – financials, energy and tourism and leisure have been hit pretty hard. A few of those sectors probably have some medium-term structural headwinds. Financials, for example – if you are a spread business, lower rates aren't helpful, but some of the other sectors will clearly benefit from a cyclical bounce.
Do you think that people have become too carried away?
One of the sectors that has clearly benefited is stay at home or work from home companies, and retail is obviously a part of that. I think it's a bit early to get too negative on that part of the market. It's become a bit of a consensus view now that these stocks are about to roll over. But if that continuation of the strength in earnings was to continue into AGM season, for example, we could see another leg up in those names.
What are some of the major markets that interest you at the moment?
Inflation expectations have really picked up a lot, especially when you look at certain parts of the US bond market. Despite Fed intervention, you're actually starting to see some outflows into the high yield credit market and credit spreads are starting to widen, which is typically not a good sign for markets. So, there are a few things we're watching that are making us a little bit cautious.
Do those two indicators have a direct impact on the stocks you buy?
Yes, some of the stocks are impacted by bond yields and credit spreads. But it's more a sentiment indicator and looking at some potential stress starting to emerge in different asset classes where we are not invested, to make sure that we're looking at the things we need to in terms of equities.
Does the US election factor into your thinking?
I'm unlikely to take a really strong view on such a binary outcome, but you're definitely going to see some volatility. As we saw in very small changes around probabilities of who wins post that debate, markets really had an interesting day. You're going to see volatility, but until we’ve got a level of certainty, we're unlikely to take a strong view either way.
Do you think there's a credible case for a return of inflation?
I am a bit sceptical. Over the short-term, supply chains and inventories could get restocked and drive pricing or inflation. But over the medium term, I think we've learned that free money and money printing is deflationary. So, you've got a lot of zombie companies and companies that potentially wouldn't exist without that free money. What they're doing is pushing down pricing in the sectors where they're operating. The US shale industry, in the oil and gas sector, is a perfect example.
Central banks have all been quite clear that, regardless of what we see in terms of growth over the next few years, lower rates are here to stay.
Amid speculation about a cure, is this something already priced into the market, and how does this affect your positioning?
That is the most important question at the moment. There are pockets of the market where I think it’s priced in, but we're still finding a few opportunities where there's medium-term value on offer.
Sydney Airport (ASX: SYD) is one of the stocks we think is really interesting at the moment. Our framework for looking at whether or not some of these stocks are pricing in a recovery or not is considering whether they’re companies we would own on a normalised basis. How did that company perform in a normal year, and then based on those earnings, where did that company trade for the 12 to 18 months on a multiple or evaluation basis coming into that? And what sort of valuation would that imply?
On that basis, Sydney Airport (ASX:SYD) is pricing taking five to six years, for example, to get back to that normalised earnings profile. And I think that is giving you a pretty good risk reward. They have also done a capital raising and they've pretty much taken the balance sheet off the table. So, if there was some delay, you've got a balance sheet that's strong enough to carry you through that process.
But you're also getting a monopoly asset at a significant discount. You don't get many opportunities like that in your life.
Take advantage of market dislocations
The Paradice Long Short Australian Equities fund provides investors with a style-neutral, long/short, active extension exposure to Australian equities.
For more investing insights from David Moberley, please follow him here.
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