To successfully ride (and take advantage of) short-term sentiment in equity markets, investors need to understand that there are two fundamental, yet intrinsically linked processes, which must operate in tandem to achieve long-term outperformance.
1#: Stock choice - the process by which equities are assessed and chosen
The Hyperion team identifies and invests in growth-oriented companies with solid, long-term fundamentals. We like companies with predictable medium to long-term earnings streams, above-average growth potential and high-quality business franchises in large and/or growth addressable markets. And while much of our outperformance can be attributed to our ability to successfully identify quality, structural growth companies, a significant proportion is also attributed to our portfolio construction process.
2#: Portfolio construction – the process in which equities are combined over time
We apply a rigorous, proprietary process, which exploits non-fundamental short-term price volatility while keeping a weather eye on long-term fundamentals.
Our investment process is focused on generating long-term alpha for our clients by systematically comparing current share prices that are heavily influenced by short-term, non-fundamental volatility, to relatively stable but structurally growing long-term intrinsic value estimates.
But what do we mean by short-term volatility and long-term fundamentals?
It may sound self-explanatory, but the reality is that investors do not always understand the key differences between short-term opportunities and long-term fundamentals, or that exploiting short-term alpha opportunities is profoundly different from exploiting long-term alpha opportunities.
At the same time, short sellers have also become very effective at influencing media as well as the short-term sentiment, regardless of the long-term fundamentals of a stock. It can be very difficult to retain and grow positions in the face of short seller and media-driven negative feedback loops and price momentum, if you don’t understand why you own the stock in the first place, and don’t have a strong knowledge-based conviction.
Short-termism is alive and well in equity markets
Most market participants are obsessed with short-term alpha and share price-based returns. To maximise short-term alpha, they try to predict short-term share price movements by buying stocks they think will outperform in the short term and selling stocks that they think will underperform over a similar time period. Broadly, these traders are trying to predict the short-term direction of share prices, which requires them to constantly reassess their short-term directional thesis.
In our view, this is very difficult to consistently do well because share prices are highly unpredictable in the short term. Additionally, when investors adopt a short-term mindset, they tend to focus less on the long-term fundamentals of the stock, and more on news flow and meeting or beating short-term consensus expectations as the dominant reasons for going long or short a stock. And, to add to the problem, most market participants are trying to do the same thing at the same time.
Focus on business fundamentals, not the market noise
Market participants who don’t have a good understanding of the underlying economics of the companies they buy and sell, are unlikely to understand a business’s intrinsic value, so can buy in at the wrong time or be forced out of the stock at the worst possible time.
This can be attributed to the market being directionally efficient in terms of news flow in the short term. In other words, if stock-specific news is negative or positive, then the share price will generally go down or up, as a result, relative to the market.
The challenge for investors in this scenario is that news flow tends to be unpredictable at the individual, industry and wider macro level. In fact, financial markets and economies are inherently random and unpredictable in the short term due to the influence of crowd-based behavioural factors and the general complexity of these systems. Markets and economies are complex adaptive systems, heavily influenced by human sentiment and behaviour, and extremely difficult to consistently predict in the short term.
Unfortunately, investors tend to overweigh the importance and meaning of recent share price movements, which are largely random and driven by non-fundamental market noise over short time periods. In order to overcome this problem, we have built multiple risk adjustments into the process in order to limit behavioural biases. In addition, we draw on over two decades of market knowledge and understanding to assess the long-term fundamental relevance of the negative price momentum and the associated negative news flow.
A contrarian portfolio construction system – why investing with conviction and a long-term view is key
Portfolio construction expertise is essential to long-term success, yet many market participants underestimate the importance of right-sizing portfolios and how much this contributes to overall risk-adjusted returns.
While we actively avoid falling into the trap of short-termism, it does not mean our investment process doesn’t incorporate taking opportunistic advantage of short-term share price volatility to produce long-term alpha for our investors. In fact, our investment process has consistently added long-term alpha regardless of the direction and quantum of short-term share price movements.
Instead of aiming to predict stock price direction, we take advantage of short-term share price volatility, and by using a portfolio construction process which shifts stock weights up and down as appropriate, typically from less than one per cent to a maximum of 13 per cent. In practice this means we often buy when individual share prices are weak and sell when they are strong. This is the opposite to most short-term alpha seeking investors who are sucking liquidity out of the market because they are trying to buy positive momentum stocks and sell negative momentum stocks.
While most market participants try to generate alpha by implementing investment processes that are reliant on correctly predicting the direction and duration of short-term share price movements, at Hyperion we do not attempt to generate short-term alpha through trading strategies such as momentum, near-term news flow, feedback loops, shorting or short-term macro trends.
An essential foundation of our process is the ability to retain positions against the crowd, based on our knowledge-based conviction. And as short-termism becomes ever more prevalent, and short sellers ever more aggressive, conviction-based fundamental analysis has become even more important.
This article was co-written by Mark Arnold and Jason Orthman, Chief and Deputy Chief Investment Officers at high-conviction equities manager, Hyperion Asset Management.