In markets like the present, the ability to go either long or short is invaluable. With potential outcomes ranging from a quick return to all-time-highs, all the way through to a deep recession or depression, the long/short strategy can position to profit either way.
In July last year, Paradice Investment Management assigned their experienced Portfolio Manager, David Moberley, to handle the new Long Short Australian Equities Fund. While it's certainly been a challenging time to start a new fund, Moberley has hit the ground running, posting significant outperformance against the benchmark during the volatility. I recently got in touch with David to hear how he's investing following the recent crash and bounce.
What’s your net exposure right now?
At time of writing our net exposure is around 85%. Our long short is a 130/30 style product and this is toward the lower end of our allowable limits. More importantly the beta of the long book is around 0.9 and the beta of the short book is around 1.25. This probably is more telling around our positioning which remains conservative. Given the volatility, our gross exposure is modest and our goal at the moment is to continue to focus on capital preservation while keeping an eye on medium term value opportunities.
Short term, the outcomes from the COVID-19 virus will continue to drive markets. Most economies globally have been put into hibernation in an attempt to “flatten the curve” and provide an opportunity for our health system to keep up. The result of this is some of the worst global economic data of our generation, with most economists forecasting the sharpest contraction since the great depression. While we have seen significant monetary and fiscal responses, we see this more as life support as opposed to stimulus.
We are not epidemiologists or virologists, however like most we have sought advice widely on these matters. We see the peaking of cases and a slow relaxation of current containment measures as providing short term hope to markets. However, given safe vaccine development is likely 12-18 months away, unfortunately we are likely to be dealing with this situation for some time. We are also cautious about how quickly economic activity can recover after such a significant shock.
While you would expect a bounce in equities after a material liquidation event like we saw last month, we have been surprised at the speed and duration of the current rebound, particularly when we consider the number of risks and issues currently facing the market, including:
- A deeper recession than the GFC,
- Permanent impairment and structural changes to a number of industries,
- Ongoing high unemployment, with the likely drag on consumption, housing and potential solvency/bankruptcy issues
- Huge increases in government debt
- Geopolitical concerns
- Risks of a second wave.
The modern global economy is extremely complex and not something that can be switched on and off like a lightbulb. Domestically we have been one of the best, in terms of virus outcomes and policy response, however we will still emerge with a high level of unemployment and dented confidence in consumer and business sectors, and we have significant exposure to the global outcomes regardless.
Is the negative outlook baked into the equity market yet?
Unlikely. The difference in performance between real world markets like oil and financial assets like equities is one example of a widening disconnect between the real economy and the stock market. While hope can sometimes drive markets, ultimately the fundamentals like earnings and cashflow will be the reality check.
If we look back at prior bear markets to see where PE multiples troughed, it was well below current levels. For example if we look back at the GFC, markets bottomed with a price to earnings ratio of around 10.7x and if you had perfect hindsight to where earnings actually came out it was around 11.5x. The current 12 month forward PE multiple for the ASX200 is around 16.5x. While interest rates are lower this time around and some would argue this enables you to pay more for equities to get the same “earnings yield” this does not provide enough of an offset and there are longer term growth implications to consider. When we look top down and bottom up at the earnings estimates in the market, in many cases we see a goldilocks scenario of a rapid return to normal or V shaped recovery, which is possible, but low probability.
We would be willing to look through the valley in earnings if we had some certainty around:
- The duration of the decline
- The run rate of growth on the other side or
- If the price was so attractive it forced our hand
We also think expectations or the assumption of further central bank policy to be the “buyer of first resort” for almost every asset class may be tested at some point in the future, with a disconnect between what the Fed has been saying versus what the market is currently projecting.
We see risks of outcomes as skewed to the downside compared to what is priced, but acknowledge there is the potential for further hope rallies on reopening bullishness before reality sets in.
What three market signals would you need to see before taking a more bullish positioning?
We continue to watch market distress indicators across various asset classes. We also think credit spreads are very important at the moment given bankruptcies are likely to be one of the catalysts to potentially drive markets lower. Finally, we continue to monitor how the market is responding to bad news. Interestingly, we note the market has stopped responding negatively to some of the horrific macro prints in the US suggesting the short term impacts are now priced. But again we think the duration of the downturn and the risks discussed above are mispriced.
What theme or sectors are you short?
Once we realised the virus was likely to spread globally creating significant economic impacts, we increased shorts in cyclical sectors such as consumer discretionary, financials and energy. We expected credit spreads to widen and took positions to benefit from this.
Balance sheets are always king in a crisis so shorts in over geared companies also provided protection. This event also provided us the catalyst to initiate shorts we had been watching with speculative or bubble like valuations many of which are reliant on external equity funding for existing growth. Our short book typically has elements of the above anyway as part of our process so in some instances it was just a matter of dialling up existing positions.
Our short book was down around 36% in March which added to performance significantly and was a key in capital preservation. We have started shifting some shorts away from heavily oversold stocks towards those that are stretched or overbought in this bounce.
Correspondingly, where are you long?
Our long book is defensive in nature with overweights in staples, healthcare and lower beta materials such as gold and iron ore. In general, we have been high grading the portfolio in the recent correction adding high quality growth names, however we have opportunistically added to medium term value opportunities when valuations became attractive enough, despite short term headwinds persisting.
Staples are currently benefiting from a significant household restock. While we expect this to be somewhat transitory, this appears to already be discounted with multiples coming back to levels that represent good value for the future level of growth beyond COVID-19.
Our healthcare longs are in very liquid large cap names that are either unaffected or benefiting from the current environment or likely to be one of the first to benefit from a reopening of the economy. With broader growth concerns we see this sector as being able to continue to deliver growth and strong return on capital independent of the economic cycle and these stocks are likely core holdings for the foreseeable future.
Gold is expected to continue to benefit in the current environment as central bank balance sheets explode higher with asset purchases. While we see emerging risks and continue to monitor supply demand dynamics, the large cap iron ore miners are producing huge amounts of free cashflow at current prices and their balance sheets remain very strong. In a liquidation draw down like we saw in March, correlations converge towards one and our long book was down only marginally less than the market however given our cash holdings this meant in aggregate including our short book we did about 5% better than the index.
Complete this statement: A long-short fund provides investors with...
A long-short fund provides investors with the ability to compound at better risk adjusted rates of return through the cycle, with increased capital preservation in down markets and an ability to leverage alpha in up markets.
A 130/30 or alpha extension fund gives a better pure equity substitute when implemented successfully as it provides the portfolio manager with:
- An opportunity to take advantage of negative views on stocks or sectors that are not big weights in the benchmark (the biggest view against a stock for a long only is its benchmark weight)
- Manage sector risks and industry positioning in a heavily concentrated market like the ASX to avoid unintended bets or style bias
- Leverage a strong information ratio by reinvesting back into existing alpha opportunities
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.
Joining the dots …. The 1918 ( non- ) Spanish flu pandemic killed tens of millions and then fizzled out. There was no vaccine to fight it for another 20+ years ( up to the early 1940s ) and yet there was no pandemic recurrence in between. The 2009 swine flu pandemic infected more than 500 million people and killed an estimated 280,000 people. Just emerging from the GFC, the world did not stop to try to fix the pandemic and now, just eleven years later it is largely forgotten. The 2020 Covid-19 pandemic has infected 3 million and so far killed around 220,000 people. The world has panicked and shot itself in the head. The long term economic fallout of the global economic lockdown and self inflicted massive unemployment not seen since the great depression will continue to be felt long after Covid-19 is forgotten. Each year, seasonal flu kills an estimated 500,000 people world wide and the world has learnt to live with it. Time to think realistically.
Great article Patrick - David knows his stuff. Lots of valuable ideas I can steal in there. David the one thing that puts me off Long Short funds is the experience of a Long Short fund manager that I used to sit next to. He constantly underperformed and in frustration closed his fund. His comment was that the idea that you can go short as well as long works great in the marketing (the idea that you can take advantage of the good AND the bad - of course its better) but the reality (for him at least) was that being habitually short effectively negates some of the benefits of the long term uptrend...by always being short somewhere. He could not keep up with a bull market trend and a bull market was the dominant long term backdrop. If I was marketing a Long Short fund I'd like to see the comment that "At times we will be all long, and leverage the fund to being long" and "we only use shorting for specific (possibly rare) opportunities, not out of habit". When the market falls over Long Short funds come into their own over a long only fund, but in a bull market the habitual use of shorting, just because you can, leaves a you dragging an anchor. Having said that I wish I could short as well! But I'd only use it occasionally. Thanks for the article.
Great point Marcus. I'd just add to that though some some investors may appreciate the lower average beta that would be achieved by a strategy like you described - equities with the risk dialled down a touch.
Hi Geolato FYI Wikipeadia states that the 2009 swine flu H1N1 epidemic had 1.6 million confirmed cases but the estimated number was between 700 million to 1.4 billion. There were 18,499 lab confirmed deaths by WHO. In relation to the swine influenza virus it was isolated in 1931 and first identified 5 years later. It was found to be a close relative of human influenza virus and shown to be a surviving strain of the 1918 H1N1 Spanish flu virus. In 1933 the influenza A strain was discovered and in 1940 the influenza B strain was discovered. These are the 2 strains responsible for seasonal flu. In 1936, 2 separate vaccines for influenza A were developed. A vaccine for the Spanish flu H1N1 was not developed, it was for influenza type A.
How can markets rise when there is no visibility on the length of the impending viral plateau? Markets are forward looking yes but they are flying blind currently.