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Benefiting from a market regime shift

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Stockholm (HedgeNordic) – The last several years of risk seeking investor sentiment has made growth stocks significantly outperform value stocks. Going into 2016, the valuation gap was at levels not seen since the peak of the internet bubble in the late 1990s. According to James Clunie, Head of Strategy, Absolute Return at Jupiter Asset Management, the market correction in the first two months of 2016 might well indicate that this anomaly is about to unwind, potentially creating rich opportunities for a flexible long/short equity strategy.

”We see the recent change in risk appetite as beneficial to the way we approach markets. Rather than holding a structural long bias to the equity market, we seek to maintain a flexible investment mandate over time, particularly looking to exploit opportunities in the short book”, Clunie explains.

According to Clunie, who runs a Jupiter Global Absolute Return Strategy at Jupiter, a long/short equity strategy with a variable bias, the current environment is opportune for the way he approaches portfolio construction, in his views.

”Our approach builds on creating robust portfolios that are able to cope with sudden shifts in risk appetite. Our focus on adding diversifying short positions to a long book of what we believe to be under-priced securities under most scenarios, has shown great resilience during the market turmoil in the early parts of 2016”, Clunie says.

As part of the strategy employed by Clunie, tactical positions are traded around a portfolio of long and short holdings that are more strucutural in nature. Admittedly hard to time, Clunie is currently adding to the tactical short book of the portfolio.

”There is always a critical timing component to finding profitable tactical trades, especially when shorting stocks. Our strength I believe lies in our understanding of stock lending and short selling data that feeds into the investment process. By reviewing this data on a daily basis we get a good feel for when to enter a trade and when to stay out, besides it give us valuable information about the overall market sentiment”.

”We see rich opportunities in the short book as what we perceive to be over-priced growth stocks now are undergoing a re-evaluation compared to value stocks. Value companies have been out of fashion for quite some time but as investors are re-pricing risk in the wake of increased uncertainty about the global economy, these are representing good value from a risk/return standpoint”, Clunie explains;

Clunie argues that many of the high profile growth stocks that have seen massive rallies in recent years have profited from the combination of a risk seeking environment and successful ”storytelling”. By storytelling he refers to a behavioural aspect where stakeholders in a company, such as the management team, brokers and investors, rely upon a compelling story to propel valuations to levels seemingly difficult to justify using standard valuation metrices.

”The value of a good story tends to play a more significant part in the market ́s perceptions of acceptable valuations bwhen stock prices become disengaged from fundamentals”, Clunie says;

”With economic growth scarce and interest rates extremely low, the market has been willing to chase companies with optimistic growth strategies, which include a high amount of leverage and a tendency to make serial acquisitions and to use cash flows for share buybacks – a short sighted strategy that could prove devastating for long term shareholder value”, he argues.

As examples of companies benefiting from storytelling, Clunie mentions the so-called ”fangs” (Facebook, Amazon, Netflix and Google) where he sees risks in how the market is pricing these stocks relative to their fundamental characteristics.

”The prices these stocks command suggest the market is certain of these companies succeeding and not discounting any probability that they might fail, or at the very least hit speed bumps along the way”, Clunie says.

Clunie mentions Netflix as an example of a stock which he believes has been overly rewarded for its growth prospects where investors are buying into its disruptive force in the television market.

”Netflix is a prime example of a company with disruptive technology that commands a high market premium, it is emblematic of the sort of ’glamour’ growth stock that is very much in vogue. It currently trades at a price to earnings ratio of 285 times as compared to a sector average of about 16. At that level, the market is expecting an exponential growth in subscriber numbers and unfettered execution of the company ́s business strategy. There is little discount for risks such as an increase in content costs or competition from the likes of Amazon and Yahoo.

Clunie also recognizes how little emphasis is put on the impact of global economic events on these growth companies. Investors have bought into the disruption story with full force and largely ignored events in the larger economy, such as worries about China and the efficacy of central bank policy to stimulate growth, that has had signficant negative effects on the commodity sector for example. There has been a sense that fangs and growth stocks like them have somehow been immune to macroeconomic risk factors.”

Clunie and his investment team have found opportunities to ”trade against the grain” as the valuation gap between growth and value stocks has widened and are currently net short of equities in the investment mandates they are running.

”We have a meaningful short exposure to growth businesses in the US that we believe either have hubristic capital intensive growth strategies and/or unsustainable market ratings. These positions are balanced against a long book of ”value out of fashion” stocks that we believe are undervalued in relative terms and that we anticipate have the potential to outperform as the current risk regime unwinds and investors start focusing on fundamentals again.”

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Jonathan Furelid
Jonathan Furelid
Jonathan Furelid is editor and hedge fund analyst at HedgeNordic. Having a background allocating institutional portfolios of systematic strategies at CTA-specialist RPM Risk & Portfolio Management, Mr. Furelid’s focus areas include sytematic macro and CTAs. Jonathan can be reached at: jonathan@hedgenordic.com

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