Stockholm (HedgeNordic) – Equity market investors have been rewarded handsomely since the 2008 financial crisis, with some questioning the utility of active or long/short equity strategies in the presence of cheap generic ETFs and other passive investment products. Some of the drivers of the recent equity bull market, namely low nominal interest rates and multiples expansion, may no longer drive the stock market returns one has come to expect.
“Long-only equity investors will still be rewarded going forward as businesses keep innovating and generating earnings growth,” says Malte Heininger, portfolio manager of Carmignac’s European Long Short Equity strategy. “But with nominal interest rates increasing and valuation multiples compressing, market conditions are not ideal for equity investors in the immediate and medium term,” he emphasizes. “The flexibility long/short equity strategies offer can be a true benefit in a diversified portfolio, particularly in difficult or neutral market conditions.”
“The flexibility long/short equity strategies offer can be a true benefit in a diversified portfolio, particularly in difficult or neutral market conditions.”
With long/short equity managers operating in a relatively more fertile market environment, Heininger believes this is the right time to differentiate oneself and deliver to your investors’ expectations. Heininger is part of a three-person investment team running Carmignac’s European Long Short Equity strategy, which he describes as a “classic bottom-up stock-picking strategy with active management of the net equity exposure to ensure great responsiveness to market fluctuations.”
THE BUILDING BLOCKS
The “classic” discretionary approach relies on four main pillars: building an investment thesis (1) based on a non-consensus view (2), with catalysts in place (3) and an attractive risk-reward profile (4). Heininger and his team always rely on this checklist to populate the portfolio across several building blocks, including core longs, special situations, and alpha shorts, among others.
“As the name suggests, our core longs form the core of the portfolio, traditionally accounting for 60 percent of the portfolio,” explains Heininger. This basket of between 10 to 15 names includes high-quality businesses with strong structural drivers. Heininger calls these “long-duration” stocks due to their sensitivity to rising interest rates.
“We decreased our allocation to long-duration stocks before the turn of the year in anticipation of higher interest rates as a result of rising inflation,” recalls Heininger. With valuations becoming more attractive in the recent market rout, “we have a wish list of companies where the expected return on a three-year horizon, based on conservative assumptions, start to look attractive and we aim to build or increase positions in this bucket over the coming months.”
THE SHORT SIDE COMES TO THE RESCUE
As long-duration assets, the core longs were the biggest detractor from performance this year in the European Long Short Equity strategy of Paris-based asset manager Carmignac. Successful stock picking on the short side has broadly offset the performance drag from that part of the portfolio. The strategy edged up by 0.1 percent through the first three quarters of 2022 and is now down less than 3 percent year-to-date through mid-October.
“We have spent 95 percent of our time this year picking stocks to short,” says Heininger. The effort and time have paid off. When looking under the hood of the short book, one can notice short positions against businesses in structural decline, against firms with aggressive accounting practices, but also shorts against outright frauds such as Wirecard. “The short position we had in Wirecard is our most profitable investment ever, but we have been short almost all high-profile corporate frauds and scandals in recent years,” according to Heininger. “Accounting numbers don’t lie,” he claims.
So far in 2022, short positions in companies with aggressive accounting practices, which tend to overstate financial performance, have contributed most to the performance of Carmignac’s European Long Short Equity strategy. “Structural shorts have not delivered as expected this year,” acknowledges Heininger. “Different components of the portfolio tend to perform at different times.”
“Different components of the portfolio tend to perform at different times.”
Heininger goes on to emphasize that “we still have strong idea flow on the short side.” According to Heininger, “the consumer discretionary and industrials sectors have been very good hunting grounds as the mixture of rising raw material prices, high inventories and fading demand from a squeezed consumer create a toxic combination.” The prevailing opportunity set, both on the long and short side, determines and influences the net market exposure run by Carmignac’s European Long Short Equity strategy.
With a beta-adjusted net exposure in the low teens over the past few years, the strategy has generated an annualized return of 7.2 percent over the past three years ending September. “We are not required to maintain a static exposure and can adjust our risk profile in response to market volatility,” says Heininger. “This flexibility has provided higher returns than the market and with much lower volatility.”