189. The long and short of making money for investors

14 April 2022 (pre-recorded 5 April 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we look at the fully flexible BlackRock European Absolute Alpha fund which is comprised of both long and short positions, in order to try and create positive returns regardless of market conditions.

Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today I’m joined by Stephanie Bothwell, co-manager of the Elite Rated BlackRock European Absolute Alpha fund. Stephanie, thank you very much for your time today. 

Stephanie Bothwell (SB): Thank you for having me.

[INTERVIEW]

RLA: Now your fund can use both long and short positions to make money. Can you explain to our listeners, in quite simple terms, what this actually means, please?

SB: Absolutely. So when we talk about long positions, what we’re actually saying is that we’re owning a stock with the expectation that the value will rise at some point into the future. On the other hand, taking a short position on the stock means the opposite. So we are taking a view that the share price is going to decline in value over time. 

In this strategy, we run a large diverse portfolio of both long and short positions. And we think that having this flexibility can help investors manage their investment risk. The fund can help protect against market volatility in downturns better than other investment benchmarks. We have the ability to take the fund to max net long short plus or minus 25%. Right now we’re slightly net long the market, i.e. that means the total value of our long positions is slightly larger than our short positions.

I think that one of the most differentiating and important factors to note about this strategy is that we express all of our views via single stocks. So we don’t use any complex instruments like derivatives or indexes for example. All of these individual names have gone through a rigorous process of stock selection and are backed by a high degree of convict from us as portfolio managers. We think that this approach can bring a high degree of transparency for our clients. Our views are built from a bottom up analysis. So that’s having a strong understanding of company business models, industry landscape, including competitive positioning, which enables us to gain confidence over company earnings and cashflows over time. 

On those long positions, we seek guide companies which have a high degree of resilience in their business models. We invest in management teams who have a strong history of value creation over time, a focus on return on invested capital earnings and cashflow visibility. And really importantly, we seek to avoid a material capital loss. And then for short positions, it’s really the opposite of what we look for in our longs. So we’re looking for those companies with limited pricing power, where returns are falling, financial leverage, and finally, where there is a strong chance of disappointment versus expectations.

Identifying short opportunities can however be somewhat challenging and often more so than going long, it can require a mindset shift and often taking a more anticipated approach. Being early to identify change. It is often identifying change at both a company and industry level where we think the most profitable returns can be found. So staying close to the investment case through regular company meetings, monitoring data points and revisiting expectations continually is very important. 

In addition, there are just many more individual short positions by number than long positions in the portfolio. So having a very large European equities team of some twenty experienced investment analysts and PMs to support this strategy, to share insights and work together on ideas generation and development is something that we really think sets us apart from others.

RLA: Thank you, Stephanie. And being able to benefit from falling markets must have been quite useful for the fund in the last few months. How have you managed to benefit and what’s the fund been doing?

SB: Yeah, so you’re right, 2022 has certainly been a much more challenging period for global equities. Stock markets have sold off on concerns over inflation compounded further by Russia’s invasion of the Ukraine, the potential for interest rate tightening and the impact all of this could have on the global economy. 

So our ability to go long and short has really helped us ride through this period. With our short book, having protected the fund during these periods of sell off over the course of the last couple of months. Our short exposure, particularly those with limited pricing power, which has given away given way to margin contraction and unexpected earnings pressure have sold off heavily during this period. 

And on the other hand, our long positions have, in general, been much more resilient versus the wider market. Some good examples of this would be companies positively exposed to the industrial CapEx cycle who can continue to post strong levels of earnings growth despite short term cyclicality in underlying markets or indeed life sciences companies, which are generally pretty much agnostic to where we are in the cycle.

RLA: And so perhaps to bring that to life a little bit, have you got an example of maybe a long and a short that you’ve closed off now, but gives us a sort of tangible example of what you’re doing in the process.

SB: Yes, absolutely. So what I’d like to say up front is that we are continually revisiting our original investment thesis on both the long and the short side. We always want to make sure that we’re on the right side of fundamentals. As well, markets can be driven by whole host of factors in the short term. On a longer term basis it’s really our view that being right on the earnings and cash flows is what will drive outside returns. But while stepping to this core investment philosophy we do have to be pragmatic thus, when a thesis plays out or just when key parts of the thesis are not coming through as we expected to, we have to move on. We can however be patient. 

So in our long book, for example, we have owned shares for more than five years. Whereas on the short book, our holding periods do tend to be a bit less. Being really disciplined is even more important on the short book. Here we really just don’t have the luxury of rising markets bailing us out if the thesis doesn’t work out in our favour. 

So maybe just going back to your question in terms of some examples of where we’ve closed off ideas. So the first one and the best one is really on profit taking. So as markets have fallen over the course of the last few months, due to the points I’ve just noted, we did see a sell off in some of our short positions, which have been particularly vulnerable to economic slowdown. And this included shorts that we had within the European banking sector. So for the most part, we still consider many parts of these business models to be unattractive, and they really don’t fit the criteria to go into this European Absolute Alpha strategy. However, given how much the valuations had declined, the derating of shares, we had to close out these positions as we didn’t see any more absolute downside.

Another example where we closed off ideas is really around pragmatism and intellectual honesty. So where things just haven’t done in our favour, we do have to take this pragmatic approach. And we have had a number of instances where we have owned stocks as long positions, but our thesis just didn’t come through as we expected. So as a result, we sold the position and then after conducting quite a bit of additional due diligence and work, we took a short position on shares. 

I think this really demonstrates our willingness to take a flexible approach, but also that we do stay very close to the investment case over time. We monitor and use flow, and we use this knowledge base to our advantage to take advantage of opportunities as and when they arise, we’ve successfully executed this strategy in the team on a number of end market segments, including consumer and also on payments.

RLA: Thank you. So that’s given us a look back on what you’ve done in the portfolio, but perhaps looking a bit further forward now, where are you finding opportunities in at the moment in the face of a really challenging outlook for Europe?

SB: Yeah, so the macro environment has indeed been shifting extremely quickly after a very strong year of recovery for the economy and for markets in 2021. 2022 I think is fair to say is likely to be a period of slower growth as cost pressures, especially on the energy side become more acute and supply side challenges persist on things like logistics and raw materials. I would say that we’re not outright negative on equity markets. We continue to have a fairly upbeat look at industrial CapEx cycle. For example, however, we are growing more cautious on the European consumer of late. And this I would say is particularly with regards to the lower income cohort, those people are having to grapple most with the rising costs of living, fuel, utilities and even food. And this is an area of the market where we’ve been increasing our short exposure over the course of the last few months. 

In order to get ahead and really track some of that information real time we do have a dedicated data scientist on the team who works closely with us. All this can enable us to track credit card spending, brand heat and sentiment, and importantly help us identify those all-important turning points in the market, which going back to my earlier points is where you typically see the largest downsize returns. 

But I would also say that the market sell off has also provided opportunities on the long side. And it is in this more challenging type of market environment where we think the best companies with the strongest business models will shine through. Again, really having that deep industry and company knowledge of the business model is extremely important as it does enable us to capitalise on these opportunities as and when they arise. And that is something that we have been doing on the long side of the portfolio. So adding to existing positions in a number of names, which have become oversold, but also taking the opportunity to add new names to the portfolio again, where the market had overly penalised those business models.

RLA: Thank you. And you also look for holdings that have low correlations to markets and quite low volatility as well. Have you got maybe a couple of examples of these kind of holdings that you’ve got?

SB: Yes. So what I would say is that this strategy is set up as a means to provide a differentiated return. And that is backed by fundamental conviction, which should give our clients a low volatility stream of alpha. So within that, statistical risk is a really important consideration, but also very importantly, we also think about business model risk and really ensuring that where we generate our revenues from is well diversified. Understanding the volatility of our long business models, as well as their share prices, is an important component of this. Our market exposure is typically driven by the opportunity subset on the long and the short, but also really having an informed view and understanding of where we are in cycle, which we do build from a bottom up basis. We also have the ability to alter the funds profile to help further influence the volatility of the funds. 

I think overall, I’d really like to leave you with a message that we’re trying to create a fund that is quite simple to understand it’s composed of only single equity ideas, all of which are backed by deep fundamental conviction. So we don’t use any complex instruments and this provides good transparency for our clients.

RLA: Well, that sounds like a really neat place to finish Stephanie. So thank you very much for your time today.

SB: Thank you very much.

SW: This pan-European fund offers a very wide range of opportunities – opportunities that are increased by investing in both ‘long’ and ‘short’ ideas. As Stephanie explained the managers have a key focus on capital preservation and low levels of volatility. The fund aims to provide balance and stability in portfolios. To learn more about the BlackRock European Absolute Alpha fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts. 

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.