We short to reduce market risk but in doing so take on a different kind of risk. Our short book is what gives our equity long/short Absolute Return product its non-correlation to risk assets: its ability to make (and lose) money in all market environments and the possibility of generating market beating returns with lower than market volatility. In periods of market drawdown the existence of the short book has protected the assets of the fund (see Figure 1. Argonaut Absolute Return drawdown analysis vs Market (at Market drawdown). Without a short book this non-correlation would be lost and the return profile of our Absolute Return fund would simply replicate that of our long only Alpha product. In addition to the non-correlation benefits, over the past few years we have also generated positive returns in our short book which have added to the overall return on the fund (see Figure 2. Argonaut Absolute Return Cumulative Performance by long and short book). The existence of a short book is therefore essential to the unique nature of the product and its return profile.
Figure 1. Argonaut Absolute Return drawdown analysis vs Market (at Market drawdown)1
(Source: Lipper, Argonaut Capital Partners)
Figure 2. Argonaut Absolute Return Cumulative Performance by long and short book2
(Source: Bloomberg, Argonaut Capital Partners)
Argonaut’s only dogma in selecting stocks for our short book is that they must have an asymmetrical downside risk in that the market is over-estimating likely corporate profitability over the next few years. Although in the early stages of a downgrade cycle this can be contrarian, most stocks in the short book will already be experiencing an earnings downgrade cycle with the most relevant debate now over its depth and duration. Because our fundamental belief is that stock returns are for the most part highly correlated to future near term earnings forecasts (which is why we believe our process works more consistently than growth or value styles) our short book will as a consequence usually also have negative price momentum. In other words, whilst we seek out negative earnings momentum, in our short book negative price momentum will nearly always be a derivative of this style characteristic. Therefore it is highly likely that our portfolios – particularly after a strong run of performance – will exhibit strong price momentum characteristics.
But our style risk will almost always make the performance of the short book vulnerable to “short squeezes” where laggard stocks are bought (or shorts closed) on the basis of often short-term mean reversion trades. Indeed, all of our most significant annual drawdown periods (see Figure 3. Argonaut Absolute Return drawdown analysis) have not been caused by market drawdowns (and have therefore been non-correlated to the market) but short squeezes: August 2013, April 2014, October 2015 and February 2016. These squeezes will nearly always be short and violent precisely because trades are being made on the basis of technical price and positioning rather than fundamental change in the outlook for company profits. Somewhat bizarrely, none of these significant drawdowns has been caused by any specific faulty stock analysis: indeed throughout all the drawdown periods our long book has continued to receive positive earnings momentum and the short book negative. As such these drawdown periods have not endured arguably because they occur independently over any fundamental change to their corporate earnings forecasts.
Figure 3. Argonaut Absolute Return drawdown analysis vs Market (at Fund drawdown)1
(Source: Lipper, Argonaut Capital Partners)
Of course diversification of the short book could in theory better manage the risk of these drawdowns. Although there have been many more macro opportunities over the past few years on the short side compared with the long side, we are always keen to diversify our factor risk and hold more dear idiosyncratic risk in terms of our position sizing. But the one factor we cannot ever diversify is our style risk. This means that when all stocks with earnings downgrade momentum squeeze up precisely because of their negative earnings (and likely price) momentum we suddenly find ourselves with a short portfolio of stocks which have become highly correlated, not because of similar factor risks or sources of profit downgrades, but because they all share the style risk characteristic: negative earnings momentum. Ironically, this is precisely the risk factor we always want to take and not diversify away, precisely as we believe it is the key element in generating our returns.
Investors often talk about contrarian investing as virtuous in isolation. But unless it is coincidental to significant stock specific or macro inflection points which impact the outlook for corporate earnings, contrarian investing rarely works for all but the most short term skilled traders. Our observation is that inflection points in fundamental factors which affect earnings are actually quite infrequent. As such the frequency of the turnover of names in the portfolio is in most years relatively low and our average holding period at 18 months relatively long. Our aim in our stock analysis is to better predict corporate earnings surprise over this 18 month period (and subsequently be rewarded with price momentum over the same period). Therefore we must judge the success or otherwise of our investments over the same 18 month time period whilst noting that there will likely always be (often violent) short term counter trend rallies within a longer term more significant trend. In other words, being right in the end will inevitably involve being wrong over short term time periods. As such it is inevitable that every successful long term investor will suffer short term periods of poor performance.
In periods of drawdown or heightened volatility our risk management involves reducing our gross exposure. We never change the characteristics we look for in stocks (nor given our long term track record should anyone ask us to); nor do we shorten our investment time horizons (for even if liquidity allowed the chances of being whipsawed by a capricious market would be high). Although short squeezes and style rotations are often easily identified in hindsight, we remain somewhat sceptical that this kind of technical analysis has any useful predictive power so that gross exposure can be confidently reduced in advance of an imminently expected draw-down. However, it is also worth pointing out that that even if this could be incorporated successfully into our investment process it would only mitigate rather than prevent drawdowns. If you short, squeezes and drawdowns are an unavoidable evil.
Barry Norris
March 2016
