Diversifying style bias, discounting the discourse of doom and the worst policy error since the assassination of Archduke Franz Ferdinand led to the outbreak of WW1
Every Fund Manager has an inherent style bias in stock selection which - when rewarded by the stock market for a prolonged period - is often confused with investment genius. Experience of previous stock-market cycles should bring an understanding that any style bias cannot generate permanent outperformance indefinitely; that not all bull markets bid-up the same industries and that even very long duration investment cycles are subject to short-term style momentum reversals.
We regard ourselves as stock-pickers attempting to generate consistent “double alpha” from long and short books, but we have come to recognise that our approach will unintentionally result in an underlying style bias in portfolio construction. Since the Great Financial Crisis our “earnings surprise” investment philosophy has, given the anaemic macro environment, overall (but not exclusively) resulted in a second order effect of being long more expensive, innovative “growth” stocks, able to compound earnings, with our market risk hedged through short positions in more cyclical “value” stocks, often in sunset industries, which although appear optically cheaper, have for the most part been perennial profit-warners.
A decade long experience of managing a long/short fundamental strategy has given us a self-awareness of the risks of our own investment process.1 Through intermittent failure we have recognised our own vulnerabilities. Our experience is that the reflationary part of the economic cycle (the return to normality from distress) is the most dangerous for our inherent style risk, in that there is heightened risk from a sharp “momentum reversal”, where the fund suffers a non-correlated draw-down from an inadvertent style bias of being long “growth” and short “value”. Since mid-May 2020 we have witnessed the most intense rotation into “value” and out of “growth” since March 2009, yet the fund has not suffered a significant drawdown. This is arguably an achievement on a par with our more spectacular gains during Q1 2020.
During the “reflation” period the stock market will look through currently observed earnings trends and having previously ignored cheapness will now reward “value”, at least until the economic recovery is confirmed. These periods always occur at points of acute economic distress (hence they are contrarian) and necessitate an uncomfortable incrementally risk tolerant re-positioning of the fund. We do not regard this as style drift to our philosophy of “earnings surprise” since the market is merely anticipating a short, rapid bounce-back of global growth which will lead to superior positive earnings surprise amongst cyclical stocks.
Since “lockdown” began our regular blogs have predicted how the market would sustainably recover and eventually rotate2. We continued to take profits from successful shorts, selectively add cyclicality to the long book, increasing our net exposure. We articulated this in an aggressive fund repositioning, but our reward for our prescience has merely been to lock in YTD gains rather than benefit more fully from the recovery. This in part has been owing to concerns as to how long it would take the market to begin to discount our non-consensual view on the virus (and lockdown) but also out of our desire to maintain our secondary goal of uncorrelated returns.
Our experience of reflation is that it is the only stage of the economic cycle when beta is appropriately rewarded for its risk and therefore it may not be possible to generate meaningful positive returns without compromising correlation. Hence this poses a dilemma: even if we are correct in identifying the reflationary stage, not only do we have to better diversify our legacy style bias, but we would inevitably have to tolerate a modest correlation to the market (having previously been totally uncorrelated). We have had many previous instances over the past decade where we have correctly identified the reflation part of the cycle, been too cautious to reflect this in our positioning, and as a result failed to capture any of the return opportunity. This is in our opinion a worse outcome than compromising on zero correlation.
We believe that the statistical population mortality risk from COVID has been grossly and wilfully exaggerated. Perhaps this was understandable when governments knew relatively little about the virus, but as the negligible mortality statistical risk for the young and working population became clear, public policy failed to adapt: governments became prisoners of their original propaganda that the world was on the verge of a second “Spanish Flu” 1918 type pandemic, which evidently was never the case. We think that the efficacy of “lockdown” in preventing infection is unclear (given the nosocomial nature of most reported infections and the likelihood that not only was the virus never growing exponentially but given incubation periods its growth rate had possibly already peaked before “lockdown” was imposed). As such we believe that “lockdown” was at best a sledgehammer cracking a nut; but more likely the worst collective policy error since 1914 when the assassination of Archduke Franz Ferdinand led inexplicably to the outbreak of WW1.
We expect market sentiment will continue to be volatile. We are unlikely to witness a mea culpa from those who have whole-heartedly supported the “lockdown”3 and therefore must accept that the “science” is not in fact data driven but has become and will remain politicised, with the irony that opposition politicians (who might be less concerned about economic damage) have argued for even stricter impositions. The continued reporting of the crisis has also highlighted that official expert scientific opinion, mainstream media and politicians are so obviously asymmetrically motivated by the discourse of doom with a complete absence of penalty for incorrectly predicting apocalyptic outcomes that they inhabit a parallel universe to those making investment decisions where the risk of being too bearish and excessively bullish is more evenly matched with direct and immediate career risk. In our opinion, we should be as sceptical of sensationalistic selective media reports of “second waves” of infection as of imminent effective vaccines (the chances of which would seem extremely remote but the discourse on which actually serves to perpetuate “lockdown”)
Even though we have strong conviction that we are now in the reflationary stage of the cycle, uncertainties remain around the shape, timing and evenness of the recovery. Hence, we have been asking ourselves what now constitutes the most effective market hedge? We began the year with a short book tilted to Chinese and commodity plays. We then rotated these into European lockdown losers. The choreography now compels us to look more closely at companies whose long-term growth has been over-extrapolated by the effects of lock-down, which will likely prove good shorts as economies normalise and future growth expectations recede. Nevertheless, I would currently categorise our short book as evenly split between long-term doomed equity stub “cyclical value”, over-extrapolated expensive “defensive growth” and finally outright “frauds” with no style category other than dishonesty. It is important avoid a binary bet on recovery but equally important to recognise that a portfolio that continues to be exclusively long of growth and short of value is today articulating a view that the global economy will never recover.
Economies are now emerging from lockdown restrictions. The pace of normalisation is both patchy and ponderous. Having witnessed unprecedented falls in business activity, near-term recovery is now inevitable. I would expect this to be a “travel and arrive” trade: once recovery is confirmed it will be time to exit. Whilst the longer term is always subject to greater forecasting risk, we do not currently have any conviction in a longer term “value” bull market, seeing this merely as “Buggins’ turn”4 as the global economy normalises from a period of intense distress.
Barry Norris
Argonaut Capital
June 2020
1https://blog.argonautcapital.co.uk/articles/2020/03/18/diversified-double-alpha/
2https://blog.argonautcapital.co.uk/articles/2020/03/30/the-free-will-of-cavemen-herd-immunity-and-the-value-of-contrarian-truth/
https://blog.argonautcapital.co.uk/articles/2020/04/17/the-rational-risk-taking-of-the-restless-caveman/
https://blog.argonautcapital.co.uk/articles/2020/04/14/only-a-perma-bear-brings-a-knife-to-a-bazooka-fight/
https://blog.argonautcapital.co.uk/articles/2020/05/11/the-expert-opinion-of-the-shaman-and-the-cavemans-search-for-truth/
3 Erna Solberg, Prime Minster of Norway, has been an exception when she noted: “I probably took many of the decisions out of fear. Worst case scenarios became controlling and we kept thinking, ‘how can we be a leader?’”
4 “Buggins’ turn” is a system by which appointments or awards are made in rotation rather than by merit