Retour 
An alternative view of the American Dream
Citywire Selector – Chris Sloley
Following a solid 2019, investors remain positive on the outlook for US equities but many are edging towards a more defensive posture.
The only way is up, it would appear, but what does that mean for long/short managers who also look for opportunities on the downside?
Kurt Feuerman, Citywire AA-rated manager of the AB SICAV I-Select Absolute Alpha fund, believes a return of volatility in 2020 could pose problems for investors who are more familiar with last year’s relative calm.
‘One of the continued challenges for long/short managers is the “v-bottom” nature of market corrections experienced throughout this cycle,’ Feuerman says, whose $869 million (€778 million) fund has most recently been focused on the US’ IT and financials markets.
‘This type of quick, aggressive correction and recovery makes it difficult to manage portfolio exposure around a positive longer-term market view. We will evaluate each correction as it occurs to determine whether our long-term view remains intact. Then we will look to optimise our exposure to changes in market conditions.’
Feuerman believes the US market has been relatively calm after what he calls a ‘year of angst’, which was typified by the market collapse seen in Q4 2018. However, expecting the mellow markets of 2019 to persist forever could be a mistake.
‘The prospect of higher growth and low interest rates could fuel further stock gains,’ he says. ‘But, we would be remiss if we ignored the many variables which could cause market volatility in 2020: trade tensions, global growth projections, central bank policy and US elections. While these could create more volatility, that volatility could, in turn, create both long and short selection opportunities for long/short managers.’
Even those in the know would struggle to stay ahead of the pack if market conditions change too quickly, says Fabrice Seiman, a fund manager at boutique group Lutetia Capital. ‘Our biggest advantage when it comes to delivering outperformance in a complex environment, remains our ability to act on changing market conditions by constantly creating new, superior knowledge.
‘In the arbitrage space, and particularly in the US investment market, market participants quickly become aware of how pioneers exploit market inefficiencies and anomalies and copy their approach. The result is that these investment opportunities are arbitraged away very rapidly and no longer offer profitable strategies for active management. Research and innovation are key to remain relevant,’ he says.
Finding new hunting grounds
For some managers it makes sense to go fishing for stocks in under-researched areas of the market, especially when longs and shorts appear so highly correlated.
Christopher Hillary, CEO and founder of hedge fund Roubaix Capital, has focused his fund, and its Ucits-compliant equivalent, Prosper Stars & Stripes, towards long and shorts centred on small-cap stocks.
‘We had pretty poor earnings results in 2019 and that is a big part of the narrative. It looks like earnings for smaller caps were down to high single digits this year compared with the S&P which is about flat.
‘It looks more likely that small-cap earnings could exceed 20% in the year ahead, according to a Bank of America projection of 14% growth for the S&P 600. I think we had an earnings recession in 2019 for all markets but especially for smaller companies. Historically, small caps have been more sensitive to things like global growth.’
Hillary says there has been a general bottoming of data in major markets such as China, Europe and the US. ‘If you get that then you get better sentiment towards small caps and we have seen that play out. Small caps lagged large caps again last year and it has been a relatively wide gap.
‘It isn’t our job to forecast these things but there has been an unusual divergence in earnings growth and with small-cap stocks lagging large-cap stocks and it seems like some pieces are in place for that to change in 2020,’ he adds.
This has drawn Hillary to back many ideas that actually weighed on performance in 2019. He names companies such as advanced composite materials firm Park Aerospace, components producers Rogers and medical device company Transmedics.
All of these ideas, which sit within Hillary’s long book, have suffered from the heightened correlation and top-heavy nature of the market, he says. ‘As we head into 2020 we feel that a number of our most compelling investment ideas haven’t played out.
‘So, that said, we are particularly enthusiastic about a number of our largest positions and if those stocks continue on track, the value of those equities coming up is likely to be quite strong next year.’
Polls apart
However, even the most confident of manager, whether long-only or long/ short-focused, cannot move too far without bumping into the topic of the US presidential election. For Feuerman this sits at the top of his ‘to-do’ list and will go a long way to determining his thinking over the course of the year.
‘One of the largest risks for markets is the US election. What is particularly concerning to us, is the prospect of a far-left Democrat winning the presidency alongside a democratic sweep in Congress.
‘If this were to occur, we believe markets could become significantly more volatile. More volatility may create dislocations in the market where the stock prices of high-quality businesses with solid fundamentals come under significant pressure.’
Feuerman says the need to evaluate all exposure becomes much greater in a scenario such as this, and would prompt him to assess all new and existing positions for their respective merits.
‘We cannot predict the outcome of the election, so we will be monitoring the situation closely to ensure that we are prepared to optimise our exposure as changes occur in the political landscape. Currently, one of our largest short positions is a hedge against political risk. This is a basket of companies that could be negatively impacted by an Elizabeth Warren presidency.
‘As is the case on the long side, we will evaluate short opportunities on a stock-by-stock basis.’
Not everyone has placed such a strong emphasis on how the US decides to vote. Fellow long/short equity investor Seiman believes the market is more important than the politics that sit above it. ‘Much attention will focus on US politics, and if investors have learned anything in recent years, it is that one man can throw many spanners into the political machinery.
‘That said, in our arbitrage space, this factor won’t have a strong impact. The main drivers will remain the rise of quantitative strategies combined with the decline of investment bank trading, which together led to an unprecedented level of equity arbitrage opportunities.
‘Mispricing is on the rise and we expect this trend to continue.’
This article originally appeared in a special report published in January 2020.
Reporting (EN)
Publication – Citywire Selector – February 14th, 2020
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