Portfolio Manager Luke Newman highlights the distinct challenges the pandemic posed in 2020 and considers the prospects for absolute return in the months ahead.
- For absolute return, the use of gross and net exposure can help
to mitigate or augment risk, reflecting expectations of volatility in the market.
- COVID-19 presented challenges that required a broader toolkit
for looking at businesses than has been used over the past
- A more predictable environment, reflected in higher stock dispersion, should encourage investors to deploy capital, which should be supportive for valuations.
There have been so many unknowns in 2020, in the shape of the economy as countries reacted and adapted to the spread of COVID-19, and the frantic political circus around Brexit and the US elections. Underlying investor sentiment was initially encouraging, buoyed by perceived clarity around Brexit under a Conservative government with a clear majority, signs of de-escalation in tensions in the Middle East and progress in US-China trade talks. This all changed towards the end of the first quarter as the market rapidly priced in a period of significant economic disruption as COVID-19 spread, and it dawned on governments that we were facing a global pandemic.
For absolute return as a strategy, the use of gross and net exposure can help to mitigate or augment risk, reflecting expectations of volatility in the market. At the same time, at various stages throughout 2020, there have been opportunities on both the long and short side of markets to invest. We identified four distinct phases that each required a broader toolkit for looking at businesses than has been used over the past few years: risk reduction, recapitalisation, ‘unlocking’ and value rotation.
Four phases of risk and opportunity
The first phase saw a sharp period of risk reduction as the pandemic first hit. The difference in prospects for businesses supplying essential foods and goods was in stark contrast to those forced to shutter as governments took steps to limit the spread of the virus. Moving into early summer, the focus was on businesses looking to improve their financial health, which saw a range of risks and opportunities for both long and short investors. We saw many businesses that — while not having an immediate liquidity problem (credit facilities were being honoured with help from central banks) — were urgently looking to address their debt levels.
From there, as the summer progressed, we saw the start of the ‘unlocking’ trade, as businesses reopened and activity began to recover. At that point, in the UK, we saw clear value for investors, with many stocks heavily discounted on operational uncertainties, and attractive dividend yields on offer, relative to other markets (and fixed income). But talk of a ‘value rotation’ seemed premature and, indeed, it was not until November that investors started to move to take advantage of these valuations, shifting away from the ‘growth’ stocks that have been so strong since 2017.
In terms of visible risks that remain, Brexit uncertainty has been a persistent drain on sentiment towards the UK and it continues to hamper business efforts to make plans. We also question if the risks of higher inflation in 2021 are accurately reflected in share prices, following significant efforts from governments and central banks to provide life support to the economy during the pandemic.
Clarity breeds confidence
Nonetheless, equity markets rallied strongly after the US election on 3 November 2020 and with breaking news on the development and deployment of several vaccines — Pfizer being the first to announce a breakthrough. While the US post-election handover has been complicated by disputes over the voting result, contested control of the legislature (the Republican Party unexpectedly resisted a ‘blue wave’ in the US Senate), means that the prospect of significant tax increases in the US has receded. Important news ahead for global markets will be the scale of any government support package under President-elect Biden, with the consequent impact on recovery and growth.
Political risk and the COVID-19 pandemic have been significant factors in 2020, but a more predictable environment should encourage investors to deploy capital, which should be supportive for valuations. With the first vaccinations rolled out in the UK in early December, the list of ‘known unknowns’ within markets is shortening, and with it, our conviction grows. Domestically exposed businesses and sectors with a high degree of sensitivity to the economy, such as industrials, are areas that are expected to benefit as we see a ‘gradual retreat’ from COVID-19 measures. On the short side, greater stock dispersion creates opportunity, particularly with those businesses where expectations for a return to pre-pandemic levels of profitability seem overly optimistic, or where pre-existing problems have been amplified by the events of 2020.
Long/short: Long position are securities bought in the expectation that they will rise in value. A short position is one bought in the expectation that it will fall in value. For a strategy that invests in both long and short positions, the intention is to profit from price gains in long positions, and from falling prices in short positions. This type of investment strategy has the potential to generate returns regardless of moves in the wider market, although returns are not guaranteed.
Gross/net exposure: This is the amount of a long/short portfolio's exposure to the market. Net exposure is calculated by subtracting the amount of the portfolio with short market exposure from the amount of the portfolio that is long. For example, if a portfolio is 100% long and 20% short, its net exposure is 80%. Gross exposure is calculated by combining the absolute value of both long and short positions. For example, if a portfolio is 100% long and 20% short, gross exposure is 120%.
Growth investing: Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Value investing: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Stock dispersion: How much the returns of each stocks differ from the average.
Yield: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.
Recapitalisation: The process of restructuring a company's debt and equity mixture, usually to improve a company's financial situation. This can be achieved by issuing new shares to raise money that can be used to pay back existing debt, or conversely, issuing bonds to raise money to buy back existing shares. By reducing the number of outstanding shares, a company expects to increase the prevailing share price.
Value rotation: A term used to describe a shift in investment behaviour, with investors favouring ‘value’ stocks instead of the ‘growth’ stocks that have been in high demand in recent years.