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Targeting positive returns in an uncertain climate

A decade after the financial crisis, the uncertain economic conditions it ushered in are starving Europe’s investors of returns. We believe this makes our approach to long/short equity investing more valuable than ever.

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With growth in the eurozone stuttering and inflation expectations falling, interest rates are likely to remain low. This explains why yields on core European bonds have fallen towards zero once more and cash returns remain negative.

For many investors, turning to the equity market is no perfect solution either. Though the long-term merits of investing in equities remain unquestioned, the volatility at the end of 2018 was unacceptable.

That leaves European investors still in search of strategies able to generate positive performance and cushion them from volatility. Extracting returns from both owning and short-selling equities, long/short alpha funds can deliver positive returns through a range of market and economic conditions. Their balance of long and short positions gives a naturally hedged exposure to markets.

At Columbia Threadneedle Investments, our European Absolute Alpha strategy invests in high quality, growth stocks with the pricing power to generate strong and sustainable returns. At the same time, we short-sell companies with poor competitive positions which lead to lacklustre performance, weak cash generation and low growth.

For more than 10 years we have used Porter’s Five Forces, named after a Harvard professor, as a framework for successfully selecting companies with strong competitive positions. We also use the framework to identify candidates for short-selling that are likely to underperform. Markets often focus on short-term trends and ignore longer-term threats to businesses.

Researching Europe’s companies, these are fruitful times for stock picking. On the long side of the portfolio, market dislocation is creating opportunities to buy large growth stocks that are mis-priced and offer prospects for capital appreciation. When it comes to short selling, disruptive forces are affecting several industries, leading to falling profitability and stock prices.

INTEREST RATES REMAIN LOW, EQUITIES ARE VOLATILE

Europe’s investors have rarely faced more challenging times. Germany’s benchmark 10-year bund yield has fallen to around 10 basis points after rising to 60 basis points in early 2018,1 and bonds across Europe offer investors negligible returns. Meanwhile, the European Central Bank deposit rate has a negative yield of 40 basis points,2 leaving investors to pay for the comfort of cash.

Turning to equities, the recent short-term volatility has been more than some investors can stomach. Between October and December 2018, the MSCI Europe index plunged by close to 15% (Figure 1) as worries mounted over slowing global economic growth. With a net exposure to equity markets averaging just 30%-40%, strategies such as European Absolute Alpha should be significantly less volatile.

Figure 1: MSCI Europe index (€)

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Source : Bloomberg, 04/03/2019.

MARKET DISLOCATION OFFERS OPPORTUNITIES

Our strategy’s long positions tend to be in companies with strong brands, from sectors such as consumer goods, consumer staples and luxury goods. Using Porter’s Five Forces analysis, we identify those able to generate strong and sustainable long-term returns.

Akzo Nobel,3 Europe’s biggest paint company, is a good example. Both its branded decorative paints (the Dulux brand) and its performance paints benefit from pricing power. The company announced at the end of 2018 that it was planning on paying out €6.5 billion to shareholders, at a time when its total market capitalisation was just €15 billion.4

Another stock that demonstrates this is Cellnex, the Spanish company that provides shared telecoms masts. As Europe rolls out 5G mobile telephony, telecom operators will need up to 10 times more cells interacting with mobile phone users. And it’s not just phones that will need them: driverless cars and the Internet of Things will also need network capacity. Telecom operators do not have sufficient capital to invest in new masts, while Cellnex is perfectly positioned to deliver the extra capacity.

SHORTING DISRUPTION

By contrast, the companies we are shorting tend to come from sectors that are being disrupted by current trends, including real estate and airlines. Regulators and governments are also putting regulated industries under pressure. While the market is aware of these structural pressures, it is underestimating some of them.

An example is healthcare, where governments in the US and Europe are pushing for lower prices. We have identified several pharmaceutical and MedTech companies that are likely to suffer regulatory pressure.

PROFITING FROM CHANGE

With European investors looking for investments that can deliver not just positive returns but also cushion them from volatility, long-short strategies such as European Absolute Alpha offer a genuine alternative.

While more traditional investments are struggling with today’s uncertain and disruptive environment, accelerating technological changes and shifting consumer behaviour mean that our approach to long/short equity investing is more valuable than ever.

Frédéric Jeanmaire , April 30

Article also available in : English EN | français FR

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