03 Apr 2019
James Clunie, Head of Strategy, Absolute Return
Nevertheless, the environment in 2017 and 2018 was notably difficult for the strategy, admits James Clunie, Jupiter’s Head of Strategy, Absolute Return. Over the past two years in particular, the bull market has been characterised by the exceptional performance of “growth” stocks versus “value” stocks. As the strategy tends to be long value stocks and short growth stocks, this has been a challenge. An additional impediment has been the rise in value of the US stock market, which reached record-highs in 2018, while most other markets around the world rolled somewhat from their peaks. The strategy’s short positions are currently mainly in the US, and its long positions are mainly found outside of the US, often in “unloved” countries including the UK, Russia and Japan. The strategy also has a slightly negative view on equity market direction. A sustained market rotation out of glamour into value, and from the US into the rest of the world, would likely benefit the strategy.
In short, the strategy has been leaning against some of the key distortions in markets over the past few years. In recent months, some of these dynamics have shown signs that that might be starting to unwind. In James’s view, the strategy has the potential to offer uncorrelated returns as the regime evolves and in particular has the potential to benefit from a narrowing of the valuation gap that has been in evidence since the global financial crisis.
The short book has been the key alpha engine for James, whose PhD thesis was on short selling. James has taken a boldly contrarian stance in shorting some of the most “glamorous” stocks of recent years, including Amazon and Netflix. In broad terms, he says academic literature “shows how value wins out over the long term, because investors over-estimate growth, and find it hard to fairly value stocks that are highly sensitive to small changes in growth”.
Homing in on specifics, James is concerned that Netflix could eventually become vulnerable to oversupply as other media players launch streaming services. He says, “whenever there is an arms race in content, usually when there is a gush of investment, you will get oversupply and returns disappoint”. In the short term, Netflix has been a painful short, staging a violent resurgence from its lows at the end of 2018.
On Tesla, James believes that investors are not paying attention to the company’s balance sheet, and he has been surprised by the stock’s resilience amid what he dubs as “catastrophic news-flow”. Tesla faces significant competition, and it has consistently missed sales and production targets. James believes the company’s share price reflects “story-telling” rather than its poor fundamentals. He was perplexed by the share price response to Larry Ellison joining the board and buying the company’s stock, and questions whether Ellison conducted significant due diligence.
Other glamour shorts include internet furniture retailer Wayfair. While the company has been growing revenues at a breakneck speed of 75%, it has negative cashflows, widening losses, a negative book value, current liabilities above current assets, and a need to raise more capital through dilutive convertibles. James is amazed that no sell-side research notes mention Wayfair’s balance sheet. In his opinion, “they must be living in a mythical, magical world where paying bills has no meaning”.
Elsewhere in the short book, Middleby and Transdigm follow the so-called borrow and buy “platform” business model of levered acquisitions. Middleby’s results have consistently missed consensus earnings forecasts, and the company also has accounting issues. Transdigm has a very weak balance sheet, with net debt of around 8x EBITDA, yet James thinks “excitable” investors seem to be more focused on what he calls its “promotional rather than conservative” management team, who are producing growth for its own sake.
Glamour growth stocks are only one part of James’s short book. His short ideas have also had remarkable success in other areas, including some consumer staples stocks that were perceived as anything but glamorous.
Back in 2013, James noticed that Campbell Soup, General Mills and Kraft Heinz, were not quite as defensive or high quality as they appeared. The companies’ accounting was quite aggressive, with especially big gaps between actual and stated earnings. For instance, acquisition accounting blurred real profitability, and balance sheets were quite levered. The companies’ shares kept rising because margins were growing, partly due to cuts in advertising spending, which meant sales growth was decelerating – yet this was not priced in.
James’s reverse discounted cash flow (DCF) model suggested that the share price of Campbell Soup, for example, was factoring 5% growth in perpetuity, when in fact sales growth was slowing down to nearer 2%. These short positions have worked well for the strategy: since 2013, the share prices of General Mills and Campbell Soup have more than halved. Meanwhile, Kraft Heinz has made write downs in relation to acquisition accounting and re-upped its advertising spend, reducing margins. At the exposure’s peak, James had around 7% of the strategy short food manufacturing companies.
He is tactical in taking some profits on some shorts. For example, in December 2018, James covered shorts in a number of positions including UK retailer ASOS, car maker Aston Martin, and satellite operator Globalstar.
The portfolio is broadly market neutral in exposure terms, with shorts of 49.3% roughly counterbalanced by longs of 46% (including a physical gold ETF) as of year-end 2018. The long book is populated by very unloved UK, Japanese and Russian equities, with cheap valuations.
In the UK, the strategy’s largest long exposure, James has started to rotate towards domestically orientated stocks, which have greatly underperformed global names, partly based on Brexit fears. Examples include outsourcer Serco, website comparison portal Go Compare, Land Securities, and Intu Shopping Malls. The last of these is controversial as retailing has clearly suffered from the growth of internet shopping. However, James argues that certain first-tier mega-centre shopping complexes that offer other attractions such as skiing, cinemas and other entertainment should continue to thrive, even if some second-tier ones perish.
Outside of the UK, James holds a number of well-known Russian stocks including gas producer Gazprom and Sberbank, as well as some less widely held firms including a steel maker and a toy retailer. Russia has been shunned by investors due to ongoing concerns over geopolitics and sanctions.
Elsewhere in the long book, James also owns some contrarian commodity companies that are down as much as 90% from their peaks, but which could make strong recoveries from what may be cyclical lows. Loss-making uranium miner Cameco, for example, has been cutting back capacity along with other producers in Kazakhstan, and the uranium price has jumped from its lows. Another holding in the strategy, oil-rig operator Transocean, could benefit from a revival of deep-water drilling.
Going forward, James believes that the perception of fundamental value will ultimately be recognised by the market. Currently the strategy would enjoy a rotation from growth to value stocks; a rotation from US equities towards shares outside the US; and a general fall in share prices. When looking back over stock market cycles, growth stocks currently look stretched against value stocks in historic terms, as do US equities compared to the rest of the world. Consequently, James thinks the risks he’s taking make sense. He remains prepared for a change in market regime, which many market signals suggest might be is underway. Overall, a move towards greater risk awareness in markets would likely benefit the strategy, potentially reaffirming its credentials as a portfolio diversifier for investors.
Important information
This content is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. It is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the author at the time of writing, are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Company examples are for illustrative purposes only and are not a recommendation to buy or sell.