Long/short – a strategy for all seasons

From

The current investment environment

Any discussion about the outlook for the Australian economy and Australian sharemarket needs to start with China.

It’s no surprise that China has been a massive influence on Australia over the past decade or so. We have witnessed one of the most rapid urbanisation and industrialisation processes that the world has seen. This has had massive ramifications across world markets, particularly steel markets and bulk commodities, and had a huge influence on Australia’s key resource exports; iron ore, hard coking coal and thermal coal.

The rapid urbanisation pulled in people from regional areas and resulted in enormous demand for housing and infrastructure, driving a wave of fixed asset investment across China. Cheap labour and a favourable exchange rate resulted in a large number of manufacturing industries investing in China, further fuelling its industrialisation and creating a virtuous cycle for a long period of time.

A lot of profit from this growth was recycled back into property and as illustrated in Figure 1, resulted in a massive property boom post the GFC; this coupled with considerable stimulus and increased debt accumulation helped fuel this boom to great heights.

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However, this process is entering its twilight years. There have been material falls in Chinese property prices, which is symptomatic of an oversupply of existing housing with more construction coming down the pipeline.

This has resulted in a slowdown in new housing commencements and reduced demand for building materials, the knock-on effect of which has been a collapse in the price of locally produced steel. While the Chinese are still exporting to the rest of the world, internal consumption has started to shrink. This is significant when global iron ore capacity is still expanding with lower cost capacity additions. This expansion is likely to continue unless there is a hard landing in Chinese growth which means that it is difficult to see any recovery in the iron ore price.

What does this mean for Australia?

As China makes the transition from a focus on fixed asset investment toward a consumer-driven society, it will create a shock wave that will also reverberate throughout the Australian economy. As shown in Figure 2, capital expenditure (capex) intentions rebounded strongly post the GFC with stimulus in China, but for the last couple of years have been waning with projections similarly negative.

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This is a big headwind for the Australian economy, as investment is seen as a major growth driver.

Investment has a multiplier effect, driving employment not only in the mining sector, but also in many ancillary businesses. The profits from mining and high commodity prices get recirculated right through the economy and drive a lot of other business activity.

Collapsing mining investment poses a major challenge to Australia’s economy and future growth.

The Reserve Bank of Australia (RBA) has seen this coming and has been cutting interest rates to stimulate other parts of the economy. As a result, the property market has rebounded strongly and residential building construction continues to grow to fill the gap left by the declining mining sector. It’s important to note that the mining boom is not coming back, it’s a structural super cycle that is now waning.

A degree of rebalancing has been achieved. Jobs growth has been strong in the building and construction sectors, as rising house prices have encouraged investment and robust growth.

On the downside, this is also driving increased household gearing and once again, a concentration around one sector of the economy. This is a high risk strategy that relies on no more shocks in the economy and there is no clear exit strategy.

What we don’t have is a buffer against shocks in the economy. History tells us that most booms end with a bust; a ‘hard landing’ in China could be such a shock and the RBA does not have a lot of scope to make further interest rate cuts to stimulate the economy. Fiscal policy is constrained by an already expanding budget deficit leaving a weaker Australian Dollar as the only escape valve. The benefits of a weaker currency can act with considerable lags though, and may not be sufficient to offset increasing unemployment and any potential financial system stress.

Increased gearing and higher asset prices will drive activity for a while – however, there will be challenges ahead for the Australian economy and therefore, the Australian sharemarket.

What does this mean for investors?

Globally, increased volatility is a common theme. We have been through a few years of strong asset markets, partly driven by QE programs in Europe, Japan and the United States, but this phase of the recovery is coming to an end. While the US looks ready to embark on the process of policy normalisation, Europe, Japan and China all face various structural challenges to growth. As macro forces shift, increased volatility is most likely.

It is particularly hard to avoid that volatility in the Australian market when you have such a high concentration of companies within our market. In fact, Australia has one of the most highly concentrated equity benchmarks in the world.

The Australian sharemarket is small by global standards and is dominated by a small number of large companies. In fact, the top 20 stocks comprise approximately 60% of its market capitalisation. When using a benchmark for constructing an equity portfolio – such as the S&P/ASX200 Accumulation Index (ASX200) – the performance of a traditional fund that takes long only positions will be determined by the size of that fund’s holding of those very large companies relative to that company’s weighting in the benchmark.

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It is very difficult for a traditional equity manager to deliver positive returns in a volatile market while managing a fund to an equity benchmark such as the ASX200. Trying to beat that benchmark means that portfolios become concentrated, or take on style bias with managers leveraging themselves to macroeconomic shocks if there are big style shifts.

How long/short funds can unlock potential and deliver positive returns in a volatile environment

As the name suggests, a long/short equity strategy holds both long and short equity positions – in other words, it is a strategy that allows an investment manager to act with true conviction.

If the manager believes a company’s share price will appreciate, it can go long and buy shares in that company. Conversely, if the manager believes a company is overpriced or unlikely to prosper due to structural, economic or company-specific factors, they can go short and sell its shares.

A long short equity strategy seeks to profit from share prices appreciation above the index in its long positions and price declines below the index in its short positions.

The mechanics of short selling involve borrowing stock from a lender (generally a passive index fund) with an agreement to return the stock in the future. The stock is then sold in the market, raising cash which can then be invested in a long position in another stock. When the short trade is closed, a long stock is sold and the cash is used to repurchase that short stock and return it to the lender. As long as the shorted stock has delivered a worse return than the long stock (fallen more or risen less), then the trade will be profitable. This process is conducted many times across the Fund to generate higher investment returns.

There are two primary benefits from employing a long/short strategy:

  1. The investment manager can tap into underperformance of the market by identifying losers as well as winners. Traditional managers leave that information on the table as they can’t do anything with it. A long/short fund unlocks that potential and gets extra returns out of the ‘losers’.
  2. Increased diversification – because of the concentrated nature of the Australian equity benchmark, traditional managers are forced to take concentrated positions. Rather, the combination of long and short positions enables greater diversification which helps to mitigate risk, particularly in a volatile market.

The opportunity to take both long and short positions allows for more active decision making. This flexibility allows the portfolio to more accurately reflect the outcomes of the underlying investment process where the manager is really adding value.

There is the potential to achieve higher levels of return relative to the benchmark than can be achieved for funds which only take long positions. However, this is partly achieved by taking additional risk. The incremental risk reward trade-off can be more attractive than that offered by long only funds.

 

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions.
All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.
Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2015 Grant Samuel Fund Services Limited.

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