Market anomalies present opportunities for active investors: PM Capital

From

Paul Moore

Just like human anomalies can make all the difference in sporting teams, picking anomalies in equities and fixed income markets can help investors achieve winning performance, according to PM Capital.

This month PM Capital is hosting a series of investor forums across five Australian capital cities exploring how the manager goes about finding and interpreting anomalies to drive risk-adjusted returns.

PM Capital’s founder and Chief Investment Officer, Paul Moore, refers to the book and movie Moneyball, which tells the inspirational story of the cash-strapped Oakland A’s baseball team and how its general manager Billy Beane thinks differently to find excellent value-for-money replacement players. The A’s go on to set a record-breaking winning streak

Mr. Moore said the theory of Moneyball also applies in the financial world.

“In Moneyball, Beane’s secret is turning his back on accepted baseball wisdom and searching for players, who, for whatever reason – age, appearance – were unliked or overlooked, and therefore mis-priced.

“With investing it is no different. The best investment opportunities will find few who are interested, many who are dismissive and some who will even ridicule.“Many people may think they are taking extra risks if they are investing differently. But in our opinion, the real risk is you are not doing anything different. Never let the opinion of the crowd stop you from acting on what you know to be right,” he said.

“From an investment perspective, to be a successful investor you have to be doing something that others are not.

“Anomalies can arise because other investors are afraid of underperforming their peer group, lazy research or relying on perceptions rather than facts,” Mr. Moore added.

Mr. Moore pointed out two market anomalies that he believes represent great opportunities for active fund managers and investors: ‘Bondnado’ – a reference to the chaotic horror film Sharknado, and passive investing.

‘Bondnado’ is coming for long-term government bond investors

Bondnado is a termMr. Moore used to describe how the likely hikes in interest rates could be harmful for investors in government bonds.

In Sharknado a freak cyclone causes Los Angeles to be hit by a watery tornado of man-eating sharks.

“’Bondnado’ is how we are describing the carnage investors may see in long-term government bonds.

“In 1989 the standard variable rate in Australia was 17%. We now have interest rates in the low single digits when debt is at record levels and inEurope some variable mortgage interest rates are actually negative. It’s all driven by central bank flows and investors may be underestimating how far from normality we really are,” Mr. Moore said.

Passive investing – the more subtly anomaly

Mr. Moore noted that passive investing was dominating fund flows but that this investment approach did not take account of underlying corporate valuations.

“This surge of passive investing has caused a greater likelihood of distortions in market prices. Ironically, the greater the concentration of flows into passive, the greater distortion in asset pricing and thus opportunity for a genuine long term investor.

“Investors may expect historically low net returns from a blended portfolio that includes passive equities, increasing the need for high conviction managers,” Mr. Moore added.

Jarod Dawson, director and Portfolio Manager of PM Capital’s Enhanced Yield Fund, also warned that interest rate duration was overlooked by many credit investors.

Interest rate duration represents the sensitivity of bonds to changes in interest rates. The longer the duration, the more a bond’s price is likely to fall as interest rates rise.

“As Australian and indeed global interest rates have fallen, interest rate duration in the commonly used Bloomberg Composite Bond Index has increased. Part of the reason is that companies and governments are issuing debt with longer and longer maturities in order to take advantage of low rates.

“Counter to this, we are confident we’ve seen the inflection point in long-term interest rates, and thus we strongly believe that investors should have little to no exposure to interest rate durations in their portfolios. This is not what the index will give you.

“In a more normalised environment where rates have gone up by at least 2-3%, we’re actually talking about potential 10-15%+ type capital losses from a portfolio with a similar duration to the index – that is, with an average interest rate exposure of around 5 years. That is very different from what many investors would expect from their fixed income portfolios in terms of volatility,” Mr Dawson said.

In addition to interest rates, Mr Dawson also discussed other overlooked players in credit investing, such as ANZ and Westpac bank subordinated debt.

“The nuances within specific subordinated bank securities created a huge opportunity to invest meaningful capital for our clients. We have generated a return of about 40% on these investments over the past 12 months – an equity-like return but with a low degree of capital risk.

“Unlike the broader fixed income industry which generally prefers to lean on excessive diversification – almost to the point of eliminating any value add from an individual investment in a portfolio, PM Capital would rather have meaningful exposures to a smaller number of investments that represent true investment anomalies in global markets. This means that each anomaly that we identify actually makes a meaningful contribution to the performance of the portfolio,” Mr. Dawson said.

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