Diversify in to alpha: Pengana

Investors should look to alpha-focused strategies because they do not depend on market direction and they are uncorrelated or lowly correlated to market indices, a leading fund manager advises.

Pengana Capital’s Damian Crowley says that ‘beta-investment strategies which generate returns mainly due to the market are unlikely to perform as well in the next three to five years’.

Crowley agrees that alpha managers may introduce new risks to portfolios, but he adds, ‘the more fundamentally different risk-and-return drivers that are in a portfolio, the more diversification it has’.

The assumption that markets are efficient and that investors should be ambivalent about the timing of their investment is not borne out in practice,’ he says.

‘Equity market beta – the return attributable to the market only – is a volatile and unpredictable source of returns. It can generate significant gains and losses, and gives limited diversification from other equity markets. Also, timing is everything in this area.’

In contrast, Crowley says, a market-neutral strategy has a low exposure to movements by hedging out the market risk through short positions in equities or equity derivatives such as futures.

‘Because most of the market risk is removed, the returns are generated by the manager’s investment skill, rather than rises or falls in equities overall,’ he says.

This alpha is far more stable, consistent and predictable, he says. The range of returns and maximum peak to trough loss (or maximum drawdown) is far narrower and the correlation with the equity market is negative in a number of periods.

As to the cost, Crowley says ‘beta is cheap, but it isn’t free’. The management of a beta only portfolio can approach 0.5 per cent a year, taking into account market impact, rebalancing, holding costs and commissions.

‘Alpha on the other hand is more expensive, but it’s scarce so arguably it should be,’ says Crowley. ‘Hedge fund managers typically charge higher fees when compared to traditional long-only managers, but expressing the fee as a percentage of the alpha generated puts hedge fund managers in a far more favourable light.’

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Weaker Australian dollar creating opportunity in many sectors.

The weaker $A will benefit tourism, education, agricultural and even the mining industry, a leading fund manager says.

Pengana Capital’s Australian equities fund manager Rhett Kessler says ‘a lower $A represents lower global purchasing power for us as consumers. However, we expect several important domestic industries to benefit materially from the currency shift’.

‘These include the tourism, education, agricultural and even, dare we say it, mining industry. Many companies have been forced to streamline their operations to cope with the high $A.’

Although we have been biased towards a weakening $A for some time, the speed of its decline has been surprising.

Kessler is pessimistic about the short- to medium-term outlook for discretionary spending and employment levels, despite the falling $A possibly translating into very high profits for some companies.

‘Having said this, we expect most domestically orientated companies to report muted trading activities (at best) while also being cautious in their outlook statements.

‘The recent unusual political activity continues to impact negatively on consumers and corporates alike while the unseasonably warm winter has severely dented discretionary fashion retail sales.’

Commenting on the US Fed ‘frightening’ investors during May and June with several ‘tapering’ of fiscal stimulus statements, Kessler says the Fed highlighted its flexible approach to ensure a sustained US economic recovery.

This saw a widespread relief rally with most equity markets – S&P500 (+4.9 per cent), FTSE 100 (+6.5 per cent) and the Euro Stoxx 50 (+6.4 per cent), closing significantly higher.

The Australian market followed with resources (+10 per cent), materials (+9 per cent) and energy (+6 per cent) leading the charge.

Conversely the weaker sectors were REITS (-1 per cent), information technology (0 per cent) and consumer staples (+1 per cent).

The Australian dollar continued its slide against the US dollar falling another 2 per cent (to print) to below 90c for the first time since August 2010.

‘It appears that the combination of political uncertainty, a deteriorating fiscal position, weakening mining sector and persistent concerns regarding the outlook for the Chinese Economy continues to weigh on the domestic economy (read lower interest rates) and consumer confidence,’ he says.

The long list of companies issuing profit warnings during the lead-up to the 2013 financial year reporting season has highlighted the impact these issues are having on trading conditions.

Mining services companies have been hit particularly hard due to the triple whammy of:
a) a difficult comparison with a robust prior period
b) the sharp slowdown in mining activity generally
c) the effect of the larger mining houses laser-like focus on cost-cutting

While this may provide some relief for financial and industrial companies due to less competition for scarce resources (labour and capital in particular), the transition is expected to take some time and be the source of some pain, says Kessler.

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Australian dollar on the downward track

The fall in the $A is not surprising over the previous six months however the speed of the correction was somewhat surprising, a leading fund manager says.

Pengana Capital emerging companies fund manager Steve Black says the $A fell almost 8 per cent, triggered by an RBA rate cut, and a stronger $US due to the first hint from the Federal Reserve that QE may taper soon.

This fall in the $A sparked international investors to dump Australian shares which had been seen as “safe” in recent times due to the relatively high dividend yields.

‘The domestic economy appears to have faltered in recent months, with retailers such as David Jones, Fantastic Furniture, Target and Myer reporting soft sales,’ says Black.

‘Consumer sentiment and business confidence surveys support this, suggesting a postponement of activity pending the outcome of the election in September. We have sold shares which are exposed to this weakness (eg Seek), and will revisit after results season.

‘The rising $A is another reason to avoid discretionary retailers, due to the rising cost of importing products from China in $US.’

Australian shares fell 4.5 per cent during May, driven primarily by a sharp correction in banks, property trusts and Telstra.

While industrial shares fell, resources stocks rose 2.5 per cent in a volatile month.

Small-cap stocks also fell sharply, although resources stocks were down 5.4 per cent despite the strength in larger mining shares.

Mining services stocks were hit by a number of profit downgrades, as the downturn we had feared kicks in, says Black.

‘This vindicates our move to dramatically reduce our weight throughout 2012, with many stocks in the sector down 20-40 per cent during May.

‘We had also taken profits in some of our larger holdings such as Amcom, and REA Group recently on valuation grounds, which protected us from some of the pain in May as these more expensive stocks fell harder than the overall market.

‘Our portfolio is reasonably well-positioned should the $A fall further, as we are not heavily exposed to discretionary retailers, and our holding in Resmed benefits from the translation of its international earnings back into $A at an improved rate.

‘We maintain a skew to stocks not heavily tied to the economy. The overall picture remains highly fertile for stockpickers, with recent volatility highlighting opportunities for both profit taking and selective buying where valuations have allowed.’

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Pragmatic investors need to be alert for well-managed companies with the business models and balance sheets to take advantage of three dynamics.

‘The first is the US economy’s ability to consistently re-invent itself combined with the potential ‘game changer’ of becoming energy self-sufficient due to its recently accessible (and massive) oil shale reserves, followed by the Chinese authorities’ efforts to reinvigorate (or at least stabilise) economic growth may be successful.’

‘The third factor is the significant reduction in interest rates domestically may be creating a base for consumer confidence,’ Kessler says.

Investors need to focus on companies with resilient business models that have the balance of power over their suppliers and customers . Examples include:

• Ryman Healthcare with high-quality aged care facilities and capital-efficient business model
• Resmed with its dominant global position in sleep-apnoea medical device solutions
• Telstra as the provider of superior wireless communications services and scalable fixed-line construction services
• Caltex with its position as an integrated liquid fuel procurer, storage and distribution facilitator and marketer
• ANZ Bank through its Asia Pacific banking services network – in particular for five reasons:
  1.       a high-quality member of the domestic banking oligopoly
  2.       management’s focus on improving productivity
  3.       results to date in this area have provided a key underpinning to after-tax cash earnings
  4.       the after-tax-cash-earnings yield generated by these businesses deserve focus
  5.       a resilient business model due to the scale required to create a robust technology platform and diversified funding base.

‘Our reliance on structural competitive advantage allows for shareholder benefits as weaker competitors fall by the wayside,’ he says.

‘Australian businesses are still fighting cyclical and structural factors such as a cautious consumer, lack of confidence in the Government’s policy decisions, the increasing effects of a strong Australian dollar on domestic business’s competitive position and growing uncertainty in the mining and related sectors,’ Kessler adds.

Continuing attempts by the US, European and Japanese monetary authorities to dilute their respective currencies (to de-monetise their debt and stimulate their export sectors) will translate into “higher values” for hard assets and companies with well-diversified and robust cash flows.

‘Robust share prices have narrowed the investable opportunity set, and business activity levels continue to be muted with many sectors reporting evidence of a deteriorating operating environment.

‘The re-rating of many companies’ share prices may be due to the (not immaterial) impact of a lower cost of money environment and the resulting positive effect on long duration assets (particularly off a low base) rather than the improvement in the outlook for revenues and earnings.’

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