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The long and short of it: the absolute return crew's best trade ideas
by Annabelle Williams on Nov 09, 2012 at 07:00
Wealth Manager asks a batch of absolute return fund managers where they are finding their best long and short ideas in the market volatility.
As the government moves to trim public sector spending, Cartesian partner Andrew Kelly has found shorting Healthcare Locums to be a good play.
Kelly, who manages the Cartesian UK Equity Long/Short fund, says he avoids shorting stocks that are moving around on market dips and rallies and concentrates on finding business models that are likely to come under pressure from external forces. ‘Healthcare Locums is a business that had a number of red flags that alerted us to the possibility that it could be a good short,’ he says, pointing to a change in accounting policy.
‘Another issue for the company was that it announced a bid approach that then collapsed. If you imagine what’s happened in a bid situation, this has given the company the chance to go through the accounts and all the due diligence that we don’t have access to.’
Although investors were not privy to the full reasons why the bid was dropped, it alerted them to the fact there might be issues, Kelly says.
Finally, Healthcare Locums bought a business from the husband of its chief executive, a move Kelly describes as ‘a very peculiar set of circumstances in itself’.
This was the catalyst for significantly raising his small short position that had been in place since early 2010. A year later, the company announced a profits warning and management change. The company was refinanced and shares fell by 90%, with Kelly able to profit.Tightened purse strings at the consumer level have meant opportunities for managers able to short retailers dependent on discretionary spending.
Citywire A-rated managers on the Legal & UK Absolute fund Robert Churchlow, Guy Rushton and Graham Taylor took a position in a general retailer that focuses on car maintenance at the end of 2011.
‘The idea was instigated because the business was coming under significant pressure through increased competition, and previous key growth markets, like Satnavs, were reversing,’ they say. ‘On a macro level consumer discretionary spend was tightening, which the market failed to recognise.’
The share price began sliding as the retailer issued multiple profit warnings in July 2012, and the managers successfully closed the position.Their fund has returned 11.17% over the last year compared to the FTSE 100 TR's 16.36%.
Meanwhile, concerns over slowing growth in emerging markets have led some EU-listed companies that are heavily reliant on overseas markets to issue trading warnings.
The luxury goods sector is a prime example and James Clunie of Scottish Widows Investment Partnership (Swip) has been shorting both Burberry and Mulberry. ‘I know those stocks had done very well – Burberry had gone up from 20p to £20 at one point,’ he says.
‘But luxury seems to do well in certain times; it seems to be somewhat cyclical. Wherever there’s an asset bubble somewhere in the world and people get rich quickly, that’s when luxury does well.’
Clunie, who manages the Swip UK Flexible Strategy fund, notes that the rise of the Burberry and Mulberry’s sales in overseas markets – particularly China – coincided with a massive boom in Chinese property prices. As prices came crashing down, he expected the luxury sector to also be hit.
‘The Mulberry short was difficult because the stock was going up so much and we had to be very careful about that, but this year it has halved from its peak,’ he explains.
‘Burberry was a little bit easier. It had been more stable and we shorted it at the time Mulberry had its profit warning, but then Burberry announced there had been a rapid deceleration in their growth rates.’
The Citywire A-rated manager has returned 25.96% over the last three years, outperforming the 2.44% return in LIBOR GBP 3 Months.
Turning to the financial services sector, a string of recent scandals and an increase in regulatory demands means these stocks have been among some of the most beaten-up recently.
Richard Howarth, co-manager of the Absolute Insight UK Equity Market Neutral fund has been hedging long positions with the likes of trading technology company Fidessa.
‘Cutbacks at their banking customer base make for a difficult trading backdrop,’ Howarth says.Howarth is a Citywire AA-rated manager and part of the Citywire Selection list of top managers.
Over three years his fund has returned 9.01% compared to a 0.13% return from LIBOR USD 3 months.
Howarth focuses on shorting companies whose profit margins are likely to be squeezed, alongside earnings risk and those with weakened end markets.
Sectors he is shorting include oil companies with unimpressive growth prospects, and he has also been playing the weakened construction sector by shorting Balfour Beatty.
The stock price has fallen significantly since it hit a three-year high of 357p in February 2011, and while there has been a recovery in price, Howarth expects the stock to continue to trade low. ‘We judge any recovery will be late cycle,’ he says.
Commodity production companies have also made good shorts for some managers. George Cheveley, manager of the Investec Enhanced Natural Resources fund, has had shorts on Anglo American and Lonmin Mineral Resources, both mining companies with operations in South Africa where labour unrest has disrupted production.
‘With problems in South Africa they have lost a lot of production and don’t have a healthy balance sheet,’ he says of Lonmin.
‘The Anglo American short has worked reasonably well. They have obviously had problems in South Africa and their coal business has suffered in Australia. Even though they are a diversified company, they have underperformed the market and come off slightly this year.’
Cartesian’s Kelly has prospered from a soft commodity play, in the form of New British Palm Oil. Bad weather meant unexpectedly poor harvests for the palm oil grower, while the cost of production in Papa New Guinea became crippling as the local currency soared in value.
‘Clearly the employees are paid in local currency, and what happened this year was that the kina was the strongest currency in the world over the last 12 months,’ he says. ‘Something out of their control but it meant that they are selling a product in dollars, but their costs are rapidly appreciating.’
Specialist healthcare has been a strong sector for Legal & General’s UK Absolute fund co-managers Robert Churchlow, Guy Rushton and Graham Taylor this year.
The trio say one of their best long plays has been a position in specialist drug company Vectura, which develops inhalable therapies for people with respiratory problems.
Shares were oversold because of delays in regulatory approval for one of their main drugs. They bought in earlier this year when the shares were trading little above cash plus the value of their existing stream, which essentially meant the market was disregarding Vectura’s upcoming drug releases.
‘No value was being attributed to its pipeline of late stage drugs,’ they say. ‘We reasoned that the problems were merely short-term delays and not fundamental issues and subsequent positive news on its drug pipeline has seen the shares rally. We believe there is plenty more to come and it remains a core holding.’
The L&G managers have also found success from going long ‘misunderstood’ high street retailer Sports Direct. Shares were cheap in the wake of its initial public offering (IPO) but the L&G team maintains Sports Direct is the market leader in sports retail, and is gearing up for expansion both at home and overseas.
‘The market remained focused on the disappointing IPO and concerns over Mike Ashley, the flamboyant founder and chairman,’ they add.
‘We took a different view, recognising it as the market leader in sports retail with a rapidly growing online offering, pricing advantage versus competition resulting in strong market share gains and opportunities for international expansion.
‘Since purchase, the shares have increased significantly and have partially discounted many of these factors. We believe there is more upside and while some profits have been taken it remains a core position.’
Niche technology firms have also been doing well, and Insight manager Richard Howarth said he made an 104% return from going long on electronics manufacturer Pace.
The company makes set-top boxes for cable TV operators. In May, Howarth, believing a new director-level appointment would help set the business straight, established a position in his Absolute Insight UK Equity Market Neutral fund at 83p.
‘In March, Roddy Murray arrived as finance director, with a strong track record from his previous role at BSS. We backed the turnaround story and remain shareholders,’ he says, adding the stock is now trading at around 169p.
He points to Ophir Energy as another successful long. The gas exploration company has interesting prospects in East Africa, and he bought the position in January priced at 299p.
‘We bought ahead of a 2012 drilling programme that yielded 100% success and increased their discovered resource threefold. We hedged the position with a mixture of oil-focused stocks with less attractive growth prospects,’ he explains.
Howarth closed the trade in September when shares were priced at 600p.
Although some parts of the construction industry have yet to see a consistent turnaround in fortunes since the credit crisis set in, Howarth has made a 50% return going long US construction firm Keller.
He began building the position during the second quarter at between 360-400p and has since seen the share price rise to 560p.
‘Keller is often thought of as the first spade in the ground since they prepare the foundations and ground work for projects,’ he explains.
‘US construction is in recovery, as illustrated by an improvement in new housing starts from 647,000 to 872,000. This has yet to be reflected in forecast profits,’ he adds, saying he hedged the trade with Balfour Beatty.
For Kelly, one of the best long positions of the last year has been ITV, which has done well from revamping its TV shows. ‘We wouldn’t normally rate management teams highly enough to talk about good management, but this particular team, led by Archie Norman, is outstanding and got involved in the business at a time when terrestrial broadcasting is dwindling,’ he says.
Kelly says concerns over falling viewing figures are overdone, and blockbuster shows such as Downton Abbey have also boosted ITV’s profile. ‘Although things like X Factor are in decline, it’s not coming through in viewing figures, which are still huge,’ he adds.
He has also done exceedingly well out of recently listed company Snoozebox, which he bought on IPO and now has a market capitalisation of £30 million.
Snoozebox takes shipping cartons and converts them into hotel rooms with air conditioning and Wi-Fi. The company picked up business during the Olympics and the Queen’s Jubilee in places where there is a shortage of hotel space.
‘Their management are a mix of hotel staff and ex-army people. They have a fabulous combination of people who can prepare those sites… It is exactly what the stock market should be there to support because they need capital to build out those units. They cost money upfront but once they are built, they become very cash generative,’ Kelly says.