Looking back at the first half of 2016 brings to mind the well-known Chinese curse: “May you live in interesting times”. Whether it was February’s sharp recovery in oil and commodity prices, or the UK’s surprise vote to leave the EU, or the almost surreal situation of a reality TV star running for the US presidency, we seem to have been living in interesting times of late.
Interesting times tend to make for challenging times for equity investors. So far this year, the FTSE 250 Index of medium- sized UK companies has seen two peak-to-trough sell-offs of more than 13%. The first was as the Chinese economy seemed to be falling into the abyss. The second as investors reacted to the shock of the Brexit vote. But perhaps more surprising was the speed and scale of the market recovery after both sell-offs. This is a common characteristic of maturing bull markets – there may be incremental returns still on the table but investors have to endure much higher volatility to get them.
We hedge our long positions with short positions and run the fund with very low net exposure to equity markets. Currently the net exposure is almost zero. Historically, this approach has enabled us to deliver steady returns through stock-picking and sector allocation, but with minimal correlation to equity markets and with low volatility.
We haven’t changed the positioning of the fund a great deal since the EU vote. The long book of the fund remains focused on a diversified selection of businesses that offer either uncorrelated structural growth potential, or the ability to generate high amounts of excess cash which can either be returned to shareholders, or re-invested as industries consolidation. In a low growth, low return world, these are the sorts of businesses that should do relatively well.
The fund’s largest long position, Paysafe, is a payment processor, which is benefiting from rapid growth in online payments. The takeaway portal Just Eat is another large position – it recently reported very strong sales and profit growth, confirming the strength of the business model. Just Eat benefits as consumers increasingly order their takeaway online rather than over the phone.
We also hold significant long positions in RPC (a plastic packaging business) and Micro Focus (a software business), both of which are well run companies with strong management teams. Both businesses reinvest their excess cash into acquisitions, and extract value from them by improving efficiency.
Our net exposure to economically sensitive, domestic businesses is minimal. We have kept our holdings in house builders and the more differentiated retailers, but these are largely hedged with short positions in more challenged UK-facing businesses.
On the short book, we continue to run a mixture of single stock short positions, together with a balancing short position on the FTSE 250 ex-ITs index. The single stock shorts are spread over a wide range of industries. We look for businesses with long-term structural challenges, as well as those where valuations have become too rich, or where we think market expectations for profits are too optimistic.
We are lucky to have a large and diverse universe of UK stocks from which to pick. So while the outlook for the economy and equity markets may be more uncertain, the opportunity set, both on the long and short sides, is as compelling as it has ever been.