Nick Dignam from Fortitude Investment Partners shares insights with Lachlan Maddock from Fortitude Investment Partners on how a diversified portfolio in mid-market private equity is structured. The Inside Adviser
The world of alternative investments is at a crossroads. As markets defy expectations and liquidity concerns take centre stage, investors find themselves forced to rethink how they deploy capital in an increasingly complex environment.
Lessons from the short side
There has long been a saying in Australian investment circles that shorting the Big Four banks was the “widow maker”. The same could be said for a short selling strategy in general during what has been a near decade long bull market.
It takes a different kind of mindset to launch a short selling strategy amid the strongest bull market in modern history. Yet global asset manager Schroders is doing just that, with a domestic long-short equity strategy that extends their considerable analytical experience into the short side of markets.
One of the key benefits of short selling is also one of the key traits that most advisers and investors are searching for today: non-correlated or asymmetric returns. Non-correlated returns from investments have become invaluable in a world where the correlation between equity and bond markets has grown.
Strategies don’t get more asymmetric than short selling, where the capital gains are ultimately capped at 100 per cent, i.e., if a company goes to $0, and losses are infinite, as share prices can theoretically rise forever. So what can advisers learn from a short selling strategy?
One of the key lessons from Schroders impending fund launch is the importance of breadth. Breadth of research, experience and analysis. For one to run a short selling, active extension style strategy, you need to have enough resources to cover every investment in that universe. At Schroders this represents a team of 12 investment facing people. For advisers, having this level of breadth in investments is impossible – but what they can do is reduce their scope, specialise, and increase the breadth of their knowledge within certain niches.
In a world where the difference between the top performers and the bottom has never been greater, Ray David, Portfolio Manager of the Australian Equities Long Short Fund, highlights the importance of understanding and acting on red flags as a key to success. Acting as the filter between their clients and the wide world of markets, advisers are well aware of many red flags – quoted inflated returns, too good to be true deals or special, tax-driven offers.
As a short seller, and adviser, you must always think about what can go wrong. Despite the fact that most markets are trading at or above all-time highs, Joe Koh, Portfolio Manager, highlights that on average some 40 per cent of all companies in the ASX200 deliver negative returns every year. Importantly, this tends to spike after strong years like we have seen in 2021.
Whereas advisers are best rewarded by focusing on avoiding the worst companies, short sellers are rewarded by going out and finding them, David says. In fact this can be a consistent form of alpha in increasingly volatile equity markets. His focus is to “avoid (or short) flawed and challenged business models, fads and expensive valuations” by monitoring objective signals rather than subjective signals such as red flags, earnings expectations and industry developments.
The team relies on a complex tool built over a decade in the industry that brings a “healthy level of scepticism” into their analysis and highlights current or emerging red flags.
“Financial statements can be misleading. Even cashflows, for limited periods of time, can be manipulated to paint a better picture than reality,” David says. “However, by looking at various financial and operational metrics of a company, evidence may be uncovered that contradicts (or confirms) the narrative put forward by management or market consensus.”
Some of the key metrics they focus on are “aggressive revenue recognition, accounting accruals, return on assets trends, leverage trends and earnings revisions”. Importantly, it is about seeing the trend of worsening returns or increasing leverage before others.
Recent examples included the decision to short a company after seeing signs of increasing inventory levels, slow down in cash flow and sales channels. Other examples include roll up strategies where aggressive M&A is not resulting in higher cash flow or earnings, new entrants into industries and general changes in industry returns on capital.
“Shorting on the basis of valuation isn’t enough,” David says – a statement proven by the power of momentum in driving returns in recent years. What is becoming more important, however, is looking beyond traditional sources of data and analysing it in different ways. Data science is a key part of Schroders’ approach, and the company employs “a data scientist (James Bandara) with expertise across the full spectrum of data collection to assist in augmenting the objective data used by analysts in determining the quantitative assumptions incorporated in financial models.”
The addition of data science helps both improve the methods of data collection and ensure decisions are based on facts (rather than opinion) to the greatest degree possible.
