“I’m managing a fund in what has been, for the last three years, the most unpopular asset class, in the least popular region, Europe,” says Michael Browne (pictured), tongue in cheek. Browne co-manages the Martin Currie European Equity Long/Short Strategy with Steve Frost.
With approximately USD168million in AUM, the fund has built an impressive track record since inception on 1 January 2001, generating cumulative returns of 105.7 per cent. By comparison, the MSCI Europe (LC) index has contracted some 24 per cent. Year to date, the fund is up 11.2 per cent; the average equity hedge fund, according to Hedge Fund Research, is up 4.4 per cent.
Explaining the investment philosophy, Browne says that the team takes a research-intensive, bottom-up fundamental approach to stock picking, confirming that no derivative contracts are used for building short positions: “Every position we’ve taken since 2003 has been in individual equities. We therefore rely on two elements for outperformance: capturing alpha, and using our internal quantitative/qualitative system to capture market beta. The aim is to generate bond-like returns from equity instruments and since inception our average rate of return has been around seven per cent.”
The portfolio comprises 62 company positions out of a possible investment universe of 600 companies. Two thirds of these positions are held in the long book, which have an average time horizon of six to 24 months, with one third held in the short book, using a shorter time horizon of up to nine months.
In recent times, macro headwinds and a continual risk-on risk off sentiment have proved a real headache for stock pickers. As Browne says succinctly, anyone focusing on the macro this year “would have lost money”. And whilst a macro framework is used to help guide exposure management, great emphasis is placed on ignoring “macro noise” and focusing on company fundamentals at the micro level.
To that end, this is a classic pure play long/short equity fund. Perhaps unsurprisingly, then, the major contributor to the fund’s success over the years has derived from long book alpha.
“Returns are always going to be less in the short side of the book, the most I can make is 100 per cent. The majority of returns have therefore come from the long book. Periods like 2001 and 2002 were good for generating long alpha, 2006 was fabulous. This year has also been good and we’ve created a bit of value from short alpha as well,” notes Browne.
Companies favoured by Browne are those that can adapt and succeed in the face of changing political and economic conditions. Furthermore, with investor concerns over liquidity risk, especially in Europe, most stocks held in the portfolio have a market capitalisation of between USD2bn and USD10bn. From a risk management perspective, this allows 95 per cent of the portfolio to be liquidated in one day, 100 per cent within two days.
Early warning system
As mentioned, Browne and Frost have complete conviction in companies based on a deep microeconomic understanding of a company’s balance sheet and management structure. This allows them to avoid getting caught up in the whipsawing markets arising from global macro developments, but for strategic reasons they nevertheless employ a two-tier system that acts as a macro overlay.
“We are fundamental stock pickers but you need to have strong macro views to spot potential trouble ahead and avoid losing money. These views act as a preventative measure,” says Browne, who goes on to explain: “We have two systems. One is a traffic light system based on eight questions, which we started using in 2003. We debate those questions (such as capital raising for growth opportunities, financial gearing, falling/rising credit spreads) once a month and build a view. If there are five lights in one place i.e. all green that gives you a strong steer for where things are heading. There’s been a steady drift from right to left, things are beginning to look fairly optimistic.”
To clarify, the more green indicators there are, the more they are representative of a bull market, with red indicative of a bear market.
The second system is a quant-based solution which the team developed in 2008. Essentially this uses a range of different global economic indicators, which have been back-tested to 1992 to see if they had any predictive power for European markets. The pattern, says Browne, is most compelling when using a six-month interval. By acting as a kind of early warning system, it helps identify possible inflection points: “What we found was that when the indicator broke through the 30 per cent line it was absolutely brilliant at telling us to divest and take a precautionary measure. The average percentage figure (for positive indicators), for example, rose quite significantly between January and April 2009. We were able to use the system to good effect that year. It allowed us to build up our gross and net exposures early to capture the market rally.”
In down markets, the system not only helps protect investor capital by allowing the team to understand which parts of the portfolio are most vulnerable, but on the flipside it also helps identify potential short selling opportunities.
Browne notes that since the end of August this year, investor appetite has started to return for European equities. With investors in the US concerned with the fiscal cliff, and Mario Draghi’s recent decision to approve the ECB’s bond buying program having stabilised the European market to a degree, suddenly there’s an awareness that being heavily exposed to US equities may not be so wise.
“We’ve suddenly started seeing a return of interest from prospective investors in the US who previously would do no more than politely listen to what you had to say,” comments Browne. European equities are not the tainted asset class they were a year ago, and with some of the market uncertainties such as the US and China leaderships being decided recently, Browne is mildly optimistic on Europe’s economic recovery over the mid-term, although growth is likely to remain low in 2013.
Nevertheless, Browne says that there are abundant opportunities to find high quality companies with low valuations today. He notes that pricing has been “one of the great conundrums of this economic cycle”, and believes that valuations are akin to those of the 1980s. The portfolio is running 76 per cent net exposure, with companies in France presenting some particularly good opportunities.
“Dassault Systemes is a leading developer of 3D CAD software, and has a been a fantastic stock. Gemalto has been another good stock; they are a technology company that designs secure payment systems for mobile phones.
“France gets slated all the time but the reality is completely different; if you look beyond the macro noise there are a lot of undervalued companies so for us there have been some good pickings in France this year.”
Other key holdings in the long book this year include Publicis, BIM Birlesik, which has been held in the portfolio for an incredible seven years, and Persimmon, the UK housing developer.
On the short side, the portfolio is holding positions in European building constructors, specifically in Belgium, the Netherlands and France where the removal of a tax break is causing a slowdown in French private building projects. Says Browne: “In France you are now only able to build properties on a “Buy to let” basis in deprived areas; such areas are typically found in cities where land costs are extortionate. Factor in that rents will also have to be capped, and what previously made up half of France’s residential housing market is going to fall to zero.”
As for the general outlook, Browne postulates: “If you look at company valuations and combine them with an earnings cycle which is mildly positive, that’s quite a potent cocktail. We think the momentum is there for a recovery in Europe but it could take a year, it could take five years.”