European value stocks now represent a ‘structural opportunity’ says RAM Active Investments
Risk concentration in investor portfolios has been building in a prevailing ‘risk-on’ environment, leading to substantial growth in global equity markets over the past decade. There are numerous reasons for this, led principally by the decisive action of central bankers to print money through quantitative easing. This has led to an artificial suppression of market volatility causing equities to boom and fixed income yields to head into unparalleled negative territory.
However, such a concentration of risk represents a potentially significant source of volatility, should the markets switch to a ‘risk-off’ regime in 2020. And for systematic equity funds, that is just what they need to outperform.
Emmanuel Hauptmann is a Founding Partner at RAM Active Investments and Senior Systematic Equity Fund Manager for the RAM Long/Short European Equities Strategy. The fund uses a multi-strategy, multi engine model using a number of distinct style biases to discover diversified sources of alpha. He believes that in a higher volatility regime, European companies that have benefited from cheap financing over the years, could provide some compelling opportunities to discover alpha on the short side.
“It feels like we are finding a bottom to Europe’s negative interest rate territory. Any market tension from here on in, and it could be bad for highly leveraged low-quality companies.
“Industrials offer a lot of dispersion and short opportunities, and in Germany and Switzerland, which have the most pronounced negative interest rates, there are a fair amount of short opportunities where firms are over-reliant on these negative rates,” explains Hauptmann.
Negative interest rates, the looming threat of recession and assessing the historic risk-return performance of hedge funds in investors’ portfolios relative to conventional assets, will be some of the key themes discussed at ABN AMRO Clearing’s Amsterdam Investor Forum (AIF) 2020, which takes place at the bank’s headquarters in Amsterdam on 5th February.
Hauptmann will be speaking on the panel, “Equities - a revived strategy for the future”.
In Hauptmann’s view, low quality companies across Europe have prospered in a benign market “but they have not been very responsible with their finances over the last few years, increasing their financial leverage. As such, in a more challenging market, we think they would struggle.”
The proportion of highly leveraged companies unable to cover their interest costs, also known as ‘zombie’ companies, has increased in the market, because the conditions have facilitated it: low interest rates and tight credit spreads. Any threat to this, however, and the ability for such companies to survive would fall.
“These zombie companies with a persistent need for refinancing are the perfect short for us,” asserts Hauptmann.
Hauptmann explains that the short book not only hedges against downside market moves, it has been designed (and stress tested) to work in the most bearish market environment.
“When we built the book we had 2008 in mind. We wanted to ensure we still had strong alpha generators in the most stressed environments. The asymmetry comes in when the cycle turns and credit spreads widen. That is when we see the beta of short stocks shoot up, providing a great hedge for the portfolio,” comments Hauptmann.
On the long side of the book, the momentum engine has done relatively well this year and captured some of the growth trends observed in the market. It has been more challenging to deliver upside in the strategy’s value- and quality-focused strategies, in all caps, but this does not detract from Hauptmann’s medium-term confidence. Indeed, he sees similarities in Europe’s equity markets to the late 90s.
Back then, growth stocks dominated relative to value stocks, and large-cap stocks were abundant.
“Easy monetary policy conditions have led to a sustained bull market and we are now getting pockets of high valuations, especially in mid-cap growth stocks in the technology and healthcare sectors. And on the other side of the spectrum, you have low quality, highly leveraged companies that have yet to see a fall in price levels and as such offer massive downside potential if the cycle turns,” says Hauptmann.
On the long side, he notes that the dispersion of valuations has reached extreme levels. With negative interest rates arguably finding a floor in the Euro-zone (-0.5 per cent) and Switzerland (-0.75 per cent) amid concerns that such policies are adversely impacting their economies, stocks with low valuations in the market “will likely be less penalized by the market going forward”.
“We think we might be at the start of a structural value opportunity for investors,” suggests Hauptmann. “During the last couple of months, our value-biased engines and machine learning engines have done well capturing some of these low valuation opportunities in parts of the market.”
“If you look at the market correction in 2000 to 2003,” says Hauptmann, “you had massive dispersion in small- and mid-cap valuations and greater return opportunities, which we believe could be the case again.”
“On the long leg of the value trade, we think a higher volatility regime would also present us with good opportunities. Our long value picks tend to be strong cash flow generators and can hold well on the downside.”
The fund strategy uses sentiment indicators for market timing, in its value and quality engines and to help limit drawdowns a number of low risk income engines are also used in the portfolio, the aim of this being to reduce medium-term risk. The strategy’s momentum engines, which tend to be higher risk and pro-cyclical, have delivered good upside since the start of the year, as equities have continued to rally.
Looking ahead into 2020, he is confident that market volatility will return, to some degree, to European equities. Extended risk-on periods tend to be followed by higher volatility as fundamentals and valuations converge: “We are expecting 2020 to present good fundamentals-driven opportunities for the strategy,” states Hauptmann.
Hauptmann’s panel at the AIF 2020 will also feature Nikki Martin, portfolio manager at Trium Capital, Selvan Masil, Founder and CIO of Westray Capital Management, and Mads Ingwar, Co-founder and CEO of Kvasir Technologies.
A key topic they intend to cover is how actively managed equity strategies will position themselves in 2020 to seek out new sources of alpha in the event of a market downturn and what risk management techniques will be needed to remain agile.
Furthermore, they will address how different equity strategies – be they discretionary, quantamental, AI-focused, systematic, momentum, quality / value focused or, like the RAM Long/Short European Equities fund, a combination of AI and other systematic engines – seek to capitalise on market dislocations across geographies and industry sectors.
Hauptmann’s confidence in an imminent return of market volatility should contribute to an interesting debate.