Absolute returns: two decades of balancing growth and risk

What was the first stock you shorted?

With the 20-year anniversary on the horizon, I had a look through some old files and came across the folder for our first-ever portfolio, back in 2004. I was quite taken aback at how different it was. Our original ‘big’ short was BP. I have zero recollection as to what the investment rationale was, but given that it is a volatile stock, we have been in and out of it several times.

Another of the original ‘big’ shorts was insurance company Aviva, a stock we have held in both the short and long books over the years. It is interesting that as we approach the 20-year point, the share price in capital terms for Aviva is below where it was 20 years ago, when we first took that short position! Time, inevitably, changes the opportunity set for every company, which really underlines the advantages of an absolute return strategy that can position for either a positive or negative outcome. You’re not just reliant on the share price moving in one direction, in absolute and relative terms.

How different was the composition of the market in 2004?

The market structure was quite different when we started, moved by different players, and with a very different range of stocks. Go back two decades and active flows had a much more significant impact on share prices. Asset managers and investment banks were all out there trading. Now, you have sector ETFs, large-scale passive strategies, etc, which has fundamentally changed how share prices move.

These days, there is much more results sensitivity. Short-term negative earnings announcements can get heavily punished, whereas back when we launched our strategy, investors and analysts would try and look through short-term news to get an understanding of intrinsic value. Understanding what has impacted a company’s revenues is so fundamental to the investment process for active managers.

What surprised me back then was how many names among our biggest 10 shorts and longs are no longer listed. From names I see on the long side in our first portfolio, BAA was delisted in 2006 after being targeted by a hostile takeover from Ferrovial; Corus merged with Tata Steel in 2007; Property developer Minerva delisted from the LSE in 2011 following a takeover from Jupiter Properties; Punch Taverns delisted in 2016 in a deal with beer conglomerate Heineken.

On the short side, Cadbury Schweppes demerged in 2008, Northern Rock’s very public collapse ended in its nationalisation in 2008; the list is long. About 40% of the portfolio no longer exists in the market now. It might seem impossible to think that anything can disrupt companies that are so dominant in the market at one point, but the market evolves faster than you might imagine. The status quo rarely persists, and there is a constant flow of changing investment opportunities.

What positive investment decision stands out for you?

For us, a key decision was when the FSA (replaced by the FCA in 2013) introduced a ban on short selling for financial stocks on 18 September 2008. As it explained at the time, “sharp share price declines in individual banks were likely to lead pressure on their funding and thus create a self-fulfilling loop”.

The timing of this was relevant, as it, naturally, coincided with when the financial market crisis was really accelerating. We held a pretty hefty short position on financial stocks at the time, a position that we had held for some months. We understand why the FSA intervened the way it did, but the consequent rally for affected stocks obviously had a negative impact on the bottom line for us.

The decision at that point was whether or not to cover those positions and exit to safety (with a loss). If we went ahead, we would not have been in a position to put them back on, given the short sale ban. So we decided to hold our nerve. It was one of those crunch moments. We were almost forced to commit seeing it through to the next phase, and we ended up running the positions for probably longer than we would have done, had we been left to our own devices. But the outcome was extremely positive in the end.

What negative investment decision stands out?

Micro Focus, a British software company, stands out as a ‘lesson learned’ moment for me. This was a stock that we really liked, and which had done very well for the strategy for some time. The business model was really interesting, built around buying ex growth software stocks that had run out of momentum, rebuilding their operations to cut costs, paying down debt and then leveraging up for the next deal. Until that one day when it bought Hewlett Packard’s software business, which it struggled to integrate, which was then followed by a massive profit warning as the macro environment deteriorated. Despite the fact we had a great experience with the firm, we took our medicine and moved on. That was a good decision, and a moment that underlined the importance of good discipline.

Has the job become tougher (or easier)?

I think it is more a case of the world – and stock markets – evolving. The one constant is that I think there are greater prospects for better performance when money (borrowing) has a cost, at least as far as an absolute return strategy goes. We saw a very long period where companies could borrow significant amounts of money at a very low cost to finance growth; but it also meant that a lot of businesses that were uncompetitive, or struggling with debt, were able to refinance and keep going, despite little chance of positive change (so-called ‘zombie’ businesses).

In an environment where interest rates have normalised, and borrowing money has a cost, there is considerably more focus on business models, spending, debt, etc, and we see capital acting less irrationally. So businesses that do not really have the right product or operational structure to justify their survival are more likely to fold. That greater dispersion in performance, as a fair reflection of company fundamentals, makes it much easier to more accurately value businesses.

Do you plan on doing it for another 20 years?

At this point, I would say that I see myself as “definite ‘til 60”, so at least another decade. At that point we will have a 30-year track record on the strategy. My youngest child will also be 18. I enjoy doing this. I see it as a privilege to be doing it as a career. So as long as I am delivering for investors, I think it might be difficult to not keep going.

Managing an active equity trading strategy or managing five children – which is more difficult?

Two challenging life experiences! Equity markets don’t care about your personal life. Children have no interest in your professional life. You are forced to just get on with it. Both can quickly humble you.

What was the most challenging time period in the last 20 years running your strategy?

It has to be the period from 2019 to 2022, where bond yields had turned negative globally. As mentioned previously, in that environment it can be considerably more difficult to accurately value businesses. Lacking conviction in the investment case for individual stocks, we allocated less capital to the core book than we would ordinarily, which resulted in some pedestrian returns. It was frustrating, but our job is to not swing and hope. In those environments, we look to keep the scoreboard ticking over, to minimise volatility, and avoid doing things just to be active.

How do you maintain good relationships with company management at times when you have shorted their stock?

Most management teams are okay about us being short, although you do get occasional exceptions. On the positive side, they often want to try and understand the rationale. The best management teams see you as a potential buyer if they can convince you that you have misjudged their strategy. They can also be motivated to prove you wrong – in a good way. You can tell if management are being too aggressive or defensive in their decisions, so it is important to distinguish between a management team that is focused on achieving their strategy, rather than responding to you. Most understand that shorting a stock is not a personal reflection of them as individuals.

How can asset allocators use absolute return strategies?

It is important for investors to be clear about what they are looking for when making their asset allocation decisions. There is such a significant range of absolute return strategies out there, with significant divergence in their objectives, exposures and positioning. I look at it simply. If an absolute return strategy manages its exposures well, it is possible to leave investors with more money in their pockets at the end of the year than they started with, no matter what is happening with the market.

To coin a football analogy, absolute return is like a holding midfielder – invisible and effective. It forms an integral part of a team, sitting in the background, while flashier ‘flair’ players drift in and out of the game.

How long have you and Luke Newman been working together? How do your skillsets complement each other and the rest of the team?

It has been a real pleasure to be part of what is a really close-knit team. I have known Luke since I was (un)fortunate enough to do his original graduate interview, way back in the 1990s. One of our analysts was in the year above me at university. Another had been working with us for several years in a separate capacity before joining the team.

We are friends outside work too, which gives us a great framework for frank discussions without worrying too much about ruffling any feathers. We are all objective focused; but come to the table with different opinions and ideas. I think that has been really fundamental to maintaining such a stable team for such a long time.

Why did you get into fund management?

I would love to claim that I was reading the FT and cutting my teeth on model portfolios at 14. In reality, post-university saw me, like pretty much every other graduate, applying for lots of jobs and hoping to get a break in something that I had an aptitude for. I was fortunate that the application that stuck was for a role in fund management. It was definitely luck rather than design, but I can’t envisage a career I could have enjoyed more.

Does the current outlook provide appealing opportunities for long/short investors?

In short, yes. We are really positive about the range of opportunities we see across sectors, both on the short and long side. It isn’t a coincidence that since bond yields turned positive, which would have been some time around September 2022, we have started to see a good pickup in stock dispersion, giving us greater capacity to deploy capital with confidence. There is so much going on at present, in terms of businesses, valuations, and across the market. It is a really good environment for absolute return investing, and we remain focused on exploiting those opportunities for our clients, as long as it lasts.

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Important information:

References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.

Volatility measures risk using the dispersion of returns for a given investment.