CFP Equity Fund

Four sub-strategies in a high-conviction setting

Originally published in the April/May 2013 issue

The CFP Equity Fund launched late last year and is the first hedge fund to come from CF Partners, which is active in advisory work and trading in the energy and renewables space. The fund focuses on six industry groups: regulated utilities, vertically integrated utilities, independent power producers, oil, infrastructure and renewables. CF Partners on the other hand trades all the relevant commodities for utilities: oil, coal, gas, electricity and also carbon emissions – where it is one of the top two market-makers on the street. This fund could also trade these commodities.
The emphasis is on concentrating investments where CFP has most expertise. The investment universe is only around 150 stocks in Europe and Latin America that meet CFP’s liquidity criteria, typically involving market capitalisations above $1 billion and CFP will not own more than three days of average trading volumes. Although these are large and liquid stocks, CFP thinks they are not well covered by the sell side or by other hedge funds – and more important, they are not well understood. Regulation is the common thread running through the sectors, and this complicated area is one where CF Partners’ knowledge is widely sought after by more than 500 clients including utilities, sovereigns, state-owned entities, multinationals, airlines and institutions seeking solutions and risk management advice. CF Partners has extensive dialogue with policy makers and officials – and so was not surprised, for instance, by the recent collapse in European carbon emissions prices.

This is just one example of the synergies that can be cross-fertilized from other parts of the CF Partners organization.

CFP contends that their investment landscape is far more diverse than investors might guess from the number of stocks. “Each of the six sub sectors has different performance and drivers. It’s a mini S&P 500,” says lead manager Alvaro Ventosa who cites “Inflation, interest rates, GDP growth, commodity prices, and regulations” as the key macro concepts.

In particular, the six sub-sectors have historically demonstrated low or no correlation to one another. The wide performance dispersion between the sub-sectors makes it much easier to build a portfolio that is well diversified in terms of factor exposure and drivers, even with a concentrated portfolio.

This high-conviction fund will seldom hold more than 40 stocks, currently it has just 24 positions, and turns over the portfolio up to twice a month – to trade around core positions and help control volatility, which is targeted below 10% annualised. If some shorting-shy funds do not deserve to be dubbed “long/short”, CFP has the courage of their convictions. In the first five months of its life the fund has already been net short as much as 35% but on average 16%. The manager thinks that some government-controlled firms are more or less immune from takeover risk, removing one of the major pitfalls of shorting. Over a full market cycle the expectation is that the fund will on average be broadly market neutral – but the managers do not have any reservations about taking tactically long or short exposure. The net figure can be up to 50% in either direction, with gross exposure up to 200%. Index and sector instruments can be used, although bottom-up stock picking is the primary way of expressing views.

“Government intervention and structural changes to power generation markets” explains why German utilities have been such poor performers in recent years, says Ventosa. The theme of austerity-induced regulation is seen elsewhere in Europe as well. And besides regulation there are plenty of other negatives for power producers. Demand for electricity has been very weak, mainly due to low GDP growth in Europe – but also because of green initiatives such as encouraging insulation. There are also weak fundamentals in commodities with coal prices coming down as China’s demand slows and as infrastructure makes it easier to transit coal and shale gas. Carbon has been over-supplied in Europe. The renewables build-out has been more expensive and successful than expected. CFP think that some high dividends in the space could comeunder threat, and continue to identify interesting shorts. “People have bought utilities for the wrong reasons,” says Ventosa.

Moving onto the long side, wind is a favourite area at present, both in terms of manufacturing and developing. CFP admits that there is regulatory risk, especially in Spain and Romania, but the manager views valuations as very compelling as wind turbine manufacturers are aggressively cutting costs to adapt to the new economic environment. Ventosa draws analogies with the technology sector at the turn of the century. With both US tech stocks in 2000 and wind stocks more recently, “everything was priced for perfection,” when the bubble formed, he says. Now the pendulum has swung round, “everything is priced for failure like technology in 2002,” he says. CFP sees a real need for wind in emerging markets, and points out that lower costs now mean that the technology can be profitable without subsidies.

As well as traditional long/short stock-picking, CFP has event driven, opportunistic trading and relative value sub-strategies. The event strategy can involve mergers and acquisitions but is more likely to be taking views on regulatory events. In M&A there has been a two-way traffic of assets between Europe and Latin America. While European companies struggling with economic growth that is anaemic at best are lured by the dynamism of faster growing emerging economies, equally there are cash-rich companies in Brazil that are hungry for cash cows in Europe. Spanish utility Iberdrola has big holdings in Chile, Brazil and Mexico while European players EON, GDF and Fortum are “looking for growth outside Europe,” says Ventosa.

Interestingly, regulation in some Latin American markets can be easier and more transparent to grasp than it is in some European countries. Chile and Brazil are currently CFP’s preferred Latin American markets, with Columbia also investable. Brazil offers some other unique features: on average, more than 80% of its electricity is generated from hydro sources, where marginal costs can be near zero and weather conditions such as droughts and rainfall can be critical factors. Having been forced to ration energy as recently as 2002, Brazil needs to build up its infrastructure. That means there are plenty of under-valued growth stocks.

The last of the fund’s sub-strategies, the relative value book, is a form of statistical arbitrage that profits from shorter-term mean reversion between pairs of stocks. Even here, though, there is fundamental input with discretion exercised to filter out around one-third of the statistical signals. Essentially if the team is aware of sound reasons or newsflows that justify performance divergence, they will refrain from putting on a convergence trade. The relative value strategy has made about 25% of the fund’s profits so far.

The sub-strategies work well under different types of market environments. Events by their nature require catalysts, so can be a quieter space when less is happening. The best overall environment for the fund would be very over-sold conditions. Growing stock dispersion improves opportunities for generating alpha from the long and short books. Greater volatility tends to provide more chances for technical mean reversion trades.

The strategies need not be mutually exclusive. One stock can be held across two, three or four sub-strategies. For instance a cheap stock, that has recently underperformed its peers, is cheaper than a pair, and is likely to benefit from event catalysts, could be held in the long/short, opportunistic, relative value and event books. Energias de Portugal was a recent example of a stock that appeared in more than one book. On a standalone basis, the absolute valuation seemed attractive, particularly in light of its renewablesunit, EDPR. Additionally CFP thought EDP looked cheap relative to one Italian and one Spanish utility – so two pairs trades were put on. Ventosa stresses that the team has “a very systematic and organized way of building the portfolio and managing risk”. If most funds are either fundamental or technical, CFP combines the disciplines. Plenty of sensitivity analysis is carried out to look at companies from multiple perspectives, he says.

Six front office investment professionals are solely dedicated to the fund. Lead portfolio manager Alvaro Ventosa formerly spent 15 years at hedge fund Cygnus and at Morgan Stanley trading pan-European energy equities. Head of research Roland Vetter overlapped with Ventosa at Morgan Stanley, and also spent some time at European equity long/short fund Egerton. If Vetter is oriented towards European markets, the in-house Latin America specialist is Andre Resende, who has 14 years of experience at Brazilian asset manager BNY Mellon ARX and also worked for Santander Brazil. Analyst Ihor Okhrimenko comes from the sell side where he was at JP Morgan and Liberum. Commodities specialists Carlo Sbraccia has experience of energy trading at Asian commodity trading giant Noble, Constellation and Goldman Sachs. Sbraccia, an experienced quantitative strategist, also acts as CFP’s quant analyst. All of the team get a share of the total profits to ensure that the focus is on the overall fund performance. Dedicated execution trader Nicolas Montero has spent his career in market making and trading. Head of Risk Jonathan Navon, who co-founded CF Partners, has power of veto to enforce limits such as a 15% cap on position size and a 7% monthly fund loss.

The team have together had more than 500 meetings with senior management of companies in their investment universe over the years and continue to meet with management, government officials and regulators whenever possible. Rather than relying on external research, they produce their own valuation and sensitivity models and will also look at a range of valuation measures including PE ratios, EV/EBITDA, P/BV, SoP.

The outlook is constructive, with strong opportunities in all sectors followed and CF Partners has a $25 million commitment to the fund and a further $5 million have come from Ventosa, performance and external investors. The fund began with bias towards Europe, but that could be different in future. The monthly dealing, Cayman-domiciled, fund, primed by Morgan Stanley and Credit Suisse, is expected to soft close at $500 million. Investors should watch this space for more launches from CF Partners.