Look on the Right Side

ECM Asset Management’s special situations strategy

Originally published in the April/May 2013 issue

“The habit of looking on the bright side of every event is worth more than a thousand pounds a year.” – Samuel Johnson, English poet and writer, 1709 – 1784

When Johnson made this observation in the eighteenth century, it was before the age of short selling. Today, in managing our event-driven special situations (ESS) strategy, we consider potential mispricing opportunities on both the long and short side of each event. We don’t just try to look on the bright side; we aim to be on the right side of each trade.
The current macro environment highlights the exciting opportunities for a fund like this. Think of Europe’s debt crisis and the contingent moral hazard, creeping debt monetisation, the inflation or deflation debate, and escalating currency wars.

But even more important than these, perhaps, we would note the increasing importance of stock selection and a growing dispersion in returns between markets.

Event risk in action
Event risk is the lifeblood of a special situations fund. Here are four recent examples from the first quarter of 2013 that illustrate the opportunities available to shrewd special situations investors:

  • ‘Bail in’ risk. The Dutch government took control of SNS Reaal NV on 1 February after real estate losses brought the financial services group to its knees. The news left holders of SNS’s 11.25% Tier 1 bonds facing a 57-point loss in a single day.
  • LBO risk. Liberty Global bought Virgin Media in February for £15 billion. But the American company’s takeover took the form of a leveraged buy-out (LBO) in which around half of the proceeds would come from raising debt against the UK-based media company. Virgin’s 5.5%     First Lien bonds fell 11 points after the bid terms were announced.
  • Regulatory risk. Back in March 2012, TNT agreed to be bought out by larger US rival UPS, in a deal that would enhance further the European footprint of the world’s largest delivery company. But the deal was scuppered by objections from the EU Commission on competition grounds, leading to a 43% fall in the price of TNT shares in one day.
  • Dividend risk. In a low-interest-rate environment, dividends have becoming highly prized by investors. This had been reflected in the valuations of high-dividend-yielding stocks, such as Aviva. So when the UK-based insurer revealed the market had mispriced its ability to maintain its 8% dividend yield, and had to cut its dividend from £0.26 per share to £0.19 in March, its share price tumbled 13%.

Current themes highlight exciting opportunities
If we look ahead to the coming quarter, we would highlight two key market dynamics that concern us – especially in context of the overall economic environment. We specialise in identifying such trends and seek to take advantage of them in context of the overall event opportunity set.
French and German equity markets have soared since ECB President Mario Draghi’s ‘bumblebee’ speech last summer and subsequent announcement of the Outright Monetary Transactions (OMT) programme. The performance of equity markets, however, is really down to central bank liquidity rather than economic fundamentals. Indeed, the longstanding correlation between PMIs and share prices has broken down, particularly in the case of France. Has this exuberance gone too far? We think so.
Meanwhile, commodity prices have been falling so far this year. Despite this, equities are on the rise, buoyed by plentiful liquidity and the search for yield. This dispersion makes little sense if the Chinese and US economies are both really performing above expectations. We believe that aluminium and copper price indices may be telling a more powerful (and believable) story about the true global recovery and demand outlook.

We believe it is an exciting time for event driven special situations investors. To be successful in this compelling area of the market, and be on the right side of the trade the majority of the time both require special skills and experience.
Our research-intensive approach uses fundamental analysis to understand events deeply. Our special situations team has more than 20 years’ combined experience in the special situations, restructuring and distressed markets, and has a focus on capital preservation. We have access to the expertise of a further 40 ECM investment professionals. With a concentrated portfolio of typically 20-30 positions we place a great emphasis on risk management.

Sohail Malik is portfolio manager of ECM Asset Management’s Special Situations Hedge Fund. ECM is an independently operated  $9.5bn multi-asset credit investor owned by Wells Fargo.