For Ben Wallace, the portfolio manager of the Gartmore AlphaGen Octanis Fund, 2008 provided a further opportunity to showcase his skill in equity long/short investing. The fund, which has more than US$300 million in assets under management, gained 29.4% in a year of often calamitous performance for hedge funds, winning plaudits for Wallace. In the first half of 2009, the fund is up 9.4%.
Wallace joined Morgan Grenfell in 1997, put in two years as an equities analyst, and in 1999 became a long-only manager of UK large cap stocks. He ran long-only money at Deutsche Asset Management until 2002 and then left to join Gartmore. He then ran long-only money for 18 months.
But at the beginning of 2004 Wallace saw an opportunity to run a different kind of hedge fund. At the time a lot of Gartmore hedge funds were relatively low gross exposure and not very directional. They also had a typically overweight bias to long term holdings and were less concerned with tactical trading.
With a dual skill set of investing in large cap stocks and active management, Wallace wasn’t afraid to take on varying levels of gross and net exposure at different points in the stock market and economic cycle. The creation of the Octanis managed account occurred early in 2004. It ran for 14 months and gained 28.5% before being spun out and opened to external investors in March 2005. As Octanis grew, Wallace eventually gave up running long-only money.
The fund has recently recruited Luke Newman, formerly of Altima Partners LLP, to work with Wallace as portfolio manager on the recently launched Gartmore UK Absolute Return and AlphaGen Octanis Funds. Newman has nine years of industry experience encompassing UK equity long-only and long/short funds, including earlier experience at Deutsche Asset Management and Foreign & Colonial.
Wallace spoke recently with Bill McIntosh, Editor of The Hedge Fund Journal.
Q: You observed in a recent note that optimism and a feeling that the worst of the recession is over are helping to support UK equities. Do you see this rebound continuing or has it pretty much run its course?
A: What became evident in March was that some of the downside risk was eliminated. We were probably net short from last April through this March. There were two things that made us move from that net short position to more of a neutral, slightly long position. First, I was very surprised at how generous equity holders were in refinancing businesses. So a lot of companies that we were short of needed new capital and were going to struggle to refinance in the debt markets. But actually a lot of equity holders such as the big life companies came in and wrote cheques at what I thought were very generous levels. Whether I agreed with it or not the fact is that was what was happening. All of a sudden there was a safety net put under a lot of businesses.
The second interesting thing was that looking through company figures you had poor numbers combined with an element of de-stocking, so actually for the first time in a long time you had an exaggerated picture of how bad things actually were. So at the very least we could see why there was restocking and why the pace of decline had to slow. We didn’t think we were necessarily going back to the sunny uplands but we could see why the pace was going to slow. So those kinds of events led us to move from net short, locking in the gains of the previous 12 months, and move to a slightly more balanced, slightly positive view.
Where things go from here is unclear, which is to say I think we can see why you get the restocking element. But six months down the line when the tax take has to go up, government spending has to go down, and then ultimately at some point rates have probably got to go up. How long this period is we don’t know. But I think the market dislocation actually threw up quite a few good solid companies which we think are good absolute long investments whether GDP growth is plus 3% or minus 3%. So that’s kind of what facilitated the move to a slightly more positive bias.
Q: From April until the end of June you shifted the book from net short to 15%–20% net long. Explain the thought process on this.
A: Yes. It has been very much driven by being able to buy long term quality franchises now at attractive long term prices. The move hasn’t been taking a view on, say, whether cyclicals are cheaper or expensive. There is merit in a lot of those companies. They could be expensive, they could be cheap. The medium term demand picture is really unclear. What became evident to us was that you could now buy companies like Royal Sun Alliance, Tesco, Glaxo – real long duration franchises with high dividend yields or in Tesco’s case quite a low rating given the global franchise which they are building out. All of a sudden you could put money into quality businesses at attractive rates for the first time in a long time.
Q: Why was the fund set up initially as a managed account?
A: What we did was carve out a portion of the existing hedge fund and that was run in the style of Octanis to build a track record with real money and make sure the strategy worked. I also needed to get used to running a long/short book and see if the strategy was viable. Based on that 14 months, it was opened up to external people rather than just doing a paper portfolio. We wanted the proper risk statistics, proper money and a proper track record.
Q: What are the key traits of the Octanis strategy that you are looking to replicate and take forward?
A: At the nub of everything we do is that I accept in the large cap world it is rare you will have an information advantage over the market. Everything I have done throughout my career is to try and look at what the share price is discounting and take a view as to whether or not you think that is rational based on the information that is out there. Although large cap companies are heavily researched what you tend to find is every analyst’s earnings estimate is 5% either side of company guidance, every share price target is 10% either side of the current share price and people don’t spend a lot of time doing their own analysis as to whether or not they think that is rational or even if the share price is discounting the current consensus. The reason I was keen to do a long/short fund is that I could see a lot more value in running a portfolio that was actively traded as opposed to just a simple buy and hold or short and hold type hedge fund. I think getting the fundamentals right is half the battle. But if you can actually tactically trade that idea well across the market cycle you can add a lot more value than just a buy and hold or short and hold strategy.
Q: Are there any specific types of research you do to come up with trading ideas?
A: About one third of the fund is what I would call the core book and these are longer duration ideas. Typically the holding period is around 12 months. A lot of the work we do on that side tends to be more traditional analysis. It is very cash flow return on investment based. We look at the strength of the franchise or the ability of management to extract earnings that are unanticipated by the market if it’s the long side. On the short side, we look for weak franchises where the market is over discounting the ability of management or whatever it might be. That’s the deep fundamental part of the book. What I’ve tended to find is that it performs differently in different market environments. In 2004 and 2005, for example, it delivered over half the return despite being only one-third of the fund when we were in that medium-term trending market. In 2008, when we were in a far more choppy, volatile market the tactical book made about 85% of the return.
Q: Is the tactical book tactical because it is traded more frequently, because it looks at market momentum? Why is it tactical?
A: The way I define tactical is positions taken on with a typical holding period of less than three months. The reality in the current market is they can be anything down to a week or a day given the volatility. We treat the tactical side differently to the core side in that we don’t tend to scale positions. Positions typically come in at between 1.5% and 2.5%. We do use stop-losses on the tactical book which we don’t on the core book. Although we don’t formally split it out we tend to find we take on two types of trades.
Part of it is just trading around fair value, so it’s saying British American Tobacco is a highly stable cash generative business and under almost any economic scenario you can forecast what earnings, cash flow and dividends BAT will deliver to shareholders over the next couple of years. There doesn’t tend to be a lot of movement. But over the course of a year the share price tends to be anything but stable as people aggressively buy defensives and then sell them to buy cyclicals. Then sell even more defensives to fund rights issues. Eventually people will want to re-enter and buy defensives again. Because the company hasn’t changed and our perception of value hasn’t changed we use that stock market volatility to trade around fair value. That is part of the tactical book.
The other part of the tactical book is more difficult to explain to investors. It is me explaining to people that I have analysed the same set of companies for the last 11 years and I have an understanding of what drives share prices in the short term. It is just us there day to day and week to week trying to make money for the fund on an opportunistic basis. It might be positions over company results or M&A situations, though the last few months have been dominated by refinancing, rights issues and placings. There is always something happening in the market which allows you to exploit those short term opportunities if you understand the fundamentals of each individual business.
Q: To go back one step, how did you learn and develop the knowledge of running a short book? What are some of the key things you learned to do that set you off from the herd of long-only managers out there?
A: If there is a business which you don’t like and you think is overvalued for any of a variety of reasons that automatically falls into your pool of potential shorts. That bit was the natural evolution. I had two things to learn on the job in 2004. First, as a long only manager I typically had a bias towards quality. So even if a company is slightly over valued, if it is a good long term franchise quite often you are willing to sit with that and let the shares grow into their rating over time. With a hedge fund that is not a luxury you have. If the share is over valued short term, it is an opportunity to exploit that on the short side. That was the first mental leap to make: even if it is a good company with a good franchise and a good management team, if it is expensive short term, it is a short.
The second thing is obviously the management of risk. Obviously your losses on shorts are effectively unlimited. So it is a case of learning how to scale the positions appropriately and be aware of concentrations, including the amount of stock on borrow compared with the free float. In addition, you also need to make sure on the portfolio construction side that you aren’t taking on too much factor or sector risk at any one point. I am a big believer that people worry too much about net in hedge funds and not enough about gross. So I could effectively have a net of zero but be long oil services, or oil exploration companies, big cap oil and be short airlines and cruise companies, and therefore have a huge factor risk to movement in the oil price one way or the other. That is something else you have to learn. Portfolio construction is even more important in a hedge fund than in a long-only product because of your ability to use gross exposure.
Q: Do you think shorting skill is limited among investment managers?
A: It is not really for me to comment on that. The statistics would probably say it is because if you look at the number of people who made money last year it was relatively low. From that point of view, the fact we were up 29.4% last year I’m pleased with. It has proved to people we are a hedge fund. We are not a geared long-only fund, if you like.
Q: We’ve talked about Tesco. But among your bigger picks are Hammerson and Qinetiq – quite different companies from each other and from Tesco. What is the investment rationale for these two picks?
A: Hammerson was very much a tactical position which is no longer in the portfolio. We took the position on during the fundraising Hammerson did. When we looked at Hammerson it looked to us that the properties were implying rental yields of about 8.5% and with base rates of 0.5% and the long end of the yield curve at 3% to 4% it was quite an attractive spread for direct property investment. The fact that the shares were also on a substantial discount to NAV was attractive as well. When that balance sheet risk was to a certain extent removed with the rights issue at the turn of the year that was a tactical opportunity to say: ‘Look, the downside has been removed and we think there is a chance that spreads will come in, because they are artificially high given the balance sheet risk’. It was a position which worked well – the shares went from about 250p to 320-330p when we bought them and then exited the position because we thought the risk reward was balanced.
Q: Now Qinetiq. It was floated by the UK government, which still has a stake. It was fairly resilient for awhile but it seems to have come off quite a bit….
A: It was a business which we didn’t own until it fell to about 150p versus a float price of 190p or so. Below 150p all of a sudden you were buying a pretty stabile medium growth business on about seven to eight times earnings with reasonable earnings visibility. There is also the potential upside of their technology development portfolio, which includes a variety of interesting assets that may be worth a considerable amount of money. But at that level it was in the share price for nothing and the ongoing franchise also looked relatively attractively valued. For us, it was a stable long term grower which had been priced as a structurally challenged or cyclically challenged business. We think it is neither.
Q: You’ve had tactical shorts on both Xstrata and Lonmin that were profitable. Have you cuts those shorts? What’s your broader view of the mining sector?
A: We remain short Xstrata. Currently there is no position in Lonmin. Overall we remain short of the mining sector, though not aggressively so. We were short the mining sector from the summer of 2008. I thought share prices were discounting high metal prices, high margins and minimal cost inflation. I couldn’t see how you could have all three. If metal prices stayed high I thought there would be a supply side response, a downturn in demand or inflation in the cost base. To me the shares were discounting high metal prices, no supply side response and no inflation in the cost base. I couldn’t see how that goldilocks-like scenario could continue. I think the pull back we’ve seen has brought some more rationality come into it so we are actually long a mining share, which is Rio Tinto. We accept they have good long term assets. The valuation is more attractive. The merits of aluminium as a metal that will benefit from the next stage of economic development is valid. So while we are still short the sector it is far less of a position than it was six months ago.
Q: Are there any other niche areas in the mining sector you like or don’t like or are relatively neutral about?
A: We had concerns about a lot of the copper exposed businesses last summer, simply due to the fact that the demand picture looked unsustainable. Hence Xstrata being one of the key exposures for us on the short side. Again down here the risk-reward is more balanced so that short position is materially smaller than it was last summer. I think for the first time in a long time risk-reward is starting to look more balanced in the sector as a whole. That is why we are actually long a mining share for the first time in a long time.
Q: On a sector basis, travel and leisure is the biggest gross position of the portfolio at about 7%. What is that you see there to have a long position of about 2.5% and a short position of almost double that size?
A: Obviously travel and leisure is quite a diverse sector. The areas we have been short of have been airline and hotel companies. For airlines the premise for the specific ones we shorted was that they were highly dependent on corporate spending. What we’ve seen happen with corporate expenditure on air travel is not a cyclical downturn. We are of course seeing a cyclical downturn but I think there is actually much more of a structural change going on. The culture of seven man deal teams all flying business class across the Atlantic every two weeks has changed for good. Whether it is just going to be technology that does it – video conferencing – or the fact that you only need a two man team to go over and the rest dial in – I just think there is a change going on in that industry. For me the share prices when we initiated the position looked to be discounting a shallow downturn but actually I think we are into a protracted downturn which won’t necessarily recover even if GDP does recover. That was the thesis on the airlines. On the hotel side, it was very much a case of seeing they were going to be hit by the downturn in the corporate market. But in the leisure market the amount of supply that’s out there meant consumers are going to be much more choosy on rates. The perception that you could push up RevPar (revenue per available room) year on year was totally wrong. I thought we would see big deflation coming through in hotel rates. When we initiated the position the share prices weren’t, in my view, discounting that. We still maintain those positions, but given the falls we’ve seen over the last month or so, especially with the airlines, the position is a lot smaller than it was.
Q: The area with the smallest gross exposure is non-bank financials. There you didn’t have any shorts, just a small long position, meaning the portfolio is effectively neutral. Is that because you believe that most of the damage to be inflicted has occurred?
A: In the mainstream financials, notably the banks, I found the situation very difficult to analyse. The equity value of most of these businesses is tiny compared to their actual balance sheet. I can understand fully the argument that the spreads on new business are highly attractive. What I’m not clear about is whether those spreads on the new business are attractive enough to offset the risk of the back book. As a consequence of this we have had very little capital deployed in mainstream banks for the last 12 months. The only exception was Barclays on the long side. We were long during March and April this year when the FSA gave them the green light that they had sufficient capital. For us thatwas the signal that the risk-reward was appropriate given the big discount on book value Barclays was trading on. The only other area in the non-bank financials where we have deployed capital is the non-life assurance sector. What is attractive is that it is an area where obviously a lot of capital has come out. Players like AIG and others are slowly withdrawing from the market. We are seeing rates actually improve and businesses are still relatively lowly valued. These types of businesses do look to be attractive investments for the next two or three years as they’ll benefit from a stronger rating environment coupled with relatively low starting valuations.
Q: The fund is short banks to the tune of 3.2%. Is this a hedging play or a fundamental call on valuations?
A: That was a tactical position in HSBC just going into the $17.7 billion rights issue. We just thought the technical situation would be large enough to drive HSBC down. We closed that out after the rights issue.
Q: Media is one of the most bombed out sectors. Big cap stocks like Pearson and BSkyB have done absolutely nothing over 10 years, while medium and small caps like Trinity Mirror and Johnston Press have been taken out and shot! Are you ready to call the bottom for this sector or suggest any long plays or do you still think it is too early to invest?
A: One of our biggest long positions is Sky. I think Sky is a fantastic franchise. There have been frustrations for shareholders over the last three or four years because Sky looks to the very long term and is always spending money on something that hurts short term earnings: switching from analogue to digital; then rolling out broadband; now HD TV. There is always something hitting the P&L short term at Sky but actually what I think they are doing is building a bullet proof long term franchise. Down here I think the shares are an attractive investment because I don’t believe Sky is as cyclical as people think. With pay-TV and sports for about £30 per month it is very much a must have … I think people would rather not eat in a restaurant once a month than give up their Sky subscription. People have been frustrated by the constant investment but for me that’s a business looking to the long term. At some point there won’t be the next great thing to invest in and the cash of that franchise will really start to flow out. And you never know they might actually see some cost deflation such as Premiership football rights actually coming down. There could be flexibility in the cost base which might mitigate some of the ongoing investments costs.
Q: In recent times the fund has been net long FTSE 100 companies and net short FTSE 250 companies. Can you give us a bit of insight into that strategy?
A: It is not something that I target. I don’t sit back strategically and think I would be long mega cap and short mid-cap. It just happens through bottom up selection. Last year we tended to find ourselves attracted to businesses that were over capitalised, self financing with relatively uncyclical end markets. That led us to be long a variety of mega cap stocks. On the flip side we found ourselves short of a lot of businesses that were dependent on credit, had cyclical end markets and were constrained by the liquidity environment. A lot of those stocks tended to be midcap companies. That is the position we still have overall despite the fund being in a net long position.
Q: How have investor concerns about transparency and liquidity affected what you do as an equity long/short manager?
A: The advantage I have is that Octanis is very much a large cap product. We have never had any liquidity or transparency issues. We provide investors with full portfolio breakdowns on a monthly basis. Despite peak to trough losing $700 million in redemptions we didn’t put up any gates, we gave everyone monthly liquidity and we performed well throughout that redemption cycle. For me it has not been an issue because of the universe in which we operate. I can imagine that if you were running a deep value, small cap special sits type of fund then the environment would be different.
Q: There have been quite a few documented changes in the way equity markets operate and I wondered whether this has affected how you operate and position your exposure?
A: I am of the view that markets are essentially long term rational, short term irrational. So what I try and do is set the portfolio up to have one third of it in long term businesses where we are betting on the rational coming out and then having two thirds of the portfolio there to exploit the short term irrational, if you like. I think having that blend of the two has served the product well over the last five years. In various years the market will be either slightly longer term rational or more skewed to shorter term irrational. Having the two sides to the fund means that you have the ability to make money in all market conditions.
Q: From what I’ve seen your exposures on both the gross and net side have been quite low. Is that a factor of volatility or a general feature that one would expect to see in the fund in the years ahead?
A: If I look back to March 2008, when we had the initial move down in gross and net, that was very much a function of selling the longs as business conditions deteriorated. Thus the gross dropped and the fund went into a net short position. What we then saw in May 2008 was that both sides of the book shrunk. So the gross came down and the net stayed the same. That was very much a function of volatility in that typically I try and set the portfolio up to achieve 15% to 20% net returns. It was reasonably evident last year that stock volatility was materially higher than the risk models were discounting or than the general market consensus view. To deliver 15%-20% net you didn’t need a lot of gross. That is why in the second half of last year our average gross was probably 60% but we still delivered 29.4%. When I look back to 2004 when we were in a very un-volatile environment our gross on average was probably 170%. For me gross is something you have to tailor to the market environment. In six months time if volatility is a lot lower and stock dispersion inter-sector is a lot lower, I think you’d expect to see the fund with higher gross exposure.
Q: Everyone is hoping that the second half of the year provides another leg of stability. Is that the most likely outcome or do you think volatility is going to return to higher levels than it is now?
A: I think volatility will remain but I don’t think it will be at the extreme levels that we saw in the second half of last year. I think it will remain because the picture is unclear. This is to say we are going through a restocking phase at the moment. How long that lasts before government spending goes down, rates go up and taxes go up is unclear. So I think the market will continue to gyrate between: ‘the world’s ok; the world’s not ok’. Volatility will remain but the extreme volatility of the whole financial system going down has to a certain extent been removed. I expect it to be more volatile than normal conditions but not the extremes we saw last year.
Q: The massive amount of money the UK government is spending to pump prime the economy – 50% of UK GDP is going to come from the government this year – are there repercussions for equity long/short managers? Are there ways you can play that?
A: We are looking at businesses whose growth has been highly dependent on public sector spending, notably in the outsourcing area of the market. Outsourcing businesses will tell you with government spending to eventually come down that it is an opportunity for them because it’s cheaper to outsource than do it yourself. I’m not sure I believe this. All of these companies have been huge beneficiaries ofthe boom in government spending in the last five years; so how can they now also be huge beneficiaries of the bust? It doesn’t seem right to me. I think more things will get outsourced but the pie will be that much smaller and will hit these businesses harder than the market thinks.
Q: Explain how the fund sits within Gartmore; what services and benefits do you get?
A: The advantage of sitting in Gartmore is that there are a lot of highly able hedge fund mangers within the firm. We all have open access systems so we can see what everyone else is doing which naturally generates a lot of interest and a lot of debate. On top of that we have state of the art risk systems which help you construct portfolios and make sure you are taking the appropriate amount of risk to deliver the returns your investor base is looking for. Also being a big house you get as much sell side corporate access as you want which you wouldn’t necessarily get in a smaller stand alone type vehicle.
Q: Does Gartmore do research internally that you draw on or do you just do your own research?
A: I can draw on internal research. For example we have a four man team that runs a financials hedge fund. We’ve got a consumer goods hedge fund. I can tap into what they are doing. It is always interesting to see how they perceive stocks in my investment universe versus their investment universe. It helps you frame, say, the attractions of Royal Bank of Scotland in the context of how banks are valued around the world.