TradeWind Capital

Taking a market neutral approach to European equities

BILL McINTOSH

The real pressure on the Euro zone economy has spilt over into equities markets. Many believe this won’t be a brief problem for equity prices but will instead bring a protracted period of uncertainty and further pain for investors.

Against such a backdrop the merits of a market neutral approach to equities investing are easy to see. The TradeWind Equity Fund, run by Amsterdam-based TradeWind Capital, will celebrate its 5th anniversary in September. Though the fund stumbled badly soon after leaving the gate (losing 32% in the last four months of 2008), it has recovered strongly and now boasts annualised performance of about 9%. In 2011, it won a EuroHedge Award for Best European Equity Fund (assets below $500 million) with a gain of 22.4%.

Including segregated accounts the TradeWind Equity Fund is managing about $200 million. The firm also advises investors on allocating capital. Leen den Hollander is the owner of the fund management business and the fund manager who has a 22 year track record in asset management, including eight years as a long/short equity manager. The firm is run by four people. Strategy is done by Leen den Hollander, Arnoud Krom is the fund analyst and the other key employee is fund trader Athur Driessen. Paul Louman is responsible for marketing and sales.

The starting point of the investment process is top-down. Hollander uses a blueprint for the macro economy that shows the sectors where the fund should be long and short. The managers don’t look to predict macro developments but instead use a screen to establish what the trends are. The specific stock names are then researched from the bottom up. The focus is on earnings estimate adjustments using valuation as a risk perimeter rather than as a selection criteria. Stocks are selected that express a particular view with the aim being to have a biased risk/reward profile. In addition, the managers want to find stocks where the team has a very different opinion from the consensus estimate in the market.

The long book has more exposure to real thematic stocks in areas like internet logistics and marketing. These are young businesses that have real growth capacity regardless of what happens with the broader macro economy. The fund is also long on semi-conductor capital goods owing to the business cycle picking up in Asia. One long play is Veeco, a US-based process equipment technology company. Another is Aixtron, which supplies deposition equipment to semi-conductor makers. In these thematic areas as well as in internet logistics and online media Hollander expects earnings upgrades to come through. The fund also gets involved in spread trading in event driven situations to access market neutral exposure to a theme. It has used this method to invest in Dutch tech firm ASM International.

On the short side, TradeWind has been shorting continental European property companies. The thesis is that net assets values are being estimated to be too high given that the managers believe rental income will be under pressure for some time. Fundamental analysis suggests that house builders are priced much lower even though they have the same fundamentals. The fund is also shorting defensive stocks with highexposure to retail consumer spending (Delhaize) and staples (Heineken). Such stocks are highly overweight in most investment portfolios, but eventually will have to be sold when fund redemptions roll in.

“We think the market is moving sideways,” says Hollander. “Prices are moving from the upper to the lower band. The shorts we are trying to find will be good if markets fall sharply. It is skewed beta names we are trying to short.”

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The investment process has three aspects. First, an investment clock (See Fig. 1) is used to tell the managers what quadrant the market is in. Currently the investment clock is stuck between the third and fourth quadrant characterised by low inflation and growth coming in below trend. The aim is to assess where things are at a point in time versus three to six months earlier. The assessment of the positioning is based on interest rates, exchange rates, real growth, inflation and the yield curve. Second, stocks are selected for both the long and short book working from the sectors related to the relevant quadrant. Valuation is used as a risk management tool to avoid shorting cheap stocks and buying expensive ones. Third, profit and loss volatility is managed through the gross, net and individual stock exposure. If the market moves against the fund’s (either long or short exposure), the exposure will be cut. This is used as an alternative to stop losses. Also, if volatility gets too high the fund will look to disengage with the market.

The fund averages 6-8% volatility. The managers are looking for ideas with a payoff three times greater than the risk taken. With the short portfolio up 60% and the long portfolio returning 10% the fund is outperforming the market by 75%. “There are not many funds who can say something like that,” says Hollander. As 80% of the fund’s shorts are in individual names, it has over time been hit by three takeovers with premiums of 60-120%, but that is included in the performance data.

In Hollander’s view, the leverage in equity markets is much reduced and therefore the risk of a major sell off is lower, too. He sees a series of short four to six month cycles, impacted by central bank policy manoeuvres, driving market declines and rallies.

Asked how the long side of the fund’s portfolio will evolve towards 2013, he says: “My bet is that there will be a temporary fix for the euro. But later on there will be more coordinated global quantitative easing. It means by then you want to be long into cyclical commodities, but for now in growth stocks.”

With finally inflation rising in 2013, which will be a game changer, companies with growing free cash flow will be favoured at the expense of, for example, no growth real estate, utilities stocks and staples. The next bout of QE is expected to have a bigger impact in the Euro zone than in the US and he is somewhat bullish on European stocks as they have lagged peers in other regions, particularly the US.