Valuation Bifurcation Persists

Value still Cinderella as Glamourous Growth prevails

Over the past five years to year-end 2018, Jupiter Absolute Return Strategy has been a worthwhile portfolio diversifier: it has generated a positive return, with negative correlation to the MSCI World Equity index, and often profited during months of higher equity market volatility.

But over the past two years of 2017 and 2018, the environment has not been easy, admits James Clunie, Jupiter’s Head of Strategy, Absolute Return. The strategy has incurred single digit percentage losses that are consistent with its controlled approach to risk management.

One challenge has been that – apart from eight months in 2016 – the ‘value’ style of investing has markedly underperformed the ‘growth’ style. This has been the case for an unusually long stretch of nearly a decade post-crisis.

An anticipated rotation from growth to value is one of three key thematic bets apparent in early 2019 when Clunie’s portfolio risks are aggregated. The other two are valuation convergence between US and non-US equities, and a slightly negative view on equity market direction. All three of these risk factor exposures are however the consequence of bottom-up stock picks, and not pre-conceived top down views. Indeed, hedges somewhat tone down these exposures as part of the risk management checks and balances.

Short book

The short book has been the key alpha engine for Clunie, whose PhD thesis was on short selling. Clunie has taken a boldly contrarian stance in shorting some of the most spectacular performers of recent years, including Amazon and Netflix. In broad terms, he cites, “academic literature showing how value wins out over the long term, because investors over-estimate growth, and find it hard to fairly value stocks that are highly sensitive to small changes in growth”.

Homing in on specifics, Clunie is concerned that Netflix could eventually be vulnerable to oversupply as other media players launch streaming services: “whenever there is an arms race in content, usually when there is a gush of investment, you will get oversupply and returns disappoint”. In the short-term Netflix has of course been a painful short, staging a violent resurgence from its recent lows around Christmas time.

On Tesla, Clunie believes that investors are not paying attention to the balance sheet, and has been surprised by by the stock’s resilience amid what he dubs as “catastrophic news-flow. There has been competition, missed sales targets, and missed production targets. The fundamentals are very poor, this is story-telling versus fundamentals”. Clunie was particularly perplexed by the share price response to Larry Ellison joining the board and buying stock: “Did Ellison do his due diligence? I’m not sure he is a skeptical, challenging character. He was taken in by the Theranos blood-testing fraud, for example”.

Other glamour shorts have included internet furniture retailer, Wayfair, which has been growing revenues at breakneck speed of 75% but has negative cashflows, widening losses, negative book value, current liabilities above current assets, and a need to raise more capital through dilutive convertibles. Clunie is amazed that, “no sell side research notes even mention Wayfair’s balance sheet. They must be living in a mythical, magical world where paying bills has no meaning”.

Middleby and Transdigm both follow the so-called borrow and buy ‘platform’ business model of levered acquisitions. Middleby has missed consensus earnings forecasts four of the past six times, and has accounting issues. Transdigm is around six times levered and has “promotional rather than conservative management that keeps on rolling up to produce growth its own sake. This attracts excitable investors”.

Clunie is generally short of leveraged firms, but given some shorts in ‘expensive defensives’, it does not follow that he is long of the ‘quality’ factor. Indeed, certain glamourous growth stocks are only one part of Clunie’s short repertoire. His short ideas have had remarkable success in other areas, including some consumer staples stocks that were perceived as anything but glamourous. Back in 2013, Clunie noticed that Campbell Soup, General Mills and Kraft Heinz, “were not quite as defensive or high quality as they appear. The accounting was quite aggressive with especially big gaps between actual and stated earnings. For instance, acquisition accounting blurred real profitability, and balance sheets were getting quite levered. The shares kept rising because margins were rising, partly due to cuts in advertising spending, which meant sales growth was decelerating – yet this was not priced into the shares”. For instance, Clunie’s reverse discounted cash flow (DCF) model suggested that the share price of Campbell Soup was factoring in 5% growth into perpetuity, when in fact sales growth was slowing down to nearer 2%. Since then, the share prices of General Mills and Campbell Soup have more than halved, while Kraft Heinz has made write downs in relation to acquisition accounting, and re-upped its advertising spend, reducing margins. At peak Clunie, had around 7% of the fund short of food manufacturing companies.

He is tactical in taking some profits on some shorts. For example, In December 2018, Clunie covered shorts in a number of positions, including UK retailer ASOS, car maker Aston Martin, and satellite operator Globalstar.

Neglected value

The portfolio is broadly market neutral in exposure terms, with shorts of 49.3% roughly counterbalanced by longs of 46% (including a physical gold ETF) as of year-end 2018. The long book is populated by very unloved UK, Japanese and Russian equities, with cheap valuations.

In the UK, the largest long exposure, he has started to rotate towards domestically oriented stocks, which have greatly underperformed global names, partly based on Brexit fears. Examples include outsourcer Serco, website comparison portal Go Compare, Land Securities and Intu Shopping Malls. The last of these is controversial as retailing has clearly suffered from the growth of internet shopping, but Clunie argues that certain first tier mega-centre shopping complexes which offer other attractions such as ski-ing, cinemas, and entertainments, should continue to thrive even if some second-tier ones perish.

Russia is clearly shunned by others due to concerns over geopolitics and sanctions. Clunie holds well known stocks including gas producer Gazprom and bank Sberbank, as well as some less widely held firms including a steel maker and a toy maker

Away from Russia, Clunie also owns some contrarian commodity plays that are down about 90% from their peaks, but could make strong recoveries from what may be cyclical lows. Loss-making uranium miner, Cameco, has been cutting back capacity as have other producers in Kazakhstan, and the uranium price has perked up from its lows. Oil rig operator Transocean could benefit from a revival of deep-water drilling.

None of these positions is likely to overwhelm the portfolio. “Absolute return funds try not to lose money.  Our job is to take calculated risks. We expect to lose about 4% in a really bad scenario, and we did lose 4.5% in November 2018” he says.

Going forward, Clunie expects that his perception of fundamental value will increasingly be recognized by the rest of the market.