“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know.”
Donald Rumsfeld, former US Secretary of Defense (2002) [1]
During market dislocations it is common to witness rapid price falls on individual stocks that appear indiscriminate in nature and often contrary to the positive rationale which fundamental investors have built up through careful research and analysis. In the absence of stock specific news, the narrative for such sell-offs is explained by macro-economic “factor risk” or “positioning” in previously successful popular trades. Stock pickers find their knowledge edge or “alpha” on individual stocks drowned out by the cruel price action of markets. Moreover, the fear of “unknown unknowns”, future macroeconomic developments over which there is no certainty, drains conviction.
Our Absolute Return strategy overall has a good track record in negative market months, having made a positive cumulative return of +2% against the market -68% and having made positive returns in 24 out of 45 negative market months since launch.[2] At the same time, in rapid market corrections single stock shorts have often been a poor market hedge. Alpha in the short book is no more likely to work during market dislocations than alpha in the long book. Such is the normal mean reversion aspect of market corrections, it can often seem like the only sure fire way to make money during the dislocation is to be long the laggards and short the glamour stocks, though this would come with the caveat that a such a portfolio might only work for a few days a year, lack a fundamental rationale and likely to be near impossible to time or implement.
Our investment process is based on an informational edge on the market from our own research through quarterly meetings with companies and their industry peers. Stock picking is a process which requires patience for the market to also recognise the virtues with the catalyst of earnings surprise that the research process has identified. Moreover, whilst volatility brings opportunities in stocks it is often a value destroying exercise to be too closely watching stock prices on computer screens waiting for the exact moment to buy and sell. Picking levels in the overall market is often even more challenging. Investors who have liquidity to take advantage of dislocations can do well but often hang on to their liquidity as the market volatility reinforces the desire for risk free assets.
If we use Rumsfeld analysis (through a Johari window see below) to break down the risks in our investment process, we can juxtapose what we know against what the market knows in order to highlight what risks we want to take against those we wish to minimise. The risk we want to take is that which comes through our research process leading to our stock picking. We want to avoid risk that comes from the market having an informational advantage through not investing in too many positions. But it is the “unknown unknowns”, particularly future macro-economic developments, that are most difficult to monitor and manage precisely as it is impossible to fully comprehend what those risks actually are.
In my 16 years of managing money, there has been at least one market dislocation every year. Most of the time this resulted in a few very painful days of mean reversion in stock prices, before fizzling out and returns then being made again from stock-picking. The risk to fundamental stock pickers is always that the price action is an ill portent of more sinister developments in the global economy, and when informational edge on individual stocks becomes over-confidence in the face of a rapidly deteriorating macro environment. This is when a dislocation can develop into a bear market.
The normalisation of US monetary policy in response to a robust US economy has resulted in rates rising globally through the steepening of yield curves. Although some emerging market economies have had to tighten policy in a defensive manner to defend their currencies, European rates have risen in response to a better growth environment. Whilst within the equity market “bond proxy” equities and high multiple growth stocks will have benefitted disproportionately from zero interest rates and quantitative easing, it is worth pointing out that in Europe at least this was always offset by the significant risk premium for fear of deflation and the difficulty that average companies had growing profits in a low growth macro-economic environment. For most of the last decade, European equity investors would have salivated at the prospect of 2% economic growth, steepening yield curves, $80 oil and the end to zero interest rates. The Great Normalisation should not be feared.
As such, the biggest risk to our asset class is not monetary tightening per se but whether Fed rate hikes in combination with rising commodity prices and trade tariff induced fears for the Chinese economy have resulted in an overestimation in duration of the reflationary part of the global economic cycle, where we have gone straight to end of cycle without any duration sweet-spot for equity reflation trades. However, we should remember that for all its opacity China has historically been adept at reflating its economy just when the red warning lights have been flashing and that President Trump’s messaging on tariffs or the Fed’s on rates might turn more conciliatory at any moment. Re-positioning the portfolio for a significant change in macro in response to price action without confirmation from higher quality sources of information such as our companies is fraught with danger, something I found to my cost in 2016.
One of the benefits of MIFID II and having a more focused investment team has been to reconnect directly with companies. The best research is always that which we conduct ourselves: meeting regularly and directly with company management and quality investor relations teams. By cutting out intermediaries and speaking directly to the company, the quality of the information is untainted by bias or inaccuracy and allows the experienced investor to pick up on subtle changes in messaging which might be significant to the investment case. Often, fund buyers like to see a big organogram in fund management organisations: I realised that trying to scale my business in a way that took me further away from my investments was a mistake which I shall never make again.
In difficult markets, often fund managers do not want to communicate their views for fear of being wrong. I am happy to share my views in the knowledge that there is a high degree of probability of error in speculating on “unknown unknowns”. It is possible that we are on the verge of a spectacular slowdown in the global economy and that the Chinese economy is finally going to crack, but it is more likely that we muddle through and that it is not appropriate to price systematic risk into the global economy and at the same time expect that the Fed continues to tighten monetary policy. We do see earnings risk in Europe from cyclical slowdowns in the automobile and semiconductor industries as well as structural challenges in other industries (e.g. retailing, banking, media, pharma). But, there are also attractive opportunities elsewhere. Ultimately indiscriminate market dislocations increase rather than decrease the potential return on these opportunities.
Barry Norris
Argonaut Capital
October 2018
[1] http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636
[2] Argonaut Capital Partners 30/09/2018, GBP I Acc share class against the MSCI Europe NR EUR quoted in local currency. The market’s performance is quoted in Euros, but the fund’s performance is quoted in Sterling, as the fund is currency hedged back to Sterling, so it should be measured relative to local currency (Euros)