Ardevora Quarterly Review - Second quarter 2021

Two Buckets of Water

The path of aggregate demand, inflation and interest rates matters to every business. But so does the weather, and all are, in our view, hard to predict.  As students of the psychology of error, we stick to the bottom-up approach (where it is slightly easier to get it right). We rely on the interplay between CEO behaviour and market perceptions. Most of the time, if a CEO behaves “well” the business does what it should, and the stock price responds as it should. But in periods when most investors prefer to speculate on the big moving parts of the economy, stocks can be used like macro betting chips. The “bottom up” influence of individual business performance can become crowded out by the “top-down” noise from what-if views on aggregate demand, inflation, and interest rates.

2020 was uncomfortable for us. There was a lot of top down, macro noise. Fortunately, the top-down shenanigans had a degree of familiarity: the behavioural cycles of shock, anxiety, and release. While investors used most stocks as proxies for their view on COVID and the economy, we were still able to stay on the right side of CEO behaviour. And CEO behaviour did matter. We were helped by our willingness to embrace newfound CEO humility.  As COVID rolled through, an unusually large number of CEOs dropped previously unrealistic plans and concentrated on reducing risk. They don’t usually behave this well, but 2020 was an unusual time. At the same time, an unusually large number of CEOs with growth plans found life got easier. This doesn’t usually happen in a macro shock. Staying with good growth companies worked just as well as embracing recovering value.

2021 has been more challenging. We tried to build our portfolios to avoid too much tilt to shifting views on top-down debates. From experience we know this is hard. Stocks often behave differently in different macro cycles. A lack of Energy, Financials, an equal weighting approach (leaving us underweight the big tech heavyweights in the index) and a preference for lower risk CEO behaviour have all worked against us.

In Q1 recovery value did well, but it was heavily concentrated in two sectors: Financials and Energy. We have cautious views on both, so we were left behind in this episode of the value rally. We have a jaundiced view on financials, based on our experience of the last major macro shock. Banks gamed the accounting and other reporting rules to hide risk, so they could behave in an irresponsibly risky way. We have avoided them ever since. Three years ago, we opened our minds to the possibility of change and hired a specialist banking analyst. We are slow and deliberate in our research. We decided (for reasons explained in other commentaries) to begin considering banks as acceptably risky investments this year. But not in time to catch the Q1 rush in bank stocks. In Q2 we concluded a few banks looked interesting. They were the unusual ones: most banks still have risky looking CEO behaviour, as they struggle to navigate a structurally difficult operating environment (that has nothing to do with macro).

Over the last few years, we have thought long and hard about what it means to be a responsible business. In our stock picking approach, we try to avoid irresponsible CEOs. They are generally risky. In our view, they can appear anywhere, in any business activity. But there are some entire business activities where, despite the best intentions of a CEO, the business activity itself is irresponsible. We decided to apply some simple economic tools to the ethical problem of what corporate irresponsibility looks like. Markets have long struggled with externalities – effects from a transaction extending far beyond the participants in that transaction (either by scope or through time). We decided to focus on two high impact externalities: damage to the environment and damage to the fabric of a fair society. In our view, any business activity that sells stuff, knowing its use causes widespread damage to the environment (possibly irreparably) cannot be thought of as behaving responsibly. Oil companies, no matter what they say about running their businesses in a carbon neutral way, still peddle product they know is used in an environmentally damaging way.

In Q2 factors flip-flopped. Energy kept running, but investors flipped back into mega-cap tech and became nervous about most other recovery plays. The lack of Energy was particularly hurtful for us. Energy still makes up a significant part of the current value factor (stocks sharing characteristics associated with investor anxiety, such as low valuations, or weak price momentum). As we have explained before, we have built our portfolios to keep an even balance between value and growth since the middle of last year. But value ex-Energy has behaved very differently to value cum-Energy this year. The combination of “transition anxiety” and the COVID Delta variant stalled the anxiety release. (We go into the details in the market commentary below).

The combination of lots of macro noise, flip-flopping factors, strongly performing “risky” sectors, and a big influence from a small number of very large stocks is a bit of a nightmare for us. Disentangling why we have lagged this year comes mainly down to our stubborn avoidance of stocks we either thought were too risky or were too big (equally weighting everything means we didn’t own enough of them).

The macro noise will abate. In our experience the persistency of effective CEO behaviour in robust businesses matters through economic cycles. We believe the cacophony of recovery vs inflation is slowly returning to normal. We believe the world is adjusting to the idea COVID will never truly disappear.

Short book review

Almost every month, since Q2 of 2020, our first thought when writing a review is “shorting has been hard this month”.  This quarter deserves a harder look at why.

Running a short book, within a 150-50 portfolio structure, has cost us around 5% so far this year, on top of 5% last year. This is, to say the least, a poor return. We short to give us downside protection without sacrificing upside beta. While the shorts have kept the “downside protection” part of the bargain, the cost of the insurance has been excessively high; we have lagged badly during market rallies. Shorting is expensive too – stock borrowing costs, counterparty fees.

We tried to short stocks with “risky” factor skews in two areas. First, we shorted stocks with high valuations and high volatility. Second we shorted “value-traps” – stocks with poor price momentum with business models which, pre-COVID, were showing clear signs of being disrupted. These two types of stocks worked very well for us during the market sell-off in Q1 2020. They have been terrible since.

Last year aerospace stocks with shaky business models, ill-equipped to survive a prolonged fallow period, such as Rolls Royce, Spirit AeroSystems and GE burned us when they popped on early COVID optimism. Disrupted legacy retailers like Macy’s and Tapestry, or tired consumer brands like Harley Davidson, relentlessly rallied. We couldn’t even get laggard pharma bets right, as we were forced to close our short in Alexion following a bid from AstraZeneca.

This year high volatility stocks with risky looking CEO plans have hurt us: stocks like Appian (we think it is an unremarkable business selling on a remarkable valuation), Ballard Power (early-stage tech in a rapidly evolving, crowded space), and some of the conference dependent Las Vegas hotel chains. Old economy value traps like Ford (we thought their EV strategy was hugely over-hyped and the cost of transition from their legacy business hugely underplayed), and Oracle (facing numerous fronts of disruption from cloud native SaaS) punished us with relentlessly rising stock prices. We were also caught in some of the high interest short squeezes in Q1, such as Teradata (a disrupted tech business) and Lumen (a heavily indebted legacy telco).

Shorts move a lot “faster” than longs; you do not get paid to be patient, quite the opposite. There is unlimited downside when a short that moves against you. A combination of risk aversion and a slow-moving short style can trigger waves of loss-control close-outs when your short-term timing is slightly out. Our short-term timing was defiantly slightly out. We have run down the gross exposure of the short book almost every month this year. We continue to hunt for new shorts, but it still feels uncommonly risky to short. After 10 years of shorting, we are taking a long hard look at the structural pros and cons. We have often unearthed poorly structured, riskily run business, but there have been far too many times when we have not been rewarded enough for our insights as stock price volatility has increased.

Market Commentary

It is over a year since the market hit peak COVID anxiety. A year ago, a recovery barely seemed possible; now it seems inevitable. The last time there was a deep macro shock (2008) recovery stocks ran for three years. The path was rarely smooth. After an initial, steep release from deep anxiety, scepticism intermittently seeped in. Doubts about the pace and durability of the recovery ebbed and flowed. 2010 was an uncomfortable year for the post-GFC recovery trade. So far 2021 has the same feel to it.

2010 was dominated by macro debates: would the recovery stall, or would it roar? The same debate rages in 2021. The differences? In 2008 the banking system and real estate crashed, twitched and ultimately revived; what emerged post-2008 was very different. In 2020 the shock has been deeper, wider and from an entirely unfamiliar source. While the overall shape of recovery looks similar (stock market indices tumbling, then bouncing) the path for sectors, industries and individual stocks has been messier. Factors have flip-flopped; what went up in Q1 has often gone down in Q2.

The economy is still recovering; it has not recovered. COVID still exerts a significant influence. Yet it feels like we are in transition: out of COVID and into something new. We do not know what the “new” will be. Hence, this recovery is confusing: it is not a recovery back to what we had before. As the quarterly reporting season kicked off, surprises were big and widespread. From the bottom-up, businesses were telling us the recovery was faster and steeper than expected. But stock price reactions were strangely muted. CEOs were becoming more hopeful, but investors can be a perverse bunch. The receding fear of 2020 left a vacuum for new anxiety: was the recovery over, was the news as-good-as-it gets?

As the quarter trundled on investors’ worries returned to more familiar territory: inflation. Since the trauma of the 1970s, investors have been raised on the fairy-tale monster of catastrophic inflation. We all fear it dreadfully. For as long as I can remember, as soon as anxiety shifts from “will a recovery happen”, it is replaced by the inflation-monster. Recently, supply chains and labour markets have struggled to keep pace as the global economy has kicked back into gear.

By the end of the quarter, stock market investing resembled the strange sensation of having one foot in a bucket of cold water, the other foot in a bucket of hot. The recovery still feels hot. For those whose job it is to predict inflation, a worrying pattern of error is emerging. Forecasts are persistently behind the evidence, commentary dismisses error as transitory. We have often seen this type of error pattern play out for those who forecast companies. Errors often have “momentum”. We suspect inflation will continue to run hot through the rest of the year. But there is also a bucket of cold water: COVID.

COVID has mutated again. The latest version is more virulent. Despite considerable progress on vaccination programs, infection rates are accelerating. The re-opening part of the recovery path is at risk again. Consistently through the pandemic Governments have struggled to tread the fine line between control and freedom. People respond best to clarity: if it is clearly dangerous, they will behave responsibly (because it’s in their interests to do so). If it is clearly safe they will behave normally. If it is somewhere in between, most people will think they know best, will distrust government messages on collective responsibility, and do their own thing. With hospital admissions still low and a significant proportion of the population feeling safe, having been vaccinated, collective responsibility is hard to enforce. Re-opening is slowing again.

The cold water of COVID derailed large parts of the recovery trade last quarter. The hot water of inflation spooked investors. Yet the overall stock market continues to go up and bond yields fell. If one bucket of water is cold and the other is hot, the mix is lukewarm. Inflation is surging because the economy is trying to recover too fast. Re-opening is a key part of the recovery. A longer, slower recovery looks the most likely. While value and growth factors may flip and twitch, it still feels like an environment where both recovery and growth plans can prosper together.

 

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This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authority’s (“FCA”) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora Asset Management LLP (authorised and regulated by the FCA). Registered office: 6 New Bridge Street, London EC4V 6AB. Registered in England No. OC351772. Past performance is not a guide to future performance. Care has been taken to ensure the accuracy of this document’s content, but no responsibility is accepted for any errors or omissions herein. The views expressed are our own and do not constitute investment or any other advice and are subject to change. In particular, we are not recommending or expressing an opinion on the merits of buying or selling any securities mentioned herein. Ardevora Asset Management LLP is authorised and regulated in the United Kingdom by the FCA, and operates in the United States as an “exempt reporting adviser” in reliance on the exemption in Section 203(m) of the US Investment Advisers Act of 1940.

Previous Commentaries

Quarterly Commentary Period ending March 2021
Annual Commentary Period ending December 2020
Quarterly Commentary Period ending September 2020

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