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Markets’ Turning Point Presents Opportunity For Equity Relative Value

Most market watchers believe we’re finally in the late stages of the cycle, and when that happens, it often takes management teams some time to adjust their thinking. One hedge fund is looking to capitalize on the dispersion a turning point like this one presents.

equity relative value
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Carlson’s Double Black Diamond was up 1.61% net for the first quarter, while its Black Diamond Partners fund was up 2.78% net. The biggest contributors to the funds’ March returns were their equity relative value, equity long/ short and event-driven strategies. In fact, Chief Investment Officer Clint Carlson said in his March letter to investors, which was reviewed by ValueWalk, that these strategies brought even better-than-expected returns for the first quarter.

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The funds' credit, rates, strategic investments and hedge didn't have much impact on their total returns, although credit was a drag on the Double Black Diamond fund. Carlson said they plan to increase their leverage during the second quarter due to the "lower risk composition of the book."

Preference for equity relative value

He noted that in 2018, cash outperformed almost all other asset classes, but the first quarter of 2019 brought the reverse. In either case, he continues to position the fund for diversification with low beta and correlation to the S&P.

He believes his equity relative value strategy is the best fit for risk-adjusted returns in the current environment. He also expects this strategy to not only continue to be of low correlation to the S&P but also to other hedge fund strategies.

"We think we have entered a period in the economy where there will be more variability in corporate earnings performance, not only across sectors, but within industry groups," he wrote. During periods of economic growth, all companies tend to do well, leading to little variation in performance. When the economy slows, weaknesses tend to be exposed, and companies are more likely to miss expectations.

He also pointed out that some companies begin to feel the effects of an economic slowdown before others. According to Carlson, the markets are currently at a major turning point, and he believes corporate management teams tend to be "too optimistic" at times like this, which means their guidance tends to be less reliable. The result is "more price dispersion between individual stocks, and more opportunity for equity relative value strategies which focus on stock-specific risk."

Opportunities in event-driven strategies

Carlson also sees opportunities in his event-driven strategies. His merger arbitrage strategy in particular has been a strong performer over the last three years, and he sees more room for the cycle to run. Even though deal activity has slowed "marginally," he expects it to pick up over the rest of this year. He also said several economic and geopolitical uncertainties appear "close to resolution," and financing is still "cheap and readily available." He also believes the 2020 election could be a catalyst to push deals through sooner rather than risking a less favorable regulatory environment after the election.

Beyond M&A, he sees a strong "pipeline of exceptional corporate actions."

"This strategy is value-oriented, since companies that are under pressure to restructure tend to have underperformed for some time," he explained. "While value bias held back returns last year, we believe that this is likely to reverse at some point this year."

Benefits of low correlation

He noted that volatility across asset classes is historically cheap right now. Although he did cut the fund's long volatility position "significantly" over the last two quarters, he feels it might be time to add some incrementally.

"Cheap is not the same as profitable, and the last ten years have shown that trends can stay in place much longer than one expects, and while volatility is cheap, it is negative carry," he wrote. "Still, when insurance is cheap, it makes sense to buy some."

As investor preference for passive funds continues, one argument we're hearing more and more about is an emphasis of low correlation. An emphasis on low correlation served Half Moon Capital quite well in 2018, and Carlson now makes a similar argument.

He feels the Fed's goal right now is to "create an environment in which everyone wins." He said one reason passive investing has become so huge is the view that it doesn't matter which stocks you pick because all of them will climb. As a result, it makes sense that stock picking would become difficult. On the flip side, this also means asset correlation is high, and "hedging and diversification appear superfluous at best" in the short term.

However, he believes last year's "market convulsions" were not the result of a Fed policy mistake, but rather, "an indication of what happens when investors are all one way, and are relying on the chimerical 'Fed put' to replace prudent risk management." Based on what Half Moon experienced with its low-correlation portfolio late last year, which placed it among the few funds with positive returns in December, it seems Carlson has touched on one of the causes of the market-wide pullback that month. Essentially, when everyone is moving in the same direction, something eventually gives way, opening up a flood of hurt.

He said in another recent letter that he had a "frustrating year" in 2019, but now he's betting that momentum will break this year.

This article first appeared on ValueWalk Premium