Alignment Capital Management pitch
In two recently published papers, our specialists in the global consumer and technology sectors discuss the wide dispersion of returns historically seen in these market segments, and the fertile ground they believe such dispersion creates for successful long/short investing.
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Strategies that aim to generate market-independent alpha by taking both long and short positions in securities offer a source of potential return that can supplement traditional “market-plus” approaches. Indeed, long/short strategies have attracted increasing attention from investors in today’s environment of high stock-market valuations and low expectations for future returns.
The consumer sector: Tailor-made for beta-neutral long/short investing
Alpha opportunities are crea ted whe n the market underestimates or overestimates business quality, growth, and/ or risk. We believe several characteristics of the consumer sector make it particularly fertile for such opportunities. In this paper, we examine these idiosyncrasies and the role they can potentially play in generating an absolute return profile that is uncorrelated with the market across different environments.
High dispersion in the long term
The higher the dispersion of returns in a market, the greater the opportunity for managers to generate alpha by picking the winners and losers. Over the long term, there has been significant dispersion in returns of consumer stocks — an attractive backdrop for long/short investing. In particular, dispersion in the consumer discretionary sector has been among the highest of any sector in the market (Figure 1).
There are two persistent factors that help explain the consumer sector’s long-term dispersion trend: wide variations in fundamentals and ongoing structural changes in the sector.
The wide range of fundamental results
In the consumer sector, the range of fundamental outcomes, such as revenue growth and profitability, is extremely wide (Figure 2). This is in part a function of the size and diversity of the sector, which is comprised of approximately 470 companies (about 367 in consumer discretionary and 103 in consumer staples) across 18 different subsectors. For a sense of the scale of the sector, Figure 3 shows that sales in three groups — retail, consumer packaged goods (CPG), and food service companies — amount to 30% of US GDP and 43% of US personal consumption expenditures.
Some consumer categories are also highly fragmented. The largest apparel company in the world, for example, has less than 2% total market share. But as another indication of the diversity of the sector, there are also categories that are dominated by a handful of players with massive scale advantages, such as home improvement.
In addition, trends in consumer sector fundamentals tend to change more dramatically from quarter to quarter than in other sectors, given the many drivers at work — from macro factors, such as weather conditions and energy prices, to fashion and other industry-specific cycles. For example, in the fourth quarter of 2015, unexpectedly warm temperatures hurt sales of cold weather apparel in the US and many apparel makers missed their sales and profit targets.
The winners and losers of structural change
A variety of structural changes are altering the consumer landscape and creating incremental uncertainty about the intrinsic value of consumer stocks that should contribute to higher long-term dispersion in the sector. Here are two examples:
E-commerce continues to disrupt the consumer sector. Since first gaining a foothold in the book business, e-commerce has grown steadily across industries worldwide. There is still plenty of room to run, with e-commerce penetration at 10% for the retail sector overall and two or three times that in some industries (Figure 4). Even at penetration of 10%, e-commerce is responsible for more than 40% of the sector’s incremental growth (Figure 5).
Amazon is, of course, the most extreme example of this disruptive force, accounting for more than 30% of the sector’s incremental growth on its own (Figure 5).1 To put Amazon’s scale in perspective, Figure 6 shows the company’s gross merchandise volume (GMV) — essentially, this is the total of all sales made through Amazon, including third-party businesses that sell through Amazon. The next 19 largest players added together have a lower GMV than Amazon.
In our view, other companies that want to participate in the growth being driven by e-commerce either need to find a way to do business with Amazon or develop their own e-commerce engine. Either choice will raise the cost of doing business, and the resulting sales will likely not all be incremental. This is creating dispersion in margin results and, for fundamental investors, can create opportunities for shorting.
• A growing number of consumer categories are being commoditized. For example, in basic apparel, which includes companies that make and sell socks, t-shirts, undergarments, and other nonluxury items, new competitors are coming in at significantly lower price points than the old guard. Primark is selling sweaters for US$8 while Gap is selling them for US$40. In large part, this trend is being driven by differences in business models. The cost structures of newer players like Primark enable lower prices and their supply chains are built for speed and high volume, which translates to lower average unit costs. Some newer players are willing to accept lower margins given the offsetting benefits of higher volume and scale. This new business model is well suited to the growing desire of consumers, especially millennials, to change styles more frequently without spending too much. Again, this is having a disruptive effect on the consumer sector — legacy players that don’t have a differentiated customer value proposition are facing deflation, the worst of all possible outcomes — and that is contributing to higher dispersion.
In many cases, these structural changes look to be accelerating. This could create larger groups of winners and losers, and as a result, we think dispersion in the sector should rise over time. As that happens, we expect an increase in valuation dispersion between the winners and losers.
Overreactions or overgeneralizations in the short term
All consumer stocks are not created equal, with widely varied fundamentals and structural changes to consider. But in the short term, the market often fails to acknowledge these differences, assuming macro factors affect all consumer stocks similarly and/or extrapolating anomalous near-term results of individual companies far into the future (in effect, overestimating or underestimating growth, risk, etc.). For example, the market tends to bid up the consumer sector broadly when gasoline prices decline, on the assumption that companies will benefit from increased spending by consumers who save money at the pump. But the reality is that only a limited group of consumer industries tend to benefit, including grocery stores, dollar stores, and quick-service restaurants. Lower-income consumers are more likely to spend the savings they realize, and these are the companies most likely to benefit.
These short periods of “broad-brush painting” by the market result in spikes in correlations (Figure 7) and declines in dispersion. Consequently, consumer stocks often trade together in the near term. We believe these short-term declines in dispersion provide opportunities for knowledgeable investors to position for a reversion to low correlations and high dispersion. The key, in our view, is using deep fundamental analysis to develop insights on long-term business prospects and identify asymmetry in upside and downside potential created by the market’s myopia.
An investment universe with ample alpha potential
We believe the idiosyncratic attributes of the consumer sector make it well-suited for beta-neutral long/short strategies. Regardless of the market environment in any given year, the sector has consistently offered a wide range of ideas for both long and short investments. Figure 8 highlights this point, with the best and worst performers over the past 16 years.
In our view, tapping these opportunities requires a qualitative and quantitative understanding of risk and reward across each company, and the discipline to consistently analyze company fundamentals and measure the upside and downside case against the rest of the universe. The investment process also requires an understanding of the factors that can move prices in the short term and the ability to distinguish them from the factors that will determine long-term outcomes.
Finally, while our focus here has been largely on consumer discretionary stocks, we do believe that consumer staples stocks can play a role in a long/short strategy. While consumer staples stocks haven’t historically experienced the same volatility in correlations and dispersion, there are consumer staples stocks that blur the lines and behave more like consumer discretionary stocks, creating similar alpha potential for fundamental investors and adding important portfolio construction flexibility. Further, investing in consumer staples may be additive to beta-neutral, factor-conscious portfolio construction.
Read the full article here via Capitalize for Kids