“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
Conspiracy theorists will delight in the idea that, post the great financial crisis, central bankers have manipulated interest rates with a view to pushing investors into riskier assets than bonds. Equity markets have undoubtedly surfed on this tide, but those seeking yield have barely been put off government bonds in an environment in which the opportunity cost of not investing in cash has been so low and inflation has been constrained at sub-target levels for lengthy periods (albeit that real government bond yields have proved negative).
However, we have seen a fundamental shift in recent times with US monetary policy beginning to normalise, putting pressure on other central banks to follow suit. Even, in Europe, there is increasing pressure on the ECB President Mario Draghi to, at least, reverse quantitative easing (QE) or, better still (in the eyes of some), begin to increase interest rates. This exposes investors to the spectre of duration risk (or the [negative] sensitivity of the capital price of a bond to interest rate rises).
Furthermore, in the equity markets, leadership has become increasingly narrowed. The extent of the outperformance of growth stocks has pulled aggregate market levels higher but this beguiles the extent of the weakness in the broader universe. For example, while, at the mid-October stage (15.10.2018), the US S&P 500 index traded at levels just 6% below the all-time peak1, after a tumultuous couple of weeks, a closer look at the underlying constituents is enormously revealing.
At this point, the share price of no fewer than 21 (4%) of S&P500 companies was trading at 40% below their 52-week highs1 (approximately equivalent to the extent of the 2008 sell-off), an additional 37 companies had seen 30-40% wiped off their share prices1, while a further 101 constituents had seen their share prices contract by 20-30%1. No wonder this has been dubbed ‘the hidden bear market’.
“[People who] earn and don’t invest will have to work for the rest of [their lives].”
- Debasish Mridha, Physician, author, philosopher and philanthropist.
It is essential to bear in mind that we live in an era of unprecedentedly low interest rates and, while avoiding exposure to conventional fixed-income securities and long-only equities, might seem to be prudent, ‘hiding’ in cash does not appear a realistic option in the pursuit of long-term investment objectives, so what are the alternatives?
The rationale supporting the equity market neutral, merger-arbitrage approach is that the opportunity set benefits from permanent drivers associated with liquidity and behavioural logic. After a takeover is announced, existing investors in the target company are typically keen to crystallise the large paper profit relating to the initial share price movement. At this point, their pay-off becomes both binary and negatively asymmetric, with the short-term upside being restricted to the residual spread (perhaps low single digit) while the potential downside becomes the total takeover premium that has just been incorporated into the share price. Consequently, these ‘natural sellers’ exert some downward pressure on the share price, effectively keeping the spread open and ensuring the opportunity is structural in nature.
Intuitively, it makes sense to harvest as many arbitrage premiums as optimally possible, since a large number of positions provide greater diversification of idiosyncratic risk. In this respect, a portfolio comprising of 60-80 different M&A opportunities is not only diversified in its own right – which helps to limit the drawdown risk – but also constitutes a useful source of diversification in a portfolio context. The major driver of risk and return is the completion of M&A deals, which is not directly related to the direction of markets or the level of volatility. As such, the fund exhibits a low correlation to fixed income, equity and alternative strategies, which is one of its most compelling attributes.
In order to maximise potential risk-adjusted returns, it makes sense to focus on the small to mid-cap segment of the market as this is where the least crowded positions can be found, offering greater premiums for absorbing the same risk of the transaction failing to complete. In fact, such a bias also reduces the risk of any given deal being vetoed for antitrust reasons, since transactions involving lower-end caps do not tend to impact the competitive structure of the overall business case.
As we have already discussed, dynamics in the US market have raced ahead. Companies with balance sheets awash with cash have been forced to decide on the best route for deployment of this wealth. For many, this has been a case of choosing between share buybacks and M&A activity. The former involves the dilution of shareholder capital (to the advantage of the listed entity) while the latter, including cross-border M&A activity, can result in the creation of shareholder value through synergies. Both these dynamics have, to a large extent, played out in the US, while Europe has lagged dismally.
Over the last month or so, we have been enthused by the orderly completion of a number of European deals, suggesting that the opportunity remains fertile. But, as yet, we are not seeing as many large transformational transactions come to market as we would hope. However, we continue to see an environment in which CEOs are keen to redeploy balance sheet cash, which is suggestive of an opportunistic and optimistic outlook. We believe that current transaction levels are supported by low borrowing costs (cash deals), high equity valuations (stock transactions) and sub-par economic growth rates which make it easier to expand market share through acquisition-based expansion, rather than organic growth.
However, in terms of spreads, we remain near the bottom end of the range. Nevertheless, by virtue of high portfolio turnover (between two and three times over the year), which reflects the short timespan between deal announcement and transaction completion, a merger arbitrage portfolio can (in fixed income terms) be described as ‘low duration’. Consequently, the strategy is able to adapt quickly to moves in risk free rates and arbitrage spreads and, indeed the potential to generate returns would be enhanced, over the year, by an increase in rates and/or spreads. The nimbleness of portfolio adjustment is also a distinct advantage in times of uncertainty and, with the valuation of many capital assets appearing stretched, the strategy’s potential as a powerful source of diversification should not be underestimated.