The hedge fund sector has struggled to generate positive risk-adjusted returns in the long / short equity arena for almost 10 years now. Historically low levels of volatility, above average stock correlations and predominately upward trending markets have made it easier to track key indices such as world equities or world growth via low cost exchange traded fund (ETF) products. However, we believe investing in the most disruptive segments of the market may offer investors a compelling return capability that utilises the scarcity of above average volatility combined with lower levels of correlation. Simply put, the disparity and polarisation of returns between winners and losers in a major industry disruption cycle are sizable, presenting exciting opportunities for both long and short investing.
Take, for example, two industries which have been facing highly disruptive internet enabled forces for at least a decade – retail and advertising. The scale of change has been so great that three of the top five companies in the world today by market value are Amazon in retail and Google and Facebook in advertising. Completely new industry leaders have been created with vastly more powerful business models coupled with low cost structures that traditional, incumbent, providers cannot remotely match. The result is that not only have these new giants seen share price appreciation of multiple times over the last decade, their incumbent competition has seen totally the opposite outcomes. In retail, the demise of US department stores is well documented. In advertising, there are numerous causalities in newsprint and radio. These types of megatrends provide excellent hunting grounds for long / short strategies but we believe that they require an in depth knowledge of the prevailing forces and the new technologies, as well as highly disciplined risk management.
Many of the disruptive trends on which we focus follow the Gartner hype cycle (Chart 1 below). In fact, all new technologies tend to follow this type of investing lifespan.
Chart 1: Gartner hype cycle
The underlying fundamentals for new technologies and disruptive business models often progress at a much more sanguine but irrepressible pace than investors have the patience for. The average investor is quick to become overexcited by the new technology and drives share prices to a peak of inflated expectations that inevitably lead to sharp declines as reality does not match the hype, at least to begin with. It is after share prices get back in touch with reality that the longer-term opportunity emerges on the long side. Warren Buffett often talks about the market being a voting machine most of the time rather than a weighing machine – the former merely registers investor sentiment and can drive share prices to extremes that are not remotely supported by the weighing machine that evaluates the share based on its future fundamentals. These extremes of hype and disillusionment are multiplied in the technology world and may offer bigger opportunities than elsewhere, thus presenting an ideal long / short setup.
The environment for technology funds has been extremely challenging over the past 20 years in both the long only and long / short spaces. This is primarily because investors forget that it is important to remain firmly grounded in both fundamentals and risk control. The survivors have been those managers who stay balanced in their thinking and respect the market; where this happens, returns can be meaningful.
During the period that we have been investing long / short in technology - a period of over 20 years - there have been many points of both exuberance and disillusionment in the cycle. A great case study is that of the solar panel industry in renewable energy. Many companies came to the market from 2006 onwards, led by two German companies in Solarpower and Qcells. At the time, neither company had invested in R&D and their only competitive edge was a transient lack of supply at a time when governments were heavily subsidising solar adoption. Qcells made its debut in May 2015 at EUR 15.50 a share. It is now bankrupt, but not before hitting a high in 2017 of EUR 83.50. The attention to this ‘lifecycle’ for the shares is so important.
It is the respect for the hype cycle effect on companies and sub sectors in the lifetime of a disruptive technology change that is a key component of our strategy. It is essential, in our view, to remain firmly grounded in fundamentals rather than momentum – focusing on the weighing machine as the basis for stock selection (what to buy / sell) but at the same time having the highest amount of respect for the market and its voting power (when to buy / sell). This may help reduce losses and volatility while allowing returns to be created in such a dynamic and fast changing sector.