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Calm in the storm

Tony Stenning As Nigel Ridge and Nick Osborne celebrate their third anniversary as co-managers of the BlackRock UK Absolute Alpha Fund, they tell Julian Marr about their considered response to a complex market environment

Is risk increasing, or is it being repriced? In the current market climate, it’s probably a combination of the two. This environment presents opportunities for absolute return investors who can look through market volatility to identify attractive opportunities.

  • This is  a complex environment that requires a considered response 
  • Although US economic growth is set to moderate, it is not expected to fall into recession
  • A long/short portfolio makes it possible to view a sector from both angles

2016 has had a tough start. To judge from some of the shriller media headlines, the world is now in crash territory with trillions wiped off share-price values in January alone. The reality, however, is rather more nuanced, suggest Nigel Ridge and Nick Osborne, the co-managers of the £208m BlackRock UK Absolute Alpha Fund, as they seek to look through the current market volatility to work out where it presents opportunities and where they need to retrench.

A key decision the pair have had to make is whether risk is being repriced or whether it is increasing and their conclusion has been that it is a little of both: The fear surrounding the Chinese economy is prompting investors to sell risk assets, which is exerting downward pressure on prices. At the same time, global growth expectations are being reassessed.

“We are thinking about it as a sort of negative QE,” explains Ridge. “QE brought a weaker dollar, lower US rates and higher financial markets and this is effectively the reverse.” He also highlights the problems posed by the interconnectedness of markets and asset prices, pointing out that lower Chinese demand brings lower commodity prices and a stronger dollar.

“Attempts to protect the Chinese currency have prompted the selling of dollar assets,” he continues. “Lower oil prices result in sovereign wealth funds selling and higher-yielding credit markets coming under pressure. This is all against a backdrop of a market still dealing with the first US interest rate rise in years.”

It is a complex environment to navigate that requires a considered response and Ridge and Osborne have progressively edged back the fund’s overall exposure to the market. As 2015 drew to a close, the portfolio was operating a 20% net long position, compared with an average of 25% over the preceding 12 months. Although this meant the fund still had some exposure to 2016’s market falls, the downside has been limited.

Furthermore, as markets have fallen, the fund’s managers have looked to take advantage of lower prices – building positions, most notably, in product-testing and certification multinational Intertek and telecoms giant BT Group. “Shares in Intertek had been sold down on concerns surrounding its oil exposure,” says Ridge. “We are confident, however, that any oil-related weakness is manageable and the new leadership team should be able to deliver strong growth. As for BT, we are supportive of the group’s merger with mobile company EE so, while the share price fell on concerns over the regulatory outcome of the deal, we used that weakness to build a position.”

Financials have been second only to commodities in the degree to which they have borne the brunt of the selling pressure since the start of the year but Ridge and Osborne continue to back the sector. “We expect it to continue to heal,” says Ridge. “Lloyds is a good example of a business that is well-suited to the modern world of banking regulation. It is also likely to see a sharp increase in distributed reserves in coming years and therefore offers an attractive dividend profile in a world where many people are talking about dividend cuts.”

Although focused on the UK, the fund does offer its investors an element of international exposure – for example, to the US through holdings such as plumbing and heating product supplier Wolseley. Equities with exposure to the US are increasingly being priced as if that economy was on the cusp of recession but, while Ridge accepts there will be some moderation of growth there, he does not expect an outright recession.
 

“We believe we understand when there is change”


In a bid to eliminate market directional risk from the portfolio, the UK Absolute Alpha team use what are known as ‘pair trades’. This strategy involves going long and short of a pair of companies within the same sector, which should have the effect of neutralising the sector performance and solely obtaining exposure to the difference between the performances of the two businesses.

At present, the fund has balanced pair positions within the housebuilding, gaming and oil and gas sectors. At the same time – and particularly in the light of their recent strong performance – the fund remains short of what Ridge describes as “expensive defensives”.

The management has, however, been taking a closer look at the food retail sector – an area on which it has previously been negative. There has been a well-flagged ongoing structural shift in the sector as low-cost groups such as Aldi and Lidl have taken market share. Combined with a move towards online shopping, this has placed enduring pressure on the incumbent supermarket chains.

Osborne flags up the “questionable economics” of the online model, adding: “Clearly there is additional cost in delivery but, perhaps worse than that, you also lose operational leverage across your stores. As a consequence, having recognised both these trends and their likely impact on profitability – as well as the potential financial vulnerability of some companies – this an area where we have had some success being pretty cautious.”

One of the key advantages of a long/short portfolio, argues Osborne, however, is it makes it possible to view a sector from both sides and this can acts as a guide towards inflection points. “We believe we understand when there is change and we have seen change of course in the retail sector,” he continues. “This is both in terms of pricing – share prices have fallen considerably so the valuation basis has changed – but also, importantly, in terms of how the companies have reacted to the changing environment.”

Here Osborne highlights a recognition of the threat the discounters pose and moves to target much more aggressively the relatively small number of angles discounters exploit. “It may not be that pricing has to be taken down across the whole spectrum of a retailer’s product base but can be focused much more in those areas where the discounters have meaningful advantage,” he explains. “That is a positive change that shows a much more considered thought process and a much more strategic response to discounter pressure.”

Osborne believes the large supermarket chains are also finally recognising the expansion in floor space they have undertaken over the past two decades has been very damaging at an industry level as, while supply may have been created, it has not necessarily contributed significantly to returns and it has been very damaging to cashflow.

“That has clearly changed,” he adds. “We have also seen a much more forthright and honest approach to the financial leverage embedded in these companies and some moves to try and remove that or to lessen the burden, which could ultimately lead to a fall in the cost of equity.” So far, however, the managers are merely flagging the sector as an area meriting greater attention in 2016 rather than seeking to build any significant positions in the portfolio just yet.

March 2016 sees the BlackRock UK Absolute Alpha Fund celebrating its third anniversary under the combined stewardship of Ridge and Osborne. Over the three years to 4 February, according to Financial Express, the fund is well ahead of its wider sector, having returned 13.9%, compared with the 8.7% averaged by its Targeted Absolute Return peers over the same period.

With investors bracing themselves for markets that, over the coming months, appear likely to be non-directional and volatile at best, Ridge and Osborne – and indeed the absolute return sector in general – will be hopeful of similarly standing out from the crowd in 2016.

 

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