May 2012

INSIDE VIEW: Drilling for returns

Drilling_platformLong-short investor Epiphanios Michael, of Bryan Garnier Asset Management, is looking at American insurers, Swedish exporters and deepwater drillers as he attempts to benefit from global structural imbalances. Today, there are are multiple opportunities to profit from structural imbalances among not only major regions such as the US and Europe, but across multiple countries within Europe. This is especially true given the current climate where there is increasing monetary, fiscal and political instability among European countries, all of which is driving market volatility.  I believe that in such markets a top-down macro approach with a focus on risk management of long and short positions is a differentiated way to create alpha. To be active on the short equity side is an important source of return given such mispricing opportunities and macroeconomic challenges.  It is these macro influences that are becoming more important when analysing stocks. Over the past few years macro factors have gained in importance when determining the direction of public equities. This is primarily a result of globalisation and of the growth of industries from emerging economies that pose a threat to industries in developed economies.  Taking a short position on German equity markets through the Dax in late March 2012 had been a rewarding play. The rationale was that the near 20% rally in the Dax for the first quarter of 2012 was not sustainable primarily due to my feeling that the optimism in the equity markets would once again falter given Germany’s reliance on industrial earnings, the exposure to the auto sector and emerging markets, in addition to the stubbornly strong euro.   As we move forward, rotating this short position and focusing on Switzerland via the SMI (Swiss Mid Cap Index) is another opportunity. The idea is that in a market panic the Swiss Central Bank may not be able to protect its currency from strengthening outside the band, consequently leading to a sell-off in the Swiss equity market.  However, the probability of this event is low but the potential return high. So why consider such a trade? Well, the Swiss equity market is due a pull on certain industries priced for perfection, such as transport services/logistics, to name one. Further, the trade does not appear to be a crowded one – therefore, this offers “optionality”. US insurers
Conversely, opportunities are emerging for public equities in Sweden that are exporters to Asia. I have chosen a basket of equities in this country that have been de-rated over the past few years in the face of structural headwinds from Asian competitors. However, it looks like they may start to regain some market share given new product launches and a re-focus as market leaders, with smaller companies failing to compete as the slowdown continues.    On the long side, we also see some opportunities. The UK house-builders where the depreciation of the pound has enticed foreign buyers from Asia and other emerging markets is one such area of opportunity.  These companies were forced to stop aggressive land bank acquisition after 2009 and to focus instead on churning existing land bank and existing business.  Looking to the United States, insurers that focus on life insurance and non-life insurance also look attractive.  They look appealing on macro, valuation and structural grounds versus their UK counterparts.  US insurers on average have kept a lot of discipline as they re-organised themselves financially and the discount to book, although warranted, is too wide. However, I believe this discount will narrow as the shareholder overhang and restructuring develops while policy pricing has improved markedly. The lukewarm equity markets are likely sufficient for these companies to push through restructuring plans and initial public offerings to extract value.  This position is offset by a short view that UK insurers have been aggressive in price discovery (one notable example being auto insurance) while life insurers are in some cases chasing yield to match liabilities.  This is happening at a time where valuations are comfortably above tangible book value, and dividend yields appear frothy. UK insurers face higher regulatory barriers through the Solvency II rules from Europe and even though they will be given time to adapt, I do not think they are taking a sufficiently cautious approach through hoarding cash. This high dividend yield in turn is attracting investors at a point when expectations should be correcting. Ships and drills
Further areas of downside may come from heavy-lift ships and deepwater drillers. Not that I have a strong view on the oil price per se, and the correlation is a little muddled, too, but the financing of future order books looks more difficult, yet valuations do not reflect this.  While the investment community is broadly focused on rates and the price of oil, I am looking at whether these businesses can grow as they did prior to the financial crisis. If they can’t, will there be a realisation that the return on equity should be significantly lower?  On the other hand, the future order books can be delivered at just the wrong time. The political landscape at present with a strengthening of trade between Asia and the Middle East has delayed this downside risk, although a risk it remains. From a top-down lens, I see strong reasons to be short on continental Europe with some unique opportunities to go long in the region where short-term macro/industry catalysts emerge. Overall, taking a long position on the UK and the US against a weakening Europe is a cautious but sensible strategy until European ministers decide to make painful changes. The long-term will offer great opportunities but a period of volatile markets until these opportunities in Europe emerge is expected. Epiphanios Michael manages the Leadership Fund at Bryan Garnier Asset Management ©2012 funds europe

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