How to come out on top thanks to the winners and losers

Participation in established, long-term socio-economic trends: this is what a traditional themed investment vehicle usually offers investors. But might it not be profitable to invest in both stocks that are on the way up and those that are on the way down?

Our experience shows that taking this kind of themed management approach to European equities (known as "long/short" in alternative investment) can also bring excellent performance while at the same time producing a smoother (less volatile) result over the longer term. In other words, this type of investment approach can lead to better performance with less risk.

This approach is therefore particularly suited to meeting investor expectations in terms of capital preservation, especially when the market environment is demonstrating increased volatility. As well as offering the possibility of selling short positions when they do not seem to be offering sufficient return for the risk incurred, UCITS III legislation now permits performance gains to be preserved by liquidating positions and using the cash proceeds or equivalent instruments up to 100% if the fund manager so desires. This additional room for manoeuvre increases the number of alternatives available for preserving capital when market circumstances require this.

However, the key to success in long/short themed management lies in having a tried-and-tested investment process. Identifying the most promising themed trends is the cornerstone of this approach, which is certainly proving its worth in the area of themed European investment. First of all, let us take a look at what could be described as "macro changes". These include the relocation of Western economic centres towards the East and South, the ageing population, the growing economic imbalances between regions and countries, the limited supply of natural resources and the increasing degree of political influence exercised over the economy. This last factor refers to subsidies for renewable energies, for example, or state intervention in the financial markets.

In terms of "micro changes", technological advances offer numerous investment opportunities in Europe, in areas such as digitisation, mobility, networks, miniaturisation and access to energy or connectivity. Furthermore, the trend towards offering more and more products and services in both top-of-the-range and low-cost segments also presents plenty of investment opportunities. There are many other trends to be exploited, such as outsourcing or the globalisation of production chains.

These trends lead to some companies rising and others falling on the stock market, and identifying them before their performance has become clearly apparent is carried out using top-down and bottom-up analysis. A top-down analysis allows the budget for different "equity risks" to be calibrated with reference to the economic cycle. It is at this stage that analysis will reveal whether there is good reason to favour particular types of stocks: growth or value, defensive or cyclical, large or small cap, or high or low quality.

Bottom-up analysis enables candidates for long and short positions to be selected. A particularly effective method of picking stocks in these two segments within each of the management themes involves dividing them into five categories. The first three contain candidates for long positions and the other two cover candidates for short positions.

These five categories are based on the fact that a company's value reflects the capital employed, the return on this capital and the average cost of this capital. Constructing hypotheses on how these parameters will develop makes it possible to forecast how the stock market value of the companies will change. Regular meetings with the management of the companies concerned also enable analysts to refine and corroborate their judgements on how the equities are likely to move on the stock market.

The first three categories of stocks in companies that are candidates for the long part of a European long/short portfolio are defined as follows: 1) shares in emerging growth companies; 2) companies with established growth; and 3) those which offer very stable returns on assets and are able to reward investors in the form of either dividends or share buybacks. In addition to these first three categories in the long segment, there is a section that deploys tactical bets, such as companies that appear to be undervalued temporarily. Finally, 4) a steadily weakening business model and 5) inappropriate use of assets by the management constitute the two categories of company that are candidates for the short segment of a long/short Europe themed portfolio.

The themed portfolio resulting from such an approach thus stands up relatively well to the see-sawing of the financial markets, as shown in the graph opposite, which illustrates the results of this type of management with reference to European companies. Alternative long/short management applied to European themed management should therefore continue to prove its worth, even when the global stock markets are vacillating…