Tim Russell is one of the stars of Cazenove’s hugely successful move into mainstream fund management – he manages a small stable of hedge funds and Ucits III absolute return mandates all focused on making money through the business cycle. Unlike his closest peers such as Mark Lyttleton at BlackRock, Russell is noticeably more bearish about the UK stock market and clearly concerned 2010 could be a very difficult year for active fund managers
Let’s start with defining your absolute returns strategy? How does it actually work at Cazenove?
TR: We had three aims when we started our hedge funds. The first is a return objective and everyone says they are absolute return, but our view is you can only claim to be an absolute return fund if you are going to run with a broadly market neutral structure through a cycle.
Because that is effectively saying we are not taking market risk, we are trying to add value from stock selection. Anyone who is running funds and claims they are producing absolute returns while essentially 50%-100% net long is probably deceiving themselves. As last year clearly demonstrated, most financial assets are correlated. So if you are net long, the chances are if the markets go down a lot, you are going to go down as well.
Our second aim is as a function of being market neutral – we are running long and short puts that are broadly the same size. If you are doing that then you are going to have low correlation with the asset class you are investing in and, lastly, you are going to have very low volatility. Absolute returns, low volatility and low correlation. And five years on, we have had broadly all three of those. We have had positive absolute returns but not as high as we would have liked.
But when we started the hedge funds interest rates were around 4.5% and after all our possibly excessive charges – but the charges are fairly common in hedge fund land, in terms of management fees and stock borrowing fees, prime broker fees and so on – after these, we were clearing about two and a bit percent interest a year. So that was one part of our return. The rest was essentially making sure our long book was outperforming our short book. That is the genuine bit of alpha. That plus your interest return was essentially your overall return.
It is a smoothed return you are offering customers isn’t it?
TR: If you can do it, it is obviously very appealing to all sorts of customers – charities, pension funds, private clients. Essentially, you are saying it is a cash-plus type return. It might not be the most exciting thing and I am not pretending this type of approach is anything other than hard work, because it is. It is very hard work. Sweating long and short books of roughly equal size to produce positive returns, but that was really what we are trying to achieve.
You do yourself a slight dis-service though as many funds offer the same attraction of smoothed returns but the way you do it is rather distinctive isn’t it ?
TR: We are slightly nuanced in the sense we did not call ourselves strict market neutral right from the beginning because we have a business cycle approach. We essentially tilt our portfolios away from cyclical shares towards defensive depending upon which stage of the business cycle we are at. And that is essentially how we arbitrage our long and short books as we go through the cycle.
How does that actually work in practice?
TR: We generally want exposure to cyclical companies when economies are accelerating and conversely want exposure to defensive shares when economies are decelerating. And in as much as the past tells us anything about the future, one can see these very clear patterns where cyclical shares strongly outperform in rising economic periods and strongly underperform when growth weakens. So the skill is trying to manoeuvre our long and short books as we go through the cycle.
There is a risk if you get the timing wrong isn’t there?
TR: We could get it wrong and we could have a negative return but at least the structure overall, being broadly market neutral, is going to allow us to claim we were in the game of trying to produce absolute returns.
Would you summarise your strategy overall then, as very much informed by business cycles? Looking down at how that impacts on sectors and then saying you want classic stock picks – do you want the best companies that demonstrate that play?
TR: A business cycle approach is basically one that understands things do not stand still – you have to recognise change. The key thing is recognising the market is not very good at valuing operation gearing. So it is not very good at valuing cyclical earnings streams.
As a result, we get very excited when cyclicals produce strong earnings growth and we extrapolate it. Then we get very fearful when they are declining rapidly. One of the key aspects of this sort of approach understands how shares correlate with each other. So broadly, all cyclicals will behave in the same way and all defensives will behave in the same way at the same stage of the cycle.
To give an example – usually we take the view if its right to be long of Glaxo, let’s say, it is probably going to be right to be long of AstraZeneca. Because they are correlated. They both have different products but are both involved in ethical pharmaceuticals. They both have the same challenge of trying to bring new products to market and replace products that are going off patent.
That is a slightly different approach to one of your competitors Mark Lyttleton at BlackRock who will try and pair stocks – one bad bet, versus one good bet !
TR: He will say that, but to me it only makes sense doing that in sectors where you do not have perfect homogeneity. So there are some sectors in the world like support services or travel and leisure, where you have both defensive and cyclical business models. So if you take travel and leisure, the bus stocks historically been very relatively defensive – demand for bus travel has not tended to be particularly GDP sensitive. So they behave like defensive shares.
Whereas British Airways is obviously a very operationally leveraged model. It tends to behave like a super cyclical. Within the support services sector, you have some companies like Galiform which are basically very operationally leveraged, and you have some businesses like Serco or Capita which are essentially growth defensives because, they’re benefiting from a long-term outsourcing trend. They have high revenue visibility – pretty much every year they know roughly what the revenue lines are going to be each year. So if we are going long one area of the market or the other, we will tend to take a basket approach and spread stock risk rather than having very concentrated stock risk.
What is inside your portfolios? What would you have in there at the moment?
TR: We are UK only and we have a block of assets on the long book which are split three ways. First, a core book for defensive longs – Glaxo, William Morrison, utility shares, Unilever, some support services companies like Babcock and VT Group and Serco – look as though they are capable of growing almost irrelevant of the economic conditions in the UK. So those are around one third of our long book
Where is the next big block of shares?
TR: Financials – we put that in at the back end of January 2009. We were a little bit too early and financials have started lagging the market again of late. Is this a warning sign? It could be. It could be the market is starting to fret about the scale of the upgrades for banks… and that next year it is not going to be as easy for banks to make the sort of great margins they have been making this year.
Our big long is really in the insurance area where we are in disagreement with some of our competitors who have big shorts in this area. And I take the rather simple view it is odd a company like Legal & General is ending 2009 at about the same price it started the year, despite the fact nearly every asset class they invested in is substantially higher than it was at the beginning of the year. And their financial position and their cashflow is a lot stronger than the market imagined it would have been at the beginning of the year – we are about 10% net long [financials] on average.
What’s the last part of your portfolio?
TR: Cyclical shares. Companies like Melrose, which is an industrial acquisition vehicle, basically a listed private equity model. A great management team who have done a very good job buying businesses, getting margins up and then selling them, retaining the cash to shareholders before they do another deal.
What about your shorts ?
TR: We have remained short high beta shares, particularly commodities. We have been short commodities through 2007 – eventually it came right in 2008. We had covered some of the shorts. Obviously the mining sector has been a very strong performing sector this year and now the valuations do not look particularly cheap. There is no great added value in a mining company – they dig stuff out of the ground and in my mind they should be very low price to earnings (P/E) businesses – and they are not.
So how has this strategy of timing using business cycles worked so far?
TR: We recognise there is one stage of the cycle where it is correct to be long equities, which is nearly always at the low point of the cycle – when corporate profits as percentage of GDP have fallen. Cashflows have also deteriorated and the operational gearing has always worked against cyclicals and so they always tend to be trading at relatively low valuations in terms of price to sale or price to book. That is normally the time when you want to start switching.
So we are talking the beginning of this year really?
TR: Actually we had been very defensive since the summer of 2006, which was a little bit too early. It was one of the reasons we produced positive returns from the second half of 2007 through to the end of 2008, when the markets were going down – because we were essentially long defensive and short cyclicals. But in 2008-09, a couple of things were holding us back – making us think it was too early to turn. One – a belief that the policy reaction, which obviously has been huge all around the world, was basically disproportionate and its removal would almost inevitably cause a double dip. Therefore we questioned how long this recovery would last. The second was actually the performance of defensive shares themselves – unlike 1992, which was the last real recession the UK defensive shares had behaved very well in relative terms, but in absolute terms, they had broadly fallen
By defensive you mean any company that is relatively insensitive to GDP growth. Food retailers, tobacco, drinks like Tesco, Diageo, AstraZeneca, Unilever?
TR: Yes. As we ended 2008 most of them were trading on around nine, 10, 11 times earnings at tops plus decent yields. Then in March, cyclicals started moving. One can look back and say fine, with hindsight that was the moment one needed to move.
At that point would you, if you had followed that theory, have piled into BHP Billiton, Anglo American and every cyclical stock you could get your hands on ?
TR: Yes.
Effectively this is an exercise in market timing using switches based on the business cycle ?
TR: Two switches each cycle – we describe it as a see-saw. Towards the end of the cycle you want to be long defensives and short cyclicals and at the bottom, you want to start moving the other way. We did not get our timing quite right this year, and as a result we have been running against momentum all year. Although it looks like we are going to finish 2009 broadly flat. Maybe very slightly up.
David Stevenson is a Financial Times columnist and consultant. Email him at davidcstevenson@gmail.com
