Record low interest rates, expensive equity valuations, soaring gold prices and no “safe” currencies drive investors to look for alternative investment opportunities.
To meet this demand, we have launched the long/short strategy DNB Financials Absolute Return under the umbrella fund DNB Multi Asset. The strategy’s investment universe will be within financials stocks and the market risk will be hedged out - a market neutral strategy.
The strategy will go long companies where we think the stock market underappreciates the fundamental value and go short in companies where markets seem to view its prospects too favourable. This means that all the positions in this portfolio are active. The return in the strategy will depend on our investment philosophy, process and knowledge (stock picking/portfolio management abilities) and to a lesser degree on market development.
The strategy’s target return is three months EURIBOR plus five percent per annum and our ambition is that the return will be stable and uncorrelated to the stock market. The team behind the strategy has run a similar test portfolio since May 2019 with good results and have a strong track record from the fund DNB Finans. The investment team is dedicated and experienced with an average of 20 years in the equity market.
In this this strategy we are not bound by the constraints set by a benchmark index. We are able to accurately calibrate the long and especially the short positions to our expectations towards stocks. We believe this increased freedom to manoeuvre will provide better opportunities in creating sustainable positive absolute returns.
Why Financials stocks as an investment universe?
“According to Darwin’s Origin of Species, it is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself.”
— Leon C. Megginson, Civilisation Past and Present, 1963
This quote could be use about the stock market and companies in general, but it is particularly relevant for the financial sector which has faced headwinds from increased regulation and lower interest rates in the aftermath of the financial crisis. New technology could be a blessing for the established players that are in the forefront of the development, but also creates opportunities for new and innovative companies to disrupt parts of the industry. The financial sector is one of few sectors that in aggregate appears to be inexpensive - both absolute and especially relative to MSCI World - even though there is large price dispersion among stocks within each sub-sector in the financial universe. We believe the dynamics of the financial sector will crystallize substantial winners and losers, something that will provide alpha opportunities for us as active managers in the sector.
The financial sector is one of the largest sectors in MSCI World, and the industry groups and companies in the sector have various sensitivities to the economic cycle and macroeconomic factors. We are 100% focused on the financial sector and believe that deep industry knowledge is an asset in the quest to generate alpha.
We are acutely aware that one of the main risks in shorting stocks is the asymmetric profit profile. If a stock falls to zero a short position gives a 100% positive return. However, as a shorted stock may go up multiple times the potential loss may in theory be infinite. Most of the stocks in the financial sector, however, are typically mature and massive spikes in short time periods rarely occurs. For this reason, we would argue that going short stocks in the financial sector is in general less risky than in many other sectors.
According to Darwin’s Origin of Species, it is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself.
Why DNB Financials Absolute Return?
We have a clear investment philosophy and a structured investment process with emphasis on risk management and capital preservation.
In the long run the price of a company is driven by their fundamental value; their ability to create value for all their stake holders. We seek to find mispriced equites through fundamental research. Our opportunities lie where our view deviates meaningfully from perception behind the current share price and where the risk of losing money is limited.
Our investment universe consists of approximately 2000 companies, and we want to have a portfolio of around 80 holdings. Needless to say, we need a structured investment process to get there. Below is a brief summary of the most important elements of our process.
Our first step is an idea generation process where the main tool is various screening models. In addition, we get ideas from networking, discussions with internal teams and themes in the market. The purpose of the screening models is to identify potentially mispriced stocks.
The ideas that we view as promising we analyse in more detail and make an estimate of their fair value based on our assessment of the company’s future value creation and growth. Our default approach on valuation is a two period Gordon growth-model, and a normalized P/E-model.
If the stocks still look attractive, we feed their fair value estimates into our aggregated scoring model which act as our selection model. This is a dynamic model where we have approximately 150 companies that we compare on various criteria. Each stock is scored on value creation, valuation and earnings revision/momentum. The score on each of our company drivers are summed to a total score for the company. The long positions in our portfolio will typically be the ones with highest scores and the opposite for our short positions.
The position size in the portfolio is a result of conviction level and constrained by potential up-/downside. The long portfolio will be fairly concentrated with 30-40 positions, whereas the short portfolio will be more diversified with 40-50 positions. We are following the UCITs criteria’s, and we also construct the portfolio to make sure that it is adequately diversified in terms of number of positions, geography, industry groups, factors and other forms of concentration risks.
We stress risk management throughout our investment process; emphasizing capital preservation and creating positive skewness in our positions. The ex. Ante volatility of the strategy will be between 3 and 8 percent and we use several risk models with various data frequencies and horizons to monitor risks with focus on macro/style factors and scenario analyses. In addition to quantitative models we also have qualitative models to monitor and control factors that are difficult to capture by numbers. To create return we must take risk, but it is crucial that we understand the risks we have in our portfolio and that we minimize unintentional risk.
As much as we believe that quantitively measures of risk are very important they should be no source of security. Risk models are based on historical relationships that not necessarily will be same in the future. Therefore, risk management is an integral part of our investment process.
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