When the sharemarket correction proved the worth of Justin Braitling’s hedging strategy for the Australian Leaders Fund (ALF) logic said the stock price should have risen.
Earlier this week when the market was down 38 per cent in the space of a month, the ALF, a listed investment company, was showing small gains. The fund’s mixture of long and short positions had worked to preserve capital.
But ALF shares fell with the rest of the market taking the share price to a near 30 per cent discount to net tangible assets (NTA), compounding a problem that has plagued the fund for at least three years.
Braitling, who is chief investment officer at Watermark Funds Management, cannot explain the discrepancy between the success of his long/short hedging strategy and the widening discount to NTA at ALF.
But the long term bear believes his strategy, which involves a net exposure to the market of about 30 per cent, is delivering what was promised to investors.
“We have been under a lot of pressure to participate in a market we thought was grossly overvalued and vulnerable to an external shock such as COVID-19,” he says.
“We would be one of just a few equity funds I suspect that have protected investors’ capital through this crisis.”
Braitling’s bearish view of the market is not a new thing. He was fully hedged against big moves in 2015. This proved smart during the big sell-off in 2016. At one point ALF shares were trading at a premium to NTA.
But through 2017, 2018 and 2019 the fund’s share price under performed the market and the discount to NTA began to widen.
Earlier this year, former investment banker David Kingston, attacked Braitling’s strategy and threatened a class action for not being fully invested in the market. He wanted to wind the fund up and return the money to investors.
“We have been criticised in some quarters for not participating in the rally of recent years,” he says.
“It has been a lonely existence in recent years as markets have got away from us. At times I have felt like Michael Burry (The Big Short) with many of our investors pulling money out of our funds to chase the market higher.”
Braitling likes to point out that since March 2009, which was the bottom of the recent sharemarket cycle, ALF is up 12 per cent per annum and the S&P ASX All Ordinaries index is up 8 per cent per annum.
Over that period the average net market position of ALF was about 30 per cent.
Braitling remains bearish despite the coronavirus induced sell-off.
He says price earnings multiples, which reached about three standard deviations from the mean earlier this year, remain overvalued. He says the surge in share prices over the past few years was not based on earnings.
“The market had moved higher with 80 per cent of the gains coming from a re-rating of shares and only 20 per cent coming from profit growth,” he says..
“With asset values as extended as they were, the size and scale of subsequent losses should not come as a surprise.”
He says investors were forced to buy into an overvalued equity market because there was no alternative. Central bank liquidity pumped up asset prices and encouraged investors to take excessive risks.
He says economic and financial market conditions are likely to get a lot worse given the hit to the global economy and the build up of $US8 trillion ($13.2 trillion) in corporate debt, much of which is sub-investment grade.
“We are still relatively early in this crisis, the number of COVID 19 cases and deaths are going to shoot up in the weeks ahead,” he says.
“Also, we are yet to see the reverberations of this shock play out in the real economy. We have a tsunami of bankruptcies and defaults coming at us.
“To put this in context, the US share market fell for 18 months during the financial crisis losing 60 per cent of its value retracing 100 per cent of the prior cycle gains.
“Today we have lost one third of the prior advance, and this crisis is shaping up to be as big as the financial crisis.
“When you look at the economic and financial impact, it is already as big if not bigger.”
He says estimates by Goldman Sachs and Morgan Stanley of a 30 per cent decline in second quarter GDP growth suggests the impact of the coronavirus will be larger than the global financial crisis.
The ALF hedging strategy involves buying shares with strong business fundamentals on attractive terms and short selling businesses that are fundamentally challenged. The proceeds raised from selling these shares are an additional source of funding for the company’s balance sheet.
These funds are either retained in cash or re-invested into the investment portfolio of shares expected to outperform.