Heads or Tails – Informer

Vincent Devlin looks at why today’s markets are a prime environment for absolute return investors.

During times of uncertainty, equity markets have tended to rally on even the slightest piece of good news and sink rapidly on disappointments as short-term sentiment – rather than company fundamentals - has dominated trading activity. While this volatility is understandably perturbing, we believe that an absolute return strategy merits some consideration for those investors grappling with today’s particularly volatile European markets.

The first quarter of 2012 was positive for Europe; the tentative rally within high quality stocks in the fourth quarter of 2011 broadened out in the first three months of 2012 to include riskier cyclical companies and financials. It seems however, that this boost to market sentiment largely afforded by the ECB’s Long Term Refinancing Operations has worn off. In the absence of any decisive catalysts one way or the other, news flow surrounding the financial stability of Greece, Spain, the other peripheral countries and the financial sector will no doubt continue to sway market movements for the foreseeable future

Is it that bad?

Despite this shaky backdrop, it’s important to remember that there are a lot of good reasons to invest in Europe. Our team at BlackRock has been vocal over the last few years about how Europe – despite its uncertainties – is home to some of the most successful global franchises whose balance sheets and margins boast, in many circumstances, very good health. Many European companies also make, on average, the majority of their revenues from international markets, where growth trends remain robust. As such, despite negative domestic market sentiment, the health of European businesses are not as strongly correlated to the tepid growth squeaked out by Western economies and consumers as some might expect. Europe is also home to the highest dividend yield of any developed market, in part because these equities are under-owned and trade on attractive valuations.

Long opportunities

It’s from these positive aspects of European equity markets that we choose the best names for our long book. We see much opportunity in those franchises that are exposed to the increasingly discerning consumer with ample disposable income in developing markets. We find names such as LVMH, Richemont and Daimler, which own some of the world’s most iconic and successful luxury brands, particularly attractive. We also look for those companies that are able to pay a reliable dividend, and grow that dividend sustainably. Irish airline Ryanair is particularly exemplary in this space, boasting very strong free cash flow generation and the willingness to return some of that cash to shareholders.

Structural capital expenditure within oil services is another one of our favourite themes. An elevated oil price allows new and more complex projects taken on by oil services firms to be economically viable. During the recent cyclical rally, we also opportunistically took advantage of the renewed strength in some of our favourite autos and materials names as their share prices rose on the back of buoyant sentiment. We remain vigilant, however, as these names often tend to be punished most during market sell-offs.

Yet despite the great opportunities available throughout the continent, it’s no secret that Europe is not yet out of the woods. As we’ve seen recently, Spanish and Italian bond yields have teetered to worrying heights and inconclusive Greek elections have called into question the stability of the eurozone’s fiscal pact. Further, while the Long-Term Refinancing Operations have had notable success in providing primary liquidity to banks, many of those banks have become critically dependent on these measures to fund their own asset base.

Short trends

Our short book seeks to make the most of these negative trends, particularly those companies which would suffer most due to a recession in peripheral Europe, as well as those that are exposed to the empty-pocketed domestic consumer. Cyclical companies which have over-inflated expectations represent another area of the market which we find attractive on the short side and indeed there are some companies that are over-bought, given their fundamentals.

It may seem as though markets are governed more by caprice than by company cashflows. We believe that a broadly market neutral absolute return strategy, that aims to make steady positive returns no matter the environment, is well placed to make the most of this changeable market. While volatility and uncertainty has contributed to investors’ under-ownership of European equities, the divergence of fortunes in Europe produces ample opportunity both on the long and short side for absolute return investors. Positive returns are possible, as our team has demonstrated, regardless if the coin turns up heads or tails next time around.

Vincent Devlin is portfolio manager of the BlackRock European Absolute Alpha Fund.