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A concentrated approach to total return investments

August 2020

A market neutral portfolio powered by alternative data

Asim Nurmohamed, manager of the Pictet TR-Aquila strategy, describes his distinctive approach to market neutral investing.

Pictet TR-Aquila is a market neutral equity strategy primarily focused on liquid US and European stocks, with about half of its gross exposure in health care companies and most of the rest drawn from the technology, media, telecoms and consumer sectors. Here, portfolio manager Asim Nurmohamed talks about how the strategy is structured and why it works.

What are the distinctive elements of your investment process?

We only invest in companies we really understand. That means being able to confidently analyse a stock, which in turn demands clearly observable inputs and outputs. We need to be able to confirm management has proper control of the top line and cost base. We need to be able to forecast its cash flow. And we also need to be able to measure the company’s performance against our expectations, not least so that we can confirm that our investment thesis is correct.

Building this depth of understanding allows us to be comfortable with a concentrated portfolio – that means around 20-40 long positions and 40 to 60 shorts. It also allows us to hold our positions for much longer than most market neutral strategies – one to three years for longs and three to nine months for shorts.

And it means we can be patient. Once we’ve identified an interesting company, we are willing to wait until it reaches the right price level before including it in our portfolio. That can be a long time. We recently participated in the IPO of a company that we had been following for over seven years. 

Deep fundamental analysis allows us to forge independent opinions. Rather than depending on sell-side recommendations, we do our own primary research. That means going beyond scrutinising company financials and talking to management. We read specialised journals, attend industry conferences and, particularly, use alternative data. 

Our overriding concern is that during times of market turbulence – like when the Covid crisis hit – our capital remains as safe and protected from losses as possible. We use a methodical portfolio construction process to ensure our fund is  market neutral and that we don’t take unintended sector, country or factors bets. We focus on idiosyncratic risk. As a result, our strategy has shown little or no correlation to equity and bond markets or to hedge fund indices in the more than two years we’ve been running it at Pictet.

Fig. 1 - Diverse
Correlation matrix for Aquila relative to relevant asset classes
correlation matrix for Aquila

Source: Bloomberg, Pictet Asset Management, based on the Total Return “Global Fundamental Market Neutral” Composite, in EUR, gross of fees. Calculated for the period from 30.03.2018 to 30.06.2020. Past performance is not a reliable guide to future performance. 

 

You focus on just a few sectors. Why these? Are they complementary?

I started my career analysing health care companies and managing portfolios of these stocks, so I have a deep familiarity and understanding of the sector. But more importantly, we only invest in sectors in which we can apply our investment process. These are sectors that can be modelled effectively, which is to say where getting the model right translates into a better understanding of where share prices are likely to head. That also means we tend to stay away from sectors that depend on difficult to predict variables such as commodity prices or interest rate levels. In other words, we don’t invest in sectors that are sensitive to the ups and downs of the economic cycle such as commodities or energy or in interest rate sensitive sectors such as banking and insurance. 

Each sector and sub-sector we invest in has its own dynamics, but they all share common analytical features: they are all rich in data that allow us to independently verify a company’s top line. Once we have understood and verified how the company achieves its revenues, we can then model it. 

Why is a market neutral approach so suited to these sectors?

Let’s take health care. This is a diverse and complex sector which means that it’s prone to being mispriced by the market. Which, in turn, means that detailed and accurate analysis can unearth stocks that are too expensive or too cheap. 

Fig. 2 - The gap between winners and losers
Return dispersion, top minus bottom quartile returns, US and Europe, 2017-19 average
Aquila dispersion chart 2.png

Healthcare sector constituents – US and Western Europe stocks with greater than USD10m daily traded volumes. Source: Bloomberg, Pictet Asset Management. Data as at 31.12.2019

For instance, health care is being transformed by several long-term trends, including well-flagged tailwinds such as ageing populations, which are bound to drive a rise in spending over many years. The sector also offers a good mix of dominant players and smaller disruptors that constantly challenge the established order.

There is the added complexity that different countries offer very different health care systems and reimbursement levels. There’s a high degree of dispersion in stocks within the sector and its sub-sectors. And, crucially for stock pickers like us, health care is home to a multitude of idiosyncratic stories that are uncorrelated to macro or market events. 

During each of the last three calendar years, there was nearly twice as much dispersion in the returns of top quartile US and west European healthcare stocks as there was within the wider market (see Fig. 2). That’s important, because the greater the dispersion – in other words the wider the gap between winning and losing stocks – the more opportunities long/short fund managers have for making outsized returns.

You use alternative data. Why?

Alternative data is an integral part of our fundamental investment process and has been for a long time, since well before it became a buzzword. This comes back to my earlier point of being able to independently verify a company’s data and being better able to predict their top line. Alternative data can provide us with an edge, especially when we manage to identify enlightening series and sources that others have overlooked.  

But it’s not just that we use alternative data, it’s how we use it. Most people buy data to find patterns and then invest based on these patterns. We take a different approach. When analysing a company, we ask ourselves a set of questions. We then source data to answer these specific questions and thus test our hypothesis about the company. We have a theory and we want the data to either prove or disprove it. 

We use all sorts of data: credit card records from online retailers; subscribers for online video games; prescriptions from doctors. But what’s really exciting is when we are able to source custom data. For instance, we regularly commission surveys. We recently polled doctors about a new drug. This helped us to better understand its pricing and potential demand, giving us valuable insights when it came to forecasting the company’s future earnings and its ability to outperform market consensus.

Do you integrate ESG considerations within your investment process?

We do. Our investment focus naturally excludes some of the least environmental friendly sectors such as energy, commodities or transportation. But even within our investment universe, we spend a lot of time analysing governance. We assess the quality of a company’s management team, its compensation and forensically review its accounting. It can be a very useful red flag, helping to steer us clear of companies that might otherwise seem attractive. Alternatively, it can support the case for taking a short position.

We benefit from Pictet's deep strengths and long experience in ESG investing.

We benefit from Pictet’s deep strengths and long experience in ESG investing. We have access to internal expertise and proprietary analytical tools. But we can also tap into the vast external resources Pictet is tied into, including academics, data providers and specialist institutions. We are party to firm-wide initiatives such as for active proxy voting – we will switch from holding derivative instruments to holding equity so that we can exercise voting rights in certain situations. And we are bound by the firm-wide exclusion list on controversial weapons. 

From a risk management perspective, what risk metrics do you focus on?

Risk control is thoroughly embedded in every aspect of our investment process – more so than any other metric we use. We construct our portfolio specifically to protect capital during steep market sell-offs, like the ones we saw during the final quarter of 2018 or the first quarter of 2020.

We do not have hard stop-loss limits. But when we add a position to the portfolio we establish a price target and a worst-case scenario. During share price pullback, we always refer back to this worst-case scenario to establish whether we might have misunderstood the company or not analysed it correctly or whether an unforeseeable, unprecedented event has led to a mispricing of the stock. Depending on our review, we might add to our position, or, alternatively, fully exit it. 

It helps that, before we invest, we do a lot of scenario analysis to better understand how the stock should react in various market conditions. This approach ensures we hold appropriately sized positions and even leads us to exclude some stocks, even though they might have otherwise interesting bottom-up characteristics. 

Factor analysis is an important part of our risk process. It’s not our intention to be perfectly factor neutral but we do aim to limit our factor exposure. We carefully review our country, sector and style exposures and are methodical in how we balance the portfolio. At times, and based on our analysis, we will make factor bets but these will be limited in scope and time. Pictet gives us a variety of tools to help us monitor and measure our risk and factor exposure. 

Can you share your views on the health care sector? Has Covid-19 changed the way you analyse these stocks?

We like the health care sector because it offers so many idiosyncratic investment opportunities. That allows us to focus on bottom up corporate analysis without having to take sector or sub-sector bets. 

Having said that, Covid-19 has definitely changed and expanded the opportunity set within health care and its various sub-sectors. What we find especially interesting now is that all companies seen benefiting from the crisis have been re-rated substantially. This indiscriminate rally is creating some very interesting long/short opportunities: not all these companies will be able to sustain their current valuations once the Covid crisis recedes. The reverse is equally true among companies seen as losers from the crisis. 

For example, we’ve counted about 150 different projects related to finding a Covid-19 vaccine. In all likelihood, no more than a small handful of companies will find an effective vaccine, but stock prices have materially re-rated for them all and continue to trade on positive headlines. Without taking views on which company will find a vaccine we believe this market move has created attractive opportunities. 

Fig. 3- Navigating the health care investment landscape
Aquila covid chart 3.jpg

Source: Pictet Asset Management