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“You can’t take the same actions as everyone else and expect to outperform.”[1] – Howard Marks, I beg to differ, July 2022
In one of Howard Marks’ (of Oaktree Capital) recent memos, he re-emphasises a point he made back in 2006 but one he believes to be just as relevant now - the route to superior returns comes through unconventionality.
“If your behaviour and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if the behaviour is unconventional is your performance likely to be unconventional… and only if the judgements are superior is your performance likely to be above average.”[2]
In recent years, this hasn’t always been the case. For most of the last decade, style factors have dominated returns. Growth trumped Value as Quantitative Easing and low rates rewarded growth stocks while punishing more cyclical parts of the market. As a new generation of investors embraced mantras such as “don’t fight the Fed” and “buy the dip”, a consensus formed around this style as a route to outperformance. The shares of many of these companies hit eye-watering highs while so-called ‘legacy’ companies were consigned to the scrap heap. Contrary to Howard Marks’ railings against conformity, it paid to be conventional during this period as the new darling stocks - increasingly large cap, growth companies - came to dominate benchmarks and returns. A sharp underperformance versus these benchmarks was the grave risk a manager ran in the pursuit of being unconventional.
2022 has marked a dramatic shift as consensual trends have been brought to a painful end and geopolitics and inflation have turned recent convention on its head. As central banks battle spiralling inflation by hiking rates, markets have been pummeled and valuations have collapsed, hitting growth stocks and small cap companies the hardest. There are few places to hide when government bonds are in meltdown and it turns out there is no such thing as “risk free”. Markets are in disarray with perhaps worse to come!
Cause for optimism
The beginning of 2023 brought a new sense of optimism and following the doom and gloom, we now see reasons to be more optimistic. As contrarian investors, we look for opportunities during periods of panic and market dislocation. “Buy low; sell high” – it seems easy, but in truth many great contrarian investments begin in discomfort. As markets fall, time horizons shorten, with investors prioritising liquidity and capital preservation. At the point of capitulation and maximum pain, most investors are so overwhelmed by fear that the few brave enough to step in find their sanity questioned. Bargains can be found, but conviction and a long term horizon are needed to withstand the immediate volatility and potential criticism.
Hunting in smaller companies
Smaller company shares were hit particularly badly by the traumatic events of last year and are about as cheap as they have been since the global financial crisis. Inefficiencies are most extreme in the less liquid parts of the market, where some exciting companies reside in dusty corners, away from the full glare of investors. Less information is available on these ‘under the radar’ ideas, creating an opportunity to be rewarded for uncovering insights that are not reflected in the share price. In embracing smaller companies, we look for winners coming out of Europe’s troubled situation and we try to build these positions at attractive valuations.
One such winner is a small Belgian shipping company called Exmar which we bought in March last year. At the time, the market cap was €300m and the stock was poorly covered by analysts. As Russia began to curtail energy to Europe, we searched far and wide for companies with critical infrastructure that could help alleviate Europe’s shortage of liquified natural gas (LNG). Buried within Exmar’s portfolio of ships was an idle Floating Liquefied Natural Gas vessel (FLNG) – a vessel that liquefies natural gas allowing it to be shipped onwards to its final destination. As Germany and Italy began to turn to other sources of LNG like the US, these FLNG assets were the bottleneck in the value chain and key beneficiary of the soaring gas prices. Exmar announced the sale of its FLNG in August for in excess of €600m– twice the market cap of the company when we started buying the shares!
Indeed, a lot of these small companies are currently being aggressively sold by the market simply for liquidity reasons. However, over the longer term the ones that succeed will likely grow their cashflows and may even benefit from a re-rating as the market discovers them (although we don’t rely on that). We are patient investors, and we believe these unique ideas will drive performance in the years to come.
Uncomfortably idiosyncratic
“Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.”[3] – David Swenson, Pioneering Portfolio Management, 2000.
We buy companies that others can’t or are reluctant to – either because they don’t want to for reasons that we understand (contrarian) or they can’t (too small, hard to find or research). A relentless pursuit of unusual (often idiosyncratic), contrarian and less liquid companies can result in an attractively priced portfolio of high quality assets. In doing so we hope to offer long term upside, but perhaps just as importantly, a differentiated portfolio and source performance which we believe will be additive to a client’s broader portfolio. Markets may be horrible for now, but unconventional opportunities abound when stocks are on sale!
Pras Jeyanandhan & Mike Clements - Fund Managers, VT Downing European Unconstrained Income Fund
Risk warning: Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein.
Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies.
Important notice: This document is intended for retail investors and their advisers and has been approved and issued as a financial promotion under the Financial Services and Markets Act 2000 by Downing LLP (“Downing”). This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. This document contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing does not offer investment or tax advice or make recommendations regarding investments.
Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
