Tuesday, January 14th, 2014

The New Revulsion Trade

In equity investment, the one constant is change. Sectors come in and out of favour. Sometimes this results from a clear change in technology or the global economy; sometimes it is more to do with investor sentiment. Always there are investors “who get it” early and those who would die in a ditch rather than admit that the world has changed. Journalists often prefer to talk about the winners, but avoiding the losers is just as important and something that we believe the Harlyn process is particularly well-suited to.

Every week we ask a very simple question, “Are we being paid for the risk we are taking? Does the total return we receive on an annualised basis compensate us for the extra risk of investing in a high volatility sector versus a low volatility sector?” If the answer is no, the process requires us to reduce our exposure to the high-volatility, low-return sector, and increase the low-volatility, high-return sector. If risk-adjusted relative returns are consistently poor, the process will recommend a substantial underweight, often for months on end, irrespective of whether the sector looks cheap on conventional valuation grounds. For example, our UK sector model has been underweight the Materials group (which is mostly mining companies like BHP Billiton and Glencore) since May 2011. It has missed some tradable high-beta rallies, but every quarter these have petered out and our underweight position has contributed to the outperformance of the portfolio.

We often notice that the same sector is underweight in more than one regional model. Thus Energy has been a consistent underweight in the Eurozone and Japan as well as the UK and the US for most of the last two years. Consumer Staples is now in this unhappy position. It is in the bottom three of the ranking in the UK, the Eurozone, Pan-Europe, Japan and the US, and has been there since the middle of Q3 2013. The highest recommendation the sector can produce is a 31% underweight in Japan; the lowest is a 75% underweight in the Eurozone. The simple average across all regions is 57% underweight and this figure has fallen every week since July 2013.

Conventional investment analysis will want to fit a narrative covering issues such as overvaluation, low beta in a rising market, and high-exposure to emerging markets, and we have no objection to this. People need stories. As far as we are concerned the explanation is simple. Investors aren’t being paid for the risk they are taking, so every week some of them sell.

What matters to us is the high level of revulsion exhibited by investors in every region of the global equity market. Past experience suggests that once a sector gets to this stage the revulsion can continue for a very long time, long after the early narratives have lost their relevance. We will continue to check the situation every week, but we won’t be surprised if Consumer Staples is an underweight in most regions at the end of Q1 and even Q2.

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