Equity Commentary: As at March 31, 2021

Source: David Picton | Jeff Bradacs, CFA | Michael Kimmel, CFA | Michael Kuan, CFA | Travis Irwin, CFA

Publish Date: Apr 15, 2021

Read Time: 8 minutes

The first quarter of 2021 provided some interesting market dynamics to write about. Following a strong month in February for our hedged equity solutions, we saw a short-term pullback in March that was primarily driven by underlying market dynamics impacting our portfolios and positioning within them. What drove the recent pull back in performance? Between the last week of February and the end of March, there was no single name or sector attributing to the underperformance but rather an unwind of stock performance where our longs that were previous winners underperformed and our shorts reversed and outperformed. Given our long history of managing long/short portfolios, we have experience managing these unwinds and aim to position our portfolios in a position of strength to benefit following the unwind.

In some cases, these unwinds are driven by a change in fundamentals that require our portfolios to be repositioned to reflect the new leadership. A recent example of a fundamental driven unwind was in early November 2020, when Pfizer announced the game changer vaccine for Covid-19, triggering a significant unwind below the surface of the equity markets which we responded to by repositioning our portfolios.

In other cases, the unwinds are driven by aggressive liquidity seeking as other hedge funds or systematic strategies are forced to degross their portfolios and sell their longs and buy back their shorts to cover. These unwinds tend to be temporary in nature and provide opportunities for us to add to our best long ideas and press shorts that have rallied, positioning the portfolios to benefit as fundamentals re-assert. A recent example of a liquidity driven unwind would be in of March 2020 with risk parity funds, strategies that lever up asset classes based on volatility. Heightened equity volatility in March 2020 triggered an aggressive systematic degrossing that led to a temporary market dislocation and opportunity for us to add to our high conviction holdings that benefited the portfolio in the following months.

Over the past few weeks, we believe the unwind has been primarily liquidity driven, as offside positioning forced highly levered strategies to aggressively liquidate positions, creating a short-term cascading impact. Here is some color on the impact to the portfolios and how we are positioning and taking advantage of opportunities:

Junk rally in shorts: top factors over the past few weeks have been cheap companies (book yield) and high debt leverage, a formula typically not associated with sustainable outperformance. The outperformance of leverage is even more surprising in the backdrop of higher long term bond yields and likely associated with degrossing by other managers. While this has negatively impacted performance as a number of low-quality shorts have rallied, our team is reviewing shorts that have rallied with declining short interest (degrossing candidates) and will be looking to press these weights into Q1 earnings.

Unwinding of Technology Growth Stocks: higher bond yields have led to a swift rotation in technology stocks with high growth/high multiple stocks underperforming and low growth/low valuation outperforming. Within the portfolio, while we were net long technology for most of 2020, we believe that higher rates will be a headwind for high multiple growth stocks and our current positioning is modestly net short technology in favor of other sectors. However, despite being modestly net short we have been hit by the significant cascading unwind within the sector over the past few weeks. Within technology, our preference is to add to growth-at-a reasonable price tech names with positive change and using rallies to add new high multiple shorts.

Commodities Underperformance: as you will recall, we have a constructive view on several commodities including copper. Over the past four weeks, many of these names have pulled back from highs including First Quantum Materials Ltd. and Hudbay Minerals Inc. down about 15%. We continue to have a constructive view on the sector as we are in the early innings of a new multi-year copper cycle and taking advantage of the unwind opportunity to add to select high conviction longs with offsetting shorts in the portfolio.

In summary, post a solid February for the funds (February was the strongest single month for Market Neutral in 15 years), the unwind has led to a pullback in performance. While it is difficult to pinpoint when these unwinds end, prime brokerage data on the hedge fund industry highlights that material degrossing has already occurred following three straight weeks of deleveraging. Further, last week’s announcement of the collapse and liquidation of Archegos Capital Management likely indicates that this unwind is in its final innings.

Like past periods of unwinds, we are actively managing to come out of this period stronger and capitalize on opportunities.

Small Cap Spotlight

One small cap company that we continue to follow closely and are positive on is Trisura Group Ltd. (TSU). Trisura is a highly profitable Canadian specialty lines insurance business with Return on Equity in excess of 20% and growing premiums >30%, with an even faster growing (balance sheet light) US specialty lines business writing in the Excess and Surplus (E&S) space. E&S is the epicenter for where you want to be in today’s hardening insurance market as the funnel is growing 20%+ and pricing is being layered on at another 20%+. We think TSU will conservatively grow EPS in the 40%+ range for the next couple years and currently trades at a greater than 10-15x P/E discount to its US peer group (15x our 2022 EPS estimate vs. US comps at ~25-30x) with exposure to the E&S market, while also growing faster. We see significant further upside for TSU.