James

Written by Jennifer Hill

January, 2021

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Adding alpha through shorting

In a year when the UK stock market slid 9.8%, the JPM UK Equity Plus long/short fund lost just 8.5% and has added nearly 2% of outperformance per annum since inception.

The fund follows the same strategy as many other JPMorgan UK equity funds in looking for stocks that exhibit value, quality, and momentum with one key difference. Described by JPMorgan as an ‘active extension’ fund, it shorts stocks expected to underperform the market. These typically account for 30% of its gross market exposure. The capital freed up is reinvested to increase long positions in stocks deemed to have outperformance potential to 130%.

‘We’re providing a different source of returns,’ said Citywire +-rated James Illsley, one of the fund’s four managers. ‘We’re still 100% UK. We still give 100% net exposure. But within that we get a lot of alpha from our short book.’

Although the managers do not formally pair trade, the fund has long and short positions within most sectors.

Retail

The fund is long Next and short Marks & Spencer. The managers like Next for its strong online offering, quality management team and good allocation of shareholders’ capital, including share buybacks and dividends which has seen the company buy-back nearly two-thirds of its shares since 2000. It boasts a high level of free cash flow  with a forecast free cash-flow yield of more than 5%. Illsley points to its ‘tremendous track record’ and ‘outstanding retail performance’.

By contrast, M&S has struggled to transition to a hybrid high street/online model. It is over-spaced on the high street with too many stores and its earnings have been in decline for years.

‘It’s one of the few large retailers left that we don’t like,’ said Illsley. ‘We keep it under active review – the valuation is low but we’d need to see a turnaround in operational performance [to go long].’

Property

The fund owns Segro and is short NewRiver REIT, which accounts for just 0.1% of the index. Both positions pre-date Covid-19 but have been benefiting handsomely from it.

An acceleration in the structural shift from bricks-and-mortar retail to online shopping is buoying warehouse operator Segro. NewRiver owns secondary and tertiary shopping centres, as well as a pub portfolio – among the areas hardest hit by Covid-19.

Although NewRiver’s shares are trading at a discount to its net asset value, Illsley says it will have to sell assets to reduce its debt from a loan-to-value of 48% to a target of 40%.

Travel and leisure

The fund owned International Airlines Group, owner of British Airways and Iberia, at the start of 2020. It reduced the position after Covid-19 was declared a pandemic but added back mid-summer.

It has more liquidity on its balance sheet than its network competitors and has aggressively cut its cost base. Its shares have rocketed following news of successful vaccine trials.

The fund is short Carnival, the cruise ship operator. Its enterprise value has fully recovered despite structural challenges around cruising and a high level of debt, which Illsley reckons it will need to tackle through equity raises.

Mining

In its long book, the fund owns Anglo-Australian diversified miner Rio Tinto. Conversely, it does not own Glencore, which accounts for 1.2% of the FTSE All-Share index, so simply not owning it gives a significant enough underweight position.

The iron ore price is surging amid rising demand from China and Rio is a good way of playing that. Production issues at Brazilian competitor Vale are also a boon.

The stock is trading at a relatively low price/earnings (p/e) ratio of 11, the company has a strong balance sheet and analysts are upgrading their earnings estimates. Free cash flow is facilitating dividend payments and the stock yields 5.6%.

Glencore is comparatively more expensive with a p/e of 14. It has more debt on its balance sheet and its commodity mix is biased to coal, where usage is in decline.

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