Well, there is some empirical evidence that, on average, high quality firms outperform their lower-quality brethren (quality for these purposes can be defined by measures such as the ‘Piotroski’ F-score*). But, of course, quality firms don’t outperform all the time and there can be distinct episodes when they underperform by some margin. So I’m open minded to short selling high quality firms from time to time, knowing that this is probably not a winning ‘strategy’, but can be a good ‘tactic’ in markets.
One firm in which I’ve had a short position this year is Diageo. After analysing the firm, I considered Diageo to be a ‘high quality company’. It had strong brands and good control of its supply chain, from ‘biological assets’ (I think this means yeast) through to brewing and distilling, maturation, bottling and distribution. The company was a ‘global winner’ in many respects.
But the shares looked dear and earnings forecasts were being revised steadily downwards by sell-side analysts. Quite simply, expectations had got ahead of themselves and the share price had already started to fall. The firm also tended to report certain costs as ‘exceptional items’ and so analysts could have been overestimating the total earnings power of the firm.
I wouldn’t want to be short of a quality firm for the long term. But short selling Diageo made money for my fund, in both absolute and relative terms.
Performance of fund vs benchmark over manager tenure
Source: FE Analytics
There are still plenty of good quality firms around the world that combine high stock market ratings with earnings downgrades. I can find examples within European food retailers, UK engineering firms and US food manufacturers. Such firms do not make for comfortable shorts, but they probably represent good tactical opportunities for making money in a tough market.
The empirical evidence shows that owning quality-stocks generally works well in the long term. However, many of these stocks have been suffering from earnings downgrades, while remaining highly-rated.
It’s very uncomfortable short-selling the shares of quality firms with good long-term prospects, but even quality firms can become overpriced. In the past year, it has been sensible, in my view, to be short of this type of stock.
In the medium term at least, the future is looking dull for most major asset classes. There might be a steady stream of low returns, or there could be periods of great returns and crashes, but in general it looks like we’ll be seeing low returns for a while.
While it’s not what any investor really hopes for, it does create an opportunity for managers to carve out value, if they have the right tools at their disposal.
* A Piotroski F-score is a nine-point scoring system that uses information found in a firm’s report and accounts (or other regulatory filings), including changes to accounting ratios, to assess the attractiveness or otherwise of a stock.
James Clunie (pictured top of page one) is the manager of the Jupiter Absolute Return fund. The views above are entirely his own, may be subject to change, particularly during periods of rapidly changing market circumstances and should not be interpreted as investment advice.
