US Equity Long-Short: The Case for Sector Specialization

Investment Insights Series
Alternative Thinking by
Alternative Investments Group
of Oppenheimer Asset Management
US Equity Long-Short:
The Case for Sector
Specialization
2013
Volume 2
March 2013

The case for specialization within U.S. equity long-short has increased over the last decade given
the increased competition within the U.S. equity market among market participants seeking to
extract risk premiums. The U.S. equity market is the most liquid and crowded equity market
relative to other regions and countries. As a result, the crowding makes the U.S. market more
efficient, and arguably the most efficient, relative to other equity markets. In our view, having a
sustainable edge in security selection requires deep domain knowledge within a sector rather
than being an all encompassing generalist investor.
Furthermore, while we are strong believers in active management and view success in active
management over time as being driven by skill, we also hold the view that the some portfolio
managers do not add value, and may destroy value. Since the financial crisis in 2008, active
managers in general, and equity long-short managers in particular, have faced significant
headwinds driven predominantly by the fact that macro headwinds and tail-risks, combined
with policy risk, have resulted in equities trading on macro factors rather micro factors.
However, to extrapolate the outlook for active equity investing based on the last 5 years in our
opinion would be an error, particularly since our investment philosophy is based on having a
forward-looking view based on the environment and opportunity set. We view the outlook for
active equity investing utilizing a long-short approach as being highly favorable for the following
reasons:
1. Central banks across the globe have provided a long-term level of accommodation
which reduces the likelihood of tail-risk events
2. The majority of macro risks and global imbalances are known amongst policymakers and
market participants
3. While governments may not be ahead of the issues and continue to provide band aid
solutions, they are not significantly behind the curve
4. The feedback loop between market participants and policymakers is functional
5. There is an increased acceptance in the private sector that we are in the New Paradigm
of anemic growth, multi-year deleveraging, and increased government regulation,
taxation and intervention. While these are clearly headwinds, the clarity and acceptance
of these enables the private sector to act accordingly
As we will show in the analysis below, over the last 5 years we have been in a period of elevated
level of stock correlation and compression of equity valuations in an environment where there
will likely be winners and losers within sectors as well as between sectors. We hold the view
that over the next 5 years, macro and policy factors will become a secondary factor to corporate
fundamental factors in determining equity valuations and therefore a premium will be placed on
skill in security selection.
We believe that investors can increase the probability of success in active equity investing if you
pursue an unconstrained long-short approach rather than an index conscious long-only strategy
where success is predicated on a positive outcome for equity markets. These long-short
portfolios should have the following attributes:
1. Unconstrained portfolios
2. Concentrated portfolios
3. Absolute long and short investments
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4. Moderate use of leverage
5. Ability to manage tail-risks through the use of derivatives
We are strong advocates of a sector-based approach to long-short investing and we believe that
the optimal solution for investors looking to invest in U.S. equity markets is to build an actively
managed diversified portfolio with investment teams that are specialized in the major sectors
that comprise the S&P 500 Index. The chart below shows the current S&P 500 breakdown by
sectors:
S&P 500 Sector Breakdown - February 2013
TELECOM SERV
UTILITIES
2.96%
M ATERIALS
3.42%
3.44%
INDUSTRIALS
10.25%
INFO TECH
18.25%
CONS STAPLES
10.94%
FINANCIALS
15.91%
ENERGY
11.11%
CONS DISCRET
11.45%
HEALTH CARE
12.27%
Source: Bloomberg
We believe in a sector-based approach to U.S. equity investing for the following reasons:
1. A sector specialist investor with deep domain knowledge through multiple years of
experience in a sector will likely have a greater depth of knowledge relative to a generalist.
2. The primary objective behind a sector-focused approach is to capture the dispersion in
performance between winners and losers in a particular sector. Historically, investors have
perceived sector specific long-short strategies as being a directional play on a particular sector.
3. In our view, having exposure to any particular sector is a secondary consideration since we
are not expressing a directional view on a sector and over time the sector exposure is driven by
portfolio diversification considerations.
4. Where we may take a strategic view, we are likely to focus on sectors and industry groups
where there is significant change which specialists are able to analyze and determine the
companies that will be winners and losers from change.
Quantitative Analysis
• A historical analysis of U.S. equity sub-sector returns since 2000 shows that no single
sub-sector persistently dominated performance, thereby making the case for industry
diversification.
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S&P 500 Sub-Sector Historical Performance
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Energy Telecom Serv Info Tech Cons Discret Financials
31.13% 35.98% 61.30% 27.57% 28.68%
Utilities Energy Materials Industrials Cons Discret
23.65% 24.05% 47.85% 26.37% 24.00%
Telecom Serv Energy Utilities Energy Cons Discret Materials Telecom Serv
19.47% 31.18% 20.53% 34.07% 40.77% 21.95% 17.93%
Financials Cons Discret Utilities Health Care Materials Industrials Energy Utilities Health Care
79.03% 17.82% 16.65% 18.92% 22.37% 20.19% 20.00% 19.44% 17.72%
Utilities Info Tech Financials Info Tech Materials Utilities Health Care Telecom Serv Cons Staples Industrials
56.01% 56.53% 13.17% 6.40% 18.69% 19.12% 19.32% 17.92% 13.74% 15.26%
Health Care Cons Staples Materials Health Care Financials Cons Staples Financials Cons Staples Health Care Materials
36.79% 45.40% 12.94% 6.30% 18.50% 16.25% 16.69% 13.85% 12.60% 15.05%
Energy Cons Discret Health Care Materials Industrials Industrials Cons Staples Financials Cons Discret Info Tech
25.33% 20.41% 10.70% 4.53% 14.39% 14.16% 14.43% 12.08% 6.17% 14.81%
Info Tech Health Care Industrials Industrials Cons Discret Cons Discret Energy Info Tech Telecom Serv Cons Staples
16.32% 19.97% 8.09% 3.55% 13.16% 11.99% 13.61% 10.11% 6.13% 10.99%
Cons Discret Financials Industrials Cons Staples Cons Discret Cons Staples Telecom Serv Utilities Utilities Energy Energy
15.46% 3.42% 11.62% 2.53% 2.24% 8.36% 11.83% 11.30% 5.19% 4.73% 4.59%
Industrials Materials Utilities Info Tech Cons Staples Info Tech Info Tech Telecom Serv Health Care Info Tech Utilities
5.80% 2.79% 2.30% 1.65% 0.97% 7.43% 7.28% 8.21% 2.81% 2.43% 1.30%
Financials Industrials Info Tech Telecom Serv Telecom Serv Financials Health Care Industrials
-15.83% -5.75% -4.12% -3.72% -5.33% -13.10% -29.11% -0.58%
Materials Info Tech Financials Materials Financials Health Care Financials Materials
-19.94% -6.44% -5.35% -10.07% -6.36% -18.14% -31.80% -9.53%
Telecom Serv Energy Cons Discret Energy Industrials Financials
-38.46% -8.93% -10.97% -28.51% -35.82% -16.90%
Cons Staples Cons Discret Energy Cons Staples
-40.86% -10.26% -14.50% -37.36%
Health Care Health Care Telecom Serv
-11.94% -18.73% -39.81%
Telecom Serv Materials Utilities
-12.06% -23.73% -40.77%
Cons Staples Industrials Energy
-25.86% -26.20% -41.08%
Utilities Utilities Info Tech
-30.03% -29.54% -47.64%
Telecom Serv
Materials
-34.03% -50.72%
Cons Staples
Cons Discret
-37.39% -55.55%
Source: Bloomberg, Oppenheimer Alternative Investments Group
• Evaluating the percentage of stocks in the S&P 500 moving in the same direction shows
that there are meaningful periods when there is dispersion (performance differential
between winners and losers) in performance among index constituents.
90%
Percentage of S&P 500 Stocks Moving in the Same Direction
(6-Month Moving Average)
85%
80%
75%
70%
65%
60%
55%
50%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Bloomberg, Oppenheimer Alternative Investments Group
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• While we have recently been in a period of compression in the dispersion of company
valuations (due to the dominance of macro specific factors) as measured by the
dispersion in P/E for the S&P 500 sectors, there have previously been periods of greater
valuation differentials among sectors, driven by fundamental factors. The chart below
shows the P/E dispersion among the 10 different S&P 500 sectors, calculated by the
differences between the 3 rd and 1 st quartiles historically.
16
14
12
10
8
6
4
2
0
S&P 500 Sectors P/E Dispersion
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Bloomberg, Oppenheimer Alternative Investments Group
• Evaluating the performance of the quartiles (based on 12 month trailing returns) of the
10 constituent sectors of the S&P 500 since 2000 indicates that there have been periods
during which the dispersion in returns has been meaningful. During such periods the
surface area for a specialist investor to generate alpha on both the long and the short
side increased. The two charts on the next page list the box plot 1 for the financial and
healthcare sectors. All other sectors have similar results: wide range of return
distributions across calendar years.
• For example, the elevated level of the equity market volatility during and immediately
after the financial crisis made 2009 the year with the largest return dispersion over the
past 5 years, where the top performer within the S&P 500 financial sector generated a
+420% return while the bottom performer lost 52% in value. Half of the financial stocks
generated annual returns between -1.2% and +43.8% in 2009.
• The wide dispersions in returns (min vs. max or Q1 vs. Q3) in 2009 and most of the other
years as showed in the charts below make the case for strong security selection within
sectors by highly skilled investment teams.
1 The Dispersion analysis (box plot) displays the worst performer, first quartile (Q1: the lowest 25% of data), second
quartile (median), third quartile (Q3: the highest 25% of data) and the best performer within the specific sector from
2000 to 2012. The widths of the box indicate the distance between Q1 and Q3 and the differences between the min
and max represent the degree of dispersion.
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Financials 1
450%
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Max
Top Quartile
Median
Bottom Quartile
Min
Healthcare 1
Source: Bloomberg, Oppenheimer Alternative Investments Group
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
-100%
Source: Bloomberg, Oppenheimer Alternative Investments Group
• The investment case for diversification across a team of specialist sector investors is
based on the data which indicated that the level of dispersion within a particular sector
since 2000 varied among sectors during discrete time periods (e.g. there was a higher
level of dispersion in the healthcare sector relative to the financials sector between
2004-2006).
1 The Dispersion analysis (box plot) displays the worst performer, first quartile (Q1: the lowest 25% of data), second
quartile (median), third quartile (Q3: the highest 25% of data) and the best performer within the specific sector from
2000 to 2012. The widths of the box indicate the distance between Q1 and Q3 and the differences between the min
and max represent the degree of dispersion.
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• When evaluating sector performance dispersion (measured by the difference between
the 3 rd quartile and the 1 st quartile), we can see that there are periods of relative
outperformance and under-performance by the different sectors since 2000 which in
our view reinforces the case for an equity portfolio comprised of sector specialists.
90%
Performance Dispersion Within S&P 500 Sectors
80%
70%
60%
Healthcare
Info Tech
Cons Staples
Utilities
Industrials
Financials
Materials
Cons Discret
Energy
Telecom Serv
50%
40%
30%
20%
10%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Bloomberg, Oppenheimer Alternative Investments Group
Manager Selection Criteria
In our experience, we view manager selection as critical to investment success. We do not
compromise on investment skill which we view as a scarce commodity. We regard having a
‘best athlete’ as significantly more important than having the right call on a particular sector. In
our view, an investor can make the correct call on the opportunity set within a particular sector
or industry group but not fully capture the opportunity by having sub-optimal manager
selection. Furthermore, based on our experience, in an adverse market environment a weaker
investment team is more likely going to encounter significantly greater headwinds than the
highly skilled investment team.
When we evaluate sector managers, we look for the following characteristics:
Sector
• Investment sector must exhibit dispersion in performance between industry groups and
companies
• Sufficient investment universe within the sector: large surface area
• Liquidity on a single name basis and appropriate average daily volume
• Ability to borrow securities for short-sales at reasonable cost
Portfolio
• Low net-exposures: looking to capture dispersion within sector vs. the direction of the
sector.
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• Ability to create alpha on both the long and the short-side- little or zero use of index
based hedges or relative shorts or pair trades which do not constitute alpha ‘bets’ and
introduce basis risk or require higher leverage to generate attractive levels of alpha
Team
• Significant years of experience in the sector, including a lengthy tenure at brand name
hedge fund firms
• Long-short portfolio management experience
• Team based approach: allows for increased analytical band-with to cover sub-sectors
and greater depth individual names
• When we have select sector teams, the search has been driven first and foremost by the
pedigree of the investment team and secondarily by their sector specialty
Process
• Disciplined investment process for sourcing and analyzing investment ideas which is
scalable and repeatable
• Differentiated analytics which results in a variant perception relative to other market
participants
Portfolio and Risk Management
• Strong skills-set in optimizing analysis and security selection into a coherent portfolio
with idiosyncratic risk and sufficient level of risk
• Disciplined use of price or risk-reward targets and combined with fortitude and
conviction to selectively increase risk in ideas in periods of risk-aversion or market
dislocation
• Ability to manage market risk, factor bets, liquidity, leverage and basis risk
Conclusions
We believe investors can increase the probability of success by investing with dedicated sector
specialists with deep domain knowledge versus the all encompassing generalist.
By combining sector focused investment teams that utilize a long-short approach, investors can
potentially build effective diversification to the major sectors which exhibit performance and
dispersion differentials over time. Furthermore, the use of a long-short approach effectively
increases the surface area for alpha generation relative to long-only investments.
Investing with sector specialists in our view does not represent a directional view on a particular
sector. We view a sector specialist as an effective investment in capturing the dispersion
between winners and losers in a particular sector. Our experience has demonstrated that
having strong understanding and experience in a sector where the portfolio manager has
narrow focus and deeper knowledge effectively enables them to analyze change and discern the
winners and losers relative to the generalist investor.
Investing in securities is speculative and entails risk. There can be no guarantee that any
investment strategy will be successful. The opinions expressed herein are subject to change.
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The Alternative Investments Group is a division of Oppenheimer Asset Management Inc., an
affiliate of Oppenheimer & Co. Inc.
AIG040313CM1
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