Hedge fund managers show skill in finding value throughout 2012

From currency trades to European financials to crude oil production, hedge fund managers have found extraordinary value in a wide variety of trades over 2012 despite challenging market conditions.

What was your best trade in 2012?

Vik Mehrota, Venus Capital
The best trade of the first eight months of 2012 has been shorting the Indian rupee as the country’s trade deficit and budget deficit deteriorated. India’s reliance on foreign inflows to fund its current account was bound to put pressure on the rupee.

Economic reforms had stalled for several years and political logjams had politicians behind the curve on the policy front.

In September the government finally started a new push for reforms and hopes to get the legislative co-operation it will need in the winter session of the parliament, beginning on November 22, to complete the reforms.

Among the major reforms is a push to let foreign multi-brand retail and insurance companies come into India.

We are also hearing of other measures to boost the inflow of much-needed foreign capital.

At the current rate of about 55 rupees to a dollar, it may be worth going long the Indian rupee now.

Some of the other reforms may include allowing foreign investors to invest in fixed deposits with domestic banks and perhaps allowing them to invest in certain commodities. If inflation is better controlled there will be a favourable interest rate environment, which will reduce the cost of capital for business.

Indian prime minister Manmohan Singh said there is a need to increase investment in infrastructure, health and education to speed up domestic economic growth. Some of the key bills that will be tabled in the parliament this session include a bill to remove the redundant and out-of-date compliance requirements for companies doing business in India and a bill to provide for the establishment of an authority to promote old age income security by developing and regulating pension funds.

All in all, India’s macro picture is shifting and next quarter should solidify the conviction of foreign investors to make further allocations to India. In such an environment, going long the rupee could be a decent bet.

Jay Feuerstein, 2100 Xenon Group
Our best trade in 2012 was the purchase of soya beans in early summer. This trade was most interesting because it is an example of the way technical trading is supposed to work

Long before the summer drought, our trend-following models established a long bias in soya beans. That means we had small long positions that would grow with confirmation of a trading signal.

As news of the coming drought spread across the marketplace, soya beans began to rally. By midsummer, when the drought was in full force, the soya bean market ‘screamed’ higher and we were able to fully capitalise on it.

For the year, even though soya beans account for only 2% of the portfolio risk, which includes 56 different markets, the soya bean trade earned 2100 Xenon more than 2.5%.

Nick Linnane, Cube Capital
European bank subordinated debt had lost its traditional investor base by the autumn of 2011 and new investors seemed slow to enter. It was not even necessary to approach the European periphery to find extremely cheap instruments. For example, the Royal Bank of Scotland (RBS) 5.5% euro preferred share (a perpetual debt instrument in effect) finished 2011 trading at a price of 43 (12.8% yield to perpetuity).

Yet for anyone examining the sector with an analytical approach, rather than getting intimidated by newspaper headlines, industry developments were mostly positive for credit. Banks faced pressure to hold more equity capital, not to pay dividends to shareholders and to reduce riskier business activities and assets.

Under Basel III, banks would ultimately need to issue more deeply subordinated instruments in future (probably replacing the existing instruments).

It remained true that many banks still had substantial embedded losses on their balance sheets. Yet the rate of these losses and their potential long-term magnitude was now much clearer as a result of improved disclosures.

“OK maybe, but where is the catalyst?” you might have asked. The major catalysts subsequently included ECB actions such as the long-term refinancing operations (LTRO) and later the outright monetary transactions (OMT).

Yet at a deeper level, all markets needed was to find some excuse to stop focusing on their fears and reappraise the startling inconsistency between the prices of these bonds and the actual likelihood that the banks would go bust.

The RBS 5.5% issue traded from 43 up to 70 (plus interest) by November.

James Kenney, Aviva Investors
Our best trade of 2012 was putting on a spread trade between German five-year government bonds and Spanish five-year government bonds during mid-March to mid-May.

In early March our fundamental analysis highlighted the deteriorating situation in Europe. The Spanish unemployment rate was getting worse and reaching critical levels. We also believed the Spanish fiscal deficit reduction targets for 2012 would be unachievable.

Growth across Europe was weak and our forecasts expected it to weaken further over the second quarter.

We decided to put the trade on in mid-March as the positive effects of the LTRO began to fade. Our risk appetite indicators suggested the bullish period over the preceding months had gone too far and another bearish period would begin.

To hedge ourselves somewhat against any European-wide move in the level of interest rates, we put on a spread trade between Spanish and German government bonds.

Later in March the Spanish government announced it was unlikely to meet its deficit targets for 2012. General economic data in Europe over March, April and May continued to deteriorate and on April 27 Standard & Poor’s cut Spain’s credit rating by two notches. All of this led to a significant widening in the spread between German and Spanish government bonds.

In May the problems of the Spanish banking system came into focus and we began to become concerned that the situation had reached a point that might elicit a policy response.

So with a desire to book profits on a very successful trade, we closed out our position with the spread between German and Spanish government bonds over 200 basis points wider than when we entered the trade, making around 1.2% for the fund.

Leonard Charlton, Dalton Strategic Partnership
To pick a single trade from 2012, a year in which market performance has been weighted towards macro and politics, is no easy task as it has been a challenging environment.

However, at the end of 2011, we believed that growth expectations of companies and countries would need to be lowered as both reacted to the unavoidable sovereign and private debt deleveraging.

We felt companies that were priced for perfection and had significant exposure to developed Europe might experience the hardest trading conditions and this could provide an interesting opportunity for our bottom-up stock-selection process to generate alpha, particularly on the short side.

One such trade that we initiated in January was shorting a high-end dental products manufacturer. Consistent with our outlook, the company’s valuation looked extremely unattractive in both absolute and relative terms (price/earnings 21 times 2012 estimate compared with peers 17 times 2012 estimate), for a company that forecast low single-digit organic growth.

We believed it would be vulnerable to a consumer slowdown in Europe (around 60% of sales), which would not be offset by strength in the US (around 20% of sales). It also appeared that the company was facing significant structural pressure from new generic/low-cost brands which would challenge their market share and erode their margins. They had already seen -340 basis points gross margin pressure through 2011 and guidance of a sharp turn­around by 2014 looked too optimistic.

We exited the position in August after the stock had declined by approximately 24%. Although our research suggested many of the characteristics of an ideal short, share price movements and a complex macro environment required us to remain flexible and pragmatic while trading the position actively throughout the holding period.

Michel Danechi, Armajaro Emerging Markets Fund
Afren, a London Stock Exchange-listed company with a market capitalisation of £1.5 billion ($2.4 billion), is an early-stage crude oil exploration and production business with assets primarily in Nigeria and Kurdistan. The company has audited proven and probable reserves (2P) and contingent resources (2C) crude reserves of one billion barrels and is currently producing at an equivalent rate of 42,000 barrels a day. Our valuation of the stock is north of £200 a share (£2.2 billion target market capitalisation) based on a combination of reserve valuation and operating metrics.

During the second half of 2011, the share price of Afren collapsed due to a number of factors, namely the decline in crude prices, the announcement of an acquisition of Kurdistan assets – which the market perceived to put pressure on the funding side – and delays in increasing production from its second development project.

Our ‘homework’ suggested funding to be a non-issue and a delay in production was more technical rather than reservoir or asset driven.

Thus, we started accumulating in the fourth quarter of 2011 and in January 2012 the company announced it had achieved the production levels as previously guided and had sourced funding for the Kurdistan acquisition. The stock rallied by more than 50% through February, after their capital market’s day, following which we started reducing our position, closing out by late April 2012.

A correction in oil prices and macro indicators gave us another opportunity to build our position, from May to July 2012, following which Afren announced successful discovery on the extension of its currently producing field.

Afren has a 12-well programme for the year and we expected some successes – but not at such an early stage.

We intermittently sold stock as it rallied and closed our position by September 19, 2012.