Riding Markets While Shorting Market Darlings
By EUGENIU GUZUN 11/04/2019
Stockholm (HedgeNordic) – Stockholm-based asset manager Rhenman & Partners, perhaps best known for its healthcare-focused fund Rhenman Healthcare Equity L/S, has been running a second vehicle since September 2016 that has so far struggled to step out of the shadows of its multiple-award-winning sister fund. Rhenman Global Opportunities L/S (RGOLS), managed by portfolio manager Staffan Knafve (pictured), gained nearly 16 percent in the first quarter of 2019, landing on this year’s list of top ten best-performing hedge funds in the Nordic Hedge Index.
This year’s solid performance, however, comes after a difficult 2018 for RGOLS, when Knafve and his team “took some short-term pain for long-term gain” after cutting down on money-losing short positions. Thus far in 2019, the high-conviction global long/short equity fund recouped a big chunk of last year’s 23 percent loss. With decreased short positions, RGOLS is rising like a phoenix from the ashes.
RGOLS’s Top-Down Approach in Combination with Careful Stock Selection
Rhenman Global Opportunities L/S combines a fundamental top-down approach with careful bottom-up analysis. “The investment philosophy stems very much from a top-down view on the world,” explains Knafve, “but then we try to find the best investments that fit into the broader themes we identify and like.” The top-down approach involves the search for a market, industry or segment of a market that is underestimated.
“We are trying to find markets that are growing, and we believe are underestimated. Within these segments, we want to find the companies that are best positioned to gain market share in their growing markets,”
says industry veteran Staffan Knafve, who has more than 30 years of experience in financial markets.
“We occasionally look at sectors that do not enjoy strong growth, but we still need to see that market participants are underestimating their prospects,” continues the portfolio manager. Whereas the top-down approach may put RGOLS ahead of the game even before the stock picking starts, Knafve suggests the stock selection process is equally important.
RGOLS owns companies in a wide range of industries including financial, energy, technology and others, yet all holdings have a few specific traits in common. “We want the companies we own to have strong market positions, to run cash-generative businesses, and we want them to manage ‘clean’ businesses,” says Knafve, explaining that ‘unclean’ businesses face money laundering scandals or other management-related hazards. “We want to see strong management teams, experienced and trustworthy board members, especially CEOs and Chairmen, and we also want to see clear ownership situations.”
Major Bets: Financials, 5G and Energy Sector
Staffan Knafve and his team made a big bet on the transition to new fifth-generation cellular networks, known as 5G. “We believe people are grossly underestimating the impact of 5G,” argues Knafve, “the impact will be absolutely huge.” This belief has prompted Knafve to build a large position in Swedish supplier of cellular equipment Ericsson, one of only a few Swedish names in RGOLS’s portfolio.
Knafve reckons that cellular equipment vendors that have already enjoyed a strong position in 3G and 4G technologies will likely benefit the most from the technology transition happening in cellular. “There are four companies – two Chinese companies, as well as Nokia and Ericsson – that could be a play on this transition,” says Knafve. “Volume for suppliers of cellular equipment will be much bigger than everyone anticipates, but there are some unknowns when it comes to pricing and profitability,” he acknowledges.
“We own wireless chip maker Qualcomm for the same reason,” he continues. “If our assessments of this macro scenario are correct, then the demand for 5G chips in general and Qualcomm’s products, in particular, will be significant.”
Another significant allocation is the energy sector. “This is a big bet based on what we believe about the oil price, not necessarily a projection that the price of oil is going to reach $100 per barrel but mostly our conviction that the oil price can be sustained at current levels,” explains Knafve. “Then we search for companies that are disciplined in terms of capital expenditures, for instance. If we are right in our assessments, well-run oil companies will be enormous cash machines for the foreseeable future.” Financials in the United States, Europe, and Asia represent another collective bet made by his team.
Map Versus Reality: Attempt to Short Market Darlings
Currently running with a net market exposure of 109 percent by maintaining a concentrated portfolio of 40 positions, RGOLS usually maintains a long-bias with a net exposure in the range of 50 percent to 90 percent. “Rarely will we go below 50 percent and rarely will we go above 100 percent in terms of net market exposure,” says Staffan Knafve. He makes decisions to buy and short companies based on what he calls “the map versus the reality.” “We always try to find companies where market participants underestimate their prospects and, correspondingly, we try to avoid or short companies where we believe the market overestimates the actual outcome,” he explains.
“We always try to find companies where market participants underestimate their prospects and, correspondingly, we try to avoid or short companies where we believe the market overestimates the actual outcome.”
Whereas short positions helped most long/short equity funds alleviate losses in the final quarter of 2018, Knafve’s short positions during all of 2018 “cost us as much money as the long side of our portfolio.” Knafve and his team sold short some technology behemoths or market darlings. “We have maintained some short positions in outstanding companies like Amazon.com and Netflix, which we believe have too stretched valuations,” says Knafve. Speaking of his short on Amazon.com, the portfolio manager says “the business is fantastic, but when companies trade at hundred times earnings, investors expect a hockey stick in profitability. We do not see that hockey stick in Amazon.”
Strengthening his case against Amazon.com, Knafve says “the company’s Amazon Web Services (AWS) account for around 12-13 percent of revenues but generate around 60 percent of profits, and this part of the business faces increasing competition from Google, Alibaba, and Microsoft.” Amazon.com is not the only market darling Knafve has shorted. “Netflix is priced to perfection, but are bleeding cash. We see them generating negative cash flows for the foreseeable future.” Yet, the portfolio manager acknowledges the difficulties associated with shorting high-quality companies regardless of how absurd valuations can be. “My short positions may not be bright, but I am not suicidal either,” concludes the portfolio manager.