Investor Letter: Market views and investment positioning

Apr 28, 2022

Written by: Christos Kontos, Founding Partner of ELIA Investment Advisors Ltd.

 

Dear  valued Investor

Please let me seize the opportunity and give you an update about some strategic changes we decided to implement in some of our managed accounts, especially the ones nominated in USD.

What was the decision:

  • Exit all exposure in single stocks
  • Keep the equivalent value in cash (call deposits, T-Bills)
  • Sell out-of-the money index puts
  • Looking forward, we will use put selling strategies on main indexes as the main way to express our exposure to the equity market

This decision was the result of an extensive internal debate, taking into account a series of parameters and market dynamics which are increasingly evident, impactful and most likely with a lasting effect.

More specifically:

  1. On a macro level:
  • The economic environment is slowing down. This is evident in the United States as well as in Europe, and there have been early indicators of this even before the outbreak of the war. US GDP QoQ reading was negative yesterday (a surprise hardly anyone paid attention to), where in Europe signs of slowing economy have been provided much earlier (Germany contracted in Q4 last year and Italy, France confirmed this trend this quarter). Small business confidence in the US has been in a decline since many months and this will inevitably hit the earnings growth in the quarters to come, put aside other effects which we will highlight later in this letter.
  • There are a series of external uncertainties, the combination and the future development of which is creating a very dangerous set of potential adverse outcomes.
  • Prolonged conflict between Russia and Ukraine- if history is an indication of how things might develop, one should be rather careful until a clear peaceful end is reached, something which is increasingly looking as a wishful thinking and a very remote scenario. Adverse outcomes of this conflict are not properly priced (just a pure reading of the Pearl Harbor attack, offers not only good food for thought but many striking similarities with the current situation, with Russia replacing the role of Japan in the current version of this act) .
  • Conflict will lead to higher energy prices for long, affecting input costs, margins, and an inevitable new game for control of energy resources and its transportation routes.
  • China covid-related lock downs will not only affect domestic consumption, but production and supply chains globally. Q1 earnings and outlook provided so far, give a very good insight on the impact this will have in the forthcoming quarters.
  • Despite the “symbolic” rate increase of 0.25% by the FED, so far not much have changed in the super accommodative monetary policy of the US. Start of the balance sheet reduction as well as more significant rate increases are expected in May and in the months to come. This will be the first main action to reverse a multi­ year monetary policy cycle and the excesses it has created.
  • Although rates spike at the beginning will be rather moderate and may lead most market participants untouched, sooner or later and once they cross the 2% level, markets shall start seeing a real impact from liquidity that will be placed in money market instruments instead of chasing luck and opportunistic returns in a speculative way all over the world.
  • A scenario similar to the 4Q of 2018 is not to rule out, should rates increase either fast or reach high – in absolute terms – levels.
  • Bonds have collapsed. For any justifiable or not reason, the reality is that fixed income is having its worst year ever, with double digit losses year to date. Even if probability of such a situation to happen is less than 5%, it is a matter of fact that it has happened indeed. And it is not only related to higher rates, since also credit spreads have widened a lot and unjustifiably, affecting also high-grade credit. What it means? It means that there is an opportunity cost in the market, and this opportunity cost is quite high, since intermediate term bonds (5 years for example) for high grade issuers have already crossed the 4% mark. It is surprising to see that despite the fact that yields offered are that high, there is still little bid and appetite in the market, leaving much room for bottom fishing high quality bonds at very good prices.
  • The events we have been experiencing over the last years, have led to collapsing of correlation dynamics and the dominance of beta macro plays, rather than alpha or single security plays. Given that the environment will continue to be driven by such major events with unpredicted outcomes, beta will prevail over alpha, and opportunistic short-term trading will prevail over proper long-term investing.

 

  1. On a micro level:
  • We have evidenced some ongoing toxic and disrupting dynamics in the US Equity market.
  • Massive stock moves, leading to multi-billion changes in market caps, within seconds.
  • No economically justifiable patterns and rationale to explain such moves. A “beat” or “miss” is always the easy excuse. But the “beat” or “miss” applies chaotically and occasionally to several factors, one at a time for each company and every quarter. Beat/Miss on sales growth, margins, free cash flow, number of subscribers, EPS, adjusted EPS, GAAP EPS, non-GAAP EPS, outlook.
  • One can simply look at the performance of some big cap names which have lost more than one third of their value, and one can realise that street analysts have kept their buy ratings throughout this rout.
  • Companies shedding 30% to 50% of their value (even more) in a quarter simply because of the financial figures they reported. Never before, have price moves been so pronounced.
  • No serious investor can accept that an investment in a company is an “Investment”, if it has the risk to go down 50% in one quarter because of a quarterly miss. Especially for those asset managers who report performance on a regular and frequent basis like us, this is a very undesired noise-creating and disrupting factor.
  • The market has moved out of being investable into being tradeable and gameable. We could dare saying, that the US market has become non-investable in the short run. Europe provides still evidence of more economically driven moves (family controlled businesses, not as widespread access of thematic index funds and ETFs covering the EUR equity space), however, with the weakness in EUR, we tend to avoid (and for a good reason so far) to keep European equity exposure for our USD portfolios.
  • The US market is increasingly driven by passive flows, something that automatically distorts the essence of investing. Do a random check of some names in the US, no matter if they are big or small caps, and you will be surprised to see that the largest investors in almost all of them are always the same suspects: Blackrock, Vanguard, State Street, namely all the ETFs providers.
  • The new “hype” in the market is “factor investing”, which on top of big cap, small cap, value, growth, sector and other types of exposure, adds a new layer of “herding”, by putting a series of stocks that (in theory) share a set of business or economic characteristics in one tradeable category (basket/index). The stocks in such baskets may keep huge valuation differences, but nevertheless their stock prices will move in tandem since the underlying business dynamics are considered similar.
  • What you end up having are just numerous tradeable instruments that represent baskets of shares, which in turn lead to the elimination of the key element of investing which is to find undervalued securities and attach a fair value to them. One can attach a “fair” value to a single name but assigning a “fair value” to a basket of securities is a rather meaningless exercise. But the baskets allow easy and fast trading, by spreading the risk among many shares. In other words, functioning of the market is increasingly relying on fast changing data points (extensive time series of stock prices), rather than on underlying economic fundamentals.
  • This leads to distortions which sooner or later implode. Leading to excessive moves in either direction, amplifying mis-valuation of many securities, for a prolonged (and uncertain how long) period of time.
  • Participation of retail investors, social media headlines, algorithmic/ robot driven programs, exaggerate the above phenomena. Too much democratisation of investing, which in turn has led to something equivalent to chaos. Democracy is good, but to be run properly it assumes well informed decision makers, otherwise it will lead to adverse outcomes. Democratisation – of investing, is already leading to such a situation.
  • I can offer many examples of the above observations if requested. One will be surprised to realise how stocks have been moving lately, away from what traditional economic and market (investing) logic would dictate.

It is an undisputed fact, that despite the high levels of volatility at single stock level, the volatility at the index levels has been kept rather low. Diversification does pay off when it contributes to the lowering of price variations. However, this should not distract wealth managers like us, from our key and paramount role, which is to generate positive absolute returns. And out of principle, we do not intend to compromise absolute return generation for being simply outperformers in a negative yielding environment.

The reason I am saying this is because there are two basic aspects to consider when it comes to equity investments nowadays. First, do the indexes provide assurance that they will deliver positive return looking forward? And secondly, what are the probabilities of various outcomes?

With regard to the first question, in our opinion, S&P, is not providing high assurance of positive return generation by year end. Despite the close to 10% drop YTD, and despite the fact that many high profile and high flying names within the index have lost more than 50% of their value, the index is still not cheap. This is because of its current composition and high exposure to some big heavyweights, which are by most economic means extremely overvalued. So replacing our stock selection with the index, is not an option since the criterion of positive performance is questioned.

On top of that, when it comes to probabilities, and with the oscillation and velocity of moves of the market lately, the chances of a large 10/20% further drop are high. Although this is not our base scenario, from a portfolio perspective, we do not want to assume such a risk, which may threaten the wealth of our clients.  Not sure what may trigger such a big drop, but the market is very fragile to events (facts) but also noise. Keep in mind that it shed almost 7% in few days, just reflecting few words that the FED President said during an interview on Thursday last week. And with FED hikes looming, elevated valuations, algorithmic and retail involvement, ETF/index focus plus all the geopolitical headwinds that lie ahead, another big leg down during the year is not to rule out. This is something that categorically we would like to avoid, even if this costs us relative performance in case markets rally.

So what this practically means for our portfolios, especially the ones nominated in USD?

We have built a core fixed income component, which provides a very appealing yield (carry) buffer. The recent sell off has cost the mark-to-market of the pre-existing positions, but also offered unique opportunities to add new positions at very attractive levels. We intend to keep a minimum 60% -70% exposure of the portfolio invested in single bonds, with maximum 1% exposure per issuer, which on average offers a YTM in excess of 6% at current price leves. At the same time, we intend to keep at least 20% liquidity, placed in fiduciary deposits, which we will use as collateral in order to sell some fully cash collateralised, out of the money options on S&P (or any other index we deem proper). The cash is already getting some positive yields, which should gradually increase to 2% over the course of the next months. The high volatility of the market offers attractive option premiums, which we think are a much safer way to get exposure to the equity market than cash stocks, given the risks described previously.

Looking forward, our portfolios, especially the ones in USD, will be less conventional and probably less exciting, missing out on potential equity rallies, but more robust, and more probable to achieve their absolute return objective. This is not an approach we intend to apply for ever, but as long as the dynamics we highlighted above do prevail, we commit to remaining vigilant, disciplined and prudent.

We think the in the months to come the probability of error and exposure to systemic events will remain elevated thus we prioritise absolute return and portfolio optimisation over any other strategy, which entails binary and quite negative (in their adverse forms) scenarios.

Sincerely

 

Christos Kontos, CFA, FRM

(Founding Partner and CEO of ELIA Investment Advisors Ltd.)

 

Eveline Bieler

Independent Advisor to the Board

Eveline is an Independent Advisor to the Board on multiple corporate topics. Eveline brings an extensive experience in supporting wealthy families in their banking and wealth management matters. Prior to joining ELIA Investment Advisors, Eveline had worked for 10 year at key client desks of UBS, Bank Morgan Stanley and Goldman Sachs in Zurich, and has also spent two years in Hong Kong as an Analyst for a Boutique Financial Advisory, Private Equity & Risk Management Firm. Eveline holds a specialist certificate in Asset Management from Hong Kong Securities and Investment Institute and has completed a Master’s Degree in Financial Consulting and the Certified Financial Planner (CFP®) programme at Zurich University of Applied Sciences.

James Bejjani

Senior Partner

James has over 17 years of experience in Portfolio Management and Special Situations in the United States, Europe and the GCC. His areas of expertise span across a range of asset classes including Private Equity and Venture Capital. Prior to joining ELIA Investment Advisors James Bejjani served as Director of a large Geneva based multifamily office, and member of its Investment Committee. Earlier, James had spent eight years at M1 Group, a Single Family Office, where he was a Portfolio Manager. In that role he led M1’s Fixed Income investment activities in public (credit and capital structure investing) and private companies in both Developed and Emerging markets. Before that, he worked at Macquarie Funds Group where he had dual responsibility as a Trader and Analyst for a multi-billion dollar Fixed Income portfolio for institutional clients. He was also previously an Associate Director and an Institutional Investor ranked Strategist at UBS Investment Bank in New York. He began his career on Wall Street at Mortgage Industry Advisory Corporation (as a Quantitative Analyst). 

James earned his MS in Financial Mathematics from Warwick Business School in the UK, his BA in Economics and minor in Mathematics from the American University of Beirut and his double LLB degree in Private and Public Law from Saint Joseph University. He also completed an executive program at the Wharton School of the University of Pennsylvania. In addition, James is a member of the NY based Fixed Income Analysts Society.

Anton Schmidt

Managing Partner

Anton has spent over a decade covering UHNW families and individuals. He dedicated his professional career to providing tailor-made and differentiated investment advice across major asset classes and whole range of financial instruments. Most recently as an Executive Director and Private Wealth Advisor in the Private Wealth Management division of Goldman Sachs in Zurich after joining from Morgan Stanley in 2012, where he started as an analyst in 2010. His prior professional experience includes Bloomberg in London and Volkswagen in Wolfsburg.

Anton holds a Business Administration Diploma (MSc) with specialisation in Banking & Finance from Mannheim University, Germany and a Postgraduate Certificate in Finance from London School of Business and Finance, UK.

Christos Kontos CFA, FRM

Founding Partner & CEO

Prior to setting up ELIA Investment Advisors, Christos worked as an Executive Director at the Wealth Management divisions of Goldman Sachs (2014 – 2019) and Morgan Stanley (2007 – 2014), offering an institutional approach to private client investing. Before entering the world of the two large Investment Banks, Christos served as a Senior Associate for Swiss Capital Alternative Investments (currently StepStone Global), a Hedge Fund company based in Zurich, dealing with the design of specialised investment solutions for pension funds and insurance companies. Prior to moving to Switzerland in 2005, he worked in the Fixed Income Derivatives department of Intesa San Paolo IMI in Milan, and Equity Trading at NBG Securities and Alpha Bank in Greece.

Christos is a holder of the Certificate of Business Excellence from Columbia Business School in New York and holds an MBA from SDA Bocconi in Milan, an MSc in Finance from Strathclyde University in Glasgow and a BSc from Athens University of Economics and Business. He is a certified risk manager (FRM) by the Global Association of Risk Professionals (GARP) and holds the Chartered Financial Analyst (CFA) designation.