Stellar outperformance targeting losers rather than winners

Just as investors ‘going long’ target companies they think will be successful, you can also make returns ‘going short’ by looking for the losers. This type of strategy has paid off handsomely for the Boston Partners Global Long/Short strategy, which blended both styles to achieve 33 percentage points, net of fees, of outperformance in 2022.¹

Short selling is the practice of hoping a share price will fall due to underperformance by the company, from having a poor business strategy to being caught up in a wider problem – or from being overvalued to start with. It is done by ‘borrowing’ a stock from an asset owner, selling it in the market, and then buying it back at a lower price in the future.²

And there was no shortage of candidates last year, when markets were rocked by the Ukraine war, bringing a bear market that better suits shorting, and a shift in investor sentiment that led to a lot of low-profit companies with high valuations coming unstuck.

The Long/Short UCITS strategy rose in value by over 15% when the wider market fell by 18%, creating alpha of 33%. “Last year was just phenomenal – it was kind of a nice rebound from a difficult period in prior years when the central banks were flooding the market with liquidity and a lot of stocks were cheap,” says Portfolio Manager Josh Jones.

“Shorting is a lot of work and it's tiring because you're constantly taking a contrarian position against the market. You're saying that other investors who own a business don't understand why they own it, and that our perception of what the business is worth is different to theirs. But it does pay off when you’re right and the market is wrong.”

“We'll typically run 100 to 150 shorts a year, but at small positions of 40-50 basis points (of total assets under management) to spread the risk. We don't want any single short to blow us up in a year. And that's the hard thing with shorting. We want to diversify the risk that statistically you're going to have stocks go up when they were supposed to go down.”

Therein lies the risk that can keep a short seller awake at night. “The payoffs can be big because there's a lot of downside to tap if a stock is significantly overvalued, but it’s hard to get the timing right,” Jones says. “So, we typically take really small short positions to help manage that risk.”

To target the right companies, Jones Boston Partners’ propriety quant model that has ironically proven better at finding the losers than the winners it would normally seek for long-only investing. “If you look at the data in the quant model, they're productive at finding winners, but they're even more productive at finding companies that are going to do poorly,” he says.

“The model is really good at identifying failure, basically. So that means we have a really productive screen for identifying shorts. And if you look at the profile of what we're typically trying to short, some of it is kind of the overvalued concept stuff. It can be, for example, these tech companies where the market thinks huge growth is coming, but the business is largely unproven, and the profitability levels are questionable.”

“Then we have our shorts in the more traditional businesses that have fundamental issues, such as over-leveraged balance sheets, poor competitive positions, poor capital allocation by the management, really poor accounting, poor cash conversion, or where we think there are accounting gimmicks going on.”

The turbulence in 2022 also assisted the Boston Partners core strategy of value investing, which on the long side targets companies whose share prices do not reflect their underlying potential. Returns are then made when the market readjusts to reward this upside.

“On the long side, the market was down 18%, but our longs were only down about 2%,” Jones says. “So, we had very significant relative outperformance on the long side from focusing on value opportunities, including a lot of Energy companies, some in Health Care, some in Materials, and even some of the more defensive stocks within Industrials.”

“Financials was a value sector that also outperformed last year. We had positive alpha on the long side because we were in more conservative banks that did well from rising interest rates.”

“On the short side, we did well with some of the ‘concept’ financials that were supposed to be disruptors but were actually really poor business models. We shorted some of the ‘buy now, pay later’ and the fintech-related companies, as well as lower-quality capital markets businesses that just were overpriced coming out of the bubble period of zero rates.”

Jones says bear markets such as the one witnessed in 2022 do make shorting easier, though you still have to target the right companies to make relative gains. “We tend to earn more alpha in down markets, because then the market becomes more discerning towards quality issues,” he says. “Last year, the market was down 18%, and our short book was down over 32%, generating 14% of alpha. This year, sentiment has improved a little bit, so shorting becomes harder.”

“One of the funny things we see on the short side is that we tend to earn more alpha in the second half of the year than the first half. Investors tend to give companies passes for poor performance earlier in the year, as there are still several quarters still to go, but they are less forgiving later in the year. If the market wasn't obsessed with a calendar year end and just kind of resetting the clocks, that probably wouldn't be the case.”

So, will 2023 be as lucrative, given the ongoing macroeconomic problems? “I think it will be a painful year for both the bears and the bulls because we’ll see some more rate rises, and the market might sell off a little bit into those,” Jones says. “But I do think inflation is going to cool down into the summer and the market will rally into late summer.”

“If inflation calms down and central banks can run easier monetary policy, shorting will become more difficult, and we would likely shrink our short portfolio. We can run fewer shorts or smaller positions. Ultimately we're believers that generally you want to be net long and take advantage of the fact that stocks go up over time.”