European Long Short Equity: Letter from the Fund Manager

The second quarter was one of the worst quarters for equities in recent history with the Eurostoxx 50 losing 12%, while the Nasdaq plunged 23%. As flagged in our last two letters, the combination of an asset price bubble, spiraling inflation and rising rates provided a difficult set-up for asset prices. We focused most of our work on the short side this quarter and found many new names, particularly in our aggressive accounting sub-bucket.

As seen in the table below, we generated positive alpha in our Alpha Shorts bucket, while our Core Longs suffered from the market backdrop.

We do not expect a V shape recovery like we have gotten used to since the 2008 financial crisis. The inflationary forces are, at least partly, unlikely to go away quickly, so central banks are unlikely to bail us out in the short run. The combination of rising rates and a recession will obviously help to bring down demand for goods and services and depress asset prices, but we are concerned that in recent history, all the zero rate policies and the money printing had a direct impact on asset prices, but there was no correlation with headline inflation. Thus, to assume that inflation will disappear or go back to 2%, only because we are reversing actions that did not influence inflation in the first place is not necessarily right. As Powell keeps on reminding us, inflation is extremely complex, and many factors are outside of their control.

That said, every crisis provides opportunities and a lot of stocks have come down a long way and seen significant multiple compression. Puma, one of our top convictions over the last few years, is down more than 40% this year, while its fundamentals remain very strong. ASM International is also down 40%, Salesforce is back to its 2018 level and even a defensive play like Nestlé is down 15%.

Given the overall bearish set-up without much green shoots on the horizon, as we wait for the stabilization of long-term rates and recessionary fears, we think the set-up for high quality businesses with strong structural drivers starts to look more favourable. We have a wish list of companies where the IRRs on a 3-year horizon with conservative assumptions start to look attractive and aim to build or increase positions here over the coming weeks and months.

We still have a strong idea flow on the short side. The consumer discretionary and industrials sectors have been very good hunting grounds as the mixture of rising raw material prices, high inventories and fading demand from a squeezed consumer create a toxic combination.