The fourth quarter of 2020 heralded the announcement of multiple viable vaccines for COVID-19, and a return to normality began to seem like a real possibility rather than a distant aspiration. It isn’t surprising that the market reacted positively. But our long short equity strategy is driven by bottom-up research, not mass movements in the market, and that didn’t change.
A Temptation for Some to Hold Their Noses and Buy a Basket of Low-Quality Stocks
From our perspective, many investors followed a strategy of buying whatever was cheapest in the hopes of participating in a “rising tide lifts all boats” recovery. However, if the events of 2020 showed us nothing else, they proved that the world is uncertain and market corrections can happen quickly and viciously. That’s why KAR’s Chris Wright, Long Short Portfolio Manager and Senior Research Analyst, continues to seek high-quality businesses at reasonable prices to own on the long side while shorting companies that are of low quality.
That said, even as we return to normal, there is a high likelihood that some consumer and business behavior may be permanently changed because of the pandemic, so what constitutes high or low quality may have undergone changes as well. That’s why we think bottom-up research is important at all times, especially for a long short equity strategy.
How Long Will This Frothiness Continue to Bubble Up?
Intervention by the Fed and government stimulus packages helped keep the economy from cratering in 2020, and we bought ourselves time to lessen the blow of the pandemic until vaccines could be widely distributed. However, there is a downside to these actions. The high level of liquidity in the system enabled companies that should have been restructuring to kick the can down the road by acquiring more debt.
The resulting asset bubbles are not sustainable, however, and we think their collapse is certain to play out over the next few years, but without a crystal ball, it’s impossible to predict the exact timing.
Short Sales, Anyone?
So, sans accurate fortune-telling, the current climate has become challenging for the short seller. High-yield spreads continue to compress in the debt market, and there’s an abundance of dry powder held by both private equity buyers and SPACs that are chasing deals. However, we’ve all seen what can happen with heavily shorted names.
We believe that proceeding with caution is the best approach for shorting in the current environment.
This information is being provided by Kayne Anderson Rudnick Investment Management, LLC (“KAR”) for illustrative purposes only. Information contained in this material is not intended by KAR to be interpreted as investment advice, a recommendation or solicitation to purchase securities, or a recommendation of a particular course of action and has not been updated since the date of the material, and KAR does not undertake to update the information presented should it change. This information is based on KAR’s opinions at the time of the recording of this material and are subject to change based on market activity. There is no guarantee that any forecasts made will come to pass. KAR makes no warranty as to the accuracy or reliability of the information contained herein.