Today’s CIO Weekly Perspectives comes from guest contributors Joseph Rotter and Jonathan Adolph.
The fourth quarter Outlook from our colleagues in Equities makes for gloomy reading. The data from their analysis suggests that a further 20% could come off both the S&P 500 Index and its underlying companies’ earnings before this cycle reaches its trough.
What’s more, the economic backdrop it describes suggests the trough could be long and volatile, unlike the strong bounce-backs we saw in 2009 and 2020.
The message we might take from that is to be cautious about equity market exposure—or “beta”—over the coming months. That’s why our Asset Allocation Committee currently has an overweight view on hedged strategies, including those that are “market-neutral,” where long positions balance short positions, isolating “alpha” and leaving as little exposure as possible to the ups and downs of the market.
But there are many types of alpha. There is simple stock-picking alpha, for example: selecting the companies that have the potential to generate the most earnings over a given time and hedging out the market risk. There is statistical alpha: trading balanced baskets of longs and shorts based on short-term patterns in their price movements.
In this environment, however, we think there is an attractive opportunity set in one particular kind of alpha: event-driven alpha.
Catalysts and Arbitrages
There are a lot of ways to think about opportunities in equity event-driven investing. We like to split them into two categories: “catalyst” and “risk arbitrage” opportunities.
A catalyst opportunity is when there is anticipation that an individual company is about to go through a significant event. That might be a change of management or a restructuring of the balance sheet, for example. It could be a plan to spin-off a slow-growing division and reinvest the proceeds in the fast-growing parts of the business. Maybe the firm finally resolved some long-running litigation or regulatory issue. Perhaps an activist investor is building a big stake and looking to shake things up.
If the market doesn’t appear to have recognized that catalyst in the company’s price or multiple, an event-driven investor might try to gain exposure to it and hedge out as much as they can of the market, sector and factor risk associated with the stock.
A risk arbitrage opportunity is when one company announces its intent to acquire another, and the target company’s share price is lower than what the potential acquirer has offered. That spread generally reflects, among other things, the risk that the deal fails to go through.
A “merger arbitrageur” will assess that risk and may take exposure, potentially trading in and out as the spread widens and narrows with news flow around the deal. Merger spreads tend to be wider and more volatile when there is more uncertainty in the market and more regulatory scrutiny around deals, potentially creating more opportunity for active trading.
The success or failure of this kind of investment opportunity, when it is well designed, does not depend on whether the market is going up or down—rather, it depends upon whether the marketplace appropriately prices in the relative value of the company’s catalyst being realized, or upon an acquisition getting completed.
That’s one reason why we think it’s an interesting approach to consider if you think the economy and the market are heading downward or sideways.
The other reason is that, when the going is tough, management and boards tend to think more about these big changes or more creative strategies because, for many of them, winning is no longer a matter of simply selling 3% more widgets than their competitors next quarter.
We think that’s why we see a market that’s particularly abundant in catalyst opportunities right now. We hear more and more anecdotes from our colleagues in Equity Research about companies planning some kind of strategic shake-up. We see a growing number of activists building stakes and writing letters to encourage change—and increasing willingness among board members and other shareholders to back them, as they seek their own sources of potential excess return in a difficult market.
Do we see a lot of risk arbitrage opportunities, too?
Not so much, and that doesn’t surprise us. An uncertain and volatile market is not a favorable backdrop for a merger. In the U.S., the average acquisition takes around five months, which is a long time in which the market price of the target company can move far away from what the buyer and seller initially agreed.
That said, there are more deals being announced than we would normally anticipate at this stage of the cycle and in this kind of uncertainty, including some sizable ones. Selling divisions and acquiring struggling competitors are among the ways businesses can attempt to capitalize on an economic downturn, after all. In addition, we are seeing private equity strategies that have entered the top of this cycle with an unusually large pile of dry powder to spend on public-to-private acquisitions.
That means there are opportunities for merger arbitrageurs, and lots of volatility allowing them to trade in an out of the spread. But it also suggests to us that activity could pick up meaningfully once markets have settled down again.
We think the same could be true of the Initial Public Offering (IPO) market. In some ways, IPOs might be seen as the ultimate blend of catalyst and risk-arbitrage opportunity, and they are often subject to an ongoing series of catalysts as they adjust to their new, public-market environment. The market is effectively closed, now, but we think it stands ready to roar back to life when the height of the volatility is behind us.
In summary, we believe this point in the cycle—heading into a difficult slowdown and looking forward to the recovery—is among the most interesting for the equity event-driven approach to investing.
In our view, it’s when company management has to be more creative, daring and decisive to survive and thrive. We think investors who can identify good teams with compelling plans, and isolate what those teams are doing from the noise of the market, could stand to benefit from the creative destruction that looks set to be unleashed during the course of this downturn.
In Case You Missed It
- Empire State Fed Manufacturing Index: -7.6 to -9.1
- NAHB Housing Market Index: -8 to 38
- U.S. Housing Starts: -127k to 1,439k
- Philadelphia Fed Manufacturing Index: +1.2 to -8.7
- U.S. Existing Home Sales: -1.5% month-over-month
What to Watch For
- Monday, October 24:
- U.S. Markit Manufacturing PMI
- Tuesday, October 25:
- U.S. Consumer Confidence
- Wednesday, October 26:
- U.S. New Home Sales
- Thursday, October 27:
- U.S. Q3 Annualized GDP
- Friday, October 28:
- U.S. Personal Income and Personal Spending