A Complete Guide to Long Short Equity Strategy

4 years ago

Long/short equity is an investment strategy generally associated with hedge funds, and more recently certain progressive traditional asset managers. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value.

What is long short equity strategy?

However, some asset managers believe that betting solely on market direction by going long or short could be a mistake for those who have “successful business models”, whether from an operational or intellectual property perspective. These managers believe that they could benefit from having “long” positions in a stock not only if it rises but also if it falls. That way it is not relying solely on market direction.

Typically, long short equity strategy involves:

  • Value investing
  • Growth investing
  • Global macro
  • Event driven
  • Special situations

The goal of a long short equity portfolio manager is to generate excess returns over time by managing risk. According to a study by AQR, over the past 40 years, the optimal long short equity portfolio would have generated annual returns of between 13.7% and 14.0%, compared with annual returns of 11.1% for the optimal long only portfolio.

This strategy can sometimes be used by structured products such as synthetic CDO’s where the goal of the long short equity strategy is to stay in line with the index.

Long short equity funds can elect to trade their assets on exchange platforms and, following the concept of “liquidity, volatility and yield”, can then be used to manage the interest rate risk of the CDs (certificates of deposit).

Another way to manage interest rate risk is to follow the direction of the swap curve or the T-bill to T-note short rates curve.

Ethical investing, with parity to the broad ethical indices, is also a way to get long or short exposure to social, political and economic events.

There are many private long short equity firms and mutual funds that have chosen to manage this strategy until the market opens to everyone. Private long short equity firms usually have a few of the above strategies in their proprietary research, and may or may not have information they are willing to share with clients.

A long short equity strategy may have various techniques to select various sectors and industry across the globe. The usuals are top down selection, bottom up method, and even quantitative screening of the universe of stocks.

Some asset managers believe that betting solely on market direction by going long or short could be a mistake for those who have “successful business models”, whether from an operational or intellectual property perspective. These managers believe that they could benefit from having “long” positions in a stock not only if it rises but also if it falls. That way it is not relying solely on market direction.

Long short equity funds can elect to trade their assets on exchange platforms and, following the concept of “liquidity, volatility and yield”, can then be used to manage the interest rate risk of the CDs (certificates of deposit).

Another way to manage interest rate risk is to follow the direction of the swap curve or the T-bill to T-note short rates curve.

Ethical investing, with parity to the broad ethical indices, is also a way to get long or short exposure to social, political and economic events.

There are many private long short equity firms and mutual funds that have chosen to manage this strategy until the market opens to everyone. Private long short equity firms usually have a few of the above strategies in their proprietary research, and may or may not have information they are willing to share with clients.

A long short equity strategy may have various techniques to select various sectors and industry across the globe. The usuals are top down selection, bottom up method, and even quantitative screening of the universe of stocks.

  1. Research stock details

The first step of the process is to find high quality companies with a competitive advantage or special situation, that appear to be undervalued. Analysis involves studying the company’s financial statements, reading the latest annual and quarterly reports and press releases. We confirm the data is accurate by meeting with management and their auditor.

  1. Value investing

The long short equity investor believes that one or three years from now the company’s earnings, cashflow and earnings will be higher than today. One popular way to think about it is that the investor will be paying $1 for $1.03, or $1.05, $1.08. Whatever the case, we believe we will make a profit on the difference.

  1. Manage risk

For example, we may confirm that the company has a balanced capital structure and does not rely on debt. If we observe unexpected higher debt relative to the firm’s risk profile, we may conclude that the company is having some problems and the stock might be a sell.

We might divide the portfolio into a value portfolio and a special situations portfolio. The former we believe is a good company with a lower price than it should be based on a discounted cash flow analysis. The latter, we believe has potential for nice returns, but is not yet to our price target because it is a speculative situation with risks that need to be mitigated.

  1. Risk management

This involves the use of Stop-loss rules, position limits and portfolio hedges. Investors employ several different measures to manage the risk of permanent capital loss, including but not limited to stop-loss rules, position limits and portfolio hedges.

Stop-loss rules are the most commonly used technique. They require an investor to exit a security at a specified price rather than a pre-defined percentage loss. Position limits enable an investor to establish requirements regarding the maximum number of shares of a security that may be purchased within a specified time period. Portfolio hedges provide specific protection from idiosyncratic risk while also diversifying the portfolio.

  1. Liquidity and trading

The portfolio is actively traded to maintain its optimal risk-adjusted exposure to the expected return. We attempt to exit positions when an investment thesis is no longer valid. So if we believe that the price will go down presently, after the company’s earnings sinks, it will be time to sell. Or if we feel the price will go up, we will want to buy back our shares.

However, we may liquidate the position because of changes to our portfolio allocations, changes to our strategy and as a result of management’s guidance regarding the company’s future cash flow.

  1. Expected returns

The expected return for the portfolio will be influenced by both beta and alpha. Beta is the expected return that the market will offer, and alpha is the return above the expected market return for the portfolio. The components of the expected return include the cash return, time value of money, and control premium.

  1. Time value of money

The time value of money is the main driver of the expected return of the portfolio. Beta is very important. It is estimated by back-testing and is a factor of the market’s volatility and the portfolio’s beta. The beta can be calculated through a statistical analysis of the historical daily returns of the portfolio. The returns of comparable benchmarks, such as the S&P 500 can be used as a fair estimate.

  1. Control premium

Control premium is the excess returns that we will make over the market as we try to identify undervalued companies and exploit their inefficiencies.

  1. Risk management
  2. Portfolio composition
  3. Liquidity and trading
  4. Ethics

The ethical investment management software monitors social, political, economic, and environmental risks and opportunities. If there is a high risk of a political crisis, or a country is in political turbulence, it may be not be a good time to invest there.

If a large natural disaster occurs, future recovery efforts and government policy decisions may exacerbate the situation and be bad for the cause of future earnings.

  1. Management alpha

We review the performance of the manager’s value investment strategy and compare it with the traditional value managers.

To find these managers we have a database of board members, investment committee members, and long time employees of the firms that are considered long short equitying focused.

  1. Transparency

We include the price target of long short equity firm, the holdings of the portfolio, as well as the trailing five years of performance. We may also include the performance of the other five years if they are more impressive.

  1. Backtested performance

Since we adopted the long short equity in the mid nineties, we will pick the top 10% of our best performers. We hope to use the performance of the top 10%, to get a sense of what the average long short equity portfolio has produced.

If we are using a quantitative backtesting, the performance of the strategy as well as the holdings of the portfolio will be included in the model.

  1. Sharpe Ratio

We look for the Sharpe Ratio on the backtested performance. This is done by calculating the average return on the total investment divided by the standard deviation of the returns of that investment over the time period.

The higher the Sharpe ratio the greater the return per unit of risk. The Sharpe Ratio is commonly used to compare the risk-adjusted performance of stocks as well as mutual funds and portfolios.

  1. Alpha

We use the alpha ratio as a measure of performance.

We look for the average return on the investment portfolio divided by the standard deviation of the return of the portfolio.

  1. Beta

The beta is a measure of the systematic risk of an investment portfolio. The beta is used a measure of risk in excess of the market.

  1. Information ratio

Information ratio measures the difference between the average return of the portfolio and the equity risk premium. We look for the average of the excess of the investment portfolio returns divided by the equity risk premium.

  1. Undervalued firm
  2. Expected return
  3. Beta
  4. Net asset value
  5. Cash flow
  6. Payout ratio
  7. Leverage
  8. Institutional ownership
  9. Beta
  10. Percent unaided
  11. Risk versus reward
  12. Average size position
  13. Market beta

Market beta is the measure of the systematic risk of a stock relative to the market. A beta of 1 indicates the stock will act in lockstep with the market. A beta of less than 1 means it tends to have below market returns. Large companies tend to have a low beta. The market beta is calculated from the beta of the stock relative to the market.

Schultz’s success is based on his investment approach that relies on a firm’s ability to provide a perceivable consumer benefit. If the company can do something better for more for less, we want to invest in such company. This is why the company’s customer base is very important to us.

Let’s look at some of the, Schultz’s career milestones from excellent investor.

  1. Starbucks – opportunity to invest

Starbucks was founded by Jerry Baldwin, Zev Siegl, and Gordon Bowker in Seattle, Washington. At that time, there were only two stores in 1984.5. Until 1987, Starbucks had grown to 67 stores. Schultz was in the right place at the right time. He had a business partner who was good friends with the founders. After a lot of difficulty to buy the companies, he finally succeeded. Schultz was the next generation in the business. He acted as a hands-on manager and has an astute business mind.

  1. Product distribution

Starbucks began as a retail business. In 1987, they had a lucrative deal to sell the beans to grocery stores.

  1. Management of cost and quality

Starbucks is a pioneer in offering specialty coffee and consumer benevolence. In order to maintain consistently high quality, they have a rigorous program to support staff training to provide a constant consumer experience.

  1. Management of cost and quality – Back to the basics

While Schultz was the CEO of Starbucks, he was the President of the Coffee and Spice division, and also the Long John Silver’s Restaurant chain. He constantly improved the quality and offered a good value at his fast food restaurants.

  1. Management of cost and quality – introduction of the beans

He began importing beans and developed the company’s first retail operation in Starbucks’ stores in Seattle.

  1. Management of cost and quality – New product line

Schultz teamed up with Richard Blum, a long-term friend, and invested in La Boulange bakery. Eventually, the bakery chain merged into Starbucks. With the efforts of creative genius and Starbucks, they have transformed it from a trusted neighborhood bakery to the new place to find comfort food for trend-conscious carnivores.

  1. There is only one Starbucks, it is not a chain establishment, it’s a brand!

When he left Starbucks in 1985, there were 15 stores. When he came back to Starbucks in 2008, there were 16,400 stores in 57 countries.

one place that Schultz is unusually passionate is his partnership with Starbucks. He is the chairman, and he has over 25% of the voting rights. His interest in strategic direction ensures that Starbucks will continue focus on innovation in the retail business.

Schultz has continued to be a high-value investor. He was one of a dozen investors that have invested in the Starbucks when it was worth $3.8 million in 1987. As a result of his astute investment decisions, he has proved that he is one of the world’s best investors and value investors.

Schultz has demonstrated great value by investing in undervalued companies and identifying value. He was able to capture the difference between the stock price and what the company was worth.

In addition, Schultz was betting against the powerful IT industry in the early 2000s. He quoted: “As a value investor, I was particularly interested in companies that had an economic moat with strong consumer franchise that would give them sustainable competitive advantage.” This way of thinking is nothing more than traditional fundamental analysis.

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