Once upon a time (1942), creative destruction was considered “the essential fact of capitalism” by Joseph Schumpeter, organically and dynamically spurring innovation and productivity to the benefit of all. One can only but wonder how Schumpeter’s intellectual descendant of 2042 will look upon our current embrace of destructive creation, which centrally and haphazardly spurs intervention and magical thinking to the detriment of all but a few. This rising tide of interventionism and magical thinking in equity markets is thankfully of no concern to the Butterwire platform which keeps helping investors navigate whatever the conditions. We chose two recent tales to illustrate, one on the recent Gamestop mania orchestrated by the Reddit army, and one on the apparent dilemma faced by value funds who see investment opportunities in the energy space but fear the wrath of the Green army.
1. Wily Wallstreetbets and the Sucker Factory
Our global indicator of global growth expectations (iGDP, see below) rolled over three weeks ago after reaching a 10-year high of 8.2%.
But did we really need a warning of over-extended market conditions after watching Chad and Jenny explain to 2 million awe-struck TikTok viewers how to make a living with a RobinHood trading account (“see a stock going up, buy it, then just watch it until it stops going up and then sell it”), or after Robinhood and other brokers stopped the trading of specific stocks being bid up to a frenzy. No stock represented the retail trading mania that has engulfed parts of the
active and free forcibly idle and assisted populations of the Western world better than Gamestop. This electronic equipment retailer represented a typical deep value opportunity back in March 2020 when market expectations trough and demand for the stock had evaporated (see screenshot below: overall fundamental score of 8.6 with value and controversy scores score at 9.9). And with a recovery score of 10.0, it also represented a prime “bottom-fishing” opportunity for when market expectations troughed by mid-April.
Roll on to end of January 2021 and Gamestop’s overall score had collapsed to 0.1 following a continuing degradation of business fundamentals coupled with a 92-fold share price increase (see screenshot below). It was still considered a “high octane” investment idea, except this time the mean expected alpha was -7.5% vs. +2.8% back in March and the play had turned from deep value to pure price momentum. As it turned out, the stock had historically been strongly trend-following (see Technical Indicator box at the bottom right corner of the screenshot below which shows significant historical trend-following at 6/10 and an extraordinarily strong 10/10 break-out at the time), and the ongoing break-out was 9 days old vs. an average of 16 days long for previous breakouts.
Of course, as we now know, the (close) share price had already peaked at $347.5 fours days prior and would go down to $63.8 by 5-Feb, after the smart money promptly cashed on the frenzy.
Rough wake up call for all the Reddit army afficionados (i.e. the dumb money) who made the short-squeeze possible but stuck at the party for too long. In turn, wily r/Wallstreetbets may have just engineered the biggest pump and dump trade in recent memory while pioneering the crowdsourcing of market manipulation (note that market manipulation is an apt description only if answering “yes” to the following 4 questions: did they have the ability to influence the price of GME, did they intend to affect its price in a way that had nothing to do with its fundamentals, did artificial prices result, did they cause the artificial prices).
Even though GME -- the stock with the best fundamentals of the lot back in March, delivered the best returns, all the stocks with provocatively high short interest ratios (as % of float) as of last March delivered spectacular returns (see scores and coloured backgrounds per March 2020 in the graph below: yellow = “interesting but high octane”, grey = “better odds elsewhere”, red = “potential short”).
Taking a step back, the reddit saga is but a mere distraction away from the “Everything Bubble” fuelled by the Fed (and the ECB) that is spurring zombie-companies like AMC Networks on (see below), likewise Chad and Jenny discovering momentum trading and the investing world learning to always “buy the dips”. So AMC and Tilray (who has been there before) are the latest momentum trades. Beyond Meat is the one having the best fundamental score, albeit entirely thanks to strong growth prospects and price momentum as well as a solid balance sheet. Unlike back in March, none of the high short interest stocks offer good value.
2. The Carbon premium dilemma that was not.
For value investors, there has recently been few better hunting grounds than the energy and commodities sector (see below screenshot of a selection of large cap high value score energy stocks). Energy is a unique sector in that our civilisations are built on it and our standard of living depends on it, yet it only accounts for 3% of global market cap. As if this didn’t sound like enough of a bargain, after years of excess supply (thanks to zombie shale companies) and fear of deficit demand (thanks to climate change initiatives), low prices have caused exploration cuts and development postponement (creating years of supply addition lag) while many marginal wells have been (permanently) mothballed. A pinch point therefore looks inevitable when energy demand returns, and no amount of magical thinking will be able to deliver a free and abundant alternative to the vast impaired supply of fossil fuels (which, despite $2.5tn invested in renewable power alone these past 10 years, still accounts for well over 80% of world energy consumption and just a few % less than 10 years ago).
No wonder then that value funds tend to be relatively more exposed to Climate Transition Risk (CT-VaR), thanks to their energy and commodities holdings (see table below, Climate Transition Value at Risk figures per CTA-Climate Transition Analytics, a division of Willis Towers Watson).
But holding energy equities also creates a legal risk (e.g. of being sued for not caring about climate change), which in turn raises the carbon premium deducted from these equities’ valuation, which then makes their valuation more attractive, which raises the active risk for a fund manager of not holding these stocks (even more so for firms that are making decisions that reduce both their physical climate risk and climate transition risk exposure).
What then is a value fund manager to do to both mitigate legal risk and performance risk, i.e. overcome the carbon premium dilemma?
One way is to adopt a barbell strategy as illustrated in the left graph below: retain the highest conviction stocks with the most provocative (attractive) valuations and (unattractive) CT-VaRs (e.g. Royal Dutch in the example below), offset these with positive VaR stocks (even if relatively less good value, e.g. Alstom in the example below), look at non-core holdings to rotate the portfolio into better value / better VaR stocks that also reduce overall portfolio tracking error (e.g. Legrand for Airbus), which is what the Butterwire’s Mitigate feature in the Portfolios section of the application does.
Another option is to run portfolio optimisations that minimise tracking error to CTA’s (Europe) Climate Transition Index while keeping within turnover and other constraints (e.g. minimum scope 1 emissions, maximum value score), which is what Butterwire’s Pret-a-Tracker feature (also in the Portfolios section) does, informing the fund manager on risk clusters and possible trade-offs.