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PIMCO recently introduced the PIMCO Long/Short Equity Strategy, a concentrated, long-biased equity strategy focused on balancing capital appreciation and capital preservation. In the following interview, portfolio manager Geoffrey Johnson, who executed the approach for nearly a decade before joining PIMCO in April 2012, discusses the strategy’s investment process, how it integrates bottom-up research with PIMCO’s top-down views, and the strategy’s dynamic approach to managing equity market exposure.
Q: What is the PIMCO Long/Short Equity Strategy?
Johnson: The Long/Short Equity Strategy seeks to let investors participate in the long-term benefits of owning stocks, while being flexible enough to move into and out of stock positions as valuations change and as markets rise and fall. The strategy features a highly concentrated portfolio of equities created through fundamental, bottom-up research. Yet it has the ability to fine-tune equity market risk, guided by macroeconomic and market views, by adjusting the mix of long and short equity, and cash positions.
The concentrated, deeply researched equity strategy looks to capture and magnify gains when markets rise. At the same time, the strategy has greater ability to manage downside risk during extended market declines given its flexibility to hold cash and selectively short stocks. Unlike many strategies that have a limited ability to raise significant cash, let alone short, the strategy’s nimble approach facilitates access to additional sources of alpha and can result in reduced correlation with broader equity market indexes.
Q: Could you discuss your investment philosophy?
Johnson: We approach the market the way I believe a prudent investor should: When the opportunities for reward outweigh the risks, we want to put capital to work and seek capital appreciation. But when the risks of loss appear to outweigh the rewards, we want to raise cash or take other steps to preserve capital. We believe that by combining fundamental bottom-up and top-down research with a flexible and opportunistic approach to trading, we can provide participation in the market’s upside while avoiding the downside during extended market declines. Over a full market cycle, we seek to deliver a positive return, and while we do accept short-term volatility, we still want to protect capital from permanent loss. Under normal market conditions, the strategy is net long and concentrated in about 20 of our best ideas, with a select number of short positions. Beyond stock selection, active management of the mix of long, short and cash positions is a crucial component of how we invest and look to navigate markets.
Q: Could you discuss your investment process?
Johnson: The process begins with an assessment of the prospects for the equity market. This view is informed by our economic outlook as well as our judgment on equity market valuations. When we have a positive view of economic and market prospects we tend to be more invested, sometimes fully invested. However, when confronted with what we believe to be a weakening economy, significant financial system risks or unattractive valuations, we are able to raise cash, short or otherwise reduce the strategy’s exposure to the market.
Portfolio holdings are selected based on deep, fundamental research – including extensive field investigations, meetings with managements, analysis of corporate filings and construction of extensive financial models. Our objective is to identify hidden value and mispriced securities. We actively trade positions as valuations and fundamentals change and sell when stocks hit our price target.
Q: What are your investment criteria?
The strategy invests primarily in long positions in undervalued companies with potential for high returns on capital and strong growth prospects. We like companies with defensible brands and significant cash flow and which are benefiting from secular trends. We also look to add selective short positions and other special situations, including turnarounds and spin-offs, in an effort to enhance returns. Once we’ve found the right company, we seek to initiate a position when the stock is at a discount to our target price and when we’ve identified a catalyst for price appreciation in the following one to two quarters.
Q: So this is different from 130/30 and market-neutral strategies?
Johnson: Quite different. Both of those strategies establish long and short exposure weights and tend to maintain them regardless of economic trends and individual stock opportunities. In the case of 130/30 strategies, the net equity exposure remains 100% and thus offers little in the way of capital preservation in bear markets. Market-neutral strategies maintain a neutral exposure to the market by remaining hedged at all times. The PIMCO Long/Short Equity Strategy is generally net long but varies its market exposure depending on the macro and market outlook.
Q: How do you determine the level of market exposure? And how do you adjust the strategy for varying market environments?
Johnson: Our market exposure is guided by PIMCO’s macro outlook as well as our views on the equity markets. In bear markets, we can go 100% into cash or establish short positions. We’re happy to hold cash if we think market or financial system risks are too high. In September 2008, for instance, the strategy was mostly invested in cash and cash equivalents and we could therefore assume the return – near zero. When we feel good about the market and the companies we own, though, we want to put capital to work and are not likely to carry much of a short book.
Q: Do you employ short positions to hedge the portfolio?
Johnson: We typically don’t use shorts just for the sake of hedging. We prefer to short individual stocks when we see an opportunity to generate alpha as opposed to simply hedging exposure. Companies we short tend to fall into two categories: fundamental shorts, or companies in secular decline, and cyclical shorts, or businesses that will be hit hardest when the economy is weakening. As is the case with our long holdings, short positions are typically initiated when they are expected to be profitable in the next quarter or two.
Q: What role might this strategy play in a client’s portfolio?
Johnson: It is consistent with the needs of many investors who are moving away from benchmark-oriented strategies in favor of highly active, unconstrained strategies that seek to limit downside risk. While we look to deliver attractive returns over a full market cycle, investors should not expect positive returns in every market environment, especially over short-term periods. Indeed, at times we are willing to sacrifice some upside in order to avoid large losses. That is different than a strategy that simply seeks to beat the market. By design, the strategy will have periods of high volatility in the short-term, but our nimble approach is designed to limit downside risk and may result in lower volatility than the equity market over the long term.
Since I began managing the strategy almost a decade ago, I have stuck to our discipline. Now, aided by PIMCO’s deep and broad resources, we seek to do the same for another decade and beyond.
Article Disclaimer
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in securities of smaller capitalization and mid-capitalization companies tend to be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Statements concerning market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.