Taking stock: Catching falling knives

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“A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron. It is our job as contrarians to catch falling knives, hopefully with care and skill.”

Howard Marks, Oaktree Capital, 2011

There is a regularly used phrase in financial markets, which becomes particularly popular in times of market stress: “Don’t catch falling knives”. Old adages like this often represent useful pieces of advice, but this is not one with which we entirely agree. Clearly, there is a grain of truth at its heart – trying to catch a falling knife is dangerous and, if it goes wrong, one could lose a digit or two. That applies as much to the world of investment as it does in the kitchen. However, just because it is difficult, doesn’t mean we shouldn’t try, as long as we do so carefully and following a lot of practice.

Howard Marks is an investor with a fine pedigree in the land of fixed income, and we agree with his assessment that some of the best investment opportunities are contrarian, challenging and uncomfortable. The rewards in equity markets are potentially even greater but if we were to wait for the discomfort to pass, the scale of the opportunity is often greatly diminished.

Earlier this year, the sky was alive with the flash of glinting blades. Amid substantial uncertainty about the early path of the pandemic and the likely economic impact of the policy response, European equity markets were falling precipitously. It was a very uncomfortable time, but our experience told us that those conditions were unlikely to last for long and that they were likely to reveal some very enticing opportunities. Hence, the RWC European & UK Equity team dusted off the 2009 playbook and started to seek out opportunities for recovery.

The risks involved with this pursuit are obvious, so appropriate safety apparel and protocols are required. The concept of fundamental value is critical – if the team can build an investment thesis around informed judgements about intrinsic value, it allows it to spot specific instances where the stock market is over-reacting to events. Prior knowledge of a business is also helpful in allowing the team to build a thesis quickly. Meanwhile, stock specific risk can also be mitigated to an extent by building recovery exposure through a collection of smaller holdings and balancing that exposure against other parts of the portfolio with different characteristics.

These are the team’s chainmail gloves and safety guidelines, which help it to spot and catch falling knives adeptly. It still isn’t a risk-free pursuit but investing never is. It is unlikely that the funds managed by the RWC European & UK Equity team would have delivered the returns that they have this year, without a contribution from falling knives expertly caught.

The opportunity prompted by this year’s market volatility has not altogether passed, however. Equity markets rallied aggressively from the March lows, but the divergence between the performance of the best performing European stocks and the worst, is vast. Some knives have continued to fall, and the team continues to investigate new recovery ideas. Meanwhile, there remains a considerable amount of recovery potential already within the portfolios alongside the team’s other favoured areas of Hyper Growth, Secular Growth, Cyclical Potential and Special Situations.

This week’s highlights

The world’s biggest hearing aid maker, Sonova, performed well for the portfolios last week, following a trading update which confirmed that its recovery from the impact of the coronavirus pandemic is progressing faster than expected. Social distancing measures had prevented many customers from seeing their doctor or hearing specialists during the first half of 2020, but the company expects to return to growth over the next six months. Indeed, its Asia region is already growing again, as are several of its European territories. We believe Sonova’s recovery prospects continue to look attractive, as does its longer-term growth potential.

Swedish online banking company, Avanza, also contributed positively last week. It is due to release its Q3 results later this month, which should build on the strong recovery reflected in its Q2 statement released back in July. Analysts have been upgrading the stock in anticipation of the results. We have been anticipating this earnings upgrade cycle and remain confident in its continuation. Growth in its customer base, net inflows and new product launches all appear to be leading the business in a positive direction.

Meanwhile, German optician, Fielmann, released a positive update last week, which confirmed it is trading ahead of expectations. It now expects Q3 profits of c. €80m on sales of c. €420m. This represents modest growth on last year’s numbers but, with 2020 as a whole likely to be lower than 2019’s performance, we believe this is another business with considerable recovery potential, as well as attractive longer-term growth prospects as it expands into new territories.

Unless otherwise stated, all opinions within this document are those of the RWC European and UK Investment Team, as at 7th October 2020.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the names shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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