This Odey Fund Explains How Shorts Can Indirectly Boost Absolute Returns

Odey’s LF Brook Absolute Return Fund had a challenging fourth quarter with a return of -4.6%, although its full-year return for 2021 was 9.9%. On the other hand, the MSCI World Index gained 22.95% for 2021. The Brook fund has enjoyed a compound annual growth rate of 12.9% since its inception in 2009.

In his fourth-quarter letter to investors, James Hanbury of Brook Asset Management said their short book actually gave their overall return a sizable boost in 2021. Amid the U.S. Department of Justice’s investigation into hedge fund shorting, this statement is significant because it demonstrates how shorts don’t necessarily have to post positive returns to have a positive impact on a hedge fund’s overall portfolio.

He also reported that their top six long positions did poorly last year, contrary to their track record of significant outperformance of their biggest long positions. They used the weakness to add to those high-conviction positions.

Biggest detractors

Since 2009, the Brook fund’s top six positions have generated an average return of 22.1% per annum until the end of 2020. Statistically, these positions are where the fund generates the most alpha as a percentage of the position, but 2021 was the first year that didn’t follow the trend. However, the rest of the fund’s long book did well in 2021, granting it essentially neutral alpha and a 26.11% return for the long book overall.

Last year, the biggest detractor was AO World, which Hanbury said was their “star performer” in 2020. AO World is a challenger in the areas of audio, TV, computing, gaming and mobile devices, which meant that it faced the worst of the supply chain issues because its orders weren’t at the front of the queue.

Hanbury believes the issues the company faced are temporary and that it responded in a “high quality manner” by putting its customers first and investing in growth. Further, AO World increased its market share in 2021.

Last year, the Brook fund’s second-biggest detractor was Jet2, Hanbury’s highest-conviction airline position. The fund did not trim the position when it trimmed its stakes in other airlines due to increased caution on the space at the end of the first quarter.

Hanbury believes the big issues for Jet2 were that the U.K. had some of the “most draconian flying policies globally” and that its guidance was constantly changing. However, Hanbury said Jet2 has one of the strongest balance sheets in the sector, and he expects it to gain share.

Other significant detractors during 2021 were IWG and Plus500.

Biggest long contributors

Oxford Nanopore and Frasers Group were the Brook fund’s two biggest contributors in 2021. Following Nanopore’s successful IPO toward the end of September, it raised its guidance by about 60% at the midpoint. Nanopore boosted its guidance again this month, meaning its revenue for the second half of 2021 will end up being about 120% higher than implied at the IPO on a currency-neutral basis.

In December, Frasers Group reported strong earnings that demonstrated the health of its business. The company grew its sales by 24% and profits by more than 70%. Its cash generation was stronger than its earnings due to its conservative accounting, which involves impairing all buildings and leases to the values they would be at if they were vacant.

Hanbury believes Fraser Group’s most misunderstood and undervalued division is Flannels, its luxury goods division. He estimates that Flannels grew its sales by about 50%, with margins above 20%. Hanbury believes the group is on track to hit its target of £2 billion by 2025, which would give Flannels alone a value that’s multiple times higher than that of the entire group.

Other exposures

The Odey fund saw robust returns from its commodity exposures, excluding oil and precious metals, at 6.51%. At 2.15%, Glencore was the top contributor, and Brook’s exposure to oil generated a solid return of 2.31%. The fund’s two drillers reported positive developments during the fourth quarter, with Maersk Drilling being bid for by Noble in an all-share merger and Jon Fredriksen, one of the largest investors in the space, building a 6% stake in Valaris.

Brook also enjoyed a robust return from its banking exposure at 5.87% last year. Its top contributor in the space was TCS, which it has now sold. Hanbury pointed out that the gap between reported and statutory earnings among European banks has closed considerably. Thus, they have been building capital and have greater chances to return it to shareholders.

The U.K. construction sector returned 2.67% for the Brook fund in 2021, and its names significantly outperformed the sector. Hanbury believes the names they have chosen are better placed to deal with the inflation the market is implying.

The Odey fund added three new meaningful long positions in ABF, Flutter and Altice USA during the fourth quarter. Hanbury added that their long book continues to be biased toward value names.

How the short book gave the long book a boost

Hanbury reported that their short book lost 11.02% in absolute terms in 2021, but despite that, it generated an exceptionally strong alpha of 7.88%. That alpha enabled the Odey fund to have a larger gross long book, indirectly increasing its absolute returns.

The biggest contributor on the short side was Peloton, which returned 3.25% for the Brook fund. The fund’s thesis that COVID demand for the company’s products was overly extrapolated and that its pricing power was not as strong as the market believed. Peloton slashed its prices multiple times last year, culminating in a significant profit warning in the fourth quarter. The Odey fund then closed the position.

Two of the fund’s top shorts were in the hydrogen fuel cell business as fund management applied the knowledge they learned when establishing their successful long position in Plug Power, one of their top contributors in 2020. Hanbury reported that the S&P Global Clean Energy Index plummeted 27% in 2021, but their shorts in Nel and Ballard significantly underperformed the index.

Nel added 0.67% to the Brook fund’s return, while Ballard contributed 1.48%. Hanbury continues to believe hydrogen will play a significant role in the energy transition but that many companies in the space will not succeed. Both companies are losing money and consuming cash.

Other key contributors on the short side in 2021 were Ashmore and Chegg, and the Brook fund closed its position in Chegg last year. The fund’s cinema shorts were also significant contributors in 2021, and Hanbury believes the structural issues with the space became even more apparent.

Significant short detractors

The Odey fund’s biggest detractors on the short side were its private equity shorts of EQT and Partners Group, which subtracted 4.16% and 1.89%, respectively. Hanbury said although the conditions for raising and selling remained exceptionally favorable in 2021, the shares of both companies rerated “enormously” during the year.

The fund retained both shorts as Hanbury remains concerned that the market misunderstands the financial reporting quality for Partners Group and both companies’ cyclical exposure.

Hanbury characterizes the positions in their short book as trading on high sales and earnings multiples, although there is a significant mixture in the types of companies they are shorting.