Geopolitical Risk Portfolio as a Risk Management and Stock Selection Tool

In the two weeks since we initiated our multi-part investigation of the Geopolitical Risk Factor (GRF), a distressing escalation in cross-border coronavirus cases is raising alarms and prompting swift action as nations scramble to avert a potential global health crisis. Our thoughts go out to those impacted and to the well being of all global citizens. Meanwhile, this situation underscores why it’s critical for investors to understand how to shield their hard-won assets against the ensuing market uncertainty caused by the outbreak along with a myriad of other geopolitical forces. In addition, investors should explore new ways to benefit from their own convictions during times of heightened geopolitical activity.

Until recently, the unpredictable and oftentimes chaotic nature of the geopolitical arena resulted in few, if any, systematic portfolio-wide strategies and safeguards of use to the investment management community. These risks were typically deemed too random, overly specific and too far into the realm of the ‘qualitative’, thus never supporting any development of more substantial frameworks to carve out these risks.

As we pointed out in the first part of this series, the GRF was developed by our partner Wolfe Research based on methodology derived from the academic paper Measuring Geopolitical Risk (Caldera and Iacoviello 2018).

Taking the GFR long/short portfolio we had constructed in our second post of the series, this week we will look at how it can be used as both (a) tool for PMs and risk managers to mitigate a fund’s exposure to the current geopolitical environment and (b) research / idea generation tool for analysts looking to isolate companies with excess positive / negative exposure to current events.

Geopolitical Risk Portfolio - Risk Mitigation Tool

To recap our exploration last week of the sectors driving geopolitical risk, we had ranked all the names in the Russell 3000 by their geopolitical risk exposures and created a theoretical portfolio that was long the top 1000 names (1/3rd) and short the bottom 1000 names(1/3rd). We found that the Health Care Sector has historically been positively exposed to the GRF (i.e. in times of geopolitical turbulence, Health Care stocks are seen as a safer haven relative to the rest of the market, and these stock prices generally move higher) and we established that the Consumer Discretionary Sector tends to be negatively exposed to movements in the GRF (i.e. in times of geopolitical turbulence, retailers and other sellers of consumer discretionary goods generally experience declining sales for what are commonly considered ‘non-essential’ goods and their stock prices subsequently fall).

While on the surface these relationships may seem a tad too obvious, they in part help confirm the validity in using the GRF models to manage risk.  Below, we form a more quantitative viewpoint on the quality of the portfolio in capturing the GRF risk in the current market environment.

Portfolio Analysis

Analysis Date: Feb 6, 2020
Number of Securities: 1616
Risk Composition:

• Total Absolute Risk: 3.50%
• Factor Risk: 91.56%
• Specific Risk: 8.44%

70% of the style risk associated with this portfolio comes from the Geopolitical Risk Factor.

Healthcare and Energy are the top overweights and Consumer Discretionary is the top underweight in our portfolio.

Please note the double arrows indicate rapidly growing exposure to geopolitical risk most recently.

Geopolitical Risk Portfolio - Stock Selection Tool

We now dive into the individual companies most positively and negatively exposed to Geopolitical Risk. These are companies where their Geopolitical Risk exposure represents a significant explanatory move in their stock price returns, in excess of the standard factors such as Value, Growth, Beta, and Momentum.

Top Names Overall - All Sectors

Beyond Meat (BYND) ranks as the highest exposure GRF name of all those analyzed.

Some analysts see limited upside in BYND following the initial euphoria, and it remains to be seen if it is a sustained long-term play benefiting from more and more consumers choosing plant-based products. But there may another interesting angle in play based on its geopolitical behavior. The coronavirus is believed to have started from so-called live markets, where animals are slaughtered on the premises at the point of sale. Live markets have been closed in Wuhan, China, the epicenter of the virus. As the world’s largest market and others grapple with making changes to their primary food sources and distribution systems, plant-based food providers such as BYND who have applicable IP and know-how may stand to benefit.

Health Care Sector

As we discovered previously, the Health Care Sector exhibits strong positive exposure to the Geopolitical Risk Factor.

It may be interesting to see how the coronavirus outbreak is impacting stocks most heavily exposed to this factor.

Top Health Care Names

Novavax (NVAX), a biotechnology company specializing in vaccines, is the highest ranking GRP Health Care company in Omega Point’s portfolio. Only last month, NVAX announced it planned to develop a vaccine to fight the virus, and its shares jumped 70%. It also filed plans to raise $100 million in a secondary offering in January.

Biotechnology company Inovio Pharmaceuticals (INO) ranked second in GRF exposure in the portfolio. Just last month, INO was riding high when it was named among a group of biotech companies to share in an $11 million grant from a Norwegian nonprofit. The grant is earmarked for companies to develop a coronavirus vaccine.

The rise in GPR for biotechs – like NVAX and INO – may have been ratcheted up by heavyweight Gilead Sciences (GILD), which announced plans this week to set up a research collaboration with Chinese authorities. The plan is to launch a clinical trial with Gilead’s antiviral drug remdesir.

The coronavirus outbreak is expected to negatively impact medical device maker Boston Scientific (BSX). BSX ranked third in Health Care GRF. It reports that it expects to take a hit in sales in 2020 of between $10 million and $40 million due to the worldwide outbreak, according to BSX’s 4th Quarter financials released last week. The impact will be felt not only in sales, but also throughout its supply chain in China, which will be affected.

It’s important to stop here and remind readers that the coronavirus outbreak is one of many geopolitical risks that can impact a stock such as BSX. In the Measuring Geopolitical Riskpaper by Caldera and Iacoviello, geopolitical risk is defined as “the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations.” Taking just the vaguery loaded within the above description of 'tensions' is more than enough to make one appreciate the vast amounts of complexity within the geopolitical risk universe.

With over $12 Billion in annual revenues, the supply chain impact of the coronavirus on medical device manufacturers such as BSX may (hopefully) be negligible and more than than offset by intrinsic attributes that positively respond to most other geopolitical events. But if the outbreak continues to worsen, it’s highly likely that BSX will also feel the pain.

One of the interesting takeaways from this section is that we were never actively looking for companies positioned to benefit from bad news surrounding the coronavirus outbreak. The GRF did all the heavy lifting for us, with many of those impacted companies floating to the top of the charts during our analysis. With 3000 names to sift through in our initial portfolio universe, this also speaks to the GRF's incredible potential as a powerful methodology for use by the research analyst community.

Top Energy Names

Five of the top 10 companies with the highest GRF overall in our portfolio sit in the Energy Sector:

#3 - QEP Resources (QEP)
#5 - Oasis Petroleum (OAS)
#6 - Centennial Resource Development (CDEV)
#8 - Whiting Petroleum (WLL)
#9 - Parsley Energy

This past week an OPEC committee convened to analyze the impact the coronavirus will have on the supply of oil and prices. It will be interesting to see what conclusions they come to, but it’s less of an issue for the firms in our portfolio.

All of these firms listed above exhibit a single, common attribute: they are independent Oil & Gas producers with 100% of their operations located in the central United States. As such, they may be better insulated from production stoppages due to geopolitical strife, and doubly benefit from higher resulting prices, while the operations at larger multi-national oil & gas producers are at much more risk.

Top 3 Consumer Discretionary names

As a reminder, Consumer Discretionary is negatively correlated with the GRF and maintains a short position in our portfolio.

Publicly traded since 1992, the glory days of Bed Bath & Beyond (BBBY) appear to be well in the past absent any unexpected future turnaround. Poor management, executive upheaval and competition by online retailers have all contributed to its current state of affairs. BBBY relies heavily on its physical store locations and coupons mailers to entice foot traffic. When viewed under a GRF lens, it carries the dubious honor as the most negatively exposed stock to geopolitical risk, which in addition to all of its other problems adds yet another layer of risk for investors to consider.

Macy’s (M) has been all over the news lately due to its announcement that it will be closing 125 of its stores, representing 1/5 of its locations. While its e-commerce efforts have been making positive inroads, online revenues are still a small percentage for this retailer that still depends heavily on foot traffic at its expensive physical store locations. Given its size, this added wrinkle could mean that it's more susceptible to suffer because of major geopolitical events.

J.C. Penney (JCP) has the same real estate problem as Macy’s, albeit with weaker market penetration and brand.

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That's it for this week's analysis. There's a lot to chew on but we hope that that you found this exercise as useful and interesting as we did. We've only barely scratched the surface here, but it seems clear that applying GRF analysis across sectors and down to individual names can deliver powerful, unique insights not seen in any previous models. As always, please reach out to us if you would like to discuss Geopolitical Risk or any other topic in our corner of the universe that we can help you with.

US & Global Market Summary

US Market: 1/31/20 - 2/6/20

• After the coronavirus-driven stock market plunge that closed out January, the market saw a temporary respite with four consecutive days of gains as investors viewed the virus’ progress as less rapid than feared.
• This short window of optimism came to a screeching halt this past Friday as the US market slid (not captured in the above chart) despite a blowout January Jobs Report (see below) on the same day. News about the death of the doctor who discovered the illness and the addition of restrictions in Shenzen, a key manufacturing hub, poured more fuel on investor fears.
• Nonfarm payrolls surged 225,000 for the month, well above Wall Street estimates for a 158,000 gain.
• Following the Iowa Caucuses, a growing number of markets participants are starting to worry over the potential for Bernie Sanders or Mass. Senator Elizabeth Warren winning the Democratic nomination.
• The uncertainty around the coronavirus is expected to continue to carry more weight in the markets than corporate earnings or the consumer inflation and spending data expected in the week ahead.

Factor Update: Axioma US Equity Risk Model (AX-US4)

• Size saw a significant jump this week to become the biggest positive mover
• Profitability abruptly reversed course this week, erasing the slow, steady gains over the past few weeks.
• The rotation out of Value continues to intensify, tumbling to -2.74 SD below the mean, and takes over the top spot from a rising Earnings Yield as the most Oversold factor.
• Growth saw a slight dip, but remains in Overbought territory.
• Volatility and Market Sensitivity continued their tandem plunge into negative territory.
• US Total Risk (using the Russell 3000 as proxy) gained 0.20%.

Factor Update: Axioma WorldWide Equity Risk Model (AX-WW4)

• Size, Medium-Term Momentum, and Earnings Yield were the only positive gainers this week, which was the identical case in the US model.
• Similar to the US model, Volatility and Market Sensitivity both saw negative normalized returns, but now share the same spot hovering in oversold territory in the worldwide model.
• Similar to the US model, Value continues to get crushed and is now Extremely Oversold.
• Profitability continues its 2-week slide deeper into negative territory.
• Global Risk (using the ACWI as proxy) increased by 0.27%, the largest absolute move we’ve measured since early December

Regards,
Omer