In their latest Q1 2023 Letter, GMO explained why investors should consider shorting junk stocks. Here’s an excerpt from the letter:
Junk stocks not only underperform, but they do so with higher volatility and particularly struggle when times get tough. Hence, Junk companies are interesting candidates for shorting in general and can additionally hedge against economic risk.
A long Quality/short Junk portfolio with material net long exposure can compound over time with significantly more downside protection than even a long-only Quality strategy, let alone compared to broad equity indices.
Today, surveying an investment landscape strewn with unproven and unprofitable business models buoyed by years of easy money seems like an opportune time to take advantage of the full range of Quality.
We saw a similarly exciting landscape for shorting Junk in 2004 when we launched a long Quality/short Junk strategy called Tactical Opportunities. The objective was to harvest the Quality-Junk spread and provide a cost-effective hedge for equity risk.
The “Tactical” in the strategy’s name denoted that we saw unusual return potential at the time given the valuation gap between high and low-quality stocks (much like we have in the post-Covid years with GMO’s Equity Dislocation
Strategy, focused on Value vs. Growth).
The Tactical Opportunities Strategy was dollar neutral, and the higher volatility of our short book relative to our long book typically resulted in significantly negative beta. Once the tactical opportunity played out (as it did spectacularly well in 2008), the portfolio reverted to a narrower use case as efficient tail risk protection.
You can read the entire letter here:
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