art vs. science, asset allocation, correlation, debt, diversification, growth vs. value, home bias, illiquidity, stock picking, stock selection, stock valuation, volatility
Well, it’s not ideal publishing another post in this series two months+ after my last post…but I’m obviously no post a day pleaser. And life, Xmas, stocks & markets, and sneaking off to the movies, all tend to get in the way! 😉 A quick (re-)read of Parts I & II might be in order, if you’re so inclined? But to recap, very briefly: In Part I, I stressed stock picking is really two distinct & independent activities:
a) Stock Valuation, and
b) Stock Selection
And all too often, investors confuse & conflate the two…
But presuming your quantitative stock valuation process is nailed down, then stock selection is obviously a far more qualitative process…it’s certainly not about ranking & selecting stocks purely in terms of their upside potential. Fortunately, there’s plenty of stock selection filters you can employ – for example, to help protect against the risks posed by home bias, bottom-up stock picking, and/or a concentrated portfolio. Of course, the overall objective here is to:
i) Ensure stock selection is as much science, as it is art, and
ii) Always strive for greater diversification & superior risk/reward in your portfolio.
Here are some other filters you may find particularly useful. No doubt, as you read, they’ll strike you as perfectly obvious…the trouble is, applying them consistently is easily forgotten when you’re considering individual stock holdings & potential buys, let alone when you’re trying to manage the overall risk/reward of your entire portfolio:
A classic failing of many a value investor is a sometimes fatal attraction to over-indebted companies. [Nothing worse than averaging down in a debt-induced stock spiral…]. But they inevitably look cheap from a value perspective: i) because the usual value metrics don’t adequately reflect the risks involved, and ii) even when adjusted accordingly, it’s still nigh-on impossible to properly evaluate & price the binary risk/outcome of individual success or failure (not to mention the leveraged volatility of their results). [And pre-crisis, investors forgot banks were the supreme example of ridiculously over-indebted companies]. Often compounded by a perception listed company failures are relatively rare – whereas, in reality, many just dilute existing shareholders into oblivion instead, and/or they struggle on never offering a decent return to shareholders. I’d call that failure too…
And much of the time, the average investor (or even fund manager) doesn’t care – if sentiment’s otherwise positive, they simply ignore the financial weakness of a company (in terms of balance sheet, or cash flows). So as a value investor, you’re: a) buying a stock you think is cheap, but which could collapse in mere days, if bad news hits/sentiment turns and finally/suddenly everybody else notices the company’s poor financials & bails out indiscriminately, or b) already trying to catch a falling knife!? What exactly is the attraction…greater upside potential? If that’s it, why not stuff your portfolio full of junior resource stocks?! As with those stocks, you have to ask some hard questions about management & the business – in this case, why is a company over-indebted in the first place? Just remember – old sins tend to beget new sins…
Companies that are unprofitable, and/or those that consume cash, can be considered to fall into this category also – they generally end up dependent on the success or failure of renewing/raising additional external financing (debt or equity). And more sophisticated investors will often avoid companies with (chronically) low margins & high fixed costs – effectively, these are leveraged companies too & present much of the same risk.
So, why crowd out your portfolio with these companies? Take a look, how many are in your portfolio right now…how seriously would a bad economy impact each of them? Why not opt for strong companies instead – you may look a little harder, but there’s plenty on offer with nearly/just as much upside, and without all that financial downside risk. And why not search & select for business models with low fixed costs & high margins? Or small companies where much of the fixed cost, i.e. HQ expense, obscures the profitability of its underlying business – how much is such a company worth if/when revenue growth drops to the bottom line, or an acquirer comes along?! Gotta love that kinda leverage… [Always check a company’s segment/divisional report – that’s where you find the potential multi-baggers!]
Over the years, I’ve progressively discarded & avoided such over-indebted & leveraged companies. The blog’s helped: We’d all love to be the genius who touted some huge recovery stock, but who wants to look a fool when one goes bust overnight – public scrutiny helps separate the bets from the investments! Absent that, if you really can’t get them out of your blood, why not treat over-indebted companies like the bets they are – carve out a little fun money from your portfolio, pick a few long shots, and roll the dice…
Here’s where many value investors also fall down on the job – they’re drawn irresistibly to small (& micro-cap) stocks, which tend to appear cheap most of the time. [Then there’s the defensive investor who only invests in lumbering large caps… Or growth investors, who have their own biases & foibles – they could employ, in appropriate fashion, some/all of these stock selection filters too]. Trouble is, they can stay bloody cheap for long periods of time. [The AIM All-Share Index, for example, has declined since its inception (in the ’90s)!] Now, I’m not arguing here against investing in small caps! In fact, studies appear to clearly demonstrate small caps substantially out-perform all other stocks (& other asset classes?) long-term. [Except maybe in the real world…I suspect the drag of investing bias & behaviour inevitably impacts average investor returns]. But an investor who’s predominately focused on small caps faces three key (& related) issues:
Valuation: As I’ve stressed before, there should be little/no difference in your stock valuation process for any company, whether it’s large or small…just let the numbers do the talking! But size is obviously relevant when it comes to stock selection – a simple tactic is to require higher upside potential. [In my mind, a large cap with 30-50% upside potential may well equate to a small cap with 75-100% upside potential]. Increased reward compensates for a small cap’s perceived lack of clarity/transparency & increased volatility and illiquidity, vs. a large cap. Even if you don’t perceive (or agree with) these disadvantages, most investors do & they price accordingly – so small caps often trade at a substantial & semi-permanent large-cap discount. But optimistic investors often disregard this, ending up frustrated & disappointed when their small cap investments subsequently fail to close this valuation gap. [Though obviously it’s not an issue for companies with a decent annual return on equity/capital – no multiple expansion is actually required to produce an attractive return over time].
Volatility: Small caps usually have lower turnover & a more limited universe of actual/potential investors – the general absence of institutional investors pretty much guarantees this. Accordingly, price action & return tends to be far more event-driven in nature – i.e. volatile/significant share price moves in response to good/bad news, results, or rumours, followed by long periods of neglect – whereas large caps tend to enjoy far more steady & measured appreciation over time.
Also, small caps are often focused domestically, and may have greater difficulty obtaining adequate financing, so they can be far more sensitive to interest rates, risk appetite & credit conditions, and the overall health of the domestic economy. For an investor who may already be suffering from home bias, this can really exacerbate their portfolio risk exposure.
Illiquidity: Of course, liquidity’s generally correlated with size, so a small cap portfolio is often relatively illiquid…and sometimes severely so, during a market correction or crisis. It’s only when you viscerally absorb this risk, do you realise a substantial portfolio allocation to liquid large caps is a great way to sleep easier at night. Sure, a sanguine long-term investor might disagree, because they’re comfortable with such a risk – but maybe they’re forgetting the opportunity that liquidity can offer…
If (& when) the market’s puking up ridiculous bargains at some point in the future, that’s precisely when small caps are guaranteed to be far & away the most illiquid. But having the ability to raise significant amounts of cash from liquid large caps, at the click of a button – to scoop up bargains all around you – could prove to be a once-in-a-decade/lifetime opportunity.
OK, in the long-term, all these small cap risks obviously become far less impactful & important. But meanwhile, that long-term is often very difficult to see, esp. when the short-term outlook starts looking grim… How comfortable will you feel if/when large caps outperform small caps for months, or even years, at a time? Can you live with a company whose stock only moves appreciably twice a year, when it publishes results? How much patience do you have when the market and a management team neglect a share price for years on end? And what are the chances you may finally crack in some crazy market meltdown, and purge your small caps at any spread & any price?
Look, we all know there’s obvious pros and cons for both large & small caps… But down in the trenches, it’s hard to predict how you’re going to experience & react to those pros and cons day-by-day, and who’s got a clue whether large or small caps will lead in the next few years – a well-rounded portfolio in terms of market cap/liquidity is an obvious & excellent solution. And while a barbell strategy is tempting, one can argue a mid cap portfolio allocation is just as important & sensible – in fact, knowing how many investors focus almost exclusively on large or small caps, mid caps may well offer the best risk/reward proposition much of the time.
Again, sit down – this doesn’t have to be a daily/weekly exercise – and tag each of your current holdings in terms of market cap, and/or liquidity (again, size & liquidity are pretty much correlated). [Yes, there’s highly liquid small caps out there…unfortunately many of them are liquid simply because they’re speculative rubbish that sucked in the punters]. No need to be exact – everybody debates respective cut-off points for small/mid/large caps, so choose your own (sensibly). If you don’t know the market cap & liquidity of some of your stocks, at least in ball-park terms…you may need to get a little better acquainted with your portfolio! And no need for fancy spreadsheets, or formulas – well, a pie chart would be a nice visual – any excuse really to consider (and/or reconsider) each individual portfolio holding is always a great idea, and shouldn’t take so long. Of course, your current (& target) market cap/liquidity allocation then comes in very handy when evaluating the most appropriate buy (& sell) candidates for your portfolio.
Next, let’s consider how correlated your portfolio is… Once again, no need to blind yourself with science, or statistics – a finger in the air & guessing the wind direction is perfectly sufficient. We have three types of correlation to think about:
Economic: What stocks do you own which have businesses (and/or business models) which are less correlated, or even uncorrelated, with the economic cycle? Food & healthcare stocks are the classic defensive sectors cited by the brokers, but there’s more out there – for example, utility stocks, and sin stocks like alcohol & tobacco. Some of my personal favourites are agriculture & undertaking…preferably not together. Of course, there are also plenty of stocks & sectors at the other extreme, i.e. they’re highly correlated with the economy – but frankly, most portfolios would benefit from less, not more, correlation.
Market: In reality, just about all stocks (even those with uncorrelated businesses) tend to exhibit a level of correlation with the market – if you invest in equities, that’s inescapable. But you can still meaningfully distinguish between stocks that display a high or low degree of correlation – usually expressed in terms of a stock being a high/low beta stock. The reason(s) for a stock being low beta are often obvious – for example, it’s a defensive food stock, but a company’s business model, the quality of its management, its earnings history, its financial strength, the size of its free float, etc. can all make a relevant contribution.
Conversely, a high beta doesn’t necessarily mean a stock’s low quality (though obviously speculative stocks/companies are usually high beta). It may simply reflect an economically sensitive stock, or a company that’s directly/indirectly leveraged to the market itself – like brokers, banks, asset managers, private equity firms, etc. And sometimes a stock is high or low beta for no discernible reason – nothing wrong with classifying it as such, as long as you keep in mind betas can & do change (sometimes abruptly, like all correlations).
Of course, hedge funds/alternative assets are another useful option… [But over the decades, the average hedge fund’s become increasingly market-correlated – global macro funds & CTAs/quant funds, for example, may be a better alternative]. Genuine event-driven stocks are also attractive – specifically, those where value-enhancing/realising events are expected to occur within a well-defined time period.
Negative: For some, negatively correlated stocks are the holy grail. These may exhibit some level of negative correlation with the economy – companies dealing with distressed consumers & businesses can particularly thrive in a bad economy, or outright recession. Distressed debt can be a particularly attractive asset class in that kind of environment. Then you also have stocks/sectors which may be negatively correlated with others in your portfolio – oil-related stocks vs. transport-related stocks (particularly airlines) serving as an excellent example in recent months. Finally, there’s the really exotic stuff – like the VIX, for example – yes, it’s negatively correlated with the market, but unfortunately its more retail-oriented incarnations to date are more likely to have negatively affected your wallet!
Overall, correlation’s a particularly interesting stock selection filter. Because it’s not always obvious how one should classify a stock, or which stocks & sectors might offer better alternatives. Which presents an obvious opportunity to dig that much deeper into a business, or a sector, and to distinguish between market myths & facts.
There’s also the challenge that classic defensive stocks are often over-priced. [Esp. today, as many are prized for their emphasis on steady/rising dividends]. Beyond a certain price, lower correlation risk mightn’t be worth paying for, or a less obvious alternative should be sought out/considered. [NB: Agriculture has its own specific issues/cycles, but I generally don’t find it over-priced in relation to its lack of economic/market correlation].
You may also need to re-examine your attitude to risk/reward as an investor – most people love the idea of an oil stock hedging an airline stock, then get frustrated when one stock always seems to be a loser, while an event-driven investment’s fairly predictable risk/reward may suddenly appear rather meagre when the overall market’s charging ahead!?
To Be Continued…
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