If you focus on the downside risk, the upside return will take care of itself




Tuesday 8 May 2012

Insurance - can play a larger role in portfolios

The reality is we seem to be in an environment where macro influences are more dominant than they have been over the last few decades. This may be because the debt super cycle is undergoing a turning point in developed markets, using the language of Bridgewater associates. As a result, we should consider having an insurance policy that protects against the negative influence of a change in the debt super cycle, the monetory cycle, or changes in productivity. These can influence the earnings of companies over different timing cycles. We can insure against these changing trends by studying how different assets move in these changing cycles. A percentage of the portfolio can then be allocated to insurance, say 5%. Using cheap insurance in securities that have a quasi correlation with a certain event occurring that may result in the equities generating negative returns - this is our offsetting element. Since we wish to deploy only 5% of the portfolio to such securities, we need to have embedded leverage, hence the usage of derivatives such as options. We pay a price to have protection against an extreme event by buying a call or put option on a certain underlying for a period of time (in general we want this product to have a similar time length as the underlying securities we have invested in).

Mr. Dalio, it´s good to think in risk, not assets

Today I must say Mr. Dalio hit me hard on the head. "Don´t think in terms of asset allocation, think in terms of risk allocation", he says. What is risk? How do you measure it? As you know from the articles in this blog, we expect to generate a certain return from an investment or will not proceed - hence our focus on valution. Our buy price is influenced by the cost of money (the risk free asset), and inflation expectations - as well as the return of other securities from that company, and the return of other companies securities. Hence our valuation is affected by our interpretation of the risks within the company, within the sector, and macro issues. If we do not see opportunities to buy securities of companies we will leave assets in cash, rather then guess what will happen everyday. We will wait for our fat pitch, the investment that we feel most comfortable with, hence we are less likely to loss money, and more likely to be successful in the investments we make. This is because we are not a large team, and because we have not built a large wealth of knowledge in macro economics, and how it affects the markets, and how macro events evolve. However, our return on investment focus, our investment process having a feedback loop from macro influences, means we do not allocate capital with a starting point based on allocation to equities or in bonds: we do not start from an asset allocation model, as Dalio warns against. We are prepared to take on a certain amount of risk for a certain return - if we do not find that opportunity, we do not deploy capital. Where Dalio differs is he incorporates in his investing that he will not know with precision what will happen. As a result he places off setting investments in case growth is not what he expects, or inflation is larger than he expects. We do this by security selection in portfolios, by having different companies in different businesses and sectors, with different catalysts and in different investment categories. However, most securities are equities, and hence will have a large beta component to their return. As a result, our instrument to fight against never really knowing everything - the margin of safety - will be of little use in the short term when markets fall - whilst Dalio´s offsetting trades can help him generate less volatility from trying to hedge where he may be wrong. We can say we dont want to spend the same amount of time on the areas we dont understand as much as the areas we do. But here we dont need to find different companies to short, as opposed to go long. Perhaps we need to spend time to find securities that are likley to bloom if certain things go against us in an investment case (this should be resolved through research of the company, unless very unclear but cheap to go short one item and long the other, then worth the risk), or maybe can offset beta risk. But the cost of shorting may eat away any alpha we may generate - hence we introduce a timing issue. When would be want to be short. When we see real problems and real extreme valuations. I have always tried to walk away from the timing problem by focusing on being long with no leverage. Each allocates capital to their skills. Business managers that dont short their sector in a recession are not poor managers - it is just they focus on the long term, rather than generating stable results on a monthly or quarterly basis. It is this preference that matters. Which depends on the skill of the manager, and the demands and expectations of the client. It is important this is well understood at the start of the relationship, or it will create problems just when their are enough problems already!

Dont forget organisation

Investing is a difficult business. The flux of information is large. As a result, an important skill is categorising data for easy reference in the future. To know what is likely to be useful, analysing this data, storing this interpretation for later reference to see how accurate the analysis was to assist in enhancing future understanding and knowledge, so past work helps to accumulate future understanding. To learn from others mistakes. Sometimes the size of this task hits you, and one must think not only about investments, but how data is organised and sorted. This helps effciency and will, no doubt, over time contribute to performance.

The Turnaround Investment Strategy

Buying a mature company whose stock price, and business fundamentals, in recent years have deteriorated is a high risk strategy. We are speculating that either (1) The business will improve more than the market believes, (2) that the deterioration has been exagerrated by the market and that the remaining earning power is being undervalued (i.e. that we better understand the business economics of the company than the market in general). We have a preference for category 2, as here we don´t have to fight the old adage, "turnarounds often don´t turn". However, in this strategy downside risks may be larger than other investment categories. We may under estimate the loss of earning power from poor management, changing market structure or obsolescence of the companies products, services and skills. As a result, venturing into this area must result in a potentially very satisfying reward - we would expect to at least double our investment in the next 5 years (approx. 15% per annum). We currently have two turnaround investments in portfolios. A defense company and an "old technology" company. Neither have significant leverage, hence have the ability to survive a financial shock in the short term should funding become difficult (i.e. less general liquidity as well as problems from their negative market label at the moment). Turnarounds also have advantages. There stock price performance can be less correlated to the market as its fortunes are often more greatly influenced by internal changes rather than external changes (i.e. less influenced by the macro environment, especially if a non cyclical revenue generator). Turnaround strategies must be followed more closely than other investment categories, i.e. relative to an asset play. We must be confident we are not seeing more deterioration than we expected - that the earning power we envisioned is still there and producing, that any changes to capital allocation are adding to sales and cash flow in a satisfactory manner. As a result, for such companies we closely follow quarterly earnings and the general news flow.