Category: Diversification

Claims of the “Death of Stock Picking” Are a Good Sign for Value Investors

A recent Wall Street Journal article highlights the macro-driven nature of today’s stock market.  In it, long-time value investors lament the current environment where stocks appear to trade in unison based on unemployment data or European bank stress test results.  If stocks are driven by macro factors instead of individual company fundamentals, stock pickers can’t get an edge.  Market strategist James Bianco of Bianco Research asserts “stock picking is a dead art form.”  Macro hedge-funds are opening at a rate equivalent to that of traditional stock funds and the big asset management firms are even launching macro mutual funds.

We think stock-picking is very much alive.  In fact, we recently wrote a 20-page investment guide that details a bottom-up approach for today’s environment.  Call us contrarian, but we couldn’t think of a better sign than this article that fundamentally-driven, bottom-up stock-picking is likely to make a comeback sooner rather than later.  Didn’t the commodity bubble burst right around the time that the asset management firms were rolling out a new commodity fund or ETF every week?  Moreover, didn’t “the death of equities” cover stories in the early 1980s signal the start of a 20+ year bull market for stocks?

The Wall Street Journal article presents data that shows the correlation of stocks in the S&P 500 between 2000 and 2006 was 27% – quite a bit of disparity indicating undervalued stocks could appreciate and overvalued stocks could depreciate as opposed to trading up or down in unison.  The article also points out that correlation spiked to 80% during the credit crisis and again more recently during the European sovereign debt scare.  As these issues petered out, correlations never dipped below 40% and today hover around the mid 60s.  However, the article does not point out the length of time over which the correlations were measured – days, weeks, months?

The time period over which the correlation is measured is critical.  “Time arbitrage” has proven to be a very effective investment strategy.  Who cares if individual stocks are correlated over days and weeks when your investment horizon is years?  Glenn Tongue (one of the Ts in T2 Partners along with Whitney Tilson) highlights this fact in a recent appearance on Yahoo! Finance.  Like us, the partners at T2 believe buy-and-hold stock picking is far from dead.  Mr. Tongue also makes a critical point about matching the duration of the investment strategy and the investors.  This is why we work very hard to ensure our investors understand our process before they become clients.

Don’t misunderstand our view.  We agree the data shows a significant increase in correlation between individual stocks (and we witness this as we watch the market and our individual names on a daily basis).  We also agree that the macro backdrop driving the market will remain for some time.  The over-leveraged PIIGS, US federal and local governments, and the US consumer will likely take years to adjust to sustainable levels.  In addition, the massive government intervention in fiscal and monetary policy does not appear to be subsiding with Bernanke and company preparing for QE2’s maiden cruise.  (We have discussed these issues at length in several of our recent quarterly letters.)  The market will certainly react to macro factors over short time periods, but that doesn’t mean significantly undervalued stocks or significantly overvalued stocks won’t gravitate toward fair value over a longer period of time.

In our recently published investment guide titled How to Prosper in Volatile and Range-Bound Markets we detail the strategy we are employing to deal with the current environment.  We believe a concentrated portfolio will be more likely to outperform – a few deeply discounted names that are returning capital to investors (via share repurchases or dividends) and that also have a catalyst can outperform even if the majority of the market moves in unison.  In addition, the flexibility of corporations to deal with macro shocks (be they slower growth, inflation, government regulation) means equities have a better chance of outperforming government bonds, currencies, or commodities (areas macro funds are more likely to play in).  Finally, we think valuation-based timing will be more important than it has been for traditional stock pickers.  While Japan’s macro-driven market now trades at close to a quarter of its peak value 20 years ago the market experienced four rallies and five sell-offs of greater than 30% over that period.  That type of volatility creates terrific opportunities for value investors to increase exposure as the macro shock of the day creates fear and to pare exposure as the fear fades away.

For a more detailed overview of our approach, you can download our full 20-page investment guide here:  www.greyowlcapital.com

Not All Diversification is Created Equal

A few days ago, the Wall Street Journal ran an article, Focused Funds Find Less Can Be More, highlighting the value of a concentrated investment strategy.  It is a good, short article on the topic, but it misses an important point about diversification.  The author writes, “Diversification is a tested way to control risk – a stock that represents 1% or less of a portfolio can’t inflict as much damage as a 5% position.  Diversification’s downside is that it limits a fund’s chance to meaningfully outperform its index.  Moreover, an overly diversified portfolio can mimic an index fund, but at a much higher cost.”  The second and third sentences are certainly true, but the first leaves something to be desired.

It is mathematically correct that if a 1% position goes to zero the overall portfolio only loses 1% of value, whereas a 5% position could cause a 5% loss of portfolio value.  However, a 100 stock portfolio may only be more diversified than a 20 stock portfolio in the number of company names it holds, as opposed to diversified from true risks.  It comes down to what you are trying to diversify and why.  Imagine recognizing in early 2008 that the financial sector was overvalued and significantly over-leveraged.  If you built a 20 stock portfolio with no financial sector exposure based on this belief, your 20 stock portfolio would have significantly outperformed the 500 stock S&P500 index during 2008.  True risk would have been diversified away.

Thinking about investment diversification based on number of investments alone is a mental crutch and a poor risk-management tool.  One needs to look at a broad spectrum of potential economic factor risks (i.e. risks that can truly impact the intrinsic value of the security you own), as well as market risks and diversify exposure to the most likely and the most potentially harmful.  A few examples of what we would consider relevant risks to diversify are:  capital structure, inflation sensitivity, supplier, consumer, and legislative exposures.