Value Investor as a Portfolio Manager
I’ll focus more about portfolio construction (so bear with some stock picking assumptions).
Stock Analyst -Value Investing
Let’s imagine you are good been value investor. While, picking stocks you are looking for opportunities where there is chaos (or in financial parlance volatility is high). Lets learn from an example:
The company you are looking for has varied less in its cost over past twenty years in comparison to competitors. As an example when looking for financial stocks the NPA in a down year is lower than competitors, & in an up year is lesser than competitors (It is called competitive advantage/Moat). Or using mathematical sense, the volatility in NPA over the time has been lower than competitors and you think the market price in its current parlance of painting all with the same brush is considering this sector (ignoring stock) to be more volatile in future. In addition, you assume nothing has changed significantly from the past. Considering these parameters you arrive a value with a range (volatility) very rough approximation. If market price is significantly cheaper then your estimate you allocate.
In essence what you are essentially betting is the future volatility (for those who don’t know exactly volatility lets say range/panic) of the stock price will be lower than current, with value converging at your estimate .
Assumption – (Considered, mathematically Law of large numbers requires, independence & bounded variance assumption, plus a lot of experiments, ergodicity, etc, but let’s leave it for some time. Let’s assume you have ensured all this with this particular company or you believe so and you have ensured this on a portfolio level)
Value investing is betting that the market is mis-pricing volatility and future volatility of the stock(Company earnings etc) will be lower, when the cycle will turn.
Assumption- (Believe me I am simplifying there are lots of other nuts and bolts).
This logic works amazing if you are a stock picker and life was easy. Lets, shift ourself to being a Portfolio manager. Or look for questions like, does it work on a Portfolio? What is the job of a portfolio manager? Why it is different from stock analyst in a value investing context? Why it is said that holding a good stock isn’t equivalent to having an excellent portfolio? Etc….etc…
Portfolio Manager (Value investor)
Let’s assume you are an excellent stock picker and you get majority of your bets (2/3rd or may be 55-60% right) & you have a positive portfolio expectancy.
Still you are likely to make some errors?
A question, a portfolio manager, needs to keep on answering is how much cash to keep in the portfolio? Or reframed another way, How much is the tail risk in the market? (By tail risk I mean market falling together almost all stocks – dependent – or crash together significantly). It happens rarely very rarely if one thinks (may be less than once a decade), though it is what makes significant difference to the returns over time.
If value investing is done sensibly a portfolio manager has to keep balance between cash and finding new opportunities.
Lets assume you are portfolio manager (You have fixed cash & you wont be ever given more money to invest) you enter the market with 100% cash, & when you enter there is a 2008 kind event, you find wonderful opportunities and may be 80% of the cash gets allocated. As the cycle matures, if you are doing your job right, the cash portion of the portfolio should go up, as you’ll see less and less compelling opportunities over time. In addition, you’ll see others not pricing the tail risk right, you’ll take slowly money off the table.
If done right, when the next crash comes (may be after decade), you’ll have high portion of cash to take advantage of such opportunities. As by definition, that is when the assets are cheapest. Having cash at such a time, when others don’t can do wonders.
If you do not so, when the next crash comes you’ll be like others having no cash to take advantage of the misplacing prevailing in stocks.
This dynamic shifting between keeping cash (Pricing tail risk) and finding new opportunities (selling volatility) is the fundamental job of a portfolio manager which is rarely talked of.
If talked to option traders (tail risk hedgers),a crude analogy could be, its dynamic adjustment of the ratio between buying vvol (otm put options- keeping cash) and selling vol (finding new opportunities).
The best portfolio manager (businessman) will price this thing in the most cost effective manner over time, in addition to deploying when opportunities arise. In other words he will be the best combination of a portfolio risk manager, in addition to an excellent stock picker.
Appendix:
Problems?
It’s very dynamic, in addition to getting the timing right is a very tough job. Since these decisions are hardly few in a lifetime, most fund managers change job profiles. Standard statistical tools fail (very few work sometimes, since there is no past data)
Plus imagine looking fool holding cash more for a long period of time or underperforming the market by 20%. It’s easier said than done.
Biggest Problem- This cost effectiveness is rarely visible.Most of the times this fund manager will underperform in excellent time, due to the cash buffer.
Are there other nuances?
If we drop our assumption of fixed cash, most portfolio manager, businessmen keep on getting additional cash each year. So it becomes a question of redeployment.
Not selling some businesses ever, actually means most of the times the fund manager wont deploy additional cash to those businesses at some new prices, which automatically increases the cash position in the portfolio.
Are there other tools?
Yes, But again these all depend on how much others are keeping slack in the portfolio vs how much you are.
There are some tools to build your portfolio – diversification, redundancy in portfolio earnings, not over betting on one kind of idea, using a time based stop loss(selling after few years if the idea doesn’t work, revisiting the thesis),checklist, etc.
What if stuck in a crash?
If you are stuck in a crash in fact, then it makes sense to switch to other cheaper stocks (considering opportunity cost).
Even if over few of such crashes the portfolio manager held cash, he is likely to significantly outperform the market.
Some other small implications:
a) Doing value investing on huge leverage is bound to make sure you wont get such opportunities. (There are graveyards of banks trying to do it)
b)Focus on talking about multi baggers or stock specific advice gets less important.
c)Very few fund managers can do it
Does it work in extreme situations or Markets which have been in drawdown for long like Japan, some European markets, Pakistan, Bangladesh or in war like situations or hyperinflation?
Yes, somewhat if the country survives, it at least gives you the cash deploy at right times in a diversified pool of assets at cheap prices or helps you avoid a significant loss of capital.
Sources:
(Not all can be listed besides experience, some which inspire or right on the similar problems)
A) Prof Sanjay Bakshi, https://fundooprofessor.wordpress.com/2017/04/26/checklist/
B) Berkshire Hathway letters, Warren Buffett
C)Raphael Douady & Thomas Barrau,Artificial Intelligence for Financial Markets: The Polymodel Approach
D) Nassim Taleb Incerto (including Statistical consequences of fat tails)
E) Tail Risk Hedging (Vineer Bhansali)
F) Safe Haven, Mark Spitznagel
G) Mathematics, Its Content, Methods and Meaning (A.D Alexksandrov, A.N Komogrov, M.A Lavrent’ev)- Not same topic but helps in getting some things
Exit Strategy 