Planning for the end of the equity party

(Ed note: First published Sep 2018). Using a party as an analogy for the current equity market, we think this ten-year ‘party’ is about to finish. While we don’t know what time the lights are going back on, what we do know is that the music is getting louder and the people are getting crazier.  

Some are dancing to the music involuntarily (most index-based funds), some have thought it was entertaining to set their hair on fire (quantitative momentum funds), and a few others have just vomited all over the floor (deep value funds).

With the signs there, how can investors prepare for the end of the party? We saw some funds prepare for a down market three years ago, only to see the market keep climbing. Our approach to managing this risk is quite simple: We plan as if it would arrive tomorrow.

We have identified some markers that are effective at confirming a market downturn in the early stage and we are monitoring these markers. We divide our portfolio into five groups so that we know which stocks we will sell in a consecutive order. We are planning a number of scenarios for selling these stocks, depending on which situation presents itself.

The key to surviving a crash is liquidity. When everyone is rushing through the door, the midget wins. We don’t mind being the midget in this cycle. Currently, 80% of our portfolio can be liquidated around two trading days by selling at 25% of average daily volume.

The other 20% are stocks that we predict will either hold through the cycle, or there is a catalyst to exit within the subsequent six months. We know we could make 5-10 times our money in the next bull market, and so there is no need to be greedy in this cycle to chase the illiquid ideas.

What is the second order effect then? We are already preparing a list of stocks to buy after the inevitable crash. It’s all about being prepared to strike when the time is right. The next ten years will be a true stock picker's market, while index funds are moving slowly to recover the lost ground.

Concentration and correlation 

The first step in wealth creation is to survive these downturns, corrections and not get kicked out of the game halfway. In a practical sense, it means Don't bet the entire farm or Don’t put all your eggs in one basket, because we know we won’t be right every time. That is the reality of operating in the financial sector.

The second step is to ensure we don’t suffer a severe drawdown during a downturn. Every bull market provides the opportunity to make 5-10 times the money for a good fund manager. Our goal for portfolio risk management is to position the fund to better exploit the next bull market.

Portfolio risk management is all about controlling the luck factor. If an investment provides a guaranteed return that is satisfactory, we could just put all the money there and keep it ‘safe’. Unfortunately, nothing is certain in life. We need a portfolio because we do not know where luck will strike. As such, the two central aspects of portfolio risk management are concentration and correlation. 

We believe that a quality investment idea is a much lower risk proposition than many OK ideas. Because we know that the number of great asymmetric risk-reward bets are rare, we think that a concentrated portfolio of the best bets is the lowest risk approach. 

The key to managing concentration is to impose mandatory limits, such as 12% of the portfolio for any stock at purchase, and 30% at all time. These limits are there to prevent psychological biases of our success, such as falling in love with a great story, or overconfidence in our knowledge or analysis of a stock. 

The opposite of concentration is diversification. An adequately diversified portfolio is essential in order to adapt to a changing world. Having exposure to various trends allows us time to readjust the portfolio and to get in on the ground level when a new trend presents itself 

Correlation is to be avoided. This is because correlation increases concentration in an unintended way. When evaluating correlation, we need to consider the second and third order effects. 

• For example, a sharp movement in the Australian dollar would impact the profitability of an importer, which is the first order effect.
• The second order effect is the impact on the value chain of this importer, such as its customers, which may be related to another portfolio investment.
• The third order effect is how would domestic and overseas investors price these investments differently, as the relative attractiveness of Australian equity has changed compared to other investment opportunities in the Asia Pacific region. 

A good way to understand correlation is to determine the risk exposure for each stock and aggregate them on the portfolio level, then put some stress testing on each risk exposure, as well as in aggregate. 

For investors looking to create significant wealth over a 50-year timeframe, based on historical precedents you are likely to see at least 15 market corrections, 7-8 major downturns (including one GFC-scale one), and maybe a war or two. With this as your operating environment, it will be important to be prepared.