The Problem With Stock Picking in a Down Market (SAN)

Roger Nusbaum submits: A friend pinged me this morning asking/saying we are in a bear market. He then said "now I know why you are not bottoms up." This was a reference to my a being top down manager in which the focus is on the big picture first, then focusing on sectors, countries, market cap, style and a couple of other things before selecting stocks.

It is kind of tough to label, what is now, a single digit correction as a bear market. There was a point last week where the S&P 500 was down double digits but that was just for a couple of hours. While the idea of 10% equals correction and 20% equals bear market seems too simplistic, I would not be surprised to see the market go lower, which has been my thought for this year all along.

In the last six weeks, picking stocks has been very difficult. During periods like this, when nothing is working (by the the way, there is nothing unprecedented here) picking a good company to buy is like swimming upstream. While I haven't tried to find one, I can't imagine that there are too many emerging market stocks up since May 10.

I have been writing about my fondness for Chile as an investment destination for more than a year. There are two catalysts, global demand for copper and systematic public pension contributions going into the stock market every pay day which means constant demand for stocks.

Neither of those catalysts have changed but the stock I own for Chile, Santander Chile (SAN) has gone down 19.5% since May 9 (I chose May 9 instead of the 10th as above because it closed higher on the 9th than the 10th). Assume for a second that I am right about the fundamentals about Chile -- that has not mattered. What has mattered is that emerging markets have been sold down and Chile went along for the ride.

To me, this is a big pitfall for relying solely on bottom up stock picking.

Comments

[Amit Chokshi:]

If you're not a value-oriented bottom up manager you're going to struggle in volatile markets. Disciplined bottom-up managers have at least some anchor point on valuation that they can reference. While those points are widely subjective to model inputs, value-oriented investors are generally conservative in these estimates when trying to determine whether a stock is a good buy or not.

It's tough to find stocks with adequate margins of safety, you picked an emerging market stock that at $7BN in market cap is probably a bellweather market stock/proxy for the Chilean market. When investors get scared, stocks like SAN will take the brunt of the punishment for the Chilean market, just like TKC would for the Turkish market.

I'd imagine bottom up investors have a much more patient time horizon from which to realize investment returns as well. Big deal if you lose 20% off a sound investment and sound valuation point due to a market correction, buy more if the fundamentals still support it. Averaging down for general investors who play without a margin of safety is one thing but in many cases the decision that results in whether you win or lose on an investment is what you do with it once you take a hit off your initial position.

Also, you speak of your fondness for the Chilean market, I would argue that many of the basic macro/top-level points are the first things to be priced into any stock. Witness how CTC has done over the past year.

Secular bear markets serve fundamental, value-oriented bottom up managers the best. Rotating in and out of sectors based on mainstream macroeconomic ideas will run up transaction costs and most times the manager will be too late to accrue the real alpha of that sector (real returns might be 30% for a sector but by the time the manager gets in he only gets 15%, which might be poor on a risk adjusted basis).

Bottom up analysts do value general economic trends but the focus is on industry specific trends and views that can directly impact a company and not broad secular themes.

2006 Jun 20 02:43 PM

[Amit Chokshi:]

Top-down approaches result in herd mentality in that top-downers generally focus on broad secular themes that everyone, including the market, is/has already priced into securities. In essence returns are largely just driven by the risk assumed. By the time one figures out what sector to get into, the initial "risk-free" gains have already been made.

Also, time frame needs to be considered. If you're going long in any emerging market, the higher volatility requires one to be willing to have a stronger stomach and higher level of patience. Big deal that SAN is down 20% from its high, it's a large bellweather stock on the Chilean exchange and like a TKC on the Turkish exchange, serves as a proxy for its country's market. If the fundamentals are strong, buy more. The focus on the initial buy-in or a 52 week high price is a behavior flaw. The real value of a money manager is from what he/she does when a stock is down that 20% in terms of adding more, getting out, or just being patient.

2006 Jun 20 09:24 PM

[Roger Nusbaum:]

Amit,

You have made a lot of generalizations that have not been the case for the portfolios I manage. You can visit my blog if you are so inclined but I started reducing emerging markets in late April.

Further I have chronicled several defensive steps taken that have allowed the account I manage to hold up well during this.

I don't know about any other top down people but your comments <strong>very<... of the mark if you are applying them to me.

2006 Jun 21 07:34 PM