Investing in Equities is all about managing risk. It really doesn’t matter where the market has been recently or where it is predicted it will be next week. That doesn’t matter. What is important is to understand the risks within your portfolio, your own risk tolerance and how well aligned each investor has these measures.
I manage several equity strategies, so in my world there are many ways to manage and measure risk. Basically, there is risk at each level of portfolio construction: portfolio level, sector, industry and for each stock.
Many portfolio managers measure each stock by its beta and then the entire portfolio by its sector exposure and its beta. This incorporates some top down theory with a mostly bottom up approach. The bottom up approach dominates the equity industry; the stock pickers. This is not because it is the only approach. I know technical traders who at times blow by bottom up stock pickers, in many market environments. I also know top down allocators who can out-perform many stock pickers. Each school of thought has its advantages, times to shine and its flaws.
The sectors themselves have developed reputations, but as in all facets of life, beware of stereotypes. There are growth oriented (think technology), cyclical (think industrials and consumer discretionary) and conservative (think consumer staples, utilities and healthcare) sectors by reputation.
Reviewing last week’s carnage, the smallest losses were in staples, healthcare and utilities, respectively, also known as the conservative sectors. But don’t always count on these sectors. Year to date it is still industrials and consumer discretionary which both touched plus 20% YTD at one point in April that are still up in this now flat to down market. So should investors pile into the less volatile and lower beta names and sectors as fast as they can? My answer is only if they are traders, have no tax considerations, have virtually no trading fees and have a blind eye to risk. You see the risk can be to the upside. The risk can be not participating in key parts of the market. A large part of the risk can be sectors not behaving as their reputation suggests.
I discussed some of my staples holdings with a reporter late last week, including some of the companies I have written about previously such as Procter & Gamble Company (NYSE: PG), and also included J.M. Smucker Company (NYSE: SJM), as well as Pepsico, Inc. (NYSE: PEP) in the discussion. These are S&P 500 multinational companies that pay nice dividends. They also come with risks. What exposure to Europe and the Euro does each firm have? Are these firms currency hedged? What about exposure to other global markets? Where will their profits come from in Q3 and Q410? How about 2011 and 2012?
I also looked at our healthcare holdings. The majors are having their own issues and markdowns based on continued legislative issues in this country and abroad. China is aiming for healthcare for most or all of its citizens, where will that lead? I lean away from the bigger integrated firms, but not completely.
Utilities are regulated and electric use is down almost everywhere. Factories are generating some of their own power through domestic, low cost, lower pollution natural gas. Where is growth going to originate for this sector and when?
So the knee jerk flock to lower beta sectors can work for a short time, but it is not an investment strategy. I didn’t sell Apple Inc. (NasdaqGS: AAPL) this week even though it dropped materially more than its sector and the S&P 500. The risk may also be to the upside, so perhaps I should have added to my AAPL position. The risk is not beating the market when it goes up as well as protecting on the way down. The biggest risk is clearly not being where one needs to be as this very uncertain, emotional, choppy market makes its way through the rest of this year and the next 10 years.
The risk can be a bailout of Greece with a plan for other weaker nations causing a global melt up after last week’s melt down. Earnings season, along with the ADP job’s report are telling a story that is different than the story the market told us last week. A wise investor who I have the privilege of working with says: the market is never wrong. I believe in him, his wisdom and his statement. My take-away from his statement is that the market is never wrong long-term. I believe the market is inefficient and highly emotional short-term.
I use volatility and relative comparisons to stocks, industries and sectors to measure risk, and it helps direct each of my strategies to align with a specific risk tolerance. On the other hand, I can raise or lower portfolio risk with a minimal number of surgical trades at anytime.
Are we back to a 2008 market for the rest of 2010? I do not believe so, but I am positioned to be properly aligned at a tick’s notice.
Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is currently long PG, AAPL, PEP, and SJM.