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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • High Beta Value Isn't Working Right Now  4 comments
    Oct 29, 2012 10:59 AM | about stocks: SPY

    As 2012 drags toward a close, I'm looking at a modest 6% level of outperformance for the year to date, hardly consistent with the risk assumed. Using a screener, I've developed a number of strategies that backtest well, and involve less risk than what I usually do.

    A portfolio of low beta, high quality dividend payers would have done extremely well over the past ten years. An article on the screen collected a lot of page views, and a fine stream of comment and discussion. That leaves me with a decision to make: should I change basic strategy, or continue with my normal approach, which hasn't been working?

    This article is about using a screener to backtest a simulation of my basic investment style, in an effort to develop an opinion as to whether I should continue with it.

    High Beta Fundamental Value Investing

    Looking back at over ten years of investing, I've always looked for value in the sense of low multiples on common metrics, primarily P/E and P/B, or the similar P/CF and P/TanB. For whatever reason, I have a history of favoring high volatility, reflected in an average beta well above 1 for my portfolio. Here's a screen:

    • In S&P 500
    • Beta > 1
    • Long term debt < 50% of Capital
    • Rank by (PtanB*1.5)+(P/CF), select best (lowest) 30
    • Rebalance every 3 months

    Taking the maximum period available for the back-test, from 1/2/1999 to the present, this portfolio returns 10.3% annually, with a maximum drawdown of 69% and alpha of 7.7%. Risk and reward are in balance, and there's nothing wrong with doing it like that if you can stomach the volatility.

    Here's the rub: this same approach, backtested from 4/1/2011 to the present, returns -10.3%, annualized, and provides alpha of -17.5%. My results for both time frames are similar, so the screen is useful as a general description and model of how I invest my discretionary portfolio.

    How Fast Does It Snap Back?

    This approach is not designed to track the market, and it will underperform from time to time. Here's a chart of its relative 1 and 2 year performance against the S&P:

    (click to enlarge)

    Periods of outperformance and underperformance alternate, with underperformance lasting for 2 years or more. Just looking at the chart, the relative 1 year performance has been rising, and if it maintains its trajectory and reaches previous highs of 40% or better, good things will happen.

    The going up will be worth the coming down.

    Stocks: SPY
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Comments (4)
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  • Richard Glenn
    , contributor
    Comments (111) | Send Message
    I really appreciate your willingness to share things that are not working. Can you really stomach a 69% drawdown? That would feel awfully close to a total wipe out to me. I think limiting max drawdown is one key to a system that you can stick with over time. The longer I invest, the more conservative I get, I guess. Thanks again.
    29 Oct 2012, 03:12 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Richard,


    Thanks for your comment. I went through a drawdown somewhat worse than that, during the financial crisis, and stuck with my style. If I had changed style or panicked I would not have been able to recover. I don't want to do it again.


    Curiously, if the beta rule in the screen under discussion is reversed, to require beta less than 1, the max drawdown goes to 42%, compared to 55% for the S&P, plus the annualized return increases to 13%.


    I'm a little suspicious of the role of beta in this backtest. It could be that we are at the peak of a risk-off cycle that will reverse sharply, or that betas generally will start to come down if volatility stays low.


    One advantage of being a retail investor is, I don't have clients to impress, so I can discuss these things and get some feedback.
    29 Oct 2012, 04:32 PM Reply Like
  • Richard Glenn
    , contributor
    Comments (111) | Send Message
    Backtesting through the 07'/08' crisis is a good way to look at a worst case in action, but I wonder how useful it will be looking forward. Insurance stocks and banks traded like biotechs, but I would bet that we will see a huge mean reversion in beta for them over the next decade as the "lessons" of the crash are slowly forgotten. It seems to me that a lot of risk has been taken out of these sectors, and now they are a lot cheaper as well (vis a vis normalized earning power).
    30 Oct 2012, 03:26 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » I've been looking at the 2000-2001 bursting of the tech bubble also, it's possible to construct credible portfolios that would have had very good outperformance during that period. Anything that stays pointed at fundamentals would have done well.


    Before the tech crash, the market lost sight of the fundamentals. Before the financial crisis, the market lost track of financial risk, even as the players involved were devising progressively more risky business models. The result is extreme risk aversion.


    So I think you're right, what I'm seeing as trouble with high beta generally will revert to the mean, whether betas go down, or market acceptance of risk goes up.


    Long-term I'm planning to do something that has slightly less beta than the market, but for now I'm going to stick with what I've been doing. The market just doesn't value the earnings of certain companies at any kind of a multiple, it's as if risk trumps everything.
    30 Oct 2012, 04:23 PM Reply Like
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