Thesis Asset Management's head of research discusses instinct versus research when it comes to stock risks.
'Markets are at high valuations and it is getting trickier to make compelling equity allocations. With many companies priced for perfection, stock-specific setbacks can cause shares to fall sharply. This can be a concern for alpha funds as concentrated portfolios are vulnerable to stock-specific news in an environment where the distribution of returns is skewed to the downside.
Investors may well seek to recycle the proceeds of profit taking into areas that have lagged. This is not straightforward on a geographical basis however; Europe and emerging markets do not present the valuation opportunities that they did a few months ago. An area which has performed weakly versus the overall market this year is value style investing. Small cap has also lagged in the US.
Followers of the work of Eugene Fama and Kenneth French will recognise these as components of their three-factor model, which extends the capital asset pricing model. For a similar level of systematic risk, Fama and French showed that value stocks (those with a low price-to-book) tend to outperform, compared to those with a high price-to-book.
Similarly small stocks tend to outperform larger stocks. This chimes well with our instincts. Who would not want to buy cheap shares rather than expensive ones, and the large companies of tomorrow rather than the large companies of today?
It is never a bad time to revisit core portfolio holdings that can work for the long term. With enduring potential for outperformance, boosted by a comparatively attractive entry point, these are styles that are worthy of consideration on a global basis. Moreover, both are areas where well-diversified exposure can be gained cost-effectively, via passive or smart beta funds.
Instinct suggests that active management would give the best prospects for smaller companies. They are less well researched, have less diversified businesses and are more exposed to idiosyncratic risk. This should be prime stock picking territory. However a study of the performance of global small-cap funds by Steven Richards at Thesis concludes that the biggest performance differentiator in recent years has not been stock selection, but allocation decisions between the various major global markets.
Some managers have been good at this and some bad, but the allocation effect tends to swamp the impact of their stock picking talent. One could take the active risk of picking a manager with allocation ability, but over long periods a global small-cap tracker performs very respectably against the active funds. We are buyers of the Vanguard Global Small-Cap Index fund.
Exposure to the value factor across global markets can be gained in a cost-effective systematic way via smart beta products such as the UBS FTSE RAFI Developed 1000 Index fund. The RAFI methodology weights companies according to fundamental measures, resulting in a counter-cyclical investing style.
Value investors run the risk that a stock is cheap for a good reason: it is a value trap. The large number of holdings in this tracker helps to dilute the effect of these companies, however, and the inclusion of free cashflow as one of the fundamental weighting factors helps to avoid some of the worst culprits.'
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