Improving Risk Management Protocols For Value Equity Investing
By David Kaiser
Many investors can agree that when investing in equities there should be a focus on risk management, from securities selection to monitoring and managing the portfolio as a whole. Unfortunately, there is no universal standard for what constitutes risk management.
While this is a challenge for the portfolio manager it is of equal concern to sophisticated institutional investors, both for when they are conducting due diligence vetting on the investment processes of multiple portfolio managers under consideration, and then for monitoring a portfolio’s exposures once they have invested with the manager they chose.
When it comes to value equity investing, and the traditional approach taken for it, things can get tricky regarding risk management protocol selection and execution; again, both for the portfolio manager and prospective sophisticated investors. The reason is that traditional value investing tends to follow a subjective, fundamentals-based approach to conducting company research, securities selection and managing the resulting portfolio. That can be challenging for defining risk management protocols that can be followed with consistency.
How subjective and how structured?
These are among the questions institutional investors ask themselves when evaluating value equity managers and looking into the risk management protocols embedded in their investment processes. Also critical is whether risk management related protocols are being set and followed with consistency.
How is the portfolio manager attempting to determine if a company is discounted and whether it should be bought, sold or held? The more subjective the investment process, the less structure it may have, and the resulting gray areas of strategy implementation may result in variability as to the guidelines a portfolio manager may be following. How much might a value equity manager’s investment methodology shift and drift, and what might that portend for the value of its risk management decision making?
Sophisticated investors can rightly feel that the more amorphous a portfolio manager’s ‘must have’ and ‘nice to have’ characteristics are for company selection the weaker risk management may be for that stage of the investment process. Further, could the manager’s reasoning for buying and selling companies in the portfolio change over time, or as market conditions shift? (The reasons why a portfolio manager buys and later sells a company could be completely different.)
This is where a prospective investor evaluating a value equity manager will be looking to uncover whether subjective bias and rationalization are potential risks not addressed well enough in the investment methodology. Having strategy implementation consistency regarding why a portfolio manager buys, holds and sells, can help better identify and mitigate risk. Lacking that consistency, the value equity manager may end up making risk management related decisions on a case-by-case basis. That can reasonably make a prospective institutional investor wary of variability in that manager’s strategy implementation.
Could risk management be improved for value investing?
We believe the answer is Yes.
We believe that the key to improving risk management protocols for value equity investing is to apply a data-driven, multi-factor analytics, rules-based methodology. By applying a fixed, quantifiable structure, there is the potential for more consistent investment decision making for the portfolio manager as well as improved portfolio evaluation and monitoring ability for the prospective investor.
Contrary to what many people often assume, the idea of data-driven and rules-based value equity investing is not a foreign concept. Value investing legend Benjamin Graham was a fan of formulas and parameters. Back in his time, when financial data was hard to come by and had to be compiled and analyzed manually, he spoke of what he referred to as Net-Net investing analysis: analysis focused on a firm’s net current assets. Graham had criteria in place for what he believed was an acceptable investment. Today we have ready access to far more company specific information as well as tools to aggregate and analyze it more effectively and with greater consistency.
When conducting value investing with a methodical, evidence-based analysis focus, the entire universe of companies can be the starting point for filtering down to a portfolio manager’s investable universe. Further — and we have found this to be a fascinating point — portfolio managers implementing a data-driven style of value investing are not limited by what particular companies or industries they believe they know in depth or have extensive exposure to.
If one can structure and apply a data-driven approach for value investing then an often asked question from prospective investors — Is it a repeatable process? — can be answered Yes. The reasons for these can be as consistent and as simple as, We buy and own it if it meets our criteria. If it no longer does, we do not own it. It can be black and white risk management protocol.
Additionally, we understand that no single metric equates to stock appreciation or to downside protection. Therefore, we believe it is prudent to take a more holistic, multi-factor analytics approach that views the whole picture. Some metrics may be more heavily weighted than others but taking a group of metrics into account can be helpful for both analyzing companies and a portfolio of holdings.
Monitoring the forest while keeping an eye on the trees
We believe multi-factor, data-based analytics can improve value equity portfolio risk management at the portfolio level as well as at the individual stock level. As sophisticated investors (and portfolio managers) appreciate, the investment objective should be that the portfolio as a whole does well, not that every holding in the book becomes a win. For this, a quantifiably measurable combination of company holdings characteristics that comprise the average for the portfolio’s whole basket of holdings could be compared and contrasted to, say, some appropriate index benchmark. This can be a transparent way to see whether a portfolio is delivering more and stronger company strength and discounted valuation characteristics, or not.
Importantly, we believe that owning a value equity portfolio that in aggregate is discounted could result in upside potential and more downside protection to the book. A data-based analytics driven investment process can have the potential to measure and monitor that.
Examine the risk management rules
For the prospective investor evaluating the value equity portfolio manager’s process, inquire about their active management of the book. For instance, are there set parameters relating to actively monitoring at the portfolio-level, whether in terms of portfolio price movement or other factors? Also, evaluate risk management protocols at the stock picking and asset allocation stages. What thought has the portfolio manager given to what type of companies are allowed in the portfolio? Additionally, what do they do if company specific factors change (e.g. if a profitable company becomes unprofitable), what valuation-related risks do they tolerate, and how often are these factors being evaluated?
The more structure and consistency to rules-based risk management that you find in the stock-level buy, hold and sell decisions and with the portfolio-level monitoring and active management at the basket of holdings level, the better. Those can be signs of a repeatable value equity investing process. Add to that the removal of subjectivity and potential bias in portfolio management decision making, which a data-driven multi-factor analytics approach further adds to the mix, and you may uncover opportunity to allocate where you think there is the potential for a strategy to deliver an improved risk/reward profile due to improved risk management protocols.
David Kaiser
Managing Partner & CIO
Methodical Investments LLC
Our intended role within an investor’s total portfolio is to provide capital appreciation potential from exposure to potentially undervalued companies that have, in our opinion, strong operating characteristics.
Our goal in our flagship fund, Method Investments, LP, is to outperform the Russell 2500 Value Index benchmark over a 5-year rolling period, in an attempt to add alpha without adding commensurate risk.
from website: personal bio (different than bio at end of article):
David has over 19 years of industry experience and worked with quantitative strategies before entering the financial industry. He always looks for efficient and effective ways to grow assets using equities. His passion is value investing, but his focus is on quantitative, automated, and unbiased approaches.
