Identify Your Strategic Risk Points

• The ease of Momentum Investing
  
• Patience rewarded
  
• The lessons from sports
  
• Managing the strategic risk in the portfolio

The ease of Momentum Investing

The great investment counselor Will Rogers told us to invest in stocks that went up and not the ones that went down. In essence he captured the kernel of momentum investing. Find a series of numbers that go up with each reading, higher than the prior one. When the string is broken get out. Simple enough to say, but more difficult to put into practice - nevertheless many try. Below are some of the time series that investors have used:

• Daily, weekly, monthly, last 50 or 200 trading days’ stock prices: the longer the period the more volatile the average change.
  
  
• Sales: currently this is in vogue, coming off a cyclical recovery that has not yet entered into full bloom.
  
  
• Announced earnings per share: favored by both the press and the data base providers, like the certainty of a number without any adjustment for its composition.
  
  
• Operating earnings: an initial attempt by the accountants to remove non-recurring earnings. These are not the same items that an analyst might adjust for an early or late Easter, price changes, new product launches, etc.
  
  
• Pre-tax margins (sometimes known as returns on sales): a measure of how much of the sales dollar comes down to the bottom line before paying income taxes without any adjustment for changes in selling prices, costs, or quality of product and services.
  
  
• Net income rank within a sector presumes that each corporation is attempting to maximize the results during the period.
  
  
• Return on capital (or return on capital employed, which deducts from capital any identified excess capital): a measure that does not differentiate between the sources of capital, e.g. short and long-term borrowing, temporary capital or float, preferred shares and common equity.
  
  
• Return on invested capital: usually calculated to include long-term debt and equity.
  
  
• Return on equity: usually calculated to include all forms of equity compared with net income.
  
  
• Return on tangible capital which removes goodwill (goodwill is particularly useful in comparing acquirers of intellectual property producers).
  
  
• Return on gross assets or ROGA was a measure I learned analyzing defense companies, comparing corporations that had a mix of government owned and privately owned facilities.

The above is not an exhaustive list. The way the momentum game is played is that one holds or buys the security as long as the current reading is higher than the last one. As soon as the number is less than its predecessor, one sells. Many of the followers of these techniques describe themselves as growth stock (fund) investors. Over the years General Motors, IBM and airlines have been labeled as growth stocks. Not only are there risks to this kind of investing (the potential of a lower reading), but there is a bias in the numbers that changes.

Patience rewarded

In the eyes of too many quasi-sophisticated investors and much of the financial press, the opposite of growth-oriented investing is value focused investing, which at its essential is a view that the current price does not represent the current value. (There is a half way house of "growth at a reasonable price" or GARP which requires both the expectation of growth-momentum and a less enthusiastic price.) Often the key to value investing is the belief that the current price only reflects the immediate past. The value investor has patience and expects that better results, using many of the same measures of the growth investor, will occur soon. In an engineering sense they have built some “fault tolerant” elements into their analysis. We all recognize that too much patience can lead to low returns or losses, even when ultimately successful. To avoid exercising too much patience, the value investor identifies where the prospect security is, relative to its past cyclical behavior. Other approaches average the results over distinct periods of perhaps five or even ten years, with the thought that over time the results will return at least to average.

The lessons from sports

As many of our blog community members know, I view handicapping at the race track as one of my two most formative educational institutions. Further, from a professional investor standpoint, I follow the ups and downs of the National Football League teams and players. Both of these experiences teach that while it is exhilarating to cheer or bet on the continuation of a winning record, the odds are that all strings will break sometime. The “normal” is that one’s choices include some victories and some losses. This is by design. At the race track, officials attempt to see all the horses finish exactly the same by setting the conditions for the race, including the level of weights carried. The genius of a number of professional sports leagues is that on any given day any team can win beating a team with a better record. One of the many lessons from watching these results is to occasionally throw out or disregard a specific contest, particularly the last one, on the basis of weather, location, and/or health of a key participant. A second lesson is to adjust one’s thinking due to an expected change in tactics. Perhaps, the most important lesson is to believe in luck. If for no other reason, the randomness of luck suggests that additional bets (or if you will, diversification) are often appropriate.

Managing the specific risks in your investment portfolio

A portfolio that is exclusively built on the belief in momentum, or current price discounts from value, is likely to move largely at the same time. That is why we often hear that “this market” is good for growth or value investors. I suggest that a portfolio that is entirely focused on one or the other is likely to experience the biggest career risk to an institutional investor. If the “market” is going up for some time and your portfolio is not participating, you are likely to be terminated as a manager. Additionally, you will likely experience the further pain that many of your positions suffer from similar investors being forced to dump their holdings as assets are redeployed. In many cases the biggest risk to an institutional portfolio is the co-venture risk, when too many others have the same or similar positions in a market that changes emphasis dramatically. The best way to defend against these risks is to have some balance of growth and value opportunities, as well as not to own institutional favorites. Currently, many of the portfolios that I see are much more value oriented, and where they do have growth investments, they are one way or another related globally to the Internet. Be careful: luck normally falls on a smaller population than a larger one.

What do you think? Please let me know.
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