Risk Control in the Pursuit of Alpha

By Chris (originally posted to Flickr as DSC_0051) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

I’ve explored a few investment strategies in the past that I strongly believe is able to deliver market beating returns, but many I’ve ended up abandoning because they would get absolutely annihilated in a doomsday scenario (eg. 1920s depression or 2008 financial tsunami).

So what investment strategies can beat the market but would get absolutely annihilated in a doomsday scenario? Any strategy that involves small cap to medium cap and disregards valuations, specifically the NCAV strategy and the SpinOffs strategy respectively.

Before I delve into why I don’t pursue either strategy, I need to explain why I choose these two strategies specifically for illustration purposes. NCAV strategy (buy companies with at least 1/3 discount to its’ net current asset value (total current assets – total liabilities)) is arguably the defining strategy of Benjamin Graham (old school value investing), and SpinOffs strategy is arguably the most well known strategy from Joel Greenblatt (new school value investing).

Even though both strategies will yield ridiculously good returns, the fact that most of these companies don’t have extremely durable moats means that just in case you’re holding on these stocks while the stock market is entering a bear market, these companies might not survive the bear market due to narrow or no moats, or they will drop in value much more due to being in small to medium cap.

Whether or not you believe beta is a good way to quantify risk or not, the fact is that small to medium caps have higher betas than large caps thus will rise faster than large caps during bull markets but drop faster than large caps during bear markets.

And that just doesn’t appeal to me, even though rationally speaking my sentiment is irrational considering “what… if the path from start to finish is a little more bumpy or a little different than everybody else’s so long as it’s all going to work out well in the end?

But “you have to adapt your strategy to your own nature and your own talents“, and considering my preference for 2-3 year holding periods, selling whenever margin of safety is gone, low maintenance and low tolerance for volatility, I’m forced to stick to a strategy that is not the most highest yielding strategy on the planet.

And my strategy is basically a re-hash of Joel Greenblatt’s Magic Formula strategy, where the stocks in consideration must possess wide moats with at least 25 years dividend growth history to protect my downside during economic downturns (Magic Formula stocks usually don’t have wide moats), valuation is based on a conservative estimate of how much I stand to earn in a three year time frame through capital gains and dividends, maximum stock commission I will pay is 1.5% [1], and selling occurs when fair value is reached (or if it is a dividend aristocrat, when price far exceeds fair value).

Also to further accommodate my low tolerance for volatility, I will hold cash based on how much the Shiller P/E is higher than the mean. The key to success with this strategy relies on my ability to stick to the strategy through the ups and downs, so I need all the cash I need to give me the emotional stability needed to execute the plan.

And to compensate for my muted returns due to holding significant amounts of cash, I’m open to borrow money to act as my emergency reserve while my original cash emergency reserve is able to be freed up to invest. This ensures that I don’t have to use the debt to invest and thus means that my monthly salary only needs to pay debt interest while the principal is returned from the debt itself, which significantly reduces the risk of blowing up while allowing me to max out on the amount of money I can use to invest.

That is, of course, if I have at least 1.5 years worth of cash in my portfolio. For now I’ll stay on the sidelines.

[Notes]

[1] 1.5% stock commission implies a 1% expense ratio over 3 years. 3 years is the holding period that a stock usually takes to resume to fair value and 1% expense ratio is the maximum amount of fees I’m willing to pay to pursue a strategy that potentially offers better than market returns.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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