Month: December 2011

Elegant framework for gauging and monitoring investments.  By focusing on stock ideas that have a clearly identifiable ‘narrative’ – you provide yourself a convenient due diligence tool.  The narrative becomes the straight and narrow that the stock must proceed along.  As long as the current situation is consistent with your narrative the stock is appropriate – if it diverges – the narrative needs to be updated or the stock needs to be sold.  The Narrative becomes the qualitative manifestation of your ‘path of future intrinsic fair value’.

Simplifies not only the ongoing due diligence, but also client communication.  Makes the investment process more scale-able and keeps the analyst from getting bogged down in the necessary weeds of minor details.

A good narrative should be succinct enough to get through in less than a minute.  It should capture answers to 1)Key Drivers, 2)Why Now?, and 3)A Kicker or Sweetener.  And ideally, it should help the analyst gain comfort in the thesis’ potential appeal – if there is a compelling narrative for the stocks future, it is far more likely to become more broadly understood and be rewarded with a premium valuation.

An investment portfolio that incorporates bets that stocks will fall in value inherently involves speculation.  Whether that speculation hinges on mis-valuation or deteriorating fundamentals, it is still not a pure ‘investment’ in the ‘Graham & Dodd’ sense of the term – an allocation of capital with an expectation of an economic return.

Given this constraint, how can you work to incorporate this type of speculation into an investment portfolio, consistent with a disciplined long-term approach, in a way that enhances the investor’s ability to add alpha to the portfolio, mute volatility, and improve the portfolio’s risk controls rather than deteriorate them?

My intuition suggests that a portfolio structure that oscillates between 80% and 150% net long exposure (depending on market conditions and risk/rewards trade offs available) – offers the most dependable framework for long-term superior performance.  Going beyond that band risks allowing the speculation to outweigh the investment.

Except in extremely rare circumstances, I think arbitrage speculations (M&A, Converts, Paired trades) require too much risk capital for too little potential gains (accepting Black Swan risk in often crowded trades).  In my mind, short positions should be limited to securities where there are clear flaws in business model.  Either through obsolescence that the market recognizes, deteriorating fundatmentasl that will result in cash flow draining from the company, or near-term catalysts that will cause momentum investors to capitulate.

For the same reasons that buying a long position without growth drivers or catalysts just because it’s cheap (it can always get cheaper) is dangerous, the reverse is even more dangerous – particularly because the risk exposure and position grows as you get more wrong.

In the context of risk management, big positions on the short size are very dangerous from a behavioral perspective (easy place for investors to get themselves in trouble).  Also, it’s critical to recognize that technicals matter more here, and ‘crowded shorts’ pose just as much (if not more) risk than popular momentum trades on the long side – capitulations can be even more devastating.

In sumary – I believe a long-short approach is consistent with my investing ‘world-view’ albeit it with a constrained and limited application.  In my opinion, mixing “Market-neutral’ and bottom-up stock-picking is a difficult proposition – not only to achieve, but also to convince investors that they should participate.