Managing equity risk in volatile times
Being involved in the investment market takes a lot of guts and a specific kind of acumen to ensure success. The latter months of 2015 have seen higher volatility in equity markets than in the past four years, a easy monetary policies around the world have ensured a steady flow of funds into riskier, higher-yielding assets.
Looking ahead, we would expect this volatility to remain relatively high over the near term, particularly in emerging markets like South Africa, as uncertainties remain over the withdrawal of this supportive monetary policy in the US, exacerbated by mounting concerns over sluggish global growth due to slowdowns in major economies like China, Europe and Japan.
Constructive methodology
It is common for investment companies to employ several different methods in constructing and managing portfolios to mitigate the downside that comes with volatile conditions. These can be useful for investors in these uncertain times.
First, do not underestimate the importance of diversification. If you take more measured positions across many shares rather than concentrating risk in a few, then in the event that your view is wrong, the capital loss is not detrimental to the fund’s overall performance. Your position size in each share should be scaled in proportion to the expected return.
In selecting shares to overweight and underweight in a portfolio, it is best to avoid taking positions based largely on forecast macroeconomic variables like interest rates, the rand exchange rate or commodity prices, since these prices have all proved impossible to forecast.
Rather, identify shares that are over- and under-valued using a strict valuation based approach comprising a bottom-up analysis of each company and the industry in which it operates.
This would include using measures such as price-to-earnings ratio, price-to-book value ratio and dividend yield to determine if a share is cheap, compared to its own history and to other shares.
Choose companies wisely
Another way to reduce portfolio risk is, when considering all the companies that you identify as being cheaply priced, to opt to own high-quality companies wherever possible. Such companies have a history of using their assets and working capital efficiently, while demonstrating an ability to deliver consistent healthy growth.
Here you would look at company metrics like:
• a sustainable return on equity above the cost of equity;
• a stable return on net assets;
• positive growth in free cash flow, and;
• growth in intrinsic value.
Additionally, you can minimize risk in an equity portfolio by pair trading within sectors. This means overweighting one share (or more) that is considered cheap, and underweighting others in the same sector.
In this way, you exploit mispricing between companies with similar fundamental drivers, reducing potential losses should the market move against you.
Effective management
Once you have constructed an equity portfolio, managing it is equally important. As market prices move over time, you should monitor all your positions to ensure the portfolio remains within the appropriate risk measures while also considering the risk of not holding shares.
In other words, look at the opportunity cost of not having certain shares in the portfolio.
When stock prices plunge – as they do periodically (the S&P 500 Index has experienced 5% falls an average of 3.4 times a year since 1928, according to BofA Merrill Lynch) – then it is critical not to panic and join in the selling. This will only lock in losses which can prove difficult to recover.
Taking a long-term perspective is important; history has shown that prices typically correct over time, so it is best to hold your positions and ride out the volatility. Being out of the market means you are at risk of missing some of the likely upside.
