Risky moves...
An investment process that is focused on risk budgeting involves closely managing the asset class, sector, individual instrument and theme risks in the context of an overall investment portfolio. Sufficient diversification of the various independent alpha drivers helps to manage the risk of a material drawdown and avoid permanent destruction of the capital.
An ability to consistently generate competitive, risk-adjusted returns through a full market cycle can be achieved through active investment management. This is based on asset class and equity selection being integrated with modern portfolio construction processes that are aimed at allocating risk to investment ideas where there is mostly conviction. Intrinsic valuation, both at asset class and individual stock level is the only sustainable basis for success.
An intimate understanding by the portfolio manager of the embedded risk helps to stimulate debate on the contributors of risk. It is crucial that there is alignment between the quality levels of the research outputs, an appropriate allocation of the risk budget by the portfolio manager and an efficient and consistent representation of those ideas in the client portfolios.
Scenario-based approach
Investment professionals should never claim to be accurate about the future. The key to a sound investment philosophy is that the future is always uncertain. Consideration should be given to various scenarios in order to try and crystalise where an assessment could be wrong.
Preference should be given to attaining a comfortable margin of safety to cushion the investment view, coupled with an awareness of the downside risks if it turns out to be incorrect. The application of robust and realistic scenario permutations to both asset allocation and stock selection decisions is therefore important.
Investment analysts should be industry specialists and should be incentivised like portfolio managers in order to ensure that they take more accountability for their investment recommendations. The key to an analyst’s ability to provide sound guidance is a focus on understanding the dynamics and changes of the competitive forces in the industries they assess, which will help to better understand the drivers behind the company’s return on equity (ROE).
A three-tier approach
A sound investment decision framework should include three aspects: the quality of the company, the consideration of the business cycle and the investment themes that might impact the company.
This three-tier approach to investment decision making has advantages. Firstly, valuations based on a sustainable ROE are more consistent through time than valuations based on an earnings estimate. Secondly, the breakdown of the ROE into components can help an analyst understand the drivers behind the company and their impact on the valuation.
Understanding the impact of financial leverage on the ROE is as important as the efficient use of leveragethat can significantly enhance shareholder returns in certain cases. Companies that sustainably generate an ROE higher than their cost of equity, create value for their shareholders and should trade at a premium, while companies that earn an ROE below the cost of capital destroy the value and should trade at a discount.
A stock’s risk and reward
The future is uncertain and how a base case investment thesis on a company will play out can never be predicted. It is therefore important to investigate how a base case could be wrong as the answers to this question can lead to upside and downside scenarios.
A well-defined and researched portfolio construction process, which entrenches risk budgetting and a team approach without collective decision making is the core component of a sound investment strategy. This investment management methodology ensures self-discipline and a consistent approach to the alpha generation and downside risk management.
