Structuring portfolios for long-term alpha
Successful equity investors understand that there are two fundamental, yet intrinsically linked processes, which must operate in tandem to achieve long-term outperformance. The first is stock choice, the process by which equities are assessed and chosen, and the second is portfolio construction, the process by which equities are combined over time.
When it comes to stock choice, at Hyperion, we seek to identify growth-oriented companies which will produce predictable medium to long-term earnings streams, have above-average growth potential, and high-quality business franchises in a large and/or growing addressable market.
As for portfolio construction, we rely on a proprietary, research-based process, which exploits non-fundamental short-term price volatility while keeping a weather eye on long-term fundamentals and ignoring short-term market noise. And, while much of our outperformance can be attributed to our ability to successfully identify quality, structural growth companies, a significant portion can also be attributed to the portfolio construction process.
But, what do we mean by short-term volatility or long-term alpha?
It may sound simple, but the reality is that many market participants do not understand the differences between short-term opportunities and long-term fundamentals, or that exploiting short-term alpha opportunities is profoundly different from exploiting long-term alpha opportunities.
Short-termism is rife in equity markets
Most market participants are obsessed with short-term alpha and share price-based returns. To maximise short-term alpha, they try to predict short-term share price movements by buying stocks they think will outperform in the short term and selling stocks that they think will underperform over a similar time period.
In essence, these traders are trying to predict the short-term direction of share prices, which requires them to constantly reassess their short-term directional thesis.
Our view is that this is very difficult to do consistently because share prices are highly unpredictable in the short term. In addition, when investors have a short-term mindset, they tend to focus less on the long-term fundamentals of the stock, and more on news flow and meeting or beating short-term consensus expectations as the dominant reasons for going long or short a stock.
To add to the problem, most market participants are trying to do the same thing at the same time. Many short-term alpha-generating processes are well known, and commonly used by participants – which makes it a very competitive space to play in. Short-termism is a very crowded trade and becoming more so over time.
Focusing on the short term can have unintended negative consequences
Investors who do not have a good understanding of the underlying fundamentals of the companies they buy and sell, are unlikely to understand a business’ intrinsic value, so can then be forced out of the stock at the worst possible time. Or alternatively, buy in at the wrong time.
The market is directionally efficient in terms of news flow in the short term. That is, if stock-specific news is negative or positive, then the share price will generally go down or up, as a result, relative to the market.
The challenge for investors in this scenario is that news flow tends to be unpredictable at the individual, industry and wider macro level.
In fact, financial markets and economies are inherently random and unpredictable in the short term due to the influence of crowd-based behavioural factors and the general complexity of these systems. Markets and economies are complex adaptive systems, heavily influenced by human sentiment and behaviour, and consequently, extremely difficult to consistently predict in the short term.
Unfortunately, investors tend to overweigh the importance and meaning of recent share price movements, which are largely random and driven by non-fundamental market noise over short time periods.
In order to overcome this problem, we have built multiple risk adjustments into the process in order to limit behavioural biases. In addition, we draw on over two decades of market knowledge and understanding to assess the long-term fundamental relevance of the negative price momentum and the associated negative news flow.
The difficult reality is that short sellers have become very effective at influencing the financial media as well as short-term sentiment, regardless of the long-term fundamentals of a stock. It can be very difficult to retain and grow positions in the face of short seller and media-driven negative feedback loops and price momentum, especially if you don’t understand why you own the stock and don’t have a strong knowledge-based conviction.
The importance of conviction and long-termism
Successful investing requires conviction and a long-term focus. Rather than be swayed by short-term opportunities, our focus is on long-term business fundamentals and long-term valuations. And while we actively avoid falling into the trap of short-termism, it does not mean our investment process doesn’t incorporate short-term share price volatility.
In other words, we take advantage of non-fundamental short-term price volatility to produce long-term alpha for our investors.
Our investment process has consistently added long-term alpha regardless of the direction and quantum of short-term share price movements. This is in stark contrast to how most market participants try to generate alpha - by implementing investment processes that are reliant on correctly predicting the direction and duration of short-term share price movements.
Instead of aiming to predict stock price direction, we take advantage of short-term share price volatility instead, by using a portfolio construction process which shifts stock weights up and down as appropriate, typically from less than one per cent to a maximum of 13 per cent.
A contrarian portfolio construction system
Portfolio construction expertise is essential to long-term success, yet many market participants underestimate the importance of right-sizing portfolios and how much this contributes to overall risk-adjusted returns. Hyperion’s portfolio construction system tends to be contrarian in nature and provides liquidity to the market.
We tend to be buying when individual share prices are weak and selling when they are strong. This is the opposite to most short-term alpha-seeking investors who are sucking liquidity out of the market because they are trying to buy positive momentum stocks and sell negative momentum stocks.
Conclusion
Despite what some believe, simply investing in some of the stocks we hold will not produce the investment returns that our process produces. An essential foundation of the process is our ability to retain positions against the crowd, based on our knowledge-based conviction.
And as short-termism becomes ever more prevalent and short sellers ever more aggressive, conviction based on fundamental analysis has become even more important.
Mark Arnold is chief investment officer at Hyperion Asset Management and Jason Orthman is deputy CIO.
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