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Stock-picking: Strategy for success
Mukul Pal
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December 18, 2007

A pension fund losing money is the last thing people want to hear. But with pension funds losing money in the US, the golden times of great returns are getting trickier. Fund managers have assumed that they understood the asset classes they were investing in when markets surprised them.

According to National Association of State Retirement Administrators, public funds increasingly don't have enough money to pay future benefits. Pension funds have deteriorated from a $20-billion surplus in 2001 to a $381-billion deficit. The conservatism of the past has gone; pension funds behave more like high-risk funds today with large allocations to hedge funds and alternative assets.

The market risk itself has moved beyond local rationales as poor performance has forced stock-pickers and fund managers to employ new analytical tools to understand market risk. Unlike the bottom-up approach of stock picking, the top down approach times market risk.

However, the top down approach needs a thorough understanding of the macro picture, sector rotation, intermarket linkages, intermarket cyclicality and relative strength.

Ian Notely, the legendary time cyclist, says playing with an asset trend and against it can seriously determine your chances of success. The odds can move up from 3 for 1 to 20 for 1 if you are against the trend. This simple logic of playing counter trend can determine the success of any investment strategy.

The markets are changing so fast that by the time you realise your understanding of the "familiar" asset class is limited and incomplete, it might be too late. This is what bottom-up stock pickers are facing now with recurring market risk, which they don't know how to diversify out of.

The parameters influencing local valuations have just increased multi-fold. This is why any pure regional bottom-up approach of stock picking is like playing against the trend with huge odds.

However, it's all not gloom, there are always outperformers. Jim Simons, the world's best hedge fund manager, has produced annual returns of 37 per cent since 1989.

While most funds were cracking under the subprime crises, some high fee charging funds were already short on the ABX Subprime Index, looking for negative correlation and acting on it in time pushed up the profitability for the respective fund.

But it's not easy to find negative correlation or understand correlation in the first place. In times of contagion, correlations are found to be high.

But according to Invesdex, an alternative investment firm, correlations are not just high in periods of panic but are generally positive. And barring dedicated short bias strategies and managed futures, all other strategies viz emerging market, equity market neutral, event-driven, global macro and long-short equity have a positive correlation between 0.6 and 0.1, compared to the broad market indices.

So finding negative correlation to reduce risk is not easy. However, strategy styles like pattern recognition, mean reversion and short-term momentum can help reduce portfolio risk.

Then there is Sam Stovall's sectoral rotation, which has an in-built risk mitigation factor. Sam linked the stock market or economic cycle with relative sectors explaining when a sector leads and lags.

Why is the energy sector a leader in the late expansion stage? And why when markets are in the early contraction stage of the economic cycle do FMCG and utilities take over? He also explains how tech and financials are late economic contraction and early economic expansion sectors.

The current market situation in India clearly exhibits where technology, energy and staples stand today versus the broad market Index. Technology underperformed in 2007. Playing with or against emerging sectors can be a key profitability differentiator for a fund or investor. And since sectoral underperformance cannot last forever, knowing when the cycle is turning can really push the fund up in relative rankings.

Above sectoral cyclicality, we have the asset cyclicality, which illustrate the intermarket relationship between commodities, bonds, currencies and stocks. Why do bonds generally go up with stocks? Why do commodity prices generally move opposite to stock prices? Why is the value of cash cyclical? And why is deflation or stagnation risk a part of the credit cycle? Asset cycles are larger than sectoral cycles.

The commodity cycles turned down in eighties for nearly 20 years as equity cycles rose during the same period. The commodity cycles turned up in 2000 and we witnessed the equity market turbulence. The healthy disinflation and high savings rates in Asia might have delayed the deflationary effects.

But as baby boomers retire and inflationary pressures increase, the sectoral cycles and existing asset trends have changed. And if the interest rates cycles end, as they are anticipated to do so around 2009, top down investment approach might come a lot handy to find assets for capital conservation and growth.

And then we have the climate cycles, which are linked with economic cycles just like they are linked with wheat cycles. Institutions are already waking up to this link of environment, carbon and economics which they are redefining as green finance.

Stock-picking without understanding long term climate change on economics is another under-utilised strategy, which is not only negatively correlated to traditional assets but is also extremely profitable.

According to the Stern Review on the Economics of Climate Change, the benefits of strong and early action far outweigh the economic costs of not acting. The report estimates that if we don't act the overall costs and risks of climate change will be equivalent to losing at least 5 per cent of global GDP each year, now and forever.

The author even mentions of major disruption to economic and social activity, on a scale similar to those associated with the great wars and the economic depression of the thirties.

Capital markets have already started acting. We have a whole new suite of products designed to finance projects such as green buildings, clean energy, plants or low emission means of transport, etc.

The capex in large alternative energy projects has enabled investors to participate in green finance. This has led to the new green stock-picking. The climate awareness is reshaping industries as companies like Virgin get into fuels, and green grids define which auto company is better than the other. Barring Nissan and Toyota a majority of car manufactures are still far away from a cleaner technology focus.

After ten years, weather derivatives are picking up and playing a bigger role. The urgency in essentials like water and energy is visible. Markets don't see one billion people in the world with no access to electricity and two billion people with no access to clean water as a crisis, but as a price inefficiency which will eventually correct as players jostle for 1 per cent of the planet's fresh water.

The cost of drinking water is expected to increase five to ten times in the next 15 years. There are long only funds for alternative energy, healthcare, environmental services, finance, micro finance and water management. And there are funds shorting the non environmentalists, something like long a solar energy stock and short a company selling coal fired generation equipment.

The markets are changing the way we look at energy, banking and autos; the way we look at correlation and the way we look at equity. By the time nuclear energy companies list in the global exchanges, uranium would have gone through the roof and by the time we look away from the rising oil prices, John O'Donnell, CEO, Ausra might have changed the world with his solar mirrors. Wealth creation is easy if we come out of the extreme short-term thinking and all that bottom up mirage.

The writer is CEO, Orpheus Capitals, a global alternative research firm.

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