How to achieve outperformance without taking on crazy risk

By Craig Martin

Considering both the global and local economic landscape investors in the JSE would be forgiven for being somewhat cautious. The dilemma is that if the US economic recovery continues, and Europe continues to pump money into the markets, then equities might continue their run. Is it therefore possible to seek outperformance without taking on crazy risk?

Craig Martin shares insights on how investment experts develop decision-making. This is the first in a series.
Craig Martin shares insights on investing.

To mitigate risk, some investors simply decide to sell out part of their portfolio and then hold cash as they wait for the correction. Firstly, how do they which shares to hold and which to sell? Secondly, if the correction takes longer than anticipated, they are left with an underperforming portfolio.

Investors do not tend to think of risk in terms of mathematical terms, but instead tend to perceive risk as the prospect of an undesirable outcome, such as achieving a loss, or underperforming the market as a whole. However risk can be measured and when designing a portfolio, investors should be aware of the potential risk that they are taking on.

At its simplest, the risk of an individual shares is measured as the level of its volatility against the returns of the market. The most common measure used for this is “beta.” This measures stock price volatility based solely on general market movements. Typically, the market as a whole is assigned a beta of 1.0. So, a share with a “beta” higher than one is predicted to have a higher risk and a higher potential return than the market. So a company with a beta of 2.5 would outperform by a factor of 2.5.

For example, if the market increased by 10%, then this share could potentially increase by 25%, but obviously in a bear market this could reverse by the same degree. Conversely, if a share has a beta of 0.8, this would indicate that if the market increased by 10%, this share would likely return only 8%. However, if the market dropped 10%, this stock would likely drop only 8%.

The danger is that if the bull market is over and bears come visiting, then it is the high beta shares in your portfolio that will potentially underperform the market. You need to identify these shares in your portfolio and have a plan of action. If you decide that it is time to reduce your exposure to equities, these are the shares that you should be selling.

A viable solution could be to put together a portfolio made of two-halves. Firstly, what I refer to as “the huggers.” These are shares with a beta of around one or slightly under. They will tend to deliver returns that are in line with the benchmark index. Then, for the second half of your portfolio, select those “beta busters” that offer the potential of a higher reward for their arguably higher risk. In the event that the market turns bearish these are the shares that you can consider selling out of, while still been left with “the huggers”.

In terms of my analysis[i], the best candidates that I could find in the JSE Top 40 index that are likely to at least perform in line with the market, was, British American Tobacco (BTI), Firstrand (FSR), Old Mutual (OML), Remgro (REM) and Life Healthcare (LHC). I excluded Remgro from the model portfolio as it is an obvious proxy for the market, and has direct and indirect exposure to Firstrand as well as Medicross (which is in the same sector as Life Healthcare and included in the “Beta Busters”). So, I opted to go a little lower down the list and include Bidvest (BVT) as the fifth “hugger” and which is not likely to fall as much as the overall market in the event of a downturn.

The highest beta shares in the Top 40 are currently Mr Price (MPC), Aspen (APN), Naspers (NPN), Mondi (MND) and Mediclinic (MDC) – in that order. These shares are those that would be held only until it becomes clear that the bulls have stopped running.

It would be naïve to think that you are managing your risk in your portfolio simply by means of diversification. If you are holding a diversified portfolio made up only of high beta shares, it might be time to consider looking for those market “huggers” as well.

Outperform without Crazy Risk

[i] I assumed a risk-free rate of return of 4,5% and looked at the top 40 counters of the JSE. Using five years of data, up until the closing prices on 22 September 2014, I used the simple average rate of return of the FTSE/ALSI and the individual companies to arrive at their “smoothed beta”.

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