Risk Management—Why Bother?
<December 17, 2019>
After eleven years of limited downside and seemingly endless upside, risk management has become the decaffeinated coffee of the current market cycle—why bother? Although some investors argue modern central banking has made financial markets safer and less volatile, we believe risk—which we define as a permanent loss of capital—is elevated. In fact, based on our belief small cap valuations are more expensive this cycle than in the technology and housing bubbles, we feel risk within our opportunity set is higher today than at any time during our careers. As such, it’s our view that managing risk at this stage of the market cycle is more important than ever.
Risk management at Palm Valley starts with a very simple investment principle: When we’re getting paid to take risk, we take it, and when we’re not, we don’t. And we will never, ever, knowingly overpay for an investment simply to remain fully invested and keep up with the herd.
Although refusing to overpay sounds easy, it is not. During prolonged periods of overvaluation, refusing to overpay can require considerable patience and cause us to hold a large cash position. As a result, we may incur significant tracking error, opportunity cost, and career risk.
The value of patience is especially difficult to recognize during market booms and valuation extremes. For instance, the number one question we receive in periods of overvaluation is “Why should I pay you to hold cash?” Of course, once the cycle ends and assuming opportunities return, the answer becomes self-evident. But until then, patience can be a very difficult message and position to maintain.
Although a strict valuation discipline that requires patience makes a tremendous amount of sense to us, there are other risk management strategies available. Most, in our opinion, are likely easier to implement and maintain, especially for professional investors concerned about career risk. We’ve listed some of the more popular strategies below.
First One Out
As small cap managers, the concept of avoiding losses by being the “first one out” has always caught our attention. We’re fascinated by this risk management strategy as we have considerable experience in illiquid investments and fully appreciate the difficulty of being the “first one out.” Historically, we’ve found getting out of a position is much harder than getting in, especially when a specific stock or the broader market is in distress.
During sharp market declines, a stock’s bid can seemingly disappear. By this we mean the bid becomes very thin (often only 100 shares with small caps) and each time the bid is hit, it can “air pocket” to the next bid until sufficient volume or liquidity is found. For a large seller, it can be particularly frightening, especially if the seller must exit the entire position before the end of the trading day. The fear of not being able to complete a sell order before the market closes is very powerful and can lead to panic.
When the current market cycle ends, we believe many mutual funds and ETFs will simultaneously receive outflow notifications. At that time, we expect many fund managers, especially those less experienced, will receive a “crash course” in the concept of liquidity. Technically speaking, it will be impossible for every portfolio manager to be the first one out. And while smaller investors may be nimbler, how many will attempt to get out and how many will follow this cycle’s muscle memory of buying the dip?
In conclusion, while being the first one out sounds great in theory, in practice we believe it will be much more difficult to implement, especially in periods of illiquidity and broad-based selling.
Central Bank “Insurance"
In our opinion, this cycle’s outsourcing of risk management responsibilities from private investors to central banks has been one of the most important developments in the history of financial markets. Essentially, investors relying on central banks to protect their capital believe monetary policy will be used to limit asset price declines. And even if asset prices decline sharply, central banks will come to the rescue by resuscitating financial markets via additional rate cuts and asset purchases. Similar to the Federal Deposit Insurance Corporation initials (FDIC) used by banks, we often joke that the fictional, but implied, Federal Reserve Insurance Corporation (FRIC) initials should be placed under stock market indices 😊.
Considering how the Federal Reserve has responded to market declines over the past three market cycles, it’s hard to blame investors who believe their capital is insured by central banks. However, for professional investors, relying on central banks for risk management, in our opinion, is insufficient and careless. We can think of several scenarios where central banks will be unable to come to investors’ rescue. For example, current central bank tools, such as debt monetization and asset purchases, could become ineffective or counterproductive in periods of inflation, currency instability, bond market declines, and a rising intolerance of wealth inequality. In effect, we are not as confident in the “central bank put” as most investors appear.
We actually like the idea of shorting as a risk management tool. Unfortunately, by shorting, we could run the risk of incurring large losses before valuations reverted to more justifiable levels. An important lesson we learned during the technology and housing bubbles is if a stock can trade at twice its intrinsic value, there is no reason it can’t trade at 3x, 4x, or 5x above its true worth. Put simply, there is no limit to how irrational prices can levitate during asset bubbles or how much can be lost on a short position. Therefore, while short selling makes tremendous sense to us philosophically (plus it just feels good shorting an overvalued stock!), we do not feel qualified or comfortable short selling to manage risk.
Rotating capital away from overvalued assets to undervalued assets is another risk management strategy available to investors. Intuitively, this strategy also makes sense to us, especially if the implementor has extensive knowledge of multiple asset classes and has the proven temperament to buy low and sell high. Our main concern related to asset rotation today is what if we’re in an “everything bubble” and all asset classes are inflated? While asset rotation may be effective in a more traditional market cycle, given our view that most asset classes are broadly overvalued this cycle, moving capital from one expensive asset to another does not appeal to us.
Sector rotation is similar to asset rotation, but instead of focusing on asset classes, investors rearrange their exposure to certain sectors within the economy. This strategy has been effective in recent cycles. For example, rotating out of technology stocks and into beaten down industrial stocks in 1999-2000 worked out wonderfully in 2001-2002. And in 2007, avoiding financial stocks and rotating into less cyclical sectors helped mitigate losses in 2008-2009. More recently, investors appear to be rotating into what have traditionally been labeled lower risk sectors, such as utilities and consumer staples.
We acknowledge that rotating into less cyclical sectors near the later stages of a market cycle can be an effective way to reduce risk. However, given current prices of many high-quality businesses, instead of reducing risk, we believe investors may actually be increasing risk—specifically, valuation risk. For example, during the current market cycle, the median EV/EBIT of the S&P 500 utility index has more than doubled! At today’s valuations, does rotating into utilities reduce or increase the risk of overpaying and incurring meaningful losses?
As investors pile into defensive sectors, they also appear to be avoiding more cyclical and historically volatile sectors, such as energy. Interestingly, while we believe risks in traditionally safe sectors are currently elevated, we’re finding valuations in the highly cyclical energy sector to be relatively more attractive.
Fully Invested and Diversified
A very popular form of risk management is to remain fully-invested and diversified. This strategy attempts to limit risk by owning many securities, sectors, and asset classes. In effect, spread it around and never sell. We appreciate this form of investing, especially in periods of moderate valuations and run-of-the-mill booms and busts. However, over the past twenty years, in our opinion, we’ve been in a period of rotating asset bubbles that have created amplified booms and busts. Considering our belief that we are in another extraordinary market cycle boom and a broad-based asset bubble, we do not believe remaining fully invested and diversified will prove to be an adequate form of risk management at the end of this cycle.
In summary, while the topic of risk management may sound uninteresting and unnecessary at the moment, we believe it will ultimately determine the winners and losers of the current market cycle. With so many forms of risk management available to investors, we are anxious to learn which strategy proves most effective. As absolute return investors attempting to generate attractive returns over a full market cycle, refusing to overpay and remaining patient during periods of overvaluation makes tremendous sense to us. We believe in it so much, we’ve bet our capital and careers on it.
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
Index performance is not indicative of a fund’s performance. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
References to other funds or products should not be interpreted as an offer of those securities.
Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.
Whilshire 5000: a market-capitalization-weighted index of the market value of all US-stocks actively traded in the United States. One cannot invest directly in an index.
S&P 600 Small Cap Energy Index: comprises those companies included in the S&P SmallCap 600 that are classified as members of the GICS energy sector.
S&P 500 Utility Index: The S&P 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS utilities sector.
S&P 500 Consumer Staples Index: The S&P 500 Consumer Staples comprises those companies included in the S&P 500 that are classified as members of the GICS consumer staples sector.
Bid: A bid is an offer made by an investor in an effort to buy a security, commodity, or currency.
Shorting: Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price.
EV/EBIT: is a valuation which includes the market capitalization and debt of a company divided by its earnings before interest and taxes. It is used by investors to help determine if a stock is expensive or inexpensive.