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Why traditional equity portfolio risk y q y pmeasures fail long-term investors
The Way Forward a.k.a.
Standing for Real Action
Dr Manny PohlManaging Director &
Investment Committee ChairHyperion Asset Management
“ b k ‘ l f f f ’ ”This communication is not a securities recommendation.
Any person considering action on the basis of this communication must seek individual advice relevant to their particular
“To quote my broker, ‘Past results are no guarantee of future performance’.”
3
Any person considering action on the basis of this communication must seek individual advice relevant to their particular circumstances and investment objectives.
Traditional equity portfolio risk measurement fails long-term investorsfails long term investorsModern Portfolio Theory fails long-term investors by:
• Assuming risk is symmetrical when it is one sided• Ignoring agency issues
F i th h t t• Focusing on the short-term• Being pre-occupied with quant• Overlooking the quality of the underlying businessesg q y y g• Being based on unrealistic assumptions• Encouraging diversification as a substitute for due diligence• Promoting relative returns versus absolute outcomes for clients• Promoting relative returns versus absolute outcomes for clients
Thereby resulting in incorrect risk assessments and sub-y goptimal returns for investors
4
“It sounds a little too perfect. What’s the downside?”
Failure 1. Assuming risk is symmetrical when it is really one sidedreally one sided
Expected return
Risk is the component of the uncertainty of future events relating
6
p y gspecifically to the probability of an adverse outcome
“ ’d h b h f h bl h i f h l i ”
7
“I’d rather be a huge part of the problem than a tiny part of the solution.”
Failure 2. Agency Risk
• Investment risk versus business risk - Agency issues di b h li fcreate a disconnect between the alignment of
investors and fund managers
• Investors wish to maximise returns… many managers y gwant to do this and maximise their FUM. These objectives are mostly incompatiblej y p
8
“On Wall Street today, the stock market corrected its previous correction,
9
y, p ,and is pretty sure it’s got it right this time.”
Failure 3. Short-term focus
• MPT is based on measures of short-term volatility and• MPT is based on measures of short-term volatility and it can be proven to detract from long-term returns
Th i i i l id th t h t t h• There is empirical evidence that short-term share price movements are driven by factors other than i t i i lintrinsic value
• Monthly returns are much more volatile than 5 or 10 year returns and are more often negative than returns measured over the longer term
10
Rolling Returns, P/E Ratio and EPS Growth for 1 Year
80%
100%
80%
100%
40%
60%
han
ge Monthly Rolling 1 yr Hist Index
40%
60%
han
ge Monthly Rolling 1 yr Hist Index
0%
20%
Pe
rce
nta
ge C
h Return
Monthly Rolling 1 yr EPS Growth
0%
20%
Pe
rce
nta
ge C
h Return
Monthly Rolling 1 yr EPS Growth
60%
-40%
-20%
An
nu
aliz
ed
P
Monthly Rolling 1 yr ch in PER
60%
-40%
-20%
An
nu
aliz
ed
P
Monthly Rolling 1 yr ch in PER
-100%
-80%
-60%
-100%
-80%
-60%
11
Jun
-61
Jun
-63
Jun
-65
Jun
-67
Jun
-69
Jun
-71
Jun
-73
Jun
-75
Jun
-77
Jun
-79
Jun
-81
Jun
-83
Jun
-85
Jun
-87
Jun
-89
Jun
-91
Jun
-93
Jun
-95
Jun
-97
Jun
-99
Jun
-01
Jun
-03
Jun
-05
Jun
-07
Jun
-09
Jun
-61
Jun
-63
Jun
-65
Jun
-67
Jun
-69
Jun
-71
Jun
-73
Jun
-75
Jun
-77
Jun
-79
Jun
-81
Jun
-83
Jun
-85
Jun
-87
Jun
-89
Jun
-91
Jun
-93
Jun
-95
Jun
-97
Jun
-99
Jun
-01
Jun
-03
Jun
-05
Jun
-07
Jun
-09
Source: Credit Suisse, Goldman Sachs, DataStream, Hyperion Asset ManagementMar-10
Rolling Returns, P/E Ratio and EPS Growth for 10 Years
40%
50%
40%
50%
20%
30%
Ch
ange
Monthly Rolling 10 yr Index
20%
30%
Ch
ange
Monthly Rolling 10 yr Index
0%
10%
Pe
rce
nta
ge C
10 yr Index Return
Monthly Rolling 10 yr EPS Growth0%
10%
Pe
rce
nta
ge C
10 yr Index Return
Monthly Rolling 10 yr EPS Growth
-20%
-10%
An
nu
aliz
ed
Monthly Rolling 10 yr ch in PER
-20%
-10%
An
nu
aliz
ed
Monthly Rolling 10 yr ch in PER
50%
-40%
-30%
50%
-40%
-30%
12
-50%
Jun
-61
Jun
-63
Jun
-65
Jun
-67
Jun
-69
Jun
-71
Jun
-73
Jun
-75
Jun
-77
Jun
-79
Jun
-81
Jun
-83
Jun
-85
Jun
-87
Jun
-89
Jun
-91
Jun
-93
Jun
-95
Jun
-97
Jun
-99
Jun
-01
Jun
-03
Jun
-05
Jun
-07
Jun
-09
-50%
Jun
-61
Jun
-63
Jun
-65
Jun
-67
Jun
-69
Jun
-71
Jun
-73
Jun
-75
Jun
-77
Jun
-79
Jun
-81
Jun
-83
Jun
-85
Jun
-87
Jun
-89
Jun
-91
Jun
-93
Jun
-95
Jun
-97
Jun
-99
Jun
-01
Jun
-03
Jun
-05
Jun
-07
Jun
-09
Source: Credit Suisse, Goldman Sachs, DataStream, Hyperion Asset ManagementMar-10
“Here are some of my investment assumptions.Find something to base them on ”
“Here are some of my investment assumptions.Fi d hi b h ”
13
Find something to base them on.”Find something to base them on.”
Failure 4. Pre-occupation with quant as the source of truthsource of truth
CEO f h dCEO comment of the day
”...be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms... these models tend to look impressive... Beware of geeks bearing formulas.”
Warren BuffettWarren BuffettCEO
Berkshire HathawayBerkshire Hathaway
14
“ i i id lif b h h h h l i h b ?”
15
“Can a rising tide lift a boat that has a huge hole in the bottom?”
Failure 5. MPT overlooks the low quality of the underlying businesses in an indexunderlying businesses in an index
• MPT is preoccupied with indices as the basic d i f i kdenominator of risk...
A stock’s index weight is unrelated to its long-term return outlook
• Strong evidence exists that low quality/ high risk stocks produce lower returns over the long-termstocks produce lower returns over the long term
A i d i l lit t k• An index may comprise low quality stocks16
Failure 6. MPT incorporates unrealistic assumptions
• The assumptions:• Expected returns are normally distributed
• Investors are rational
• Risk is the variability of expected returns
d d h b k d• MPT does not distinguish between risk and uncertainty
• Real world outcome is very different – the real risk is h h f ll i k h i bili i k
17
the short-fall risk not the variability risk
MPT may assume returns are normally distributed but evidence indicates otherwisedistributed but evidence indicates otherwise
As the quality of the firm
Speculative/ the firm
increases, the -100% long-term return outcome
becomes less
highly geared firms tend to produce low
returns on equity, becomes less likely and the
mean outcome starts to become
more
lower free cash flows, have wider
return distributions and
more representative of
the expected return
produce abnormally low
returns
E t d t
18Area under the green and red lines is the same
Expected return
“I was spreading some risk around, and
19
p g ,apparently it all wound up in your portfolio.”
Failure 7. Diversification has been substituted for due diligencefor due diligence• Diversification has been seen as the safety net and
ignores the quality of the underlying businesses in theignores the quality of the underlying businesses in the portfolio
• High quality businesses:• High quality businesses:• provide less risk of bad return outcomes • are less likely to go bankrupt• are less likely to go bankrupt • are less likely to suffer permanent declines in free
cash flowcash flow• have better opportunities to grow their earnings
with lower fundamental risk
20
“Something is definitely going on. We’re back to eating dog food.”
21
g f y g g g g f
Failure 8. Relative short-term returns to investors are promoted ahead of long-term outcomesare promoted ahead of long term outcomes
• Clients perceive risk as absolute not relative…. p
Cash is the benchmark in a bear market however it’s b t l t it l ti d th dabout long-term capital preservation and growth and
matching the investment horizon to the investment bj tiobjectives
V l tilit i ti d li l th• Volatility is mean reverting and cyclical over the longer term and therefore of diminished importance
22
Risk management tools for portfolio construction in the real worldin the real world
• Longer term focus in order to match investors’ time h ihorizons
• Insensitivity to indices use indices correctly as• Insensitivity to indices – use indices correctly as benchmarks over the longer term and not as the basis for portfolio constructionbasis for portfolio construction
• Due diligence on business quality rather thanDue diligence on business quality rather than unquestioning reliance on diversification so as to understand and manage shortfall risk
23
Hyperion is a manager that produces long-term resultsresults
24
Source: van Eyk
... and executes quality investing with absolute disciplinediscipline
Source: van Eyk
Gro
wth
tabi
lity
nanc
ial
nditi
on
petit
ive
anta
ge
utlo
ok25
G St Fin
Con
Com
pA
dva
O
Products, Platforms, Ratings and Blending
Focused on quality Same team for 14 yearsFully aligned – we eat our own cooking
Products: portfolios of approx 22 quality stocks
Ratings:L R d d
y g g
quality stocks
• Hyperion Australian Growth Companies Fund
• Lonsec – Recommended
• van Eyk – A
• Standard & Poors – Four Stars
• Hyperion Small Growth Companies Fund
Platforms:
• Morningstar – Recommended
• Zenith - Recommended
Blending:Platforms:• BT WRAP• Colonial First Wrap
i W
Blending:
Blend with an index fund or deep value manager
• Macquarie Wrap• NetWealth
Distribution:Pinnacle Investment Management 26