Many fundamental analysts have become confused over the last 6 months or so, when their portfolios have shrunk by almost as much as the general index. “Why?”, they question, “does the stock price of a good company fall just as much the stock price of a bad company’? Is it really worth trying to pick good companies, or shall I just focus all my energy on trying to time the general market instead?” Since Jan 08, many blue chips have shed between 30 and 50% of their market cap no matter how sound their business model or balance sheet is. Good counters like Genting, DIGI, SIME, Tanjong, and even defensives like Dutch Lady have not been spared.
This level of convergence of stock price volatility and correlations with the general market index has been so strong that traditional diversified portfolios have also suffered. In the last 6 months, all major asset classes - equities, bonds and commodities have tanked and cash has flocked to US treasuries, bringing its yield down to effectively 0% (taking into account inflation). For this reason, many hedge funds which are supposed to be immune to market movements have not been spared and are facing redemptions as a result. As a result of this strong correlation, some have sought to challenge traditional asset allocation strategies and fundamental analysis.
If you possess a few ‘value companies’ or have built a such portfolio, and like many other managers, are experiencing the same niggling uncomfortable feeling that the foundations of what you thought was a well built strategy are being chipped away by poor performance and this sick realisation , let me provide some further food for thought.
In focusing on prices in this way, the Correlation Argument actually incorrectly assumes that fundamental traders adopt a buy-and-hold strategy. This is flawed because it forgets that fundamental traders should be buying into companies which have superior price-value relationship and selling those with inferior price-value relationships. If properly applied, a portfolio would actually constantly change depending on available bargains at the time. Although this does not ensure that your portfolio will provide a positive return every year, it does mean that at times like this when the whole market is going down the trader is actually buying into good companies which have fallen at a faster rate compared to its peers and the index. Note that this is not the same strategy as averaging down, because the composition of the portfolio is changing all the time.
By continuously buying into the best price-value (i.e. cheapest) company on the block, this exercise helps ensure that your portfolio stands the best chance of zipping right to the bottom without going through the agonising pain of also shrinking on the way there. By way of a crude analogy I describe as follows:
Imagine several escalators side by side each travelling downwards at different speeds, and that each step on each escalator has a different height (each escalator represents owning a stock in a particular company). Imagine also that you possess a certain amount of money which decreases at the same rate as the escalator your are on, and that your object is to reach the bottom a) in the shortest amount of time, b) by jumping down the highest steps you can find around you and c) which are on the slowest moving escalators so that your capital is preserved.
By adopting this hop and step technique, the trader preserves his capital, positions himself best for the eventual upturn and actually ends up timing or bottom picking his trades without realising he is doing so. Portfolios such as these tend to contain neglected gems which tend to go down more slowly than the index and go up more quickly when optimism returns. To state that fundamental analysis supports market timing and bottom fishing may seem counterintuitive and even a bit of an anathema, but I hope that it makes sense.
So next time your broker tells you that he doesn’t believe in buying-and-holding, you’ll know exactly how little he knows about fundamental analysis!
(PS If you look at my portfolio and conclude it has not been following the approach described in this article you’d be right, but it is because as I have not been updating it much lately. This isn’t because I haven’t traded but because I have technological problems updating it on this blog. If the problem isn’t fixed soon I will remove the portfolio.)
Happy Trading!