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Factor Investing | Portfolio Yoga

Tag: Factor Investing

Investing Style and Perspectives

For #Fintwit India , the favorite whipping boy for a while has been Momentum. While its usual to get whipped when one is on the losing side, this time around even winning doesn’t seem to matter for the guys who follow this methodology are being whipped for paying taxes on their profits. 

Most of the persons on the other side follow Value Investing even though there are as many divisions on what exactly constitutes value. Is buying Reliance Communications when it is below a Rupee constitute buying a crap company or a Cigar butt investing?

Its hurting to see a strategy that one  believes in ridiculed and more so by guys who seem to confuse between systematic momentum and random buying but calling it momentum.

But the more I interact with people on the other side of the fence, the more I appreciate what they are trying to achieve. It’s not something I may do though there is always a itch to try and identify a stock well before the market as a whole does. 

Size is a limiting factor for Momentum. Most fund managers on the other hand are managing money on a size that is 100 or even 1000 times more than what an optimal AUM for momentum would be. There is just no way that even if they somehow were to become believers in momentum can execute the same without slippage killing them. 

Almost all great investors one can name can be bracketed as Value investors – it could be deep Value or Growth at Reasonable Valuations or any of the other nuances they may wish to identify with but the approach they take is one where the Valuation of the business takes a predominant role.

All intelligent investing is value investing says Charlie but what is “intelligent investing” anyways. Last year, I bought Tata Elxsi as one of my portfolio stocks. I continue to hold the stock which is up 200% from where I bought. If given no context on how I bought the stock, does it merit being an intelligent investment? Afterall, as Charlie says, all good investing is value investing.

The objective of all styles of investing comes down to managing Risk. Value investing does that by way of buying securities where the buyer sees a margin of safety. A momentum investor on the other hand limits his risk by cutting down on stocks that lose out on momentum. 

We have been doing things that are contrary; the things that people tell us won’t work from the beginning. In fact, the only way to get ahead is to find errors in conventional wisdom

Larry Ellison

One of the biggest reasons for why a lot of investors fail is peer pressure. Pressure to do things like the winners do even though they lack the resources that are available to the big guys. Coat tailing is rampant but given our lack of understanding on the reasons and more importantly portfolio construction of the investor we wish to coat tail, our returns will almost surely be worse than the person we are attempting to copy.

Peer pressure of doing things similarly is not limited to investing either. The other day, I, with a friend of mine, visited a famous dosa hotel in Bangalore. If one were to try and list the most famous dosa hotels in Bangalore, this would come Second or Third. The first is so famous that the waiting time these days can be as much as an hour.

One of the trademarks of the most famous dosa hotels is the way the dosa is carried by the server as he comes to serve the customers. Multiple dosas are piled up on one another making it in itself something of a curious sight of its own.

The dosa hotel I went to never had this kind of serving. Dosa’s were brought mostly in a tray and served to the customers. But this time I could see a difference. The server brought in about half a dozen or more dosas piling it one top of the other. But he was when he reached the table next to us clearly uncomfortable and afraid of spilling it all. He asked the customers themselves to reach out and take out the dosas slowly and only when it was reduced to a couple was he more comfortable.

My friend commented on this about how despite being well known, even the hotel was getting driven by peer pressure of doing something that they weren’t in reality comfortable just to make it more similar to the more famous hotel.

Thinking about it made me wonder as to how much of this was related to investing. First we have this benchmark that we wish to beat. Then of course, there are always other guys whose returns we wish to beat. 

The pressure of a friend being able to generate a higher return most of the time forces the others to take more risks that they are comfortable with in the first place for what if one’s returns are lower – it would make one look bad or worse.

The pressure of wanting to get rich and rich fast is what attracts most people to derivatives, even those who know that in the long run (which may not be that long in the first place), most derivative traders have blown up their capital many times over. Yet, the attraction of what seems like an easy endeavor from the outside makes one keep trying before most quit – some when they aren’t too behind in the game while many when they are thrown out once and for all. No one really quits when it is working for who does that.

Momentum Investing is fascinating for clients for it seems to suggest that there is a possibility of making a great deal of money, more than what you could do otherwise if you just stick with the system. How hard it is to make the changes once a week or a month says the newbie. 

But there is no free money, not in Momentum, not in Value or in Quality. Whatever the additional returns that a strategy makes can most of the time be drilled down to higher risks that were taken and one that got paid.

It’s been five years since I started investing by way of systematic momentum, 15 if I count the number of years I have been a follower of systems (trading and not investing in the past). I think I have a better understanding of the strategy today vs 5 years back. But the real deal is only once I complete 20 years for then I shall surely know whether I did the right thing by following a strategy that is anathema to most but one I believed shall work out well.

It’s tough to be contrarian, but if one wishes to have results different from the herd, one needs to embrace it and accept that one’s path may not all the time be accepted by the peers whose respect we wish to have. 

Is Momentum Strategy Inherently Risky?

With Momentum as a investing strategy gaining more followers, one of the common threads in all discussions I see is that they are described as inherently more risky – more risky than what I wonder. Equities itself is Risky – if you aren’t willing to bear the cost of temporary loss, maybe this isn’t a asset class you should be getting worked upon.

After all, the basic rationale for investing is to ensure a better life in the future but if that comes with stress that takes a toll in terms of health, such a investing strategy isn’t worth following even if the returns on paper seen awesome.

But before we dive into Risk of Momentum Strategy, the broader question is, What is Risk?

Warren Buffett defines risk as Permanent loss of Capital. When you book a loss in a stock, you are essentially booking a permanent loss since regardless of where the stock moves from hereon, it will not impact your bottom line.

The fear of stocks bouncing back post booking of loss aided by Anchor Bias means many a investor are willing to stick with a stock till its either too painful to hold or till the exchange itself decides to delist. While the loss till the point of time of booking can be considered a quotation loss, in reality even before the final blow is laid, even the investor knows that there is very little chance of getting his money back.

Every Infotech stock went down post the boom and bust of the Dot com bubble. Recovery was seen in just a handful of stocks that survived. 90% of stocks don’t even exit today making it seem that even if one had got caught in the boom, one would have recovered his investment if he had patiently waited it out.

The key in such investment is to know when it’s a temporary loss and when it has turned into a permanent loss and one worth exiting. This of course isn’t as easy for bad stocks have recovered from what at one point of time would have been seen as a write-off while good stocks have fallen more quickly than you could have said 1-2-3

The basic philosophy of Momentum Investing lies in its belief that the market knows better – in other words, markets are efficient for most periods of time and there is no reason to fight that. Its much easier to row a boat with the flow of water than to row against the flow.

We believe in betting on great industries only when the herd is betting on the same. The moment that herd starts to dissipate, we exit our position in favour of something else that has caught the attention of the crowd.

This may appear to be speculative and risky, yet this is one of the only strategies that can be tested to see the weakness and the risks it carries. When deciding how much to risk on a stock or a strategy, it’s always useful to know Ex-ante rather than Ex-post when you can do little but hope that the trend reverses back.

Momentum Investing in may ways can be compare to Micro Cap Investing – both are risky yet both have the capability to deliver higher returns than any comparable strategy.

When you buy a stock, you aren’t buying a ticker symbol but buying a part of a business is the new age voodoo when it comes to investing. Nothing wrong with the thought perse, but unlike say in US where most managements don’t hold enough stock to even block resolutions, promoters here hold majority or more making it tough for both the small and the large shareholder to question.

Take for example the crack in price recently when Prabhat Dairy sold its dairy business to Lactalis for Rs1,700cr. Theoretically as a shareholder you should rejoice for this means that the price has nowhere to go but up considering that the market cap is less than half the cash inflow the company shall see.

Instead, what we saw the stock fall of 24% in the week when the announcement was made as the market believes that the management shall not share the spoils with investors who hold nearly 50% of the company’s equity. So much for buying what seemed like an undervalued business.

A previous example and there are many such examples would be of Lloyd Electric which post selling their brand let no money flow to the minority investors.

As a shareholder, you can cry, crib, scream and make a ruckus. What you cannot do is change thing for the management holds all the cards. Bet with good management is the lessons well-meaning fellow investors will tell you without telling how the hell is one supposed to discern that. Zee, a stock held by Mutual Funds and Institutions alike fell 26% on reports of possible debt issues and corporate governance.

How Risky is Momentum:

I was chatting with a friend the other day and he said that while he understood the value of Momentum as part of his portfolio, he wouldn’t be comfortable investing a large part of his equity portfolio in that given the “Riskiness” of the portfolio.

This made me wonder, how do we measure risk and whether Momentum is really Risky. Here is a table I prepared comparing Nifty 50 representing the Large Cap Index, Nifty Mid Cap 100 representing the Mid Cap stocks in the market and Nifty Small Cap 100 representing small cap stocks and compared data versus Nifty Alpha 50 which is follows a Momentum philosophy. The data used is Weekly with time-frame being from 2004 to 2019.

Do note that while for while the other indices are weighted by market capitalization, Nifty Alpha 50 is weighted by Alpha and this can make a large difference in volatility.

What can we summarize from this?

The weekly change, measured either by way of average or median is highest for Nifty Alpha 50. Not surprisingly, the worst weekly return honour is bagged by Nifty Alpha 50 though the best weekly return isn’t. In other words, when things go bad, Nifty Alpha 50 can go bad pretty fast.

Yet, it has closed more weeks in positive territory versus other indices. More than returns, this is important from the physiological point of view.

Let’s turn our attention to 3 year rolling returns. Nifty Alpha 50 is the undisputed leader here – but this higher return comes with deeper draw-down {Minimum is the % return at the end of the worst 3 year period} and higher volatility.

While Nifty Alpha 50 on an average generates 44% higher return than Nifty 50, it also has 81% higher volatility. No Pain, No Gains.

Investing in Nifty 50 also means that you have a higher probability of being in positive at the end of 3 years versus other Indices. While Momentum is Persistent, when it comes to Consistency, at least during the period of testing, Nifty 50 comes on top of the game.

Draw-down for Nifty 50 is the lowest and highest for Nifty Alpha 50. Do note that higher the draw-down, longer the time for recovery. While a buy and hold approach will work on all the indices, the ability to hold for a long duration is the key to getting the historical returns.

Finally, overall returns. What would investing 1 Rupee in each of the Indices at the start of 2004 been worth today?

Overall, it indeed seems like investing in Nifty Alpha 50 is riskier than investing in say Nifty 50. But just looking at numbers in isolation can lead to wrong conclusions. So, lets try to go for a holistic approach.

Looking through the Lens of Asset Allocation:

Interest rates in developed nations are so low that the only path to generating higher returns is through investing in alternative asset classes like Equity. India is nowhere close to that situation with short term debt funds generating nearly 8-9% return per annum.

Debt funds are able to generate this with little volatility – the assumption here is that you don’t go for funds peddled by those looking for commission and one where there is a risk of both credit and interest rate.

If you can generate 9% with very little risk, what should be your minimum acceptable return for generating return with risk in assets where there is risk of loss of capital?

The key to deciding how much to invest in Equities regardless of strategy comes down basically to two key numbers – the return you require to reach your goals and the volatility (lets measure this as maximum drawdown from peak) you are willing to bear.

If you are able to reach your goals if you can get a compounded annual return of 12% over ‘n’ years, how should you allocate? Do note that that equity returns are lumpy while debt are much smoother. Most years, you shall either generate return much higher than your target or a return that is much lower than the one you seek.

Based on data from Nifty 50, you can get 12% returns by being 100% invested in equity. But being totally invested in equity brings its own set of risks even for those who think they can take such risks.

Assuming an 8% return on Debt and 18% return on Equity, equity to debt ratio of 40:60 should provide you with that return while at the same time halving more than half the max drawdown you may experience.

What if you assume that equity will deliver 15% vs 18%? This will change the Equity:Debt equation to 57:43 in favour of Equity. But if you can get a return of 24% on equity, you need to risk only 15% of your assets in equity to generate the required return.

Higher returns by equity can compensate by enabling you to reduce the overall risk of the portfolio by adding debt component and yet achieving similar returns. The higher returns like what we see in Momentum index while seeming like risk actually can reduce risk of one’s overall portfolio of financial assets.

Market crashes are mostly due to reversal we see in the economic growth of the country which in-turn means greater risk of unemployment. It’s during those times that one can be assured if the debt component is significantly higher for it gives comfort that not all is lost.