Do Price Targets Matter In Volatile Markets? (And, Why Alpha Theory Should Be A Starting Point Even In Turbulent Times)
This blog was co-authored with Alpha Theory’s Customer Relations Manager, Dana Lambert. “Stock prices will continue to fluctuate – sometimes sharply – and the economy will have its ups and downs. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.” – Warren Buffett, famed investor “While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. “- Bill Ackman, Pershing Square 3Q08 Investor Letter The recent market environment has proven challenging for many funds, including Alpha Theory clients. The market has been volatile, but the real challenge is directionality. As of September 28, the S&P was down 11% over the prior 49 trading days, with 30 of the 49 days being down. Alpha Theory clients generally benefit from pure volatility (large ups and downs without a direction) because they are buying on dips and selling on rises (mean-reversion). The problem with a uniformly down directional market is that clients are continually getting indications to add to their longs and trim their shorts – the proverbial “catching the falling knife”. Although Alpha Theory cannot overcome persistent negative correlation between scenario estimates and outcomes – in other words inaccurate research – it does offer three options to help clients deal with these circumstances. OPTION #1 – RAISE PREFERRED RETURN. When the price of an asset falls, its probability-weighted return (PWR) rises. When the PWR rises, the normal action is to increase your position size. But when all asset prices fall, all PWRs rise and thus the longs become more attractive and the shorts less so. This suggested increase in long exposure may not be tenable and there may be a general skepticism regarding the price targets. In this situation, a manager can raise the preferred return for longs and thus raise the ‘hurdle rate’ required to be a full position in his or her fund (i.e., before you required only a 40% PWR to be a full position, but in this market environment you require 60%). This will immediately lower long exposure and only suggest adding to the best ideas. In the extreme example of February 2009, clients raised their hurdle rates to 70% or 80% and were able to see quickly numerous compelling ideas and how to shift capital appropriately. OPTION #2 – RELATIVE INDEX ADJUSTMENT. As the market falls, the “market multiple” decreases – which has ripple effects through the price targets in Alpha Theory. For those who cannot re-underwrite all of their targets for the new market paradigm, the application offers an easy-to-use feature called ‘Relative Index Adjustment’. This basically adds back the move of the market to an asset’s expected return, and the following would be an illustrative example. If the market is down 11%, then most assets’ prices will also be down and their suggested position sizes will increase. Now let’s turn on the Relative Index Adjustment. If every asset is down 11%, commensurate with the market move, then Alpha Theory will adjust the prices so that there is no change (-11% Stock Move minus -11% Market Move = 0% change) and thus no suggested change in position size. The beauty of this system is that you can turn it on and off and the Market Move is calculated since the last price target update. So if an analyst updates a price target, the Market Move gets set back to zero because the analyst would take into account the new “market multiple.” OPTION #3 – RE-UNDERWRITE CONSERVATIVE PRICE TARGETS. Fundamental investors recognize that there is no absolute intrinsic value for each asset because their assumptions are subjective. There is, however, a range of assumptions that span from aggressive to conservative. Down markets imply that pushing your assumptions to the conservative end of the spectrum may be appropriate. After doing this, you can see which assets are still suggested buys and which are not. The confidence imbued by using the most conservative assumptions allows you to be aggressive with add and trim decisions. A few views to help isolate where to start the re-underwriting process are: Performance view : shows those assets that have suffered the most on an absolute and relative basis Group by Risk/Reward within 10% : groups the assets that are within 10% of Reward and 10% of Risk targets (click to enlarge) While consideration of the aforementioned steps certainly is appropriate, as you develop conviction about downward directionality for the market, it is also worth noting that volatile markets can often be followed by periods of relative calm and distinct upwardly-biased directionality – and of course this has been the pattern for the past several years now. So where in one week an analyst or PM sees a 1-year target as likely to be unachievable, the next week suddenly the expected return gap narrows considerably. In short, just when you may be losing faith in your targets, they can quickly fall back into an attainable range. Directional markets that move quickly are challenging for many reasons. It is easy to throw up your hands and rationalize that “price targets don’t matter” or “our research is wrong”. It is hard to restrain those emotions and redouble your efforts to find the value that has been exposed in the quick, volatile relocation of asset prices. To do so requires a rigorous, disciplined process that begins with retesting assumptions (i.e., raising return hurdles, adjusting for the market move, and setting more conservative targets). If, after re-underwriting price targets and portfolio inputs, Alpha Theory is still recommending upsizings, then you can feel confident in your actions … even in a volatile, directional market.