For portfolio managers who wish to manage risk objectively, using forward-looking metrics.
Instead of relying on backward-looking metrics like beta to assess risk, we advocate adopting forward-looking, objective metrics to measure and manage risks effectively. This approach is designed to identify companies with weak fundamental outlooks and multiple high-risk profiles, equipping portfolio managers with the necessary tools to evaluate and mitigate risks both at the individual stock and portfolio levels. Specifically, we address risks stemming from internal, external, and market factors while safeguarding against significant declines in I-EVA. We aim to assist portfolio managers in objectively assessing and efficiently managing these risks.
The Short, Underweight Strategy
The I-EVA test remains a central component of the risk management approach. We identify companies facing risks from three areas, often contending with the potential for a significant decline in I-EVA.
Poor Incremental Value Creation Outlook: Weak Forecast I-EVA
This reveals companies with limited prospects for future profitability, indicating a possible downturn in value creation, profitability, and valuations.
Stocks with High External Risks: Lengthy I-CAP Values
Investors face external risk rooted in misplaced confidence in long-term profitability and excessive optimism about favorable market conditions, which is captured by our I-CAP metric. Lengthy implied competitive advantage can magnify risk as the bulk of the cash flow stream is expected to come through in the distant future. This makes it vulnerable to factors such as deteriorating fundamentals, geopolitical risks, and rising interest rates.
Stocks with High Internal Risks: Expansionary Capital Allocation
Another risk of internal origin lies in management making serious errors in capital allocation decisions that may erode shareholder value. For instance, deploying capital into projects with poor returns. Aggressive capital allocation strategies can worsen financial strain, increasing the risk of deteriorating competitiveness and industry downturns.
Stocks with High Market Risks: High Embedded Expectations
There’s also the risk of investors overpaying for a stock when the price has already surged to reflect positive news, sometimes driven by irrational exuberance, which is captured by our measure of embedded expectations. Over-hyped stocks with inflated market perceptions create opportunities for shorting as reality eventually sets in and prices adjust.
The Short, Underweight Strategy Stock Selection Criteria
Speculative stocks:
Stocks Carrying High Overall Risks. These exhibit aggressive capital allocation by management, a lengthy I-CAP reflecting a long cash flow duration, and high embedded expectations indicating share price exuberance — all amidst a deteriorating I-EVA outlook.
Management execution risk:
Stock carrying High Internal Risks. These exhibit aggressive capital allocation by management against a deteriorating I-EVA outlook.
Duration/valuation risk:
Stock carrying High External Risks. These stocks have lengthy I-CAP values, suggesting that much of the cash flow generation will occur in the distant future against a deteriorating I-EVA outlook.
Embedded expectations risks:
Stocks carrying High Market Risks exhibit high embedded expectations, indicating share price exuberance against a backdrop of a deteriorating I-EVA outlook.
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