asymmetrical
return profile:
Weighing Risk Against Upside Potential
White Paper
Asymmetrical Return Profile: Weighing Risk Against Upside Potential
MILES Capital // 01
Table of Contents
03 Introduction
04 Evaluating the Climate of Risk
06 Appreciation Potential and
Downside Determinations
07 Reassessing and Re-evaluating Targets
09 Additional Risk Management
09 Conclusion
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Introduction
At Miles Capital, one of the distinguishing characteristics of our active equity
management process is to calibrate the asymmetrical return potential
(“ARP”) of a given stock, which in essence means evaluating its upside
potential versus its downside risk. As a general guideline, we believe absolute
downside should be limited to 30 percent, and if the stock does not possess
appreciation potential that at least doubles that risk—i.e.60 percent—then
the stock will be rejected. We simply call it prudent, and believe the point is
that such a mentality illustrates our firm-wide commitment to preserving our
clients’ portfolios without significantly limiting the upside potential.
While the asymmetric return potential concept originated in hedge fund
management with a focus on absolute return generation, we believe it
provides worthwhile contributions to long-only strategies as well. This active
risk management focus is an absolute measure, and goes beyond traditional
passive approaches, which include measuring portfolio risk characteristics
such as beta or tracking error relative to an index. These passive measures
provide transparency and are comparable between strategies and managers,
but they do nothing to control the probability of portfolio losses.
We maintain a broader focus on active risk mitigation to support our clients’
goals. Insurers need to grow surplus to support their business and ratings.
Endowments and Foundations strive to maintain purchasing power in order
to preserve intergenerational equity. Our process, which leverages the
asymmetric return profile, is designed to help meet these needs.
Asymmetrical Return Profile: Weighing Risk Against Upside Potential
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Evaluating the climate of risk
In his 2006 book, Asymmetric Returns: The Future of Active Asset
Management, Alexander Ineichen championed the many benefits of
controlling downside volatility, defining risk in more specific, absolute
terms and generally turning the conversation about skewed returns on its
side. However, exciting as he made asymmetry seem for readers, it was a
somewhat short-sighted simplification to narrow the focus solely to positive
absolute returns. Long-term excess returns may be part of the ultimate goal,
but this hinges upon strong evaluation capabilities, which means reverting
back to sound stock-picking practices. In utilizing the ARP technique, we
believe investors can establish a more reliable expected range of outcomes—
both positive and negative. This is, in essence, the basis for the fruitful
skewed return.
As market volatility
has taken on a
different magnitude
in the post-recession
economy, the equity
investment process
must adapt.
As market volatility has taken on a different magnitude in the post-recession
economy, the equity investment process must adapt. Although still caused by
the same drivers—e.g. macroeconomic or market turbulence—heightened
volatility is one of the primary distinctions of today’s market. We would be
remiss to overlook the fact that the landscape of the global economy has
been permanently changed and, therefore, so too have its inherent risk factors.
Below in Figure 1 is a sample Monte Carlo simulation demonstrating
potential outcomes for the S&P 500 over the next 5 years. Given current
forward looking forecasts for the S&P, along with historical risk measures, the
likelihood of maintaining the original (inflation-adjusted) principal investment
of $5 million is only 69 percent after 10 years. This obviously supports the
need for diversification into multiple asset classes to decrease dependence
on large cap domestic equity. However, we believe it more importantly
highlights the need for ensuring a focus on evaluating the upside versus
downside spread. If—admittedly, in just one asset class—one only has a
69 percent chance to generate growth, leveraging tactics that increase the
likelihood of realizing upside potential are critical.
Asymmetrical Return Profile: Weighing Risk Against Upside Potential
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Figure 1. Monte Carlo Simulation, S&P 500 Index
Source: Miles Capital and Zephyr AllocationAdvisor
An appropriate focus on asymmetric return profile is increasingly important
for clients, especially since the 2008 financial crisis and in the face of a
rising-rate environment. As volatility increases in the traditionally stable fixed
income markets and forward-looking asset class assumptions are lowered,
lowering the volatility in the portfolio’s other asset classes will become an
even greater focus.
Asymmetrical Return Profile: Weighing Risk Against Upside Potential
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Appreciation potential and
downside determinations
Figure 2. Symmetric vs.
Asymmetric Returns
SYMMETRY RETURNS
ASYMMETRIC RETURNS
So what, then, defines a profile that is asymmetrical in its return potential?
It is a truth that market returns—and the potential returns of any given
stock—are asymmetric. They have fat tails and skewness. And if we accept
that the potential return set is not actually grouped around a mean, then
it is important to determine whether the stock has positive skewness—an
asymmetric profile that trends toward positive values.
Further, we at Miles Capital believe equity strategies should offer strong
upside with limited downside risk. Our target for appreciation potential is
at least twice or greater the downside potential, with a maximum downside
of 30 percent. In short, stocks that can’t realistically reach those criteria are
roundly rejected in the interest of maintaining a portfolio’s value for the long
term. And beyond, investors should understand why a risk management
framework such as Asymmetric Return Profile is critical. It helps inject
an element of certainty into the portfolio by ensuring that any potential
holdings with large downsides will not be purchased.
The 30-percent downside limit, which may seem high at a glance, is
ultimately reasonable. At that level a decline can typically be offset by
appreciation from other stocks within a reasonable timeframe. And in
periods of high market volatility, it becomes challenging to identify strong buy
candidates that do not have a downside potential of 30 percent or greater.
Upside and downside should be analyzed together, not independently. The
two sides to a potential investment’s profile are mutually affected by a
number of factors. For example, in bear markets, stocks with higher multiples
tend to compress more, as there is more air to let out of the tire, so to speak.
However, if we adhere to the 2-to-1 upside-to-downside discipline, then we
are highly unlikely to purchase stocks with unreasonable multiples, leading to
less multiple compression.
More specifically, we believe it sound practice to take a more conservative
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If an investor focuses
on a desire for
symmetrical returns,
he or she may achieve
balance and maintain
diversification,
but not necessarily
positive returns.
approach to evaluating downside in the interest of putting upside in
perspective. For example, a stock deemed to possess a 30 percent upside
versus 10 percent downside is more attractive than one whose risk and
appreciation potentials are relatively equal at, say, 50 percent. If an investor
focuses on a desire for symmetrical returns, he or she may achieve balance
and maintain diversification, but not necessarily positive returns. A positive
return requires a greater likelihood of profit than loss. Downside analysis
provides a balance—a reminder that even if the upside potential is high, so
too is the likely volatility, which may outweigh the reward.
Losses do in fact weigh more heavily than gains, and not simply in
psychological terms. Recovering from portfolio losses mathematically
requires gains of greater magnitude. Managing downside risk appropriately
from the beginning is paramount. This is where labeling all asymmetrical
return strategies alike is somewhat misleading. Our risk management
practices call for analysis to err in favor of an aversion to volatility, because
we believe investor portfolios and today’s markets require it.
Reassessing and
re-evaluating targets
The Miles Capital approach focuses primarily on fundamental and valuation
criteria, evaluating historical profit margins as well as projected sales
growth. Additional drivers include historical and expected leverage, liquidity,
and free cash flow. Valuation analysis is predicated on a variety of metrics,
including price-to-earnings, price-to-sales, price-to-cash flow and enterprise
value-to-EBITDA, all within the context of comparison to a stock’s own
historical performance and that of its peers. It’s critical to have a firm
understanding of the fundamental drivers of a stock’s quality for several
reasons. In strong bull markets, an inordinate focus on valuation or upside
potential may lead to the purchase of too many deep value stocks, which
may simply be value traps. Both components—fundamental and valuation
analysis—are equally important.
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Once we have our assessment of the stock’s quality, we reach the upside
and downside targets by assessing its potential under both a reasonably
bullish scenario and a strongly bearish scenario. For example, we analyze the
depreciation potential that may occur if the company wildly disappoints on
fundamentals, and a corresponding correction in valuation occurs.
An Example: To illustrate our determination of upside and downside targets,
we will examine the purchase of an Energy name made in 2013. Our downside estimate
of $51 represented depreciation of 20 percent. We based this forecast on an annualized,
disappointing first quarter 2013 operating margin, which represented a 6-year low and was
well below the average of the previous 5-6 years. The downside estimate was also based
on a forward P/E multiple at the lowest point exhibited by the stock since the financial
crisis of 2008. This downside estimate contemplated both fundamental downside—margin
disappointment—and valuation compression. Bolstering our confidence in our downside
estimate, we took into account the strong financial profile of the company from both a
leverage and liquidity standpoint.
Our upside estimate was nearly 60 percent, which represented our estimate of where
the stock could trade in 2 years assuming a normalization of profit margins and a ‘normal’
P/E multiple. For margins, we assumed the holding would revert back to 20 percent EBIT
margin by 2015. For valuation, we assumed a return to the normal historical forward P/E of
13x. Accordingly, the major driver of our upside scenario was earnings growth from margin
expansion off of historically low levels. And indeed, over the next several months this energy
holding significantly outperformed the stock it replaced in the portfolio.
Furthermore, we do not evaluate the stock’s potential just once. We determine our upside
and downside targets at the time of purchase and again as often as company news warrants,
continually challenging our assumptions.
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Additional risk management
There are a number of long-term benefits to downside risk mitigation—the
discipline that under no circumstances will a stock be purchased if its
downside is estimated to be more than 30 percent from its current price
level. But perhaps more important from an investor perspective is that this
component of the process ties into Miles Capital’s methodology and outlook
as a whole. The Miles Capital risk management philosophy includes a sell
discipline that complements downside protection.
That broader risk mitigation methodology includes five potential triggers for
sale, which range from fundamental deterioration to the stock exceeding the
original price targets. However, the most stringent is a rule mandating that
if a stock underperforms its sector by more than 20 percent over a given
period—one month or three months—it will be sold. While this is a relative
measure and compared to the sector of an index, it is absolute and prevents
any potential emotional attachment to a holding.
Conclusion
While it may appear elementary, implementing a sound investment strategy
requires the organization to balance—and indeed, attempt to optimize—
three often competing goals: 1) minimizing risk, 2) maintaining the
necessary liquidity profile, and 3) earning a reasonable return.
In an environment where upside is so frequently emphasized, it is
paramount to success to spend adequate time, energy and resources
determining the volatility and downside potential associated with any given
purchase. This is, we believe, critical to designing and managing investment
portfolios that support our clients’ objectives. It has proven to be an
essential and productive component of both Miles Capital’s active and risk
management approaches.
Asymmetrical Return Profile: Weighing Risk Against Upside Potential
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Sources:
Miles Capital Equity Investment Handbook
ipe.com/why-asymmetric-returns-work/18931.fullarticle
books.google.com/books/about/Asymmetric_Returns.html?id=GWCFvwiu9iIC
Disclosures:
The information contained herein is solely for informational purposes and does not constitute
an investment recommendation or an offer to sell any investment product. This document
does not take into account the particular investment objectives or financial circumstances
of any specific person or entity who may receive it. Before making an investment, investors
are advised to thoroughly and carefully review financial, legal, and tax consequences of all
investments to determine suitability. All investments involve risk including the loss of principal.
Past performance is not indicative of future results. There can be no guarantee that any
investment strategy discussed in this Presentation will achieve its investment objectives. As
with all strategies, there is a risk of loss or all or a portion of the amount invested.
All expressions of opinion and predictions in this report are subject to change without notice.
All information contained herein is believed to be correct, but accuracy cannot be guaranteed
and should not be relied upon for legal or investment decision purposes. Miles Capital makes
no warranty and assumes no legal liability for the accuracy, completeness, or usefulness of any
information disclosed.
This document is provided on a confidential basis by Miles Capital. Accordingly, the
presentation may not be produced in whole or part, and may not be delivered to any other
persons without the consent of Miles Capital. This Presentation is not a solicitation of an offer
to buy or sell any security or other financial instrument or to participate in any trading strategy.
1415 28th Street, Suite 200 | West Des Moines, IA 50266
(800) 343-7084 | www.miles-capital.com
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