The portfolio of Overvalued Predictable Companies consists of the top 25 stocks that have high predictability rank, but are most overvalued as measured by their intrinsic values. The intrinsic values are calculated from the DCF model. Therefore, this portfolio is in the opposite of the model portfolio of Undervalued Predictable companies. The performances of these two model portfolios will be compared. We expect that the model portfolio of Overvalued Stocks will underperform both the market average and the undervalued stocks.
If one runs a portfolio by being long on the undervalued stocks and being short the same amount of overvalued stocks, the performance of the portfolio will be decided by the difference in the performances of the undervalued stocks and overvalued stocks. The shorted stocks serve as the market hedge, and the portfolio will be market neutral. The performances of the general market will not affect the returns of the portfolio. If the undervalued stocks gain more than the overvalued stocks when the broad market goes up, and lose less when the broad market goes down, this portfolio should deliver relative steady gains regardless how market goes.
As one can see, this portfolio may well underperform in an up market, and outperform in down market. The daily market fluctuations are smoothed out. We expect that this strategy outperform the market over a full market cycle when the broad market is overvalued, and positioned for slim returns.
Similarly, we created the model portfolio of stocks that are traded at historical high P/S ratios. This portfolio is in the opposite of the model portfolio of historical low P/S stocks, which gained 19.1% in 2010.
We created these model portfolios to observe the long term performances of overvalued stocks relative to undervalued stocks. As the market is overvalued, investors may need a way to hedge the market risk.
A number of gurus we track hedge their portfolios. John Hussman hedges his portfolio through the combination of index options. When fully hedged, the performances of his portfolio is equal to the difference between the performances his stocks and the general market. This strategy helped him avoid deep losses in 2008 but dragged his performance in 2009 and 2010, when the market goes up in double digits.
A lot of hedge fund gurus in our List of Gurus hedge their portfolios by shorting the stocks they think will underperform the market. These stocks are overvalued to them. This strategy is widely used by Julian Robertson and his Tiger cubs.
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