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Hedge Your Portfolio and Profit from the Convergence of Valuations

March 17, 2011
gurufocus

gurufocus

332 followers
The stock market decline since the last week has reminded a lot of investors (again) that stock market can also go down. The steep decline triggered by the Japan earthquake quickly wiped out all the gains accumulated in 2011. This is exactly what John Hussman has warned us for months: that at overvalued levels, the market may continuously climb marginally. But the marginal gains are usually followed by abrupt declines.

How we wish that we had hedged our portfolio when we read Prem Watsa’s latest shareholder letter! He told that he was 100% hedged! Watsa wrote: We began 2010 with about 30% of our common stock hedged. In May and June we decided to increase our hedge to approximately 100%. Our view was twofold: our capital had benefitted greatly from our common stock portfolio and we wanted to protect our gains, and we worried about the unintended consequences of too much debt in the system – worldwide! If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today.

In a January article titled How Should You Hedge Your Portfolio?, we wrote that the market is probably overvalued. It is an interesting idea to hedge your portfolio at this point. We can long a group of undervalued stocks and short the same amount of overvalued stocks and profit from the convergence of the valuations. For this purpose we created model portfolios of overvalued stocks after running the model portfolios of undervalued valued stocks for two years. In opposite to the model portfolio of undervalued stocks, 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 overvalued stocks can be used to hedge the undervalued stocks. Like any other model portfolios on GuruFocus, these two model portfolios are rebalanced once a year.

If 100% hedged, the investment return is the differences in the performances of the undervalued portfolio and the overvalued portfolio. This is the result we have so far for the year:

1. Undervalued Stocks Outperformed Again

The model portfolio of the undervalued predictable companies outperformed again in 2011, after the rebalance on the New Year’s day using the close prices on Dec. 31. As of today, the S&P500 is about flat, the undervalued predictable stocks gained 1.46%. Since incepted on Jan. 1, 2008, this portfolio has gained 89.87%, while the S&P500 gained 39.15%. Neither number includes dividends. The portfolio gained 54% in 2009 and 21.5% in 2010.

This is the performance chart for year-to-date in 2010.

vari_chart_all.php?mp=smallcap&period=75

2. Overvalued Stocks Did Underperform

Ever since incepted on Jan. 1, 2011, the model portfolio of overvalued stocks has been underperforming the market. The performance is shown in the chart below in blue. Over the past two and half months, the model portfolio of overvalued stocks lost 2.7%, while the market is almost flat.

vari_chart_all.php?mp=overvalued&period=

The underperformance of the overvalued stocks is what we have expected. The underperformance will serve well for the hedging purpose.

3. Profit from Hedging – Convergence of the Valuations

As mentioned earlier, if our portfolio of undervalued predictable companies is 100% hedged with overvalued predictable companies, the overall performance is the difference between the two portfolios. The chart below is the performance chart of the hedged portfolio. The portfolio performance is in blue, while the S&P500 is in black.

vari_chart_all.php?mp=smallcap&mph=overv

We can see the hedged portfolio has smaller volatility. When the market was going straight up until February 18, the hedged portfolio unperformed the market. But when the market started its decline 4 weeks again, the hedged portfolio has held its gains. As of today, the portfolio gained 4.16%, while the market is almost flat.

4. Compared with Index Hedging

Like John Hussman, you can also hedge your long positions with the index options that move in opposite direction of the general market. In this way your performance is equal to the outperformance portion of your stocks relative to the market. If we had done that, the hedged undervalued predictable companies would return 1.6%. Therefore, the relative underperformance of the overvalued stocks contributed more to the 4.6% gain of the hedged portfolio.

Compared with index hedging, shorting overvalued stocks looks more risky because those overvalued stocks may outperform the market. While there is always a chance for that, we reduce the chance by shorting relatively diversified group of overvalued stocks. The performances of these companies are predictable and consistent; therefore the chance of surprises can be reduced.

Portfolio hedging through shorting overvalued stocks is the strategy that legendary hedge fund manager Julian Robertson and his tiger cubs use in their portfolios. It is also a strategy that renowned hedge fund manager David Einhorn employs in his portfolio. Mutual fund guru Steven Romick also has a short portfolio. These long-short strategies reduced portfolio volatility, mitigated losses during market crashes and generated relatively consistent returns.

5. Degree of Hedging

In this article we assumed the portfolio of undervalued predictable companies is hedged 100%. That is, we long and the short the same amount of funds at the beginning of the portfolio. This is the extreme case. The performance of the portfolio is totally market neutral and is only dependent on the difference in the performances of the long stocks and the shorted stocks.

In reality, one does not have to be always fully hedged. For instance, David Einhorn mentioned in his latest shareholder letter that he was 70% hedged, Steven Romick is about 20% hedged, while Prem Watsa and John Hussman were 100% hedged.

We believe that the degree of hedging should be dependent on the overall valuation of the broad market. Short term factors may play a role in the degree of hedging, but it is hard to predict.

Therefore, one can reduce the degree of hedging when the market is fair or undervalued, like it was in March of 2009; increase the degree of hedging as the market goes up, and reaches 100% hedging at some point. When 100% hedged, the gain is from the difference in the performances of the long and shorted stocks.

We will share more about the degree of hedging in future articles.

Hedging while the market goes up certainly sacrifice some of the upside potentials, but it does protect the portfolio from market risks. To value investors, the market becomes more risky as the market goes up and everyone else is happy.

Also read: How Should You Hedge Your Portfolio?

Check out the model portfolio of Undervalued Valued Stocks and Overvalued Predictable Companies for the details of the companies in the portfolios. As always, if you are not a Premium Member yet, we invite you for a 7-day Free Trial of the premium membership.

About the author:

gurufocus
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.0/5 (26 votes)

Comments

Adib Motiwala
Adib Motiwala - 3 years ago
Just want to point out that David Einhorn does not short stocks purely on valuation. In fact, he looks for frauds as the ideal candidate. If not a fraud, he prefers companies that are highly leveraged where if its hit a rough spot, the stock will be revalued down. I learnt with personal experience that shorting stocks purely on over valuation is a recipe for disaster.
gurufocus
Gurufocus premium member - 3 years ago
Adib,

we understand that it is risky to short purely on overvaluation. We have recently observed what happened to NetFlix shorts.

But here we are talking about a portfolio hedge strategy. We are reasonably diversified with the short portfolio. We are not shorting one stock, but 25 with equal weighting. Also we short the companies within our predictable list of companies to avoid surprises. We don't short hot stocks.

We believe that there might be surprises from the shorts. But the weighting from each one is relatively small. Most of these companies are boring and overvalued.

So far what we observed is the elimination of volatility. That is one goal to achieve when the overall market valuation is high.

The hedge worked well so far. Of course we need more time to test the strategy.

Thank you for the comments and feedback!

DaveinHackensack
DaveinHackensack - 3 years ago
Even if you are using a portfolio of shorts, you ought to consider using some factors in addition to valuation to select the stocks. For example: net insider selling, relative financial distress, basic technical analysis (e.g., not shorting companies in an uptrend, such as NFLX was when Tilson shorted it), presence of red flags suggesting accounting irregularities, etc.

Adib,

we understand that it is risky to short purely on overvaluation. We have recently observed what happened to NetFlix shorts.

But here we are talking about a portfolio hedge strategy. We are reasonably diversified with the short portfolio. We are not shorting one stock, but 25 with equal weighting. Also we short the companies within our predictable list of companies to avoid surprises. We don't short hot stocks.

We believe that there might be surprises from the shorts. But the weighting from each one is relatively small. Most of these companies are boring and overvalued.

So far what we observed is the elimination of volatility. That is one goal to achieve when the overall market valuation is high.

The hedge worked well so far. Of course we need more time to test the strategy.


Thank you for the comments and feedback!

gurufocus
Gurufocus premium member - 3 years ago
Dave,

As mentioned in the article, we short the companies that have high predictability rank, but are overvalued. Hot stocks like Apple or NetFlix will never make into the list because they are either not predictable or not having enough history to make into our list of Predictable Companies.

Not sure net insider selling, even Peter Lynch told us that insider selling does not say much. Companies that not in up trend? Not sure. Relative financial stress? Maybe. But the effect of this on stock price can be dramatic. The prices of these stocks are usually volatile. It may shoot up a lot when macro economic condition becomes favorable.

We try to make to profit from the convergence of valuations when the overall market valuation is high. Our back testing shows as a group, overvalued predictable companies consistently underperformed the undervalued groups. That is the area we are trying to work with.

This is certainly something new for us. But we feel confident about it. We are putting a large percentage of personal portfolio in this strategy.

Thank you for the feedback!
DaveinHackensack
DaveinHackensack - 3 years ago
No problem, GuruFocus.
superguru
Superguru - 3 years ago
How do Buffett, Klarman and Watsa hedge?

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