Two Portfolios: Pick One (Carefully)

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Two Portfolios: Pick One (Carefully)

Two Portfolios. Pick One by David Merkel, CFA of AlephBlog

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I’m going to show you two portfolios — I’m not initially going to tell you much about either one, but then you can consider which one you might like better.  Here’s portfolio A:

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Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More

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And here is portfolio B:

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There is one obvious difference in the two portfolios: portfolio B has gone up more than portfolio A in the past year.  But the hidden story is that portfolio A’s stocks have had price returns of -85% or worse over the past four years, whereas portfolio B’s stocks have has price returns of 1000% or better.  They are the only stocks with current market caps of over $100 million that meet those criteria.

Now, which one would you choose, if you had to hold one portfolio for the next year? The next four years?

Oddly, the right answer might be portfolio A.  Currently, I am reading through a book called Deep Value, which I will review in a week or two, and they cite in Chapter 5 some research by Thaler and De Bondt which indicates that portfolios that have gone through extreme failure tend to outperform portfolios that have gone through extreme success.

Though the momentum anomaly (weak as it has been recently) usually favors portfolios with stronger price momentum, the relationship breaks down over longer periods of time, and more severe moves, where mean-reversion tends to take over.  One thing that I can tell looking at the two portfolios — the expectations are a lot, lot higher for portfolio B than portfolio A.  Things only have to stop getting worse for there to some positive price action there.

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.  Until then.

PS — as an aside, it will be fun to review the relative performance of these portfolios.

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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