1 August, 2014
Benefits of diversification across “sources” of risk
Delivering Alpha conference
Recent Delivering Alpha conference attracted many prominent names in the investment management industry. List of speaker included such high-profile fund managers as Nelson Peltz, John Paulson, Carl Icahn, Bill Ackman, Ken Griffin, and many others. Among them was another well known, but less media-covered person. It was Leon Cooperman, founder of the hedge fund firm Omega Advisors. He shared with guests his investment ideas, and we believe one can extract some valuable insights from his presentation.
Leon Cooperman’s stock picks
First, while Carl Icahn with Bill Ackman were bragging about Herbalife stuff and other speakers presented only a few of individual names, Leon Cooperman gave a whole list of 12 stock picks. Last year he gave 10 companies which returned about 19% on average over the next 12 months. The 2013 list included Express Scripts, Qualcomm, Thermo Fisher Scientific, Qualicorp, Sandridge Energy, Arbor Realty Trust, Atlas Resource Partners, Chimera Investment Corp, THL Credit, and KKR Financial Holdings. The 10 stock picks the fund manager pitched in 2012 also performed well and returned 36% on average over the next 12 months.
Second, and more interesting aspect of stock picks was that Leon Cooperman grouped them into four categories. The categories were “growth at reasonable price”, “income and growth”, “asset restructure” theme and “high risk/high return” companies. The list of companies included Actavis, Citigroup, Thermo Fisher, Atlas Energy, Gaming and Leisure Properties, KKR Financial, Nordic American Offshore, QEP Resources, Supervalu, Louis XIII Holdings and SandRidge Energy.
Event-driven strategy benefits
There are two angles from which one can look at such categorization. First, the purely quantitative angle. Lets imagine one would take all picks and form an equally weighted portfolio. The concept whereby positions with such diverse risk/return profiles as income and high risk/high return are combined together is a well-known one. Investors often structure whole portfolios or individual positions this way. It is relatively easy to implement the approach in practice. “Income” holdings can provide a stable, but relatively low, stream of returns with lower than average volatility. This income, in turn, will compensate for possible losses in “high risk/high return” part of the portfolio that provides significant upside optionality and is often associated with higher volatility.
The second angle is a more qualitative one. The categories introduce diversification by sources of risk. A REIT stock with high dividend yield can expose the investor to real estate market dynamics while high risk/high return situation might obligate one to take risks in such areas as turnaround process execution, quality of corporate governance or management’s abilities. It is much harder to efficiently and effectively diversify the portfolio across risk sources. It is exactly this ability of portfolio managers that is being highly sought out by investors and is the source of real alpha: identification of different risks, their analysis and, finally, their pricing or investment decision. It is hard to come across managers that think actively about this dimension of their portfolio, never mind the ones that are capable to implement it successfully.
In this dimension of portfolio management the event driven strategy shines brightly. The focus on different events and situations provides a built-in process of generating ideas with multiple sources of risk. The quantitative profile of investments is also being improved almost automatically. Specific corporate transaction, such as a large share buyback, guarantees return of capital to shareholders, which, in turn, “creates” a more exact risk/return borders. Finally, a value investing philosophy can be a strong base on top of which higher dimensions of portfolio management exist.