Managing the Risk of Stocks

Portfolio Management Overview:

A commitment to the stock market involves a certain level of risk. As a result of the 2008-09 housing market collapse and the ensuing bear market in stocks, investors have become more uncertain about the markets and the appropriate amount of risk to take in their investment portfolios.

While risk can never be eliminated from a stock portfolio, we believe it can be tempered with careful management. For investors who have grown overly confident due to the stock market rally of the past few years, risk reduction strategies may now seem less important or even unnecessary.  At Clearview Wealth Solutions, however, risk management is central to all of our decisions. We believe a responsible investment manager must provide not only solid long-term returns but also a portfolio that will better withstand the twists and turns typical of today’s stock market.

Here is a review of our risk management strategies that allow us to manage volatility and risk:

1. Adequate Diversification: In Core equity portfolios we purchase 30-40 individual stocks. In Focus 20+ we buy at least 20 individual names, and in our Dividend Growth strategy we buy 25-30 individual stocks. This is done to provide adequate diversification and to limit overall portfolio losses if one name suffers a setback. Our purchases cover a variety of industries and economic sectors.

We purchase both growth stocks and value stocks to support more consistent returns regardless of the cycle. Typically when one style is out of favor the other is growing in popularity. Growth stocks are usually bought in anticipation of rapid sales or earnings growth whereas value stocks are purchased based on attractive valuation ratios.

Both large and mid-capitalization stocks are purchased. Most of our investments are large, proven companies, but we will occasionally buy a mid-size company (mid cap stock) with high potential. We do not buy small company stocks (small caps) because they are difficult to trade, typically have little business overseas, and little pricing power in a low inflation environment similar to the experience of  recent years. Also, we do not buy initial public offerings (IPOs).  IPOs are usually overpriced, are not yet seasoned companies and in many cases have not yet earned a profit.

We participate in a wide variety of industry sectors. While we may be attracted to the investment potential of certain industries, we will not eliminate the less popular or less exciting industries. Managers who greatly overweight the “hot stocks” risk getting caught in the next bubble, much like the tech bubble of the late 1990s. Reasonably priced opportunities exist in most industries and we strive to take advantage of them.  Industry diversification is crucial for reducing risk.

2. Reasonable Valuations: We avoid unproven companies, ‘hot stocks’, and those that have become popular due to price momentum. We use fundamental analysis to determine if a stock’s price is an attractive value. Fundamental analysis is the study of how a company’s stock price compares to its business performance.

The exact metrics or financial ratios vary by industry but typically we buy stocks with relatively low Price/Earnings ratios (P/E). Faster growing companies deserve higher valuations. Whether a company is a fast grower or not, its stock must be at or below the P/E ratio we have determined to be reasonable for its industry.

We also consider other valuation ratios when analyzing stocks depending on the industry. For example, we will look at Price/Sales (P/S), Price Book (P/B), and Price/Cash Flow (P/CF) when appropriate. Analyzing the value of a company’s underlying assets is also done in certain cases.

3. Monitoring and Rebalancing: We monitor Core positions closely and rebalance as necessary in order to avoid dangerously overweighting any one stock. Over-weighted individual stock positions are trimmed if they appreciate to more than 8% of the equity portfolio, and we invest no more than one third of the equity portfolio in any one economic sector (while maintaining industry diversification within that sector).
4. Strict Sell Discipline: Knowing when to sell a stock is much more challenging than the buy decision because emotions can get in the way, especially with a big winner. Here are some of the disciplined reasons we sell a stock:

• The forward P/E ratio is more than twice the 3 year estimated growth rate in earnings per share.
• The forward P/E ratio is more than one and a half times the forward P/E ratio for the S&P 500 stock index.
• The fundamental business story has deteriorated.
• Our sector strategy has changed.

5. Market Timing: We do not engage in market timing. History has proven that big market returns often occur in short, unpredictable bursts (for example, 2013). The bigger risk for investors is being out of the market. In a recent study of the stock market from 1992-2012 (source: Schwab Center for Financial Research), investors earned an annual rate of return of 8.2% in the S&P 500 stock index. If, however, investors missed the 20 best days in that 20 year period, their annual return was almost cut in half to 4.5%. Clearly time invested in the market is more important than trying to time the market.

Some Final Thoughts

There is no denying that the stock market has grown more unpredictable and returns more volatile in recent years. While we cannot eliminate the risks and market swings associated with equity investing, we believe our careful criteria and disciplined strategy can manage those risks making them more acceptable while still allowing our investors to benefit from the market’s long term potential.

Our goal is to meet each client’s individual objectives while allowing them to sleep at night. If the stock market’s volatility proves to be too stressful, we suggest a reduced exposure to stocks. We believe, however, that most of our clients have come to terms with increased volatility and now understand that being out of the market is fundamentally more risky to their long term (inflation adjusted) wealth than being in a carefully selected stock portfolio. Our investors accept that risk cannot be eliminated but can be controlled through careful risk management.