The Return of Volatility…How to Generate Alpha

I’ve been preaching about increased volatility for months now. The days of easy money driving up all assets is firmly in the rear view mirror. Instead, we now have markets without unlimited underlying bids supporting every minor downdraft.

For those investors who sit idly in their stocks, choosing to ignore the gyrations of the markets, the return of volatility marks the end of virtually inevitable double-digit market returns.

However, for those of us who take the time to understand the fundamentals of their holdings, who watch the trading in the markets, and who are willing to be active in their portfolio management, the increase in volatility in the market creates opportunities to enhance returns.

For the past several years, it’s been tough to outperform the indexes without simply owning the FAANG stocks and letting them ride. Not only did these stocks act very one-directional (upwards), they dominated the indexes. Active managers who weren’t in these names underperformed.

This paradigm changed in the last couple weeks. Valuations on these companies have reached levels that are unjustifiable, and there is now vulnerability to the downside. Just look at FaceBook and Google’s charts; they are breaking down.

Which is not to say that these aren’t great companies and you should short them. I, frankly, don’t have much of an opinion on their current share prices. Instead, what I’m saying is that the days of them driving the market higher, and of every holder of FAANG stocks just sitting there watching them grow, is over. What is going to happen now is that portfolio managers are going to be exiting some of these holdings and reallocating funds. Quite possibly, this will be out of stocks in general.

It is possible that stocks take a much bigger hit from here. It is very likely, however, that stocks will continue to have increased volatility and that the indexes will make wild moves, like we saw this week.

Which brings me back to my point. For those of us willing to be active investors, this volatility is going to create opportunities. The indexes may be flat to down, but the economy remains strong and, as a result, there’s still tons of opportunity in the market.

The New Rules of The Game
They say a rising tide lifts all ships. Well, the tide has stopped coming in and it very well may have turned altogether. This means that the dart-picking method of stock selection is probably not the best. There are going to be new rules to the game for the foreseeable future. Make sure your investments fit within these rules and you should be off to a good start.

  1. Valuations matter. It almost goes without saying that valuations matter except, for the last few years, they haven’t. But, like all things in life, the market is cyclical and we are coming back a time where undervalued stocks will outperform overvalued ones.By the way, this means that, if your stock has seen substantial appreciation, there’s a good chance it will reverse and give back some of the gains. Taking some money off the table was painful last year; it will be prudent in 2018.Google is an example of this. The stock rallied hard after the sharp selloff with the market in February. Yet, the rally stopped and it’s back to those lows again…the point being that big moves in any stock are not going to be as sustainable as in the past and they should be faded to some degree. In an up market, getting out means you’re gone…in a flat to down market, you can likely reenter lower after a big rally.
  2. Balance sheets matter. In the post QE world we are entering, expect money to be tougher to come by. For companies that are burning cash, they are going to find that 2018 is a rude awakening.Corporations need three things right now. A) a strong balance sheet. B) strong financial backers with deep pockets. C) strong bankers. If you don’t have the first, you had better have the next two. Without all three you’re really dead meat.If you are expecting your portfolio company to complete another round of financing soon, it might be wise to sell the stock and repurchase it after the deal closes.A great example of this is RESN, which priced a deal today. The stock closed at $3.80, priced at $3.50 and ended the day at $3.30. Resonant found it very tough to raise money and this was before Friday’s downdraft; it’s only going to get harder going forward. However, on the back end of this, RESN shares are now fully-funded to well beyond positive cash-flow and make for a great investment opportunity; I backed up the truck at $3.30.
  3. Catalysts matter. Without trying to sound overly simplistic, if a company has a very positive event coming soon, investors will allocate cash to it. If it doesn’t, during a time of weaker markets, there is no urgent need to put money to work; cash was painful during an up market, it’s a salve in a down one.I’m allocating more funds to companies with known, near-term catalysts. An example of this is ChromaDex.

How I’m Handling this Market
Quite honestly, I love these kinds of markets. When it’s a time of uncertainty and volatility, the ability of a good stock picker to add value is greatly increased. The rising tide lifting every stock is done. The days of people saying, “I just own (pick your FAANG) and am up 50%!” are gone. In order to make significant returns in this market, you need to do your homework and be nimble.

The Tailwinds Select Portfolio is not ideal for this market in that our investments are small and illiquid. They can, and typically will, get smacked when the market is under pressure. On any given day (or week) it can get ugly. This last week was a great example, with the average stock down close to 10%.

Yet, when you look at Tailwinds over any longer time frame, the likelihood of outperformance has historically increased dramatically. This shows in the year to date performance; Tailwinds is up 13% with the market down 2%.

So, what am I actively doing to try to continue this outperformance? The portfolio is transitioning to have our companies and weightings fit the rules of the market as described above. I have built a proprietary matrix that analyzes companies on many different factors, generating a model weighting.

Historically, the Tailwinds Select Portfolio has been static. When a stock went in, it got the average weighting, which changed only with the underlying performance. It will now more closely reflect this model I’ve developed and, consequently, my personal investment weightings.

Needless to say, you can assume that I’ll be more active in investing around catalysts and price movements. While certainly not day-trading, and always maintaining a core position, the activity level of the Tailwinds Select Portfolio will increase.

For Those of You Keeping Track at Home…
Which brings me to an exciting announcement, Tailwinds will shortly be launching a premium subscription.

In keeping with our model, all Tailwinds content will be available to everyone for free, including the newsletter. However, the weightings of the Tailwinds Select Portfolio, and the trades taking place within the portfolio, will be reserved strictly for premium subscribers. There will be more to follow on this service in the future.

For now, I hope you had a great weekend and are surviving the volatile markets.

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