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Equity Perspectives

Why stress testing, an underappreciated risk-management tool, matters with equity investments

Anyone who has had a stress test knows that eight minutes at a steadily increasing pace on a treadmill can reveal the risk conditions of your heart and lungs. By the same token, stress testing is an equally important risk-management tool for determining the health of a portfolio, an investment strategy, a company, or a business model.  

While standard risk systems can help evaluate known risks, we spend a lot of time on stress testing the positive or negative impact of emerging risks, those just on the horizon that may not even be likely but are certainly possible. This area is really where portfolio managers can get blindsided. If there is a hidden risk that we can discover and then quantify for them, that would be very valuable to our investors.

Take, for example, the potential effects of a “border-adjustment tax” currently under consideration by Congress, despite concerns that such a tariff might trigger a trade war.

According to the Tax Foundation, a border-adjusted tax is a levy that is applied to all domestic consumption and excludes any goods or services that are produced in the United States, but consumed elsewhere. A border adjustment conforms to a so-called “destination-based” principle, which states that the tax is levied based on where the good ends up, rather than where it was produced.

Shortly after Donald Trump defied almost every prediction and won the presidency, David Linsen, Lord Abbett partner and director of research, and I wasted little time sounding out equity analysts on the potential impact of a border tax on the companies they cover. 

The issue resonated loudly with John McMillin, Lord Abbett partner and research analyst, and his fellow Lord Abbett analyst Anthony Attardo. McMillin covers consumer staples (food and staples retailing; food, beverage and tobacco; home and personal care products). Attardo covers the consumer discretionary sector (which includes durable goods, such as auto and home, apparel, entertainment, travel and leisure).

While consumer staples tend to be conservative and defensive stock plays, and consumer discretionary stocks tend to be cyclical, the two historically have been pillars of prudent diversification for retail and institutional portfolios. As of December 31, 2016, those sectors together represented nearly 22% of the Russell 1000® Index.

Amid heightened uncertainty about the new administration, McMillin reported that eight companies in his universe could be adversely affected by the proposed border-adjustment tax, including some major retailers and a multinational consumer goods giant. 

For his part, Attardo warned that the border-adjustment tax would have a profound effect on his companies, since most retailers and apparel companies import goods from Asia. The retail group alone imports 80% of its goods for sale in (already strong) U.S. dollars, largely from Asia. This implied a material and structurally challenging problem for many companies in retail and apparel, Attardo said, adding that earnings per share could be hard hit by such a tax-rate increase.

Testing Diversification with Stress Tests
Since the global financial crisis in 2008–09, institutional investors have grappled with ways to manage risks more effectively, in both up and down markets—with mixed results. 

In a recent speech to institutional investors, including endowments, we pointed out the risks of relying on a benchmark, or benchmarks, for prudent diversification. Twenty years ago, “diversification” simply meant owning a large number of stocks, perhaps in excess of 100, or even 200. This approach by itself is no longer enough, or even a reasonable assumption. (See Table 1.) It is easy, even for a portfolio with many positions, to have a strong bias (intentional or unintentional) embedded in it, for example, a tilt toward higher oil prices. (See Table 2.) Using modern portfolio management tools, such as a factor model, a macro model, and a battery of stress tests, we can construct a portfolio today that is diversified across factors, is less subject to existing or emerging market stresses, and, hence, allows security selection (idiosyncratic performance) to shine.

Stress tests are an important and often overlooked element of this process of measuring and ensuring diversification. These benefits of stress testing apply to liabilities as well. Many institutions immunize themselves to moves in interest rates from an asset-liability standpoint, but there are, perhaps, other market forces that still can cause a disruption; for example, dramatic moves in credit spreads; volatility; or an unexpected change in the stream of liabilities or contributions. Institutions need to analyze as many slices of risk as they can get their hands on to make sure they are not missing a scenario that could really hurt.

This is not to suggest that institutions should focus on the exact probability of rare events; but since financial markets have “fat tails,”1 rare events may be underestimated or initially overlooked. And an event with a 5% annual probability is almost guaranteed to occur over the course of an investor’s career.

 

Table 1. Deeper Diversification Analysis Looks at Emerging Risks

Source: Lord Abbett. For illustrative purpose only.

 

Table 2.  Three Degrees of Risk Management: Only the Most Diligent Explore Thematic Risks

Source: Lord Abbett. For illustrative purpose only.

 

Robust Stress Testing
Just as cars can be crash-tested and analyzed to further safety innovation, risk managers can provide portfolio managers and analysts with deeper insight into how portfolios and individual stocks may perform in extreme circumstances.

After all, risk is usually nonlinear, which is to say that liquidity usually becomes scarcer as markets go down, volatility goes up, and correlations go to 1. (A correlation of 1 implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction.)

A fragile portfolio is one in which losses would accelerate if markets tumbled. History can provide some lessons on the importance of rigorous stress testing, as the crash of 1987 showed (when the Dow lost 22.6% of its value). So can the ways certain sectors reacted to market concerns over, for example, “Brexit” (the Dow dropped 900 points in two days) and the spread of the Zika virus (historically, the market’s initial reaction to SARS and Ebola proved to be overblown).

All of which tees up some important questions; for example:

  • What large concentrations of risk are in your portfolios? The risks may be subtle; e.g., a focus on non-residential construction in an equity portfolio. 
  • Under which scenarios do you expect to fail and how likely are they? We don’t need to build a portfolio to survive a 100-year flood, but it should be able to stay dry at high tide.
  • How exposed were you to the historical long-term failure of the Japanese stock market?
  • How exposed is your portfolio to crowded trades, or, for that matter, the heavy presence of short-term speculators as opposed to long-term holders? 

The Bottom Line 
It would be nice if nothing ever went wrong—but something always goes wrong. Stress testing can help keep things from going really wrong.

It’s also really nice to do a lot of this in advance. I remember waking up on a Saturday and hearing that North Korea was shelling some islands in South Korea. I was probably one of the few risk managers that already knew, without even looking, that the inevitable drop in the Korean won and stock markets would not negatively affect our portfolios, so I took the news calmly from an investor’s point of view.

Put another way, more deliberate risk-taking and stress testing across a wide variety of scenarios improves one’s chances of investing success. 

 

1 Fat tails are a statistical phenomenon that may represents a greater likelihood of extreme events occurring similar to the financial crisis.  As Nasdaq explains on its website, “Since the magnitude of fat tails are so difficult to predict, left tail events can have devastating effects on portfolio returns. As a result, sufficiently protecting a portfolio requires tail risk hedging from unexpected market events.” In other words, while widely used financial models assume a normal distribution of returns, the marketplace is less than perfect and largely influenced by unpredictable human behavior, which leaves us with fat tail risks.

 

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. 

The Russell 1000® Consumer Staples Index comprises companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco and producers of non-durable household goods and personal products. It also includes food & drug retailing companies as well as hypermarkets and consumer super centers.

The Russell 1000® Consumer Discretionary Index encompasses those businesses that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, leisure equipment and textiles & apparel. The services segment includes hotels, restaurants and other leisure facilities, media production and services, and consumer retailing and services. 

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided here is for general informational purposes only. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual re turns or results will not be materially different from those described here.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Small and mid cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid cap companies typically experience a higher risk of failure than large cap companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.  Investing involves risk, including possible loss of principal.

Diversification does not guarantee a profit or protect against loss in declining markets.

Forecasts and projections are base d on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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