Equities by nature entail risk.  Buying a stock is, after all, predicting the future.  The biggest risk to a portfolio is a stock that falls, to state the obvious.  Risk management is an effort to find investments that rise or hold steady to offset the impact of the ones that fall.

Maximum position sizes.  A stock can fall for company-specific reasons. A portfolio should therefore have numerous stocks to diversify away that risk.  A 2% position is high enough to make a difference if you are right but low enough not to wreck the portfolio’s performance if you are wrong.   For very high convictions or extremely low betas, a 5% position can be used.  Above 5% is asking for trouble.  If you cannot find at least 20 high-conviction investments in a market of 4000 stocks, then you are not working hard enough.  Size limits also spread opportunity.  At 2% each, you can participate in the upside of money-losing disruptors like Netflix and Amazon without suffering intolerable damage if they don’t work out.

Industry diversification.  A stock price can also fall because of something industry specific.  For this reason, a diversified portfolio should consist of as broad an array of industry groups as possible to prevent a sell-off in one industry group from adversely affecting the overall portfolio.  You will, however, find little or no exposure in our portfolios to energy (prices in secular decline), biotech (too much unknowable information needed), telecom service providers (undifferentiated products, highly competitive, high fixed costs), or automotive (undifferentiated products, highly competitive, high fixed cost).    

Inverse correlations.  A stock price can also fall because the market itself falls.  There is a high correlation between the market and most stocks, but it is not 100%.  Often, a utility or consumer staple stock will rise in a market decline as the market places a premium on the reliability of their revenues.  For this reason, a portfolio should have a major commitment to the utility and consumer staple investments with the most promise.  For long-short portfolios (DHF does not do these currently), a high-conviction short position is wonderful to have when the overall market declines.  Retail and energy today abound with short opportunities.

Repeatable Revenues.  Utilities and consumer staples are not the only industries with highly reliable and repeatable revenues.  Cadence Design Systems and more recently Adobe are classic examples of companies that transformed their revenues from higher value, lower frequency purchases to lower value higher frequency purchases.  Alphabet and Facebook, whose betas are well below parity, also fit into this highly reliable revenue stream category despite being growth stocks.  These are rare investment opportunities.  Consumer staples, traditionally considered reliable revenue producers, are seeing the value of their all-important brands being eroded by consumers who trust social media friends more than brands and by Amazon whose direct shipments reduces the scarcity value shelf space.  Recent academic studies show that low beta stocks outperform over time

Repeatable Revenues:  Low or no inventory exposure.  Inventory is destructive of shareholder value precisely because it disrupts the repeatability of revenues.  Excess inventory buildup not only slows unit sales but hurts the pricing of those sales.   If you can postpone the purchase of, for instance, a long-cycle product like a car, then you are at risk for value destructive inventory build.  Alphabet and Facebook carry no inventory so are not subject to this type of value erosion, one of the reasons for their surprisingly low betas.

Repeatable Revenues:  Minimal FX exposure.  When sales and profits are reported in dollars, foreign currency exposure adds disruption to the reliability of sales.  This is destructive of shareholder value and should be minimized to the extent possible. Currency hedging done separately from the stock does not calm dollar investors who are not hedged so does not avoid value destruction. Predicting a currency is a multi-variable exercise entailing inflation, trade deficits, GDP growth, PPP, etc. that is fraught with risk in the best of times. 

Repeatable Revenues:  Minimal cyclical exposure unless you know something.  If you can postpone a purchase, then by definition you do not have an urgent need for that product.  Classical finance would have us believe that an efficient market prices in cycles, but the uncertainty of the purchases is a permanent destruction of shareholder value that should be avoided if there are better opportunities.  These investments are not long-term holds.

Valuation.  A company trading at a recently achieved high multiple of earnings detracts from attractiveness and often leads us to avoid or sell the stock.  Mitigating factors include whether the company is a disrupter, has a small market capitalization, is growing extremely rapidly, is choosing to reinvest profits back into growth, or has highly repeatable revenues.  Investors in cyclical stocks have little confidence in the sustainability of revenues.   

Low PE.   A low PE does not provide downside protection for a stock.  Just because Ford’s PE was 8 did not prevent the stock price falling from 14 to 10.  Valeant’s PE was 8 before it fell to six, a 25% decline.  Mathematically, the lower the PE, the higher percentage decline can take place without the PE noticeably changing.  That is small comfort. Conversely, a consistently higher PE can be a source of protection because, accompanied by a low beta, it reflects a high degree of confidence by investors in the stock. A high PE does not always mean high growth.  Low-beta, high PE stocks often have highly reliable revenue streams characterized by a high frequency of low-monetary value transactions.  PE should be understood in context of  beta. 

Capital Structure.  Investors today are taking too much credit risk (junk bonds) and equity risk (high-yielding common equities) to achieve their income goals.  The period from 1979 to 2007 was an anomaly, when the demand for funds was abnormally high to re-build an oil-dependent, war-torn economy.  Today is the reverse.  The five largest companies in the US by market capitalization do not need outside capital despite their high growth rates.  Risk-free capital today is also yield free, unfortunately.  Our belief is that investors seeking safe yield should move further out on the capital structure of, from bonds to A-rated preferred equities of top companies.  This was the solution commonly used to produce income in the post-war period before 1979, a period of low rates not unlike today. 

Time horizon management of cash flows.  Cash received now is safer than cash promised for the future.  Projected growth is a promise.  Free cash flow is a promise kept.   Growth stock investors did not think they were paying 60x earnings for Cisco in 1999.  They were paying 20x Cisco’s promised 2002 earnings.  Cisco’s stock broke its promise and the stock collapsed.  Accrual accounting, i.e., net income not backed by FCF, is a promise.  Cash accounting, when NI = FCF, is a promise kept.  A company that pays no cash dividend is inherently more risky than the same company that pays a dividend.  Undistributed earnings are a promise.  Distributed earnings are a promise kept.