There was a story in the Wall Street Journal in early November about how small cap growth stocks have done very well in 2013. As of the story's publication, the average small cap growth mutual fund had risen 33% year-to-date, according to Morningstar. For many funds, the out-performance had been driven by their holdings in technology stocks.
Naturally though, this was regarded as a bad thing because, well, small cap growth funds that had the foresight to overweight their portfolios with technology holdings were now over-exposed to them and were therefore shouldering some unusual portfolio risk.
In fact, according to a Morningstar analyst quoted in the story, investors "should take note of how much these funds have appreciated, and consider shifting some assets to parts of the portfolio that haven’t done as well."
Now I'm a believer in the virtues of regular portfolio re-balancing as both a risk control measure and an alpha generating strategy. But stock prices are not only a reflection of some intrinsic value, but are also a barometer of the market's expectations for a company's prospects.
Completely selling the shares of one of your best performing investments is like punishing yourself for…being right. A rising stock price doesn't make a good company into a bad one. There's a lot of reason to believe, in fact that a rising stock price is an indication that you got your analysis right and the company underlying the stock continues to do all the things (e.g., take market share) that caused you to buy it in the first place.
So how do you balance these two worldviews? You have one that says, "Your successful investments have made your portfolio top-heavy with big winners" and another that says, "A rising price is validation of the company's competitive position: ride your winners!
The way we handle it is through quarterly re-balancing. As part of this disciplined process, we check all our current holdings and for those that have done well, but which still pass our quantitative screen we simply reduce them back to our standard position, which is 2% of the total portfolio.
This way, we "cream" off the alpha created by that position's excess returns, but we remain exposed to the company and the possibility it will continue to outperform.
And if the company has given all it's got and declines all the way back to where we originally bought it, we're still ahead overall because of the profit we took back when it was flying high.
Of course, as part of our re-balancing effort, some companies do get completely sold. This happens for the simplest of reasons: we don't think they are good companies anymore. Whether they've gone up, down or sideways during our ownership, if we think they're no longer outperforming their competition, we sell them to zero and replace them with companies in which we have greater confidence.
And as it turns out, the proportion of the Crabtree Technology model devoted to "pure" technology stocks has been steadily declining. According to Morningstar's Separate Account database, the Crabtree Technology strategy was only 47% tech at the end of August. A full 20% was in industrials, with healthcare and telecom services making up 15% and 10%, respectively.
Do we mind that this is happening? Are we actively trying to stray away from technology? "No" to both questions. We actually prefer this diversification because by having lower exposure to pure tech, we diminish the ups-and-downs caused by the influence of tech-focused exchange-traded funds, where sector rotations drive whole sectors up and down in lock-step.
And we still look for companies converting innovation into higher levels of profitability and increased market share. Example: Hexcel (NYSE: HXL), which is a leader in aerospace composites. Hexcel is classified as an industrial, but enjoys 15% operating profit margins, roughly twice that of its other aerospace and defense peers.
To sum up: 1) having winning stocks is a good thing; 2) re-balancing our portfolio helps us capture the upside of winners (and diminish the pain of losers); 3) being exposed to more than "pure" tech is our strategy for reducing volatility; and 4) we liquidate stocks not because the share price has done well, but because the company has done poorly.
Overall performance for the Crabtree Technology portfolio in October was very good on an absolute basis but mixed on a relative one. The model rose 3.9% in the month, compared with a 2.5% gain for the Russell 2000 (RUT) benchmark and a 5% gain for the S&P 500 (SPX).
Our internal benchmark, the Merrill Lynch Technology 100 (MLO) rose about 1.1% in October. The most widely held technology ETF, the State Street Global Advisor's Technology Select SPDR (XLK) rose roughly 5.0%.
November will bring with it our quarterly re-balancing, after we run our quantitative model in the middle of the month. One name we've already sold, however, is The Active Network (NYSE: ACTV), which received a take-over offer back on September 30 for $14.50 per share in cash.
As we've noted before, we aren't running a risk arbitrage business here at Crabtree, so we've simply decided to take the cash right here and right now, instead of running the risk that the deal comes apart.
We'll let you know in December about the portfolio changes brought about from the re-balancing.
DISCLAIMER: aThe investments discussed are held in client accounts as of October 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
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Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures. For information about Covestor and its services, go to http://covestor.com or contact Covestor Client Services at (866) 825-3005, x703.
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