Correlation…Schmorrelation!

Personally, my focus over the summer’s been on correlation. Some investors are great at stock-picking, risk management & portfolio construction, while others are abysmal..! But, all too often, there’s precious little difference in respective performance. Because we’re all terribly correlated with the market, and with the economy – yep, we’re all making pretty much the same big bet! A preference for discounted assets, special situations & stocks with specific catalysts is my attempt to escape this correlation risk. Medium-longer term, I think this approach offers a genuine ‘edge‘ via lower beta stocks. Trouble is, shorter term, market correlation (especially in market setbacks) can simply trounce all other factors…

 Think of, say, a company with excellent results, or an oil major in a rising oil price environment. Now, picture the market dumping 25% – how well do you think those stocks are going to perform, regardless of their strong fundamentals..?! Unfortunately, if you’re a stock picker, it’s v difficult to avoid this short term market correlation. Unless you want to retreat into market-timing, trading and the weird & wacky world of specialist ETFs… For the rest of us, though, there’s some hope…

The logical & ultimate extension of my approach is to seek out investment ideas that are uncorrelated, or negatively uncorrelated, with the economy. Once you can shake off short term market correlation, this focus can offer a genuinely lower correlation/risk portfolio. There’s also the potential to earn better/decent long term returns even in an awful market/economic environment.

Ideally, I prefer uncorrelated to negatively correlated investments. The reason? Well, uncorrelated offers the possibility of sustained positive returns, while negatively correlated offers inverse returns instead. [People forget this. They add negatively correlated investments, and then grow increasingly frustrated with their losses - which are presumably offset by higher than normal returns elsewhere in their portfolio. This frustration (& over-confidence) ultimately boils over, and they dump these investments at probably the v worst moment...]. On the other hand, returns on many uncorrelated investments (e.g. Risk Arb.) are often competed away for this very reason – so annualized returns may still look attractive, but absolute returns can be positively anorexic (esp. from a private investor perspective).

From least to most attractive, I think there are three / four investment categories to be looking for:

i) Negatively Correlated Sector Stocks:  These stocks actually aren’t negatively correlated with the economy – ironically, they’re usually the most cited, the classic ‘invest in umbrellas & ice cream‘ broker pitch. Yes, they ostensibly offer a hedge against another sector allocation in your portfolio. Unfortunately, we now live in a decade where gold stocks barely appear correlated with the gold price! So I’ve become somewhat dubious of the reliability and/or benefit of this category…

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ii) Negatively Correlated Stocks:  These stocks are genuinely negatively correlated with the economy (you should always rigorously test that premise). Economic downturns actually improve their revenues & margins, and/or offer a chance to invest in attractive opportunities at compelling prices. Current examples in my portfolio include Asta Funding (ASFI:US), Colony Financial (CLNY:US) and Fortress Investment Group (FIG:US). Much of my summer’s been spent searching out more stocks that offer decent exposure to distressed consumers/companies/assets, particularly in Europe. This is proving to be a bit of a tall order..!

iii) Uncorrelated Stocks:  The underlying business model & returns are unrelated to the economy. Let’s ignore short duration event driven investments, we’re looking for longer term stock picks here. Good examples of stocks in this category would be corporate wind-downs (presuming an adequate discount to intrinsic value), certain arbitrage/activist investing vehicles (but, frankly, many are pretty correlated), certain agri stocks, and also litigation funding companies. I thought it would be fun to add a new/fourth category here – it may seem like a bit of a golden unicorn, but… 

iv) Uncorrelated Stocks, with Guaranteed Returns:  Of course, uncorrelated stocks in your portfolio is highly attractive (and nice for your peace of mind), but it doesn’t actually guarantee you positive returns… Or it may ‘condemn‘ you to low returns, albeit with a (much) reduced level of risk. Well, that’s simply not good enough! I want a) uncorrelated, b) significant, & c) guaranteed returns..!

Yes, and I guess I’d also like a time machine, please. But that’s exactly what I’ve finally come across: A business that offers reasonable (i.e. non-threatening) leverage, low expenses, a substantial discount to intrinsic value, and guaranteed & uncorrelated returns that will significantly increase that intrinsic value over time. Still working on it, but much more to come on this baby in due course…