How to manage risk in your portfolio

Most of us tend to be better at buying and holding stocks than we are at selling.  After all, buying is the fun part – it’s when optimism is kicking in.  But knowing how to sell is just as important when it comes to your returns. Because recycling capital into higher quality stocks with a lower downside risk is how you improve the quality of your portfolio.

Finding the investment trigger

Over the past few months we have written a number of investment cases for companies that exhibit nascent changes in their business profiles that we believe should result in a significant change in their earnings growth profile. These emerging changes are objective pieces of evidence that confirm that changes are taking place in the company supported by quality and/or valuation. By identifying these changes or as we call “investment triggers” we strengthen our investment thesis, thereby reducing the risk and improving the quality of the position. 

Identifying a company with a new investment trigger is an exciting time for the investment team but it really only makes up half of the decision. The other half relates to what this new stock replaces in our portfolio and what we have termed “The Recycling of Risk.” We replace or recycle existing positions with what we see as a similar or greater upside exposure but with lower risk and therefore improve the overall quality of our portfolio.

While new portfolio entrants are companies with upside potential for improving earnings growth or quality of earnings, the companies exiting the portfolio or decreasing in weight are ones where the expected upside from fundamental change is complete and/or reflected in the share price. There are also instances where our analysis and thesis of the change in the business has been proven incorrect by time or new information and these also fall into the category of a down-weight or exit. 

Improving the quality of the portfolio

As a result, the Australian Eagle investment team are constantly assessing and trying to improve the quality of the portfolio while managing the risk and exposure levels in accordance with market conditions. Reallocation of capital sometimes occurs within a sector. For example, in 2022 the investment team replaced two separate positions in Fortescue Metals Group (ASX:FMG) (iron ore miner) and OZ Minerals (ASX:OZL) (copper miner) with a higher quality but less expensive resources exposure in Rio Tinto (ASX:RIO) (diversified miner with iron ore, copper and aluminium).

Other stocks with emerging change may replace companies in a different sector where we see similarities in earnings growth profiles or thematic exposures. During 2022, the team saw the potential improvement in distribution growth from Transurban Group (ASX:TCL) as a result of improved revenue outcomes from higher inflation, slower expense growth from fixed interest costs and a return to traffic volume growth. A position was initiated in TCL, replacing positions in both Telstra (ASX:TLS) and Chorus (ASX:CNU) which are both telecommunications companies versus TCL being in the industrials sector. In spite of their obvious differences, all three companies operate privileged infrastructure assets that represent risks that are determined by changes in their distribution or dividend yield.

As mentioned previously, there are times when our identification of positive change in earnings growth or quality is proven incorrect or invalidated by updated information. In other words, we were just plain wrong! This happens frequently with new portfolio stocks but these are easily replaced when detected early as the weight in the portfolio is usually very small. However, there are times when a company shows strong evidence of business transformation momentum over time, resulting in a larger portfolio position but subsequent information has invalidated our investment thesis. At that point in time, the important thing for the portfolio is how the position is managed. If we see imminent downside risk, we look to exit quickly. Given that larger portfolio weights are usually supported by either strong business quality ratings and/or demonstrable valuation support, we are normally afforded time to manage the position out of the portfolio with replacements that offer better risk/reward opportunity and with similar exposures.

The Australian Eagle investment process focuses on careful management of both entry and exits of the portfolio. Our underlying aim with managing the portfolio is to recycle capital into higher quality stocks with a lower downside risk profile while maintaining broadly similar exposures and upside potential. When making changes to the Australian Eagle portfolio, there are always two sides to a decision, meaning every position is managed for risk and return, relative to its replacement.

The Montgomery Funds own shares in Rio Tinto and Transurban. This article was prepared 23 March 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies Insurance you should seek financial advice.


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