Aside from our fundamental review of each decision, our risk management techniques are centered on three features of the portfolio management process: (1) a built-in sector rotation, (2) an automatic asset allocation between stocks and cash, and (3) the quality, or stability, of the growth potential (premium) we capture.
Built-in Sector Rotation: Market leadership to the upside follows stocks that have positive changes in growth potential, so portfolio turnover created from buy/sell signals of the Q.E.P. Index is actually a rotation into those stocks and sectors that will become the next market leaders. This built-in sector rotation, therefore, eliminates the need to invest in poorly performing sectors specifically to satisfy diversification. The portfolio will automatically be invested in the best performing sectors in the benchmark Index, and in the best performing stocks in those sectors, excluding those non-growth sectors which we do not follow, such as utilities and REITs, or sectors with greater risk which we underweight due to their link to commodity markets (i.e., oil, metals). While a more concentrated portfolio with a heavier weighting toward one or more sectors can create greater alpha, through both bull and bear cycles that have occurred since 1992, no one industry or sector has dominated our portfolios.
Asset Allocation Between Stocks and Cash: Historical analysis demonstrates that in a rising market the vast majority of the returns in a narrower market Index are provided by the stocks in the top half of the Index. Our methodology of defining a change in growth potential helps us select stocks that often populate that upper half. Therefore, in a bull market a portfolio created from a narrow Index, such as the Dow Jones Industrial Average, will typically be fully invested in approximately 40 to 45% of the stocks that comprise the benchmark, or about 12-14 stocks. Approximately 6.75 to 7.25% of the portfolio will be allocated to each stock exhibiting positive internal growth potential. For a portfolio created from the broader S&P 500 Index, the portfolio will be fully invested in approximately 13-15% of the stocks that comprise the Index, or about 65-75 stocks. Approximately 1.5% of the portfolio will be allocated to each stock.
With growth potential being the primary factor in our stock selection process, our strategy defaults to cash when fewer stocks meet our investment criteria. While rare, in an extreme bear market up to approximately 70% of the portfolio may be in cash. Our clients prefer this to forcing the portfolio to be more fully invested by increasing the allocation to each stock, or selling stocks short, as a hedge fund would do. The benefit is that the increase in cash levels works to de-leverage the portfolio against a market decline, creating a return target greater than, and a risk target lower than, the overall market. Conversely, in a bull market the portfolio will be fully invested as more stocks show positive internal growth potential. The exception is the Institutional LCG product which remains fully invested (< 5% cash) at all times.
Growth Potential and its Stability: A stock's price is a function of both growth potential and the quality of the growth potential relative to market risk. As noted above, the market reacts to changes in growth potential by pricing a growth premium into or out of the price of a stock, and the ability of a stock to maintain that premium in a volatile market is a function of the quality of its growth potential. The Q.E.P. Index not only measures changes in growth potential but also identifies the quality, and by extension the stability, of that potential by the position of the Q.E.P. Index along an established scale (see White Paper for details). As the Q.E.P. Index descends along the scale, growth potential builds and becomes more stable as the influence of capital allocation toward growth via new products and markets, acquisitions, share repurchase and dividends becomes greater. With greater stability the stock price is less influenced by external market forces and gains are maintained as price volatility relative to the market is reduced. As the Q.E.P. Index ascends along the scale the opposite happens, and growth potential diminishes and becomes less stable as earnings expectations and external factors exhibit greater influence. Lower stability leads to greater influence by other market forces and price volatility increases as market volatility increases. As a result, a portfolio of stocks with positive, high quality growth potential tends to generate excess returns with lower levels of volatility as measured by standard deviation, when compared to a benchmark index.
Because of our reliance on the Q.E.P. Index, external factors such as business valuations, long-term earnings expectations, PE and other price ratios, relative strength, and technical patterns are not considered. In addition futures, options and other derivatives are not used in an effort to enhance the returns of the portfolio.