A Great Flood: Finding Our Approach and the Benefit of Relative Value

By kevin E. Meier, cfa

My analyst and I sat with my clients, the founder of the firm and one of his portfolio managers, in the founder's corner office that looked out over the San Francisco bay.  This was 2011, and I was working for a New York based broker/dealer, covering institutional clients from San Diego to Seattle.  I did not know at the time that this would be the last visit to this particular office, but I did know that things had changed. They were polite, friendly even, as my analyst performed the postmortem.  The damage had not been that bad, considering what had happened.

What had happened was a flood, massive and widespread, that had wiped out the majority of the production capacity for an entire industry.  An industry that my analyst had passionately and persuasively argued in favor of.  An industry in which my clients had invested a lot of money, spread out among the best positioned companies.

They listened and then,  seemingly satisfied,  asked, "So what else do you have for us?" Everyone in the room was experienced enough to know that things happen that are beyond control.  The only options were to quit or move forward.  We all moved on.

My analyst broke into a new investment thesis, with the utmost conviction I might add, and I found myself looking out the window and thinking about what could have been done differently.  No, we were not to blame for an act of God, nor were we responsible for my client's portfolio management and risk control.  But still, my compensation was dependent on the investment ideas I brought to my clients' doors, the product and labor of this man sitting next to me and my other analysts in New York.  This was an eat what you kill world, but I was not the hunter, I was the bird dog.  And all of the sudden I felt helpless, completely at the mercy of others.  That had to change.  In that moment, I resolved that if I was going to sell something (and all business is sales), then I needed it to be my own ideas, on my own terms.

So the question remained, though slightly revised, "What could I have done differently?"  I looked out at the bay and imagined the water rising, flowing into the streets, engulfing buildings and businesses. And a simple thought occurred to me: if I wanted to buy one of those companies, for some reason or another I had determined that it was the best investment opportunity on that particular street or in that given industry, could I sell its next door neighbor (a peer company) at the same time?  Then, if the flood waters came, literally or figuratively, the gain from the company I had sold (short) would offset the losses in the one I had purchased.  Without paying huge premiums for downside protection, I could insulate my portfolio from certain catastrophic risks.

What's more, if catastrophe did not strike, but I did get my analysis right, then I could be profitable in any market scenario.  Similar companies are affected by different market factors in similar ways, and thus generally move in the same direction but with different amplitudes.  So if I indeed bought the better relative investment (and sold short the relative worse), then the stock I bought would go up more, or down less, than the one I sold short.  Up, down or sideways, I would make more then I would lose on the overall paired position.  No longer would I, or my clients, be at the mercy of exogenous forces: supernatural, macroeconomic, or otherwise.  By taking offsetting long and short positions in peer companies, I could effectively hedge out market, sector, and industry risks and focus solely on companies' relative investment values.

Admittedly,  this was not a novel idea; traders and hedge funds have been using some version of pairs trading for years, though recently it has survived mostly as an ancillary quant strategy.  Many believed that there was little alpha left in the strategy, that the machines had arbitraged it out.  But to me, it seemed both intuitive and logical at the same time.  It would make investing more like real life, where we assess something's value by comparing it to something else.  In the moment, it was was just an idea, the start of a method that I would further develop and extensively test.  Ultimately, it would become an approach to investing that makes complete sense to me, and a method that can be profitable when other strategies, certainly the majority of equity strategies, can not not be.  I could not be certain, but I was pretty sure that I was on to something.