What price the upside in mid-cap stocks? (excerpt)On the Trading DeskSM—
By Peter Nulty
Here with an interesting perspective on risk and return is Bryant VanCronkhite, CFA, CPA, portfolio manager at Wells Capital Management, in this excerpt of On the Trading DeskSM from Friday, February 21, 2014. Mr. VanCronkhite is a manager in the mid-cap value space and was recently named one of Fund Industry Intelligence’s “2014 Rising Stars of Mutual Funds.”
Investors often look for upside potential, Bryant, the return on their investment. But you caution, “at what price?” Why is that? Can you explain?
We find that most investors, both individuals and professionals, spend the majority of their time thinking about the upside potential when they invest in a stock. But for us, we think it’s only one-half of the equation. We’re as intensively focused on knowing, “what’s the price for being wrong?” Because, as investors, we will be wrong at times and we need to know that, if a stock is going to go down, how far will it go down? And it’s only when you can quantify that downside risk with that price for being wrong that you can truly have confidence to allocate capital when buying a stock.
Let’s talk for a minute now about how you approach this. In your opinion, what price is appropriate for a stock with upside potential? How do you determine that value?
In general, what we like to see is an asymmetric return-to-risk ratio, meaning three times as much upside as there is downside price risk.
How does this approach help you in selecting companies?
The best way to think about it is if we go through a specific example here, with two stocks both trading at $15.00 a share. In one case, we think company A is worth $30.00 a share on the upside, so $15.00 of upside, and company B is worth $35.00 a share, or $20.00 of upside. Most investors, we think, would buy company B, the one with greater upside. But, for us, that’s only half the equation. If company B—which has $20.00 upside—has $10.00 of downside, that means the reward-to-risk ratio is 2:1. But company A, which has $15.00 upside (less upside) but only $5.00 of downside, has a 3:1 reward-to-risk ratio. We will always buy company A versus company B. We will forgo the extra upside to make sure we are properly being compensated for risk. Having that relative way of looking at things helps insure that we’re buying companies that we are being compensated for taking on the risk.
And, on the other end of the buy is the sell strategy. How do you determine that the upside has been achieved and it’s time to trim or move on?
It’s a great question. We try to remove the emotional portion of this decision by using that same reward-to-risk ratio to know when to trim a company and eventually sell it. So, as the company appreciates its value toward our upside, the reward-to-risk ratio becomes less attractive because it’s moving away from the downside and toward the upside. As it goes from a 3:1 reward-to-risk ratio to a 2:1 ratio, we start to trim it down in position size. If it goes down to a 1:1 ratio, we sell it. It’s always about the ratio of reward to risk.
Your calculation, Bryant, of this risk and reward, what is that based on? How do you make that calculation?
Sure [laughs], I usually spend a half hour with people talking about that exact question. I’ll try to boil it down into an abbreviated answer for this purpose. Our price targets are a function of our projections of cash flows in the future, added to what we believe the company can do through value creation potential by deploying their balance sheet. Companies that have flexible balance sheets are able to buy other companies, invest to accelerate organic growth, or they will buy back their own stock. They can do a lot of things to create value. The market typically ignores that until it becomes realized. Our job, when looking at how to value a company, is [determining] what’s the cash flow potential at three years out and what’s the value creation potential in deploying that balance sheet? That goes into both our upside price target and our downside price target—meaning what’s the worst-case scenario for that cash flow in the future, and what happens if they blow that balance sheet on bad transactions? And that’s how we arrive at both our upside and our downside price targets.
And now with the moment that remains we welcome a parting thought.
Whether you are a professional investor or an individual investor, I would say focus on two things. Focus on companies that control their own destiny and focus on understanding not only the upside potential but also the downside price risk. Knowing when you’re being paid to take on risk is a key element to successful investing, in my mind.
Bryant, thank you so much for joining us here On the Trading Desk.
Thank you very much for having me.
The views expressed are as of 2-26-14 and are those of Bryant VanCronkhite, Peter Nulty, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.