From the October 2023 lows through the first quarter of 2024, global equities are up over 25%, some specific industries are up over 50%, and many artificial intelligence-related assets are up over 100%. Such a strong market backdrop can entice investors to deviate from the process put in place to attain their long-term objectives. The process is seen as too restrictive. “Just buy a little of the hot asset that’s leading the market, live a little,” Mr. Market’s voice implores. “It is an obvious home run,” the TV commentator declares, as they slam their hand on the “Buy, Buy, Buy” button and a bull sound effect goes off. Chasing often hurts investors. Whether it is chasing the hot asset an investor may not understand or chasing the stability of cash near the bottom of a bear market, both can lead to permanent losses of capital. Stray from the process enough, and the investor may get left praying they can achieve their objectives.
If process is so important, what drives the process practiced by Osborne Partners? Risk-reward. If you have talked with a Wealth Counselor or heard from a member of the Investment Team you’ve likely heard this term. What does it mean?
Scenario Analysis
Risk-reward at Osborne Partners has two key premises: 1) The future is uncertain; and 2) Uncertainty creates opportunity. Therefore, any investment thesis at Osborne Partners undergoes the risk-reward process starting with an analysis of a range of scenarios instead of focusing on a single future scenario.
The analysis is built on two pillars: Fundamentals and Valuation. Within these pillars, an extensive list of questions far beyond the scope of this article are assessed, but here is a flavor:
Taken together, the fundamental and valuation estimates create a range of estimated fair value scenarios, some bearish, some bullish.
Upside-Downside
When the bullish and bearish scenarios are compared, they create an upside-downside ratio. The riskier the asset, the higher the required ratio. Usually, we require over two-or-three times more upside than downside with low-teen percentage downside or better to initiate a new position in the portfolio.
Sticking to this discipline creates a margin of safety. After all, an asset’s value drivers rarely evolve perfectly. The required ratio aims to reduce the risk we care about, the permanent loss of capital on the downside, while improving the odds of attaining an attractive return on the upside despite inevitable volatility.
The upside-downside framework acts as a grounding mechanism amid volatility. It shows the level of market confidence in the probability of an outcome. For example, a 1:3 upside-downside, where there is three times as much estimated downside as upside, means the current market price implies there is a 75% chance that the upside happens. Equal upside-downside implies there is a 50% chance. A 3:1 upside-downside implies market confidence is low, with only a 25% chance. As we said earlier, uncertainty can create opportunity.
Allocation Lifecycle
If an investment thesis makes it through the scenario analysis and upside-downside phases of the process, it starts the allocation lifecycle by being added to the Watch List. To get off the Watch List and into the portfolio, it needs the final component of an attractive risk-reward: a positive catalyst path. This involves events, both fundamental and non-fundamental, that could improve the odds of realizing the upside scenario.
When the scenario analysis leads to a compelling upside-downside, and the catalyst path is attractive, it is time to buy. Importantly, the initiation is a meaningful starter, not a full-sized weight. Time is taken to observe whether the fundamental thesis is materializing as expected. It is important to note that the riskier the asset, the lower the initiation and full-sized weight.
While this is the build phase of the allocation lifecycle, there are two other phases: maintenance and exit.
Maintenance is comprised of holding, rebalancing, and trimming. If an asset’s risk-reward remains consistent with its current allocation target, we hold. If an asset has outstanding returns to where its actual weight in the portfolio is materially above its target and the asset’s risk-reward profile has stayed the same, we are inclined to rebalance the position’s actual weight to be in line with target, by selling some of the position. On the flipside, if an asset lags, causing its actual weight to sit materially below target and the asset’s risk-reward profile has stayed the same, we are inclined, assuming the catalyst path is attractive, to rebalance the position by buying more shares. Finally, if an asset is around target but the risk-reward no longer justifies that weight, we will lower the target weight, trimming the position.
Exit is when the risk-reward is so highly unattractive we eliminate the position.
Across the allocation lifecycle, we monitor the asset’s risk-reward (the scenario analysis underpinning the investment thesis; the upside-downside; and the catalyst path) and compare that to its allocation weight to decide whether the position should be increased or decreased.
Portfolio Impact
This process is executed across asset classes. The asset classes act differently from each other as they play different roles in the portfolio. The bedrock of the risk-reward process at the individual asset level when overlaid with the diversification at the asset class level, creates a resilient portfolio. This construction helps portfolios navigate multiple possible environments, from strong ones like recently from the October 2023 market lows and weaker ones fraught with uncertainty. It may not seem as exciting as the hot asset up 100% hyped on TV, but the Osborne Partners investment process is aligned with the goal of enabling clients to achieve their long-term financial goals and not having to pray for a miracle.