Portfolio Construction Process
We believe Somar’s portfolio management process is accretive to our returns. Our process allows us to
- Quantify and monitor our expected portfolio performance for the next 12 months
- Easily weigh trade-offs between opportunities and risks among different industries and geographies
- Use market volatility to our investors’ advantage by sizing up positions on weakness when their risk-reward improves and harvesting positions on strength as their risk-reward declines
Our Portfolio Management process is anchored on Somar’s proprietary assessment of the risk-reward of the 200+ companies under our analysis. We centralize our insights in an internal database we call: “central opportunity monitor”. This monitor identifies the most compelling risk-rewards for long and short investments and guides our security selection and sizing decision. The central opportunity monitor is updated at least daily to reflect:
- Changing security prices
- New information that affects our assessment of the risk-reward (data science insights, earnings, other news)
- New securities analyzed
The central opportunity monitor allows us to determine what return we expect for our portfolio over the next 12 months, assuming our investments hit our base scenario projections. We track this on our portfolio and we aim to achieve a level that comfortably positions our portfolio to achieve a level that exceeds our own targets for the portfolio. This gives us strong confidence for the future of our portfolio. More importantly, our companies’ reports have been, on average, in line with our base case assumptions.
We want to make sure that we constantly deploy capital in attractive opportunities so that our prospective return is always high. We don’t want to allow current performance to come at the expense of future performance. To use numbers, let’s say in the beginning of January, we saw a 20% embedded return on our portfolio. Assume further that we deliver an 8% return in January, so that at the beginning of February our embedded return would be “only” 12%, absent our constant portfolio management. While our investors may be celebrating the January performance, at Somar we are always working hard to replace the ideas that have worked in our favor with more compelling risk-rewards. Our constant calculation of embedded returns provides early warning signs of this and keeps us focused on delivering superior performance and making sure the embedded return in our portfolio meets or exceeds our targets.
Through our central opportunity monitor we compare opportunities across industries and geographies and
move capital accordingly. While this may seem easy to implement, it is quite hard. Usually firms have
different analysts covering different geographies and industries. Their assessment of base case and adverse
case scenarios may follow strikingly different philosophies which make risk-reward comparisons among
them hard if not impossible for the Portfolio Manager. At Somar we work as a team to debate and test the
assumptions of each scenario which in the end is modelled by myself as the Portfolio Manager. Therefore,
all base scenarios and adverse scenarios have been built with the same philosophy and level of conservatism
and can be compared.
How do we measure Risk and Reward?
At Somar we believe that each asset is worth the amount of Cash Flow it delivers to its owner discounted
to the present at an appropriate rate of return. On our base case scenario, we model the company’s operations
down to the key operational drivers, according to what we believe the company will deliver. This work is
supported by our diligence, including our insights from Data Science.
Our adverse scenario assumes we are wrong about the operational drivers: in the case of a long assuming
an underperformance from the company; in the case of a short assuming an outperformance of the company.
We compare the value obtained in our base scenario with the current market price and calculate our expected
return. We also compare the value obtained in our adverse scenario with the current market price and obtain
an expected loss in the case that we are wrong. By comparing the expected return with the expected loss we
calculate our risk/reward. For example, if our base case points to a 30% return and the adverse case to a
10% loss, we have 3 = 30%/10% risk reward. At Somar we focus on achieving at least a 2x risk reward.
Somar’s assessment of the risk/reward changes as the price of the stock changes and new information
becomes available (either from due diligence or public announcements from the company). As the
risk/reward changes, Somar’s exposure to the company changes accordingly.
The process in action: HealthEquity Illustration
Somar’s trading in HealthEquity illustrates our portfolio management process in action. In the graph below
you can see Somar’s trading in response to the company’s price as well as fundamental developments
Fig. 1 shows that Somar’s trading on HealthEquity has been price sensitive in response to changes in our
estimated risk/reward. During January we also upgraded our assessment of HealthEquity’s opportunity in
response to several proposed legislations from the governing Republican party that expand the scope and
size of Health Savings Accounts in the US. This led us to raise both the price at which we are buyers and
the price at which we are sellers.