Getting Rich In a Poor Market, Part V
In my recent posts we’ve looked at various strategies investors might turn to if we find ourselves mired in a long period of unacceptably low investment returns. We’ve evaluated higher equity allocations, taking better advantage of the return premium associated with illiquid investments, and departing from indexing to try to find more alpha among the managers we use. In this post, we’ll look at opportunistic investing.
In a sense, all investing is opportunistic. We buy or sell stock A versus stock B because we think it will give us an opportunity to beat other stocks. We hire manager A versus manager B because we hope that manager will give us the opportunity to beat other managers.
But I’m speaking of something more specific now. An “opportunistic” investment for these purposes is an investment that would not otherwise have a place in the portfolio. In other words, investors believe that investment A has a good chance of producing good returns even though it doesn’t fit into the investors’ normal asset allocation strategies or, perhaps, even into their normal risk tolerance.
Let’s take a particular – and so far unsuccessful – example. When oil prices suddenly collapsed a few years ago, astute (but, unfortunately, not infallible) investors noticed an interesting anomaly. While master limited partnerships (MLPs)* directly linked to the price of oil collapsed in price in line with oil prices, MLPs that were only remotely linked to oil prices also collapsed.
In other words, a fairly typical behavioral phenomenon had occurred – investors had panicked and thrown the baby out with the bathwater. Shrewd investors bought the baby and sold the bath water. The “baby” was transportation MLPs. If you are a pipeline company you don’t much care what the price of oil is. You operate a highly stable business charging, typically on a BTU basis, to transport energy from point A to point B.
This is a typical opportunistic investment. When things calm down, investors will look around and say, “Oops, why did we sell pipeline MLPs when we should only have sold exploration MLPs?” Those investors will repurchase pipeline MLPs and the prices of those MLPs will rise and the astute investors will make a lot of money.
So far it hasn’t happened. Part of the problem, among others, was that the collapse in oil prices caused dislocations the shrewd investors hadn’t anticipated. Prices got so low that some oil and gas companies began to consider bankruptcy, a development that might have allowed them to abrogate their pipeline contracts. In any event, pipeline MLPs lost scads of money and they haven’t earned it all back yet, though they still might.
But whether the opportunistic bet on pipeline MLPs works out or not, it’s a good example of the sort of thing investors might want to do a lot more of in a very low return environment. No matter how much the global economy might slow, and no matter how low equity returns might get on average, there will always be dislocations in the market that can be taken advantage of. Not all of them will work out, of course – we still don’t know about the MLP bet, for example. But many of them will and they can add significant return to an otherwise lackluster portfolio.
Of course, in order for opportunistic investing to add serious value in a low return environment, investors have to be serious about it. Risking 1% of the portfolio on an opportunistic position simply isn’t going to get us there. Instead, investors should consider a 1% or 2% position as the first step in enlarging the position to at least 3% to 5%. Otherwise, even if the bet works out, it won’t move the needle.
Most important of all, investors will want to build an entire portfolio of opportunistic investments, each of them designed to be independent of and uncorrelated to each other. If, for example, we’ve decided to set aside 20% of our portfolio for opportunistic investments, it would be far better – and far less risky – to divide the 20% among four or five very different ideas rather than risking all the capital on one bet.
It’s impossible to know now where those opportunistic investments will be found, of course. But the best place to look for them is in situations (like the MLP example) where other investors have behaved badly, driving prices far out of line and creating opportunities for more thoughtful investors. Beyond that, opportunities are likely to arise in very complex situations that most investors don’t have the skill or patience to exploit.
Historically, most investors haven’t pursued opportunistic investing at all. And investors that have made opportunistic bets have typically put very little capital to work in them. But in the future, it might be useful to set aside an explicit percentage of the portfolio for opportunistic investing, if only to force the search for such investments. It’s hard work and it’s nerve-racking, but in a return environment that doesn’t begin to meet our needs, it’s worth trying.
*A master limited partnership is a publicly traded security engaged in the business of exploration, extraction, refining or transportation of various energy products. MLPs have certain tax and yield advantages that can make them attractive to taxable investors.
Next up: Getting Rich in a Poor Market, Part VI