Taking on too much risk can be a fatal mistake for traders, but do you even know how much risk you’re taking?
Whether it be through trailing stop orders, sector and style diversification, or cash levels, there are many different ways to allocate your risk budget. This week we consider some risk budgeting strategies, using cloud-based life sciences software company, Veeva (VEEV), as a specific example.
Sector Risks: One of the old fashioned ways to allocate your risk budget is among market sectors. For example, how much volatile technology exposure do you want, or how much low-volatility utility company exposure do you want? In the case of Veeva, it is in the healthcare (NYSEARCA:XLH) sector, which is a sector known to be less volatile (and have less stock market beta exposure) than other sectors. The sector has also been a laggard this year, and if you’ve had too much exposure you’ve likely lagged the market. For reference, here is a look at recent performance for Veeva (below). For a healthcare stock, Veeva was performing quite well year-to-date, but has recently pulled back.
Style Exposures: Another way to think about your risk budget is style. Do you want more exposure to growth stocks? Value stocks? Momentum stocks? In the case of Veeva, it is a cloud-based software company, and that is a “growth” theme that has performed very well in recent years, albeit with more volatility, for example over the last month, as you can see in the Veeva chart above. As a trader, how much of your risk budget do you want to allocate to a certain theme? Are you even aware how much of your risk budget you are currently “spending” on certain themes?
For perspective, value investing is a style that has tended to perform better than growth over long periods of time and market cycles. However, in recent years, growth stocks have been performing significantly better than value. Have you allowed too much growth stock risk to creep into your portfolio? Will you be impacted significantly if/when the tide shifts back to value stocks?
We’ll have more to say about Veeva later in this report because one of our trading models has currently taken a long position. But first, here are a couple more “risk budget” things you may want to consider.
Cash Levels: Simply holding a higher or lower level of cash in your trading portfolio can dramatically change your risk profile. On one hand, it can reduce the affects of volatile market swings, but on the other hand it can cause you to miss out on return opportunities. The market tends to always go up over the long-term, but can you handle the volatility(NYSEARCA:VXX)? Do you even want to be in the market for the long-term depending on your unique situation?
Stop Orders: How tight you set your “stop orders” is another way to allocate your risk budget among trades. In theory, a stop loss order is designed to protect you from suffering the full impacts of a sharply declining market. However, if you set your stops too tight, you can end up getting stopped out of your positions thereby missing out on future (and often swift) market rebounds.
I am suspending the publication of the performance table. While performance has lagged since last fall, that is not my main reason.
The purpose of the Stock Exchange series is to feature trading methods, problems, and some specific ideas. We added the table when some readers requested it, partly to compare the different models. Instead of being a supplement that would allow readers to cheer for a specific approach, it became the focal point for many.
I also discovered that some readers thought this to be a performance report for all of the NewArc programs. That is definitely not the case. We invite interested readers to reach us directly about any of our programs. My own fundamental choices often contrast sharply with those of the model, as readers of my WTWA series would expect.
Meanwhile, our trading models, including some new additions, will continue to feature approaches and ideas each week. This has always been a sampling of what we are doing, chosen for generating interest and discussion. I hope readers will continue to enjoy the series in the intended spirit.
Expert Picks From The Models
Note: This week’s Stock Exchange is being edited by Blue Harbinger. Blue Harbinger is a source for independent investment ideas.
Holmes: I bought shares of Veeva on September 9th. How do you feel about that trade?
Blue Harbinger: Well, I have mixed feeling. I know you purchased the share for “technical” reasons, but it is also interesting from a fundamental standpoint.
Holmes: Yes, I did purchase for technical reasons. I am a technical trading model. Generally speaking, I like to “buy the dips,” and Veeva displayed a very attractive technical set up.
BH: As a fundamental guy, I pay attention to technicals, but I let fundamental analysis drive the ship. And if you feel like coming over to the fundamental side, here are a few bullish thoughts from Morningstar analysts Soo Romanoff (she thinks the shares are undervalued by about 23%):
“Veeva is the best-of-breed vertical with less than 40% share of the overall addressable market with opportunity to further penetrate a highly fragmented market. The rapid adoption of the company’s new modules further entrench Veeva into mission-critical operations of customers, making it increasingly challenging for competitors to gain a foothold. Veeva’s close co-development partnerships with customers enable the company to develop robust offerings addressing market needs that provide incremental growth vectors.”
Holmes: That is interesting perspective, but it’s subjective (it’s written by a human instead of a computer model, like me), and it’s too long-term focused. I usually exit my positions after about six weeks. And by the way, what would be interesting to me is if she actually balanced her statement out with some of the risks, instead of just that one-sided cheer leading piece.
BH: She gives some bearish comments too. For example, she writes:
“Given Veeva’s size it will be increasingly difficult to achieve the 20%-plus revenue growth, which investors have come to expect. Larger ERP providers could develop competing SaaS verticals for the life sciences industry. Litigation or regulatory headwinds may slow the company’s expansion into adjacent industries or limit growth.”
By the way, from a risk budgeting standpoint, I like that Veeva gets the lower volatility benefits of being a healthcare stocks (it’s in the healthcare sector), plus it benefits from the whole “move to the cloud” theme–a theme that I believe continues to have legs. Even if you are an emotionless, lifeless computer model, thanks for bringing this to our attention.
Emerald Bay: While you two exchange pleasantries about Veeva, I want to highlight a position I purchased on September 9th, Arconic (ARNC). Are you familiar with this stock?
Blue Harbinger: They are an industrial company. They engineer, manufacture, and sell lightweight metals worldwide. Why’d you buy?
EB: Because I seek exposure to the highest momentum names in our large cap equity universe, adjusted for volatility. Specifically, I like to base my position sizes on volatility with more capital invested in the less-volatile stocks.
BH: Nice to to see you’re paying close attention to volatility in your risk budget. Sounds smart. Especially since so many of our readers are more sensitive to volatility than others. Thanks for sharing.
Hunting big attractive returns is exciting, especially when you capture some. But adhering to your risk budget is often equally as important, especially when markets get volatile. For example, Veeva can be an interesting expenditure in your risk budget considering it has attractive healthcare sector characteristics, as well as benefiting from the secular trend of moving to the cloud (plus the recent price dip makes it even more interesting, as Holmes has pointed out). When you place your trades, do you look at them each as an isolated opportunity to capture potential gains? Or are you viewing them as part of your larger portfolio (or trading book) and paying close attention to how much of your total and composite risk budget each trade is consuming?
Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome. You can also access background information on the “Stock Exchange” here.