What to do when everything is going up but your stocks are not?

Investment in the stock market can be fun if the stocks in your portfolio increase more, compared to the market or compared to your peers' portfolios. This can be even more exciting when you hold a concentrated portfolio; the market is highly volatile and you are on the right side of the volatility. 
 
However, the increasing excitement does not come freely. Rather, it comes with an increasing amount of risks and many investors may not understand the inherent risks that the portfolio carries. Having a more diversified portfolio may reduce some of the risks. However, even if you form a well-diversified portfolio, the risk of underperforming in the market or underperforming in the peer group will always be there.
 
Even if you have a great investment thesis, and have the most undervalued stocks in your portfolio, you may underperform in the market for a considerable period of time. This often happens when the rally is mostly driven by increased liquidity in the market and expansion of P/E multiple, rather than earnings-driven rally. These are periods where 'P' gets more focus than 'E' and earnings multiple expands, especially in the case of micro-cap and small-cap stocks, as opposed to growth in earnings. 
 
Momentum investors are very active during these periods and they become the 'Investment Guru' because they can often tell with precision which one will go up on which day and by how much. Investors who are not quite convinced by the momentum-driven rally are neglected and they are often questioned for being boring in an exciting market. 
 
Even if they buy stocks with a greater margin of safety, they see that undervalued stocks get more undervalued and overvalued stocks get more overvalued. 
 
These are the periods where their temperament and investment acumen are being tested and they often question their ability to select appropriate portfolios. These are the periods where investors make the most mistakes and inexperienced investors are more vulnerable in these periods than veteran investors. 
 
Individual investors are more vulnerable than institutional (who are truly institutional in their approach) investors. If they get impatient, they often pay the price for it. 
 
It is, however, a good exercise to revisit your thesis and question your assumptions to understand where you are wrong compared to the market or what information is priced in the market compared to what information is still not priced. 

Illustration: TBS

These are the periods where investors may react to the short-term vagaries in stock prices and shift the portfolio in a way that is inconsistent to their investment philosophy or inconsistent with their competitive edge. 
 
Every investor has their investment philosophy and they invest in a way according to their investment philosophy and according to their competitive advantage. There is no one right investment philosophy and not everyone is investing with the same mandate. 
 
While underperforming in the market is painful, investors should keep in mind that no investment manager outperforms the market in all episodes of the market.
 
Every investment manager has their own style of investment. But in the market, sometimes growth stocks are more valued than value stocks, and sometimes small caps are more valued than large caps. 
 
What is dangerous is that investment managers react to the short-term performance pressure and change the investment style in a way where they do not have a competitive edge. 
 
The tendency for investment managers to deviate from their investment style due to short-term gyrations of the market are greater in an environment where the board or the investment committee are not well aware of how the investment industry works, does not understand how performance attribution works, puts too much weight on quarterly/yearly earnings per share. 
 
This situation can also arise where the pressure from clients is very high and they redeem their investments in order to reallocate the investment with other investment managers who are performing well recently. 
 
Since investment managers are forced to deviate from their investment philosophy either because of the external environment or because of their own emotional biases, they often do not know what to do when the cycle reverses, and often with reduced liquidity but increasing volatility.
 
Since they cannot react quickly in that scenario, they are often left with stocks that are bought at the peak of the cycle and the sudden surge in liquidity evaporates.
 
This can be even more painful and costly than underperforming a single quarter, half-year or a year or two. We should remind ourselves that investing is a long-game, they are like a Test match where you can beat the opposite team in a session or two or a day or two and still can lose the game.
 
So, what can an investment manager do when they are underperforming in the market?
 
Rather than reacting to the short-term underperformance, they can reevaluate their portfolio and ask the following questions and try to seek the answers to the question before changing the mix of the portfolio. 
 
The questions are not an exhaustive list. One may come up with more questions and answers to confirm or reject their hypothesis. 
 
Checking one's position in the market cycle, who are the main actors in the current market cycle, which stocks are outperforming are equally important here. 
 
What good news is being priced in the stocks that are rallying?
 
It is also necessary to find out whether good news is being priced in the stocks that are rallying. Also, one must figure out whether the influx of liquidity will be for a short period of time. 
 
Finding whether similar events and narratives took place in the past and how the current rally and narratives are different from similar past events are important factors to be noted. Investigating the consequences of the events is also necessary. 
 
People need to find out what causes the liquidity to change, how leverage in the market helps, what can cause the market cycle to reverse and the existing assumption's relevance to the current market system.
 
Asking and seeking answers to the above questions often help to understand our portfolio positioning compared to peer companies and the market. 
 
This often puts a pause to your initial thinking and you can come up with more structured thoughts that will help you to perform the necessary rebalancing of the portfolios. 
 
A champion Test batsman never reacts to the opponent team's sledging. He does not nudge when the ball is in good length and just outside the off stump. He lets the ball come to his zone and he hits the ball only when the ball is in his strong areas. 
 
Different batsmen may have different techniques and different styles of batting but they all can be champion Test batsmen. 
 
Investing is very similar to that. It is very easy to say the aforementioned things sitting in a commentary box, but playing the actual game is extremely difficult and even the champion player makes mistakes occasionally.

Md Nafeez Al Tarik is the managing director and CEO of Asian Tigers Capital Partners Asset Management Limited

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.