Effective Risk Management in Turbulent Markets
One of the greatest challenges in investment management is navigating the complexities of risk correlations, which can rapidly shift and increase portfolio risk. Recently, we experienced a correlation spike that affected stocks related to artificial intelligence and cyclical value stocks, leading to higher-than-desired downside capture. To adapt to this changing environment, we employed a decision-making framework inspired by former Air Force fighter pilot Colonel John Boyd’s OODA loop (Observe, Orient, Decide, Act).
This framework enables us to quickly respond to emerging risk events, distinguish between true signals and noise, and make informed decisions. The OODA loop consists of four stages: observing the portfolio to identify potential risk problems, orienting ourselves to understand the root cause of the issue, deciding on the necessary actions, and acting on those decisions.
In the recent correlation spike, we observed a significant increase in downside capture, prompting us to orient ourselves to the specific stocks causing the issue. We identified AI-related stocks and cyclical value stocks as the primary drivers of the problem. To address this, we decided to raise our healthcare exposure and reduce our holdings in power and cyclical stocks. We then returned to the orientation stage to continually monitor and adapt to the changing market environment.
Our risk management process is designed to distinguish between structural and tactical risks. In this case, we determined that the correlation spike was a technical selloff rather than a fundamental shift in the economy. We based this assessment on our main recession risk metric, credit spreads, which did not signal an imminent recession. Additionally, we considered the unwinding of the Japanese carry trade as a contributing factor to the volatility.
Our investment approach focuses on compounding shareholder wealth through a complete market cycle. We achieve this by avoiding permanent losses of capital, employing an absolute valuation discipline, and continually stress-testing long-term fundamentals. While our OODA loop framework is essential for navigating volatility storms, it is only one aspect of our broader risk management process.
In the third quarter, our portfolio underwent significant changes in response to the correlation spike. We added new positions in healthcare, utilities, and financials, while exiting holdings in industrials, IT, and consumer discretionary. Our largest additions were UnitedHealth Group and Vistra, while our largest exits were Union Pacific and Atkore.
Despite the challenges posed by the correlation spike, our portfolio remains positioned to take advantage of emerging opportunities. We continue to have lower absolute valuation metrics than our benchmark, with roughly 50% greater expected growth in earnings and free cash flow over the coming year. Our OODA loop framework and broader risk management process enable us to adapt to changing market conditions, making us well-equipped to navigate the complexities of the investment landscape.
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