As the market makes new highs, technology stocks lead the way. Technology’s contribution to our daily lives fosters fierce loyalty which causes many investors to overlook the risks. One of my managers, Wayne Himelsein, has made a lot of money with tech stocks like AMD and Nvidia. Last week, he bought AES, an energy company, because it showed signs of strength as good as any tech stock, and diversified his portfolio. Today, I asked Wayne whether we should be getting out of tech stocks.
Ken Kam: Last week you moved away from tech stocks with a recommendation for AES, an energy stock. Do you think its time to get out of tech stocks?
Wayne Himelsein: No, not at all. I previously discussed the benefits (and risks) of diversification, and to do so, started high level, noting the differentiated price behavior across large scale sectors. Technology and energy are two of the most disparate sectors; both in conceptual contribution to our economy and in trading characteristics. I thus recommend some energy exposure, but at the same time, it is crucial to have core exposure to technology.
On top of sector diversification, there are benefits and risks to diversifying within a single sector. The risks of diversification at the “micro” level are similar to what I discussed at the “macro” level; that picking an inferior position in aiming to diversify can lower the quality of a portfolio. In portfolio-land, we give up conviction for breadth.
But the benefits — when conviction exists — are essential. And to explain why, I’d like to talk about a recent pick of mine in technology that did not go so well, and concurrently, introduce a new one that’s been dazzling me: Arista Networks.
Kam: I remember this point from our discussion two weeks ago. The major point was don’t just diversify, find a stock that is high quality on its own right. But isn’t that hard to assess?
Himelsein: Precisely, a true diversifier needs to add value on its own, not merely added to the portfolio for the sake of diversification. In fact, the distinction has been dubbed “diversification” vs “diworsification”. Let’s not diworsify! In trading terms, accepting lower quality in exchange for perceived comfort is not a trade I’m willing to make.
That said, sometimes an assessment of high quality can face an adverse future. Two weeks ago, I introduced Xilinx, which I loved for numerous reasons as shared, and which I’ve been long for some time now. But a few days ago, Xilinx announced a not so appreciated earnings number and the stock gapped down about 16%.
This was both a disaster, and a perfect highlight of the problem with even the best stocks, and hence, the reason for diversifying!
Kam: Ouch. That shows exactly how hard the future is to assess. Nonetheless, you keep on performing with an amazing long term record. Please connect this seeming contradiction?
Himelsein: Thanks for complimentary words. And, yes, it does seem like a contradiction, but I’m here to share how it’s absolutely not. Every stock picker is a fortune teller to a degree; our conviction of an unknown future is sort of a contradiction. One cannot know the unknown. But what we can know is the continued success, en masse, of a strategy we utilize.
In other words, every individual stock has its own unique risk, what professionals call “idiosyncratic” risk. This is distinct and separate from the broader mechanism, or consistent approach one takes, to picking stocks, aka, the strategy. In my case, I have a long proven successful strategy but consistently face idiosyncratic risk.
Kam: That brings it together nicely. The approach works, but inside it, adverse events can occur. Doesn’t that frustrate you? It’s like you can’t win.
Himelsein: Maybe a little, but mostly not. Because you absolutely can win. Xilinx, as the perfect example, was still the right bet at the time I assessed it. Like when you’re playing blackjack and you have an edge, say 55% in your favor, you need to make the same play every time. Even if you lose, you did the “right” thing because that’s the strategy that works. Same here.
In my strategy, I have consistently discovered large scale behavior that works in the market. I believe in it because I believe deeply in the persistence of human nature. It is a fundamental fact that human beings exhibit “herd” behavior. Ideas snowball throughout society and culture, and within the growth of that snowball, the crowd reveals repeated behavioral patterns.
Given that the “market” is, of course, a bunch of human beings imposing their decisions (even if they are behind computers), we should expect the market to reflect our nature.
Kam: That all makes perfect sense. But now that Xilinx didn’t do as expected, what is next for it?
Himelsein: Xilinx, although damaged heavily on a single day, made a strong 3% come back the very next day. More so, even with its entire drop, it is still up incredibly on the year, about 40%. Plus, its stopping point on the drop was well above its late January break out. In no way is this a lagging stock. Quite the contrary, the power it demonstrates, even during this heavy crack, is compelling.
As of today, I remain invested in it, but continue to survey. After I see more follow-through of this event, I will comment; the character of a stock after a shock event requires time to assess. Let’s come back to Xilinx next week.
Kam: I love that process. You are patient and need to see evidence build before being sure enough to decide and to share that decision. So can you tell us more about the quality in Arista Networks?
Himelsein: Arista fits the classic “tell” of crowd behavior; it did almost nothing for a long period of time, broke out of that “nothing,” and then confirmed its breakout with vengeance. From 2014-2016, the stock was fairly flat, at least compared to what the behavior its future. In early 2017, it broke out from this resistance and established a new high – on heavy volume, aka the crowd was all in! Following, ANET went on to gain approximately 140% in 2017 – an incredible feat.
Kam: That is amazing. The kind of momentum that a stock experiences when it goes straight up for an extended period of time can be scary! But is this what you liked about it?
Himelsein: Actually, no. You’re quite right, I would have been very wary of buying it in late 2017 after it had run up so much, and especially in early 2018 after it experienced a slight pullback and started showing increased volatility. The interesting thing was that, after moving sideways in a fairly volatile fashion for the next nine months, it tried to continue its trend starting in September of 2018, but then got slammed with the Q4 market correction, finally posting a return of -10% for 2018.
However, most recently, in March of 2019, the eventual response to this tumultuous period has been revealed. Following its 2018 lull, of pausing and breathing after having run a 2017 marathon, it has powered its way back, and all the way through its previous price ceiling of around $315, breaking out to new highs and establishing a new base from which to operate.
The crowd is screaming. Their vacation from Arista lasted long enough, and they are now re-energized and ready to rumble and climb to new heights.
My Take: As the market makes new highs investors have to be careful not to fall in love with tech stocks.
Stocks go through a predictable cycle. At first, when no one sees their potential, they sell at dirt cheap prices that attract mostly deep value investors. Then, as the companies bring products to market, GARP (growth at a reasonable price) investors notice the growth and bid up stock prices. After that, growth investors — perhaps the group with the most capital today — carry the stock from reasonable prices to fair prices. At the end of the good part of the cycle, momentum investors, who buy stocks primarily because it is already moving up, carry the stock to over-valued levels.
When tech stocks are over-valued, the last person who will tell you to sell is the manager of tech fund. Fortunately for us, Wayne is not a tech fund manager. Because he is one of the few managers who has made money across many sectors, I am counting on him to warn us when its time to get out of tech stocks. We are not there yet.
Wayne Himelsein’s Logica Focus Fund (LFF) has an 18+ year track record that extends through 2 market crashes, numerous corrections, and sector rotations. Over that period, Wayne’s model averaged 11.96% a year which compares well to the S&P 500’s 6.00% return for the same period.
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