SMART METHODS TO INSULATE PORTFOLIOS
While the financial markets took a battering last year and lay at the mercy of oil prices, two CMU-Q professors helped develop smart beta portfolios that could weather these turbulent conditions.
While it is no secret that Qatar is an economy that is heavily dependent on oil and gas, there has been a deliberate and conscious effort by the government of the State of Qatar to diversify and reduce its reliance on commodity markets. As a result, a number of the large local enterprises have been seeking offshore investment opportunities to smooth out the highs and lows of commodity price movements and add stability to their operations.
“We put these efforts to the test by designing a smart beta portfolio of companies selected from the Qatar Stock Exchange (QSE) and testing their performance against the recent oil price decline. This project was run as part of Financial Markets, a capstone business education course at Carnegie Mellon University in Qatar (CMU- Q). The project used Q- SmartLab, a CMU- Q initiative that facilitates big data analytics to support academic research, curriculum expansion and projects that provide cutting-edge solutions to corporate partners,” say Dr John O'Brien, Associate Dean and Associate Professor of Accounting and Dr Fuad Farooqi, Assistant Teaching Professor of Finance at CMU- Q.
The Financial Markets course had students screen all of the companies listed on the QSE along different metrics like earnings quality, liquidity and market depth. Working with a shortlisted set of firms, the students conducted a detailed fundamental analysis of each company to arrive at an intrinsic value.
This analysis accounted for growth projections in light of the oil price movement and how this would impact the sales and costs. While the analysis was simple in some cases, in other firms the oil price drop posed downward pressure on both revenue and costs; using quantitative tools, the students arrived at the net impact on these firms to come up with the target share price.
It is challenging, to attempt to figure out how low oil prices would affect each of the companies. “Take the example of a consumer goods company,” says Dr Farooqi. “While naturally the cost of logistics, like importing and transportation, may have gone down, other factors like a demand slowdown would have a negative impact.” So the team had to analyse each case deeply to tie in all the variables.
“Mapping the intrinsic value against the market price, we computed the expected return for each selected firm. This forwardlooking measure of return, coupled with the historical volatility, was used to arrive at an optimal portfolio mix from this group of 15 firms. As a risk mitigation measure, we ensured that our single firm or industry exposure was capped at certain levels to allow the opportunity to diversify,” says Dr O'Brien.
The final portfolio included ten firms that, when combined together, helped the returns stay insulated from market swings (see chart). It is evident that the returns were not impacted too much by the drop in the commodity market, which can be construed as the success of the local economy to diversify so that the companies, collectively, remain protected from a repeat of the swings in prices recently seen in oil and gas.
While this particular methodology is proprietary and was developed for educational purposes and not for use by any external agency, it would buoy the prospects of investment firms in the region to fine-tune their portfolios. Dr Farooqi asserts that despite the climate, there are still gems in the financial markets and scientifically assisted portfolio building can still help you turn profits.