Knowing the Range of Likely Outcomes – XYL

“We don’t know what is going to happen next, but we do know what the distribution looks like” – Michael Mauboussin, Head of Global Financial Strategies, Credit Suisse

As we often say at EidoSearch, there’s no better gauge for the most likely forward return outcomes than historical precedence.  This quote above by Michael Mauboussin hits the mark spot on, and the concept is particularly valuable in factoring risk.

Risk modeling has continued to become more and more sophisticated.  Third party and home grown risk management systems have been widely adopted for decades to help investors and firms better understand risk within their portfolios, with the number of “factors” being utilized continuing to grow.  A typical risk model will incorporate dozens of potential environmental influences from the macro to micro level including Currency, Political impact, Market/Sector Factors and Style (Momentum, Growth, etc.).  As the number of factors rises however, it’s natural that the process becomes less transparent to the end users.

As well warranted investment in risk management practices continues, a likely challenge will be with the ease of integration for the investor.  In some respects, the increased sophistication and “black box modeling” creates challenges for the adoption by Portfolio Managers and Traders.  The other challenge is that while risk management models are well integrated for evaluating existing positions and portfolios, these inputs often times do not play as significant a role when new positions are being evaluated.  In this regard especially, there is no better starting point for determining the risk profile than identifying what the distribution of likely outcomes looks like.  How do we get an objective measure of this that can be easily incorporated into the investment process?

EidoSearch takes a snapshot of the current market environment, through its price pattern, and looks back historically at securities with similar patterns to see how investors reacted to these environments.  The great thing about using price as the proxy for capturing historical precedence is that it naturally incorporates the overriding “factors” and how the environment is impacting the security at that time.  The market conditions and other factors are never exactly the same as they are at current, but we’re not after a perfect match.  What we’re identifying, heading into an investment decision, are what the RANGE of likely outcomes are based on how investors have reacted to these similar environments in the past.

Making good bets is concentrated in the fundamentals, but factoring in a “behavioral risk” measure to understand the likely distribution of returns is a powerful tool in the investment mosaic.  Now, with the push of a button, you can get a mathematically driven risk profile for every investment and trade decision in a few seconds.  Better yet, in EidoSearch these statistics are transparent so the investor can apply their experience to these past market environments to confirm or disregard their relevance.

With that in mind, we headed into this week looking for a security that presented a good risk profile.  We quickly found one for a stock in the S&P 500, Xylem (XYL)

3 month price trend for Xylem

53 most similar historical instances of the current 3 month price trend of XYL in Industrials stocks, and the 1 month forward return of each dating as far as back as 1982.  The historical instances are up 5.9% on average, but focusing on the range of outcomes you can see that only one time was the stock down more than 8%, where there are 20 instances of the stock being up more than 8%.

Replicating the Market Call in EidoSearch (Clients Only)

• Go to New Search tab
• Type in XYL as the symbol and hit Enter
• Then hit the 3 month button at the top of the chart
• Hit “Search” button at the bottom of the chart to search this current trend in Industrials stocks
• Click on “Return Chart” to view the distribution of returns above and click on table to review in further detail