Source: Keydifferences

When picking securities from a fast-growing sector like the cybersecurity (HACK) sector, after performing fundamental analysis to examine stocks that should be added to your portfolio, it is equally imperative that you perform a risk analysis. When performing a risk analysis, a peer-based risk analysis is recommended. This provides a basket of comparison for the stocks in your portfolio. While risk analysis can’t be used to predict future returns, it can help understand three things:

  1. The success and evolution of a group of highly correlated stocks over the years.

  2. Investors’ sentiment and attitude towards the stocks as captured by the level of volatility which is often driven by management’s performance, guidance, and the level of macro uncertainty.

  3. The risk to reward measure of the stocks.

In this analysis, we will be performing a risk assessment of eight cybersecurity stocks from October 2013 to December 2018. The stocks are:

  1. BlackBerry (BB)

  2. Check Point Software (CHKP)

  3. CyberArk (CYBR)

  4. FireEye (FEYE)

  5. Fortinet (FTNT)

  6. Palo Alto Networks (NYSE:PANW)

  7. Proofpoint (PFPT)

  8. Symantec (SYMC) now Norton-Lifelock

Since these stocks are in the same peer group, with a positive correlation in returns, we expect them to respond to macro events in a similar way. Since they share the same sector risk, the difference in individual stock performance should come from the difference in dynamics between management’s strategy, guidance, competitive positioning, and investor’s sentiment towards each name.

Source: using Data from ycharts

Starting with the annualized returns, we can determine the performance of each stock over the years. The assumption is that stocks with the highest annualized returns have recorded the most earnings beat and positive sentiment, which can manifest itself through multiples expansion and analysts raising their price target. The stock with the highest annualized return can also be assumed to have acquired the most market share. From the chart above, Palo Alto Networks has realized the highest annualized gains between 2013 and 2018. This is followed by Fortinet and Proofpoint. As expected, these stocks have gained the highest market share by revenue in the cybersecurity market. Given their huge market share and device install base, it is easy for them to improve their average customer value (leads to improved operating margin), which will ensure their continual success in the near term given the high retention rate of their products driving a better competitive edge.

Source: using Data from ycharts

Next, we move on to the annualized volatility (standard deviation of returns from the mean). This is a measure of the uncertainty or pain experienced by investors for holding these stocks over the selected period. The assumption is that stocks with the highest volatility deferred investors’ expectations by the widest margin. The wider the margin, the higher the chances that investors will be forced to make irrational decisions like panic selling, catching a falling knife, or experience FOMO (fear of missing out). From the chart above, FireEye recorded the highest volatility. This means management consistently gave forward guidance that beat or disappointed analysts’ expectations. To confirm this, we can pull the maximum drawdown chart for our set period to measure the drawdown evolution of the stock over time.

Source: using Data from ycharts

As assumed, FireEye has recorded massive drawdowns within this period. It has recorded over 80% drawdown from its all-time high. The stock consistently underperformed its market share expansion expectation between 2014-2017. This drawdown reversed after new cost reduction, and cloud initiatives were announced in 2018.

Source: using Data from ycharts

Next, we can compute the Sharpe ratio, which is a return to volatility measure adjusted for the risk-free rate. Here I’m using a risk-free rate of 2% over the five years between 2013 and 2018.

From the chart above, Palo Alto has the highest return to volatility ratio. This means investors enjoyed the most return for the level of uncertainty experienced while holding shares of Palo Alto over the five-year time frame. Fortinet comes in second place while Check Point took the third position. It is interesting to know that network security plays occupied the top three spots. Given the huge size of the network security market, it is not surprising that investors expected these stocks to outperform their peers over the years. This is obvious from the volatility chart shared earlier. Network security vendors have the largest total addressable market driven by the land and expand strategy built around their network appliances. As a result, they are expected to keep dominating the market in the near term.

Again, it is important to remind investors that the point of this exercise is to help understand the importance of picking stocks that match their risk appetite. Even if a stock is meant to outperform its competitors over a five-year time frame, its huge volatility can cause investors to panic sell or lose confidence in their thesis in the period of high volatility.

Assuming you are risk-averse investors (little appetite for huge daily price swings) who wants to construct an equal-weight portfolio of all the stocks highlighted above, we can build an efficient frontier curve to compute the maximum return to volatility point for various portfolio weights. This can help determine the difference in return between the portfolio allocation with the highest returns and our hypothetical equal weight portfolio.

Source: using Data from ycharts

The green point on the curve represents the portfolio mix with the highest return to volatility ratio (maximum Sharpe ratio allocation). The blue point represents the portfolio mix with the lowest volatility, while the yellow point represents the return to volatility ratio of an equal weight portfolio.

Given the proximity in returns on the y-xis between an equal weight portfolio and a minimum volatility portfolio, risk-averse investors can allocate an equal weight to all eight stocks in the analysis.

However, given the wide gap in returns between the maximum Sharpe ratio allocation (green point) and an equal weight portfolio allocation (yellow mark), a risk-loving investor might prefer to buy the top three stocks with the highest Sharpe ratio. In this case, these are Palo Alto, Fortinet, and Check Point. YTD, these three stocks haven’t been bad investments.

Using the assumptions from the end of our analysis, which is December 2018, if we decide to buy the top three stocks with the highest Sharpe ratio while shorting the stocks with the lowest Sharpe ratio as our portfolio strategy for 2019, we will have been spot on. The YTD returns confirm this from the table below.

Source: Seeking Alpha

They are also projected to grow faster than their sector average as they continue to buy up smaller competitors, given their huge cash position.

Source: Seeking Alpha

Finally, an extremely risk-loving investor can buy the stock with the highest Sharpe ratio in the peer group. In this case, this is Palo Alto. If the assumptions of market leadership and the huge total addressable market, which has led investors to lower their risk premium on the stock, are valid, Palo Alto’s aggressive market share strategy will continue to hold as it acquires smaller unprofitable players. Again, different strokes for different folks.

Risks & Shortcomings

Investors shouldn’t put too much faith in the efficient frontier curve when determining the maximum Sharpe ratio point. The efficient frontier curve is a product of assuming varying portfolio allocation. As a result, a slight shift in portfolio weight between stock A and B in a portfolio can generate a wide shift in excess return to volatility.

Instead, this exercise should be geared towards forming a better understanding of the behavior of investors in a peer group of highly correlated stock and how the behavior can affect your decisions and expectations going forward. Using Palo Alto as a case study, it is safe to assume that investors in the stock are in it for the long term. Management has executed to near perfection over five years. As a result, the investors’ confidence in the stock has improved over time. To confirm this, the chart below shows that Palo Alto Networks is the only cybersecurity stock on the list of the most oversubscribed stocks by hedge funds.

Source: Goldman Sachs

Lastly, stocks that have underperformed end up getting acquired by bigger competitors. These acquisitions often come at a decent premium to their trading price. Investors who are into mergers and acquisitions bets shouldn’t overlook this fact.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-12-01