John Murphy, a financial network rep at Union National Community Bank in Lancaster County, Pa., had been one of the $500 million-asset bank's top producers from 2005 to 2007, and he wanted it to stay that way.
But when the financial crisis hit, his clients suffered along with everyone else. Last year Murphy's average return was negative-32%, only 7% better than the Standard & Poor's 500 index.
Though Murphy had been raised on modern portfolio theory and believes in the principles of asset allocation, that strategy clearly wasn't going to weather this storm.
Impelled to do something to make up for his clients' losses, Murphy decided to do what brokers used to do before buy-and-hold and asset allocation became the norm. For a portion of client portfolios, he went back to old-fashioned stock picking.
" 'Buy and hold' was the mantra that was drilled into our heads, but after a decade of not making anything, I realized you have to trade on volatility to be successful," he said. That thinking kept Murphy in the top producer slot for 2008, and he's on track to do it again this year.
Diversified baskets of funds and annuities account for two-thirds of most of his clients' portfolios — but the last third is now dedicated to a concentrated position in a few carefully chosen stocks.
Murphy said his clients are happy with the results. So far this year they are enjoying an average return of 15%, compared with 11% for the S&P. Many of his clients have been with him since he joined Union National 15 years ago, and he describes them as "average Joes with money," whose accounts range from $250,000 to $500,000. He has 900 clients, mostly age 55 to 65.
Murphy said he's enjoying his new role. "This strategy consumes more time than annuities or mutual funds, but it hones my market skills and forces me to the top of my game," he said. "I'm always very aware of what's happening in the markets, so I can always offer clients a very pertinent and timely opinion." He puts in extra hours, typically from 9:30 p.m. to 11 p.m. after dinner and 6 a.m. to 7 a.m. before breakfast. "You don't get much sleep in this business," he said.
Murphy spends those hours digging up undervalued stocks, which appreciate 15% to 20% in three or four months — or less. The idea is to take advantage of substantial volatility in current markets.
"I tell my clients you have to take what the market gives you," Murphy said. "Right now, we're seeing volatility off the charts and a market in constant rotation in terms of asset classes, which is where the opportunities are. I'm trying to take advantage of the market, to slice out what it gives."
To mitigate risk, he searches out stocks that have rock-solid balance sheets and have been unfairly beaten down.
He said he uses the ClearStation database, operated by a subsidiary of E-Trade Financial Corp., to search for stocks that show a greater short-term movement than their long-term averages would suggest is normal. Often these are stocks likely to be unduly affected by the news.
Timing is critical. If investors expect a stock to do well based on rumor, and the earnings results come in below expectations, the stock price may be unjustly punished, Murphy said. "A stock may have ultimately exceeded expectations," he said. "But because the market traded on what might happen as opposed to what did happen, the stock price may be unfairly pushed down."
Murphy uses his experience studying accounting in college to study the balance sheets and understand the fundamentals of likely candidates.
He said he checks for relative strength, strong momentum, attractive debt-to-equity ratios and earnings momentum. "I look at current assets, which keep the company afloat and its long-term debt position," he said. "I eliminate intangible assets as they're meaningless; I look at receivables and inventories because the company could collect on those or there may be an influx of new business. Really, it's just a common sense analysis."
Murphy has outperformed the S&P in client portfolios made up two-thirds of equity and one-third of bonds. "I've had more success than the traditional, asset-allocation-minded manager," he said. "So long as I manage client expectations, I find that most are happy with what's going on."
Exchange-traded funds are too broad for this strategy, and therefore don't work for trading on volatility gaps, Murphy said. And he claims that his stock-trading strategy is far safer than using double- or triple-leveraged ETFs, which he describes as a "ticking time bombs" that could lead to a triple loss as easily as a triple gain. "What I do is straight up," he said. "There's no leverage."
While Murphy is pursuing a decidedly active strategy now, he maintains that buy-and-hold is not dead. Volatility was very low between 2003 and 2007, so he couldn't have used his current strategy then. But volatility exploded between 2007 and 2009, leaving the adviser little choice but to let his clients take it lying down or to change strategy to capitalize on current market conditions.
"Volatility will subside, but not for a few years," he said. "Right now, it's not good enough to advise clients to buy an index fund and hang on, but my current strategy is something I can work with for a while."