Even as a portfolio strategy

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Most investors will agree that meme stocks have no place in a fundamentals-based portfolio. Names like AMC Entertainment (AMC) have become associated with momentum, searing volatility, and even irresponsible commerce.

However, the “zero or one” nature of meme stocks in which long positions are exposed to unlimited upside but limited downside (in this case, up to 100% of committed capital) caught my eye. If the same craze persists, the AMC could be used like a bar to increase the absolute and risk-adjusted performance of a growth portfolio.

How it works

Let’s play a toss game: for a cost of $1 per draw, heads you win $3, tails you lose your dollar. Is it a good game to play forever? Clearly yes, provided $1 isn’t too much money for the player – that is, they can comfortably afford to lose it.

AMC is not a much different, albeit more complex, game (sorry, but let’s call a spade a spade: AMC trading is currently a game, not an investment). It is almost impossible to know if this stock will rise or fall today or this week. What has been seen a few times this year, however, is that stocks can “go to the moon” when they go up.

Here’s a strategy for playing asymmetric odds: make periodic small bets on the same stock of equal dollar amounts. If the shares crash, the investor loses “only” their capital – up to 100% of the initial investment, which again should be a very small number. If stocks go up, the investor can gain 200%, 400% or more.

How to run

There are many ways to create a dumbbell style wallet. I would suggest (but not recommend, as it is not investment advice) the following:

  • Allocate 99% to a “boring” asset, like an S&P 500 (SPY) ETF;
  • Each week, direct 1% of the portfolio’s initial value to a meme stock like AMC, thereby resetting or rebalancing the allocation to the meme bucket;
  • Repeat the process, still cashing in on the previous week’s gains or losses.

Assume an initial portfolio value of $100,000. When AMC took off in the week of Jan. 25, rising 280% in just five trading days following a massive short-term squeeze, the portfolio’s $1,000 allocation (1% of value original) would have reached nearly $3,800 in no time.

When AMC fell the following week, dropping almost 50%, the portfolio would have lost only $500: 50% of the new 1% allocation, or 0.5%. The net profit over the two weeks would have been $3,300: the gain of $3,800 minus the loss of $500, for a total portfolio gain of 3.3%.

Notice how the weekly reset dumbbell strategy performs better in the case of extreme volatility and expected lunar returns. On the other hand, traders who bought AMC just before January’s “meme attack” and simply held stock until the end of the week of February 1 would have only gained 95% on AMC. in two weeks, instead of 330%.

The graph below illustrates the performance of the “SPY-AMC 99/1 Dumbbell Portfolio” since the start of 2021. Notice the significantly better performance. Absolute returns would have been higher in this case due to the strong rise in the AMC so far this year.

Source: DM Martins Research

More subtly, the volatility-adjusted performance of the portfolio would also have been higher (Sharpe ratio of 0.66 versus 0.45 for the S&P 500) and the risks lower. This is partly due to the negative correlations between AMC’s daily returns and those of the general market so far this year: correlation factor of -0.26.

Below is the comparison between volatility and hypothetical declines between the barbell portfolio and the S&P 500:

  • Annualized volatility of 36.9% vs. 38.5% for the overall market
  • Maximum decline of 3.9% compared to 4.1% of the broader market

Beware of risks

Remember though: play with fire and you risk getting burned. Incorporating a meme approach into a traditional portfolio strategy can certainly backfire.

The main risk is that AMC gradually declines over time (remember that a single very sudden decline is less of a problem), as the meme mania breaks down and the fundamentals catch up with the course of action and valuations. In this scenario, the portfolio would lose a good chunk of its 1% allocation to AMC every week, and the losses could amount to something substantial.

There are, however, several ways to mitigate this risk. One is to stop trading the stock itself as soon as it produces a predetermined dollar amount of losses for the portfolio – a sort of manual stop loss. Another approach is to diversify across many meme stocks, including GameStop (GME) and others, so the strategy isn’t dependent on one name hitting a home run again.

Last words

I must apologize to the regular reader who expects me to focus my research on the fundamentals. This is generally the case for pretty much every other ticker I’ve covered on Seeking Alpha. But in my opinion, when it comes to meme stocks, business analysis currently matters little, if at all.

The important takeaway from this article is that even traditional long-term investors can still find ways to capitalize on the meme mania. All it takes is a little creativity, a lot of risk management and a little luck.


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Don F. Davis