Author Archives: Scalper1

Creating A Strategy Index From Long’s Law

Long’s Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry. For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economic “Laws” should best be termed Economic “Tendencies.” The rule roughly holds across a vast array of industries. In August of 2013, I outlined an illustrative portfolio of companies which ranked highly under the criterion of having few competitors. Here’s why this is important. The robber barons understood the long-term competitive advantage of owning oligopoly businesses. You should too. An interesting characteristic that some of the businesses below share is that they are toll bridge-like businesses. For example, if you want to hedge or to speculate in the futures market, chances are you will be doing so through the futures exchanges. If you want to pay for goods or services using a credit or debit card, chances are you will be using Visa or MasterCard’s payment network. You get the picture. Here is an illustrative portfolio of companies which rank highly under Long’s Law: Major Payment Networks (Network Effect Businesses) Visa (NYSE: V ) MasterCard (NYSE: MA ) PayPal (NASDAQ: PYPL ), formerly owned by eBay Major Futures Exchanges (Network Effect Businesses) CME Group ( CME ) Intercontinental Exchange ( ICE ) CBOE Holdings ( CBOE ) Major Online Auction Marketplaces (Network Effect Businesses) eBay (NASDAQ: EBAY ) MercadoLibre ( MELI ) Major Credit Rating Agencies (De Facto Regulators) Moody’s ( MCO ) McGraw-Hill Cos. ( MHFI ) Internet Search (Dominant Online Advertising) Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) Financial Database Firms FactSet ( FDS ) Morningstar ( MORN ) Capital IQ (owned by McGraw-Hill Financial) Thomson Reuters ( TRI ) Index Providers S&P Indices (owned by McGraw-Hill Financial) MSCI ( MSCI ) Morningstar Here’s how this portfolio performs vs. the S&P 500 (please note that EBAY was used in place of PayPal due to its limited trading history since the spinoff). We equally weight the 14 stock portfolio and rebalance annually. (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge The portfolio does well but is highly correlated to the market. Perhaps we can do better. Perhaps decreasing the correlation of the portfolio to the S&P 500 can increase its returns. We can see that the drawdown profile of this strategy follows that of the broader market. It would be great to get less correlated to broad market drops. (click to enlarge) Click to enlarge What could we do to further increase the strategy’s safety and performance? As I have noted in a variety of ETP-only strategies, the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA: TMF ) (a 3X leveraged long duration government bond ETP) has the potential to act as an imperfect hedge of sorts if equity markets crash. Because the long duration government bond ETP is leveraged 3x, we can dedicate far less capital to the bond portion of a traditional stock/bond mix. The TMF instrument almost acts like a call option on long bonds. Unfortunately, interest rates are artificially low, making the TMF portion of the strategy a very imperfect hedge indeed. However, unlike a risk-parity portfolio, because the leverage is inherent to the TMF instrument, there is no margin leverage in this strategy index. And even if long bonds get decimated due to a hyper-inflation, the TMF portion of the portfolio can only go to zero in any given year in an extreme scenario. How do the companies outlined above perform if we equally weight them at 5% each, then add a 30% allocation in the portfolio to TMF? (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge We can see that the portfolio becomes less correlated to the broader equity market, and also, the Sharpe and Sortino ratios rise sharply. Let’s take a look at the drawdown profile of this strategy. (click to enlarge) Click to enlarge The drawdown profile of the portfolio is far improved! Of course, the TMF hedge is by no means perfect, but what a difference it makes. Going forward, we will examine a variety of strategy indices which combine individual stocks with ETPs, as opposed to our usual practice of just creating ETP-only indices. Consider examining whether the addition of additional asset classes can improve the risk/return profile of your own stock portfolio. Thanks for reading. As always, our cutting-edge strategy indices are only available to subscribers , but I hope that some of the strategy indices presented here will provide inspiration for readers to create their own methods for dealing with an increasingly difficult investment environment. If this post was useful to you, consider giving our service a try . Remember, hope is for people who do not use data. Wise investors plan using evidence-based methods. Thanks for reading. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results. 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. I have no business relationship with any company whose stock is mentioned in this article.

Health Care In Emerging Markets: A Compelling Investment Opportunity

Click to enlarge Many emerging market countries today are struggling to find a new growth model. Those that are reliant on commodity exports have been hit especially hard in the wake of China’s economic transition and a broader slowdown in the developed world that has weighed on commodity prices. Policy tightening in the U.S. has put additional pressure on developing markets that are heavily influenced by capital flows. Those with precarious fiscal positions, including trade/current account deficits and elevated foreign debt levels have been particularly affected. These dynamics, along with more than four years of economic growth and earnings deceleration, have led to increasingly negative investor sentiment about emerging markets. Meanwhile, valuations have generally become very attractive. Although we continue to wait for an inflection point in economic growth before becoming more bullish on emerging markets, select opportunities for discerning investors exist. We believe that certain investments in the health care sector offer attractive long-term investment opportunities. Health care services/products are underpenetrated in emerging market countries and total spending on health remains well below the levels seen in developed markets. Click to enlarge Relative to developed markets, out-of-pocket expenses as a percentage of total health expenditures are high. Generally, greater consumption of health care products and services occurs as out-of-pocket expenses fall. Click to enlarge Insurance products are also becoming more ubiquitous, and government expenditure on health as a percentage of total government spending is low. These factors in aggregate suggest that there is considerable scope for growth in emerging market health care spending as emerging economies move more in line with their developed market counterparts. Click to enlarge In addition to emerging markets having the scope to increase health care spending, developing economies have the benefit of rapidly rising levels of income and wealth, especially compared to developed markets. Empirical evidence shows a strong correlation between rising incomes and increased spending on health care, as medical care is one of the first areas in which individuals tend to increase spending as incomes grow. With wages and salaries expected to continue rising in emerging markets, consumers are slowly gaining access to services and products that were once out of reach. We believe that this trend will create myriad investment opportunities for years to come. Furthermore, we expect this investment theme to be more insulated from cyclical economic factors given the vital, essential nature of obtaining better health care. As an example, consumer health expenditure growth in many emerging markets remained robust throughout the Global Financial Crisis; 2008 – 2009 annual health spending per capita in Brazil, Russia, India, and China grew 11% on average. We believe the beneficiaries of this investment theme will be present across a number of different industries within the health care sector. These include insurance providers, pharmaceutical manufacturers, hospital owners/operators, medical equipment and supplies manufacturers/distributors, and other health care service/goods providers. Target companies do not need to be domiciled within emerging market countries to benefit from this theme provided a significant share of revenues and operating profits comes from developing markets. Despite the favorable structural backdrop for rapid growth in emerging market health care spending, it is important for investors to understand individual country dynamics and reforms that may aid or impede the consumption of health care. Investors should focus on fundamentally sound companies that have above average growth rates, attractive valuations, and are taking share at the expense of their competitors.

Passive Investing – I Doth Protest Too Much

One of my favorite blogs, The Monevator blog , did a brief write-up on my new paper this weekend . If you don’t read their website you’re missing out because they consistently post some of the best financial content around. Anyhow, they had a very fair and objective view of the paper and approach to portfolio construction. However, one point that I seem to lose a lot of people on is my discussion of active and passive investing. So, I wanted to take this space to clarify a bit. Financial commentary doesn’t have a uniform definition for passive investing. Googling the term brings up the several different results: Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. – Wikipedia Passive investing is an investment strategy involving limited ongoing buying and selling actions. – Investopedia The first definition is vague because there are limitless numbers of market cap weighted indexes these days, some of which are not well diversified and not low fee. Additionally, why should passive indexing be limited to market cap weighted index? Is it really correct to say, for instance, a fund like MORT , with 23 REIT holdings, reflects passive investing better than say, the equal weight S&P 500 ETF? An “index” is a rather arbitrary construct in a world where there are now tens of thousands of different indexes. The second definition is equally vague since an investor can hold a handful of stocks in a buy and hold strategy and limit ongoing buying and selling. Clearly, we shouldn’t call that passive investing in the sense that a low fee indexer would advocate. The new technologies such as ETFs have really muddled the discussion here as there’s now an index of anything and everything. So, as Andrew Lo notes: “Benchmark algorithms for high-performance computing blurred the line between passive and active.”¹ Along the traditional low fee indexing thinking I am tempted to define passive indexing as any low fee, diversified & systematic indexing strategy. But that could include all sorts of tactical asset allocation strategies that have systematic allocations. I don’t think it’s appropriate to call a tactical asset allocation strategy “passive”. So we’re back to a very blurry area in this discussion. In order to clarify this discussion I arrived at the following simple distinction: Active Investing – an asset allocation strategy with high relative frictions that attempts to “beat the market” return on a risk adjusted basis. Passive Investing – an asset allocation strategy with low relative frictions that attempts to take the market return on a risk adjusted basis. This definition has its own problem because we have to define “the market”. Is “the market” the USA, global stocks, global bonds, etc.? I’d argue that “the market” is the Global Financial Asset Portfolio, the one true benchmark of all outstanding financial assets. Therefore, anyone who deviates from this portfolio is making active decisions that essentially claim “the market” portfolio is wrong for them. This would mean that the only true “passive” strategy is following the GFAP. Obviously, not everyone does that and in fact, probably no one does it perfectly so that would mean we’re all basically active. Some people are active in silly ways (like day traders) and others are active in smart ways (diversified inactive indexers). Of course, I am a full blown supporter of low fee, low activity indexing. So please don’t confuse this as an attack on “passive indexing”. And yes, I am admittedly being overly precise. I certainly doth protest too much as Monevator says. But I am really just trying to establish a cohesive language here because I see too many people these days claiming they’re “passive” when they’re really being quite active. The worst offenders of this language problem are high fee asset managers who sell “passive” strategies cloaked as low fee platforms. I find that dishonest and extremely harmful. A little bit of clarity in this discussion is helpful in my opinion. ¹ – What is an Index? Lo, Andrew.