Category Archives: etf

How To Pick Value Stocks

I find it ironic that more research is being done today than at any point in time in the past, yet a lot of value investors are failing to beat the market. Ironically, the mountain of articles on popular investing websites just aren’t helping. Part of the problem might be due to the “more brains” problem Graham cited years ago. Since everybody on Wall Street is so smart, all those brains ultimately cancel each other out. This glut of brain power, investment research, and investors clamoring for bargains does not mean that you can’t beat the market. But, knowing how to pick value stocks is a key requirement, along with having a good strategy and being prepared to do things that most other investors aren’t. Where You Should Hunt When Picking Value Stocks One core piece of the puzzle is leveraging your biggest competitive advantage as a small investor: your size. Let me explain… Professional money managers manage billions of dollars each year. In fact, the entire mutual fund industry in the USD in 2012 amounted to $13 Trillion and the size of the average mutual fund was a staggering $1.72 Billion. Legal regulations make owning more than 10% of a single company, or having a single company make up more than 5% of assets, a real burden for a fund company. Given that managers want to keep positions below 5% of their fund, the pool of investment candidates open to money managers is tiny. These restrictions essentially limit a manager’s universe of stocks to firms that are $860 Million in market cap or larger. That means focusing on roughly 500-600 of the largest companies in the US. With that much money sloshing around the markets, small, medium, and large cap companies are, understandably, extremely picked-over. This suggests a powerful advantage that small investors can leverage: investing where the pros aren’t investing. That really comes down to investing in micro cap and nano cap companies. It’s in this universe, among the thousands of tiny publicly traded companies available, that a small investor can pick the most promising value stocks. What Value Stocks to Concentrate On 15 years of experience in investing has taught me a few very valuable lessons. The first is that, despite your research, you’re probably not as important to the end result as you’d like to think you are. Sure, you can conduct an analysis and your stock can go up just as you predicted, but it may not have advanced for the reasons you thought. Sometimes the stocks that you assume that will work out well… don’t. And, at other times, the stocks you thought were real dogs will advance in price. Another core insight I’ve had over the previous decade is that I (and likely you, as well) am not Warren Buffett . Small investors can’t bring the same amount of skill and experience to investing as he does, and blindly following how he invests today is what I call falling into the Warren Buffett trap . Luckily, a small investor doesn’t have to have Buffett’s investing prowess to know how to pick value stocks and succeed as an investor. Investing is a probabilistic exercise, and I’ve found leveraging a statistical investment strategy (i.e. “Mechanical” investing style), extremely rewarding. Leveraging them means being able to earn the same investment returns that drew you to value investing in the first place… without you having to be an investing guru. By simply buying a basket of stocks that are undervalued relative to some value metric, you can leverage those statistical returns to propel your portfolio to large profits. What Sorts of Strategies am I Talking About? The sorts of strategies that I’m talking about fall into the “classic value investing” or “deep value investing” categories. These are the value strategies that Benjamin Graham talked about years ago when he taught his students how to pick value stocks. These strategies have been extensively tested, and used successfully in practice for decades. Low PE – One of these strategies is the classic Low Price to Earnings strategy. This strategy has been employed successfully by contrarian managers such as David Dreman , whose funds returned 16-17% per year over decades. In general, as reported by Tweedy Browne , a Low PE strategy is good for an average annual return of 16%. Low PB – Low Price to Book value is another classic value metric that yields market beating results. Using the strategy investors should expect to bag a CAGR as high as 14.5%. That’s a fat 45% in excess of the market return over the course of your life. Low PC – One of the more recent classic value strategies, and focuses on finding stocks low relative to Cash Flow. This strategy performs a bit better, recording a CAGR of just over 18% . High Dividend Yield – Mario Levis at the University of Bath conducted a study called, “Stock Market Anomalies: A Reassessment Based on the UK Evidence.” He found that the highest dividend yielding stocks returned 19.3% on average. Not bad for a basket of cheap stocks! Net Nets – But the king of these strategies is Ben Graham’s famous net net stock strategy. This strategy has consistently beaten the market both in studies and in practice by roughly 15% per year. That amounts to a 25% CAGR, and you can achieve even higher returns with a basket of net nets by screening for other key characteristics . And, my own portfolio has done very well using this strategy. Of course, the catch is that while you can always find enough stocks to fill a portfolio using the first 4 strategies, during bull markets domestic net nets dry up, making it almost impossible to use the strategy. At least, that’s what popular websites will tell you — which tripped me up years ago. By expanding your universe of investment candidates to include friendly international markets you can fill your net net stock portfolio under all market conditions. How to Pick Value Stocks Once You’ve Nailed Down a Core Strategy This is where hunting for tiny stocks comes into play. When picking value stocks, you’re going to find your best opportunities within the universe of small companies. I’m going to come at this from the perspective of a net net stock investor, since this is where I’ve chosen to specialize. That being said, the process is the same for any statistical value strategy. As it turns out, not only do small stocks offer the best opportunities for value investors, but statistical portfolios of the smallest value stocks also offer the best portfolio returns. When it comes to net net stocks, Xiao & Arnold found that a portfolio of the smallest net nets returned significantly more than the largest net nets studied, 30.6% per year vs. 17.2% per year. That’s a staggering difference in return. The same trend is found among other sorts of classic value stocks. Tweedy, Browne found that the smallest 1/5th of Low PE stocks outperformed the largest, 19.1% to 13.1%. So, no matter what strategy you use, go small. Go tiny, in fact . This is where major investing websites really start to trip up investors. The focus on large investing sites is almost always on large stocks, and that causes small investors to give up a much more promising universe of investment opportunities in favor of trying to compete against the pros. Plus, you can only take advantage of a net net stock strategy if you’re buying tiny companies. Once I’ve narrowed down my list of possible investment candidates to the smallest, I like to look for additional metrics that are highly correlated to outperformance versus the benchmark. For net nets, one of those characteristics is a Debt to Equity figure below 20%. Companies with low Debt to Equity ratios drastically outperformed the benchmark in Tweedy, Browne’s study, What Has Worked In Investing , recording a CAGR of nearly 35% compared to their universe of net nets which returned 28.8%. That’s 6% per year of extra return! I also avoid firms with major Chinese operations, due to the flood of reverse merger scams , as well as resource exploration companies, pharmaceutical companies, real estate companies, and companies in regulated industries such as finance. None of these make for the highest quality net nets, and I’m after the highest possible returns. In the end, you have to stick to the most promising industries, and this usually means focusing on your domain of competence. How to Craft Your Portfolio If you do a good enough job using additional criteria to screen out the less promising candidates, building a portfolio really takes care of itself. At the end of the process you should be left with a very manageable number of firms. From there, spend time ranking the firms from most to least promising and then spend an equal dollar amount on the 20 most promising investments. That’s it. ….sort of. There are also nuances in portfolio construction and management that can really impact your returns, but that’s not the focus of this article. I’ll write that article at some point in the future. By now, you should have a great idea of how to pick value stocks for your own portfolio. Investing is really not as difficult as you think it is but, ironically, a lot of people try to make it more difficult than it needs to be. The hardest part is really sourcing the investment ideas and then narrowing down the pool of investment candidates you pick from. At Net Net Hunter, we start with over 450 statistical international net nets but then narrow the pool down to the 30 most promising, which gives you some idea of the amount of work to do if you want to buy the best investment opportunities. 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.

What Should You Do In The Next Bear Market Rally?

Bull markets have corrections. Specifically, long-term uptrends often hit roadblocks where stock assets may pull back by 10%, 14%, even 19%. Those who may have been holding some cash typically benefit from buying into weakness at significantly lower prices. Bear markets have bear market rallies . Selling pressure typically abates long enough to allow buyers to push stocks higher by 10%, 14%, even 19%. During long-term downtrends, however, attempts at “bargain purchases” can exacerbate portfolio losses and damage psychological resolve . Consider what transpired in 2008. In the first half of the year between March and May, the Dow rallied 11% off its lows from 11,740 to 13,028. The ten weeks of “good vibes” had convinced many people that the worst was behind them. They were wrong. Now look at the epic one-week period from October 27, 2008 through November 4, 2008. The Dow catapulted from 8175 to 9675 for a monster 18% rally. Surely the worst had to be in the rear-view mirror, right? Unfortunately, many buyers who bought in those early days of November later found themselves with assets worth roughly 70 cents on the dollar. (Again, attempts to eat directly out of a bear’s paw can exacerbate overall portfolio loss as well as kill one’s psychological commitment to market-based investing.) Not surprisingly, there was a third head-fake. The Dow’s late November mark of 7550 jumped all the way back up to 9034 by the first trading day of 2009. That’s a 19.6% bear market rally that, ultimately, failed to inspire investor confidence. “But Gary,” you protest. “The Dow and the S&P 500 are currently trading between 13%-14% off of there all-time highs. How do you know this isn’t just another stock market correction in a longer-term uptrend?” I don’t know for sure. Nobody can. I may have made the case for the strong probability that the market had hit the top in the summertime. (Review August’s Market Top? 15 Warning Signs , or July’s 5 Reasons To Lower Your Allocation To Riskier Assets .) Nevertheless, there are no certainties when it comes to percentage moves for stocks, bonds, currencies or commodities. There’s more. If the Fed came to the rescue on a shining white unicorn with QE4 tomorrow, then a bear market for these two indexes might be stopped in its tracks. That is not an endorsement for quantitative easing; rather, it is an acknowledgement that an open-ended 4th iteration of electronic money creation could indeed inflate asset prices yet again. On the flip side, the evidence for why the bear market likely began in May of 2015 is colossal. For example, in bear markets, impressive rallies fail to recapture former high-water marks. Both the S&P 500 and the Dow failed to eclipse respective highs initially set in May – first in July, then again in October. What’s more, the long-term (200-day) moving averages of the indexes began sloping downward in August-September. The failed rallies as well as the negative slope for the Dow Jones Industrials are shown in the chart below. Failed rallies and downward sloping trendlines are only part of the story. In a bull market, investors embrace a wide variety of different risk assets. People go after growth, momentum, small caps, foreign, high yield, MLPs, REITs, IPOs; there is very little in the way of discrimination. As a bull market matures, many gravitate to the safest and largest stocks, eschewing asset groups that they once owned with reckless abandon; they crowd into fewer and fewer companies in fewer and fewer economic sectors. As a bull market transitions to a bear market, falling prices across an array of individual securities and key economic sectors eventually drag down market-cap weighted benchmarks. An observer of U.S. stocks can see the transition from indiscriminate risk-taking to guarded skepticism via breadth indicators. For example, when the bull market is robust, an equal-weighting of stocks in the S&P 500 usually outperforms the market-cap weighted index. As participation in the bull market wanes, and as fewer and fewer corporate shares succeed, equal-weighted proxies typically under-perform their market-cap weighted benchmarks. Not surprisingly, then, by July of 2015, the Guggenheim S&P Equal Weight ETF (NYSEARCA: RSP ) had struggled to make any progress for eight months, even as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) was close to an all-time record high. Similarly, RSP outperformed SPY right up to April of 2015. The RSP:SPY price ratio demonstrates that it has been in a downtrend ever since. Another measure of breadth is the New York Stock Exchange (NYSE) Advance/Decline (A/D) Line. It measures the extent to which advancing stocks are outpacing declining stocks, and vice versa. When the Dow and the S&P 500 are near their highs, but the A/D Line is falling, participation in the bull market is becoming increasingly narrow. It follows that narrow participation by stocks listed on the NYSE regularly precedes bearish downturns. In July of 2015, the NYSE A/D Line’s 50-day moving average crossed below its 200-day moving average for the first time since the beginning of the euro-zone crisis in 2011. (See Remember July of 2011? The Stock Market’s Advance Decline Line Remembers .) The Fed launched “Operation Twist” to lower longer-term borrowing costs in late September of 2011 and, in October of 2011, the European Central Bank (ECB) provided a series of bailouts to ailing countries and banks in the European Union. Today, there are no plans for extraordinary U.S. central bank stimulus, only “gradual” stimulus removal. The ongoing deterioration in the A/D Line since July increases the likelihood that the bear will officially come out of hibernation. Unfortunately, the problems are not solely technical in nature. There are precious few bright spots for the U.S. economy. Manufacturing has contracted for 4 consecutive months. The services sector (non-manufacturing) is at a 27-month low. Major financial institutions have raised the odds of a U.S. recession to 40%-50%. Even strength in jobs data ignore the declines in both household income and labor force participation . There’s another way to gauge economic weakness versus economic strength. Specifically, one can examine the spread between 10-year U.S. Treasury bond yields and 2-Year Treasury bond yields. The spread tends to widen during expansion; it typically narrows when there is economic distress. The current spread of less than 1 basis point (.99) is the narrowest since 2009. Meanwhile, going into 2015, nearly every traditional measure of valuation (e.g, price-to-earnings P/E, price-to-sales P/S, CAPE PE10, Tobin’s Q, market-cap-to-GDP, etc.) placed stocks at extremely overvalued levels. Going into 2016, very little had changed because corporate earnings had declined for three consecutive quarters and corporate revenue had declined for four consecutive quarters. The contraction in both top-line sales and bottom-line profits may not mean as much when treasury spreads are widening and/or market breadth is strengthening. However, when these market internals are deteriorating, fundamental valuation suddenly starts to matter again. Many of my moderate growth and income clients at Pacific Park Financial, Inc. remain significantly less exposed to stock risk than they had eighteen months earlier. Then, the reward for a typical allocation of 65%-70% stock (e.g., large-cap, mid-cap, small-cap, foreign, etc.) was worthy of the risk. Since that time, a gradual scaling back toward our current allocation of 45%-50% stock – only large-cap U.S. stock – has been decidedly beneficial. We continue to own lower volatility securities via the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), better balance sheet corporations via the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) and dividend aristocrats via the SPDR Dividend ETF (NYSEARCA: SDY ). Would I make a tactical decision to lower the current allocation to stock even further? If market internals (e.g., breath, credit spreads, etc.) continue to weaken alongside increasing economic strain, I would use the inevitable bear market rallies to lower the allocation from 45%-50% U.S. stock to 35%-40% U.S. stock. Moreover, I might increase exposure to ETFs that track the FTSE Multi-Asset Stock Hedge Index . The “MASH” Index currently boasts a 20% differential with the S&P 500 over the past 3 months. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

How XIV Earns Value (Hint: It’s Not Through Contango)

From 2012 through mid-2014, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ), an inverse VIX-futures ETN was a very profitable investment. It rose over 900% during that time. Since the end of that period, however, it’s shed over 60% of those gains, returning to 2013 levels. Any trading vehicle that dynamic is risky. Trading it profitably…and even just avoiding large losses…requires a solid understanding of what drives its movements. Unfortunately, however, many retail investors trade XIV and other VIX-futures ETNs like the ProShares Short VIX Short-Term Futures (NYSEARCA: SVXY ), the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ) and the ProShares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ), based on an explanation of their value changes that’s inaccurate. The prevailing ( but incorrect! ) wisdom goes like this: ” The inverse volatility products (including XIV and SVXY) profit during contango by buying the cheaper front month, selling the more expensive second month and keeping the difference as profit. Since the term structure is in contango most of the time, this ongoing positive roll yield generates profits for the inverse volatility ETNs and drains value from the forward volatility ETNs VXX and UVXY.” You can find this explanation offered many places, including articles on Seeking Alpha: Before diving into what’s wrong with this explanation, I’d like to establish some background with a quick overview of futures and a description of how the VIX-futures ETNs are structured. I’ll then describe the real reason these ETNs’ value changes and look at why XIV was such a profitable investment from 2012 through mid-2014. I’ll discuss the association between contango/backwardation and profitability in the VIX-futures ETNs, then end with some observations on XIV’s dramatic rise and fall that may provide insight for trading these vehicles. The terms contango and backwardation are used throughout, so let’s explain those right away. When the futures term structure is in contango, the price of the front month future, M1, is lower than the second month, M2. In backwardation, the reverse is true. Figures 1 and 2 below illustrate this. Click to enlarge Figure 1. Contango. Click to enlarge Figure 2. Backwardation. Futures Overview Quick disclaimer here: I’m not a futures trader. What I know about the mechanics of this market comes from reading and from analyzing and trading VIX-futures ETNs. A long position on a future is a contract to buy a commodity, a bale of cotton for example, on a certain future date at a certain price — the purchase (i.e., contract) price at which the future was obtained. If market price for that commodity remains low until that contract’s delivery date, the purchaser pays for the benefit of having locked down the price ahead of time. The contract’s seller, on the other side, has the short position and collects a holding fee for storing the commodity and for guaranteeing its price in advance. Using futures, both buyer and seller can establish pricing guarantees for their respective businesses. At first, it may seem the benefit is all on the side of the seller, however, things can go wrong for the seller. Suppose the seller’s warehouse is destroyed in a fire or hurricane, or workers go on strike. If the contract to deliver is for a time far in the future, the seller may not obtain the commodity until after having agreed to its selling price. In all cases, the seller is essentially placing a bet on being able to obtain and/or store the commodity at a low enough price prior to the delivery date to generate a profit. In other words, the buyer is paying the seller to assume a risk on the future price and availability of a commodity. Since both short (seller) and long (buyer) positions can be bought and sold on a futures exchange, these contracts create opportunity for speculators to buy and sell futures without ever getting involved in the physical delivery of the commodity. The VIX futures have a slight twist in that the VIX itself plays the role of physical commodity and the value of the VIX is its spot price. Delivery is purely electronic. Instead of a bale of cotton appearing on the delivery date, the buyer receives (or pays) the difference between the VIX and the final settlement price of the future; the short position’s account pays (or receives) the negative of that amount. In other words, to fulfill the contract at expiry, the seller “buys” a purely numeric value (the VIX) at its spot “price” and delivers that difference to the account that holds the long position. This is equivalent to what would happen in a physical delivery contract if, instead of delivering the physical commodity from a warehouse, the buyer and seller settled in cash for the difference between the contract price and the current spot price. One last point: futures are settled daily. At the end of each trading day, the exchange establishes a settlement price — usually based on the last few trades. All contract positions — short and long — are settled daily by crediting or debiting the difference between the prior contract price and that day’s settlement price. This is equivalent to starting each trading day with a new contract that has the prior day’s settle as its contract price. Design of the VIX-Futures ETNs The VIX-futures ETNs XIV, SVXY, VXX and UVXY, represent a mixture of M1 and M2 contracts. This mixture is rebalanced daily to maintain the equivalent of synthetic future contracts with an expiration date that’s always one month in the future. This rebalancing progressively weights M2 higher and M1 lower until, when M1 expires, all contracts have been moved (rolled) to what was M2 on the day it becomes the new M1 (since the old one has just expired). This daily roll from M1 to M2 to maintain a constant one month expiration date appears to be the source of much confusion. It should be clear from the previous section that profit and loss occurs via the nightly settlement. The daily roll occurs after that profit or loss has already accrued and does not, in itself, change the ETN’s value any more than trading two fives for a ten changes one’s cash total. Sources of Profit and Loss in the VIX-Futures ETNs The daily change in ETN value that occurs via the nightly settlement is the one-day change in contract price of M1 multiplied by the number of M1 contracts plus the one-day change in contract price of M2 multiplied by the number of M2 contracts on that day. To see what might influence these price changes, consider what the VIX futures prices represent. For volatility futures, there’s no storage cost, because the commodity is virtual. It’s a measurement produced, published and maintained by the CBOE. That means the difference between these futures and spot VIX represent the current risk premium to hedge against a rise in VIX prior to the future’s expiry. Buyers are transferring that risk to sellers and sellers charge that premium for carrying that risk. This difference in value, which is constantly being readjusted as market conditions change, represents the current premium longs need to pay to induce short positions — it’s the going market cost of volatility insurance. If the VIX subsequently spikes up above the contract price and remains high, the risk premium may have been an inadequate compensation and the inverse ETN’s value declines to reflect that loss. Conversely, for buyers, their hedge paid off, sheltering them from at least some market downside. If the VIX remains low, however, sellers pocket the risk premium as profit. Contango, Backwardation and the Mythical “Roll Yield” One reason the conventional (but incorrect) wisdom summarized at the start of this article seems so plausible is that it appears to be supported by evidence. XIV and SVXY do indeed tend to go up during periods of contango and down during periods of backwardation, while VXX and UVXY move inversely. Let’s look more closely at that association. When the term structure is in contango, a positive risk premium is in effect. This is the normal state of affairs because without that premium, sellers would have no inducement to de-risk the chance of volatility spikes for the buyers of these contracts. If contango were not the normal state of affairs, there would be no market. Contango is the result , not the cause, of the ongoing risk premium that’s required to make the market in volatility futures. When the VIX spikes above the values of both M1 and M2, the term structure shifts into backwardation. M1 (and usually M2) contracts rise in price to reflect the higher estimate of future VIX based on this spike, but typically remain below spot, since prior VIX (which was lower before the spike), is also factored into the market’s estimate of future VIX. The inverse-VIX ETNs lose value when this happens, while volatility hedges represented by the long side of these contracts pay off. Backwardation is not the cause of these valuation changes; it’s only their visible manifestation. Contango and backwardation are thus lagging indicators. They show what’s already happened, not what’s about to happen. The “roll yield” that’s so commonly described as a profit-loss mechanism in the volatility ETNs simply doesn’t exist. As described previously, profit and loss happen during settlement and are due to changes in the prices of both M1 and M2 as the forward estimate of future VIX adjusts to changing market conditions. The rebalancing, or roll, happens after this valuation change. Where did the misconception regarding a roll-yield profit/loss come from? The confusion may have arisen because the term “roll yield” is commonly used in futures trading — but with a different meaning. It’s used in the context of buying (or selling) a future, letting it expire, then buying (rolling into) a new future with the same duration. That’s different from how VIX-futures ETNs work. And even in the strategy of rolling an expiring future, the term roll yield is just a bookkeeping convenience. The past profit or loss from an expired contract is not changed by subsequently opening a new contract. Each new contract is an independent bet (or hedge) on the future value of VIX. Its net profit or loss still comes from paying or receiving a risk premium and from the difference between past-estimated and future-realized values of the VIX. The Spectacular Rise and Fall of XIV If it’s not due to contango and it’s not due to roll yield, why did XIV rise so vigorously from 2012 through mid 2014? Take a look at the chart in Figure 3, where this period of steady rise on plots of both the VIX and XIV is highlighted. The period of steadily rising XIV is notable for exactly corresponding to the period in which the VIX declined steadily and relatively smoothly to its lowest point since the 2009 crisis. After mid 2014, the VIX began ratcheting back up — slowly at first, then more aggressively, in an upward trend that started in the latter half of 2015. After spiking in August 2015, the VIX failed to return to its earlier lows. This is the point at which XIV finally breaks down. In between mid 2014 and mid 2015, both XIV and the VIX became much more volatile than before. Although XIV put in a new high during that time, once the upward trend in the VIX took hold, XIV began its precipitous fall. Figure 3. XIV and the VIX (aligned). Closing Remarks In summary: There is no yield from rolling VIX futures and contango does not determine profitability for the VIX-futures ETNs. It seems almost too obvious, yet the bottom line here is that changes in the market’s expectation for the future value of the VIX are what matter for the VIX-futures ETNs. Those expectations can be altered by changes in the trend and behavior of the VIX itself. This was a long discussion. I hope it shed light on how these volatility products work and their drivers for profit and loss. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV, VXX, OR UVXY over 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.