Tag Archives: arithmetic

Dimensions Of Expected Return: Patience Is A Virtue

Giving investment advice should always aim to meet investors at their level of understanding. I do not expect everyone to have a Ph.D. in economics, so it is important to focus on big ideas that are the most crucial to understand. This can include ideas such as diversification, costs and discipline. With that said, I also recognize that many investors who have been engaged in their finances for some time or have a longstanding relationship with their wealth advisor deserve to continually learn more about investing. Today, we are going to delve further down the rabbit hole with the investment strategy that I recommend to investors. The dimensions of expected return are a finer topic that most investors are unaware of. It is hard enough motivating individuals to embrace a passive investment strategy let alone speaking about multiple regressions and time-tested data. Nonetheless, it is extremely important not only from an academic standpoint, but also from a successful investment experience standpoint. History Starting in the 1960s, financial economists began researching the behavior of stock prices. Two major events led to this particular movement in the field of economics: the development of computers and the establishment of the Center of Research in Security Prices (CRSP) at the University of Chicago. In other words, economists now had the most comprehensive dataset of stock prices and large machines that could make many computations in a reasonable amount of time. You put these two things together and all of a sudden you have an entirely new concentration in the field of economics. Decades of research and thousands of peer review academic studies into the drivers of stock market returns have led to amazing discoveries about how different types of stocks move in relation to one another. We can slice and dice the market by different factors such as market capitalization, fundamentals like book value or sales compared to market price, and region to see how different types of stocks compare to one another. From a practical standpoint, in terms of being able to translate academic findings into actual investment strategies, 4 factors or “premiums” have been found within stocks and successfully implemented (there are 2 factors that drive the behavior of bond prices): Click to enlarge That is, we know that historically stocks have outperformed bonds, small cap stocks have outperformed large-cap stocks, value stocks have outperformed growth stocks, and stocks that have high profitability have outperformed stocks with low profitability. Furthermore, we have been able to design investment strategies around these different factors. Now we are not suggesting that focusing on these “premiums” is a free lunch: quite the contrary. Traditional economic theory would suggest that higher expected returns must be associated with higher risk, which we believe for the most part is accurate. Other theories have suggested that these premiums may be associated with behavioral biases, but unfortunately, proponents of the behavioral theory have not presented an economic model to support it. Regardless, both theories still point to passive investing as the prescription. We are in essence pursuing different areas of the market that have been shown to reward investors but that involve taking risk. As we will show later on, there are periods of time where investors are not rewarded for pursuing these areas in the market, which is why they are considered to bear “risk premiums.” It is important for investors and advisors to have a healthy respect for these risk premiums when suggesting a particular asset allocation. Why These 4 in Particular? Before we go further, it is important to understand that there have been many factors found in academic research, but we stick with these particular 4 factors for the following reasons: They are sensible Persistent across time periods Pervasive across markets Robust to alternative specifications Cost-effective to capture in a diversified portfolio In other words, there is a very high degree of confidence that investors will benefit from focusing on these particular factors. From a fiduciary standpoint, it is crucial that we only do things that have been shown to be successful through rigorous scientific inquiry. Historical Performance of These Factors We now have a general understanding about dimensions of expected return. Historically, investors who have focused on these particular factors within equities have been rewarded with higher returns. Below we see the historical size, relative-price and profitability premiums for US, International/Developed and Emerging Markets using the longest dataset available for each market. Click to enlarge For example, within Emerging Markets Stocks, value stocks have outperformed growth stocks (relative price premium) by approximately 4.47% per year from 1989-2014. The highest premium has been the profitability premium in Emerging Markets, delivering 7.12% per year from 1996-2014. The smallest premium has been the size premium in the Emerging Markets, delivering 1.82% per year from 1989-2014. No Such Thing as a Free Lunch As we mentioned earlier, pursuing these different premiums in the market is no free lunch. If we want to be rewarded with higher expected return, then we have to take risk. While we should expect these premiums to be positive in any year, there are periods of time where they do not. Many clients of IFA are probably well aware that the relative price premium (value stocks) in US stocks did not deliver for the last 10-year period ending 12/31/2015. The charts below show the annual performance for each premium in the US from 1928-2014. A blue bar indicates a positive premium while a red bar indicates a negative premium. Click to enlarge As you can see, there are definitely more blue bars than red bars, but there are time periods where there are multiple years in a row where different premiums do not show up. Although the average premium observed over time has been positive, there is extreme variation around that average. For example, just looking at the relative price premium in the US, we can see that the historical average has been 3.64%. There have only been 9 years out of 87 where the observed premium was within 2% of the historical average. See the chart below. Click to enlarge The dashed line represents the arithmetic average (3.64%). The gray area around the dashed line represents the 2.00% range around that average. The dark blue bars represent the annual observations that fall within the range (1.64%-5.64%). While the average relative price premium in the US has been less than 5%, it is more likely that you will experience a much higher or much lower premium in any given calendar year. The same conclusions hold for the size and profitability premiums in the US as well as all of the premiums around the world. Patience is a Virtue While many investors are well aware of diversification in terms of investments, many people cannot fully grasp diversification in terms of time. I recommend diversifying investments as a risk control. Because we do not know with a high degree of certainty which area of the market is going to be the next winner, we hold many different types of stocks. Diversification has been shown to improve returns in terms of risk. Time diversification is the idea of following a particular investment style over time. As we mentioned before, premiums do not always show up in any given year, but the longer we hold onto them, the likelier we are to capture their benefits. If instead of looking at 1-year returns we now looked at 5-year rolling returns, how do the premiums look? Click to enlarge Each bar shows the 5-year period ending in that particular year. For example, the first red bar under the “market premium” is for the 5-year period ending 1932. The next red bar is the 5-year period ending 1933 and so on and so forth. What do you notice? Compared to the 1-year annual returns shown above, there are far fewer red bars in the 5-year rolling returns. In other words, once we move from looking at premiums from 1 year to 5 years, the probability of seeing a positive premium increases. Again, just to highlight the relative price premium in the US, below is a chart showing the historical 5-year annual rolling returns. Click to enlarge Looks like a smoother ride for the investor versus annual returns. Following the same logic, what if we looked at 10-year rolling periods, what do we expect to find? Click to enlarge As you can see, this looks even better than the 5-year rolling returns. Very few red bars across all 4 premiums. Once again, just to highlight the relative-price premium in the US, below shows the 10-year annual rolling returns. Click to enlarge As you can see, once we present the data in terms of 10-year periods, the pursuit of this premium looks very attractive. From 1941-1995, there was not a single 10-year rolling period where value stocks underperformed growth stocks. With that said, you can also see that in the 10-year period from 2005-2014, the value premium did not deliver. The table below shows the historical performance for the market, size, relative-price and profitability premiums in the US in terms of having a positive observation. Click to enlarge For example, looking at historical 15-year rolling periods for the market premium, there have been positive premiums 96% of the time. You can also see that across every single premium, the number of positive observations increases as we increase the time horizon. Things Can Turn Quickly We have already discussed the extreme variability around the historical averages for each premium. This variability means that things can quickly turn either positive or negative, highlighting the importance of long-term discipline when pursuing these risk premiums within a portfolio. The chart below shows the historical 10-year annual rolling observations for the relative-price premium sorted from lowest to highest. Click to enlarge You can see that for the 10-year period from 2005-2014, the value premium was slightly negative (-0.78%). This isn’t odd, as you can see other 10-year periods in history where the value premium was significantly negative. But if we go back just one more year and look at the 10-year period from 2004 to 2013, the value premium switches to being slightly positive (0.79%). This just emphasizes the importance of having a long-term focus when deciding to pursue these risk premiums within your portfolio. Conclusion As advisors, it is our duty to constantly educate our clients into understanding the reasoning behind their particular investment strategy. This not only allows us to be transparent, but it is crucial in building long-term discipline of the investment process. Beyond investing in index funds, academic research has found certain factors or premiums within the market that explain the variation in its returns. By pursuing these premiums we can increase the expected return of the portfolio for our investors, but this does not come without accepting a higher degree of risk or variability of returns. Because there is significant volatility around these premiums in any given year, it is important to maintain a long-term focus. Historically, the number of positive observations for each premium around the world increases as we increase the time horizon. Because I believe in a long-term approach to the investment process, I believe that pursuing these premiums within portfolios will be beneficial for investors, with the ultimate goal of creating a positive investment experience. 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. Additional disclosure: We utilize strategies from Dimensional Fund Advisors in the portfolios that we build for our clients. There are no profit-sharing arrangements between my firm, Index Fund Advisors, Inc., and Dimensional Fund Advisors, LP.

Aqua America – A Retirement Stock

Analyst project positive revenue and earnings. Financial strength A-. Great price momentum. Retirement investing is a little different than the Total Return Investing you may have been doing all your life. You used to swing for the fence knowing that time, volatility and regular capital additions to your portfolio would prove the principles of long-term dollar-cost averaging. During retirement and distribution phase of your life, dollar-cost averaging works against you and becomes your worst enemy. Your new goals are: Capital preservation A conservative total return that exceeds your withdrawal rate, taxes and inflation A return that beats the market You fully research a stock and make sure you have the information needed to rationally decide the stock is a good addition to your portfolio. I use a screener provided by Barchart to find stocks that currently are having a positive price momentum and then make sure they fit the criteria listed above. When I screened the Russell 3000 Index stocks today, Aqua America (NYSE: WTR ) was right near the top of the list. Aqua America is one of the largest U.S.-based, publicly traded water utilities and serves nearly 3 million people in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia. First I make sure the stock is outperforming the market. Why would I want to add a stock to my portfolio unless it significantly does better than the market? I use the Value Line Arithmetic Index as my Market benchmark for 2 reasons: 1) it contains 1,700 stocks with a total capitalization of almost 95% of the U.S. stock market, and 2) it is not weighted by capitalization, so the big stocks have the same weighting as the small ones. During the last year, while the market was down 2.79%, WTR gained 17.30%: I like to research the stock’s underlying fundamentals to see if that price momentum is warranted. Market Cap $5.28 Billion P/E 23.26 Dividend yield 2.45% Revenue expected to grow 4.80% this year and another 5.30% next year Earnings are estimated to increase 5.80% this year, an additional 7.10% next year and continue to compound at an annual rate of 5.55% for the next 5 years Financial Strength A- The overall sentiment of the investing community is very important. A stock will not maintain its upward momentum is some of the major players are starting to bail. Wall Street analysts have issued 4 strong buy, 2 buy and 4 hold recommendations on the stock to their clients Institutional investors own about 48.18% of the outstanding shares. During the last year, 170 added to their positions, while 140 decreased their shares for a net gain of 1.998 million shares Insiders decreased their positions with 22 buys and 36 sells but the net result was only down 225,665 shares On TheStreet, Jim Cramer’s staff gave the stock an A+ buy rating I like to follow the individual investors on Motley Fool, and its readers voted 540 to 32 that the stock will beat the market Short sellers have almost doubled their positions from around 2.846 million shares at the beginning of the year to 5.747 million shares recently I use Barchart for technical momentum data and only consider day from the current 6-month period: 100% technical buy signals Trend Spotter buy signal Above its 20-, 50- and 100-day moving averages 9 new highs and up 3.75% in the last month Relative Strength Index 63.29% Barchart computes a technical support level at 29.02 Recently traded at 29.99 with a 50-day moving average of 28.71 I try to compare my stock to the largest 3 stocks in the same sector. In the Water Utility sector, Aqua America gained 17.30% in the last year, while America Water Works (NYSE: AWK ) gained 14.00%, Companhia de Saneamento Basico do Estado De Sao Paulo (NYSE: SBS ) lost 23.21% and American States Water (NYSE: AWR ) gained 22.19%: Additional comparisons: American Water Works Market Cap $10.56 billion P/E 21.82 Dividend yield 2.40% Revenue expected to grow 5.40% this year and another 4.90% next year Earnings estimated to increase 6.50% this year, an additional 7.20% next year and continue to increase at an annual rate of 7.34% for the next 5 years Wall Street analysts issued 4 strong buy, 7 buy and 5 hold recommendations on the stock Financial strength B+ Companhia de Saneamento Basico do Estado de Sao Paulo Market Cap $ 3.02 billion P/E 44.00 Dividend yield 1.94% Revenue expected to decline by 53.50% this year but grow again by 16.50% next year Earnings are estimated to decrease 66.10% this year, increase by 168.40% next year and compound at an annual rate of 12.30% for the next 5 years Wall Street analysts issued 2 buy and 2 hold recommendation on the stock They did not rate the financial strength America States Water Market Cap $1.53 billion P/E 24.19 Dividend yield 2.23% Revenue expected to decline .70% this year, rise again by 4.10% next year Earnings are estimated to increase by 1.30% this year, an additional 6.30% next year and compound at an annual rate of 4.00% for the next 5 years Summary: My opinion is that the 2 best in the sector are WTR and AWR, but I think Aqua America has a slight edge. It has good price momentum, stable revenue and earnings projections, high financial strength and is expected to give investors an annual total return in the 11% range for the next 5 years. Below I have included a chart of the price against the 20-, 50- and 100-day moving averages plus a 14-day high/low turtle chart, which shows recent upward price momentum. If you’re looking for an exit point to protect your gains, the 50-100 Day MACD Oscillator has been a reliable technical trading strategy for this stock.

A Case For Active Investment Management

Summary Investing in fundamentally strong companies. Active Management vs. Benchmarking. Potential for reduced exposure to declining markets. “The most successful investment managers generally possess three qualities: independent thought, discipline, and consistency of application” – John Train in his book The Money Masters. “It is impossible to produce superior performance unless you do something different from the majority.” – Sir John Templeton. Screening for Fundamentally Strong Companies For over 15 years I have been a multi-asset class investor, advisor and analyst. My teams over the years have managed a variety of active strategies. While different in focus, every equity based strategy incorporates fundamental investment principles. Regardless of the fad of the day or the hot company everyone is talking about, consistent performance and risk management depends on these principles. I have recently collaborated with a group of CFA charterholders to form an all-cap equity strategy from our most successful strategies with the sole purpose of generating exceptional risk adjusted returns. Below is a summary of the parameters we use. All Alpha Strategy Parameters Price to Book < 1.5 7 years of positive operating margin 3 years roe > 15% Lowest 20% of growth adjusted free cash flow multiple Companies with above average operating and net margin within their respective industry Below average debt to equity Positive cash flow ROA growing D/E declining Current ratio, gross margin, asset turnover growing Cash flow > net income Consistent earnings growth Momentum parameters Thanks to Henry Crutcher and Equities Lab for creating a great quantitative tool that enables us to generate and successfully back test the performance of our fundamental and technical based strategies for the periods we don’t have actual trading history. See the output since 1997 from the program below. Here is a list of every trade for the past 15 years. Recently passing companies: (click to enlarge) The results from the model were strong. Upon verifying the data, 13.12% annualized is accurate. I then combined it with a proprietary risk management model that helps us anticipate significant market declines and the results were even more encouraging. I nvesting in fundamentally strong companies Investing “is pursued most successfully in a simple, straightforward way.” – Brad Perry, Winning the Investment Marathon. Buy stocks of high-quality companies at good prices and continue holding them as long as the companies’ performance merits doing so. Do this consistently and the probability an investor will enjoy above average returns substantially increases. Below are brief descriptions of the investment parameters. 1. Price to Book < 1.5 As a primary measure of value, the price to book ratio is an initial screen that seeks to pass securities that have moved away from their true value due to neglect and are typically out of favor. These securities over time have proven to be successful investments. 2. 7 years of positive operating margin Consistent operating margins are a positive sign a company's underlying business is successful and seemingly sustainable. 3. 3 years roe > 15% Strong and consistent return on equity is essential. 4. Lowest 20% of growth adjusted free cash flow multiple Using price/free cash flow multiplied by 5 year growth of free cash flow is a valuation measure. 5. Companies with above average operating and net margin within their respective industry This measure helps us choose the leaders in each investment’s respective industry. 6. Below average debt to equity Because overleveraged companies are not attractive. 7. ROA growing We prefer the companies we invest in to get better at what they do over time. Additionally, we look for companies that invest internally and that return produces consistently growing ROA. Otherwise, our money is better invested elsewhere. This is a year over year measure. 8. D/E declining Efficient use of debt is important, as well as consistent retirement of debt. 9. Current ratio, gross margin, asset turnover growing Measures of liquidity, profitability and business activity. 10. Cash flow from Operations > net income This is a simple accrual accounting check to avoid companies that may be attempting to manage earnings. 11. Consistent earnings growth Earnings growth attracts attention. We again use year over year measures that help us identify companies that are poised to move. 12. Momentum parameters in the form of relative strength play an important role in our growth oriented screen. It helps identify companies with attractive price movement but remain appropriately valued. In addition, we tend to focus our attention to price movers that are within 15% of recent highs. Active Management vs. Benchmarking So I guess you now have me pegged as an active investor. I personally don’t consider myself active or passive, I consider myself a fundamentally based technical investor, meaning I buy when it makes sense and sell when things start looking uncertain. My current domestic exposure, managed with a beta weighted futures overlay on a long portfolio, is 100% hedged due to current volatile economic conditions. The exposure metric was derived by analyzing market valuations and economic indicators. It is updated monthly, which may also be considered an actively managed strategy. Regardless of my bias, active management has taken a beating over the past few years and rightfully so, in many instances, such as the “active” managers that are more concerned about underperforming than actually providing value to their clients. In other cases, active management can provide an investor peace of mind and tremendous value if the strategy is fundamentally sound and is implemented consistently. William Sharpe stated in the Arithmetic of Active Management (The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9): If “active” and “passive” management styles are defined in sensible ways, i t must be the case that 1. before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and 2. after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar The problem with this statement from William Sharpe is that it assumes the active manager seeks to benchmark a specific market such as large cap, small cap, etc. As a business, active managers live and die on performance against their respective benchmarks. Knowing this, many use enhanced benchmarking. Enhanced benchmarking involves an active manager investing in an essentially passive portfolio of securities that mimic a benchmark. However in addition to this passive allocation, these active managers will use derivatives or some other portable alpha to “enhance” portfolio performance in an attempt to reduce the risk of underperforming the benchmark and providing the possibility of outperforming at any random time. Additionally, active managers may also stray from their benchmark allocations by adding smaller cap and potentially higher returning securities. This is known as style drift and measured by tracking error. Oftentimes, these additional measures do not add sufficient alpha to offset higher risk and fees. These are reasons a high percentage of active managers perform poorly after fees compared to passive index investing. Potential for reduced exposure to declining markets As seen in the Business Cycle Overlay data, the potential for reduced exposure to declining markets can be substantial if executed properly. The model effectively reduces equity risk when valuations become rich and economic conditions warrant more caution. Returns from effectively managing downturns is termed the buy-and-hold equalizer. The buy-and-hold equalizer (Why Market Timing Works, Journal of Portfolio Management, Summer 1997), represents the increased leverage an active investment strategy gains by preserving capital during a market drop. The more money an investor has to invest when the market turns up, the greater the performance leverage. The following passage is from NAAIM . When properly implemented, active management strategies should lessen an investor’s exposure to declining markets, blunting the impact of bear markets and preserving capital and the majority of prior gains. Moving out of the market prior to the majority of a decline means you have more money to invest when the market heads upward. Active investment management is most effective over a full market cycle (3 to 5 years). The reality of down markets provides the rational for active management. Down markets hurt investors in a number of ways. First, the more investors lose money in a down market, the more they lose valuable time and opportunity. Over the past 70 years, the major indices spent nearly 60% of the time sitting out bear markets and then returning to earlier highs. Only about 40% of the time were real gains being made. Through the use of active management strategies, money managers seek investment approaches that moderate the volatility of the market, helping investors stay the course and benefit from the long-term gains of the market and improve risk adjusted returns. Additionally, active management offers potential benefits beyond performance. Unlike with passive approaches, active managers are not required to invest cash inflows at the time of receipt when market conditions or prices may not be conducive. They can screen for quality and use buy/ sell triggers as a means of reducing risk. While a passive manager must own everything in an index, an active managers have the freedom to look for attractive stocks across the targeted universe. Summary Active management is an effective tool if used properly. It can not only lead to larger gains, but also reduce risk. However, it is very important for investors to understand the underlying investment strategy of a particular investment regardless of whether it is active or passive. Moreover, an investor should compare the statistics of an active strategy (Total Return, Standard Deviation, Calmar Ratio, Sharpe Ratio, Information Ratio, and Tracking Error) to that of a similar passive to determine if the higher fees are producing sufficient additional gains to warrant an investment. I will follow up this article with regular investment and economic analysis specific to these strategies, highlighting passing companies and providing economic rationale for managing an investment portfolio. Follow me to stay informed.