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8 Questions That Should Be Keeping Buy-And-Holders Up At Night

By Rob Bennett Set forth below are eight questions that should be keeping Buy-and-Holders up at night. 1) What are the top ten changes that have been made in the Buy-and-Hold strategy as a result of Shiller’s “revolutionary” findings? Yale Economics Professor Robert Shiller showed in peer-reviewed research published in 1981 that valuations affect long-term returns. That “revolutionary” (Shiller’s word) finding changed everything we thought we knew about how stock investing works. If valuations affect long-term returns, stock risk is variable rather than fixed; that means that we can reduce risk by taking valuations into account when setting our stock allocations. Shiller’s book exploring this finding in depth was a national bestseller. He was awarded a Nobel prize for his work. Given the importance of this advance in our understanding of how stock investing works, one would have expected that the Buy-and-Holders would have made scores of changes to their strategy to reflect the new understanding. Can the Buy-and-Holders identify even ten changes? Can they identify even one? 2) Why was there no reaction from the lead promoters of Buy-and-Hold when Brett Arends of the Wall Street Journal wrote that they are “leaving out half the story” of how stock investing works? I have been writing about the dangers of Buy-and-Hold for 13 years now. So I was encouraged when I saw the Arends article saying that to ignore the effect of valuations on long-term returns is to leave out half the story of how stock investing works. I was amazed to see the article go down the memory hole without generating comment (except by me). Arends could be wrong. But, if he were, it would be in the interests of the Buy-and-Hold advocates to point out his mistake. Why did no one do this? 3) Why has there been no clear explanation of the errors that were made in the Old School safe-withdrawal-rate studies? I pointed out the error in the famous “4 percent rule” in May 2002. I got a lot of flak from Buy-and-Holders for doing so. But 13 years later just about every major publication in the field has run an article noting that the 4 percent rule is not backed by the historical data and that it would be dangerous for retirees to continue to follow it. How was this mistake made? Why did it take so long to discover it? What can we learn from the mistake? 4) How was Shiller able to predict an economic crisis that began in September 2008 in a book published in March 2000? I am the only person in this field who has blamed the economic crisis on the heavy promotion of Buy-and-Hold strategies (the idea that investors don’t need to lower their stock allocations when prices reach insanely dangerous levels caused the out-of-control bull market of the late 1990s and the loss of the $12 trillion of pretend wealth created by the bull market caused consumer buying power to constrict enough to cause hundreds of thousands of businesses to fail). Except for Shiller. Shiller has not said in the wake of the 2008 crash that Buy-and-Hold caused the economic crisis. But he did predict the loss of trillions in pretend wealth in Irrational Exuberance , a loss that he suggested would likely take place late in the first decade of the new century. How did he know? And why have others not drawn the obvious conclusion that, since Shiller’s investing model was the one that predicted the crash and the economic crisis, it has earned credibility in the eyes of fair-minded people? 5) How did Bogle come up with his rule that investors never need to lower their stock allocations by more than 15 percentage points no matter how high stock prices go? A regression analysis shows that the most likely 10-year annualized return for an index-fund purchase made in 1981 was 15 percent real. In 2000, it was a negative 1 percent real. An 80 percent stock allocation makes sense in the former circumstance. A 20 percent stock allocation makes sense in the latter circumstance. That’s a change of 60 percentage points, not 15. Bogle’s number is off by 400 percent. 6) Why do Buy-and-Holders become so emotional when their claims are challenged? I have been banned at over 20 investing discussion boards and blogs. It is a common experience for me to receive apologies from the site owners who ban me in which they note that they believe that my work has great value and that they consider me one of the most polite and warm posters on the internet. They say that they are banning me solely because their Buy-and-Hold readers demand it and because they don’t want to lose the business brought by these followers of a purportedly research-based strategy. Huh? Why would followers of a research-based strategy be upset by challenges to their beliefs? Wouldn’t they see such challenges as a way to confirm and thereby strengthen their convictions? 7) Why was Wade Pfau not able to find a single peer-reviewed study showing that long-term timing doesn’t work or isn’t required? I worked with Academic Researcher Wade Pfau for 16 months. Wade holds a Ph.D. from Princeton. He performed an in-depth search of the academic literature trying to identify a single study showing either that long-term timing (changing one’s stock allocation in response to big valuation shifts with the understanding that it might not produce benefits for ten years or longer) doesn’t work or isn’t required without success. Could it be that, contrary to the core belief of the Buy-and-Holders, one form of market timing always works and is always 100 percent required for investors seeking to keep their risk profiles roughly constant? 8) Is there any reason to believe that price matters any less in the stock market than it does in every other market known to humankind? Price is what makes the car market run. Price is what makes the banana market run. Price is what makes the sweater market run. Price is what makes the grass-seed market run. How can we be so sure that price does not matter when buying stocks? If large numbers of the participants in these other markets became convinced that it was not necessary to take price into consideration when making purchases, it would cause them to collapse. Could that be why we have been seeing so much turmoil in the stock market in recent years? Disclosure: None

Building A Bulletproof Portfolio Of Lower Beta Stocks

Summary An investor can “bulletproof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start by narrowing down your universe of stocks. We explore the second method here. The stock we start with are ones with lower betas. Although CAPM predicts lower beta stocks will have lower returns, evidence suggests the opposite is the case. Since lower beta stocks are not without risk, owning them within a hedged portfolio can make sense. We recap the hedged portfolio method, show how you can build a hedged portfolio of lower beta stocks yourself, and provide a sample portfolio. Seeking Beta The traditional view of lower beta stocks, encapsulated in the Capital Asset Pricing Model ( CAPM ), is that they offer lower risk than higher beta stocks, but also lower returns. Seeking Alpha contributor and hedge fund manager Dr. Eric Falkenstein is one of the researchers who has challenged that, presenting evidence that lower beta stocks actually generate higher returns than higher beta stocks. In a 2012 Seeking Alpha article (“Is Low Vol A Beta Phenomenon”), Falkestein included the chart below, showing that, among the top 1500 stocks by market cap (excluding financials), stocks with lower beta (average beta of 0.85 versus 1 for the market) had outperformed both the market and high beta stocks since 1990. The Risks of Investing in Lower Beta Stocks As with any style of stock investing, when investing in lower beta stocks, you face two kinds of risks: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. By definition, the market risk of lower beta stocks should be less than that of the market (assuming the lower beta stocks you buy remain lower beta, which isn’t always the case, as Seeking Alpha contributor Matti Suominen has noted ), but the idiosyncratic, or stock-specific risk of lower beta stocks may come as a surprise to some investors. Six months ago, for example, how many investors in Wal-Mart (NYSE: WMT ) (beta: 0.82) would have thought they would be down nearly 25% on the stock by mid-October, as the chart below shows? (click to enlarge) Two Ways of Limiting Stock-Specific Risk One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article (“How to Limit Your Market Risk”), we discussed ways to limit market risk for a diversified portfolio. In this post, we’ll look at how to “bulletproof” a concentrated portfolio of lower beta stocks using the hedged portfolio method . In that method, you limit both stock-specific and market risk via hedging. Below, we’ll show how to use that method to construct a “bulletproof”, or hedged portfolio for an investor who is unwilling to risk a drawdown of more than 16%, and has $250,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 26% decline will have a chance at higher potential returns than one who is only willing to risk a 6% drawdown. In our example, we’ll be splitting the difference and using a 16% threshold. Constructing A Hedged Portfolio We’ll outline the process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising lower beta stocks Most brokerage websites offer screeners that let you screen for lower beta stocks. Since you’re going to hedge your stocks, you’ll want to limit your screen to stocks that are optionable. Next, you’ll need to calculate potential returns for your lower-beta, optionable stocks. One way to do that is to look up the consensus price targets for each stock, and derive potential returns in percentage terms from them. We offered an example of doing that for Novo Nordisk (NYSE: NVO ) in a recent article (“Building A Hedged Portfolio Around A Position In Novo Nordisk”). In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-16% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs, but, in any case, you’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return 7% declines, they all had positive net potential returns when hedged against > 16% declines. Nevertheless, the site rejected GOOGL. Why? Because of its share price ($695.32) relative to the size of the portfolio ($250k). For a portfolio of this size, the site attempts to allocate equal dollar amounts to 4 primary securities. Since a quarter of the portfolio would be $62,500, and a round lot of GOOGL would have cost more than that ($69,532), the site eliminated GOOGL from consideration for this portfolio. As it allocated cash to each of the stocks we entered, it rounded down the dollar amounts to get round lots of each stock. In its fine-tuning step, Portfolio Armor added Tesla Motors (NASDAQ: TSLA ) as a cash substitute, to replace most of the cash leftover from the rounding down process. TSLA happens to be a higher beta stock, but the site doesn’t take beta into account when adding cash substitutes; instead, it looks at which securities (whether stocks or exchange traded products) have the highest net potential returns when hedged as a cash substitute. Let’s turn our attention now to the portfolio level summary. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 14.33%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.19%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 13.77% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets its potential return (since three of these positions are uncapped, it’s theoretically possible that the portfolio could return more than 13.77% if each of the uncapped stocks exceeds its potential return). A More Likely Scenario The portfolio level expected return of 5.52% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. By way of comparison, the average 6 month return for the SPDR S&P 500 ETF (NYSEARCA: SPY ) over the last 10 years was 3.84%. Each Security Is Hedged Note that each of the above securities is hedged. TSLA, the cash substitute, is hedged with an optimal collar with its cap set at 1%, HRL is hedged with an optimal collar, with its cap set at its potential return, and the other 3 primary securities are hedged with optimal puts, which are uncapped. In our series of 25,412 backtests conducted over an 11-year period, the average actual return of a security hedged with an optimal put was 1.93x that of one hedged with an optimal collar, so the site aims to hedge primary securities with optimal puts unless their net potential returns, when hedged with collars, are > 1.93x higher. That was the case with HRL, which is why it’s hedged with an optimal collar. That wasn’t the case for the other three primary securities, which is why they’re hedged with optimal puts. Here’s a closer look at the optimal put hedge on MO: The cap field above is blank, as this is an optimal put, which is uncapped. As you can at the bottom of the image above, the cost of the put protection on MO was $840, or 2.04% as a percentage of position value.[i] Note that, although the cost of this hedge was positive, the overall cost of hedging the portfolio was negative . Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging Tesla. [i] To be conservative, Portfolio Armor calculated the hedging cost using the ask price of the puts; in practice an investor can often buy puts for less (for some price between the bid and the ask). The other hedges in the portfolio were calculated in a similarly conservative manner, with the puts priced at the ask, and the calls priced at the bids, so the actual cost of hedging this portfolio would likely have been lower than shown (i.e., an investor would have collected more than $465, on net, after opening the hedges).

Ameren Offers Utilities Investors With Protection From Higher Interest Rates

Summary Midwestern electric and natural gas utility Ameren has seen its share price perform well YTD, with even a disappointing Q2 earnings report proving to be just a speed bump. Following years of underperformance compared to the peer average, Ameren is changing its focus so as to take advantage of demand for new transmission infrastructure. Its Illinois operations will provide it with a buffer against higher interest rates due to that state’s regulatory linkage between allowed return on equity and interest rates. While Ameren’s shares are overvalued on a forward basis, a warm winter in its service area due to El Nino could create an attractive long investment opportunity. Shares of Midwest electric and natural gas utility Ameren (NYSE: AEE ) have rebounded strongly since setting a 12-month low at the end of June, with a disappointing Q2 earnings report only providing a slight bump on the way to an 18% price increase since then. The company has not been one of the sector’s better performers in recent years as weather volatility and arbitrary regulator behavior have held it back. Its regulatory outlook has improved this year, however, in a way that will reduce its exposure to higher future interest rates. Adverse weather conditions in Q4 will provide short-term headwinds first, however. This article evaluates Ameren as a potential long investment opportunity in the context of this operating environment. Ameren at a glance Headquartered in St. Louis, MO, Ameren is a relatively large electric and natural gas utility with more than $20 billion in total assets and a market capitalization of $10.7 billion. The company operates in a 64,000 square mile service area that includes much of eastern Missouri and most of Illinois, excluding Chicago and its surrounding environs. Its operations are divided into 3 segments. Ameren Missouri oversees electric generation, transmission, and distribution plus natural gas distribution in that state’s share of the service area. It currently has 1.2 million electric customers and 127,000 natural gas customers, with the former receiving electricity generated by the company’s 10,200 MW generating fleet. Unlike many of its peers, Ameren Missouri remains heavily reliant on coal, which comprises 53% of its fuel mix (the balance is split between nuclear, natural gas, and hydro). Unlike its counterpart across the Mississippi River, Ameren Illinois only engages in electric and natural gas distribution activities. It has 1.2 million electric and 813,000 natural gas customers in the state. Much of the electricity that it uses is sourced from Ameren’s generating capacity in Missouri via the third and final segment, Ameren Transmission Company of Illinois, which operates 4,600 circuit miles of 345 kV regional transmission lines. Historically, Ameren Missouri has made the primary contribution to the company’s total rate base, reaching 63% in 2011 compared to 29% from the Illinois operations and 8% from the transmission operations. This has negatively impacted Ameren’s past consolidated earnings due to the lack of a favorable regulatory scheme in Missouri. While the state’s scheme does provide utilities with a fuel cost recapture mechanism that insulates them from the type of fuel price spikes that are not uncommon during Midwest winters, its use of historical test years result in a large amount of regulatory lag. This lag prevents Ameren from recognizing higher rates due to infrastructure investments and similar capex for roughly 2 quarters despite incurring higher depreciation, O&M, and property tax costs during the interim. The regulatory scheme employed in Illinois, on the other hand, has improved in recent years. The most substantial change has been the decision to base the allowed return on equity for electric utilities on the 30-year Treasury rate plus 580 basis points. While this formula currently results in a below-average allowed rate for Ameren Illinois, it will mitigate the impact of higher interest rates following the Federal Reserve’s planned rate hike on Ameren’s consolidated earnings. Furthermore, electric utility rates are based on a year-end rate base and provides for the recovery of “prudently incurred” actual costs, greatly reducing regulatory lag. Illinois natural gas utilities operate within a similar scheme that bases rates on future test years and includes infrastructure riders, similarly reducing lag. Finally, Ameren’s transmission operations are governed by a federal regulatory scheme that reduces regulatory lag by employing forward-looking calculations with an annual reconciliation mechanism. Ameren has reported slow but steady earnings growth since 2013, although its annual EPS results have yet to return to their pre-financial crisis highs. Its annual EBITDA, meanwhile, has remained flat over the same period, highlighting the lack of growth in its service area over the last several years. The company was hit especially hard by the 2008 financial crisis and slashed its dividend in that year. Since then the dividend has only increased by 10%, causing the company to lag significantly behind its peers. Its yield had been much higher than the sector average before the crisis and remained high even after the cut, however, and as a result, it has a forward yield of 3.9% despite this low growth rate. Q2 earnings report Ameren reported Q2 earnings at the end of July that missed the analyst consensus on both lines. It reported revenue of $1.4 billion (see table), down by 1.4% YoY and missing the consensus by $40 million. Revenue from its electric operations increased by 1.2% and provided 89% of consolidated revenue as higher demand in Illinois more than offset reduced demand in Missouri as the latter state experienced a mild early summer. Natural gas revenue fell by 18% YoY due to a 3.2% decline in volumes as Illinois experienced a warmer than normal spring, reducing the number of heating degree days. A sharp fall in energy prices over the previous 12 months also contributed to the lower natural gas revenues in particular. Ameren financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 1,401.0 1,556.0 1,370.0 1,670.0 1,419.0 Gross income ($MM) 1,049.0 975.0 880.0 1,273.0 1,031.0 Net income ($MM) 141.0 108.0 48.0 293.0 149.0 Diluted EPS ($) 0.58 0.45 0.20 1.20 0.61 EBITDA ($MM) 447.0 459.0 336.0 762.0 522.0 Source: Morningstar (2015). Gross profit rose slightly to $1.05 billion from $1.03 billion YoY despite the revenue decline. The increase was the result of the company’s cost of revenue falling by 9.3% YoY due to lower fuel prices, more than offsetting the negative impact of lower revenues. Operating income fell sharply to $237 million from $322 million in the previous year. While a large loss provision for the construction license of a new nuclear unit was the decline’s major driver, higher O&M and depreciation costs resulting from regulatory lag in Missouri also contributed. Ameren’s consolidated net income fell to $141 million, or a diluted EPS of $0.58, compared to $150 million, or a diluted EPS of $0.62, in the previous year, missing the analyst consensus by $0.03. The most recent result included a $52 million boost resulting from the recognition of a tax benefit via the resolution of an uncertain tax position that the company treated as discontinued operations. EPS from continuing operations came in at only $0.40 versus $0.62 YoY. EBITDA also declined, falling from $522 million YoY to $447 million. Outlook Ameren reaffirmed its FY 2015 EPS guidance range of $2.45-$2.65 during its Q2 earnings call based on the assumption of normal temperatures in Q3 and Q4. The company’s service area did experience more cooling degree days than average in Q3, reinforcing this range. El Nino can be expected to impact its Q4 earnings, however, by bringing warmer than normal temperatures into the company’s service area between October and January. This year’s event is expected to be one of the strongest on record and previous such events have introduced warm weather in Missouri and Illinois during the quarter, reducing demand for natural gas. Ameren is unlikely to be as exposed to El Nino’s adverse weather impacts as many of its peers since the bulk of annual consolidated earnings have traditionally been brought in via its electric operations during the Q2 and Q3 summer months. Furthermore, temperatures in its service area have historically returned to normal by February during past El Nino events. Investors can expect its Q4 earnings to be lower than normal, however. Ameren’s earnings in FY 2016 and beyond will be driven by the company’s ability to utilize its planned capex in a manner that takes advantage of its regulatory environment where possible. The company expects capex to drive a rate base CAGR of 6% through FY 2019 as it invests in a combination of reliability, environmental, and new capacity projects. The latter will be the most important as they are designed to increase the share of its total rate base attributable to its transmission segment from 8% currently to 19% by FY 2019. The transmission segment will achieve a rate base CAGR of 27% over the same period, ultimately reaching $2.3 billion in total capex. The company expects that this will in turn result in an EPS CAGR of 7-10% through at least FY 2018. The company’s ability to achieve and maintain this earnings growth target will ultimately depend on how quickly the Federal Reserve implements its expected interest rate increase. At first glance, Ameren is more exposed than many of its peers to higher interest rates due to its BBB+ credit rating from S&P and Fitch (the credit ratings of its state units are higher). Interest rate spreads have widened in recent weeks as expectations of a Federal Reserve rate increase occurring by the end of the year have grown, with the largest increases occurring for lower-rated debt. At first glance, this would suggest that Ameren will be at a disadvantage to those of its peers with superior ratings. Unlike many of its peers, however, a substantial segment of the company’s operations reside within a regulatory scheme that links the allowed return on equity to interest rates. While this has kept the return on equity below the peer average during the current era of low interest rates, it will support Ameren’s ability to both finance its planned capex and mitigate the negative impact of higher interest costs on its earnings. Looking beyond FY 2016, Ameren’s Missouri operations are likely to be burdened by the U.S. Environmental Protection Agency’s [EPA] recently released Clean Power Plan, which requires individual states to achieve predetermined reductions to the carbon intensities (greenhouse gas emissions per unit of electricity generated) of their respective state utilities beginning in 2022. Illinois has one of the country’s highest carbon intensities and must achieve a 28% reduction by then, while Missouri is not far behind with a required 19% reduction . One advantage of these reductions is that they could pave the way for additional capex to convert existing coal-fired power plants to natural gas and possibly even build new, cleaner capacity. The presence of substantial regulatory lag in Missouri would contribute to earnings volatility. Valuation The consensus analyst estimates for Ameren’s diluted EPS in FY 2015 and FY 2016 have increased modestly over the last 90 days in response to warmer Q3 weather and the Federal Reserve’s decision not to increase interest rates in September, as had been widely expected by the market. The FY 2015 estimate has increased from $2.55 to $2.56 while the FY 2016 estimate has increased from $2.70 to $2.72 over the same period. Based on a share price at the time of writing of $44.10, the company’s shares are trading at a trailing valuation of 18.0x and forward valuations of 17.2x and 16.2x, respectively. The forward ratios in particular are at the high end of their respective 5-year ranges, albeit lower than they were at the end of 2014, suggesting that the company’s shares are modestly overvalued at this time. This is especially true for the company’s short-term outlook given the likelihood of a warm Q4 in its service area. Conclusion Ameren’s shares have exhibited an above-average amount of volatility in 2015 to date as the company has attempted to recover from its past history as a relative laggard in the electric and natural gas utilities sector. Recent developments have mostly been favorable, with its Illinois regulatory scheme changing to link the allowed return on equity to interest rates and the company’s own focus shifting away from Missouri’s poor regulatory environment to its growing transmission operations. This new approach will be necessary if Ameren is to bring its earnings growth closer to the sector average, let alone above it. Fortunately, the combination of new transmission projects, reliability investments, and environmental controls will provide it with large capex opportunities over the next 5 years that will be necessary to support faster earnings growth. Furthermore, its forward dividend yield of 3.9% is relatively high already. The main draw that Ameren has to offer to potential investors is its linkage between allowed return on equity for a substantial segment of its operations and interest rates, as this will offset one of the market’s major current concerns about utilities in general. The company’s shares are also overvalued on a forward basis, leaving them exposed to a substantial decline in the event that this year’s El Nino has a greater than expected negative impact on its Q4 and potentially also Q1 2016 earnings. Yield-seeking investors who wish to be insulated from higher interest rates could view such an event as a potential buying opportunity, however, and I would consider Ameren’s shares to be attractively valued in the event that its forward P/E ratio falls back to 14x its FY 2016 earnings, or $38 per share, as it has already done twice in the last 3 months.