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Dead-Cat Bounce Or Continued Bull Market? How To Invest If You’re Uncertain

Summary Financial pundits disagree, as usual. No one knows what the future holds. One way of dealing with uncertainty is to stay invested while protecting yourself against intolerable losses. We present a way for investors to do that while maximizing their potential returns. Before the market opened on Wednesday, Mark Hulbert offered a reason to be bullish in a post on Market Watch (“This Stock Market Gauge Predicts Double-Digit Gain For S&P 500″). The gauge Hulbert referred to was a combination of the market’s P/E ratio and the ” Misery Index “, which is the sum of the unemployment and inflation rates. According to Hulbert, the current level is associated with historic annualized stock returns of 13.2%, as indicated in the chart below, which Hulbert included in his column. (click to enlarge) After U.S. markets surged to ~4% gains on Wednesday, following six days of losses, John Auther of the Financial Times, in his video note (“Correction Foretold”) suggested the day’s market action was a “classic dead cat bounce”, and argued that a renewed bull market would depend on a renewal of earnings momentum, which has effectively run out of steam, as the chart he shared below indicates. (click to enlarge) Dealing With Uncertainty One way to deal with this sort of uncertainty is to invest in a handful of securities you think will do well, and hedge against the possiblity that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). Below we’ll recap how you can built a hedged portfolio yourself, and present an example of a hedged portfolio created for an investor with $100,000 to invest who can’t tolerate a drawdown of more than 15%. Risk Tolerance, Hedging Cost, 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”) — the lower his hedging cost will be and the higher his expected return will be. In a previous post (“Keeping A Small Nest Egg From Cracking”), we created a hedged portfolio for a small investor who could tolerate a drawdown of as much as 20%. In this case, with an investor who can only tolerate a 15% drawdown, we would expect a lower potential return. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high 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 securities with high potential returns. For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding securities that are relatively inexpensive to hedge. For this step, you’ll need to find hedges for the securities with high potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-15% 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. Buying securities that score well on the first two criteria. In order to determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-tuning portfolio construction. You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Stocks such as Priceline.com (NASDAQ: PCLN ), trading at more than $1200 per share, wouldn’t work in a $100,000 hedged portfolio, because the investor wouldn’t be able to purchase one round lot. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return. While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11 year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest and the largest drawdown you are willing to risk (your “threshold” — in this case, 15%), and the tool does the rest. This portfolio was generated as of Wednesday’s close (results will vary at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: a $100,000 to invest, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 15%. Worst Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst case scenario for this hedged portfolio. If every security in it went to zero before the hedges expired, the portfolio would decline 14.28%. Negative Hedging Cost Although minimizing hedging cost was only the secondary goal here after maximizing potential return, note that, in this case, the total hedging cost for the portfolio was negative, -0.70%, 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 put legs. Best Case Scenario At the portfolio level, the net potential return is 11.76% (as predicted, it’s less than the potential return for the 20% threshold portfolio we alluded to above, which was 17.79%). This represents the best case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.30% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the five underlying securities – Foot Locker (NYSE: FL ), Hologic (NASDAQ: HOLX ), Netflix (NASDAQ: NFLX ), the ProShares UltraShort QQQ ETF (NYSEARCA: QID ), and Sketchers (NYSE: SKX ) is hedged. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, HOLX: As you can see in first part of the image above, HOLX is hedged with an optimal collar with its cap set at 17.44%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy HOLX if it appreciates beyond that over the next six months.[i] The cost of the put leg of this collar was $1250, or 6.46% of position value, but, as you can see in the image below, the income from the short call leg was $425, or 2.2% as percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on HOLX was $825, or 4.26% of position value.[ii] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Foot Locker, Hologic, Netflix, and Sketchers shares were included as primary securities in this portfolio because, as of Wednesday’s close, they were all among the top securities in Portfolio Armor’s universe when ranked by net potential return, and they had lower share prices than other securities similarly highly ranked. Recall from our discussion above about fine-tuning portfolio construction, that it can be difficult to fit round lots of securities with higher share prices in smaller portfolios. Regarding the inclusion of the inverse ETF QID as a cash substitute here, note that Portfolio Armor is agnostic about whether a security is a stock, ETF or inverse ETF when it ranks them by potential return and hedging cost. QID was included as a cash substitute because it had one of the highest net potential returns when hedged as a cash substitute. 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 recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Investors With Lower Risk Tolerance The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 15% over the next six months, but the same process can be used for investors who are more risk averse, willing to risk drawdowns of as little as 2%. Notes: [i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first. [ii] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Nigeria’s Diversified GDP Offsets Oil Price Risk

Summary Nigeria’s GDP is extremely diversified, offsetting the risks of the current low price of oil, which has attributed to a sharp decline in the Global X MSCI Nigeria ETF. The main strengths of the ETF include the construction and banking industries, while the consumer products industry is characterized by high valuation and low growth. The sharp drop in the fund’s price since late November has created low valuation, and consequently a buy opportunity. I remain optimistic about Nigeria’s economic future, despite the fact that oil has plunged to a 6.5 year low. Citigroup even says that there is a 90% chance that oil will drop closer to $30/barrel soon . The impact of the declining price of oil has resulted in a significant decline of the Global X MSCI Nigeria ETF’s(NYSEARCA: NGE ) stock price, and this trend is certain to continue if the price of oil declines further. As 70% Nigeria’s government revenue and 90% of its export earnings come from oil exports , its struggle in a low price oil environment is inevitable. This can be seen historically in the decline of this ETFs price since late 2014, as well as examining Nigeria’s economic development since 1999 , when oil prices began to increase to an all time high by 2008. Moreover, Boko Haram can be seen as a threat to the fund’s performance, as it has previously also been responsible for a decline in the fund’s price. NGE data by YCharts However, I still take a bullish view on Nigeria on the basis of a newly emerging diversified GDP, that is not completely dependent on oil revenue; oil exports account for only 14% of the country’s GDP. The country’s Annual GDP growth is projected to increase from its current level of 2.57 to 3.61 by the 2nd quarter of 2016. The key strength of Nigeria is its banking industry, which is the second largest, only outsized by South Africa. Recent financial performance of the holdings in this industry, as well as their extremely low valuation, further edifies the value of this fund. The growth, financial performance, and current valuation of the construction industry can also be seen as a positive driver for this fund, as Nigeria is one of two countries that is projected to have higher construction growth than China. The consumer products industry is a hot topic in Nigeria, as consumption in Nigeria has been on the rise. I am, however, concerned with the future outlook of this industry, due to its relative high valuation and slowed growth in net income. Overall, a low oil price environment has created a buy opportunity for Nigeria, and the new diversified economy is strong enough to continue thriving. However, an increase in the price of oil in the future is necessary for full reconciliation of the fund’s price. Industry Specific Performance Each industry achieved the following level of growth in net income between 2012 and 2014 ; these calculations are based on the average growth of the fund’s top 10 holdings: Consumer Products Industry: 5.3% decline Construction Industry: 65.8% growth Banking Industry: 57% growth As of June this year, the average valuation for the industry was as follows: Consumer Products Industry: P/E=50.5 Construction Industry: P/E=14.9 Banking Industry: P/E=5.8 Therefore it is easy to make the following industry generalizations: The consumer products industry can be characterized as being in a bubble, and having disappointing financial growth. Its high valuation and low growth presents a minor threat to the fund’s performance. The construction industry can be characterized as having attractive valuation and substantial growth. It can be considered one of the positive drivers of the fund. The banking industry had substantial growth and has extremely low valuation. It can be considered the core competency of the fund. If there were Nigerian banking ADRs, then I would recommend solely investing in them rather than investing in this ETF. Consumer Products Industry 2015 Outlook: High Valuation with Moderate Growth Projected 1. During the 2nd quarter of 2015 , Nigerian Breweries PLC’s net revenue grew by 13% YoY and it also had 24% growth in EPS. Consequently, the company is now more attractively valued, as its P/E is now 21.7; its P/E in June was 26.3. 2. Nestle Nigeria’s net revenue declined by 17.6% YoY in March 2015, and the company’s profit decreased by 103% during this time as well. Its current P/E is 39.7 , which is slightly higher than its P/E of 35.9 in June. 3. Guinness Nigeria PLC’s net income declined by 12.2% YoY in March of 2015. Its current P/E is 61.2 , a drastic improvement from its P/E of 89.3 during June. Overall the consumer products industry can be considered a weakness of this fund, with an average P/E of 40.9, and disappointing growth during 2015. (click to enlarge) Source: Trading Economics The appeal of the consumer products industry in Nigeria is very obvious, given the substantial increase in consumer spending since 2012. The consumer products industry does have an overall favorable outlook between now and the 2nd quarter of 2016 : Consumer confidence most recently decreased by 12.4%, but is projected to decrease by 10% YoY during the 2nd quarter of 2016. Consumer spending is projected to increase at a modest rate of 2.3% during the next twelve months. Disposable personal income is projected to increase by 9.5% Overall the consumer products industry holdings are not ideal, but do not offset the appeal of the fund as a whole. Approximately 30% of the fund’s assets invest into this industry, providing the opportunity for the fund to benefit from the relative strengths of other industries. Despite disappointing growth and high valuation of these holdings, they do have a positive outlook throughout 2016. This fact, coupled with the positive industry outlook for the next 12 months, provides a somewhat favorable future outlook for these holdings. Reuters projects that Nestle Nigeria PLC’s EPS will increase by 7.6% between December 2015 and December 2016. Reuters projects that Guinness Nigeria PLC’s EPS will increase by 13.8% between December 2015 and December 2016. Reuters projects that Nigerian Breweries PLC’s EPS will increase by 8.9% between December 2015 and December 2016. Construction Industry 2015 Outlook 1. Lafarge Africa’s net income grew by 22% YoY during the 2nd quarter of 2015, reflecting a continued growth trend, although the growth has been slowed when compared to 2014. Consequently it is more undervalued at the moment, with a P/E of 11.42 ; the company’s P/E was 13.3 in June. 2. During June 2015, Dangote Cement’s net revenue rose by 15.94% YoY, and its operating profit grew by 9.3% YoY. Its current P/E is 15.33 , slightly lower than its P/E of 16.5 in June. Overall, the holdings in the construction industry have become cheaper, and were able to achieve substantial growth during 2015. The construction industry can now be viewed even more so as a positive driver for this fund, with a consistent demonstration of high growth and low valuation. However, these companies only account for around 11% of the fund’s total assets. Banking Industry: A Gem for Value Investors 42.16% of the fund’s assets are invested into the banking industry, which is the strongest segment of this fund, due to exceptional financial performance and incredibly low valuation. It is the strength of this industry in particularly that leads me to strongly justify investment into this ETF, amidst the risks associated with low oil prices and politics. Moreover, it is a strong complement to the relatively slower growth and higher valuation of the consumer products industry. 1. Guaranty Trust Bank PLC increased its net income by 34.1% YoY during the 2nd quarter of 2015, which is a substantial improvement from the growth experienced between 2012 and 2014. This has consequently created even lower valuation, as the company currently has a P/E of 5.45 . 2. Zenith Bank PLC increased its profit after tax by 12.1%, which is significant to note as its net income fell by -0.9% between 2012 and 2014. Its valuation is also substantially more attractive, as its P/E is currently 4.13 . 3. FBN Holding PLC had a 4.9% YoY increase in its profit after tax during the 1st quarter of 2015. Its P/E has now dropped even lower to 2.25 . 4. Stanbic IBTC Holdings PLC did not fare well during 2015, with a 52% YoY decline in Profit after tax during June 2015. Its net income previously grew by 230.3% between 2012 and 2014. This company is no longer listed in the top 10 fund holdings, indicating that less than 4% of the fund’s assets invest in this company. The company’s P/E is currently 7.98. 5. Ecobank Transnational Inc.: During the 1st quarter of 2015 , the company’s profit after tax rose by 65% YoY. The company’s P/E is currently 5.12 . Four out of five of the holdings in the banking industry were able to drastically increase their bottom line, and now consequently have substantially lower valuation; the average P/E for these five holdings is 5. This industry has demonstrated consistent financial performance, and is clearly being unfairly harmed by the low oil price environment. Therefore, it can be said that the low price of oil has created a substantial buy opportunity for the banking industry in Nigeria, and consequently the Global X MSCI Nigeria ETF, which invests 42.16% of its assets in the industry. What if Oil Prices Drops Further? The fund’s price has consistently declined from its 52 week of 15.56, due to the decline of oil prices beginning in late 2014. Consequently, the fund now currently has a P/E of 8.8, a far cry from the valuation of other ETFs. It is clear to see that the financial performance of the companies that the fund invests into has been exceptional, and that Nigeria has developed a new economy that is not entirely oil dependent. While it appears that oil may drop closer to $30/barrel in the future, this should not be viewed as a long term threat. Waiting for a further drop in the fund’s price, when the price of oil declines further, would be a wise endeavor. However, the takeaway is that this fund has massive upside potential once oil prices recover, and that most of the companies have fared well amidst low oil prices. The consequent irrational drop in the fund’s price has created a valuation paradise situation, for investors willing to risk investing in Nigeria. I first published an article stating my bull thesis for Nigeria when the fund was trading at 9.73; its price is lower now, but so is its valuation. Conclusion Nigeria is an excellent long term buy at the moment, with an inevitable rebound once oil prices recover. However, the country’s GDP is now diversified, and company’s in the construction and banking industry particularly have had exceptional financial performance amidst low oil prices. A further drop in the fund’s price due to declining oil prices would create even more attractive valuation. Regardless of the timing or price of the buy, a long term approach to Nigeria would be a wise endeavor for investors. My main concern is the high valuation and low growth of the consumer products industry, but this can not be avoided since the none of the fund’s holdings are listed on US exchanges. The Global X MSCI Nigeria ETF is holistically an excellent pick for investors who are willing to hold it long term, and profit from Nigeria’s economic growth. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Best And Worst Q3’15: Mid Cap Value ETFs, Mutual Funds And Key Holdings

Summary The Mid Cap Value style ranks seventh in Q3’15. Based on an aggregation of ratings of 15 ETFs and 141 mutual funds. SYLD is our top-rated Mid Cap Value ETF and HAMVX is our top-rated Mid Cap Value mutual fund. The Mid Cap Value style ranks seventh out of the 12 fund styles as detailed in our Q3’15 Style Ratings for ETFs and Mutual Funds report. It gets our Neutral rating, which is based on an aggregation of ratings of 15 ETFs and 141 mutual funds in the Mid Cap Value style as of July 20, 2015. See a recap of our Q2’15 Style Ratings here. Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Mid Cap Value style ETFs and mutual funds are created the same. The number of holdings varies widely (from 39 to 559). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Mid Cap Value style should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 (click to enlarge) * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Four ETFs are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 (click to enlarge) * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Nationwide Herndon Mid Cap Value Fund ( NWWQX , NWWPX , NWWNX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. The Cambria Shareholder Yield ETF (NYSEARCA: SYLD ) is the top-rated Mid Cap Value ETF and the Harbor Mid Cap Value Fund (MUTF: HAMVX ) is the top-rated Mid Cap Value mutual fund. SYLD earns a Very Attractive rating and HAMVX earns a Neutral rating. The RevenueShares Mid Cap Fund ETF (NYSEARCA: RWK ) is the worst-rated Mid Cap Value ETF and the Touchstone Mid Cap Value Fund (MUTF: TCVAX ) is the worst-rated Mid Cap Value mutual fund. RWK earns a Neutral rating and TCVAX earns a Very Dangerous rating. The Gap, Inc. (NYSE: GPS ) is one of our favorite stocks held by Mid Cap Value funds and earns our Very Attractive rating. Since 2008, the company has grown after-tax profit ( NOPAT ) by 5% compounded annually. The company currently earns a top-quintile return on invested capital ( ROIC ) of 16%, which is up from 12% in 2008. Operating efficiency has improved and the NOPAT margin has risen from 7% in 2012 to the current 9%. Despite these improvements, the stock remains undervalued. At the current price of $37/share, Gap has a price to economic book value ( PEBV ) of 0.9. This ratio implies that the market expects the company’s profits to permanently decline by 10%. If Gap can grow NOPAT by just 3% for the next five years , the stock is worth $48/share – a 50% upside. Navios Maritime Holdings, Inc. (NYSE: NM ) is one of our least favorite stocks held by Mid Cap Value funds and earns our Dangerous rating. Since 2011, the company’s NOPAT has declined by 23% compounded annually. ROIC halved from 6% to a bottom-quintile 3% over the same time period. In addition, Navios’ free cash flow yield is a subpar -3%. The market has not yet caught on to Navios’ poor underlying fundamentals, and the stock remains overvalued. To justify its current price of $3/share, the company must grow NOPAT by 7% compounded annually for the next 11 years . This level of NOPAT growth might not seem like much, but considering the recent trend of declining profits and that Navios has only grown NOPAT once in consecutive years in its history, we believe expectations in the current stock price are overly optimistic. Figures 3 and 4 show the rating landscape of all Mid Cap Value ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst Funds (click to enlarge) Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Funds (click to enlarge) Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Max Lee receive no compensation to write about any specific stock, style, style or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.