Tag Archives: etfs

Value Investing In Cyclical Stocks

Cyclical stocks tend to be reliable profit generators in a value investor’s portfolio. Cycles exaggerate the valuations because they cause uncertainty in the market. So arguably, value investing should work very well. In practice, it can be hard to identify the right investment candidates and pick the right time to invest. We all know that value investing involves buying stocks at prices depressed below the intrinsic value. Cheaper the stock, better the purchase, as theoretically, the potential returns (normalizing the price to value) are higher and the inherent risk of capital loss is lower (the stock is already at distressed levels, where investors have given up). Most cycles in essential commodities are predictable. Phase 1 – Growth and Investment: The business in an industry goes through a period of growth, managers become more confident and hire more employees, invest in assets and new projects and build new plants and increase capacity. There are new entrants in the industry as it grows with above-average profits. The analysts build Discounted Cash Flow and other models that assume good earnings growth for the near future and a possible terminal growth rate thereafter (which is almost always a positive number). This results in higher multiples being assigned to the stocks in the industry than the historical average. Wall Street firms do a lot of business with these growing companies flush with profits, and are therefore inclined to look upon them in a kind light. Investors pile in. Phase 2 – Peaking: All the capacity expansion via new capital investments and new entrants in the industry finally reaches a point where it starts to exceed market demand. The profit margins get squeezed as the marginal unit of production starts to sell at cost or below cost. The high-cost and smaller economies producers start to exit the market. A few players may merge to improve their economies of scale or add in new line of businesses to support the company until the cycle in this line of business recovers. Wall Street starts getting disappointed many quarters running, as the earnings come in lower than expected. Phase 3 – Decline and Disinvestment: Supply now starts to exceed the demand. Product price falls. Weaker and high-cost producers are unable to stay in business, and make an exit. Larger and lower-cost producers may choose to exacerbate the situation by making counterintuitive moves, such as increasing production, to drive the prices further down and hasten the exit of weaker competitors – as long as they are able to at least break even. Predatory pricing is generally illegal in most developed economies, but increasing production is not, and can easily be blamed to an error in judgment. Analysts don’t understand what is going on, and if they do understand the competitive games being played, they do not talk about it. Investors start to lose interest and move on to greener pastures. Businesses disappear, jobs are lost, capital projects are cancelled or postponed, assets are scrapped, and eventually, the supply starts to decrease. Phase 4 – Trough: Supply has finally dipped below the demand. The surviving businesses have started to gain their pricing power back and have begun to enjoy improved profit margins. They have also emerged from the cycle with a bigger market share as a large number of competitors closed shop. At this point, Wall Street has likely lost all interest in these companies, and analysts have dropped coverage of their stock. In Phases 3 and 4, the stock is likely to be undervalued. The cheapest and safest time to invest is in Phase 4. However, timing the bottom of a cycle is difficult and almost impossible. The best a value investor can do then is decide to invest some time after the decline has started and has gone to some depths, and then choose the stocks of the companies that are more likely than others to survive and come out with an increased market share. Which Kind of Industries Does Cyclical Investing Work In? In industries with low-to-zero cost of entry, such as software or internet, cycles do not exist, or if they do, they are short-lived. Some barriers to entry for new competitors can be established by increasing the switching costs for existing customers – it is difficult for the whole enterprises to switch over to Macintosh when all their business systems are written for Windows. However, these switching costs are not insurmountable. The story is very different in industries where a significant capital investment is required to enter an industry or a market. For example, airlines, mining, shipping, automotive production, most manufacturing, real estate development, etc. In these industries, capital projects may also have multi-year lead times before they start contributing to the business. Therefore, a project started today (such as a new ship ordered to be built when the market was doing very well) could take years to complete. When it is complete, though, the company may be adding new capacity in an environment of glut. Therefore, the cycle of boom and bust may be quite drawn-out in these industries. To invest profitably in these cycles, 3 things are required: Pick an industry that is not going to disappear anytime soon or be substituted out with something completely new. Pick companies that are strong enough to outlast the down cycle, or at least, are stronger than most of their competitors. Wait. Understand that these industries are going to go through structural changes and countless investor confidence ups and downs before the winners and losers are determined. Track if your pick continues to be a strong contender as a winner, but otherwise, mostly wait. Finding Values in Phase 3 and Phase 4 Stocks Finding good value stocks in Phase 3 and Phase 4 of the cycle can actually be very hard. As value investors, we are trained to look for the following: Low P/E ratio stocks – These are the companies whose earnings have been decimated. If anything, a great value stock here might actually sport a sky-high P/E ratio. The trailing 12-month or 5-year values are no longer typical, and the future earnings estimates are worthless. Low P/B ratio stocks – Since we are looking at asset heavy industries, it is worth pointing out that the valuation of the assets on the books typically get written down when the industry is in stress like this. Profitability ratios like ROI, ROA, etc. are all atypical and therefore useless. Therefore, cyclical investing for a value investor is much more of an art than science. Things like the strength of the balance sheet , economies of scale, management experience and skill, customer relationships, their ability to raise funds, cash and debt levels in the business, etc. become much more important. We still need to consider the valuation, and the valuation comes from asking the question: What is this business worth to a sophisticated buyer (competitor, private equity, etc.)? Sophisticated buyers are the ones who are buying for long-term strategic advantage. Now consider the plight of a retail investor who has no time to analyze these companies, and more than likely there is no longer any Wall Street coverage on these stocks (or if there is, it is much reduced from its heyday). These stocks will be volatile, and if you think you are getting a great value, it should not be a surprise that the stock is an even greater value a few weeks or months down the line. For most cyclical investments like this, I generally ease into my full allocation by starting small and then adding more and more over time when the cost can be improved. Sometimes, the extent of the future declines may surprise, but the declines themselves are to be expected. It takes time to hit Phase 4 and then turn around.

Why Does Dual Momentum Outperform?

Those who have read my momentum research papers, book, and this blog should know that simple dual momentum has handily and consistently outperformed buy-and-hold. The following chart shows the 10- year rolling excess return of our popular Global Equities Momentum (GEM) dual momentum model compared to a 70/30 S&P 500/U.S. bond benchmark [1] Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages for more information. GEM has always outperformed this benchmark and continues to do so now, although the amount of outperformance has varied considerably over time. In 1984 and 1997-2000, those who might have guessed that dual momentum had lost its mojo saw its dominance come roaring right back. In Chapter 4 of my book, I give a number of the explanations why momentum in general has worked so well and has even been called the “premier anomaly” by Fama and French. Simply put, reasons for the outperformance of momentum fall into two general categories: rational and behavioral. In the rational camp are those who believe that momentum earns higher returns because its risks are greater. That argument is harder to accept now that absolute momentum has clearly shown the ability to simultaneously provide higher returns and reduced risk exposure. The behavioral explanation for momentum centers on initial investor underreaction of prices to new information followed later by overreaction. Underreaction likely comes from anchoring, conservatism, and the slow diffusion of information, whereas overreaction is due to herding (the bandwagon effect), representativeness (assuming continuation of the present), and overconfidence. Price gains attract additional buying, which leads to more price gains. The same is true with respect to losses and continued selling. The herding instinct is one of the strongest forces in nature. It is what allows animals in nature to better survive predator attacks. It is built in to our brain chemistry and DNA as a powerful primordial instinct and is unlikely to ever disappear. Representativeness and overconfidence are also evident and prevalent when there are strong momentum-based trends.Investors’ risk aversion may decrease as they see prices rise and they become overconfident. Their risk aversion may similarly increase as prices fall and investors become more fearful. These aggregate psychological responses are also unlikely to change in the future. One can easily make a logical argument for the investor overreaction explanation of the momentum effect with individual stocks. Stocks can have high idiosyncratic volatility and be greatly influenced by news related items, such as earnings surprises, management changes, plant shutdowns, employee strikes, product recalls, supply chain disruptions, regulatory constraints, and litigation. A recent study by Heidari (2015) called, ” Over or Under? Momentum, Idiosyncratic Volatility and Overreaction “, looked into the investor under or overreaction question with respect to stocks and found evidence that supported the overreaction explanation as the source of momentum profits, especially when idiosyncratic volatility was high. A number of economic trends, not just stock prices, get overextended and then have to mean revert. The business cycle itself trends and mean reverts. Since the late 1980s, researchers have known that stock prices are long-term mean reverting [2]. Mean reversion supports the premise that stocks overreact and become overextended, which is what leads to their mean reversion. We will show that overreaction, in both bull and bear market environments, provides a good explanation for why dual momentum has worked so well compared to buy-and-hold. Dual Momentum Performance Earlier we posted Dual, Relative, & Absolute Momentum , which highlighted the difference between dual, relative, and absolute momentum. Here is a chart of our GEM model and its relative and absolute momentum components that were referenced in that post. GEM uses relative momentum to switch between U.S. and non-U.S. stocks, and absolute momentum to switch between stocks and bonds. Instructions on how to implement GEM are in my book, ‘ Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk’ . Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages, linked previously, for more information. Relative momentum provided almost 300 basis points more return than the underlying S&P 500 and MSCI ACWI ex-US indices. It did this by capturing profits from both indices rather than from just from a single one. We can tell from the above chart that some of these profits were due to price overreaction, since both indices pulled back sharply following strong run ups. Even though relative momentum can give us substantially increased profits, it does nothing to alleviate downside risk. Relative momentum volatility and maximum drawdown are comparable to the underlying indices themselves. However, we see in the above chart that absolute momentum applied to the S&P 500 created almost the same terminal wealth as relative momentum, and it did so with substantially less drawdown. Absolute momentum accomplished this by side stepping the severe downside bear market overreactions in stocks. As with relative momentum, there is ample evidence of price overreaction here, since there were sharp rebounds from oversold levels following most bear market lows. We see that overreaction comes into play twice with dual momentum. First, is when we exploit positive overreaction to earn higher profits from the strongest index selected by relative momentum. Trend following absolute momentum can help lock in these overreaction profits before the markets mean revert them away. Second is when we avoid negative overreaction by standing aside from stocks when absolute momentum identifies the trend of the market as being down. Based on this synergistic capturing of overreaction profits while avoiding overreaction losses, dual momentum produced twice the incremental return of relative momentum alone while maintaining the same stability as absolute momentum. We should keep in mind that stock market overreaction, as the driving force behind dual momentum, is not likely to disappear. Distribution of Returns Looking at things a little differently, the following histogram shows the distribution of rolling 12-month returns of GEM versus the S&P 500. We see that GEM has participated well in bull market upside gains while truncating left tail risk representing bear market losses. Dual momentum, in effect, converted market overreaction losses into profits. Market Environments We can also gain some insight by looking at the comparative performance of GEM and the S&P 500 during separate bull and bear market periods. BULL MKTS BEAR MKTS Date S&P 500 GEM Date S&P 500 GEM Jan 71-Dec 72 36.0 65.6 – – – Oct 74-Nov 80 198.3 103.3 Jan 73-Sep 74 -42.6 15.1 Aug 82-Aug 87 279.7 569.2 Dec 80-Jul 82 -16.5 16.0 Dec 87-Aug 00 816.6 730.5 Sep 87-Nov 87 -29.6 -15.1 Oct 02-Oct 07 108.3 181.6 Sep 00-Sep 02 -44.7 14.9 Mar 09-Nov15 225.7 89.4 Nov 07-Feb 09 -50.9 -13.1 Average Return 277.4 289.9 Average Return -36.9 3.6 Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages, linked previously, for more information. During bull markets, GEM produced an average return somewhat higher than the S&P 500. This meant that relative momentum earned more than absolute momentum gave up on those occasions when absolute momentum exited stocks prematurely and had to reenter stocks a month or several months later [3]. Relative momentum also overcame lost profits when trend-following absolute momentum temporarily kept GEM out of stocks as new bull markets were just getting started. Absolute momentum on its own can lag during bull markets, but relative momentum can alleviate the aggregate bull market underperformance of absolute momentum. Relative and absolute momentum therefore complement each other well in bull market environments. What really stand out though are the average profits that GEM earned in bear market environments when stocks lost an average of 37%. Absolute momentum, by side stepping bear market losses, is what accounted for much of GEM’s overall outperformance. Large losses require much larger gains to recover from those losses. For example, a 50% loss requires a subsequent 100% gain to get back to breakeven. By avoiding large losses in the first place, GEM has avoided being saddled with this kind of loss recovery burden. Warren Buffett was right when he said that the first (and second) rule of investing is to avoid losses. Increased profits through relative strength and loss avoidance through absolute momentum are only half the story though. Avoiding losses also contributes greatly to investor peace of mind and helps prevent us from becoming irrationally exuberant or uncomfortably depressed, which can lead to poor timing decisions. Not only does dual momentum help capture overreaction bull market profits and reduce overreaction bear market losses, but it gives us a disciplined framework to keep us from overreacting to the wild vagaries of the market. [1] GEM has been in stocks 70% of the time and in aggregate or intermediate government/credit bonds around 30% of the time since January 1971. See the Performance page of our website for more information. [2] See Poterba and Summers (1988) or Fama and French (1988). [3] Since January 1971, there have been 9 instances of absolute momentum causing GEM to exit stocks and then reenter them within the next 3 months, foregoing an average 3.1% difference in return.

Book Review: Free Capital

Summary Guy Thomas profiles twelve private investors. The interviewees remain anonymous and speak frankly about their successes and failures. Free Capital is an inspirational and educational read. The Market Wizards of U.K. amateur investors. Actuary, private investor and honorary lecturer Guy Thomas put together a terrific read called Free Capital: How 12 Private Investors Made Millions in the Stock Market after a thorough process of selecting and interviewing over 20+ private investors. The book consists of interviews with twelve private investors. It could have been part of the Market Wizards series by Jack. D. Schwager and an appropriate subtitle would have been: Interviews with the U.K. best amateur investors . If you enjoyed the Market Wizard series you are almost certain to like this book. The final selection of interviewees is made up of investors employing a variety of styles. The author segments the styles as follows: Geographers: top-down investors. Start from a macro perspective and search companies that will benefit from that trend. Surveyors: bottom-up investors who look at individual company financials. Activists: Investors taking an active approach to their investments. Putting a large percentage of their portfolio in a name and developing a conversation with management. Eclectics: Go back and forth between styles or don’t fit the other styles. It even includes one day trader and varies from activists to buy and hold dividend investors. Every investor interviewed had been highly successful with many racking up the balance of their U.K. tax-free, limited contribution accounts, up to well over a million. A feat than can only be accomplished by highly skillful investors. Thomas was also careful to monitor results of the interviewees over a market cycle to ensure their strategies could withstand a bear market. What is the book about? First and foremost the book in an inspirational read. Although a few of the investors in the book are exceptionally intelligent, many appear to be just above average in intelligence and some had to deal with severe setbacks in life or very tough starting conditions. Most of the people profiled struggled to keep their pre-investment career on track. Yet, they were able to achieve tremendous success through investing. They accomplished this through a variety of strategies. An important takeaway is that when you study investing, stick to a strategy that suits you and keep at it ultimately you should be able to achieve financial freedom. For many in this book, becoming a private investor enabled them to get away from company politics. Why you shouldn’t read Free Capital First of all to enjoy this book it is required you are interested in the practice of active investing. If you a convinced passive investor you will not like this book very much. The interviewees are all U.K. based private investors. The author guards their real identity which allowed them to speak frankly. The book really stands out in its genre because the people profiled do not try to talk up their strategies, try to look smart or otherwise try to boost their own ego. However, if you are looking for sophisticated literature, you should read the papers authored by Thomas (highly recommended as well). Who should read Free Capital? Read Free Capital if you are looking for an inspirational read. Quite a bit of actionable advice is dished out by the various interviewees but there are no stock tips. Of course stock tips wouldn’t have a very long shelf life any way. The book is especially valuable if you are developing your style as a private investor. You may not yet realize that it is also possible to be an activist investor from your home office. Even though most people day trading end up broke, some prosper. Perhaps you are considering to become a full time investor because you hate your career but do not dare to take the plunge yet. These people did it but all took precautions. You may think you are handicapped because you don’t have a finance or business background but neither did these people and they destroyed their benchmarks. Free Capital is certainly one of the best investment books I read in 2015 and I highly recommended it.