Tag Archives: georgia

Smart Beta Strategy: Aces Australian Scrutiny

Paul Docherty, a senior lecturer at Newcastle Business School, University of Newcastle, in Australia, has studied the performance of the factors that underlie smart beta portfolios within the equity markets of that country. On the basis of a long time-series of data, Docherty has concluded that four such factors “all generate positive abnormal returns” in those markets: value, momentum, low vol, and quality. Diversifying across these four factors is the smart way to make use of smart beta , he thinks. The other factor in the usual list of five is size . Since Rolf W. Banz’ work in 1981 , there has been speculation that small firms generate greater return than do larger firms, after controlling for risk. But Docherty can’t find evidence for this in Australia. After accounting for illiquidity and transaction costs, the remaining “size effect” is insignificant. “Not an investable anomaly,” he says. This is in accord with recent international findings. But with the other four smart-beta factors? Value refers to the book-to-market ratio. This is also known as the HML ratio, from the phrase “high minus low”, given the Fama-French argument that companies with high book-to-market ratios (value stocks) outperform those with low ratios (growth stocks). Docherty mentions that there are several other ways to measure “value” aside from book-to-market. One might use the P/E ratio, for example, or compare cash flow to price. But book-to-market “is the superior proxy for value in the Australian equity market.” The HML ratio has had a good run over most of the sample period Docherty employs, beginning in 1990, and its cumulative returns across time are impressive, but it’s important to observe that “there is an evident reduction in the gradient of the cumulative returns in recent years.” Performance of the WML factor in Australia Mean St. Dev. T-Strat Sharpe Ratio Hit Rate Max Drawdown 1991-2015 1.29% 5.19% 4.27 0.25 63% -19.96% 1991-1995 0.31% 3.53% 0.68 0.09 53.3% -7.98% 1996-2000 1.15% 5.28% 1.68 0.22 65% -19.96% 2001-2005 2.61% 5.12% 3.95 0.51 71.7% -8.51% 2006-2010 0.89% 6.53% 1.06 0.14 61.7% -13.68% 2011-2015 1.37% 4.80% 2.15 0.28 64.9% -13.41% (Source: Docherty, “How smart is smart beta investing?” Table 3.) Moving on… the momentum factor (or “winner-minus-loser”, that is, WML) is the best-documented anomaly of the traditional five. Docherty cites a recent study by Vanstone and Hahn that reports that “the capacity of momentum investing in Australia is sufficiently large in dollar terms to support its practical implementation as an investment strategy.” Low vol has been under discussion as a factor in above-normal returns since a seminal paper by Black, Jensen, and Scholes in 1972. The notion of a low vol premium by definition implies that the actual security market line is much flatter than the one predicted by the Capital Asset Pricing Model. Significant Drawdowns Docherty’s data indicates that the mean monthly return on the vol factor in Australian markets is 1.45%, the highest monthly return of any of the five factors he looked at. Both the vol factor and WML share one drawback – both have seen significant drawdowns. The max drawdown for the vol factor in Australia over the covered period in 25.56%. Then, there is quality , or quality-minus-junk (QMJ). As in all fields, “quality” in the realm of capital assets is a tricky thing to define. As Docherty understands it, the term refers to asset growth and accruals (negatively) as well as to corporate governance and profitability (on the positive side). Quality, as so understood, has “relatively modest returns compared with other smart beta factors,” he finds, but it does provide a hedge against downturns in broad market movements. What is most intriguing about Docherty’s numbers is that the correlations among the factors he discusses “are quite low and, in many cases, negative.” Given this situation , the real question is not whether smart beta is smart (it is) or which factor is smartest (that depends on where one is in the business cycle, and other matters), but what mix of the four (or, if one wants to continue including size, what mix of the five) factors is optimal.

Cold Snap Warms Up Natural Gas ETFs

Natural gas prices were thwarted by sluggish trends with the energy market rout and a milder winter so far this year. Among the issues hurting the broader energy space, ample supplies and falling demand on global growth worries are primary. This, along with considerably warmer temperature in December (due to a protracted and stronger El Nino) played foul, taking natural gas futures to a 14-year low (read: No Winter Cheer for Natural Gas ETFs?). As a result, most of the exchange traded products tracking natural gas are in red this year defying seasonal strength. Normally, Arctic Chills give life to this commodity every winter. The cold snap boosts electricity demand across the region putting natural gas in focus. In fact, in 2014, the Polar Vortex caused natural gas prices to jump over 50%. Winter Storm Jonas to Rescue This year, the winter storm Jonas recently salvaged this besieged commodity. The whiteout struck on the East Coast, with icy temperatures and a snow emergency bolstering demand for natural gas for a valid reason. As almost 50% of Americans use natural gas for heating purposes, withdrawals in natural gas supplies push up the commodity’s prices. The U.S. Energy Information Administration also gave same cues on Thursday when it declared the largest weekly drawdown of gas from storage this winter, as per Wall Street Journal. Natural-gas prices went ‘above $5 per million British thermal units in parts of the Northeast for the first time since last winter’, as indicated by Wall Street Journal. If such sub-zero temperatures continue even after the snow storm, it will bring a great deal of luck for natural gas, albeit for the short term. ETF Impact In fact, an ETF tracking the natural gas futures – United States Natural Gas ETF (NYSEARCA: UNG ) -added about 0.13% on January 22. Investors should note that natural gas equities, such as First Trust ISE-Revere Natural Gas Index Fund (NYSEARCA: FCG ), were the real winner that added 5.2% on January 22. Below we highlight a couple of natural gas ETFs that investors could use to play if the U.S. economy remains snowed in the near term (see all Energy ETFs here). iPath Dow Jones-UBS Natural Gas ETN (NYSEARCA: GAZ ) This is an ETN option for natural gas investors. It delivers returns through an unleveraged investment in the natural gas futures contract plus the rate of interest on specified T-Bills. The product follows the Dow Jones-UBS Natural Gas Total Return Sub-Index. The note is less popular with AUM of $4.9 million. It is a high-cost choice, charging 75 bps in annual fees. GAZ is down 30.6% in the year-to-date frame and gained about 2% on January 22, 2016. FCG in Focus This product offers exposure to the U.S. stocks that derive a substantial portion of their revenues from the exploration and production of natural gas. It follows ISE-REVERE Natural Gas Index and holds 30 stocks in its basket, which are well spread out across components (read: 5 ETFs Losing Half or More of Their Value in 2015 ). Southwestern Energy Company, Antero Resources Corporation and Gulfport Energy Corporation occupy the top three positions in the portfolio with a combined 16% of total assets. This indicates that no single company dominates the fund’s returns, preventing heavy concentration. The fund has a blended style and is diversified across various market cap levels with 53% in small caps, 31% in mid caps and the rest in large caps. The product has amassed $132.7 million in its asset base while sees solid volume of nearly 2.5 million shares per day. It charges 60 bps in annual fees from investors and has a Zacks ETF Rank of 3 (Hold) with a High risk outlook. The fund is down 13.7% so far this year (as of January 22, 2016). Bottom Line Though there have been some incredible price increases lately in the natural gas market despite weak demand-supply fundamentals, the commodity is due for a price reversal. The weather will likely warm up across the country with the advent of spring and natural gas demand will trip up then. This is truer in the light of the fact that present stockpiles are pretty higher than the five-year average and the year-ago level. So, investors solely relying on a weather play might proceed with a short-term notion. Original Post

Closing The Book On Breeze-Eastern

Quan and I did an issue on Breeze-Eastern (NYSEMKT: BZC ) last year. The stock has since been acquired by TransDigm (TDG ). When we did the issue, Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern. What lesson can we learn from our Breeze-Eastern experience? Here’s what we said about Breeze-Eastern’s stock price at the end of our issue: “Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.” ( Breeze-Eastern Issue – PDF ) Last year, Value and Opportunity did a blog post called ” Cheap for a Reason “: “Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil & gas, emerging markets exposure) or a combination of both. The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.” So, why was Breeze-Eastern cheap? Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future: “Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.” The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because: Breeze will have lower costs as it spends less on development projects AND Breeze will have higher sales as a result of the development projects it spent on in the recent past The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to $28 million in 2021. This would seem to suggest that we were right about two things: The stock’s illiquidity made its shares more attractive to a 100% buyer than to individual investors buying just a small, tradeable piece of the company Breeze was cheap today versus its likely future value because the company’s reported results included present day expenses as incurred but did not include the expected long-term payoff from supplying new helicopter and airplane projects that won’t be launched for several years So, maybe the two lessons we should learn from the Breeze takeover being done at a much higher price than the stock traded at or than we valued the company at are: Always value a stock based on what a control buyer would pay for it as a permanent, illiquid investment – never value a stock based on what traders will pay for small, tradeable pieces of the business (Ben Graham’s Mr. Market rule) Look for businesses that have to report bad results today even though you know they will report better results in the future Quan and I weren’t sure if Breeze would have higher revenue from these projects one day. The acquirer here is counting on future projections for revenue. However, we were sure that Breeze would spend less in the future than it did in the past. That was a sure thing. There is one problem with this analysis of the learning experience we got from Breeze. Mr. Market actually did re-value the company upwards before the acquisition – not after. Breeze went from like $12 a share in the summer of 2015 to $20 a share in the fall of 2015. You didn’t have to hold the stock through the acquisition to make money. We were wrong that Mr. Market would never pay up for such a boring, obscure, and illiquid little stock. It’s worth mentioning here that Breeze’s enterprise value had been $160 million in 2009. We even mentioned in the issue we wrote that Breeze fell in EV from $160 million in 2009 to $95 million in 2015. Yet, we didn’t speculate that Mr. Market would once again assign Breeze a $160 million enterprise value. It seemed more reasonable to us that someone would buy the whole company. So, again we proved we are really bad at guessing what Mr. Market will do. And maybe it is better to assume we know nothing about how a stock will be valued by anyone other than a control buyer. Also, we were clearly too conservative in our appraisal of Breeze. At about 7 times what we considered normal EBIT to be, it was a cheap stock when we picked it. And we probably presented it as too much of a value investment and not enough of a quality investment. I think we were biased against Breeze – we ticked off its extraordinary virtues in the text of our issue but still slapped an utterly ordinary EBIT multiple of 10 on the company – due to its small size as a stock and its low growth in recent years. We may have pigeonholed it as “microcap” value. In fact, we knew that based on signs like market structure, relative market share, and the bargaining power Breeze had when dealing with spare parts buyers that its “market power” was among the strongest of any company we’ve covered. Probably John Wiley (NYSE: JW.A ) (NYSE: JW.B ) and Tandy Leather (NASDAQ: TLF ) are as strong. Hunter Douglas ( OTC:HDUGF ) also has an excellent competitive position. Since Breeze is a small company in a very small industry, we didn’t have precise data to give on market share the way we often do. All we could say was that Breeze had “a greater than 50% global market share” in a “true duopoly” and that “the only reason customers ever seem to switch from Breeze-Eastern to UTC or vice versa is when they get annoyed that a critical spare part is taking too long to arrive.” This last sentence is probably the most important sentence in our issue. We rarely come across companies to analyze where the customers tell us flat out that they just aren’t going to switch providers. The two clearest examples of this are Breeze and John Wiley. Finally, Breeze is a classic example of a “Hidden Champion.” We’ve only done a few truly dominant companies for the newsletter. Tandy and Hunter Douglas are probably the closest to Breeze in terms of market leadership. They’re also similar in that they have no real peers. We try to present “comparable” peers in each issue. We said flat out in the issue that “Breeze has no good peers.” The same thing is true of Tandy and Hunter Douglas. There’s a lesson in here. Look for companies with no publicly traded peers. Analysts cover entire industry groups. And investors like to pick from the top down too. If you started from the top down, would you ever get to the “helicopter rescue hoist industry”? Where does that fit in a portfolio? What about leathercrafting? Most people don’t even know that’s a real hobby. Or shades and blinds? Is that housing related? For me, the biggest lessons from Breeze-Eastern are both about timing. We can time normal earnings. For example, we could see Breeze was under-earning now. This isn’t hard. We know Hunter Douglas will make more in the future than it did in the recent past (since U.S. housing was lower than normal). We know Frost will make more in the future than it did in the past (since interest rates are lower than normal). Often, you don’t know “when” this “normal future” is. But, it’s not hard to notice when the present is abnormal in some way. We can’t time the stock market. Quan and I never would have predicted that Breeze-Eastern’s stock would rise on its own – without a buyout offer – to anything like the level it did. And we never would have expected it’d do it so fast. I think it’s a lot easier to figure out what an acquirer will eventually pay for a company than what the stock market will eventually pay for a stock. So, how do we combine the ideas of finding companies that are under-earning today compared to a normal future year with the idea of ignoring Mr. Market entirely and simply valuing a stock based on what an acquirer would pay for the entire company? I guess we could distill that down to a simple investment recipe: Step One: Fast forward 5 years. Step Two: How much would an acquirer pay for this company (in 2021 not 2016)? Last Step: Work backwards to decide how much you should pay for one share of the stock today assuming the whole company is bought 5 years from today.