Tag Archives: investment

Buying Stocks Trading Below Net Current Asset Value Vs. Market Timing

Given the fees derived from selling funds to the retail public, financial institutions have little incentive to be bearish on the stock market. These financial behemoths want euphoric investors believing that Wall Street is Lake Wobegon , where every day is a sunny day and all of the stocks are above average. Following the investment strategy of remaining fully invested in stocks and not attempting to time the market does have merit. An academic paper written by Nobel Laureate William F. Sharpe showed the difficulty associated with market timing [i] . Over the study period of 1934-1972, investors who made the decision at the start of every calendar year to be in either cash or stocks had to bet correctly 83% of the time in order to outperform the Standard & Poor’s 500 Index (S&P 500®). That is a difficult hurdle to overcome. Given these poor odds of timing the market with such precision, betting black on the roulette table at a casino in Vegas looks attractive by comparison, with free drinks to boot. Should investors heed the warning of Dr. Sharpe by buying a stock index fund and abandoning any attempt at market timing? Let us take a step back for a moment before going “all in” on stocks. Is there a third way to outperform a broad market average other than choosing cash or an index fund with near-perfect timing accuracy? An alternate investment path to consider is Benjamin Graham’s value investing philosophy for the enterprising investor. Graham showed superior portfolio performance by selecting securities trading below net current asset value (NCAV). The NCAV calculation subtracts all liabilities , including preferred stock, from the current assets (the most liquid assets) on a company’s balance sheet. The NCAV calculation is converted to a per share figure, comparing the value to the company’s share price. If Mr. Market quotes the stock price below the NCAV calculation, it can be considered a buy. The chart below shows the long-term performance of restricting stock purchases to ones trading below NCAV and comparing the results to that of the S&P 500®. (click to enlarge) * Portfolio average return calculations include only stocks trading below 75% of NCAV, with no more than a 5% weighting in any one stock. Dividends and transaction fees are included in all of the calculations. As indicated on the chart, NCAV stocks outperform the index by around six percent on an average annual basis. These stellar results do not require an investor to be permanently in stocks all of the time or to engage in market timing. In approximately three of four years, part of the NCAV portfolio remained on the sidelines sitting in a money market fund. Unlike remaining fully invested in the S&P 500®, investors who restrict their stock purchases to ones trading below NCAV will at times have a portion of capital remaining in cash. These idle time periods out of the stock market due to the lack of NCAV investment opportunities occur in both advancing and declining calendar years. If the stock market moves higher for the calendar year and few stocks trade below NCAV, the portfolio will lag a fully invested index fund. If the stock market has a good year, sitting in cash turns out to be a mistake. As indicated in the chart above, temporary time periods where the NCAV remains idle in cash does not result in long-term underperformance in comparison with the S&P 500® broad market average. Embracing this form of deep value investing has the added benefit of being agnostic regarding the direction of the overall stock market. Market timing is not an issue when it comes to purchasing only stocks trading below NCAV. Investors can ignore what prognosticators on Wall Street think stocks are going to do in the future. The efficient market hypothesis implies that greater portfolio volatility must be accepted in order to achieve a greater average rate of return. There is truth to this argument. Markets are generally efficient, and the NCAV portfolio does fluctuate more than the S&P 500® does. If our measure of risk changes from portfolio volatility to worst-case return, a wrinkle in the market efficiency gospel bubbles up to the surface. We know from behavioral finance research that losses are far more painful to investors than is the satisfaction derived from an equivalent-sized gain. Using a worst-case annual return as our alternate measure of portfolio risk makes sense if money lost is more important to investors than money won in the stock market. As shown in the table below, using the worst annual stock market loss as our measure of portfolio risk, the NCAV portfolio does not suffer through as bad of a drawdown. For many years over our study period, the NCAV portfolio was not fully invested in stocks. When a portion of capital remains on the sidelines for the NCAV portfolio, it makes sense that a worst-case calendar year loss is less severe in comparison with a fully invested stock index fund, such as the S&P 500®. As already shown, this more limited exposure to stocks by investing only in securities trading below NCAV does not result in the average compounded return falling below the S&P 500® over the long term. (click to enlarge) Market timing is an exercise in futility for individual investors. As I pointed out in a previous blog , focusing on individual stock selection using a time-tested value-investing criterion, such as NCAV, is a far more productive use of an investor’s time rather than attempting to figure out the future direction of the overall stock market. Stocks trading at a deep discount to NCAV not only outperform the market over the long term but also benefit from limited downside losses when knee deep in a bad year for stocks. Although not shown in the chart, the second and third worst annual returns of the S&P 500® had a deeper drawdown than the index’s matching year NCAV portfolio return did. A patient investor willing to endure temporary time periods when deep value investing falls out of favor can still do well over the long term. This holds true without the additional requirement of prescient forecasting on the future direction of stocks. [i] Financial Analysts Journal. “Likely Gains from Market Timing” by William F. Sharpe – March/April 1975, Volume 31 Issue 2 pp. 60-69.

A Strategy To Defend Your Portfolio From Bear Markets

It is important to protect one’s portfolio from crashes like 2007-2009 where the major market indices lost more than 50%. Historically, markets have seen long 4-10 years runs of steady Bull market interspersed with shorter 1-2 year Bear markets. Most losses in a bear market come within a short span of few months. An investor playing good defense will look to time an early exit in a crash. When market is sufficiently oversold, short term bounce backs present further opportunity to make gains. An investor who remained invested during stock market crash from October 2007 to February 2009 lost more than 50% of his investment (based on SPY performance ) during that period. Similarly, between September 2000 and September 2002, fully invested investors lost ~40% ( using SPY as a benchmark ). Both bear markets wiped out 3-5 years of preceding year gains. While timing the market is a hard proposition, it is incredibly important to preserve your portfolio from a major whitewash during a crash. “Defense wins Championships” is a famous saying in football but is more aptly relevant for investors that can successfully maneuver through a bear market. NFL teams with good defense minimize points scored against them by opposition; a good portfolio needs strong defensive strategies to protect from bear market onslaught. Further just like strong defense can actually add to score by triggering turnovers, bear market presents opportunities for sizeable gains which if not exploited means missed opportunity cost. For example, investors who were too risk averse and did not participate in the post-crash rally of 2009-2011, lost out on capital appreciation opportunity of 80-90% within that 2-year period. To build a good defensive strategy, an investor needs to understand the market dynamics. The picture below best illustrates the US stock market history of bull-bear markets ( Source: Business Insider ). (click to enlarge) Key takeaways we can derive from the above picture are: The large part of this graph is dominated by long running bull markets, with most runs lasting many years or even more than a decade. During this multi-year period, the market sees steady returns with small intermittent corrections interspersed. Some examples include the bull market in 1990s, 1980s, 1950s and 1940s, all of them lasted 10+ years. Bear markets are relatively short in terms of overall duration (1-2 years), and the losses come at a much faster rate (compared to gains in bull market). For example, 2008 crash lasted 1.3 years and 2002 crash lasted 2.1 years. The longest bear market was in the 1930s and lasted close to 3 years. “Market goes up in an escalator but down in an elevator” is a famous stock market quote that can summarize the overall dynamics. Understanding the wisdom behind these select few words is important for all investors. The picture below shows 1 example of Bull-Bear cycle in SPY adjusted close graph during the 2003-2008 period ( Source: Yahoo Finance data ). Notice the steady increase in SPY for 4+ years (escalator) followed by a dramatic 1-year crash in 2008, wiping out a large part of multi-year gains. Hence the saying, market goes like an escalator and comes down like an elevator. (click to enlarge) Here is another graph that shows SPY monthly returns ( Source: Yahoo Finance data ) during the 2008 crash period. Notice even during the bear market, the bulk of losses (~-46%) came over a short 9-month period from June 2008 to February 2009. Hence the analogy of elevator coming down vertically or fast. (click to enlarge) The above historical perspective presents multiple takeaways that should influence our investing strategy. Given the long runs of Bull market, sitting out of stock market for extended period of time has significant opportunity cost of not participating in Bull rally. If one wants to protect their portfolio in the event of a crash, they need to get out of market early in a crash. However, getting out too early has risks too as it may only be a temporary dip i.e. no crash, market recovers and one has to get back in at a higher price. So timing the market exit is a balancing act between these two scenarios. Exiting out late in a Bear market can double the pain as one will take the losses but not participate in the rally that should be soon to follow. Buy and hold investors who finally give up on stocks after seeing their portfolios trounced for a year or two, have the risk of exiting out at close to bottom of crash. Building a Defensive Strategy: The above takeaways can be formulated to build a variation of Simple Moving Average (SMA) based strategy. For our example, we will use SPY as a representative market index that we play the strategy on. However, the strategy should be verifiable on most indices with varied performance. The SMA gives an overall trend of market direction that is not easily seen with day-to-day variations. So a simple strategy could be to stay long in SPY when SPY is above its say 50-day SMA and sell all holdings when SPY falls below its 50-day SMA. When SPY index is above the SMA, it is pulling the SMA upwards i.e. leading to a positive trend in index. One big drawback of SMA-based strategies is the whipsaw effect. This happens when stock dips below the SMA, we sell the index but then stocks recover, goes above SMA and we get back. Because we are selling at a lower point and then buying back again at a higher price, this leads to a loss. If this happens with large enough frequency, the strategy can lead to sizeable losses and NEGATIVE returns as compared to Buy and Hold. Since history is dominated by large bull runs interspersed with shorter bear runs, it is probably wiser to side on being long for the most part. So we assume that more often than not the market is expected to bounce back after a dip below SMA leading to whipsaw. To reduce the number of times we go out of market and whipsaw, we can use a longer duration SMA. The longer the duration, the less likely the chance of temporary short-term dips breaching SMA and giving a false sell signal. Let’s take 250-day SMA which is equivalent to 1 year in terms of trading days. Further even when SPY touches or breaches the 250-day SMA that is a major support level indicating a high chance of bounce back. So I would propose the sell SPY signal to be even lower, say when SPY has breached more than 2% below 250-day SMA. So let’s assume that we sell SPY when it’s hit more than 2% below 250-day SMA. On top of this, let’s try to take advantage of the fact that once market is sufficiently down, volatility increases and we expect to see several bounce backs from the lows. The bounce back can be temporary though as we don’t know for sure when the actual bottom is or if the bear market is close to end. To take advantage of this short-term bounce backs, we can define a lower point at SMA for market to be oversold. In this zone, we could look to do some bottom fishing by trying to do the reverse, i.e. buy SPY when SPY is below its short-term SMA, say 4-day SMA and sell it as soon as it recovers. So our strategy becomes as follows: Stay long in SPY as long as SPY is greater than -2% (say X) of its 250-day average. Sell and go in cash if it falls below X. If SPY falls below 6% (say Y) of 250-day SMA look to bottom fish. Buy SPY when it is below its 4-day SMA expecting a short term bounce back and sell as soon as it comes back above its 4-day average. These are short-term trades that take advantage of market’s volatility. Now while the thresholds pick (X and Y) may feel like magic numbers, in my test almost all combinations of X and Y where X

The PIMCO Intermediate Municipal Bond Strategy ETF: Enduring Principals

The fund is managed by a global leader of fixed income assets. The fund diverges from the tracking index, but reduces the ‘duration risk’ by doing so. PIMCO’s bond management experience may prove to be an asset as the Fed prepares to change policy. A unique feature of the once popular game show, Jeopardy , was that the answer was the question and the question was the answer. So for example, you might been confronted with the answer: “Ben Franklin, Mark Twain, Daniel Defoe, Christopher Bullock and Edward Ward” Your answer, in the form of a question of course, would be, “Who have been given credit for first saying, ‘ Nothing is certain except for death and taxes’ ?” Indeed and invariably, that seems to be the case. Each may be unavoidable in the end, but in the meantime, with careful planning an investor can take a breather from taxes without being in jeopardy with the IRS by including a tax exempt municipal bond fund in a portfolio. Oddly, compared to other types of taxable bond funds, there aren’t that many plain vanilla funds to choose from. The choices are further narrowed by the three choices of Long , Intermediate or Short maturity funds. Pacific Investment Management Company , commonly recognized by its acronym, PIMCO , is a global investment management firm, specializing in fixed income assets, with over $1.47 trillion under its care. It should be noted, though, PIMCO manages its assets independently, but it is wholly owned by Allianz (OTC: OTCQX:ALIZF ) PIMCO offers the actively managed PIMCO Intermediate Municipal Bond Strategy (NYSEARCA: MUNI ) . According to PIMCO, the fund is: . .. Designed to be appropriate for investors seeking tax-exempt income, the fund consists of a diversified portfolio of primarily intermediate duration, high credit quality bonds, which carry interest income that is exempt from federal tax and in some cases state tax… PIMCO makes a point of noting that: … Unlike index funds that typically rely solely on a rating agency for credit analysis, PIMCO applies extensive research on each municipal bond we own in the fund… …to avoid what we feel are municipalities of deteriorating credit quality in our efforts to protect investors’ capital… Having that extra level of analysis should provide the investor with an extra measure of risk mitigation. The fund tracks Barclays 1-15 Year Municipal Bond Index (LM17TR) : …which consists of a broad selection of investment grade general obligation and revenue bonds of maturities ranging from one year to 17 years… The fund was incepted on November 30, 2009 and currently holds approximately $235.5 million in net assets. Its daily trading volume is noted to be 37,881 ETF shares; hence there’s sufficient liquidity available to enter a position. Since inception, the fund has traded at par with its NAV and recently has traded at a discount of -0.13% to NAV. It should be noted that being able to purchase a bond fund at a discount gives the investor an extra advantage. That being noted, the fund’s shares have a slight bias to trade at a discount to NAV over its history, hence it may be worth choosing the moment for the best entry point. The funds current estimated ‘yield to maturity’ is 2.28% and a distribution yield of 2.29%, (distributions are monthly). Management fees are below the ETF industry average at 0.35% which, again, is another advantage in the long run. The 30 day SEC yield, i.e., after fees and expenses is 1.67%. Annualized Returns 1 Year 3 Year 5 Year Since Inception 11/30/2009 Fund NAV (after expenses) 1.80% 1.40% 2.73% 3.38% ETF Shares 1.91% 1.43% 2.73% 3.38% Barclay’s Index 2.61% 2.44% 3.49% 3.97% Fund vs Index -0.70% -1.01% -0.76% -0.59% Data from Pimco A word or two needs to be said about a few terms. First, according to Investopedia, Average Effective Maturity is a measure of maturity, taking into account the probability that a bond might be called back to the issuer. At this point it’s worth noting the term embedded option . This is a special condition ‘written into’ a security. For example, a bond might have a ‘ call date ‘: a date on which a bond may be redeemed, or ‘called’, before maturity. For the entire portfolio, which may have a mix of callable and non-callable bonds, the Average Effective Maturity is the weighted average of the maturities taking into account those with a call provision. Another important concept is that of Duration . Without going into a lot of the mathematics of finance, it may be generally understood by an example. Consider a $100,000.00, 3.25%, 15 year fixed rate loan starting today . Looking forward, in a little under 13 years into the loan, the borrower will have paid back $100,000.00 in combined principal and interest. In other words the lending bank breaks even at a little under 13 years. Now start again but fast forward ahead 5 years from the beginning. The borrower has made interest and principal payments amounting to $28093.00; ($5989.00 of that is principal). However, the lender considers those previous five years of payments, amounting to $28093.00, as paid and ‘off the table’. There’s still $94011.00 of principal left to pay. Since the original five years of ‘cash flow’ is off the table, the lender recalculates and figures out that breakeven on the future interest and principal payments occurs in just over 8.5 years. If the recalculation is done after every payment is made and off the table, the ‘breakeven’ will continue to gradually decrease to 0 years, (maturity). Just one more detail is needed: if the loan had a floating rate and interest rates declined, it will take longer to reach that breakeven point. Conversely, if rates increased, breakeven will be attained more quickly . That’s essentially Duration. It’s a way to measure how long it would take for full repayment of the original price of a bond, at the current interest rate via future cash flow and specified in years. If interest rates go up, it takes longer; if interest rates go down, it’s quicker. These calculations are of great importance to fund managers since they often open and close positions before maturity . So why should a retail investor care? The U.S. Federal Reserve sets the benchmark when it comes to interest rates. Recently, the Fed has indicated that, most likely, it will increase the benchmark ‘Fed Funds’ rate by the end of the year. The Fed usually moves in 25 basis point (1/4 point) increments. So if an investor had to choose from bond funds of equal quality holdings, the smart move would be to choose the one with the shortest duration as it would be least impacted by rising interest rates. Analysts like to look at these metrics in different ways or even ‘fine tune’ existing metrics. Indeed, this is the case with bonds. For example, Effective Duration takes into account both callable and non-callable bonds and determines the ‘probable duration’ of the entire portfolio as interest rates fluctuate. Now, having a reasonably good idea of what Duration is, the fund’s Effective Duration is currently 5.07 years. (click to enlarge) The fund’s home page Performance and Risk tab includes an interesting ‘ Key rate Durations ‘, summarized below. It’s an at-a-glance way to see how sensitive a fixed maturity is to a 1% change in market interest rates. Data from Pimco It should be noted that the greatest sensitivity occurs in the 5 to 10 year maturity range, which is 55% of the funds maturity composition. The pie charts below demonstrate the fund’s ‘Maturity Allocation’ as well as the ‘Quality Allocation’ of the fund. (click to enlarge) Just over 47% of total holdings are top quality AA- to AAA. Just over 28% are medium quality A- to A+ and almost 10% are lower quality but investment grade, BBB- to BBB+. Lastly ‘NR’ or ‘Not Rated’ means that, according to the summary prospectus , PIMCO has determined the holding is ‘of comparable quality’ with other bond rating agency grades. It’s also worth noting the fund’s maturity distribution compared with the tracking index. The chart demonstrates that the fund diverges from the index composition significantly; however this does result in a lower duration by just over 31.8%: 5.42 years vs 7.95 year. It should be noted that that the fund does weight strongly the 5 to 10 year maturity range. Those are the maturities with the highest sensitivity to interest rate variations and it does so much heavier than does the index. (click to enlarge) Data from PIMCO The fund charts its sector allocation in an interesting way, both in terms of percentage of total market value as well as percent of total duration. (click to enlarge) Data from PIMCO The holdings include a couple of ‘arcane’ instruments. First are the ‘ Pre-Refunded ‘ holdings. According to the MSRB’s glossary of Municipal Securities Terms: … a refunding in which the refunded issue remains outstanding for a period of more than 90 days after the issuance of the refunding issue… …such refunded bonds are secured solely by an escrow funded with the proceeds of the refunding bonds… …The proceeds of the refunding issue are generally invested in Treasury Securities…. … to pay principal and interest… …on the refunded issue… To put is simply, Pre-Refunded or Advanced Refunded occurs when there’s an overlap in the refunding of an existing issue. The ‘existing issue’ must still meet its obligation, and this is ‘covered’ by the refunding issue’s proceeds and held in escrow. This may partly explain the 4.08% of total holdings as being short term U.S. Treasury Notes. Another interesting holding are the ‘Tobacco Municipal Bonds’. These are bonds issued by a state and funded by a future payment or cash flow due as a result of a settlement or successful lawsuit against a tobacco company. It’s worth noting that tobacco bonds comprise about 2.5% of the municipal bond market. For more on Tobacco Bonds the reader is referred to PIMCO, ” Municipal Tobacco Settlement Bonds: Seeking Value in the Ashes “. MUNI is comparable in returns to the two other funds filtered by the Seeking Alpha ETF Hub . The Fed has indicated that its policy shift will be slow and gradual. This will, no doubt, have some impact on Duration , but when the tax advantage is considered and at the same time having the fund actively managed by the industry leader, it should all add up to make this intermediate municipal bond fund worth holding. Annualized Returns 1 Year 3 Year 5 Year Since Inception 11/30/2009 Fund NAV (after expenses) 1.80% 1.40% 2.73% 3.38% ETF Shares 1.91% 1.43% 2.73% 3.38% Barclay’s Index 2.61% 2.44% 3.49% 3.97% Fund vs Index -0.70% -1.01% -0.76% -0.59% Data from PIMCO