Tag Archives: outlook

How To Identify A Stock With A Competitive Advantage: Cross Your Fingers

When selecting a long-term stock investment, most investors take a page out of Warren Buffett’s playbook and look for companies with strong competitive advantages. History has shown that the odds of identifying such advantages are no better than the flip of a coin. Protecting the Castle A competitive advantage is one of the most sought after characteristics of any long-term investment. Wall Street analysts grade stocks almost exclusively on the strength and sustainability of a company’s competitive advantage. Value investors demand stocks that have track records of fending off competition and sustaining high profit margins. Warren Buffett describes a business with a competitive advantage as a castle with a moat around it. The wider, deeper, and more treacherous the moat, the better the investment. In a 1999 article in Fortune Magazine, Buffett said: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” This makes sense. Without some sort of advantage, a profitable business will not be profitable for long. Deterioration Not only are economic moats hard to find, they are hard to maintain. Furthermore, predicting which companies will have strong competitive advantages in the future can be downright impossible. Economic theory shows that once a business obtains an advantage in the marketplace, competitors will attempt to copy and improve upon the successful business model. This will ultimately eat away at the company’s profits and deteriorate its competitive advantage. Here, we’ll look at two case studies which have played out over the last 20 years. In one case, the company possessed all the advantages of an economic moat. In the other case, the company was rapidly losing market share and had a miserably bleak future. Today, one company is out of the business and the other has multiplied hundreds of times over. Blockbuster Video A perfect example of a deteriorating competitive advantage can be found in the case of Blockbuster Video. After opening its first location in 1985, the company became synonymous with movie rentals in the 1990s. By the late 90s Blockbuster had been able to maintain its competitive advantage and fend off its toughest competitor – Hollywood Video. Once the new millennium began, Blockbuster had a whole new set of competitors – Netflix (NASDAQ: NFLX ) and Redbox. Where Blockbuster charged over $5.00 per rental and required customers to pick up movies in person, Redbox charged only $1.00 and Netflix offered unlimited DVD rentals by mail for one flat monthly price. When both companies were in their infancies, Blockbuster could have easily copied their business models or bought them out. In 2000, Netflix offered to sell its operations to Blockbuster for only $50 million. Blockbuster passed on the opportunity to own the company that would eventually be the cause of its demise. Eight years later, as Blockbuster’s business model was teetering on the brink of collapse, management still had its head in the sand. Here’s what Blockbuster CEO said in 2008: “Netflix doesn’t really have or do anything that we can’t or don’t already do ourselves.” It can be argued that Redbox had just as big – if not a bigger – impact on Blockbuster than Netflix. After launching its first video rental kiosks in 2004, Redbox quickly became a cheap and convenient way to rent new release movies on a nightly basis. It wasn’t until 2010 that Blockbuster decided to aggressively pursue this business model with its Blockbuster Express kiosks. By then, it was too late. Apple If Blockbuster is the perfect example of a profitable business losing its competitive advantage, Apple (NASDAQ: AAPL ) is the perfect example of a company regaining its competitive advantage. Less than 15 years after selling its first computer, the company posted its most profitable year in 1990. However, things started to turn south quickly for Apple. While both founders – Steve Jobs and Steve Wozniak – moved on to other ventures, the company started losing market share. By 1996, industry experts and Wall Street analysts had left the company for dead. At the time, no one could foresee the return of Steve Jobs and the innovative products he would bring to the company. Rather than competing head-on with Microsoft (NASDAQ: MSFT ) in the PC market, Jobs decided Apple would gain a competitive advantage by focusing on music-related products. First came the iPod, then iTunes and the rest is history. Today, iPhones and iPads have transformed Apple from a $3 billion company in 1996 to a market cap of $600+ billion in 2016. Identifying a Moat Looking back, it’s easy to say that Apple was the better investment in 1996. A share of Apple has multiplied more than 200 times over in the last 20 years. By contrast, an investment in Blockbuster Video would have gone to zero. But was it possible to have seen this at the time? In investing, the past is history. The future is where profits are made. Let’s put ourselves in the shoes of a stock market investor in 1996 and try to identify which company had the better competitive advantage. According to Pat Dorsey, Equity Research Analyst at Morningstar, there are four types of economic moats: Intangible Assets Customer Switching Costs The Network Effect Cost Advantages Dorsey says, “At Morningstar, thinking about economic moats, or structural competitive advantages, is central to how we do equity research.” He claims that having any or all of the above characteristics, “give superior companies the power to stay on top.” Breaking It Down By breaking down each advantage we should be able to compare Blockbuster with Apple and see what an investor would have thought about the future prospects of each. Intangible Assets: Brand recognition, customer loyalty, patents or trademarks, etc. In 1996, Blockbuster video had strong brand recognition and customer loyalty. The company’s slogan, Make it a Blockbuster night was on everyone’s mind when they wanted a night in. The name familiarity gave customers confidence that the local Blockbuster would have a broad selection of the latest new releases and all the old classics. In order to rent from Blockbuster, customers had to have a membership card. Keeping this card in their wallets reminded customers on a daily basis that Blockbuster was where they went to rent movies. Customer Switching Costs: Time, money, or inconvenience to switch to a competitor. Opening an account with a movie rental company in the mid-1990s was like setting up an IRA. It required multiple forms of ID, proof of residence, a complete family-tree and the family dog for collateral. The Network Effect: Everyone uses it because everyone uses it. Everyone had a Blockbuster card in their wallets, so there was a Blockbuster in every town. The more customers Blockbuster obtained, the more locations they would open. The more locations they opened, the more customers they obtained. It became very convenient to be a Blockbuster customer because the stores were everywhere. Cost Advantages: Scale-based cost advantages allow for huge profit margins on additional sales. Blockbuster received payments dozens, hundreds, or even thousands of times on one VHS or DVD. If one more customer decided to rent a movie on a Friday night, it would not cost the company anything. The additional rental would be pure profit to Blockbuster. The VHS or DVD had already been paid for by Blockbuster. The customer was required to give the movie back to Blockbuster for them to rent again. On The Other Hand By contrast, Apple had none of these competitive advantages in 1996. The OS business was controlled by Microsoft, and Dell controlled the PC market. Apple was a tiny player which the market valued for less than its liquidation value. At the end of 1996, Apple qualified as a Benjamin Graham NCAV stock . It was literally valued more dead than alive. Putting It into Practice Today, there are all kinds of companies which appear to have wide moats protecting their profits. Even more so are the companies which appear to be past their prime and rapidly losing market share. The problem with insisting on investing only where sustainable moats exist, is that strong competitive advantages are impossible to foresee. It’s one thing to identify companies where moats currently exist, it’s another thing to know whether those moats will exist in 5, 10 or 25 years from now. Can you confidently predict which stocks will be the next Blockbuster and which will be the next Apple?

Beyond Miners, 5 ETFs Crushing The Market To Start Q2

Overriding concerns over weak corporate earnings, U.S. stocks hit fresh highs of 2016. This is especially true as conservative earnings estimates are actually setting the stage for positive surprises. In fact, a handsome earnings beat by one of the six largest banks – JPMorgan (NYSE: JPM ) – spread optimism into financial sector, which is the backbone of the global economy. As per the Zacks Earnings Trend , earnings beat ratio for 8.8% of the S&P 500 companies that have reported so far is impressive at 71.9%. Additionally, better-than-expected trade data in China eased global growth fears, sending the stocks higher. Further, stabilization of crude oil at around $40 per barrel is the greatest achievement in the current oversupplied oil market. Though the dollar has been weakening since the start of the second quarter, it has gained some momentum this week on more stimulus hopes from Bank of Japan (read: 5 ETFs to Buy if Oil Stays at $40 ). Apart from these recent developments, the dovishness of the Fed, an accelerating job market, a pick-up in inflation and increasing consumer confidence have continued to brace the market. Meanwhile, the appeal for government bonds and precious metals has diminished on risk-on investors’ sentiment. That being said, we highlight five ETFs that are surging to start the second quarter and are expected to continue this trend. ALPS Medical Breakthroughs ETF (NYSEARCA: SBIO ) – Up 11.5% This fund targets companies with one or more drugs in Phase II or Phase III FDA clinical trials by tracking the Poliwogg Medical Breakthroughs Index. It is a small cap centric fund, having amassed $104.2 million in its asset base. The product holds 95 stocks in its basket with a well-diversified portfolio as each security holds less than 4.6% of assets. The product charges 50 bps in fees per year from investors and trades in a moderate average daily volume of about 77,000 shares. It has a Zacks ETF Rank of 3 or ‘Hold’ rating. WisdomTree Weak Dollar U.S. Equity ETF (NYSEARCA: USWD ) – Up 10.3% This fund offers exposure to export-oriented companies that may benefit from a weakening U.S. dollar by tracking the WisdomTree Weak Dollar U.S. Equity Index. It holds 201 securities in its basket with none accounting for more than 1.84% of assets. However, about one-fourth of the portfolio is dominated by information technology while industrials, health care, consumer discretionary and materials round off the next four spots with a double-digit exposure each. USWD is an unpopular an illiquid fund with AUM of $1.2 million and average daily volume of under 1,000 shares. Expense ratio came in at 0.33%. SPDR SSGA Risk Aware ETF (NYSEARCA: RORO ) – Up 10.3% This is an actively managed ETF that seeks to provide capital appreciation and competitive returns compared to the broad U.S. equity market. Holding 90 stocks in its portfolio, the fund is moderately concentrated across the firms with each holding less than 5.4% share. From a sector look, consumer discretionary, health care, consumer staples, financial services and utilities are the top sectors with a double-digit allocation each. It has managed $2 million in its asset base and charges 50 bps in annual fees. Volume is light exchanging less than 1,000 shares a day on average. United States Brent Oil Fund (NYSEARCA: BNO ) – Up 9.2% This fund provides direct exposure to the spot price of Brent crude oil on a daily basis through futures contracts. It has amassed $121.3 million in its asset base and trades in a good volume of roughly 267,000 shares a day. The ETF charges 75 bps in annual fees and expenses. SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA: XOP ) – Up 9.2% This fund provides an equal weight exposure to 60 firms by tracking the S&P Oil & Gas Exploration & Production Select Industry Index. Each holding makes up for less than 2.8% of the total assets. XOP is one of the largest and popular funds in the energy space with AUM of over $2 billion and expense ratio of 0.35%. It trades in heavy volume of around 19.1 million shares a day on average. The fund has a Zacks ETF Rank of 5 or ‘Strong Sell’ rating. Link to the original post on Zacks.com

The Importance Of Multi-Asset Investing

Originally published on March 28, 2016 By Nathan Jaye, CFA Everyone knows that multi-asset investing is on the upswing. “Assets managed in such strategies are growing at one of the fastest paces in the industry worldwide,” says Pranay Gupta, CFA, formerly chief investment officer for Asia at ING Investment Management and manager of a global multi-strategy fund for Dutch pension plan APG. In their new book Multi-Asset Investing: A Practitioner’s Framework , Gupta and co-authors Sven Skallsjö and Bing Li, CFA, set out to answer questions about which practices and ideas actually work. In this interview, Gupta explains how the relentless quest for alpha has made allocation an under-appreciated and “under-innovated” skill, shares insights into replacing asset allocation with what he calls “exposure allocation,” and discusses why the standard model for making investment decisions has “exactly the wrong emphasis from a portfolio risk and return standpoint.” Nathan Jaye, CFA: Why is multi-asset investing so popular now? Pranay Gupta, CFA: If you look at investment management today, all plan sponsors, consultants, and asset managers – and even individual portfolio managers and analysts – are all structured with an asset class demarcation of equities or fixed income. We have equity portfolio managers and fixed-income portfolio managers. We have equity analysts and credit analysts, and we have equity products and fixed-income products. This industry structure worked well historically, as equity and fixed income were not highly correlated and allocation to these two asset classes could result in a diversified portfolio and you could earn risk premiums. It made sense. But over the past 10 years, the correlation between asset classes has increased. Financial engineering has created products which are in the middle of the traditional asset classes – hybrid products across equity, fixed income, and alternatives. So a clear distinction doesn’t hold true anymore. The rising thesis is that we should be looking at our portfolios as multi-asset-class portfolios. That’s caught on over the past few years. Assets managed in such strategies are growing at one of the fastest paces in the industry worldwide. What’s covered in your book? The field of multi-asset investing is just beginning its journey of innovation. This book is meant for the professional investor, and every chapter in the book has a number of ideas which are different from what I’ve seen across the industry. In the first chapter, we cover the traditional model – the way the world has performed with traditional asset allocation in the past five or six decades. In the remainder of the book, we examine individual components of the traditional allocation process and show how each facet of the allocation structure can be improved. These techniques are applicable at multiple levels – from a plan sponsor portfolio, sovereign fund, or pension plan making a strategic asset allocation decision to a hedge fund managing a macro strategy. They are all multi-asset investment decisions. Even individual retirement accounts are multi-asset portfolios, where allocation is done across asset classes. There are two types of innovations in this book. One is at the conceptual level, where we discuss the broad concepts of how we should structure multi-asset portfolios. The second is at the implementation level, where we detail innovative techniques, such as allocation forecasting processes and managing tail risk and designing stop losses. Some of the chapters are intensely quantitative and others are conceptual and qualitative. Does asset allocation get enough respect? We’ve all known for a long time that asset allocation is responsible for the majority of portfolio return and risk. It’s well accepted that, say, 80% of the risk and return of the portfolio comes from allocation and only 20% comes from security selection. But when you look at the structure of the industry, the resource deployment is exactly the reverse – that is, 80% of industry professionals are stock selectors and bond selectors. Less than 20% are involved in allocation. The whole of the industry’s focus has been the search for alpha. It seems quite odd, given that alpha only drives 10% to 20% of the return and risk of an asset owner’s portfolio. As I started managing various kinds of multi-asset portfolios, it led me to question the traditional process of asset allocation, and I began exploring methods to try and improve what is conventionally done in a 60/40 balanced portfolio or a strategic or tactical allocation decision. The importance of allocation has been grossly underestimated, and allocation is an under-innovated skill. In our book, we detail a number of innovations we have created and tried, but there are probably a lot more that can be made. Unlike security selection, where there’s been a lot of innovation and progress made as a result of the number of people focusing on the skill. But not many people are focusing on allocation skill. Are organizations misdirecting their resources? If you look at any plan sponsor, you normally have a very small team which does the asset allocation and puts it into asset classes. Then you have an army of people who go and hire and fire dozens of managers and perform due diligence on them. This is exactly the wrong emphasis from a portfolio risk and return standpoint. We take great pains in selecting multiple managers for diversifying alpha, but the asset allocation in the plan sponsor is done by a single group (i.e., a single strategy done at a single time horizon). We don’t diversify our allocation methodology. We don’t harness time diversification. What if we did exactly the opposite? Suppose we took 80% of the resources in the plan sponsor and dedicated them to multiple ways of doing allocation and manager selection was just effectively a side effect? In the book, we demonstrate how creating a multi-strategy structure for the allocation process and not focusing on the implementation as much can lead to a better portfolio. Discussions such as active versus passive strategies or the usefulness of fundamental indexation and smart beta then become somewhat obsolete. What’s your experience in managing multi-asset funds? I managed a global multi-strategy fund for APG, the Dutch pension plan, from 2002 to 2006. We grew the fund from a very small base to a multi-billion-dollar fund. Over this period, we experimented with many different techniques of how to manage large, multi-strategy, multi-asset funds. Subsequently, when I was chief investment officer for Asia at ING Investment Management and Lombard Odier, we implemented a lot of these techniques in managing an asset base of about US$85 billion across all asset classes. The traditional way one arrives into an allocation function is as a macroeconomist or strategist. But I happened to stumble into allocation after managing each asset class separately from a bottom-up perspective. Having gathered the real ground experience in managing every single liquid asset class, as the team size and asset size became larger, I got thrust into managing the allocation, risk, and portfolio construction of these multiple strategies in a combination. This was the perfect breeding ground for innovation. What’s your definition of commoditized beta and non-commoditized beta? We have been guided repeatedly to separate alpha and beta in our strategies, and told that we should strive for alpha. Actually, alpha and beta are very alike; they are both return distribution of assets. The only difference is that beta can be gathered by inexpensive derivatives which provide exposure to specified factors (such as market cap, value, etc.), while alpha as a collection of exposures is not available with such instruments. This distinction keeps evolving as more and more alpha exposures today become available as beta exposures in a liquid, inexpensive form. I call what is hedgeable “commoditized beta.” Equity market risk is completely commoditized by an equity future. As more and more betas are available in a cheap, liquid, derivative form, they become commoditized. The remainder are non-commoditized and are classified as alpha. So in managing portfolios, we propose that, instead of doing asset allocation, what if we do exposure allocation, where exposures are in multiple dimensions, not just equity beta and credit beta? If you allocate to this richer set of exposures to construct a portfolio, you enhance diversification where it is required most. You argue that the definition of equity risk premium should be adjusted for allocation purposes. Why? The academic way of justifying investing in equities is by the concept of the equity risk premium, which is the long return on equities above a risk-free rate. But if you have a portfolio which includes both equities and fixed income, the actual reason you would invest in equities is not the return on equities above cash but the return on equities above bonds. Look at this from a company’s perspective. A company has the option of raising capital through debt or equity. When a corporate treasurer looks at how he should raise capital, he evaluates whether it is cheaper for them to take on debt or to raise more equity. Our proposal for portfolio management is exactly within the same context, except that we are maximizing return, not minimizing cost. How do you apply this in practice? From an allocation standpoint, we want to have mutually exclusive and ideally uncorrelated buckets. So we separated equity risk premium from credit risk premium and from country risk premium and cash. It is a laddered structure for defining what risk premium is – in order to build better silos for allocation. Then we innovated the allocation process itself. There’s lots of debate about whether risk parity is better or fundamental allocation is better. People have these philosophical debates because they have only one allocation process. In the structure we’re proposing, this question is obsolete because all of these allocation methods will have value at certain points in time. Because they would be uncorrelated with each other, a framework where we use all of them – in a multi-strategy allocation structure – will give the benefit of strategy diversification and time diversification. Risk parity will work at some point in time, and so will fundamental allocation and long-term risk-premium allocation. Let’s use all of them as different buckets, because you can do allocation in many different ways. Debating which allocation strategy is better is a misplaced discussion. What is your idea for composing consensus estimates for allocation recommendations? If you want to know the consensus expectations or rating for any stock in the world, there are plenty of databases out there which will give you that information. Similarly, for economic numbers, there are databases which collate all the forecasts from economists on, say, the US Federal Reserve’s rate hike and how many people are saying the Fed will hike and how many are saying it won’t. You have a range of views, but you also know the consensus. But there is no database available today which collates the views of different sell-side strategists on recommended allocation stances. Every sell-side house has a strategy team which allocates across countries and sectors and currencies, just like they have corporate research analysts for earnings, but no one collects their views and puts them in an organized manner. If allocation is important, then why don’t we do that? These strategists are putting out reports, but there’s no database which collects all this information and uses it to say, “Here’s what the consensus allocation to this kind of sector or country is.” Surely that would have value, just like company earnings estimates have value. How should firms structure a multi-asset approach? As multi-asset investing is becoming more important, every asset management firm has gone on a rapid increase to bolster its capabilities in this area. But everyone has done it very differently. Everyone has a different take on what multi-asset means. In the book, we highlight the different approaches that “multi-asset” can mean. Firms should be clear about how they are positioning their multi-asset business. What are the capabilities that you need to have? And what is beyond your capability? You can’t be all things to all people. Why do active managers investing in Asian equities underperform relative to active managers investing in US equities? We compared active managers in Asia against active managers in the US. The data suggest that in the US, roughly half the managers underperform and half the managers outperform their benchmark. In Asia, more than three-quarters of active managers underperform and only about a quarter outperform. And of that quarter, less than 10% outperform on a three-year basis. So the quality of active management in Asia is very poor compared with the US. To understand why, we analyzed possible sources of returns for active management to exploit in both markets, and we found that approximately 82% of returns in US equities come from security selection – only 18% of returns can come from allocation decisions. In Asia, 66% of returns can be attributed to the allocation decision, not from stock selection. Yet if you talk to most active managers in Asia, most of them will tell you, “I’m a stock selector. I go and pound the pavement and pick stocks in each of these different countries.” Our hypothesis is that active managers in Asia are focusing on the security-selection decision, which is a smaller source of returns in Asia, and ignoring allocation decisions, which is the bigger source. If two-thirds of the returns in Asian equity markets are coming from allocation and active managers there are largely ignoring this decision, then maybe that’s the reason why the majority of active managers in Asia underperform. When you analyzed manager skill versus luck, what did you find? In 2007, when the quant crisis happened, there were managers who were on the ball and decreased risk on the day when the meltdown happened in August. But because they decreased risk (which was the right decision), they didn’t participate in the rebound the next day and ended up with a negative August 2007 performance number. Managers who were on the beach and didn’t know what was happening – and didn’t actually do anything to their portfolios – rode through the week and had a positive return. But that was return purely by luck. Differentiating skill from luck is the most important part of judging the value added by an active manager. In the book, we propose a framework for how active managers can analyze their own portfolio decisions and examine which of their decisions are skilled and which ones [are the result of] luck (which may not repeat itself). How important is the management of tail risk in multi-asset investing? If you look at most of the risk parameters we use in modern portfolio theory, they are based on the concept of end-of-horizon risk – that is, if you hold an asset for x months or x years. When we calculate the volatility of that asset, it’s based not on what that risk would be across the period but on what it would be at the end of the period. The practical reality – for both individuals and institutions – is that the intra-horizon risk is a much greater determinant of investment decisions while you are invested in any asset. The current portfolio management framework largely ignores that. Suppose you buy something and it goes down 50%. There is a real impact on how you will behave towards that investment, and that impact is a real risk which needs to be accounted for. In fact, in many countries, the regulator will come and tell you to de-risk the portfolio and sell that asset if you go beyond a specified asset liability gap at any point in time. But none of our risk parameters actually capture (or account for) intra-horizon risk. So we went about creating a new risk measure, which is a composite of intra-horizon and end-of-horizon risk. We did this for each asset in our portfolio. That changes the way one looks at the risk of any asset, or the risk of the overall portfolio. Then we applied it to defining custom stop-loss levels for decisions at every level – at the asset level, sector level, and asset class level. We found we were able to manage portfolio drawdown much more effectively, and it helped us a great deal practically in managing with real intra-horizon risk. You’ve found that manager compensation can incentivize portfolio blow-ups. How? The conventional wisdom is that a hedge fund compensation structure (where the asset management company gets 20% of the upside) aligns the interests of the asset manager and the asset owner. It seems logical that they say, “I don’t make money unless you make money.” That’s how it’s sold – the performance fee creates the alignment. But when we looked at how performance-fee incentive structures change the behavior of portfolio managers, we were surprised. We found that there is a greater propensity for the manager to take excessive risk when the portfolio starts to underperform. When we played this behavior out over time and examined what happens to the portfolio return distribution, we found a scenario with outperforming funds at one end and funds which blow up at the other end of the spectrum. The performance fee incentivizes these blow-ups. Our hypothesis is that while performance fees can incentivize alignment of the upside, they’re also a significant determinant of why hedge funds blow up. How has your approach to multi-asset investing evolved? I didn’t set out to write a book. All of these chapters have been written over the past 10-12 years. As I managed portfolios, I started coming across problems where the traditional solution seemed inadequate, and I thought there was room for innovation. My co-authors and I started experimenting and tried to find novel solutions. The book came about over the past six to nine months as we finally set about collating everything we have done over the past decade and making a cohesive argument. Everything in the book is actual solutions we implemented to practical issues we faced in managing portfolios. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.