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Combining Value And Momentum In Stock Selection And Market Timing

By Jack Vogel, Ph.D. Recently, we wrote two posts about how to combine Value and Momentum for stock selection purposes ( Part 1 and Part 2 ). We followed this piece with a post on combining value and momentum for market timing purposes. In this post, we review the use of combined Value and Momentum for both stock selection and market timing. First, let’s examine the combination of Value and Momentum in stock selection. A concept that has been around for many years . Setting Up a Value and Momentum Portfolio First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market cap (currently around $1.8 billion) to avoid weird empirical effects associated with micro/small cap stocks. We will form the portfolios at a monthly frequency, with a 3-month holding period – so we use overlapping portfolios, a la Jagadeesh and Titman (1993) . We focus on the following 2 variables: Momentum = Rank firms on three momentum variables: 3-month, 6-month, and 12-month momentum. The average of the 3 ranks is the “momentum” rank. Value = Rank firms on three value variables: EBIT/TEV, Book-to-Market (B/M), and E/P (inverse of P/E). The average of the 3 ranks is the “value” rank. Every month, we select the top 100 Value stocks and the top 100 Momentum stocks (and hold them for 3 months). We then equal-weight the holdings. Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. SP500 = S&P 500 Total return. LTR = Total Return to Merrill Lynch 7-10 year Government Bond Index. RF = Total Return to Risk-Free Rate (U.S. T-Bills). Results are net of a 1.00% annual management fee and 2.00% annual transaction costs. Index returns (S&P 500, LTR, and RF) are gross of any fees or transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Results (1/1/1964-12/31/2014): (click to enlarge) The results are hypothetical results, 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. Additional information regarding the construction of these results is available upon request. Takeaways: Combining Value and Momentum outperformed the market (after fees) over the past 50 years. However, the Value and Momentum portfolio does have larger drawdowns and higher volatility than the passive index. On a risk-adjusted basis, the combination value/momentum portfolio is favorable. Interesting, but active equity strategies have drawdown problems As previously discussed , we can examine what happens when we overlay a timing signal on top of the combination value and momentum stock selection system outlined above. Below, I describe the two market timing rules: Valuation-Based Signal: We use 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, we adjust the yield value for the realized year-over-year (yoy) inflation rate by subtracting the year-over-year inflation rate from the rate of 1/CAPE. h.t., Gestaltu . A higher real yield spread is better than a low real yield spread. To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%: Real Yield Spread Metric = (1/20)-3% = 2% Some details: The Bureau of Labor Statistics (BLS) publishes the CPI on a monthly basis since 1913; however, the data is one-month lagged (possibly longer). For example, the CPI for January won’t be released until February. So when we subtract the year-over-year inflation rate from the rate of 1/CAPE, we do 1-month lag to avoid look-ahead bias. We use the S&P 500 Total Return index as a buy-and-hold benchmark. 80th Percentile Valuation-based asset allocation: Own stocks when the valuation < 80th percentile, otherwise hold risk-free. In other word, get out of the market if the real yield spread metric is extreme. Momentum-based signal: Long-term moving average rule on the S&P 500 (Own stocks if above 12-month MA, risk-free if below the 12-month MA). Using the Combination Signal: Both signals are calculated using S&P 500 data (Momentum and Valuation). However, if the signals say we should be invested in stocks, we are invested in the Value and Momentum portfolio. Results of all portfolios are net of a 1.00% annual management fee and 2.00% annual transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Results (1/1/1964-12/31/2014): Here we show the results to 4 portfolios: Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (Value RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation-based market timing rule applied: Own stocks (Value and Momentum portfolio) when the valuations aren't extreme, otherwise hold risk-free. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (MA RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Momentum-based market timing rule applied: Own stocks (Value and Momentum portfolio) if they are above the 12-month MA, own risk-free if below the 12-month MA. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. Value and Mom EW (Value and Mom RM - net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation and Momentum-based market timing rules are applied, each having a 50% signal weight. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs. (click to enlarge) The results are hypothetical results, 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. Additional information regarding the construction of these results is available upon request. Takeaways: Both the Valuation and Momentum-based market timing rules decreased drawdowns (maximum drawdown and sum of drawdowns). Combining the Value and Momentum market timing rules yields the lowest drawdown, as well as the highest Sharpe and Sortino ratios. Conclusion: Combining Value and Momentum appears to work for both stock selection and market timing. One can argue that there are "better" ways to combine Value and Momentum. However, a simple approach (documented above) seems to work, at least historically. There are few caveats that come to mind: The results above are hypothetical, and the future could change. Valuation-based timing is tough (see introduction of that post), and we've cherry-picked a system that happens to work in-sample, whereas others we've tried don't seem to work that well. These systems can drift violently from standard benchmarks (i.e., one needs to be prepared for tracking error). Value and momentum stocks are much more volatile than a passive index and require a disciplined sustainable investor . Let us know your thoughts! Original Post

ALLETE: Not A Compelling Buy For Dividend Investors

Summary Reliance on aging coal-fired power generation is a risk. Capital expenditures and dividend payments exceed operational cash flow. Dividend yield is solid but has not grown and is unlikely to grow meaningfully in the future. ALLETE, Inc. (NYSE: ALE ) primarily operates as a regulated utility, providing services for customers in Wisconsin, Michigan, Minnesota, and Illinois. By comparison to some utilities, ALLETE’s largest customers are primarily industrial in nature, with these large customers (mining and paper industries primarily) drawing 54% of KWH generated. Because of this, ALLETE profit is tied directly to the health of these industries. Luckily, Minnesota mining production has continued at full-speed even in the face of a global rout in commodities that have deeply impacted the iron and steel industries. Investors who own ALLETE should focus more of their attention on the health of ALLETE industrial customers rather than traditional utility research, such as demographic trends and unemployment growth in the service areas that primarily affect residential consumers. Aging Infrastructure And Management’s Plan The vast majority of energy production for ALLETE comes from coal-fired power generation. At the end of 2014, 64% (1,277 MW) of energy production was coal-fired. The majority of these coal-fired plants are getting quite old — while units 3 and 4 at the Cohasset, MN facility are the newest (producing 75% of generation at this massive facility), these were still originally constructed in 1973 and 1980. Like a large swath of US coal-fired plants, obsolesce may soon be around the corner. The average lifespan of a coal-fired plant is forty years, according the National Association of Regulatory Utility Commissioners . While the Cohasset facility has seen many updates over the years, facts remain that the bones of the facility have aged. Those that follow my work on utilities know that I’m a big fan of natural gas and other renewable power regeneration. This isn’t driven by my own personal feelings on the environmental impact. Regardless of your thoughts on environmental regulation, investors should nonetheless be aware of the fact that the Environmental Protection Agency has begun taking a harder stance on coal and that course is unlikely to change. Regulations on pollutant emission will likely only continue to strengthen and so will the cost burden on utilities to maintain necessary updates on these aging coal-fired plants. As a recent example of the cost impact, ALLETE is nearing completion of an environmental upgrade at one of its plants; total cost will run $260M to bring the plant into compliance with the Mercury Emissions Reduction Act. While this is cost recovery eligible through rate increases on the retail customer and if approved these customers will have no alternative but to bear the cost, industrial customers (which if we remember constitute the majority of revenue) do have the option to pursue other providers with approval from the state or can generate their own electricity on-site. This is why it is imperative that investors who remain long on ALLETE as a company pay close attention to the strides the company is making in renewables and natural gas. The company is targeting a production goal of thirds — one-third of energy production with coal, one-third with renewables, and one-third with natural gas. This was most likely driven in part by the Minnesota Next Generation Energy Act of 2007, which requires 25% of retail energy sales to be from renewables by 2025, with hurdles of 17% in 2016 and 20% in 2020. These hurdles are around the corner, but luckily ALLETE does have a foundation to work off of. There is some minimal existing hydroelectric production (105 MW) spread throughout Minnesota, but the likely new crown jewel for ALLETE is its Bison Wind Energy Center in North Dakota, which produced 497 MW of energy at the end of 2014. Further bolstering renewables production is the agreement reached to purchase hundreds of megawatts of production from AES Corporation (NYSE: AES ) early on in 2015. I’m long AES Corporation, and I see this as a win/win for both companies. AES has spread itself way too thin around the globe and these asset sales make sense to let the company gain focus on more core facilities. ALLETE in return gains solid wind production facilities that will likely be immediately accretive to earnings per share. As another related victory for ALLETE in the renewables space, the deal for ALLETE to construct a wind farm for Montana-Dakota Utilities, a division of MDU Resources Group (NYSE: MDU ) shows that the company has an industry reputation for knowing what it is doing when it comes to wind construction. Operating Results (click to enlarge) Total revenue has grown at a 5.81% over the past five-year period and this trend is set to continue with revenue projected at 1.2B for 2015. Fuel expenses have fallen as coal prices have taken a nosedive, a benefit that many utilities have enjoyed in recent years. This input cost windfall has resulted in expanding operating margins. Net income growth would have been stronger if not for a burgeoning debt load; total debt now stands at nearly $1.4B, almost double the $773M the company held in 2014. This is due to the fact that capital expenditures have massively outstripped operational cash flow over the past five years. Operational cash flow totaled $1.2B in the 2010-2014 period; capital expenditures totaled $1.8B. This out-of-balance is before factoring in dividends, which totaled another $350M. This is not what you want to see from a utility. By comparison, Calpine Corporation (NYSE: CPN ), which I own, has seen nearly $3.8B in operational cash flow versus $2.8B in capital expenditures over the same timeframe. This falls back to the cost of running and maintaining coal-fired plants. Calpine primarily operates extremely new, high-technology natural gas plants, the direct opposite of ALLETE’s current portfolio. Management is guiding these costs to fall over the next five years, capital expenditures are guided to average $250M/year versus the prior five-year average of $360M. Even with those decreases, ALLETE may continue to run into a situation where they must raise more debt to fund all their obligations. Conclusion While investors might be tempted by the 4% dividend yield, investors should keep in mind the five-year average dividend growth rate has only been 2.2% and this is unlikely to change. No large catalysts exist for substantial earnings per share and dividend expansion in my opinion. Total shareholder returns are likely to lag a broader utility index and investors would likely be better off in other names with more opportunity. Larger peers like American Electric Power (NYSE: AEP ) or prior-mentioned name AES Corporation present more compelling stories for stable dividend growth. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

3 Safe-Haven ETFs To Watch On Market Correction

The global investing world, especially the risky assets, went into a tailspin recently on a host of factors including lack of transparency in the Fed tightening timeline, the rout in the Chinese economy and its repercussions in its stock market, the yuan devaluation earlier this month, an impending snap election in Greece, slowdown in the Japanese economy and an acute plunge in oil prices. In short, concerns over global growth are widespread, causing a correction in the global stock markets. The U.S. stock-index futures recorded the deepest weekly decline in about four years past week. The tumult was triggered off on August 11 when China devalued its currency yuan and eventually spread into almost all asset classes. Since then, the global market correction ate away over $5 trillion of equity value, per Bloomberg. Commodity prices dived to a 16-year low, and credit risk in Asia rose to the highest level since March 2014. Given these woes, risk-averse investors are treading cautiously as most are dumping stocks and junk bonds in favor of safe haven assets to protect their portfolio from capital erosion. Below we have highlighted three safe haven ETFs that investors can consider adding to their portfolio in the current volatility. These products are likely to gain should the turmoil worsen and volatility in the market continue to escalate. Treasury Bonds iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) Though U.S. treasuries were out of favor a few days back due to worries over Fed tightening, heightened global uncertainty brought this safe asset into the limelight. Dimming prospects of the sooner-than-expected Fed rate hike, global growth worries and severely low oil price which put a lid on global inflation led treasury valuation to soar. Yields on the U.S. benchmark 10-year notes slipped to 2.05% on August 21 from this year’s 2.50% high recorded on June 10 while yields on the U.S. benchmark 20-year notes plunged to 2.44% from the high of 2.98% on June 26. The ultra-popular long-term Treasury ETF – TLT – tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index and has AUM of $4.92 billion. Expense ratio comes in at 0.15%. Holding 29 securities in its basket, the fund focuses on the top credit rating bonds with average maturity of 26.82 years and effective duration of 17.35 years. TLT was up 1.9% last week and 5.7% in the last one-month frame (as of August 21, 2015). The fund has a Zacks ETF Rank #3 (Hold). Apart from TLT, investors can also consider the 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) and the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ) . These two ETFs were up 2% and 2.9% in the last one week (as of August 21, 2015). In the last one-month frame, each of these two ETFs gained over 9.4%. Gold SPDR Gold Trust ETF (NYSEARCA: GLD ) Gold is often viewed as a safe haven asset to protect against financial risks, and has performed well lately (despite deteriorating fundamentals) on heightened market volatility. The metal logged the largest weekly gains (as of August 21, 2015) since January. Funds tracking the yellow metal, such as GLD, can be a good choice for investors seeking safety. GLD tracks the price of gold bullion measured in U.S. dollars. The fund is the most popular and liquid bet in its space with an asset base of $25.1 billion and an average trading volume of about six million shares a day. The fund charges 40 basis points as fees and gained more than 4% in the past one week and 6% in the last one-month frame (as of August 21, 2015). Apart from GLD, investors can also consider the iShares Gold Trust ETF (NYSEARCA: IAU ) , another popular choice in this space that returned almost similar to GLD last week. Both GLD and IAU have a Zacks ETF Rank #3 (Hold). Currency CurrencyShares Japanese Yen Trust ETF (NYSEARCA: FXY ) The Japanese currency, yen, is often considered a classic safe haven asset. Yen surged to a six-week high on August 21, 2015 as China-led worries wrecked havoc on the global equity and commodity markets. Also, reduced expectations of a September Fed rate hike dampened the dollar to some extent and boosted yen. The sentiment regarding risk-aversion was so strong that yen gained despite the ultra-loose monetary policy in Japan. Investors can target this currency via FXY, which measures the value of the yen against the price of the greenback. This $106 million-fund charges 40 basis points as fees. FXY was up 1.11% on August 21 and added 1.7% in the past week as of the same date. FXY has a Zacks ETF Rank #4 (Sell) as easy Japanese monetary policy will not favor the currency for long. In fact, the fund lost about 0.1% after hours. Link to the original post on Zacks.com