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The Leap Year Approach To Investing

This year (2016) marks another special year for those who happened to have a significant event, like a birthday or wedding anniversary, fall on February 29th. The Leap Year, which is that extra day that we get every 4 years to help align our calendar year with an actual solar year (which happens to be 365.25 days), is upon us yet again. While many of us might just see this as just “another day,” there are some real advantages to having four-year intervals in our lives. We propose that one of them is looking at your investment performance, assuming you are in a target date fund or have a passive advisor handling rebalancing, tax-loss harvesting and a glide path strategy for you. Now this might sound a bit loony, but there is some real truth into what we are proposing. First of all, it allows investors to drown out the daily “noise” that the prognosticators, the “professionals,” and the entertainers are delivering across the many media outlets. These outlets have become experts in delivering second by second accounts of random news stories and extrapolating them into “advice” with an overlay of overconfidence, as if their ability to estimate market values and future events has the same precision as a Swiss watch. Unfortunately, many soothsayers are more often wrong than they are right , but the short-term attention and amnesia that affects all of us humans allows us to forget and repeat. Once we take a big step back from the second by second clutter, we are able to take a deep breath and really see the irrelevance of it all. A Leap Year approach to investing is the embracing of this emancipation. Now there is nothing unique to this approach in which we are trying to find some long-term market-timing trend that will allow you to outperform the market. Quite the contrary! This is about resetting your internal investment clock to be thinking in years — many years, that is — instead of seconds. It could have easily been the 10-Year High Reunion approach to investing or a welcome to a new decade approach to investing. But let’s be reasonable. At the end of the day, what we are really talking about is the benefit of time diversification. So what does this actually look like? Let’s assume that an investor decided to start investing back on March 1, 1928 and made an agreement with their investment advisor to not discuss nor look at any performance figures until February 29th of the next Leap Year. May seem very unrealistic, but not as much as one would think. Unless something dramatic changes in somebody’s financial situation (this does not include fear due to a short-term downturn in the market), then it doesn’t seem so unrealistic that a 4-year window to chat and reassess could be practical. There may be things going on in the background like rebalancing and tax-loss harvesting, but we are just talking about looking at performance and reassessing financial goals. Using historical performance data for IFA Index Portfolio 100 from March 1, 1928 through February 29, 2016, we have 22 independent 4-year time periods ending on a Leap Year (see table below). We know that past performance is no guarantee of future results, but we are going to be speaking more about the overall trend versus specific numbers. For example, over all 22 4-year periods, the average 4-year annualized return was 11.50%. The lowest 4-year period was during the Great Depression (1928-1931) where we saw an annualized return of -23.50%, or a painful total loss for the 4 years of 65.74%. This was subsequently followed by the highest 4-year annualized return (1932-1936), where we saw a 32.48% annualized return, which amounts to a total return of 208.06%. This would have gotten an investor back to the original investment amount from March 1, 1928 (8 years earlier). The third lowest Leap Year annualized return ended on February 29, 2012, which included the global financial crisis of 2008-2009, but still ended up with a 12.6% total return for the period. Let’s digress on this just a little bit. If we were to focus on the day-to-day news stories and volatility during that time, which included the fall of Bear Stearns and Lehman Brothers as well as the bailout of the biggest financial institutions in the world, like AIG, and the economy had lost 800,000 jobs per month, we would have expected a much different story. It was a warzone. But once we expand our view, even during a very distressing time like 2008, it was just a blip. Out of the 22 independent Leap Year periods, there were only 2 (9%) that had negative returns (both in the 1928 to 1940 period) and no negative Leap Year period returns since 1940. Leap Year Returns of IFA Index Portfolio 100 88 Years (1/1/1928 to 12/31/2015) 22 Leap Years 4-Year Leap Year Periods Annualized Return Total Return March 1, 2012 – February 29, 2016 6.18% 27.09% March 1, 2008 – February 29, 2012 3.02% 12.64% March 1, 2004 – February 29, 2008 10.54% 49.33% March 1, 2000 – February 29, 2004 9.82% 45.43% March 1, 1996 – February 29, 2000 12.12% 58.04% March 1, 1992 – February 29, 1996 13.92% 68.44% March 1, 1988 – February 29, 1992 13.82% 67.81% March 1, 1984 – February 29, 1988 22.54% 125.46% March 1, 1980 – February 29, 1984 18.49% 97.09% March 1, 1976 – February 29, 1980 21.46% 117.63% March 1, 1972 – February 29, 1976 3.23% 13.56% March 1, 1968 – February 29, 1972 9.55% 44.05% March 1, 1964 – February 29, 1968 18.29% 95.77% March 1, 1960 – February 29, 1964 9.09% 41.65% March 1, 1956 – February 29, 1960 10.39% 48.49% March 1, 1952 – February 29, 1956 19.22% 101.99% March 1, 1948 – February 29, 1952 18.44% 96.78% March 1, 1944 – February 29, 1948 13.81% 67.77% March 1, 1940 – February 29, 1944 13.32% 64.88% March 1, 1936 – February 29, 1940 -3.14% -11.98% March 1, 1932 – February 29, 1936 32.48% 208.06% March 1, 1928 – February 29, 1932 -23.5% -65.74% Source: ifacalc.com , ifabt.com , Index Fund Advisors, Inc. We could also take a look at the monthly rolling 4-year returns from 1928 to 2015. This would include 1,009 4-year monthly rolling periods. The median annualized return across all 1,009 4-year periods was 13.42%. The lowest 4-year period was 06/1928 to 05/1932, where we saw an annualized return of -36.73%. Similarly to our observation before, the highest 4-year return came soon thereafter (03/1933 – 02/1937) where we saw a 56.22% annualized return. Click to enlarge Click to see the full interactive chart on IFA.com . The Leap Year Review approach to investing is our way of resetting our investors’ internal investment clocks. Investing is not about thinking in seconds, minutes, hours, days, weeks, months, or even 4 years. There is too much randomness to extract anything of benefit from these types of time periods. Having a broader focus allows investors to tune out the irrelevant. This will help to protect investors from becoming victims of their own emotions. We have shown using historical data the benefits of time diversification . Of course this doesn’t mean that the future will be so bright, but remember, from 1928 to 2016 there have been multiple wars, conflicts, economic booms and busts, stagflation, and differing economic policies (think FDR versus Ronald Reagan). Through all of this, markets have rewarded the patient investor. Believing that somehow this is going to change in the future is pure speculation. Happy Leap Year! Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Interview: Chris Abraham On Mixing Value Investing And Options

By Rupert Hargreaves Rupert Hargreaves: You run a unique, value-based options strategy, which is designed to take advantage of price inefficiencies in the market. Could you give our readers a brief description of the strategy and why you decided to use it? Chris Abraham: It is basically a concentrated, long-term, all-cap value-oriented strategy primarily focused on the equities and options of high-quality companies. Ideally, I look for companies with a competitive advantage that trade at a margin of safety. I typically have around 10 to 20 equity holdings in my portfolio, preferably closer to 10. Regarding option positions, the way I look at the strategy is kind of like running an insurance book along with existing equity holdings – similar to Buffett’s concept at Berkshire (NYSE: BRK.A ) (NYSE: BRK.B ). Buffett has been able to create permanent capital for investing by using Berkshire’s insurance subsidiaries’ float. And that’s the kind of business model that I’ve tried to create, except with options. RH: So you write options to generate income and grow the float? CA: Exactly. The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there’s very little attention focused on longer-term options of individual companies. A lot of institutional investors just can’t invest in this sector, because their investment mandates won’t allow it and hedge funds are only interested in the short-term use of options to hedge positions. The great thing is you can find some options with significant mispricing across the entire market. A couple of weeks ago, I found options on a company with a $100 million market cap! So, there are definitely opportunities out there to take advantage of with these derivatives, but structural reasons prevent many investors from making the most of the opportunities available to them. There’s also a general lack of interest in this area. If you find a security that is undervalued and has a margin of safety, generally speaking there will be an even bigger mispricing in the options. To profit from this, you can sell put spreads or buy call spreads – the former eliminates the tail risk. If you feel comfortable just selling naked puts that will help you generate even more float, but you have to be comfortable buying the stock at the set price if it comes to it RH: One of the key caveats of value investing is minimising risk. Options trading is known for its high level of risk… CA: I think options trading is perceived as higher risk but it all comes down to the underlying stock. I think the real risk stems from a lack of knowledge about option pricing and stock valuation. As we know, a stock price will fluctuate much more than the underlying business. This stock volatility leads to some extreme volatility in options pricing, which translates into more opportunities for the options investor. If you are buying into a higher quality business, this is a great way for greater returns and a higher margin of safety. The high quality nature of the business helps mitigate risk. Call spreads and put spreads also help mitigate risk as well. RH: Do you buy the underlying equity as well or do you just concentrate on the options? CA: I have an equity portfolio, but each situation really depends on several factors. This is more of an art than a science. Sometimes it depends on the liquidity of the options or the stock, and other times it depends how expensive the options are. For instance, if I have say 14 equity positions in my portfolio already, I might just buy the option to add to my options book rather than the stock. It really depends. Another example I can give is if I’ve owned a stock for a while, and the options suddenly become really expensive, then there’s a situation where I might be inclined to add on the options side. RH: What’s your investment time frame? CA: Generally, I invest on a one to two-year time frame with regard to options since those are the longest term options widely available on the market. The reason why I’ve chosen this time frame is because those are the options that are generally the most mispriced. If I could get options longer than that I would, sometimes I can get options for two-and-a-half years. Options are priced more or less on a bell curve with some skew around the current stock price. They are not valuation based, which leads to tremendous opportunities. For instance, volatility, which is one of the primary factors in options pricing, is extrapolated for the term of the option. This leads to increased mispricing for options as the option term increases. For example, back in January and February, the market was extremely volatile and options were pricing this elevated volatility to last continuously for the next couple of years, which gave me the opportunity to sell options on strong, competitively advantaged companies at exceptionally high prices. RH: Could you guide us through your investment process? CA: Sure, let’s say a stock is trading at $100 and under my valuation, I believe it’s worth $130 to $150. If I can sell puts at $85 and collect $8 in premium, a premium that expires in one year, to me that would be very attractive. In this scenario, my net buy price, if I were forced to buy, would be $77, otherwise, the options will expire and I get to keep the float. In this specific case, assuming I’m buying this competitively advantaged company at a 40-60% discount, I would be okay selling the puts outright and not put spreads because I would be happy to own the stock at $77. By looking at it this way, time becomes your friend because every day that goes by, the options are worth less, even if the stock doesn’t move. RH: Do you keep a lot of cash on hand to implement this strategy? CA: Yes, I typically keep around 15% to 20% cash, in case of negative surprises, but it generally depends on the underlying environment. If the implied volatility has come down quite a bit and there’s nothing attractive out there, I tend to stay away. I need to make it clear that valuation of the underlying business is not enough for me to be buying or selling options. The risk/reward is clearly more favourable when implied volatility is higher. RH: You’re not selling right now? CA: No, I’m not selling right now because the payoffs available are not significant enough. I forget the statistics but the VIX has collapsed by something like 50% to 60% over the past month and we are at levels we were at pre-August last year. I’ve actually been buying a little bit of tail risk insurance one year out as it’s fairly cheap here. So you need to work with what the market is giving you. Click to enlarge RH: Could you give us an example of something you are looking at or have looked at in the past? CA: Sure, one of the most attractive options plays in the recent past has been Apple (NASDAQ: AAPL ) in my opinion. This is a company that I’ve gotten to know well over the years and when the stock got down into the $90s, it was trading at a mid-teens free cash flow yield. The market was pricing in a massive decline in iPhone sales and profitability, which I felt was a fairly low probability event in the immediate future. Every couple of years, it seems Mr. Market reflects this paranoia in the stock. At that level, you could sell puts at a strike price of $90 and collect $15 to $16 in premium, for options expiring in two years. And if you wanted to be more conservative, you could’ve bought some further out of the money puts, take a really nice spread on that, collect the premium and have a really nice float for a year. That was probably one of the best risk/reward and liquid opportunities I’ve seen in a while. RH: When you’re looking at plays like this, do you tend to stick to defensive sectors or branch out into the more cyclical sectors, which may offer a greater return but a higher level of risk? CA: I tend to stick with defensives because with cyclicals, the volatility can be quite aggressive and you can really get hurt there. But I would be inclined to buy cyclicals if they were cheap enough and they had a competitive advantage over peers. Although if I did go down that route, I would buy long-term LEAPs to cap my downside, while leaving me exposed to a long-term cyclical recovery. My priority is limiting my losses, so I tend to get to know a few competitively advantaged businesses very well, and then when the market throws up the opportunity, look at the stocks and the options and pick the securities that give you the best risk reward. There isn’t really much to add to the process in terms of investing, the options just give you another avenue with which to profit from the underlying investment, another tool in the kit so to speak. I think by selectively writing options, at times when the market is offering the best risk reward ratio, over the long term, the strategy should generate significant returns. RH: I think one of the factors that would scare most investors away from using this strategy, are the potential drawdowns that are generally associated with using options, rather than the traditional buy-and-forget style of value investors. CA: Well, first and foremost I’m a value investor. If I find a competitively advantaged business that I like, I’m more than happy to hold forever. When it comes to the drawdowns, that is a problem, but it’s a problem that can be mitigated through strategies like using put and call spreads as well as buying tail risk insurance. Sure, the performance may be a little bumpier than most investors are used to, but I think that if you’re disciplined with your underwriting, it will work out very well over time. I think psychology is important here. Mark-to-market returns, like we saw in January and February of this year can be very violent. Although, at the same time plenty of new opportunities arise, so any new insurance you’re writing will be very profitable. There is also position sizing to consider, you need to make sure your options portfolio won’t drag you down. If you’re doing cyclical recovery stories, turnarounds, reversion to the mean plays, I don’t think this strategy will work as well. You just don’t have the margin of safety that you need in my opinion. Whereas if you’re talking about companies like Apple or Berkshire Hathaway, that have strong balance sheets and competitive advantages, then you have something that you can base your value and a platform from which to base your option strategy on – you can clearly identify the price and value of the company along with the current call or put premiums to quantify potential returns. Most of the businesses I own right now have net cash balance sheets and double-digit free cash flow yields. Actually, believe it or not, when you write options on these sort of companies, there isn’t much of a market. And that’s where the opportunity is because not many people play in this sandbox. RH: Options aren’t something we cover much here at ValueWalk, and there’s a good chance that some readers will never have used options before. So, could you just give those readers a brief rundown of options investing and how they should approach the market? CA: That’s a good question, I think one of the things that puts people off this market and trips them up is approaching the options market as a purely speculative market, without considering the underlying stock they are buying. One thing I will never understand is how so many traders use options but have no idea about the underlying valuation of the security. That’s the equivalent of buying or selling insurance without knowing what your collateral is! I think if investors want to get into this, they need to understand properly how options work, either by taking a class or reading up on the subject – Buffett himself has been a major user of options and derivatives but this doesn’t get as much attention. There’s so much misinformation out there and people really need to understand how the market works and how to apply that to their own trading strategy, as well as understanding what the actual upside and downside is. A lot of people I’ve spoken to about it will say, “I’ve tried options and I’ve lost all my money” but what they don’t realise is, if you put $1,000 down, you can lose the entire $1,000. It’s even more important when you’re selling naked puts or calls, because you have unlimited downside. To the uninitiated, one of the best and free ways to learn in my opinion is to look at how Buffett has written about the options market in his previous annual letters and then try and understand how Black-Scholes options pricing works, and how it doesn’t work. I started as a value investor, and then through learning about options pricing adapted my strategy to suit me and my investment background. I’m afraid to say there’s no perfect answer to this, you just need to learn as much about the subject as possible and develop your own strategy. RH: So your advice would be to find the stock, calculate the value, buy as a value investment and then look at the options? CA: Exactly. Since your “collateral” is the underlying business, you need to gain a firm foundation in fundamental research to understand what it is worth. Once you have established a valuation range and a margin of safety, you have more flexibility in understanding which options to use. To me, it’s easier if you understand the valuation first and then the derivatives. It’s a much simpler and straightforward approach. RH: Chris, that’s great. Thank you for your time today. CA: You’re welcome. Thank you for the interview. Disclosure: Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This document contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. The views expressed here are the current opinions of the author and not necessarily those of ValueWalk. The author’s opinions are subject to change without notice. There is no guarantee that the views and opinions expressed in this document will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. No representations, expressed or implied, are made as to the accuracy or completeness of such statements, estimates or projections, or with respect to any other materials herein. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable. No part of this material may be copied, photocopied, or duplicated in any form, by any means, or redistributed without ValueWalk’s prior written consent.

How To Avoid The Worst Style ETFs: Q1’16

Question: Why are there so many ETFs? Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell. The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs: Inadequate Liquidity This issue is the easiest issue to avoid, and our advice is simple. Avoid all ETFs with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads. High Fees ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive. To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.48%, which is the average total annual cost of the 298 U.S. equity Style ETFs we cover. The weighted average is slightly lower at 0.17%, which highlights how investors tend to put their money in ETFs with low fees . Figure 1 shows that the AdvisorShares Madrona Domestic ETF (NYSEARCA: FWDD ) is the most expensive style ETF and the Schwab U.S. Large Cap (NYSEARCA: SCHX ) is the least expensive. Absolute Shares Trust ( WBIB , WBID , WBIC , and WBIG ) provides four of the most expensive ETFs while Schwab ( SCHX and SCHB ) and Vanguard ( VOO and VTI ) ETFs are among the cheapest. Figure 1: 5 Least and Most Expensive Style ETFs Click to enlarge Sources: New Constructs, LLC and company filings Investors need not pay high fees for quality holdings. The State Street SPDR S&P 500 Buyback ETF (NYSEARCA: SPYB ) earns our Very Attractive rating and has low total annual costs of only 0.39%. On the other hand, a fund such as the iShares Core U.S. Growth ETF (NYSEARCA: IUSV ) holds poor stocks. No matter how cheap an ETF (0.08% TAC), if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price. Poor Holdings Avoiding poor holdings is by far the hardest part of avoid bad ETFs, but it is also the most important because an ETFs performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst holdings or portfolio management ratings . Figure 2: Style ETFs with the Worst Holdings Click to enlarge Sources: New Constructs, LLC and company filings PowerShares ( EQAL , PXMV , and EQWS ) appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. The ProShares Ultra Telecommunications ETF (NYSEARCA: LTL ) is the worst rated ETF in Figure 2. The PowerShares Russell MidCap Pure Value ETF (NYSEARCA: PXMV ), the PowerShares Russell 2000 Equal Weight ETF ( EQWS ), the Vanguard Russell 2000 Growth Index Fund (NASDAQ: VTWG ), the Global X Super Dividend U.S. ETF (NYSEARCA: DIV ), and the Guggenheim S&P Small Cap 600 Pure Value ETF (NYSEARCA: RZV ) also earn a Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs. Our overall ratings on ETFs are based primarily on our stock ratings of their holdings. The Danger Within Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.