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New Valuation Approach – PTR: PTR-Based Fund Delivers Over 63% Annual Returns In Big Data Simulations

A new approach to stock valuation looks at the relationship of the stock price to the value of the patent technology owned by the firm. Simulations indicate that stocks with low price-to-technology ratios outperform the market. Investors may wish to include PTR valuations as part of a stock-screening exercise. A former student approached me with a new model for stock valuation that appears to have great promise. Wisdomain.com has a database with comprehensive information on patents which has been used by intellectual property professionals to manage technology. Recently, the company figured out a Price/Technology ratio that appears to be a powerful tool for screening technology investments. PTR challenges the conventional principles of long-term value investing. It takes a completely objective approach to valuation through the mining of intellectual property big data and combining it with financial big data. It is an investment indicator that provides insights into the future performance of investments by identifying undervalued companies that possess patented technologies. Because patent valuation is technology valuation, PTR uses a proprietary algorithm based on technology valuation and total market capitalization data to identify undervalued technology companies. PTR = Market Capitalization Σ (Total Value of Patents) Σ (Total Value of Patents) = Total Technology Asset Value Technology assets play a key role in facilitating the competitiveness of a company in most industries. Since the sum of the value of all of the patents owned by a company is a good proxy for the value of the technology assets owned, it can be considered to be tied to the future potential profitability of the company. Although the formula is similar to the P/E ratio in that the companies with relatively lower PTR values are considered to be the undervalued companies, it is also completely different. Historical simulations of a PTR index formed by PTR funds comprised of the top 20 lowest PTR stocks exceed the NASDAQ’s average returns by 46.4% in the 1st year and 71.9% in the 2nd year. Similarly, the simulations show that the low PTR funds outperform the S&P 500 by 5.8% in the 1st month and 78.8% by the 2nd year. The PTR Index outperforms the market 100% of the time during the simulation period, and funds held over longer periods result in higher returns relative to the market. (click to enlarge) Simulation period = 2010-2015; PTR, NASDAQ, and S&P 500 values have been normalized to 1,000; Funds purchased on a daily basis over the course of the simulation period to minimize the effect of daily variations in stock prices and obtain the average performance values of the funds over the investment periods within the simulation period. The PTR investment model shown above is based on long-term investments into funds comprised of 20 low PTR companies. There were individual cases among the 20 lowest PTR stocks where the stock demonstrated negative returns; however, funds created by combining the 20 lowest PTR stocks have been shown to deliver positive returns. Although investments into individual stocks with the lowest PTR values do not guarantee positive returns, the PTR as a stand-alone indicator has proven to be quite successful. The top 15 companies with the lowest PTR values that are currently traded on the NASDAQ and NYSE are as follows. DMRC , ESIO , CKP , RIGL , IMMU , SNMX , UIS , ROVI , SGI , ARRY , OCLR , AMD , IMI , XNPT and HTCH . (click to enlarge) Although the simulations above demonstrate that the PTR is a breakthrough investment indicator for technology-driven companies, analysts are still in the early stages of developing the methodologies to maximize profitability through the application of the PTR. Some interesting findings to date have shown that the PTR stocks in the smaller market capitalization categories demonstrate better performance relative to PTR stocks in the larger market capitalization categories. With this level of performance, it will be interesting to see what else the PTR has in store for us.

Are You Ready For CEFL’s Year-End Rebalancing?

Summary The index for CEFL/YYY was last rebalanced in December 2014, and changes to the index were made public a few days before the event. Last year, heavy buying or selling pressure in particular index components forced CEFL/YYY to buy-high and sell-low, causing significant losses to CEFL/YYY unitholders. How will CEFL’s rebalancing be handled this year? Introduction The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is a 2x leveraged ETN that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA: YYY ) is an unleveraged version of CEFL. CEFL is popular among retail investors for its high income, which is paid out monthly. (Source: Pro Spring Team ) YLDA holds 30 closed-end funds [CEFs], and is rebalanced at the end of every calendar year. The changes were publicly announced on the ISE website on Dec. 24, 2014, or about five days prior to the rebalancing event. According to YYY’s prospectus (emphasis mine): Index constituents are reviewed for eligibility and the Index is reconstituted and rebalanced on an annual basis. The review is conducted in December of each year and constituent changes are made after the close of the last trading day in December and effective at the opening of the next trading day . As CEFL is an ETN, it is not forced to buy or sell the constituent ETFs, but one would imagine that the note issuer, UBS (NYSE: UBS ), would be inclined to do so to hedge its exposure of the note. Rebalancing shenanigans Unfortunately, CEFL/YYY unitholders were hurt by the rebalancing mechanism last year. I first noticed that something was wrong when CEFL fell -2.96% (and YYY -1.25%) on Jan. 2nd, 2015, a day where both stocks and bonds held relatively steady, and where the comparable PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ), an ETF-of-CEFs that tracks a different index, rose +0.21%. A bit of detective work on my part revealed that the CEFs that were to be added to the index received heavy buying pressure in the days between the index change announcement and rebalancing day, while the CEFs that were to be removed came under tremendous selling pressure. This caused the prices of the added CEFs to rise significantly during that period, which was topped off by an upwards price spike on rebalancing day, while the prices of the CEFs to be removed declined markedly in price, culminating in a downwards spike on rebalancing day. As a consequence, the index and hence YYY were forced to “buy high and sell low” on rebalancing day, causing about 1.3% of the net asset value [NAV] of YYY to be vaporized in an instant. This findings were presented in my Jan. 4th article ” Frontrunning Yield Shares High Income ETF YYY And ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN CEFL: Could You Have Profited ?” However, the pain was not over for CEFL/YYY holders. The upwards price spike of the CEFs to be added on rebalancing day occurred on top of the artificially-inflated prices caused by the buying pressure days before the actual event. After rebalancing, the added CEFs possessed premium/discount values dangerously above their historical averages, as I warned in ” Beware Reversion In YieldShares High Income ETF And ETRACS 2x Closed-End Fund ETN ,” leading to further losses as the premium/discount of those CEFs reverted back to their original levels. How much were CEFL/YYY investors hurt? How much were CEFL/YYY holders hurt by last year’s rebalancing mechanism? It is impossible to provide an exact number, but here is my estimate. The 10 added CEFs with the largest increases in allocation rose by 2.96% in one week, while the 10 with the largest decreases in allocation declined by -3.38% in one week (as presented in my Jan. 4th article). Assuming that CEFL is equally-weighted*, these events would have caused an overall 2.11% decline in asset value. Up to a further 1.25% was lost on rebalancing day due to price spikes. Moreover, the 10 CEFs that were added to the index declined by 1.26% two weeks after rebalancing as mean reversion possibly took place (as discussed in ” 2 Weeks Later: Did Mean Reversion Of CEFs Take Place? “), contributing a further 0.42% decline of the index, again assuming equal-weight. This sums to a 3.8% loss for YYY holders, or about a 7.6% loss for CEFL holders, not an insignificant amount. Note that this number is likely to be an underestimate because only the top 10 CEFs undergoing the highest increases and decreases in allocation were considered. In actuality, 19 funds were added, and 17 were removed. *(CEFL is actually not equal-weighted, but it is not entirely top-heavy either. See my Jan. 4th article linked above for details to the index weighting methodology). An alternative methodology for calculating the underperformance of CEFL/YYY is to simply compare the performance of YYY to PCEF, as both are ETFs-of-CEFs, but track different indexes. As analyzed in ” Has CEFL Done As Badly As It Looks? ” YYY underperformed PCEF by a total of 5.3% in the months of December and January, i.e. the months surrounding the rebalancing date. Although this approach is only approximate (as the exact composition of the two funds differ), it does produce a number that is on a similar order of magntitude as the 3.8% loss calculated with the first approach. Either way you cut it, a 4% or higher loss for the index/YYY (double that for CEFL, due to leverage) because of factors outside of “normal” market behavior hurts. Moreover, the fact that the index was forced to buy high and sell low necessarily results in a lower income for the fund going forward, as the fund would not have been able to purchase as many shares of the new CEFs than it “should” have been entitled to. Indeed, each share of CEFL paid out a total of only $4.03 in 2015, down from $4.40 in 2014, representing a 8.5% decrease in income paid for the year. I lost…so who won? So if CEFL/YYY unitholders were hurt during rebalancing, who profited? Most likely, it was the savvy investors who purchased the CEFs to be added to the index and shorted the CEFs to be removed as soon as the index changes became public. This could, in fact, include UBS themselves, who are free to adjust their hedges for CEFL anytime they like (because CEFL is an ETN rather than an ETF), and not only on rebalancing day. This creates an ironic situation in which the act of UBS adjusting their hedges at more favorable prices before rebalancing could have actually and directly hurt investors in their very fund. Why is this a problem for CEFL and not other funds? The main problem appears to be the lack of liquidity for CEFs, as well as the fact that arbitraging price differences for CEFs can be risky as they often trade at premium or discount values around their intrinsic NAV, meaning that it would be difficult for arbitrageurs to determine the “true” value of a CEF. An insightful comment from a reader in my previous article reveal that this has happened to other funds as well, and also illustrates a possible solution to this problem: [We] also had a FTSE 100 tracking fund run externally by a well known global indexing house. I recall at one index rebalance, said fund had a MOC order to buy one of the new index constituents, and ended up paying about 25% MORE than the prevailing market price was 1 minute before. All index tracking funds got completely shafted as guess what, the next day the stock was back down to the price it was before its index inclusion. … Some index managers get friendly brokers to ‘warehouse’ stocks (take them onto their own book) for a few days, buying them up ahead of inclusion in a particular index, the fund then takes an average price, and doesn’t get the shaft with a MOC order. It can lead to a bit of ‘tracking error’ mind you. This time it’s…different? As a CEFL unitholder and with the end of the year rolling around, I thought I would refresh myself on the rebalancing mechanism of the index YLDA to confirm exactly when the CEF changes would be announced, so that I could…uh…you know…get in on the frontrunning action and profit at the expense of fellow CEFL/YYY holders. Just kidding, I would have definitely shared this information with all my loyal readers! (Please do click the “follow” button next to my name if you haven’t done so already if you enjoy my ETF analysis.) So I fired up the YLDA methodology guide and looked for the rebalancing date… and looked, and looked…only it wasn’t there! I then checked the date of issue of the methodology guide: December 4th, 2015. So this couldn’t have been the guide I was reading when I was writing my earlier CEFL articles this year. Luckily, I had a version of the guide stashed in my downloads folder, and the relevant section (4.3) is dutifully reproduced below (emphasis mine): 4.3. Scheduled component changes and review ( OLD v1.2 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. Component changes are made after the close on the last trading day in December , and become effective at the opening on the next trading day. Changes are announced on ISE’s publicly available website at least five trading days prior to the effective date . How does this compare with the current version of the methodology (emphasis mine)? 4.3. Scheduled component changes and review ( NEW v1.3 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. The index employs a “rolling” rebalance schedule in that one third of component changes are implemented at the close of trading on each of the first, second and third trading days in January of the following year and each change becomes effective at the opening on the second, third and fourth trading day of the new year, respectively. No prizes for spotting the difference! Not only has the statement about the announcement of changes been removed, the rebalancing is now not performed all at once at the close of the last trading day in December, but is now equally spread through the first, second and third trading days of the following year. I then used the free PDF comparison tool ( DiffPDF ) to scan for any additional changes to the methodology between last and this year’s. Besides being nearly foiled by the addition of two blank pages in this year’s edition, the software showed that, besides the aforementioned change in Section 4.3, a similar statement to the above had been removed from the index description in Chapter 2: Chapter 2. Index Description ( bold sentence in OLD guide only ) Companies are added or removed by the ISE based on the methodology described herein. Whenever possible, ISE will publicly announce changes to the index on its website at least five trading days in advance of the actual change . No changes were made to the constitution or weighting mechanisms of the fund. Appendix B of the current document lists the entirety of the changes as “Rebalance revision (4.3).” What does this mean for investors? Analysis of the old and new methodology guide reveals two major changes: The changes to the index will not be public beforehand. Instead of rebalancing the components all at once, the rebalancing will be conducted in three equal parts spread across three days. What does this mean for investors? I believe that the first change is well-intended, but may ultimately prove fruitless. The methodology for index inclusion and weighting is relatively complex, but is publicly available (it’s found in the methodology document), and I have no doubt that professional investors will be able to determine the changes even before they happen. In fact they may be doing this right now as I am writing this, and also later, when you are reading this. The second change is, I believe, a positive one, but only if it means one of two possible ways that one could construe “one-third.” The guide states that ” one-third of component changes are implemented… on each of the first, second and third trading days in January .” So if 10 CEFs have to be added to the index, does it mean that 33.3% of the total dollar value of the 10 CEFs will be purchased on each of the three days? In this case, the liquidity situation will be improved because each CEF will be purchased over three days. This would decrease the likelihood of a price spike occurring upon rebalancing (presumably by YYY, the ETF), which ameliorates the buy-high sell-low situation faced by the index last year. If instead, it means that 4 CEFs will be 100% purchased on the first day, 3 on the second, and 3 on the third, then unfortunately I don’t think that the liquidity situation will improve, as the trading in each CEF is still going to be concentrated in a single day, despite the fact that different CEFs may be spread out on different days. What do readers think about how this sentence should be interpreted? So, it appears that this time may actually be different. However, personally, I’m not waiting around to find out. I’ve recently sold all but a single share of CEFL to keep my interest in the fund, and replaced it with several better-performing CEFs (such as the PIMCO Dynamic Income Fund (NYSE: PDI )), as recommended in Left Banker’s article here .

Value Investing In Cyclical Stocks

Cyclical stocks tend to be reliable profit generators in a value investor’s portfolio. Cycles exaggerate the valuations because they cause uncertainty in the market. So arguably, value investing should work very well. In practice, it can be hard to identify the right investment candidates and pick the right time to invest. We all know that value investing involves buying stocks at prices depressed below the intrinsic value. Cheaper the stock, better the purchase, as theoretically, the potential returns (normalizing the price to value) are higher and the inherent risk of capital loss is lower (the stock is already at distressed levels, where investors have given up). Most cycles in essential commodities are predictable. Phase 1 – Growth and Investment: The business in an industry goes through a period of growth, managers become more confident and hire more employees, invest in assets and new projects and build new plants and increase capacity. There are new entrants in the industry as it grows with above-average profits. The analysts build Discounted Cash Flow and other models that assume good earnings growth for the near future and a possible terminal growth rate thereafter (which is almost always a positive number). This results in higher multiples being assigned to the stocks in the industry than the historical average. Wall Street firms do a lot of business with these growing companies flush with profits, and are therefore inclined to look upon them in a kind light. Investors pile in. Phase 2 – Peaking: All the capacity expansion via new capital investments and new entrants in the industry finally reaches a point where it starts to exceed market demand. The profit margins get squeezed as the marginal unit of production starts to sell at cost or below cost. The high-cost and smaller economies producers start to exit the market. A few players may merge to improve their economies of scale or add in new line of businesses to support the company until the cycle in this line of business recovers. Wall Street starts getting disappointed many quarters running, as the earnings come in lower than expected. Phase 3 – Decline and Disinvestment: Supply now starts to exceed the demand. Product price falls. Weaker and high-cost producers are unable to stay in business, and make an exit. Larger and lower-cost producers may choose to exacerbate the situation by making counterintuitive moves, such as increasing production, to drive the prices further down and hasten the exit of weaker competitors – as long as they are able to at least break even. Predatory pricing is generally illegal in most developed economies, but increasing production is not, and can easily be blamed to an error in judgment. Analysts don’t understand what is going on, and if they do understand the competitive games being played, they do not talk about it. Investors start to lose interest and move on to greener pastures. Businesses disappear, jobs are lost, capital projects are cancelled or postponed, assets are scrapped, and eventually, the supply starts to decrease. Phase 4 – Trough: Supply has finally dipped below the demand. The surviving businesses have started to gain their pricing power back and have begun to enjoy improved profit margins. They have also emerged from the cycle with a bigger market share as a large number of competitors closed shop. At this point, Wall Street has likely lost all interest in these companies, and analysts have dropped coverage of their stock. In Phases 3 and 4, the stock is likely to be undervalued. The cheapest and safest time to invest is in Phase 4. However, timing the bottom of a cycle is difficult and almost impossible. The best a value investor can do then is decide to invest some time after the decline has started and has gone to some depths, and then choose the stocks of the companies that are more likely than others to survive and come out with an increased market share. Which Kind of Industries Does Cyclical Investing Work In? In industries with low-to-zero cost of entry, such as software or internet, cycles do not exist, or if they do, they are short-lived. Some barriers to entry for new competitors can be established by increasing the switching costs for existing customers – it is difficult for the whole enterprises to switch over to Macintosh when all their business systems are written for Windows. However, these switching costs are not insurmountable. The story is very different in industries where a significant capital investment is required to enter an industry or a market. For example, airlines, mining, shipping, automotive production, most manufacturing, real estate development, etc. In these industries, capital projects may also have multi-year lead times before they start contributing to the business. Therefore, a project started today (such as a new ship ordered to be built when the market was doing very well) could take years to complete. When it is complete, though, the company may be adding new capacity in an environment of glut. Therefore, the cycle of boom and bust may be quite drawn-out in these industries. To invest profitably in these cycles, 3 things are required: Pick an industry that is not going to disappear anytime soon or be substituted out with something completely new. Pick companies that are strong enough to outlast the down cycle, or at least, are stronger than most of their competitors. Wait. Understand that these industries are going to go through structural changes and countless investor confidence ups and downs before the winners and losers are determined. Track if your pick continues to be a strong contender as a winner, but otherwise, mostly wait. Finding Values in Phase 3 and Phase 4 Stocks Finding good value stocks in Phase 3 and Phase 4 of the cycle can actually be very hard. As value investors, we are trained to look for the following: Low P/E ratio stocks – These are the companies whose earnings have been decimated. If anything, a great value stock here might actually sport a sky-high P/E ratio. The trailing 12-month or 5-year values are no longer typical, and the future earnings estimates are worthless. Low P/B ratio stocks – Since we are looking at asset heavy industries, it is worth pointing out that the valuation of the assets on the books typically get written down when the industry is in stress like this. Profitability ratios like ROI, ROA, etc. are all atypical and therefore useless. Therefore, cyclical investing for a value investor is much more of an art than science. Things like the strength of the balance sheet , economies of scale, management experience and skill, customer relationships, their ability to raise funds, cash and debt levels in the business, etc. become much more important. We still need to consider the valuation, and the valuation comes from asking the question: What is this business worth to a sophisticated buyer (competitor, private equity, etc.)? Sophisticated buyers are the ones who are buying for long-term strategic advantage. Now consider the plight of a retail investor who has no time to analyze these companies, and more than likely there is no longer any Wall Street coverage on these stocks (or if there is, it is much reduced from its heyday). These stocks will be volatile, and if you think you are getting a great value, it should not be a surprise that the stock is an even greater value a few weeks or months down the line. For most cyclical investments like this, I generally ease into my full allocation by starting small and then adding more and more over time when the cost can be improved. Sometimes, the extent of the future declines may surprise, but the declines themselves are to be expected. It takes time to hit Phase 4 and then turn around.