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So You Want To Be A Stock Picker

After a rough start to the new year, a lot of investors might be tempted to buy into “fallen angel” companies at or near all-time lows. They’re not hard to find. In the tech sector, GoPro (NASDAQ: GPRO ) and Fitbit (NYSE: FIT ), two profitable and recently public companies, have taken major hits. GoPro is down 90 percent from its all-time high. Fitbit has lost two-thirds of its peak value. Another sector where investors might be looking to buy low is energy, where scores of service and exploration companies are down 90 percent or more. Established names like Denbury Resources (NYSE: DNR ), Forbes Energy (NASDAQ: FES ), Gastar Exploration (NYSEMKT: GST ), Basic Energy (NYSE: BAS ), Bill Barrett (NYSE: BBG ), and Ultra Petroleum (NYSE: UPL ), among others, have all been creamed, and could seem like bargains. All I can say is: buyer beware. As far as GoPro, Fitbit, and other beleaguered tech stocks are concerned, anyone thinking about buying them should ask a basic, but extremely important question: will these companies exist in five years? There is a chance the answer to that question is no. And even if they do survive, how likely is it that they will enjoy a meaningful stock price recovery? The best-case scenario for GoPro and Fitbit could very well be that their stocks trade sideways for the foreseeable future before a larger business acquires them at a modest premium. The worst case? They disappear entirely, wiping out their shareholders. Energy is an even riskier proposition. All of the companies I named, and many more in the space, are choking on onerous debt loads. The bond markets know this. The high yields on each company’s bonds are strong indicators that many of them will chapter out before the price of oil has a chance to recover. If you think I’m being overly pessimistic, I recommend an eye-opening 2014 report (PDF) by J.P. Morgan Asset Management analyst Michael Cembalest titled, “The Agony and the Ecstasy.” Cembalest’s analysis shows that a shocking number of stocks not only go down, they stay down: Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70 percent plus decline from their peak value. [emphasis added]. Consider that statement for a moment. Over time, four in ten stocks lose almost three quarters of their peak value – and never recover . And that’s not the only grim finding. The median (note: not mean) stock massively underperforms the index: The return on the median stock since its inception vs. an investment in the Russell 3000 index was -54%. This report should be mandatory reading for both institutional and retail investors. Yet it was hardly mentioned in the financial press after its release. It should also be mandatory reading for short-sellers, because the lessons it imparts are just as valuable on the short-side as the long. During 25 years managing a long/short fund, I have watched scores of companies file bankruptcy and go to zero. Yet most short-selling funds – maybe all – have terrible track records. Famous New York short seller Jim Chanos’ Kynikos fund is reportedly down over 80 percent since inception. The largest public short-biased fund, Federated’s Prudent Bear Fund (ticker BEARX), is down 75 percent over the last 18 years. Why? Because most short-sellers try to uncover frauds and accounting scandals like Enron and WorldCom – and that is a terrible way to make money. Finding and profiting from crooked businesses is incredibly hard. For every accounting fraud, many, many more companies simply fail. Restaurant chains Boston Chicken, Chi-Chis, Planet Hollywood and Koo Koo Roo all filed bankruptcy since I started my fund; as did retailers Circuit City, Bombay, Blockbuster, Sharper Image and Kmart. Failure among public technology companies has been widespread, as well. According to Cembalest’s report, energy, information technology, and telecom stocks have the highest failure rates. Since 1980, roughly half of Russell 3000 stocks in these three sectors dropped 70 percent or more from their peak and never recovered. Looking back, it’s easy to see why most of these stocks lost value. Too bad hindsight isn’t a great investment strategy. Great investors like Warren Buffett take a clear-eyed measure of where a business is likely to wind up several years in the future. What makes this so hard, as Cembalest writes, is the excessive optimism that permeates Wall Street and corporate America: While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long-term success. I’ve witnessed this optimism bias at countless troubled companies over the years. And, as I’ve written before, one of my hobbies is collecting outrageously positive reports from Wall Street analysts. My favorite is a strong buy recommendation from a prestigious brokerage for Planet Hollywood dated one year before it filed for bankruptcy. Much like GoPro today, Planet was supposedly “building a brand.” Investors picking through the wreckage of the markets today would be wise to consider that failed logic, as well as the lessons of Cembalest’s report.

A Dynamic Equity Strategy For A Volatile Year Ahead

Introduction Global stock markets have had their worst start to a new year in decades. Many developed markets are down over -20% from their respective highs. The S&P 500 is down approximately -12% from its May 2015 peak and -8% in January alone. Approximately one-half of the S&P 500 Index’s components are down -20% or more from their 52-week highs. We’re most likely in for a challenging investment environment in the year ahead. A combination of low-volatility, momentum and liquid alternatives (liquid alts) will likely generate alpha in 2016. Low-Volatility Numerous studies have shown that low-volatility investing offers superior risk-adjusted returns compared to its high-volatility counterpart and market-cap weighted benchmark portfolio over a full market cycle. We have argued that low-volatility funds such as the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), PowerShares S&P 500 Low Volatility ETF (NYSEARCA: SPLV ), iShares MSCI EAFE Minimum Volatility ETF (NYSEARCA: EFAV ), iShares MSCI All Country World Minimum Volatility ETF (NYSEARCA: ACWV ), and the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEARCA: EEMV ) should be used as a continuing strategic component or core holding of an investor’s overall portfolio, rather than a tactical component. Less volatile stocks help provide a smoother performance pattern and stronger downside-risk protection. USMV vs. SPY One-Year Chart Click to enlarge Two-Year Chart Click to enlarge Three-Year Chart Click to enlarge Momentum Momentum investing is a time-tested strategy for building portfolio efficiency and diversification, while generating excess returns. It identifies securities with good relative performance in rising, neutral and falling markets. A momentum strategy consistently reduces the risk of holding poorly performing securities. It is particularly beneficial when combined with a value component, and thus would complement low-volatility strategies. Momentum and value each deliver positive excess market returns, but because they are negatively correlated, the combination lowers risk and improves portfolio efficiency. You can expect higher risk-adjusted returns by adding a momentum component to your portfolio. The iShares MSCI USA Momentum Factor ETF (NYSEARCA: MTUM ) tracks the performance of an index that measures the performance of U.S. large-cap and mid-cap stocks exhibiting relatively higher momentum characteristics. It currently holds 123 stocks and has an annual expense ratio of 0.15%. Consumer Discretionary (30%), Information Technology (26%), Consumer Staples (17%) and Health Care (12%) represent 85% of the fund. Its top three holdings include Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ), Home Depot (NYSE: HD ) and Starbucks (NASDAQ: SBUX ). Click to enlarge MTUM happens to be at a new high relative to the total market, which may be a bullish sign for the momentum names. Click to enlarge MTUM vs. SPY One-Year Chart Click to enlarge Two-Year Chart Click to enlarge Three-Year Chart Click to enlarge * MTUM began trading on April 16, 2013 Several other momentum-based ETFs may be worth a look. The First Trust Dorsey Wright Focus 5 ETF (NASDAQ: FV ) targets the five sector and industry based ETFs which offer the greatest potential to outperform on a continuous basis. Another Dorsey Wright-based fund is the PowerShares DWA Momentum ETF (NYSEARCA: PDP ). It follows the Dorsey Wright Technical Leaders Index, a benchmark that adheres to the Dorsey Wright relative strength methodology. Goldman Sachs has recently entered the ETF space with a successful fund. The ActiveBeta US LargeCap Equity ETF (NYSEARCA: GSLC ), which is powered by a proprietary methodology based on the Goldman Sachs ActiveBeta index, was cited as one of the best new ETFs for 2015 by Morningstar. It has one of the lowest annual expense ratios (.09%) in this ETF space. Momentum is found across all asset classes and is not constrained by geographical boundaries. The iShares MSCI International Developed Momentum Factor ETF (NYSEARCA: IMTM ) takes its factor-driven approach to the EAFE countries. This new ETF, which came to market in early 2015, features an almost 32.92% weight to Japan with another combined 21% allocated to Germany and the United Kingdom. None of IMTM’s 292 holdings command a weight of more than 2.60%. The ETF’s top 10 holdings include Novo Nordisk (NYSE: NVO ), SAP SE (NYSE: SAP ) and Unilever (NYSE: UL ) Liquid Alts Liquid alternatives put hedge-fund-like strategies into mutual funds and ETFs. They aim to diversifying away from stocks and bonds, and dampen volatility. Liquid Alts work well in a higher-volatility environment. “Market neutral” is a popular hedge fund strategy that uses both long and short position, or borrowings, to make a profit. Long-short strategies are best suited to investors who expect low returns from stocks going forward. The AQR Long-Short Equity Fund (MUTF: QLEIX ) invests in individual equities and equity-related instruments of companies in global developed markets. It combines three independent sources of potential returns: security selection, passive market exposure and tactical market exposure. QLEIX vs. SPY vs. AGG One-Year Chart Click to enlarge Two-Year Chart Click to enlarge Three-Year Chart Click to enlarge We also like the AQR Equity Market Neutral Fund (MUTF: QMNIX ). Its annual expense ratio is capped at 1.35%, which is low in comparison to other similar funds. It goes long and short equities based on fundamental measures of value, momentum and quality. The Fund strives to produce positive absolute returns by taking long and short positions in equity and equity-related instruments that, based on proprietary quantitative models, are deemed to be either undervalued (and likely to increase in price) or overvalued (and likely to decrease in price). QMNIX is not restricted by market-cap size or geography, but it invests primarily in developed markets. QMINX was up +17.60% in 2015, and this year is far outperforming the S&P 500. The fund is ahead almost 3% vs. a decline of about -8% for the S&P 500. Conclusion Investors should expect a more volatile year ahead. Low-volatility, momentum and liquid alternative investments can add meaningful alpha relative to the broader market. Utilizing a combination of all three strategies in your portfolio will likely allow you to lower your portfolio’s risk while creating excess returns. Additional disclosure: George Kiraly Jr., CFP, MBA is the president of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.

The Fat Pitch Lurking In Frontier Markets

The Fat Pitch Lurking in Frontier Markets 2015 was a challenging year for most investors as global growth concerns reduced risk appetites globally. Frontier Markets were no exception with all major Frontier Market indices posting double-digit negative returns. That said, I have not been this excited about opportunities within Frontier Markets since 2008 and the work recently completed confirms my enthusiasm. To borrow a phrase used by my former boss and mentor at GMO, Jeremy Grantham, there is a “fat pitch” lurking in Frontier Markets – a baseball reference to game situations when odds of getting an easy pitch to hit are high. This fat pitch is in value stocks in Frontier Markets. Relative valuations of Frontier Markets value stocks are near their 2008 low relative to Frontier Market growth stocks. We define “value” as the bottom two quintiles of our investible Frontier Market universe based on price-to-book and “growth” as the top two price-to-book quintiles. By creating “value” and “growth” indices, we analyzed the yearly returns of each subset of stocks. The value and growth indices were rebalanced each quarter and were calculated both by equal weighting and market capitalization weighting the constituents. The results are as follows: For the period of 2007 to the end of 2015, the value index had an average price-to-book discount to growth stocks of approximately 70% ranging +/- 10% over the nine-year period. Not surprising, value does not do well during periods of heightened market risk. Regardless of whether the indices are weighted equally or by market capitalization, value massively underperformed during 2008 and 2015 relative to growth stocks. In fact, value stocks performed abysmally, underperforming by 1,600 basis points versus growth stocks in both years. The performance of value versus growth when market risk abates and valuations mean revert is powerful. During 2009, value stocks trounced Frontier Market growth stocks by a whopping 4,200 basis points. This is remarkable and highlights the low intra-correlation among Frontier Market stocks given that the two indices are created from the same Frontier Market universe and are not separate asset classes such as stocks and bonds. In addition, by comparing the difference in performance between the market cap weighted value index and the equal weighted value index, it is clearly evident that large cap value does much better than small cap value during subsequent rebound periods. Admittedly, this is a small sample size, but it is hard to make an argument why today value should be permanently impaired. Some investors may find it psychologically easier to allocate to an asset class as it is rising. However, the recent sell-off has provided a plethora of undervalued Frontier Market stocks that are less exposed to global uncertainties. For long-term investors, the recent market rout may prove to be an excellent entry point for those who have been contemplating an allocation to Frontier Markets.