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The Dynamic Duo Of Risk Factors: Part I

The value and momentum factors have earned high praise in recent years as complementary sources of risk premia for designing and managing equity portfolios. AQR’s widely cited paper “Value and Momentum Everywhere” a few years back helped popularize the idea, pointing to applications in equities and beyond. There’s no shortage of support from the wider world of investment management. Earlier this week, for instance, Jack Vogel at Alpha Architect outlined “Why Investors Should Combine Value and Momentum.” Not surprisingly, there are several investment funds focused on the strategy, including the recently launched Cambria Value and Momentum ETF ( VAMO ). The rationale for a value-momentum mix can be summarized by reviewing the historical results. Consider rolling five-year annualized returns (a time window used in AQR’s paper), which captures a fair amount of mean reversion. The chart below hints at the possibilities from a portfolio-design perspective. Using the risk premia numbers via Professor Ken French’s data library suggests that value and momentum do in fact exhibit a fair amount zigging when the other factor’s zagging. The correlation between the two sets of rolling 5-year returns since the early 1930s is moderately negative – roughly -0.24 (based on monthly returns). That tells us that no one will confuse one risk premium for the other. But how does correlation stack up over shorter periods? From a practical perspective, the results over, say, five years offer more insight into the potential for tapping into the value-momentum dynamic. As the next chart shows, the relationship is far from static. Indeed, the rolling five-year correlations ebb and flow through time by more than a trivial degree. The implication: a dynamic system for managing risk with these factors may be superior to buying and holding. Sometimes, and perhaps for several years at a stretch, these two risk factors generate similar returns. During those times, you’ll probably read stories proclaiming the “Death of Diversification For Value and Momentum Strategies.” But if history’s a guide, the tight correlation will only be temporary. There’s nothing magical about rolling five-year windows, of course. A serious research project would review multiple rolling periods by running the numbers through a battery of risk analytics. But the preliminary, if inconclusive, profile above implies that looking at the equity market (and other asset classes) through a value-momentum prism has intriguing possibilities. One question that comes to mind: How does a value-momentum strategy fare as a buy-and-hold proposition (with naïve year-end rebalancing) vs. a tactical asset allocation application? How much improvement, if any, should we expect with a dynamic system? In an upcoming post, I’ll explore this question with a back-test and review the results by adjusting for risk. Several researchers have already run similar tests and produced encouraging results. Let’s see if we can replicate the data. The literature suggests that’s likely. But the devil’s in the details. There are several ways to define “value” and “momentum” and there’s a rainbow of possibilities for implementing tactical strategies. Therein lies the potential for success… or failure. But it’s always best to start with a simple model. If there’s truly an opportunity for enhancing a buy-and-hold version of a value-momentum strategy, the evidence should be clear in a basic tactical model.

GDX: Gold’s Resurgence Can Keep Rising

By Brenton Garen and Tom Lydon An obvious though still impressive beneficiary of gold’s resurgence this year is the gold mining industry and its corresponding exchange traded funds. That includes the Market Vectors Gold Miners ETF (NYSEArca: GDX ) , the largest and most heavily traded gold miners ETF. GDX is up 50% year-to-date. Not only is that good for one of the best performances among non-leveraged ETFs, it also puts GDX up nearly three times as much as ETFs that hold physical gold. That does not mean GDX and rival gold miners ETFs are perfect investments, not when the industry still faces headwinds. Strategists point out that costs keep rising, which has narrowed profit margins among gold miners. Recent mine closures have not improved margins. Current mining operations are also facing deteriorating ore grades. The recent decline in energy prices and depreciating currencies where local miners operate have also had minimal beneficial impact on cash costs. Gold is seeing greater support from safe-haven demand after currency devaluations across Asia added to investment demand for a better store of value than paper currencies or stocks and bonds. Gold assets look more attractive in a low interest rate environment as the precious metal is more competitive against assets that pay low interest, like bonds. Additionally, if the Fed holds off on further rate hikes, it would suggests the economy is not as strong, which would also help gold attract safe-haven demand. “I believe this could be due to the fact that the cash cost of mining the yellow metal has not only been constantly below the gold price, but also falling. For miners, any increase in the price of gold can push the income as well as profit margins even higher,” according to a Seeking Alpha analysis of GDX. Supporting miners and GDX is the dollar, which has quickly weakened. The greenback is being weighed down on speculation that ongoing uncertainty may force the Federal Reserve to refrain from hiking interest rates in the near future. Consequently, a weaker USD makes alternative assets like metals more attractive . Market Vectors Gold Miners ETF Click to enlarge 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.

The Value Of Transparency: Why Methodology Matters

Disagreement makes markets. Every time you buy a stock, someone on the other side has to be selling it. You’re making a bet that the stock is going to outperform in the future; the other person is betting that it will underperform. This point seems obvious, but it’s one that investors forget time and time again when they try to chase “sure things.” Many ignored this fact when they fell for Bernie Madoff’s Ponzi scheme . They forgot it when they chased high-flying stocks like Twitter (NYSE: TWTR ), LinkedIn (NYSE: LNKD ) or Valeant (NYSE: VRX ) (and many others ). Any investment that seems too good to be true probably is. Chuck Jaffe of MoneyLife and MarketWatch.com made an excellent point on this topic in his recent article, ” Here’s One Stock Market Tip You Really Want to Follow .” “On the MoneyLife show, money managers spend the bulk of their time discussing methodology and markets before moving to which stocks pass or fail their personal tests,” Jaffe writes. “In the end, however, what most people remember is the simple buy-sell-hold recommendation.” That’s a problem, Jaffe argues, because he often gets different money managers taking opposite opinions on the same stock. These are (presumably) sophisticated investors, with similar styles, who have taken a deep look at the same stocks and come to opposite conclusions. For every very smart investor that believes a security is undervalued, there’s usually another smart person with their own reasons to believe that it’s overvalued. Recently we faced off against another analyst over Valeant Pharmaceuticals. The other analyst put more emphasis on the company’s stated numbers, leading him to call it a good buy. We reiterated our position that VRX has questionable accounting and its business model destroys shareholder value. Investors couldn’t just look at the headline to make their decision; they had to dig into the logic and methodology of each argument to decide who they thought was right (given VRX’s 50% drop this week, we think that was us). Not only that, but on some occasions both sides could be right! A risk-averse analyst with a shorter time frame might see significant challenges for the company in the coming years and want to sell. A more opportunistic analyst with a longer horizon could see a cheap valuation and long-term growth opportunity. Neither one is wrong, they just have different criteria. Take A Look Underneath The Hood For this reason, investors always need to dig deeper than looking at a simple “buy” or “sell”. Sometimes, these ratings can be driven by factors that have nothing to do with markets or fundamentals . On other occasions, the argument might sound convincing but completely crumble when you examine some of the underlying assumptions. Even if the call looks accurate at the time, markets and the economy change constantly. For instance, let’s say an analyst rates a company a buy due to the fact that he or she believes it has pricing power, so you buy the stock. Now, if the company tries to raise prices and starts losing market share, you know that the underlying thesis does not hold up and you should sell right away. This is important, because analysts generally aren’t going to tell you when their calls go wrong. In addition, almost any call will be impacted by developments in other parts of the economy. It’s possible for analysts to be absolutely right on stock-specific issues but to miss on a more macro level. We have firsthand experience in this area. In 2012, we put Goodyear Tires (NASDAQ: GT ) in the Danger Zone . Given that the company had never earned an economic profit in any year we had data for (going back to 1998), had significant pension liabilities, and little history of growth, the call seemed eminently reasonable at the time. What we didn’t predict was the complete rout in commodities that would decrease the price of rubber by almost 80%. This price decline helped boost GT’s margins to record levels and gave it the cash flow it needed to make up the gap in its pension funding and justify a valuation significantly higher than we anticipated. We wrote back then that GT needed to grow after-tax profit ( NOPAT ) by 4% compounded annually for 10 years in order to justify its valuation of $10.16/share, a target we didn’t think was likely given that the company’s NOPAT had actually declined since 1998. Instead, the major decrease to one of its primary costs helped GT’s NOPAT grow by 18% compounded annually since our article. This major profit growth has allowed it to justify a valuation of ~$33/share today. Transparency Makes For More Informed Investors Why are we writing about a sell call we made that went over 200% in the opposite direction? Because it’s important for investors to remember that nobody has all the answers. We believe our methodology helps investors identify fundamentally undervalued and overvalued companies-and the data bears that out -but we still get calls wrong from time to time. That’s one of the primary reasons why we put such a big emphasis on transparency. It’s why we do things like: Give definitions and formulas for all the metrics we use Explain the adjustments we make to close accounting loopholes Show our calculations for the different factors that comprise our stock ratings Include links to our DCF models in all our long and short calls We want investors to understand our underlying methods and assumptions so they can analyze our findings, try to poke holes in our arguments, and make informed decisions about whether to follow our recommendations. Ultimately, our commitment to transparency comes from the confidence we have in our research. Our analysts digging through thousands of filings to create models that reflect the underlying economics of the thousands of stocks we cover, and we want people to be able to see the fruits of their labor. Compare this level of transparency with some of the other major providers of equity research out there: A lot of the work these analysts do can actually be valuable. Unfortunately, the lack of transparency makes it difficult for investors to analyze these research reports and form their own opinions. This leads to the situation Jaffe described where investors have learned to just pay attention to buy-sell-hold ratings rather than dig into methodology. We don’t want investors to just blindly buy our top-ranked stocks. Instead, we want to help them become more sophisticated by providing the data, tools, and frameworks they need to succeed. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, 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.