Tag Archives: nature

Biotech In A Bear Market. First Move? Don’t Panic!

It was a putrid week for biotech, partially triggered by a tweet from presidential candidate Hillary Clinton. The main biotech indices fell some 13% in five trading sessions. This sort of volatility is nothing new for this sector of the market. In fact, this is the fifth bear market for small cap biotech stocks since 2009. However, this too shall pass for this lucrative area of the market and brighter skies will return. Here are my time worn strategies for navigating the current turmoil in biotech. It doesn’t matter how one describes the action in the biotech sector this week, it was just plain ugly. The main biotech indices sold off ~13% including an almost five percent plunge on Friday even as the S&P 500 managed to end flat on the day. Investors in biotech have not been treated this much like rented mules by the market during one week in quite some time. (click to enlarge) Part of the deep pullback was triggered Monday by presidential candidate Hillary Clinton who tweeted her outrage about drug price “gouging” . She then made it part of her campaign as she tacks even further left for the upcoming primaries as a self-avowed socialist continues to gain against her in the polls for the contest for the Democratic Party nomination for president. It should be kept in mind that this type of electioneering is par for the course. Even if Mrs. Clinton is elected president and wanted to follow through on these primary promises, they have absolutely little to no chance of passing. The Republicans will still be charge of the House of Representatives and quite possibly the Senate. There are also no guarantees that Mrs. Clinton will be elected president or even secure the Democratic nomination for that matter. Who knows either her and/or Republican front runner Donald Trump might even develop a sense of shame at some point and withdraw from the race. In addition, this sort of turmoil is nothing new to this lucrative but volatile sector of the market. This is now the fifth time since 2009 that the small cap biotech sector has declined by at least 20% and entered an official bear market. The last time started in early March of last year. During that decline that lasted 6-8 weeks, large cap growth names in the sector like Gilead Sciences (NASDAQ: GILD ) fell back 20% to 30% before bottoming. Many small cap names plunged 50% to 70% before all was said and done. Given that I run the Biotech Forum on SeekingAlpha and approximately 40% of my articles here, on Real Money Pro and Investors Alley are centered on biotech investing; I have been inundated from questions from readers and subscribers this week. The quick downturn has caused a significant amount of anxiety. This is understandable but also part of investing in the biotech industry. I have been warning since the early summer that the overall market was overdue for at least a 10% pull back and that the biotech sector was quite possibly in a bubble as well. The weakness in the market should be no surprise and is also affecting other high beta sectors of equities with small cap stocks being down 3.6% this week as well. My first piece of advice is the same as the core theme of the cult classic “The Hitchhiker’s Guide to the Galaxy”. This is simply “Don’t Panic!”. This too shall pass. Thanks to algorithmic computerized generated trading now accounting for more than 50% of trading in the equity markets; these declines are getting deeper and quicker than they used to be as these programs decide to abandon momentum driven and high beta sectors of the market in nano-seconds. I have been successfully investing in biotech for over two decades. I have seen many such bouts of turmoil and I plan to see many, many more before I hang up my investing spurs. Over these periods I have developed several core principles to manage a well-diversified biotech portfolio that helps position these holdings to outperform the overall market over time while to help mitigate risk and lessen the overall volatility of the portfolio as well. My hope is that they can help readers manage through the current carnage in the biotech sector until sentiment once again turns positive on this part of the market. April 14th Article on Biotech Forum: The biotech & biopharma space is one of the most volatile of any of the sectors of the market. This is especially true as it relates to the small caps that make up a good portion of the companies that occupied the biotech & biopharma arena. It is not unusual to see a small biotech equity be listed as the top gainer of the day in the market with another small play in the space taking biggest loser of the day honors. Volatility is a fact of life for investors who want to invest in these high beta sectors of the markets. One does so because few if any areas of the market can offer up the five and ten baggers that are the stuff of dreams and can turbocharged the performance of one’s portfolio by just be fortunate enough to occasionally catch one of these “rockets”. Over the years I have identified many of these huge winners in the pages of SeekingAlpha including Lannett Group (LCI ), ZELTIQ Aesthetics (NASDAQ: ZLTQ ), Novavax (NASDAQ: NVAX ) , Avanir Pharmaceuticals (NASDAQ: AVNR ) and myriad others. Recently Eagle Pharmaceuticals (NASDAQ: EGRX ) has soared over 275% since I listed as a “Best Idea” on Real Money Pro on 12/19/2014. (click to enlarge) (click to enlarge) I have also had my share of disappointments like Regado Biosciences (RGDO) and Synta Pharmaceuticals (NASDAQ: SNTA ). It is simply the nature of the game. For every home run they will be at least one strike out. However, if managed right and optimized collection for small and large cap biotech & biopharma stocks can be a key contributor to overall outperformance from one’s portfolio over time. (click to enlarge) (click to enlarge) It is my passion and success in the biotech arena over the past two decades of investing that drove me to create the Biotech Forum which launched on SeekingAlpha early in April. I want to share my thoughts on how to properly manage and optimize a biotech/biopharma portfolio and some tricks of the trade have absorbed over many years of investing in this space. They will be the tenets of the Biotech Forum portfolio which will consist of twenty stocks. Five of these will be from the large cap space. These companies will already have achieve profitability, have solid products & pipelines and are selling at attractive or at least reasonable valuations on a long term investment basis. These will be labeled as “CORE” positions. The remaining 15 stocks will come from the more volatile and speculative small cap sector. These will be tagged with the “SPECULATIVE” moniker. Depending on your risk preferences you will want to weight each large cap selection three to six times heavier than each small cap pick. This will mean 50% to 75% of your portfolio will be made up of these more stable and less volatile large cap equities. The remaining portion of your portfolio we will go hunting for some multi-bag grand slams. This portfolio will be built slowly as I believe in dollar cost averaging in these areas. This sector has outperformed the overall market for five straight years and could be overdue for a pullback if sentiment sours on “risk on” areas of the market. Each month we will add one large cap pick and three small cap equities to the mix. Once we have our twenty stock portfolio we will make adjustments/modifications as we deem prudent over time. I will also offer up some future promising opportunities each month for those who might want to assemble a portfolio in a different or faster way than how we create the Biotech Forum portfolio. Our small cap selections will be focused on different technologies and disease areas to provide diversification. We will also look for concerns with multiple “shots on goal”, partnerships with larger players within the space, strong balance sheets which also could make attractive buyout opportunities. There are three terrible feelings when investing in small biotechs & biopharma stocks. The first is when a trial goes wrong or a company announces other disappointing news resulting in your investment cratering. Unfortunately, there is little one can do avoid these landmines as bringing a compound to market is a very complicated affair and is why one must make myriad small investments across promising opportunities in these sectors to provide diversification. The second thing that go wrong is when one makes an investment that comes at a very opportune time. Your stock doubles or triples in short order and you do not take any profits. Over time, the stock falls back to where you bought it or even lower and the feeling of regret of not taking any gains clouds future investment decisions. Finally, there are instances when your investment doubles or better and you cash out entirely only to see the stock triple or quadruple from there. I have had this happen many times over the decades and there are few worse feelings in investing. I have develop a rule of thumb over the year when it comes to small biotech stocks. It is to sell 10% of your original stake once one achieves a 50% gain, 20% of the original stake after the stock doubles and 20% more if one is fortunate to have your stock triple. The other half of the original stake now rides on the “house’s” money unless something drastically changes on the company’s prospects. That concludes a brief overview of some core themes that will be core drivers behind the formulation of our optimum twenty stock Biotech Forum portfolio.

Abengoa Yield PLC: Diversified Global YieldCo With Attractive Dividend And Upside Potential

Summary Attractive sustainable current dividend yield of over 8 percent; expected to increase by 31 percent next year. YieldCo sponsored by global engineering giant with a substantial pipeline of attractive acquisition opportunities. Solid diversified asset portfolio with stable cash flow and global exposure. Last week we brought readers an interesting opportunity with a renewable energy focused YieldCo in NextEra Energy Partners (NYSE: NEP ). With this article, we’re focusing on another YieldCo with substantial upside potential, along with a strong sustainable high yield dividend. This time, however, the company is more nuanced and has, in our view, a different risk profile than NextEra Energy Partners. However, we believe the potential upside with this company is significant and offers a great source of low cost diversification to an income focused portfolio. Abengoa Yield PLC (NASDAQ: ABY ) is a United Kingdom registered company that trades primarily on the NASDAQ. Abengoa Yield follows the typical YieldCo model for project developers: its sponsor, Abengoa SA (NASDAQ: ABGB ), wins contracts, develops projects and then the Yieldco has the opportunity to be the first bidder on these projects as they’re sold. The sponsor benefits by freeing up capital to pursue more development opportunities and investors in the Yieldco benefit by holding onto long-term stable cash flow generating assets that can be levered to produce a high dividend yield. The sponsor, Abengoa SA, is a global engineering company based in Spain whose expertise is primarily in the development of power projects. Its market capitalization is approximately $1 billion, with 2014 revenues of over €7 billion. As of the second quarter of 2015, the sponsor held a 51.1 percent interest in Abengoa Yield, though the company is targeting this to be reduced over time to a 40 percent interest. Unfortunately for Abengoa Yield, there are conflicting views on the financial health of the sponsor, with a recent upgrade by Standard & Poor’s in July offset by the news that Moody’s has put the company on credit watch in early August. Abengoa Yield PLC does enjoy a higher credit rating from Moody’s than the sponsor, indicating limited concern about the impact of a default or bankruptcy of Abengoa SA on the YieldCo’s immediate financial situation. However, there is no doubt that a default of the sponsor would have a considerable impact on the future project pipeline that the YieldCo has access to, and we believe that this risk is captured in Abengoa Yield’s lower valuation and higher yield. With the YieldCo business model, questions around governance are common. In the case of Abengoa Yield, we believe there are adequate governance controls in place to protect the interests of its shareholders. First, a majority of its Board of Directors are independent directors, independent of both management and of the sponsor company. The board must vote on any acquisition of assets from the sponsor and determine that the terms are set “no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances.” These terms would be determined based on a market analysis of what similar projects would be priced at in the market. While the risk remains that the board could be swayed by influence of the sponsor, it would be at great legal risk to the independent directors and so we believe that this level of control is adequate. Further, there is an inherent control in the business model as the sustained ability for the YieldCo to raise equity in the market is based upon its ability to generate attractive cash flow returns. A poorly priced deal could hamper the YieldCo’s ability to attract equity financing in the future, harming the very purpose of the fund for the sponsor. Finally, in the case of Abengoa Yield, the sponsor does plan to dilute its interest over time to only 40 percent of the outstanding shares, handing majority shareholder ownership over to the public. In terms of its asset portfolio, Abengoa Yield is a highly diversified YieldCo, with assets ranging beyond just renewable energy on long-term contracts. In addition to solar and wind generation assets, the company also owns a conventional 300 megawatt gas plant, 1,100 miles of electric transmission lines and two water treatment facilities, along with a financial interest in a Brazilian electricity transmission project. The diversified nature of its assets is attractive, with many other YieldCo type models more focused on generation specific projects. All of these assets are backed by long-term contracts, most with investment grade counterparties, allowing Abengoa Yield to apply a significant degree of leverage through project financing. The average remaining contract life for the assets is 23 years. (click to enlarge) Source: Abengoa Yield PLC’s June 2015 Investor Presentation Along with the long-term, stable cash flow contracts, Abengoa Yield has also locked down O&M costs for all of its assets. This has generally been done through long-term inflation linked O&M agreements, primarily with Abengoa SA as the contractor. This provides cost certainty not only on the revenue side but also on the cost side, offloading operating and maintenance risks to the O&M services provider. This is a common practice in the YieldCo space, and Abengoa SA certainly has the skills and global reputation to be a strong operator of these assets. Abengoa Yield is still exposed to capital maintenance expenditures for its assets, however, and increasing capital maintenance costs could pose a risk down the line. In the medium term, however, we review this risk as small as most of the assets are fairly new in vintage and won’t be facing substantial overhauls for decades. In many cases, much of the return on and return of capital for a project is captured in its initial contract term, making maintenance and renewal of future contracts an option that the company can decide, or not, to exploit down the road depending on market conditions. Beyond the diversification in the types of assets of the company, the firm is also significantly geographically diversified. Its solar projects are split between the United States, Spain and South Africa, while its wind generation is located in Uruguay, its gas generation is in Mexico and its transmission assets are in Peru and Chile. Finally, the firm’s water treatment projects are in Algeria. Some of these jurisdictions certainly add risk to the company’s profile, but we also find the diversification to be encouraging in an industry where political and regulatory risk threaten companies with over-concentrated positions. We would expect further diversification of the company’s assets geographically due to the nature of potential push down projects from the parent, which truly operates in every corner of the globe. The firm’s assets are generally supported by long-term contracted cash flow arrangements. This enables the company to pay both a high dividend and maintain a significant amount of leverage. The firm’s cash flows are based 61 percent on availability, rather than production, and 93 percent of the cash flows are in US dollars, or hedged to US dollars through a swap arrangement with the sponsor. Further, less than 4 percent of contracted cash flow is from counterparties that have less than an investment grade rating. The combination of these factors provides a very stable cash flow base from which the company can support its high payout ratio dividend. In terms of future projections, the company has published some attractive but well supported numbers, with a projected 2016 exit dividend of $2.10-2.15 per share annualized. This would be a significant increase from the $1.60 per share paid today. The company then projects ongoing growth at 12-15 percent per year based primarily upon further acquisitions of Abengoa SA projects, potential third-party acquisitions and efficiencies. We think the long-term trend might be on the aggressive side of attainable and we reflect that in our valuation analysis further on this report. Source: Abengoa Yield PLC’s June 2015 Investor Presentation The YieldCo’s primary source of expansion projects is completed projects with contracted cash flows purchased from the sponsor. The firm has a Right of First Offer on all projects that Abengoa SA offers for sale, giving it the opportunity to participate in any potential acquisition from Abengoa’s substantial project list. The sponsor had a backlog of €8.8 billion, according to its first half 2015 presentation, with significant power and infrastructure projects under development that would be ideal assets for inclusion in Abengoa Yield PLC’s portfolio down the road. Previous asset sales occurred at a 15 percent IRR, which is a significant discount to Abengoa Yield PLC’s current return on equity as calculated in our valuation, offering the potential for accretive acquisitions at its current price. Positives Diversified Geographical Exposure: The variety of geographical locations represented in Abengoa Yield’s holdings is an attractive feature for a company of this nature. Having a variety of jurisdictional exposure limits the impact of any one country’s political or regulatory changes, which can have a significant impact on these types of assets. Despite the geographic diversification, the contracted cash flows for the company are primarily in US dollars or are hedged to US dollars and therefore the firm has limited foreign exchange exposure risk. Diversified Portfolio of Asset Types: The variety of assets held by Abengoa Yield is attractive for investors. We believe that the lower risk conventional gas generation and electric transmission assets act to reduce required equity returns for the firm overall and underpin the company’s stable cash flow profile. The renewable assets are well diversified themselves with a split between solar and wind projects of varying sizes. ROFO Agreement with Abengoa SA: The firm’s Right of First Offer arrangement with Abengoa SA is highly attractive on the basis that the sponsor has a significant pipeline of developed and in development projects that could be sold down to the YieldCo at an attractive price. We expect that Abengoa SA will overcome its liquidity crunch in the medium term and this project pipeline will be realized at its full value for the YieldCo. Conservative Leverage at Hold Co Level: The firm currently reports a net debt to cash flow available for distribution of 1.8x versus its target level of 3x. This offers some ability for the company to finance future acquisitions through additional debt, rather than the dilutive equity offerings which are too common in the YieldCo space. Risks Many Assets in Higher Risk Jurisdictions: Many of Abengoa Yield PLC’s assets are located in jurisdictions that pose higher business risks than assets in North America or Western Europe. While a concentration of assets in any one high-risk jurisdiction may pose a concern for us, having small exposures to numerous jurisdictions seems to offer a higher potential return, with minimal incremental risk on a portfolio basis. That said, if future acquisitions continue to build exposure in an existing asset location, or if the risk profile of future asset locations was significantly higher, this would materially impact our required equity return and valuation. Financial Health of the Sponsor: The conflicting views on the financial health of the sponsor, Abengoa SA, are certainly weighing on this stock. We believe that Abengoa SA has taken steps to address its financial situation but the outcome of this is uncertain. Further deterioration in the financial health of the sponsor may have a material impact on the availability of projects for Abengoa Yield to acquire through the ROFO agreement. Valuation One attractive aspect of a company that is primarily driven by its dividend and distributes nearly all available cash to shareholders is the ease in analyzing and comparing its relative value along with assessing its implied cost of equity capital. In the case of Abengoa Yield, our baseline assumptions are the lower end of 2016 dividend guidance of $2.10 per share, a 90 percent payout ratio and an 11 percent annual growth rate. Why do we reduce the expected growth rate below the guidance provided by the company? Our concerns about the sponsor’s financial health are not insignificant and any major liquidity crunches at the sponsor could impact the available project pipeline for future acquisitions by the YieldCo. We do believe that the higher growth rate could be obtainable, as demonstrated by the company’s ability to beat that growth rate in 2016, if the sponsor company can maintain an adequate pipeline of projects at a reasonable cost. Into the details of the valuation, based on the September 18 share price of $19.34, these dividend, payout ratio and growth assumptions produce an implied cost of equity of 23 percent on a free cash flow to equity basis, nearly on par with the equity cost of capital determined in our analysis of NextEra Energy Partners, but still significantly higher than Brookfield Renewable’s (NYSE: BEP ) 16 percent cost of equity. Importantly, this is also a significant discount to the typical sale price of these types of assets, with the recent purchases from the sponsor occurring at a 15 percent IRR. This is reflected in Abengoa Yield PLC’s current price to book of 0.88. Arguably, the lower risk transmission assets held by this YieldCo should reduce its cost of equity compared to a firm like NextEra Energy Partners, who has a more concentrated asset exposure. Over the longer term, we believe that these YieldCos will trend towards a more reasonable 15-18 percent return on equity. This is the basis of our base case scenario for Abengoa Yield PLC of $30.00 per share (at an 18 percent return on equity). This would represent an even 7 percent dividend yield in 2016, which is much more generous than the yield on the firm’s stock earlier in 2015, illustrating significant upside potential beyond our projection. Summary Overall, we believe that Abengoa Yield offers an attractive valuation and potential upside for a set of high quality power and infrastructure assets located in geographically diverse locations. Current drag from the financial situation of its sponsor has weighed on this price but we do believe that this simply offers an attractive entry point for long-term investors. We view Abengoa Yield as having a unique risk and return profile and offsetting highly attractive qualities that together make for a bargain priced addition to a diversified portfolio. Disclosure: I am/we are long ABY, NEP. (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.

Season Of The Glitch

When I look over my shoulder What do you think I see? Some other cat lookin’ over His shoulder at me. – Donovan, “Season of the Witch” (1966) Josh Leonard: I see why you like this video camera so much. Heather Donahue: You do? Josh Leonard: It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is. – “The Blair Witch Project” (1999) Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below: Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday. – “BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015 A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments. – “A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015 Bank says data loss was due to software glitch. – “Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015 NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack. – “NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015 Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said.. – “TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015 Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?” Welcome to the Big Leagues of Investing Pain. What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here- and the reason this sort of dislocation WILL happen again, soon and more severely- is that a vast crowd of market participants- let’s call them Investors- are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker. Moreover, there’s a slightly less vast crowd of market participants- let’s call them Market Makers and The Sell Side- who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since… well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat. The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “ Ghost in the Machine ” for more). You’re making a category error, and one day- maybe last Monday or maybe next Monday- that mistake will come back to haunt you. The simple fact is that there’s precious little investing in markets today- understood as buying a fractional ownership position in the real-life cash flows of a real-life company- a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality. Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do- like buying an ETF- is allocating rather than investing. The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug. What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it. Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation. One of my very first Epsilon Theory notes, “ The Tao of Portfolio Management ,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say. Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side. Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets , especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices . One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe . But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.