Tag Archives: networks
Creating A Strategy Index From Long’s Law
Long’s Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry. For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economic “Laws” should best be termed Economic “Tendencies.” The rule roughly holds across a vast array of industries. In August of 2013, I outlined an illustrative portfolio of companies which ranked highly under the criterion of having few competitors. Here’s why this is important. The robber barons understood the long-term competitive advantage of owning oligopoly businesses. You should too. An interesting characteristic that some of the businesses below share is that they are toll bridge-like businesses. For example, if you want to hedge or to speculate in the futures market, chances are you will be doing so through the futures exchanges. If you want to pay for goods or services using a credit or debit card, chances are you will be using Visa or MasterCard’s payment network. You get the picture. Here is an illustrative portfolio of companies which rank highly under Long’s Law: Major Payment Networks (Network Effect Businesses) Visa (NYSE: V ) MasterCard (NYSE: MA ) PayPal (NASDAQ: PYPL ), formerly owned by eBay Major Futures Exchanges (Network Effect Businesses) CME Group ( CME ) Intercontinental Exchange ( ICE ) CBOE Holdings ( CBOE ) Major Online Auction Marketplaces (Network Effect Businesses) eBay (NASDAQ: EBAY ) MercadoLibre ( MELI ) Major Credit Rating Agencies (De Facto Regulators) Moody’s ( MCO ) McGraw-Hill Cos. ( MHFI ) Internet Search (Dominant Online Advertising) Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) Financial Database Firms FactSet ( FDS ) Morningstar ( MORN ) Capital IQ (owned by McGraw-Hill Financial) Thomson Reuters ( TRI ) Index Providers S&P Indices (owned by McGraw-Hill Financial) MSCI ( MSCI ) Morningstar Here’s how this portfolio performs vs. the S&P 500 (please note that EBAY was used in place of PayPal due to its limited trading history since the spinoff). We equally weight the 14 stock portfolio and rebalance annually. (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge The portfolio does well but is highly correlated to the market. Perhaps we can do better. Perhaps decreasing the correlation of the portfolio to the S&P 500 can increase its returns. We can see that the drawdown profile of this strategy follows that of the broader market. It would be great to get less correlated to broad market drops. (click to enlarge) Click to enlarge What could we do to further increase the strategy’s safety and performance? As I have noted in a variety of ETP-only strategies, the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA: TMF ) (a 3X leveraged long duration government bond ETP) has the potential to act as an imperfect hedge of sorts if equity markets crash. Because the long duration government bond ETP is leveraged 3x, we can dedicate far less capital to the bond portion of a traditional stock/bond mix. The TMF instrument almost acts like a call option on long bonds. Unfortunately, interest rates are artificially low, making the TMF portion of the strategy a very imperfect hedge indeed. However, unlike a risk-parity portfolio, because the leverage is inherent to the TMF instrument, there is no margin leverage in this strategy index. And even if long bonds get decimated due to a hyper-inflation, the TMF portion of the portfolio can only go to zero in any given year in an extreme scenario. How do the companies outlined above perform if we equally weight them at 5% each, then add a 30% allocation in the portfolio to TMF? (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge We can see that the portfolio becomes less correlated to the broader equity market, and also, the Sharpe and Sortino ratios rise sharply. Let’s take a look at the drawdown profile of this strategy. (click to enlarge) Click to enlarge The drawdown profile of the portfolio is far improved! Of course, the TMF hedge is by no means perfect, but what a difference it makes. Going forward, we will examine a variety of strategy indices which combine individual stocks with ETPs, as opposed to our usual practice of just creating ETP-only indices. Consider examining whether the addition of additional asset classes can improve the risk/return profile of your own stock portfolio. Thanks for reading. As always, our cutting-edge strategy indices are only available to subscribers , but I hope that some of the strategy indices presented here will provide inspiration for readers to create their own methods for dealing with an increasingly difficult investment environment. If this post was useful to you, consider giving our service a try . Remember, hope is for people who do not use data. Wise investors plan using evidence-based methods. Thanks for reading. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results. 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.
Follow Free Cash Flow Not EPS
Summary Momentum in earnings is a simple and effective investment idea. A company’s profitability can be described by EPS and FCFPS. Momentum in FCFPS lets investors select stocks with higher potential return than momentum in EPS. Momentum in earnings is a fairly popular criterion for selecting companies that could potentially be a good investment. The idea behind this is very simple, but also quite sound. Steadily increasing profits over a long period of time indicate that this trend is likely to continue in the future. Moreover, if profits grow at a consistent pace, it is also safe to also assume that the company will be doing well in the future. When investors talk about momentum in earnings, they are usually referring to EPS momentum – that is, companies that have a steadily increasing EPS over a long period of time. But another indicator that investors should pay attention to is Free Cash Flow per Share (FCFPS). The thing is that Free Cash Flow is seen by many investors as a metric that reflects real company profits more accurately than Net Income. This, first and foremost, is due to the difference in the way CAPEX is factored into these two indicators. We will try to figure out which momentum in which factor EPS or FCFPS lets investors select companies with the highest potential return. In order to do this, we are going to look at two portfolios. One will be based on EPS and the other on FCFPS. We are going to look at 1,500 largest US companies traded on the US stock exchange from 01/01/2008 until the present. We are going to look at EPS and FCFPS growth over the past twenty quarters (five years). The indicators are TTM. This way, we are going to get YoY EPS and FCFPS growth for every quarter. For the first portfolio, we want to select companies with stable EPS growth. Thus, we are going to select companies that post EPS growth at least 17 times over the past 20 quarters. We will accept that a company can post EPS losses no more than three times, since profit is an indicator that can be affected by temporary negative factors, which will not necessarily be reflected in future earnings growth dynamics. For the second portfolio, we are interested in companies with stable FCFPS growth. We are going to select companies that have posted FCFPS growth for at least 14 out of the past 20 quarters. The reasoning behind this is similar to the EPS-based portfolios, but the requirements are less strict because Free Cash Flow is by nature a lot more volatile than Net Income – it is directly affected by CAPEX and Working Capital changes, which are smoothed in Net Income. We are not interested in companies that posted drops in EPS and FCFPS over the given time period. In spite of the strict criteria outlined above, this is still possible if a company’s EPS and FCFPS decreased so much during a particular quarter that it was unable to recover afterward. Moreover, in order to make sure that the growth trend is not over, one of our criteria is going to be that the current EPS and FCFPS values are the highest for the given period. A lot of companies will match the criteria we have outlined. We need to focus on those who have posted the most stable EPS and FCFPS growth. In order to measure stability, we can use the EPS Growth Sharpe Ratio and FCFPS Growth Sharpe Ratio – the higher these values are, the more stable growth in EPS and FCFPS is for a given company. EPS Growth Sharpe Ratio is calculated as the ratio of average EPS growth for a given period (20 quarters) and the standard deviation of this growth. The Sharpe Ratio for FCFPS is calculated in the same way. In order to make sure that our portfolio contains securities that are posting consistent growth, we are going to select the top 40 securities by EPS Growth Sharpe Ratio and FCFPS Growth Sharpe Ratio that have made it through the previous filters. The market usually recognizes and values companies that post stable EPS or FCFPS growth over a long period of time. This is why these companies can rarely be purchased at an attractive price in terms of Valuation. Since our goal entails not only selecting stocks according to EPS or FCFPS momentum, but also evaluating which indicator can bring in more profits, we need to select securities that are moderately priced relative to EPS and FCFPS respectively. In the first portfolio, we will leave only securities with a maximum P/E ratio value of 25. In the second portfolio, we will leave securities with a maximum P/FCFPS ratio value of 25. Thus, we are getting rid of securities that are obviously overvalued. We are looking at quarterly data, so it would make sense for us to rebalance our portfolios every quarter in order to have the most relevant selection of securities. The graph below shows the comparison between the two portfolios we have described. (click to enlarge) FCFPS Portfolio performs way better than EPS Portfolio. Only in 2011 EPS Portfolio had higher return than FCFPS Portfolio. This result confirms that momentum in FCFPS is more prominent driver of stock returns than momentum in EPS. We already mentioned the possible explanation to such a result. Free Cash Flow reflects cash that was generated by the company in the recent period, whereas Net Income doesn’t include present investments but include past investments as Depreciation and Amortization. Current list of stocks in FCFPS Portfolio is the following. Apple Inc. (NASDAQ: AAPL ), AutoZone (NYSE: AZO ), CB Richard Ellis Group (NYSE: CBG ), Deluxe Corporation (NYSE: DLX ), F5 Networks (NASDAQ: FFIV ), Jazz Pharmaceuticals (NASDAQ: JAZZ ), Jack Henry & Associates (NASDAQ: JKHY ), Kennametal Inc. (NYSE: KMT ), Mednax (NYSE: MD ), The Middley Corporation (NASDAQ: MIDD ), Mettler Toledo International Inc. (NYSE: MTD ), NeuStar (NYSE: NSR ), Priceline Group Inc. (NASDAQ: PCLN ), Red Hat Inc. (NYSE: RHT ), Roper Technologies (NYSE: ROP ), Sirius XM Holdings Inc. (NASDAQ: SIRI ), Scripps Networks Interactive (NYSE: SNI ), SolarWinds (NYSE: SWI ), Universal Health Services Inc. (NYSE: UHS ), USANA Health Sciences Inc. (NYSE: USNA ), United Therapeutics Corporation (NASDAQ: UTHR ). Current list of stocks in EPS Portfolio is the following. Ametek Inc. (NYSE: AME ), AutoNation Inc. (NYSE: AN ), AutoZone , Biogen Inc. (NASDAQ: BIIB ), The Walt Disney Company (NYSE: DIS ), Fastenal Company (NASDAQ: FAST ), Home Depot (NYSE: HD ), Henry Schein (NASDAQ: HSIC ), J. B. Hunt Transport Services (NASDAQ: JBHT ), LKQ Corporation (NASDAQ: LKQ ), Mednax , 3M Company (NYSE: MMM ), Mettler Toledo International Inc. , Old Dominion Freight Line (NASDAQ: ODFL ), Omnicom Group Inc. (NYSE: OMC ), Penske Automotive Group (NYSE: PAG ), Paychex (NASDAQ: PAYX ), Polaris Industries Inc. (NYSE: PII ), Portfolio Recovery Associates (NASDAQ: PRAA ), Robert Half International Inc. (NYSE: RHI ), Roper Technologies , Ross Stores (NASDAQ: ROST ), Signature Bank (NASDAQ: SBNY ), Snap-On Inc. (NYSE: SNA ), T. Rowe Price Group (NASDAQ: TROW ), Wabtec Corporate (NYSE: WAB ), Whole Foods Market (NASDAQ: WFM ). It is noteworthy that some stocks are present both in FCFPS and EPS Portfolios. These are AZO, MD, MTD and ROP. These companies had the most consistent growth both of EPS and FCFPS. Conclusion. Momentum in earnings is a simple and effective investment idea. Companies that posted profit increases in the past have good potential for growth in the future. A company’s profitability can be described by EPS and FCFPS. The test we conducted shows that the combination of a steadily growing FCFPS and moderate Valuation by P/FCFPS allows is to select securities with higher potential profitability than the combination of a steadily growing EPS and moderate Valuation by P/E.