Tag Archives: nreum

BDCL Still Attractive With A 19.2% Yield

Summary The projected quarterly $0.9366 dividend for BDCL will be higher than that in the previous quarter. Some of this increase is due to a quirk in the calendar, which caused three of the components of BDCL not to have their dividends included in the prior quarter. The stock is still attractive for those seeking very high yields and willing to accept the risks associated with this sector and the leverage. The ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (NYSEARCA: BDCL ) will soon be declaring its dividend for the quarter ending June 30, 2015. The dividend will be paid in July 2015. BDCL is an exchanged traded note that employs 2X leverage to generate exceptionally high yields. 41 of the 44 Business Development Companies that comprise the index portfolio upon which BDCL is based have announced dividends with ex-dates in the second quarter of 2015. American Capital Ltd. (NASDAQ: ACAS ) and Harris & Harris Group Inc. (NASDAQ: TINY ) do not pay dividends. MCG Capital Corp. (NASDAQ: MCGC ) last paid a dividend in August 2014, and is not currently paying one. The calendar helps BDCL’s dividend in the second quarter of 2015 relative to the first quarter. Capital Southwest Corp. (NASDAQ: CSWC ) pays semiannually and did have an ex-date in the second quarter of 2015. KCAP Financial Inc. (NASDAQ: KCAP ) declared a quarterly dividend of $0.21, with an ex-date of April 1, 2015 and a pay date of April 27, 2015. Its latest dividend has an ex-data of July 1, 2015, so that will not be included in the July BDCL dividend calculation, but the April 2015 KCAP dividend will. MVC Capital Inc. (NYSE: MVC ) declared a $0.1350 dividend, with an ex-date of April 23, 2015. Thus, I have included KCAP, MVC and CSWC, which were not in the April 2015 BDCL dividend calculation, in the July 2015 BDCL dividend calculation. From 41 of the 44 Business Development Companies that announced dividends with ex-dates in the second quarter of 2015, I projected that BDCL’s quarterly dividend paid in July 2015 will be $0.9366. This is an increase of 13.3% from the quarterly $0.8265 dividend paid in April 2015. Some of the increase is due to the inclusion of CSWC, KCAP and MVC in the July 2015 BDCL dividend calculation, because of the timing of their ex-dates. There were 2 components of BDCL that reduced their dividends from the prior levels. Fidus Investment Corp. (NASDAQ: FDUS ) declared a regular quarterly dividend of $0.38 and a special dividend of $0.02, both with ex-dates of June 9, 2015. Thus, it paid a total of $0.40. Last quarter, the company declared a regular quarterly dividend of $0.38 and a special dividend of $0.10 for a total of $0.48. Medallion Financial Corp. (NASDAQ: TAXI ) reduced its quarterly dividend to $0.24 from the previous $0.25. Three components of BDCL increased their dividends from the prior levels. Main Street Capital Corp. (NYSE: MAIN ), which pays monthly, declared a special $0.275 dividend, with an ex-date in the second quarter. It did not have a special dividend in the first quarter. TICC Capital Corp. (NASDAQ: TICC ) increased the quarterly dividend to $0.29 from $0.27 in the previous quarter. PennantPark Floating Rate Capital Ltd. (NASDAQ: PFLT ) pays a monthly dividend of $0.095. Prior to March 2015, PFLT paid a monthly dividend of $0.09. It might be noted that CM Finance Inc. (NASDAQ: CMFN ) declared a special dividend of $0.43 on June 10, 2015. However, that special dividend is not included in my July 2015 BDCL dividend calculation, since the ex-date for CFMN’s special dividend of $0.43 is August 28, 2015. The table below shows the weight of each of the components of the index upon which BDCL is based. The prices are as of June 24, 2015. The weights are the latest on the BDCL website. The table also shows the dividend rate, the ex-dates, and the contribution by component of the components that pay dividends. Unless specified otherwise, the components pay dividends quarterly. In the frequency column, those that pay monthly have an “m”, and the semi-annual payers are denoted by “s”. Interestingly, the second-largest component of the index upon which BDCL is based, American Capital Ltd., with a weight of 9.55%, is one the 3 components that do not currently pay any dividends. The other weights of the components that do not currently pay dividends are: TINY has a weight of 0.3%, and MCGC has a weight of 0.63%. Thus, 10.48% by weight of the components of BDCL do not pay any dividends now. Some readers have asked to see the details of my dividend calculations. I have changed my procedure, and now use the contribution by component method. It should give the exact same result as my previous method that could be called the total imputed dividends divided by the number of shares outstanding method. An example of that methodology using actual numbers can be seen in the article ” MORL Yielding 24.7% Based On Projected June Dividend “. In the total imputed dividends divided by the number of shares outstanding methodology, the number of shares outstanding appears both as a numerator and a denominator. Thus, the same result can be obtained by using the contribution by component method. This method involves multiplying the net asset value of BDCL by weight of each component with an ex-date during the month prior to the month in question, and then multiplying that product by 2 to account for the 2X leverage. That product is then divided by the share price of the component. This is an imputed value for how many shares of the component each share of BDCL represents. Multiplying the shares of the component per BDCL share times the dividend declared by the component gives the contribution by component for each component. Adding all of the contributions of all of the components with an ex-date in the month prior to the month for which the dividend is being computed gives a projection for the dividend. The index upon which BDCL is based is a float-adjusted, capitalization-weighted index that includes the Business Development Companies listed on the major exchanges. The fact that 10.48% of the companies that comprise BDCL are not currently paying dividends can be looked at with either a “glass is half full” or “glass half empty” perspective. On the bright side, there could be considerable room for an increase in the dividends paid by BDCL if those components not presently paying dividends were to resume them. On the other hand, the fact that 10.48% of the companies that comprise BDCL are not currently paying dividends could be seen as a warning that other components in the portfolio might also suspend dividends at some point in the future. BDCL has existed for about three years, which allows us to run a regression of weekly returns on it versus a proxy for the entire equity market, such as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). This indicates that BDCL is relatively highly correlated to the equity market, with 72% of the variation in the ETN explained by the variation in SPY. Also, as might be expected with 2X leverage, the beta or coefficient that reflects the degree to which BDCL reacts to changes in the overall market is 1.9. This indicates that if SPY were to change by 1.0%, it would be expected that BDCL would change by 1.9% in the same direction. Even though it is highly correlated with SPY, problems with specific business development companies in the index and that sector in general have caused the ETN to underperform the equity markets in recent months. The relatively high yield and high beta or systematic risk is consistent with the Capital Asset Pricing Model. One wrinkle is that for investors seeking higher yields, BDCL may actually be a relatively efficient diversifier, if those investors are now heavily invested in higher-yielding instruments that are very interest rate-sensitive. Previously, I pointed out in the article ” 17.8%-Yielding CEFL – Diversification On Top Of Diversification, Or Fees On Top Of Fees? ” that those investors who have significant portions of their portfolios in mREITs, and in particular, a leveraged basket of mREITs such as the UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA: MORL ), could benefit from diversifying into an instrument that was highly correlated to SPY. The UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is highly correlated to SPY, while only 5% of the variation in daily returns for MORL can be explained by the daily variation in the S&P index. Since CEFL yields almost as much as MORL, this suggests that a portfolio consisting of both MORL and CEFL would have almost as much yield as a portfolio with only MORL, but considerably less risk. Adding BDCL to such as portfolio could result in a more efficient risk/return profile. There is an unlevered fund that uses the same index as BDCL – the UBS ETRACS Wells Fargo Business Development Company ETN (NYSEARCA: BDCS ). BDCS could also be a good investment for those who want higher yields and want to use their own leverage to do so. Buying BDCS on a 50% margin would return a higher, or at least comparable, yield to buying BDCL for those who could borrow at LIBOR or some similar level. Many retail investors cannot borrow at interest rates low enough to make buying BDCS on margin a better proposition than buying BDCL. However, larger investors with access to low margin rates might do better by buying BDCS on margin. Even some small investors could do better buying BDCS rather than BDCL, in some cases. For example, an investor might have $10,000 in a brokerage account in a money market fund and want to get at least some return by investing a small part of the $10,000 in BDCL or BDCS. Most brokerage firms pay just 0.01% on money market funds. The annual return on $10,000, at 0.01%, is $1 per year. If this hypothetical investor were thinking of either investing $1,000 of his $10,000 in BDCL and keeping $9,000 in the money market fund, or investing $2,000 of his $10,000 in BDCS and keeping $8,000 in the money market fund, either choice would entail the same amount of risk and potential capital gain. This is because BDCL, being 2X leveraged, would be expected to move either way twice as much as a basket of Business Development Companies, while BDCS would move in line with a basket of Business Development Companies. For this hypothetical investor, his effective borrowing cost is the rate on the money market fund. Thus, his income from the $2,000 of his $10,000 in BDCS and $8,000 in the money market fund should exceed that of $1,000 of his $10,000 invested in BDCL and $9,000 in the money market fund, since his effective borrowing rate on the extra $1,000 invested in BDCS is less than what the imputed borrowing cost that BDCL uses. As I indicated in the article ” BDCL: The Third Leg Of The High-Yielding Leveraged ETN Stool ,” the 44 Business Development Companies that comprise the index upon which BDCL is based are a varied lot. Medallion Financial finances taxi cab companies. ACAS manages $20 billion worth of assets, including American Capital Agency Corp. (NASDAQ: AGNC ) and American Capital Mortgage Investment (NASDAQ: MTGE ), which are mREITs that are included in MORL. Each of the 44 Business Development Companies that comprise the index upon which BDCL is based have their own specific risk factors. The power of diversification can make a portfolio now comprised mainly of high-yielding interest rate-sensitive instruments more efficient when BDCL is added to that portfolio. As I explained in the article ” 30% Yielding MORL, MORT And The mREITs: A Real World Application And Test Of Modern Portfolio Theory ,” a security or a portfolio of securities is more efficient than another asset if it has a higher expected return than the other asset but no more risk, or has the same expected return but less risk. Portfolios of assets will generally be more efficient than individual assets. Compare investing all of your money in one security that had an expected return of 10% with some level of risk to a portfolio comprised of 20 securities each with an expected return of 10% with the same level of risk as the single security. The portfolio would provide the exact same expected return of 10%, but with less risk than the individual security. Thus, the portfolio is more efficient than any of the individual assets in the portfolio. My projection of $0.9366 for the BDCL July 2015 dividend would be an annual rate of $3.7427, based on the trailing four quarters. This would be a 18% simple yield, with BDCL priced at $20.85 and an annualized quarterly compounded yield of 19.2%. If someone thought that over the next five years market and credit conditions would remain relatively stable, and thus, BDCL would continue to yield 19.2% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $240,602 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $18,100 first-year annual rate to $46,195 annually. BDCL prices and dividends as of June 24, 2015 Company Name Ticker Weight(%) Price Ex-date Dividend Contribution Ares Capital Corp. ARCC 9.95 16.57 6/11/2015 0.38 0.0961401 American Capital Ltd. ACAS 9.55 13.95 0 FS Investment Corp. FSIC 9.41 10.32 6/22/2015 0.2228 0.0855944 Prospect Capital Corp. PSEC 9.38 7.75 8/27/2015 0.0833 0.1274347 Apollo Investment Corp. AINV 6.46 7.29 6/17/2015 0.2 0.0746716 Main Street Capital Corp. MAIN 4.86 32.34 8/18/2015 0.175 0.0506532 Fifth Street Finance Corp. FSC 4.46 6.88 8/12/2015 0.06 0.0491631 TPG Specialty Lending Inc. TSLX 3.23 17.94 6/30/2015 0.39 0.0295846 Golub Capital BDC Inc. GBDC 3 16.87 6/16/2015 0.32 0.023976 Hercules Technology Growth Capital Inc. HTGC 2.98 11.84 5/14/2015 0.31 0.0328735 TCP Capital Corp. TCPC 2.84 15.49 6/12/2015 0.36 0.0278093 New Mountain Finance Corp. NMFC 2.83 14.74 6/12/2015 0.34 0.0275035 PennantPark Investment Corp. PNNT 2.74 9.25 6/11/2015 0.28 0.0349452 Triangle Capital Corp. TCAP 2.55 24.24 6/8/2015 0.59 0.0261505 Solar Capital Ltd. SLRC 2.51 18.47 6/23/2015 0.4 0.0229027 Capital Southwest Corp. CSWC 2.22 50.29 5/14/2015 0.1 0.0018599 BlackRock Kelso Capital Corp. BKCC 2.22 9.31 6/16/2015 0.21 0.0210981 Medley Capital Corp. MCC 2.03 9.34 5/18/2015 0.3 0.027472 TICC Capital Corp. TICC 1.65 6.87 6/12/2015 0.29 0.0293458 THL Credit Inc. TCRD 1.41 12.05 6/11/2015 0.34 0.0167622 Fifth Street Senior Floating Rate Corp. FSFR 0.98 10.01 7/30/2015 0.1 0.0123747 Fidus Investment Corp. FDUS 0.86 16.18 6/9/2015 0.4 0.0089578 KCAP Financial Inc. KCAP 0.77 6.15 7/1/2015 0.21 0.0110778 MVC Capital Inc. MVC 0.76 10.28 4/23/2015 0.135 0.0042051 Medallion Financial Corp. TAXI 0.75 8.72 5/12/2015 0.25 0.0090595 PennantPark Floating Rate Capital Ltd. PFLT 0.73 14.48 6/11/2015 0.095 0.0060537 Garrison Capital Inc. GARS 0.73 15.09 6/10/2015 0.35 0.0071338 Gladstone Investment Corp. GAIN 0.71 7.74 6/17/2015 0.0625 0.0072467 Capitala Finance Corp. CPTA 0.67 16.14 12/18/2015 0.05 0.0026235 Alcentra Capital Corp. ABDC 0.64 13.7 6/26/2015 0.34 0.006692 MCG Capital Corp. MCGC 0.63 4.71 8/18/2014 0 Gladstone Capital Corp. GLAD 0.56 8.1 6/17/2015 0.07 0.0061171 Stellus Capital Investment Corp. SCM 0.56 11.88 6/26/2015 0.1133 0.0067506 Solar Senior Capital Ltd. SUNS 0.53 16.2 6/23/2015 0.1175 0.0048589 Monroe Capital Corp. MRCC 0.52 14.9 6/11/2015 0.35 0.0051464 TriplePoint Venture Growth BDC Corp. TPVG 0.49 13.24 5/27/2015 0.36 0.0056135 American Capital Senior Floating Closed Fund ACSF 0.45 12.73 7/22/2015 0.097 0.0043341 Newtek Business Services Corp. NEWT 0.41 18.25 6/25/2015 0.47 0.0044488 Horizon Technology Finance Corp. HRZN 0.4 12.7 8/17/2015 0.115 0.0045782 OHA Investment Corp. OHAI 0.36 5.75 6/26/2015 0.12 0.0031655 OFS Capital Corp. OFS 0.31 12.39 6/12/2015 0.34 0.0035842 Harris & Harris Group Inc. TINY 0.3 2.77 0 WhiteHorse Finance Inc. WHF 0.3 12.85 6/17/2015 0.355 0.0034919 CM Finance Inc. CMFN 0.29 13.5 9/16/2015 0.3469 0.0031397 Total 0.9365937 Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long BDCL, MORL, CEFL AGNC. (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.

Selling At The Best And Worst Possible Times

In a previous article, I expanded on Peter Lynch’s “high and low analysis.” That view looked at potential returns had you bought at the high and low price each and every year. This commentary takes the opposite view: seeing what happens if you sold at the high and low price each and every year. In a previous article , I expanded upon Peter Lynch’s “high and low” analysis. This involves looking at what would have happened if you invested at the very best and worst times (the high and low price, respectively) each and every year. The process was simple, but the takeaway is enormously instructive: “Investing at the high or low, especially over the long term, is not the difference between positive and negative returns. The difference between perfect timing and miserable timing over lengthy time periods is perhaps a couple of percent. Once you figure this out, it becomes clear that you should be focusing on the amount you can contribute and utilizing a long time frame, rather than concerning yourself with unknowable short-term fluctuations.” In Lynch’s example, the difference between perfect yearly purchases and dreadful annual timing was about 1% per annum. In my example, the difference was slightly larger, but the basic conclusion remained intact: “it’s not about timing the market, it’s about time in the market.” These demonstrations were based on the purchase side: “what happens if I bought each and every year?” For this article, I wanted to focus on the selling side. To make the process simple, we can rely on the same high and low price information as generated by the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Here’s a look at the low price from each year dating back to 1996: Year Low Date Price 1996 1/10/96 $59.97 1997 4/11/97 $73.38 1998 1/9/98 $92.31 1999 1/14/99 $121.22 2000 12/20/00 $126.25 2001 9/21/01 $97.28 2002 10/9/02 $78.10 2003 3/11/03 $80.52 2004 8/6/04 $106.85 2005 4/20/05 $113.80 2006 6/13/06 $122.55 2007 3/5/07 $137.35 2008 11/20/08 $75.45 2009 3/9/09 $68.11 2010 7/2/10 $102.20 2011 10/3/11 $109.93 2012 1/3/12 $127.50 2013 1/3/13 $145.73 2014 2/3/14 $174.17 Additionally, we have the high price available as well from the same article: Year High Date Price 1996 11/25/96 $76.13 1997 12/5/97 $98.94 1998 12/29/98 $124.31 1999 12/29/99 $146.81 2000 3/24/00 $153.56 2001 2/1/01 $137.93 2002 1/4/02 $117.62 2003 12/31/03 $111.28 2004 12/29/04 $121.36 2005 12/14/05 $127.81 2006 12/14/06 $143.12 2007 10/9/07 $156.48 2008 1/2/08 $144.93 2009 12/28/09 $112.72 2010 12/29/10 $125.92 2011 4/29/11 $136.43 2012 9/14/12 $147.24 2013 12/31/13 $184.69 2014 12/29/14 $208.72 Let’s imagine that you want to supplement your dividend income , such that you take all of the dividends and also begin selling some shares along the way. Now, assuredly it is the goal of a great deal of people to never have to sell a share. However, that doesn’t mean that everyone must follow this route. Nor does it mean that we can’t think about the process. For illustration, let’s imagine that you have a portfolio balance of $1,000,000 back in 1996 (the number isn’t important, just the underlying math). Your idea is to buy shares in an assortment of holdings (in this case an index fund), collect the dividend payments and supplement this by selling an amount of shares each year. Let’s imagine that you want to sell $25,000 worth of shares beginning in 1997, followed by a 2% larger amount in the subsequent years. Here’s what your sold shares would need to amount to through the years: Year Sold Shares 1997 $25,000 1998 $25,500 1999 $26,010 2000 $26,530 2001 $27,061 2002 $27,602 2003 $28,154 2004 $28,717 2005 $29,291 2006 $29,877 2007 $30,475 2008 $31,084 2009 $31,706 2010 $32,340 2011 $32,987 2012 $33,647 2013 $34,320 2014 $35,006 Note that I’m taking a bit of a shortcut here. In reality, instead of focusing solely on the amount of shares you want to sell each year, you’d like to focus both on dividends received and the amount of shares needed to sell in a given year depending on your income requirement. However, with the high and low prices varying dramatically in dates, it’s a rather manual process to figure out the dividends received. It’s not uniform such that sometimes you have more than a year between the high or low price in two consecutive years and sometimes the time frame is just a few months. However, for our purposes, the illustration of selling a certain dollar amount of shares each year will work nicely. Let’s begin by seeing what happens in a “best case” scenario. The low price in 1996 was just under $60 per share. If you bought at this time, you would have been able to purchase 16,675 total shares. Additionally, your expected annual dividend income would have been about $21,000. We can now move on to the process of selling. In 1996, you were able to purchase shares at the best possible time. Let’s presume that you’re also able to sell shares at the best possible time – the highest price of every single year. In 1997, the highest share price was just under $99. In order to generate $25,000 in additional income, you would need to sell roughly 253 shares. As a result, your share count would go down to 16,422 or thereabouts. And so the process continues; in 1998, the highest share price was just over $124. In order to generate $25,500 in supplemental income, you would need to sell 205 shares, bringing your total share count down to 16,217. Here’s a look at your year-end share count from 1996 through 2014 if you kept selling at the high each year: Year Shares 1996 16,675 1997 16,422 1998 16,217 1999 16,040 2000 15,867 2001 15,671 2002 15,436 2003 15,183 2004 14,947 2005 14,718 2006 14,509 2007 14,314 2008 14,100 2009 13,818 2010 13,561 2011 13,320 2012 13,091 2013 12,905 2014 12,738 At first glance, this looks like pretty bad news. You started with 16,675 shares, and nearly two decades later, you’ve sold almost 4,000 shares, bringing your total share count down to “just” 12,700. Yet, it’s important to remain cognizant of what this indicates. Your share count has been reduced, that much is obvious. What’s not as apparent is the idea that you would actually be getting richer over time. Your $1 million beginning portfolio balance would now be worth nearly $2.7 million. Further, in the last 12 months, this amount of shares still would have generated $50,000 worth of dividend payments. Contrary to what many suppose, selling shares doesn’t have to be an exhaustive process to zero. I’m not necessarily personally advocating for this method, but it’s instructive to know that this option exists nonetheless. In this particular case, you would have collected hundreds of thousands in dividends, sold over half a million in shares through the years and still ended up much richer. Of course, this was also a best-case scenario – buying at the low and selling at the high every single year. Let’s take a look at the “worst case”: buying at the high and selling at the low every single year. In 1996, shares of the index traded as high as $76. Had you purchased shares at this price, you would have begun with 13,135 total shares – noticeably lower than the “best” case of buying at the low. Additionally, your expected annual dividend income would be about $17,000. (We could adjust for this in the example, but the illustration is the important part). In 1997, the low share price reached about $73. In turn, in order to reach your $25,000 supplemental income goal, you would need to sell about 341 shares. This would bring your total share count down to fewer than 12,800 (basically where the other example ended). Wash, rinse, and repeat. Here’s a look at your year-end share count each year after selling shares to reach your additional income goals: Year Shares 1996 13,135 1997 12,795 1998 12,518 1999 12,304 2000 12,094 2001 11,816 2002 11,462 2003 11,113 2004 10,844 2005 10,586 2006 10,343 2007 10,121 2008 9,709 2009 9,243 2010 8,927 2011 8,627 2012 8,363 2013 8,127 2014 7,926 Once more it’s obvious that your share count will be reduced each and every year. Moreover, it’s also apparent that this situation is markedly worse than the “best case” scenario. Yet, the output provided here is perhaps even more instructive. You began with a $1 million balance that was purchased at the worst possible price point. Then you went on to make sale after sale at the worst possible time each and every year. However, those 7,900 shares would now be worth almost $1.7 million. Further, over the last 12 months, these shares would have provided over $31,000 in dividend income. Expressed differently, even if you bought and sold at the worst possible moments, you would still get richer over time (with a larger cash flow to boot). The reason this works is due to “selling in moderation.” Obviously, you can’t go out and sell 15% of your portfolio each and every year and expect to end up with a higher portfolio balance over time. However, when done purposefully, selling shares and getting richer do not have to be opposite notions. The thing of it all is that you’re not going to complete either exercise. You’re not going to have perfect timing and you’re not going to have the worst possible timing year-in and year-out. Mathematically it just won’t occur. Yet, even if you did, at least in this illustration, it has been no great tragedy. Regardless of the situation you still ended up with a higher balance. Much like the previous example of consistently buying, it seems that having an underlying plan – rather than figuring out the “best” timing – is a much more important factor. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.

Evaluating Managers During Market Extremes

Summary Investing is a probability-based exercise; therefore, having a good decision making process is vitally important. Emotions and investing do not play well together and often lead to poor decisions. Investors should ultimately evaluate investments/managers in a way that minimizes emotional corrosion. Capital markets have a rhythm over the long term. They ebb and flow, creating investor sentiment that fluctuates between euphoria and despair. This pattern is one of the key impediments to becoming a successful investor. In order to succeed, one must master not only investment knowledge, but also investor psychology. Deciphering and filtering large amounts of data in order to make a successful investment is not enough. Investors must also control their emotions which often lead them to poor decisions. Looking at the stock markets today, the S&P 500 and the MSCI All Country World (“ACWI”) continue to climb in spite of lukewarm economic data. Through May 31st, the S&P 500 and ACWI are up 3.2% and 5.4%, respectively. This is quite a return when considering the U.S. Gross Domestic Product was reported down 0.2% for the first quarter. The three-year returns for the S&P 500 and ACWI were also very robust as these markets gained 68.0% and 53.9%, respectively. This pattern has been in place since the bottom of the market was established in early 2009. While the stock market recovery has allowed investors to regain losses from the financial crisis, the euphoria caused by accelerating markets can create doubt in one’s investment philosophy. This can overwhelm an investor’s ability to achieve their investment objectives because it can cause them to “chase returns” or “reach for yield” at the exact time in which they should be exhibiting discipline in their investment philosophy/process. At Highland, our overarching investment philosophy is one rooted in risk management. We believe investors should prudently seek return in a manner which protects them during difficult markets (i.e. large market declines). This philosophy leads us to managers which exhibit certain characteristics: Downside protection: losing less than the overall market during large, protracted declines; emphasis on intrinsic value: the price of an investment does matter; lower long-term volatility: a more consistent return pattern than the overall market (i.e. shorter peaks and troughs); and long-term time horizon: longer holding periods allows for an investment thesis to properly play out. By investing in managers which exhibit these characteristics, we believe that our investors can outperform the overall market over longer periods of time. However, in order to properly execute this philosophy, an investor must remain focused on the long term and remain patient. The goal of this approach is to enhance one’s ability to stick with their investment strategies during very difficult markets. Ironically, this investment approach tends to be most difficult to stomach during periods of rapidly appreciating markets as it and these types of managers will tend to underperform. For this reason, we will focus on evaluating managers during euphoric markets and how to determine if your objectives are still being met. Traditional Evaluation Methodology The most commonly used method to evaluate managers is to simply compare their historical performance to that of a benchmark index. While many different methods can be used, the most common method is annualized time-weighted returns. Figure 1 illustrates time-weighted returns of a global equity manager utilized by Highland: Figure 1 (click to enlarge) In order to evaluate the success of a manager, an investor must first define/understand what they mean by success. Many investors simply define success as a manager outperforming their respective benchmark. Using this measure of success, it appears that the global manager has been struggling to achieve success over the past three and five years. Based upon this analysis, an investor might be tempted to terminate the manager in search of a manager that has provided above-benchmark returns. At Highland, we believe that success is defined by an investor’s ability to achieve their long-term investment objectives. Ultimately, it is not only the return, but also how you achieve the return that determines success. We believe success is determined by the following: Outperforming the benchmark over the long term (minimum of 5-year rolling periods). Protecting capital during difficult markets. Exhibiting an overall volatility lower than the benchmark. The traditional type of analysis ultimately fails to determine success for two reasons. First, only one aspect of success (return) is being examined. Second, it can lead to poor decisions. Figure 2 compares Manager A’s and Manager B’s time-weighted returns. This chart illustrates the value added/subtracted (manager return minus benchmark return) over several time periods. Which manager would you choose? Most would pick Manager B because the value add is much higher and consistent than Manager A. The problem is that A and B are the same manager (see Figure 1 ). The only difference is that A represents data through May 31st and B represents data through February 28, 2009. This illustrates one of the major flaws with utilizing only time-weighted returns in your analysis, which is endpoint sensitivity . Figure 2 (click to enlarge) Endpoint sensitivity is a phenomenon which occurs when the conclusions of an analysis can be significantly altered by changing the ending data point (the ending date in this example). Highland’s investment philosophy employs strategies which seek to protect capital during difficult equity markets. This means that the managers in the portfolio tend to have less downside risk and lower overall volatility. Conversely, they tend to perform less well, on a relative basis, in big up markets. Therefore, this type of strategy often suffers severe endpoint sensitivity during market extremes, which was illustrated in Figure 2 . Highland’s Evaluation Methodology In order to minimize potentially erroneous conclusions caused by endpoint sensitivity, Highland employs additional analyses to evaluate manager success. The first is to consider rolling periods of compound returns (i.e. how consistent are a manager’s returns over longer periods of time). This type of analysis examines the entirety of a manager’s return stream to determine their probability of success. In addition, we examine a manager’s rolling excess performance over the benchmark to ensure consistency. By combining these two methods, we believe that we have a more predictable method of assessing whether a manager has the ability to add value. Figure 3 illustrates the global manager’s results based on this methodology. The results show that the manager has the ability to consistently outperform the benchmark, especially when examining longer time horizons (i.e. outperforming 100% of ten-year periods). This also shows how the results in Figure 1 are more driven by the extreme market environment and less by the manager’s ability to outperform. Figure 3 (click to enlarge) While the results in Figure 3 better account for endpoint sensitivity, they still only capture one aspect of success (return). To evaluate the risk aspect, Highland examines volatility and risk-adjusted returns to ensure a manager is providing the return profile required by our investment philosophy. There are numerous methods that can be used to evaluate risk-adjusted returns, and Highland uses most of them to analyze success. Figure 4 is one example, which examines return per unit of volatility over rolling periods (to eliminate endpoint sensitivity). Figure 4 (click to enlarge) Each of the methods used to evaluate success have their own set of pros and cons; therefore, one method cannot be used in isolation to properly judge a manager. Instead, Highland utilizes all of the methods discussed in order to determine if objectives are being met. This allows us to temper our emotions at market extremes and maintain sound judgment when it is the most difficult. We are then able to focus on the long term and put our clients in a position to achieve their investment objectives. Conclusion Conservative investment strategies can be beneficial for investors. They allow investors to stay calm and stick to their investment philosophy when markets are experiencing large corrections, which place an investor in the position to achieve their investment objectives over the long term. On the other hand, these types of strategies struggle to keep up with markets during long, protracted upswings, which could cause an investor to question the validity of a conservative strategy. It is important to understand that traditional evaluation tools at market extremes (i.e. peaks and troughs) often skew the appearance of success or failure. For this reason, Highland utilizes evaluation metrics that limit endpoint sensitivity. Therefore, investors can limit their emotions and make decisions in a manner that is prudent and most beneficial for their portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.