Tag Archives: premium-authors

Do Price Targets Matter In Volatile Markets? (And, Why Alpha Theory Should Be A Starting Point Even In Turbulent Times)

This blog was co-authored with Alpha Theory’s Customer Relations Manager, Dana Lambert. “Stock prices will continue to fluctuate – sometimes sharply – and the economy will have its ups and downs. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.” – Warren Buffett, famed investor “While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. “- Bill Ackman, Pershing Square 3Q08 Investor Letter The recent market environment has proven challenging for many funds, including Alpha Theory clients. The market has been volatile, but the real challenge is directionality. As of September 28, the S&P was down 11% over the prior 49 trading days, with 30 of the 49 days being down. Alpha Theory clients generally benefit from pure volatility (large ups and downs without a direction) because they are buying on dips and selling on rises (mean-reversion). The problem with a uniformly down directional market is that clients are continually getting indications to add to their longs and trim their shorts – the proverbial “catching the falling knife”. Although Alpha Theory cannot overcome persistent negative correlation between scenario estimates and outcomes – in other words inaccurate research – it does offer three options to help clients deal with these circumstances. OPTION #1 – RAISE PREFERRED RETURN. When the price of an asset falls, its probability-weighted return (PWR) rises. When the PWR rises, the normal action is to increase your position size. But when all asset prices fall, all PWRs rise and thus the longs become more attractive and the shorts less so. This suggested increase in long exposure may not be tenable and there may be a general skepticism regarding the price targets. In this situation, a manager can raise the preferred return for longs and thus raise the ‘hurdle rate’ required to be a full position in his or her fund (i.e., before you required only a 40% PWR to be a full position, but in this market environment you require 60%). This will immediately lower long exposure and only suggest adding to the best ideas. In the extreme example of February 2009, clients raised their hurdle rates to 70% or 80% and were able to see quickly numerous compelling ideas and how to shift capital appropriately. OPTION #2 – RELATIVE INDEX ADJUSTMENT. As the market falls, the “market multiple” decreases – which has ripple effects through the price targets in Alpha Theory. For those who cannot re-underwrite all of their targets for the new market paradigm, the application offers an easy-to-use feature called ‘Relative Index Adjustment’. This basically adds back the move of the market to an asset’s expected return, and the following would be an illustrative example. If the market is down 11%, then most assets’ prices will also be down and their suggested position sizes will increase. Now let’s turn on the Relative Index Adjustment. If every asset is down 11%, commensurate with the market move, then Alpha Theory will adjust the prices so that there is no change (-11% Stock Move minus -11% Market Move = 0% change) and thus no suggested change in position size. The beauty of this system is that you can turn it on and off and the Market Move is calculated since the last price target update. So if an analyst updates a price target, the Market Move gets set back to zero because the analyst would take into account the new “market multiple.” OPTION #3 – RE-UNDERWRITE CONSERVATIVE PRICE TARGETS. Fundamental investors recognize that there is no absolute intrinsic value for each asset because their assumptions are subjective. There is, however, a range of assumptions that span from aggressive to conservative. Down markets imply that pushing your assumptions to the conservative end of the spectrum may be appropriate. After doing this, you can see which assets are still suggested buys and which are not. The confidence imbued by using the most conservative assumptions allows you to be aggressive with add and trim decisions. A few views to help isolate where to start the re-underwriting process are: Performance view : shows those assets that have suffered the most on an absolute and relative basis Group by Risk/Reward within 10% : groups the assets that are within 10% of Reward and 10% of Risk targets (click to enlarge) While consideration of the aforementioned steps certainly is appropriate, as you develop conviction about downward directionality for the market, it is also worth noting that volatile markets can often be followed by periods of relative calm and distinct upwardly-biased directionality – and of course this has been the pattern for the past several years now. So where in one week an analyst or PM sees a 1-year target as likely to be unachievable, the next week suddenly the expected return gap narrows considerably. In short, just when you may be losing faith in your targets, they can quickly fall back into an attainable range. Directional markets that move quickly are challenging for many reasons. It is easy to throw up your hands and rationalize that “price targets don’t matter” or “our research is wrong”. It is hard to restrain those emotions and redouble your efforts to find the value that has been exposed in the quick, volatile relocation of asset prices. To do so requires a rigorous, disciplined process that begins with retesting assumptions (i.e., raising return hurdles, adjusting for the market move, and setting more conservative targets). If, after re-underwriting price targets and portfolio inputs, Alpha Theory is still recommending upsizings, then you can feel confident in your actions … even in a volatile, directional market.

Value Seen In Muni Bond Closed-End Funds

Guest Paul Mazzilli, Independent Fund Consultant and Senior Advisor for S-Network Global Indexes, shares his thoughts on the current attractiveness of municipal bond closed-end funds: Their ability to use leverage very effectively. Wide discounts: share price dislocation versus net asset values. The potential impact of the Puerto Rico debt crisis. TOM BUTCHER: I’m here with Paul Mazzilli, Senior Advisor to S-Network Global Indexes. ETF providers often seek to partner with innovative third-party index developers like S-Network. Using his extensive knowledge of the closed-end fund market, Paul was instrumental in the development of the S-Network Municipal Bond Closed-End Fund Index. Paul, why may municipal bond closed-end funds be attractive for investors right now? PAUL MAZZILLI: There are three attractive aspects of municipal closed-end funds, all of which are working together right now. The first, as a closed-end fund, they have a set investment, they’re run by professional managers, and since they don’t have assets coming in and out like an open-end mutual fund, they can buy less-liquid, higher-yielding securities like private placements, non-rated bonds, and they’re not forced to sell bonds when people are seeking out liquidity. The next is a unique aspect of municipal closed-end funds. They have the ability to leverage. When a closed-end fund leverages, it will borrow against its own assets and buy more bonds. Here is a simple example: For a $100 million closed-end fund, the most it’s allowed to borrow is one-third leverage. It can borrow $50 million and buy another $50 million of bonds. The $100 million in assets becomes $150 million invested. If the underlying bonds are yielding 4%, the leveraged fund would yield 6%, approximately, before any incremental costs. You get almost a 50% increase given this ability to leverage one third. The final thing is that after closed-end funds are issued, they trade as stocks in the marketplace. Based on demand and supply, they can trade rich to their value [at a premium], or they can trade cheap to their value [at a discount]. Right now, they’re selling historically cheap at about a 10% average discount. The 25-year average discount is approximately 2%. So when you’re selling at a 10% discount, if you’re buying a dollar of assets for $0.90, if you had an asset yielding 10%, you’re actually getting an 11.1% yield on the money you’re putting up. This fact that they’re trading at a discount is happening right now because investors are fearful of the Fed raising rates. They are fearful of the equity markets, they’ve been raising cash since they’ve traded stocks, they’re selling them, they’re not looking at the underlying value, and it’s created a real buying opportunity. The discount has one other final advantage: If bonds were to sell off, but you’re buying at a 10% discount and it goes to a 5% discount, you actually could have a capital gain, even though the underlying bonds sell off. BUTCHER: Is the prospect of debt restructuring in Puerto Rico going to have any impact on municipal bond closed-end funds? MAZZILLI: Very good question. I think there are two different aspects. First, what does Puerto Rico do to the general municipal bond market? It is a significant issuer. It could have some impact in terms of how bonds trade. I personally believe a lot of that is already reflected in the market. Second is, what does it do to our index of municipal closed-end funds [S-Network Municipal Bond Closed-End Fund Index, CEFMX]? Our index currently has a very low exposure of about 0.43% to Puerto Rico. And that comes from two reasons. One: municipal closed-end funds tend to buy higher-quality funds, which would exclude Puerto Rico right now, or in the past. Two, we buy only national municipal closed-end funds, or our index represents only national municipal closed-end funds. And the national funds buy very little Puerto Rico exposure because they have a lot of other ways to diversify. BUTCHER: Paul, thank you very much for joining me today. MAZZILLI: Thank you. Index returns are not Fund returns and do not reflect any management fees or brokerage expenses. Investors cannot invest directly in the Index. Returns for actual Fund investors may differ from what is shown because of differences in timing, the amount invested and fees and expenses. Index returns assume that dividends have been reinvested. S-Network Municipal Bond Closed-End Fund Index is a rules based index intended to serve as a benchmark for closed-end funds listed in the US that are principally engaged in asset management processes designed to produce federally tax-exempt annual yield.

Choose The Game You Play Wisely

Expert decision making, especially in the stock-picking world, is not reliable. Stock picking by speculators is not a skill that can be mastered. Value investing needs to be thought of in the context of playing the long-term odds. Daniel Kahneman’s remarkable work, ‘ Thinking Fast and Slow ‘, discusses in detail overconfidence in the professional world and when experts can be trusted in their predictions. He had collaborated with psychologist Gary Klein on a project that researched this very question, as Klein was prone to believe that expert intuition was to be trusted when a decision had to be made, while Kahneman had concluded that algorithms are more trustworthy than human intuition. Their work was interesting, to say the least. Kahneman felt that algorithms could drown out the noise that human emotion brought to the decision-making process, but Klein laughed at the very thought of a machine making a critical decision in the heat of the battle. After numerous discussions and long debates, the question was asked what type of “expert” they were analyzing? Klein had in mind nurses and fire fighters and the like; people who had to make split-second decisions because lives depended on it. However, Kahneman had been thinking of political science forecasters and stock pickers. Kahneman had earlier done studies at a financial firm, analyzing the company’s stock advisors. His findings were not encouraging. Kahneman had been given data on the firm’s advisors and their records over the course of an 8-year period. When the rankings of the advisors were compared year by year, Kahneman found a correlation .01 – basically showing that the stock-picking skill was non-existent within the firm. Those who did well one year were likely to do worse the following year and vice versa; regression to the mean prevailed. He notes that the executives at the firm as well as the advisors basically swept the findings under the rug. They were collecting fees from their clients anyway, right? Kahneman and Klein concluded that stock picking occurs in a low-validity environment. There are no set rules to play within, like a grandmaster would encounter in a game of chess. Intuition can be trusted in such a high-validity world, proven by Gary Kasparov’s success against IBM’s (NYSE: IBM ) Deep Blue in a number of man vs. machine chess matches. The stock-picking world is different, with too many variables and moving parts to ever become “skilled” or “expert”. Stock picking is more like the roll of the dice than a game of poker, according to Kahneman. This is why mutual funds, with their fees and transaction costs, constantly underperform the overall markets. Just ask Jack Bogle! However, anyone who has been around the investing world for more than about 10 minutes is familiar with Warren Buffett’s ‘ The Superinvestors of Graham-and-Doddsville ‘. Mr. Buffett eloquently refutes the idea that the stock market is efficient and discredits the belief that success in investing comes down to a coin flip. It is hard to argue with Mr. Buffett’s logic, backed by his exceptional and illustrious decades-long performance. Buffett fits Kahneman’s description of the former in the “hedgehog and the fox” parable. The hedgehog is good at one thing. He believes himself to be an expert and, so, is overconfident in his predictions. The fox is a more global thinker and opened-minded. He is mindful of the black swan and concedes that he will be wrong on occasion. He constantly questions his position and looks for flaws in his logic. While the hedgehog’s ego prevents him from admitting his mishaps, the fox looks at mistakes as learning opportunities. The fox has historically outperformed the hedgehog. So, what can we conclude from all of this? Many have gone into great detail on the differences between speculating and investing. I categorize Kahneman’s group of stock advisors as speculators, as I do many money managers of today. They have little incentive to outperform the indexes, but their careers are on the line if they make a wrong call. Due to the structure and competitiveness of corporate America and the “instant gratification” mindset that characterizes today’s “investors”, money managers don’t have 5 years to wait for an investment to pan out. Status quo keeps them employed. The proven way is the long-term, value investment strategy employed by Buffett and his skulk of foxes. A true poker player knows that he’ll succeed eventually, if he continues to play the odds. Know that you will occasionally be wrong, keep an open mind, learn from your mistakes, and don’t listen to the pundits of mass media. Speculating is a game of roulette; invest like you’re playing Texas Hold ’em for the long term.