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Chickens And Eggs

Are you a chicken farmer, or an egg farmer? Chicken farmers raise chickens for their meat. Egg farmers raise chickens for what they lay. Investors who plan to sell their stocks to pay for college or to buy a second home are chicken farmers. Investors who hope to use the income from their investments are egg farmers. The financial press doesn’t understand egg farmers. Every day they report market prices and how they’ve changed. But they almost never report on dividends. This bias sometimes causes income-oriented egg-farmer investors to forget who they are and believe that they are chicken farmers. If they get confused, they may have a hard time reaching their goals. Prices are volatile. If you’re a chicken farmer, when you buy, and especially, when you sell, is extremely important. A chicken farmer needs to watch the market like a hawk. But if you’re an egg farmer, the most striking aspect of dividend payments is how boring they are. They just don’t jump around very much. Both kinds of portfolios need oversight, but managing a dividend stream is different. Risk doesn’t come from market swings, but from factors that endanger a company’s ability to earn profits and pay investors. Egg farmers like bear markets, especially bear markets that don’t threaten corporate revenues. When the market falls, investors can adjust their portfolios without taking gains and paying taxes. By contrast, chicken farmers hate it when prices fall. But chicken farmers love mergers and acquisitions. The buyer almost always has to pay a premium. But for egg farmers, takeovers just complicate things. Acquirers – especially serial acquirers – usually aren’t as generous with their dividends. Both approaches are valid, but they meet fundamentally different needs. So you never have to ask which comes first.

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.

Is The Value Style Outperformance Sustainable?

Until the market’s (S&P 500 Index) recent rebound from the February 11, 2016 low, investors have essentially gone two years with flat returns in stocks. Certainly it has not been a market that has just traded sideways, but one with significant volatility, both up and down. The most recent recovery has pushed the S&P 500 Index back into the trading range in place since late 2014. Technically, this recent rally into the higher range opens up the potential for the Dow to move to the top of this higher range, 18,300 and the S&P 500, 2,130. Contributing to the improved equity market since the February bottom has been the strength in value and cyclically oriented sectors: energy, financials and industrials. As the below chart shows, energy is up 15.8%, financials are up 14.4% and industrials are up 11%. These three sectors are more heavily weighted in the value oriented indices like the iShares S&P 500 Value Index (NYSEARCA: IVE ). Financials account for over 25% of the value index versus an 8% weighting in the growth index (NYSEARCA: IVW ). Energy represents 12% of the value index versus only 1% in the growth index. The improvement in the value segments of the market has led to the large value index outperforming its large growth counterpart since the February bottom and so far in all of 2016. One reason investors should consider maintaining a written record of their thoughts around their market decisions is the ability to go back and review the outcome of those decisions. With respect to this value/growth phenomenon taking place in 2016, the market went through a similar adjustment in early 2014. I wrote a post on March 26, 2014, almost exactly two years ago, Why It Matters That Value Stocks Are Outperforming Growth Stocks . Subsequent to that post, and for the following two years, growth actually outperformed value. Click to enlarge One factor I noted in the 2014 post was value would outperform if economic activity was strengthening. What actually occurred though was a peak in GDP growth at 4.6% in Q2 2014 which declined to 2.1% in Q4 2014 and .6 in Q1 2015. In fact, economic growth weakened and growth resumed leadership until the beginning of this year. One economic variable discussed in the post from two years ago was the strength in industrial production. Until January’s data was reported in February, the monthly change in industrial had been negative for three consecutive months. As the below chart shows, industrial production exhibited strength in January. Additionally, manufacturing was positive on a year over year basis with Econoday noting, “Total year-on-year industrial production also remains in the negative column, at minus 0.7 percent, a disappointment but a contrast to manufacturing where the year-on-year rate is modest but accelerating, at plus 1.2 percent.” “A negative in the report is a downward revision to December, to minus 0.7 percent from minus 0.4 percent. But the revision doesn’t take much away from the January surprise where strength, based in manufacturing and underscoring January’s rise in retail auto sales, should help ease concern over the economy’s first-quarter performance.” As seen in the sector chart earlier in this post, energy and financials have been strong performers in this value rebound. Energy related stocks have seen an improvement due to the increase in oil prices into the high $38/BBL area from the mid $20/BBL reached on February 11th. I am not convinced this rally in oil is sustainable given the continued oversupply in the oil market. Lastly, both large and small value have outperformed the S&P 500 Index on a long term basis going back to 1927. Of late though, value has lagged its blended index counterparts over the last 10-year time period as can be seen in the below chart. Click to enlarge Source: The BAM Alliance The takeaway for investors is the risk of going all in or all out of any one style. One can invest in the blended index of course, or simply tilting one’s allocation between growth or value may be a better approach. With that said, maybe a tilt towards value is an opportunity at this point in time. The one caution is the much higher weighting in energy within the value index and the anticipated volatility in energy prices.