Monday, May 16, 2016

Institutional Investor Teach-in Part 3: Security Selection

The Art of Security Selection

Once we determine the appropriate allocation across high/low/alternative beta sleeves, the security selection process begins. Assets are invested using Exchange Traded Funds (ETFs). ETFs have come to prominence in the past decade as an alternative to mutual fund investments. One of their benefits is that they can trade throughout the day and offer the liquidity of a stock with the diversification of mutual funds.

How do we determine which ETFs to put in your portfolio?

First, from a due diligence standpoint, it is worth mentioning that we’ve learned what doesn’t work:

What doesn’t work? The intent is not to sound casual or flippant, although we dedicate little attention to investment-related news, Wall Street analysts, company management, consensus earnings expectations and companies’ self-reported results. We’d rather “turn off the T.V.” and “put down our books.” We have a strong belief that most of the abovementioned sources of information are just “noise.” If this sounds different than what other investment managers say, it should.

To illustrate why, consider the following surprising and unpredicted market reactions to the most important market-related events over the last 15 years:

·         The U.S. hikes interest rates for the first time in 9 years and bonds trade up (December – February 2016)
·         The U.S. loses its AAA credit rating from Standard and Poors and treasury bonds trade up (Summer of 2011)
·         9/11 occurs and oil goes down. The stock market bottoms in 2002.
·         The U.S. Federal Reserve injects money-center banks with over $1 trillion in freshly minted money, and this fails to cause any inflation whatsoever. Commodities plummet (2008 – today)
·         Europe and Japan join the money-printing business, and this too fails to cause any inflation. Commodities plummet (2008 – today).
·         News is extremely dire and the stock market goes up (think year 2013 and consider Greece/Cyprus, the entire European Monetary Union staring into the abyss and the debt ceiling fiasco in October of that same year). The S&P rises 30%.
·         News is extremely positive and the stock market goes down. If someone told you that in 2015-2016 the unemployment rate will be at 5%, that company valuations will be extremely reasonable, company stock-buybacks will be occurring in record numbers, IPOs and mergers will be abundant, inputs costs will be at record lows (thanks to $30 oil), inflation will be low and that CNBC’s Jim Cramer’s favorite stocks — Facebook, Amazon, Netflix, Google — will be near record highs, you wouldn’t have expected two 10% + stock market swoons in the space of 4 ½ months.
·         Companies report blockbuster earnings and often trade down (pick your favorite stock)
·         Companies report disastrous earnings and oftentimes trade up (pick your favorite stock)

What does work?

Controlling Costs

As mentioned, we in exchange-traded funds (ETFs). There are over 2000 such funds, but many of them trade infrequently and charge high annual expenses. We don’t invest in those. Instead, we choose from among the most liquid, and least costly ETFs in the world to form an investment universe of about 200-250 ETFs. In other words, we capitalize on the attribute that investors have the greatest control over – costs. The cost of investing is perhaps the only part of the total return that one can control.

Understanding Supply and Demand Dynamics

From here the investment selection process becomes a work of art:

The basis of our work is an interpretation done each week of the chart patterns of almost all listed stocks and virtually all OTC stocks for which there is sufficient daily trading activity on which to form an opinion. On average, the universe of stocks, ETF and Indices comes to 5,000 individual names.

In this “bottom up” approach, judgments on individual stocks are synthesized to arrive at broader judgments on the prospective action of industry groups, market sectors and finally, the market as a whole (all of which can be invested in via ETFs). The approach to larger groupings is inductive. The objective is to be “right” in the interpretation of individual chart patterns and thereby to be right about the larger sectors, and ultimately the market as a whole. We form our opinion about every ETF based on this bottoms-up approach.

The investment universe reviewed each week is re-evaluated and updated daily for the purposes of monitoring and acting upon, as the reader will soon see, the “footprints” left by the “the Big Boys,” or larger investors.

The approach is not only purely technical (in that fundamental factors are not taken into account) but limited to an analysis of four data points: high price for the day, low price for the day, closing price and share volume traded for the day. Relative strength (i.e. how well an ETF is doing compared to the market), and moving averages are heavily relied on, but they derive from these four bits of data. Thus, the work consists purely and simply of pattern interpretation. What we will attempt to show next is that technical analysis, in coming of age, has become increasingly unbuttoned. It has long since reached the point where a case can be made for it to form the backbone of one’s investment thesis.

In essence, we actually study the supply and demand for shares directly. After all, every important change in a security’s price and volume can be thought of as changes in the supply and demand for its shares. What’s more is that it has become increasingly well known that the biggest changes in share supply and demand come from large institutional investors. This particular group has grown to have the largest influence on a security’s price. We simply try to understand their “footprints.”

Key point. It makes no difference if we are right, fundamentally, about a particular investment or market circumstance. If the “Big Boys” at Fidelity, T. Rowe Price, Vanguard, or Blackrock are selling, the security in question will go down even if we think the fundamentals suggest the opposite. The list of unpredicted market examples mentioned above provides the evidence one needs to know that fundamentals can’t be the only driver of changes in security prices.

So what kind of chart patterns are we looking at?

Simply saying that we form our opinion about a particular security based on the impression that its chart gives us shouldn’t be enough. That would be like the reader trying to picture what the Mona Lisa looks like from someone else’s verbal description. That description might read like this: 

“She is sitting with her arms folded; she is pale, but has a slight glow; her expression is somehow both stoic, pleasant, and serious all at once; trust us, this is what she looks like!”

Showing the actual picture would be appropriate now. Not the Mona Lisa, but our picture:


Disregard the coloring of each data point and look at the two parallel lines drawn below. The chart below is of the U.S. Dollar ETF (ticker: UUP) from June 2013 to June 2014.  What should be clear here is that the two parallel lines form an important boundary. It is in this boundary that share supply and demand appear to be in balance. 




Notice one key feature of the chart above. Look at the arrow just below the lower parallel line. This arrow shows that a slight amount of trading “action” took place outside of the equilibrium zone only to quickly reverse course. The message that this chart is beginning to convey is that those traders have become “trapped” selling below the security’s fair value.

Now look at the next chart below.  This is the same security several weeks later. We have added two important pieces of information. This chart shows that the security successfully “re-tested” near the point where the “trap” occurred, and never traded lower. It also shows that price action resumed northward and actually broke an important downward sloping trendline. We have a potential change in trend underway, all “kicked off” by an initial “trap.”  It is at this point that we would buy the security. We have fulfilled three criteria that form the backbone of our security selection process: a trap, a successful re-test and a break of trend in the opposite direction.



What ensued for the U.S. dollar was quite breathtaking see chart below:




What the above three criteria ensure is that we are not the “first builder on a vacant lot”. We wait for price action to stabilize before buying. We avoid catching the proverbial “falling knife”. This ultimately protects investors from drawdown. We protect you at the security selection level.  We anticipate sellers to become “trapped” out of their positions only to have to buy later at higher prices. This in turn, fuels more buying. We buy as soon as the overall trend changes from negative to positive.



Key Takeaway:

Drawdown is ultimately determined by security selection. It is important to select securities based on cost considerations, and an analysis of the supply and demand of shares directly.










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