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:
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.
