University Endowment Trends

This paper is somewhat dated (2008), but it still points out interesting trends in university endowments over a decade or so. Note big difference in endowment size between private (especially Ivy) and public. This really sticks out when examining endowment/student.

Asset allocation shows movement out of fixed income in favor of alternative assets. Some stats (medians):

2005 Overall

n = 726
endowment size = $72 million
return = 9%
AA equity = 59.6%
AA fixed income = 20.4%
AA alternative assets = 7.6%

Interestingly, Ivy League AA in 2005 was 38.1% equity/13.0% fixed income/37.1% asset allocation.

Of course, we now know that those increased allocations toward alternative assets were a source of pain during the credit meltdown of 2008-2009. Many alt investments, particularly illiquid ones, were crushed when bid/ask spreads fell thru the floor.

Still, the attractive characteristic of many alternative assets is that they can be less correlated with other asset classes, which makes them useful for diversification purposes.

position in SPX

Suppot and Resistance Tutorial

Defining support and resistance is perhaps the most useful of all technical analysis skills. Here is a nice little tutorial on various approaches for finding support and resistance.

Leverage

Leverage is borrowing funds (i.e., using debt) to magnify potential returns. Of course, risk is also magnified when using leverage.

Nice article that explains the two edged sword of leverage and some ways to leverage in a portfolio.

The Sentiment Cycle

Anyone looking at a chart of stock prices can see that markets move in ebb-and-flow cycle patterns. In fractal-like fashion, cyclical patterns reveals themselves across various time frames--from granular minute-to-minute action to secular decade-long swings.

The nascent field of socionomics equates cycles with changes in 'social mood'--alternating periods of collective optimism and pessimism that cause investors to run with the pack (a.k.a. 'herd behavior').

Here is an interesting diagram that reflects various emotional states as a market cycle progresses. Note that extreme optimism is associated high risk. This is because euphoria has driven investors to bid up prices. At some point, extreme optimism reverses as do prices.

This model suggests that best value is obtained at lows in the sentimental cycle. Extreme pessimism drives investors to sell and to stay away from assets marked way down.

I personally find it useful to overlay these concepts on my fundamental analyses. For example, a question that I've been asking myself over the past couple of weeks is where on the diagram is general stock market sentiment currently?

We entered a bullish uptrend off the March 2009 lows. Since then, markets have been rising on increasing optimism. This has been a strong bull run, with major indexes like the S&P 500 (SPX) up nearly 100% off the lows. Now, however, the uptrend is more than 24 months old and general market valuations are extremely rich. Technically, we're approaching a level (SPX 1250) which, if decisively pierced, would reflect a trend change.

From where I sit, collective sentiment may have topped out at 'Euphoria' at the end of April (approx SPX 1370). Investors are currently at 'Anxiety' after a 7% decline from the highs. If correct, then we have more work to do on the downside. Stages of fear, panic, capitulation (e.g., 'forced selling') lie somewhere ahead. I have been trying to position accordlingly.

I'm not totally pessimistic, however, as some individual names have been beaten down to the point where the negative sentiment coupled with interesting fundamentals suggests value. Cisco Systems (CSCO) is one of those names.

Over the past few months, CSCO has reversed nearly all of its gains off the 2009 lows as recent quarters have fallen short of expectations. Sentiment in this name is horrid, and portfolio managers have been busy unwinding positions in CSCO as prices go down.

Our diagram, of course, suggests that extremely negative sentiment is likely to wring risk out of a security. Pessimism encourages selling over buying. All else equal, the lower the price of a security, the better the value.

I happen to believe that CSCO's competitive advantage is still intact and durable. Using similar reasoning to my entry into this name, I now think I can buy a large multinational company with a durable franchise, strong balance sheet, and $9 billion in free cash flow, that I conservatively value at $90 billion, for a market price of about $60 billion.

The risk, of course, is that the fundamentals of the company have been permanently impaired, and markets are in the process of revaluing the franchise.

Could be, but the current disparity (market says it's worth $60 billion; I think it's worth $90 billion), gives me a decent margin for error in my assessment.

position in CSCO, SPX

Local Farmers Market

For the past couple of years, my neighborhood has sponsored a farmers market on Sundays. This year, the weekly market will be set up in the town square.

Markets are often explained in terms of sellers and buyers. For instance, markets are often defined as places where sellers and buyers come together.

In the farmers market case, the sellers are customarily considered to be the farmers with their produce. The buyers are viewed as the neighborhood folks heading to the square with cash (broadly defined) in hand.

Generally, then, sellers are typically seen as those who bring goods and service to the market; buyers are those who bring the money.

But what exactly is money? It's often defined as a medium of exchange. But corn or apples are also mediums of exchange.

At its essence, money in the form of paper or coins is meant to represent a portion of income from productive effort. One dollar might represent 4 ears of corn from a farmers' production, or a fraction of a customer service representative's phone conversation assisting a client. It is the fungibility of paper or coins money that makes it a desirable proxy for income in social situations.

Typically, then, a farmer is seen as 'selling' 4 ears of corn to the customer service rep, who 'buys' them with a dollar bill. Just as accurately, however, the CSR can be seen as 'selling' the fraction of a service call to the farmer, who 'buys' the call with 4 ears of corn.

Precisely who the seller is and who the buyer seems a subjective matter.

More accurately, then, markets are places of trade or exchange. In market exchanges, people trade portions of their income or (when the paper or coin money used in trade is created by fiat) claims on other people's income.

Viewed thru this lens, sellers and buyers do not populate markets. Traders do.

The Case for Extreme Overvaluation

This analysis provides insight into the general relationship between aggregate stock valuations and long term returns. The study indicates a strong relationship between real returns and the level of valuation at which an investment is made.

The chart below captures one presentation of the results.

Essentially, the proposition goes like this:

The higher the market P/E ratio when an investment is made, the lower the return over the next decade.

The same thing holds true when dividend yields are low:

The lower the market dividend yield when an investment is made, the lower the return over the next decade.

This analysis suggests that, presently, markets offer little value in aggregate. Currently the S&P 500 sports a ten year normalized P/E of about 27 and dividend yield of 1.8%. Subsequent ten year returns associated with made at these levels have historically averaged about 1% annually or less.

In fact, the case could be made that current markets are extremely overvalued in aggregate.

btw, these findings very closely parallel the work of John Hussman.

position in SPX

Free Cash Flow

This weekend while doing some valuation work, I began to wonder about the free cash flow (FCF) calcuation, typically found as follows:

FCF = operating cash flow (OCF) - capital expenditures

My question: What exactly should be included in capex? In addition to the capital expeditures line item, which nearly always appears as the first item in Cash from Investing Activities directly underneath OCF, aren't other line items, such as 'acquisitions,' also capex?

By ignoring acquisitions, we would significantly over-estimate FCF for acquisitive companies like Johnson and Johnson (JNJ).

After some research and thought, however, the answer to this question is 'no.' While acquisitions are certainly a form of capex, they should typically not be included in FCF calcuation. The 'free' in FCF is supposed to denote the cash that is 'free' for deployment to shareholders after a company has laid out money to maintain and advance its current asset base. That money deployed toward a company's current asset base is what should be considered capex in FCF terms.

Acquistions nearly always involve procurement of new assets, which is one opportunity of many that FCF may be used for to enhance shareholder value (other opportunities might include new product development, issuing dividends, or paying down debt).

Thus, I have confidently concluded that I have not been miscalculating FCF all these years...

position in JNJ

Personal Stock Screen

At the RISE conference two weeks ago, many portfolio managers and analysts noted that they employed 'stock screens' to whittle the universe of possibilities into a subset more conducive to in-depth analyses. Most of the screens employed by these people are software algorithms that scour databases and identify stocks with attractive characteristics such as high return return on equity, low dividend payout ratios, or strong price momentum.

Many brokers (like Schwab) and investment info sites (like Morningstar) possess screening capability.

When looking for equity investments (not short term trades but long term investment), there is a screen that I like to employ. However, it is a low tech, non-mechanical screen--one that builds on my analytical strengths and personal taste preferences. One 'edge' that I may have over some market participants is skill in industry analysis and knowledge of factors that drive sustainable competitive advantage. I also have a taste for value, and believe that lower prices reduce risk and provide margin for error.

As such, I like to use that following criteria when looking for potential equity candidates:

Favorable industry structure. Think Porter's (1980) five forces. I like industries where the forces are favorable for industry profits over time. A pile of research suggests that choice of industry explains more variance in company profits than company-specific factors. Thus, I would rather consider stocks where the industry forces are blowing at the propsective company's back rather than in its face. It has become harder and harder, btw, to locate such favorable industry contexts.

Organizational factors. Research (e.g., Collins & Porras, 1994) suggests a number of factors that relate to sustainable competitive advantage over time, such as home grown experienced management, ideosyncratic cultures, demonstrated track records at coping with disruptive change. To evaluate these factors I need access to the inner workings of organizations. This can be obtained by personal contact, or (more frequently) by devouring what has been written about potential candidates by the media. You might be surprised at how much you can learn about organizations thru secondary sources.

Strong, dominant brands. I prefer firms that have gained mindshare with customers and marketshare from competitors. Strong brands drive higher profit margins as customers are willing to pay more for a branded goods relative to me-too generics. Moreover, large market share increases bargaining power and helps companies be a price maker rather than price taker.

High profit margins. I like enterprises that consistently produce gross profit margins north of 50% and net margins of at least 10%.

High cash/low debt. Debt reduces strategic freedom, even when the cost of credit is low. As an investor, I like my companies to have piles of cash since it is likely come back to me either directly or indirectly. As a general rule, I like to see balance sheet cash of at least 2x debt. Conceptually, I like to know that companies I own can extinguish all their debt overnight while still having a nice cash stash left over.

Free cash flow. Cash flow is the lifeblood of a business. Cash flow is also the theoretical basis for securities analysis and valuation. I am attracted to firms that generate gobs of free cash flow (FCF).

Valuation. While I review tradional valuation metrics such as P/E, I prefer valuation metrics directly employ FCF. Lots of FCF alone does not suffice--the price that you pay for the FCF is really what matters. When using my 'quick and dirty' comparison of enterprise value:FCF perpetuity, I like to see ratios of 1.0 or less. The lower the ratio, the greater the potential discount I am getting. Stated another way, cheap valuations provide higher 'margin for error' in my decisions.

Once I have a list of candidates, I can do more in-depth assessment. I can also overlay my macro view on candidates to get a more complete picture of risk vs reward.

Currently, my screen whittles down the universe of stocks into a pretty small list.

References

Collins, J.C. & Porras, J.I. 1994. Built to last. New York: Harper Business.

Porter, M.E. 1980. Competitive strategy. New York: Free Press.

Managing Real Risk

Last week's RISE conference reiterated my sense that portfolio managers generally do not manage tail risk well. They have been raised on the portfolio theory concept and know how to manage idiosyncratic, security specific risk. But they are largely unprepared for systemic risk that takes all risky assets down in a correlated fashion.

Coincidently, this morning I happened across this article on John Mauldin's fine site. The author distinguishes between trivial risk and real risk. Real risk is the risk that can wipe you out. He argues that many measures of risk in the mainstream finance demand (e.g., beta, standard deviation, VaR) do not capture real risk.

He includes the above chart to demonstrate that severe stock market losses occur much more frequently than predicted by normally distributed models (we've shown similar data in class).

He offers the interesting concept of birthday risk. Most people have a 15-20 year window for serious investing. Depending on when you were born, this window fall over a 15-20 year period where risky investments go thru the roof (e.g., 1981-2000), or when risky assets tread water at best (e.g., 1966-1980).

He implies that the argument that 'stocks always go up in the long run' is an impractical one. It won't matter for investors who by chance are dealing with the 'wrong' investment window and who may not be able to stick around for the 'up' cycle.

He concludes with some ideas on how to manage tail risk, including the potential value of market timing and considering asset allocation in terms of assets that are truly uncorrelated.

Overall, an interesting and recommended read.

position in SPX

Wealth vs Money

People often equate weath with money. Wealth and money are not the same.

Wealth is created by productive work. Productive work combines labor with other factors of production to create economic resources of value. If I am a baker, then my labor in concert with capital equipment (stove) and raw materials (flour, water, etc) creates bread. The bread is wealth, as it is an economic resource that can add to standard of living.

Money is not an economic resource. It is merely a piece of paper or a digital accounting entry. Save for the effort required to create the money, there is no productive work or value creating outcomes.

Envision a world where all people are sloths. Everyone sits around all day engaging in leisure; no one engages in productive work. The only 'worker' is someone who prints money and distributes it to the masses. Everyone receives a pile of dollars adding up to $1 million.

Is this a wealthy people? Of course not. There has been no productive work. Valuable economic resources have not been created. The standard of living of all those paper millionaires will be primitive.

While money does not create wealth, what it does do in modern economies, however, is facilitate wealth transfer. Society currently treats fiat currency as a legitimate claim on wealth. Thus, if someone who does not engage in productive work can procure dollars from the 'money printers,' then they can use those dollars to obtain the bread baked by others.

Those who engage in productive work to accumulate real wealth lose some to those people who hold the freshly printed dollars.

People who equate the massive money printing programs of central banks with general increases in economic activity, i.e., productive work and real wealth creation, are disillusioned. General standard of living does not increase with more money.

Money printing can at best transfer wealth--meaning that some will gain economic resources at the expense of others.

Core Positions

The 'core position' concept may be worth considering as we begin building the Haile Fund portfolio. Core positions provide strong exposure to asset classes or sectors being pursued by the investor. Usually, core positions are 'low maintenance' in that they do not require constant review and oversight. As such, time horizons associated with core positions are usually long term in nature.

When putting a portfolio together, I personally like to look for core positions early in the process. This is because core positions can serve to anchor my portolio in the asset classes that I am interested in. Once the portfolio is solidly anchored, then I can pursue other, more specialized (or speculative) positions that help tailor the overall asset class composition toward more specific views.

As an example, I would view the Rogers International Commodity Index fund (RJI) discussed yesterday as a potential core position in commodities because it provides broad, market weighted exposure to the sector. Once I have positioned a broad fund like RJI in my portfolio, then I can look for other, more specialized commodity investments, such as DBA (ags), JJC (copper), or GLD (gold), that better express my preferences toward specific commodities.

In equities, core positions are often reflected by large cap stocks that dominate attractive industries. Due to its size and influence in the tech sector, Apple (AAPL) can be considered a core equity position.

One problem I often encounter with acquiring core positions is that they are often overpriced (from where I sit, anyway). Two strategies that I use to cope with this problem are a) sit on my hands and patiently wait for the security to be put 'on sale' by the market (this happens more often that you might think), or b) take a small position now at the current price with plans to add more shares if/when price goes lower.

Recently, I have employed strategy b) to begin building core equity positions in my personal portolio (I have not owned stocks for quite some time). I have initiated small 'starter' positions in a few large cap tech and healthcare names such as Microsoft (MSFT) and Johnson & Johnson (JNJ). My work suggests that these names offer decent--but not great--value here. These starter positions give me initial exposure, while leaving the door open for using lower price to my advantage to build more meaningful core positions down the road.

Should stocks rip higher from here and never look back, at least I have some core exposure that will allow me to participate.

Anyway, you might find the core position concept useful as you search the investment landscape for ideas.

positions in GLD, JNJ, MSFT, RJI

Price to Earnings Ratios

The price to earnings ratio (P/E) is the most common valuation metric applied to stocks. The higher the P/E, the more expensive the stock.

P/E has many shortcomings. The 'E' represents net income as determined by accounting convention. Accounting earnings can be subject to considerable manipulation and often do not reflect the true cash earning power of an enterprise.

Another drawback is that the 'E' typically reflects a 12 month performance window. Company performance is sure to change over time, so basing valuation on a one year time frame can be short cited.

Moreover, Wall Street is notorious for using earnings estimated by analysts for the next 12 months when generating P/Es. Research suggests that analysts are overly optimistic when forecasting the future, meaning that the so called 'forward' P/Es provide an illusion of value that often disappears when P/Es are based on 'trailing' (i.e., trailing 12 month or TTM) performance.

Finally, P/Es often appear most attractive when business cycles have peaked. Cyclical expansions increase earnings. Higher earnings drive P/Es lower, and those lower P/Es can entice investors into thinking that they are buying stocks on the cheap just before cycles turn down. This missive from my friend Vitaliy suggests that we may be facing just such a situation currently.

That said, P/E can still be a useful valuation metric--particularly when employing aggregate P/E measures to assess overall market value. John Hussman is a sharp valuation guy who employs this approach. An example of his work can be found here.

After reading it, answer these questions: Where do we stand currently with respect to overall market P/E compared to history? What is the historical relationship between P/E and future stock returns? What does John Hussman forecast for 10 year market returns given current aggregate market P/E?

position in SPX

Head and Shoulders Pattern

On the back of our discussion yesterday on copper, I noticed this chart of Southern Copper Corp (SCCO).

The stock seems to be tracing out a textbook head and shoulders pattern (bearish implications). Should SCCO break below support at 40ish, then technically it has 'room' lower to 32ish.

Interesting that various copper miners (see also FCX0 and refiners are trading 'heavy' relative to the underlying commodity.

position in copper

Market Cap and Enterprise Value

Last week we discussed the concepts of market capitalization and enterprise value, and how they can be used in valuation methods.

Here's some more on the subject using a pre meltdown example of General Motors (GM) as an example.

no positions

Dow Theory

One theory that many market participants subscribe to is known as 'Dow Theory.' In its general form, Dow Theory posits that trends in the Dow Jones Industrial Average (DJIA) are healthiest or most valid when they are paralleled by similar behavior in the Dow Jones Transportation Index (TRAN).

The rationale is that strong financial markets are grounded in strong economies, and strong economies require lots of transportation activity to move goods between sellers and buyers.

Currently, the DJIA remains in a very strong uptrend:

Recently, however, the TRAN has not been following along:

Instead, the TRAN has broken thru its uptrend line and is currently showing a wedge (a.k.a. flag or pennant) pattern that is likely to resolve soon.

This constitutes another divergence worthy of half an eye's attention...

Volatility Indexes and Sentiment

The Volatility Index (VIX, VXO) estimates the 'implied volatility' baked into S&P option prices. When market participants sense big pending movements in stock prices, they pay more for options, which sends implied vols higher.

Volatility indexes provide useful gauges of investor sentiment. When markets move higher, investors are often less willing to hedge their long positions with put options (when you buy a put against a long stock position, you are essentially buying insurance to protect your position against a price decline) or to speculate in puts outright. Less demand for options causes implied vols to fall.

Declining vols are commonly associated with conditions of 'complacency' in markets, as investors are less willing to pay for insurance to protect their long positions.

Typically, when market prices decline, investors suddenly wake up to the need for downside protection (or to speculate on lower prices by buying puts outright). The lower prices go, the more investors are willing to pay up for put options, which in turn drives implied vols higher. As such, rising vols commonly reflect 'fear' in markets.

Take a look at the two charts below. First is a chart of the S&P 500 (SPX) over the past five years.

Second is a chart of the VXO over the same time period.

Note the inverse relationship between the SPX and the VXO--particularly during periods where the SPX declined. The VXO hit its zenith during the waterfall decline in stocks in late 2008, early 2009--indicative of major fear in the markets. Note also that this fear was reactive--implied vols didn't spike until after prices began cascading lower.

Since the March 2009 stock market lows, the VXO has been generally grinding lower while the SPX has been grinding higher (interrupted by last spring's 'flash crash' phase). The VXO currently stands at multi-year lows--indicative of significant complacency.

Please note that the VXO is not an effective forecasting tool. For example, just because implied vols are relatively low today does not necessarily mean that a market decline is eminent.

Instead, volitility indices are better regarded as coincident indicators--more reflective of current levels of collective sentiment rather than of future sentiment or its consequences.

Nonetheless, smart market participants keep an eye on volatility indexes in order to gauge sentiment in the here and now.

position in S&P

Time Horizon and Treasury Yield

The 10 year T-note yields (TNX) that we examined a couple weeks back broke above near term resistance last Friday. This break out suggests to many technicians that interest rates may be headed higher. On 10 yr Treasuries, resistance now resides above--perhaps at about 4%.

As noted in class, it often pays to review price action using different time horizons. The chart below shows the TNX using weekly data over the past 6 yrs. Note that a downtrend remains in place, although current yields are right at resistance as reflected by the downtrend line.

The final chart below shows ~ 20 years of monthly TNX data. The picture here suggests that the secular downtrend in 10 yr yields is firmly in place. Technically, this secular trend won't be broken unless/until 10 yr yields rise to nearly 4.5%--almost 100 basis points higher than current levels.

Nice demonstration of how the technical picture can change depending on the time horizon...

In the here and now, investors need to grapple with what rising long bond yields mean. Strengthening economy? Inflation? Increased borrowing costs? Changes to Fed policy?

Judging by recent stock market action, the 'dominant logic' seems to be that the rising interest rate picture is bullish for equities. Perhaps it is. But make sure you see the bearish picture as well, as there are surely two sides to this trade.

position in Treasuries

Defining Profit

As observed here, there are many possible meanings for 'profit.' The same can be said for 'earnings.'

Imprecise meanings increase potential for misinterpretation. Be careful when processing information about profits and earnings. You and the information provider may not be on the same page...

Support

Like many risky assets, silver has had a nice run since last summer. The commodity nearly doubled in price from August to early January. A tradeable proxy for silver is the ishares Silver Trust ETF (SLV).

Recently, SLV broke its uptrend line and began following thru to the downside.

Technicians may be eyeing the 24-25 level as 'support.' Support reflects a price level that may impede further price declines--at least temporarily. The conceptual argument in this case is that when silver gapped higher last November, it left lots of potential buyers behind. Many of those would-be buyers told themselves that if SLV ever returned to the 24-25 level, then they would not miss the opportunity to get long again.

Essentially, then, support levels identify price levels where potential demand may reside.

Should SLV drop another buck or so from there, then watch to see whether that potential demand doesn't materialize--at least for an opportunistic trade...

no positions

Divergences

Small cap stocks have been leading domestic markets higher. The Russell 2000 (RUT) is up well over 100% since the early 2009 lows.

Over the past week, the RUT has shown some weakness. In fact, the multi-month uptrend line in place since last summer was violated last week.

On the other hand, larger cap stock indexes such as the S&P 500 (SPX) continue to show strength. Uptrends are still technically in place.

This is an example of a 'divergence.' Divergences occur when market indicators that are 'supposed' to move together fail to do so. Often, divergences portend a change in market character. Perhaps investors are rotating out of small caps because they see relative value in large cap stocks. Maybe weak small caps reflect declining risk tolerance among investors.

Of course, perhaps this divergence is just a random phenomenon that merits no meaningful interpretation...

In any event, I've found it useful to look for divergences and keep them in mind when making sense of the tape.

position in SPX