A Better Way To Build Investment Capital

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Includes: SPY, SVXY
by: Peter F. Way, CFA

Summary

As an investor in securities, do you place a high value on your time?

Are you concerned that your investments won’t get you from where you are now, to where you want to be?

Are you willing to take personal responsibility to ensure your success?

Do you feel it is possible to do better than Buy and Hold with some other investing discipline or strategy?

Then read on.

As an investor in securities, do you place a high value on your time? We have noted in several Seeking Alpha articles that time is a precious resource.

Are you concerned that your investments won't get you from where you are now, to where you want to be? We hear from many investors that the passage of time has crept up on them, now making the reach of earlier planned life milestones difficult.

Are you willing to take personal responsibility to ensure your success? If farming out the job of managing your investments has turned out to be inadequate, this may be a necessary step.

Do you feel it is possible to do better than Buy and Hold with some other investing discipline or strategy? Building financial wealth through investments with a buy&hold strategy, either yours or by others, for many investors has turned out to be disappointing.

Do you believe there is a way to repeatedly minimize losses and augment gains to outperform an index like the SPDR S&P 500 Trust ETF (SPY)? During the last ten years that index has grown at only 5 ¼% per year. In that period SPY averaged interim price drawdowns of -5.8% in just 3 months. The average drawdowns daily over the next 6 months have been -8%. Those are price retreats larger than the growth rate. If one of these occurs just when you have an unexpected need for spend-able capital, the hypothetical definition of risk transforms into a reality.

Respected professionals and academics consider outperforming that market average's annual growth by 3% to 4% per year as a significant, laudable accomplishment. In your situation is it now necessary or desirable to build your wealth by better than 8-9% yearly?

Are you willing to take a more active role in managing your investments if it would offer a better proportion of gain vs. loss, return vs. risk, than what you get with SPY?

Would it be worthwhile to learn how to double the likelihood of attaining your goals?

There are ways to do it. Here is one:

That is now being done by investors who have adopted an active investment approach, rather than a passive, buy&hold strategy. The active investment style benefits by avoiding investing additional time and the continued capital investments in stock or ETF investments that may have recently performed well but regularly give up most of those interim gains as the securities continue to be held.

Instead, active investing regularly replaces the fatiguing issue performers with investment candidates having better current odds for gains and histories of smaller exposures to capital losses.

This fatiguing is what turns otherwise possible substantial double-digit shorter-term gains into crippled, single-digit "long-term" returns like those seen in SPY. The fault is not only the capital loss during the periods of retreat, but the continued investments of time that dilute the growth rate of the remaining gains.

Instead, selection of stocks and ETFs whose prices are well-positioned for gains can provide odds-on opportunities to build wealth while minimizing the potentials for risk exposure. Such selections are being identified in advance on a continuing basis by investment market professionals.

Those forward-looking identifications are vetted by prior actual market results, and provide clear expectations of price targets signaling when opportunity is accomplished, and profits are taken. Profits whose growth is compounded by successive active capital commitments that keep capital continually at work.

The combination of adroit (but not perfect) selection, with disciplined attention to the investment of holding period time, results in compound annual growth rates (CAGRs) that are multiples of market average gains from buy&hold over multiple years. The results of active management this way are typically regarded by conventional money managers and academics as TGTBT - "too good to be true."

An illustration

Being aware of their blindness to reality, we set about to demonstrate what actually can be done, in "real time" in actual market experience. To that end we provide daily evaluations by market professionals of coming price ranges for over 2500 widely-held and actively-traded stocks and ETFs. Their expectations are ranked by the odds-on performances of similar prior forecasts in each specific security by these professionals. Lists of the top 20 of each market-day's rankings are made available to our subscribers at their demand.

We rely on the subscribers as our "auditors" verifying that the "Intelligence Lists" they receive are actually provided in a timely way and can be acted upon. (Intelligence here is used in a military or competitive information sense, not in an intellectual sense.)

In the first half of 2016 more than 1450 of the over 2,000 investment candidates named (some repeatedly) on these daily lists either reached their pre-specified sell targets, or exhausted their holding time allotments. Their average CAGRs are at a +30% price gain rate, importantly due to average disciplined holding periods of 58+ days (8+ weeks).

To illustrate what such selections can accomplish, we constructed a portfolio from the lists of the first half of the year 2016, a portfolio holding 20 position-threads. A proper Monte-Carlo simulation of hundreds of thousands of randomly-generated portfolios is beyond the scope of this article, but an effective alternative is at hand to avoid an illustration suspected of biased selections and management.

The hypothetical portfolio consists of 20 holdings of $10,000 initially, each of which is managed by the TERMD discipline frequently discussed in Seeking Alpha articles published before the start of the year 2016. Each holding is treated as a continuing thread of activity, with gains or losses of successive commitments in that thread of capital compounding its progressive value. The TERMD portfolio management discipline dictates the termination dates of holdings and of their successive replacements.

The 20 positions are initiated at a rate of four each day during the first five market days of the year so as to diversify possible single-day bias. At the 6/30/2016 close of markets the values of the 20 threads are marked to market to determine the portfolio's progress over its initial cash values.

All transactions take place at end-of-day market closing price, so no bid-offer spreads are involved. Transaction commissions are provided for at competitive rates. Dividends are ignored, but may augment the results.

We employ the value of perfect knowledge to initially establish each of the 20 thread holdings, by picking (from after-the-fact knowledge) the ten best-available CAGR results of the day, and the ten worst ones. Each day of the first week two best and two worst are selected as of the date of commitment. There are to be no duplications of holdings at any point of the test, although non-duplicating repeats of a stock or ETF at different holding periods are permitted.

The same selectivity is used in thread investment replacements for closed-out positions, as dictated by the TERMD portfolio discipline. The best and worst (fully known) available, non-duplicating holdings on the date in question are used. The end result then is ten threads of best-possible choice investments, pitted against the ten worst-possible investment threads. Their ending dollar values are combined to value the overall portfolio and provide a measure of capital performance.

This is not a perfect measure, but its results can be contrasted against the average (geometric mean) returns of all investment candidate listings during the initial six months of the year. Details of the 20-thread portfolio provide an insight into the extremes of the experience YTD and suggest strategy adjustments that may improve future performance when using the Intelligence List information.

The "Best-Worst" portfolio results

Here are the details of the first four threads (best in green, worst in red) initiated on 1/4/2016:

Figure 1

Click to enlarge

source: blockdesk.com

The TERMD portfolio discipline requires a position be held until its top of forecast range price is reached or exceeded. If that has not happened in 63 market days (3 months) the position is closed regardless of loss or gain.

The four threads presented here were selected for this illustration from the 1/4/2016 Intelligence List, knowing after 6/30/2016 what the outcomes would be.

After the initial capital commitment date on 1/5/2016, TERMD caused position closeouts at appropriate dates dictated by market actions of the positions. The initial four thread choices were made without consideration of the specific subsequent replacement candidates. At the appropriate dates those replacements were again chosen to be the best or worst available on that specific date, with prior knowledge of what that outcome would produce from that selection, but with no further determination. To that extent, the dates of subsequent actions were random.

It should be apparent that best positions typically had shorter holding periods and led to more replacements, while worst positions all ran to their full 3-month allowable lengths. The differing impact of compounding is a years-ago anticipated design feature of the discipline. The loss of one fourth to one third or more of a position's investment is illustrative of what can happen under an unmodified conduct of TERMD.

On the other hand, a series of beneficial experiences can compound to boastful levels. As is evidenced here, that can easily offset ugly loss experiences. This portfolio is constructed to force equal investments in best and worst, even though winners outnumbered losers 74% to 26%. In real life those results are not known with certainty in advance.

But we do know that more than one and a half times as many profitable outcomes occur than do losses in closed out positions from Intelligence List names. That is what happened during the first 6 months of 2016 and regularly has occurred in prior periods. And the CAGRs of the gains typically dominate the CAGRs of the losses.

Here is a summary of the outcomes from all 20 threads of this best-worst perfect-knowledge portfolio. The details for all threads can be found on-line here.

Figure 2

source: blockdesk.com

Real-life market experiences produce some unbelievable tragedies and benevolences. Biotech drug-trial failure announcements are emblematic of the former.

One of the latter is present in Thread 9, when Computer Science Corp (NYSE:CSC) was identified on the Intelligence Lists as attractive for several days. That was just prior to CSC announcing its decision to merge its business with Hewlett Packard Enterprise Company's Enterprise Services (NYSE:HPE) business, which will be spun off from the parent company.

This deal brings together CSC's strengths in insurance, healthcare and financial services along with HPE's Enterprise Services expertise in industries like transportation, pharma, technology, media and telecom.

Within two weeks after appearing a number of times on the Intelligence Lists, the announcement was made and the stock jumped about +50% overnight. An advantage of the Intelligence List is that its readers have no specific company information that could be considered "inside". The CSC appearances were less than 1% of the identifications of the first half of 2016, so this is not a "normal" or a "to be expected" occurrence and should be no basis for SEC concerns.

Lessons learned from the best-worst illustration

First, not to expect many portfolio CAGRs of > +50%.

Next, to appreciate the power of compounding returns, both good and bad.

Further, to understand the irregularity and unpredictability of such compounding events. As created under the TERMD discipline, they are what are known as Markov Chain experiences.

A Markov chain, as involved here, is a series of events occurring through time where what happens next depends only on the current state of the system, not upon what has preceded it. Our ranking system is constant, but what is fed to it changes randomly, depending on the perceptions of market-makers at the time. So it is generally impossible to predict with certainty the state of a Markov chain (one portfolio thread's value) at any given point in the future.

In our situation it is important to fractionate the portfolio into a series (threads) of actions so as to diversify the specific irregularities into a more evenly-progressing performance.

That way the overall capabilities of the market-making community to estimate future price possibilities becomes a more reliable guide.

The diversification takes place not only among selected securities, but among action dates and holding periods. A buy&hold strategy forces that diversification by requiring continued holdings across all relevant time. Unfortunately, buy&hold locks in the bad (capital loss) periods in the process.

Active portfolio management trades off that guaranteed b&h timing risk exposure for one of selection risk, with each selection having its own perceived timing risk. By comparing the selection's current forecast with prior forecasts having similar upside-to-downside balances, such risks have been shown to be minimized.

A key characteristic of all such forecast comparisons is the proportion of similar prior forecasts that conclude (under TERMD discipline) with a profit. Labeled "Win ODDS" in our discussions, an experience of 7 wins out of 8 has Win Odds of 87% or 87 / 100. We tend to avoid investment candidates with prior Win Odds of less than 6 out of 8 (75%).

Skillful investment portfolio managers manage to achieve Win Odds of 55% to 60%, using conventional industry practices.

The proportion of TERMD-profitable Intelligence List investment candidates named during the first half of 2016, is 61% at the year's mid-point. That includes many positions only marked-to-market at mid-year, not yet reaching a TERMD conclusion. Of those that were concluded under the discipline, 73% were profitable at mid-year; now half a month later that has risen to 76%.

The key role of time

For wealth-building investors striving to reach important, difficult financial milestones, the rate of investment capital accumulation is a matter of singular importance. Because of that, there are two special columns of blue data in the details of Figure 1.

They are the Calendar Days Held for each position, and the BP / day. The BP / day calibrates the speed of capital accumulation, or where negative, the speed of its dissipation. BP stands for basis points, each equal to one 100ths of one percent.

The "plodder" in Figure 1 is Thread 2's position in EXP, rising in price at "only" 14 basis points per day for over ten weeks, to add +10.5% to its value. Thread 2 also sports the Lamborgini vehicle of the display, the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) racing ahead at 210bp/day to overtake EXP's gain in only a one week lap of the time-racecourse with a gain of +14%.

Looking at the worst-case threads 11 and 12, their 3-month losses are painful in the first calendar quarter of the year, but less so in the second. That, despite the perfect knowledge that those second-quarter selections on the day enacted were the worst results to be had. Loss speeds can be variable, just like gains.

The average speeds of best capital accumulation in threads 1 to 10 were +46 bp, easily overpowering the -16 bp average dissipations of worst threads 11 to 20.

For the 1451 list positions of 2016 that were closed out by mid-year, 73% had capital accumulation speeds averaging +41bp/day, while the 27% losers dissipated capital at -12bp/day. Combined those 1451 averaged +26.4bp/day.

In comparison, SPY bps/day, measured over the identical holding periods of those closed-out List positions, averages +11bp/day, suggesting an "speed-alpha" for list names of 15bp/day. The not-yet closed out positions still in process have a mark-to-market gain that is trivial at mid-year, but is a gain, not a hiding place for losers.

If sustained at an even pace for a half-year that "alpha" would generate a gain of +31%, making the Best~Worst "portfolio" illustration of +26% seem conservative, rather than ambitious.

Conclusions

Market professionals continued in 2016 to show that they have better-than average daily insights into equity securities prices in yet-to-come near months.

Their current expectations, vetted by prior similar specific insights, preferences of prior best-odds and best-prior payoffs on a daily basis produced over 1400 instances of disciplined strategy outcomes. Average gains of these outcomes are multiples of the gains in SPY, a fair proxy for market-aggregate buy&hold investments.

The period under examination has a market average CAGR only half what is often considered a long-term trend. Still, the rates of gain in the 1400+ outcomes are multiples of, not just additives to, even the long-term equity market trend.

In the 2400+ list of investment candidates (not just the closed out ones) direct comparisons with identically timed SPY positions shows a preponderance of price gain advantage to the list names over those in SPY.

Investors struggling to reach financial planning milestones should consider following an active-investment strategy instead of a buy&hold dominated one, if they can get the benefits of market professionals' forward-looking insights, and will follow a disciplined, active portfolio management regimen.

Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information (earlier) helping professional and [now] individual investors discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro bono consulting for a limited number of not-for-profit organizations. We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So our information presents for their guidance what the arguably best-informed professional investors, through their own self-protective hedging actions, believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided. Our website, blockdesk.com has further information.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.