It's "earnings season," but perhaps the investment community sometimes pays too much attention to earnings when it may pay to simply get back to basics - for example the basics of supply and demand.
Assuming consistent demand, when supplies get tight, prices go up. So you'd think that if a company uses its free cash flow to reduce its float, or number of shares outstanding, that would drive the share price higher.
Yet over the long term, most investors assume that it's a company's "intrinsic value" that drives the share price. The problem, however, is that "price" and "value" aren't the same thing at all. Prices only exist because we disagree on value. Otherwise there would be no market for stocks.
So in the long run, do shares of stock move higher and lower based on the law of supply and demand?
Charles Biderman, CEO of Trim Tabs Research says yes.
His company has been providing highly detailed research on stock market liquidity to institutions for more than 20 years. Last October, he and his colleague Minyi Chen became co-portfolio managers for a new actively managed ETF called the Trim Tabs Float Shrink ETF (TTFS).
The premise behind the fund is a simple one. Invest in companies that reduce their float - essentially the supply of shares available - and do so using their free cash flow. Why? Because over time if the same amount of money chases fewer and fewer shares, prices should rise.
What's more, given that corporate insiders are the most informed market participants, following their lead seems to make more sense than following analysts who only focus on predicting earnings and revenues.
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The Biderman Market Theory: Just stocks and cash
I talked to Charles about the Float Shrink ETF to learn more about his theories on stock market liquidity and how it impacts share prices. His theory is a simple one. It's the "Biderman Market Theory," and it holds that the stock market is simply that, a market of stocks. That's all there is, just shares of stock and money.
Charles points out that most fundamental investment approaches, such as the discounted cash flow method, attempt to exploit discrepancies between intrinsic value and market price, but that there are far more reliable ways to make money in stocks over the long run.
"Why guess about intrinsic value?," Charles explained. "Minyi and I contend that the prices of stocks are like the prices of any other good, set by underlying conditions of supply and demand."
"All too many strategists ignore the simple fact that stock prices are a function of liquidity, not value," he added. "As long as a company is reducing its float out of free cash flow, but not increasing its leverage, history shows that its price should tend to rise."
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Not just a "buyback" fund
One thing I want to make clear is that the Float Shrink ETF is not simply another "buyback fund." For example, the PowerShares Buyback Achiever ETF (PKW) is a passively managed fund which holds companies that tend to buy back their shares.
But not all buybacks are created alike. Just because a company is buying back shares of stock does not mean it's reducing its float. For example, a company might swap debt for equity. Or a firm might buy back shares and then re-dilute itself by issuing employee stock options.
That Buyback Achievers ETF will hold companies that are simply buying back a certain percentage of shares, but the Float Shrink ETF only holds companies that are buying back shares for the "right reasons."
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Investing "with the house"
Charles compares the stock market to the inner workings of a casino. Or to put it more precisely, "The Biderman Market Theory" says that "the house," or the companies themselves, have an advantage over the rest of the players.
"Top insiders at a company know more about its fundamentals than the investing public," Charles said. "These insiders can influence the price of their shares by timing equity issuance and stock buybacks to their advantage. Our approach simply takes advantage of the opportunity to invest with the house."
Here's how the fund "invests with the house"
Of the roughly 3000 largest cap companies, essentially most of the Russell 3000 index, Charles and his team identify the ones that are reducing their float - whether through stock buybacks or other actions such as reverse stock splits or spin offs. Their criteria requires that companies have plenty of free cash flow and do not employ leverage simply to reduce the number of outstanding shares.
Based on this research, each stock is given a "liquidity score" and the top 100 stocks are included in the fund. The holdings are equally weighted and rebalanced as Charles puts it, "as often as necessary."
Here's a chart showing the fund's sector weighting compared to the iShares Russell 3000 ETF (IWV)
As you can see, the TTFS is overweight companies in the consumer discretionary and technology sector, where there's more float "shrinkage," and underweight sectors such as energy and financials where there's probably more "bloat in the float," so to speak.
The Trim Tabs Float Shrink ETF was started in October of 2011, so there's not a lot of performance history yet, but as of August 1, 2012, the fund had certainly kept up with the Russell 3000 ETF with little to no additional volatility.
If you buy TTFS, you should know that Charles thinks investors with a long-term time horizon should dollar cost average their way into the fund, for example on a monthly basis. TTFS is a low-volume ETF right now, but I'll leave it to Charles to explain "Why Low Volume ETFs Should Not Be Avoided." Just be sure to use limit orders so that you're not paying a significant premium to net asset value.
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I would say that this actively managed fund has the potential to be a good alternative choice for long-term investors compared to passively managed funds like the IWV or even the S&P 500 ETF (SPY).
With TTFS, you have a highly diversified portfolio of companies that, for the most part, are making effective use of their excess cash. You're investing in profitable companies that are making their shares more desirable by reducing the supply of shares using their leverage free cash flow.
In fact, you might call it "supply side investing."
Ronald Reagan once said "an economist is someone who sees something happen in practice and wonders if it would work in theory."
But if the theory of supply and demand holds for shares of stocks, the Trim Tabs Float Shrink ETF could be a way to take that theory and put it into practice in your portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.