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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
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Hidden Gems and Red Flags
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The Valuation Handbook
  • Portfolio Management Rating: Methodology For Predictive Fund Ratings 4 comments
    Jul 19, 2012 11:29 AM

    The Portfolio Management Rating of an ETF or a fund is based on the aggregated stock ratings of the securities it holds as well as its overall Asset Allocation rating, which is defined here. The Portoflio Management Ratings and the Total Annual Costs ratings combine to determine our Predictive Fund Ratings.

    New Con­structs' stock rat­ings are reg­u­larly fea­tured as among the best by Barron's over the past three years.

    Figure 1 displays the criteria and thresholds that go into the Portfolio Management Rating of every ETF, mutual fund or portfolio we cover. Note that the Portfolio Management Rating is the same as a stock rating except that it incorporates our rating on the fund's Asset Allocation.

    Figure 1: Portfolio Management Rating Table

    (click to enlarge)Sources: New Constructs, LLC

    New Constructs' ratings on the stocks held by funds are aggregated according to the allocation the fund makes to each stock. The aggregated ratings of the holdings translate into the Portfolio Management rating of the ETF, mutual fund or other portfolio. Details on New Constructs' stock rating system are here. Below is a summary of the criteria that drive the Portfolio Management rating.

    We assign rat­ings to every stock under cov­er­age accord­ing to what we believe are the 5 most impor­tant cri­te­ria for assess­ing the risk ver­sus reward of stocks. Those cri­te­ria are divided into two cat­e­gories: "Busi­ness Strength" and "Valuation".

    1) Business Strength: the quality of the economic earnings of the company and the strength of its business model based its ROIC.

    a) Quality of Earnings measures how reported accounting income compares to the economic earnings of the stocks in the fund.

    b) Return on Invested Capital (NASDAQ:ROIC) measures the aggregate cash on cash returns of all stocks in the fund.

    2) Valuation: based on the expectations embedded in stock prices. Investors should buy stocks/funds with low expectations.

    a) Free Cash Flow Yield measures the true cash yield of the companies held by the fund.

    b) Price to Economic Book Value measures the growth expectations embedded in the prices of the stocks in the fund.

    c) Market-Implied Duration of Growth (Growth Appreciation Period) measures the number of years of future profit growth required to justify the current valuation of the stocks in the fund.

    3) Asset Allocation: The Asset Allo­ca­tion Rat­ing informs investors of each fund's level of allo­ca­tion to cash (non-equities) as well as how that level com­pares to other equity funds. We assume investors in equity funds pre­fer those funds to be max­i­mally invested in equi­ties given that investors can much more cheaply invest in cash on their own. We do not believe that most investors want to pay the fees asso­ci­ated with equity funds to invest in cash.

    a) Cash Allocation measures the percent of the fund's assets allocated to cash.

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  • Kiran Pande
    , contributor
    Comments (237) | Send Message
    Your portfolio management ratings are based exclusively on factors which favor value companies. It seems ironic to note that historically value stocks are riskier than growth stocks.


    An ETF that includes companies whose valuations are high does not imply that A. management is poor nor that B. the companies are poor investments.


    I've seen your articles repeatedly hammer PSCC for its holdings, but you must have missed that the ETF is tracking an index, which happens to represent A. historically the highest performing market cap (small-caps) and B. historically the highest performing sector (consumer staples), both combined. In fact, past data suggests it might be the best performing class of equities of all time, and somehow ended up at the top of your list of ETFs with the worst holdings. Interesting.
    20 Nov 2013, 07:32 AM Reply Like
  • David Trainer
    , contributor
    Comments (1167) | Send Message
    Author’s reply » Kiran:
    Thanks for your comment.
    I am not sure I share your sense of irony. Value stocks are not usually more risky than growth stocks, but, of course, that statement relies entirely on how you define "growth" and "value".


    Second, index investing is often a myth, As I explain here (http://bit.ly/19GGM3K). Just b/c a fund calls itself an index does not mean that subjective investment decisions do NOT play a role. They do...simply b/c there are so many indexes and b/c there are no official standard definitions of indexes.


    Third, past performance is not and should not be relied upon for future performance. Your argument for "best performing class of equities of all time" is quickly defeated by pointing out that the great past performance means that future performance will be weak as those stocks have all maxed out their valuations. It is hard to argue that they will be the best performing forever as that would imply they are of infinite value.
    20 Nov 2013, 09:41 AM Reply Like
  • Kiran Pande
    , contributor
    Comments (237) | Send Message
    1. Value stocks have been proven to be inherently more risky than growth stocks in all equity asset classes by the research of Fama and French (http://bit.ly/18o0q8T) and the widely accepted Three-Factor Model. Data encompasses all relevant financial data since 1926.


    2. The two ETFs used in your dubunking of ETFs example do not have the stated purpose of tracking a single index, and thus do not apply.


    3. Past performance is and should be relied upon when a sample of data is large enough. In this case, data indicates that small-cap consumer staples have outperformed every other class in almost every possible period of 5 years or more, including recessions. The classification of small-cap also means that securities that grow too large are removed and replaced; their subsequent valuations are irrelevant. Their value is not infinite because investors are psychologically risk averse and not willing/able to accept the level of volatility that will be present in periods less than 5 years for small-caps.
    20 Nov 2013, 11:39 AM Reply Like
  • David Trainer
    , contributor
    Comments (1167) | Send Message
    Author’s reply » Hi Kiran:
    Thanks for your comment.


    1. I think you are deriving more information than appropriate from the article - sort of like people tend to extract more meaning from beta than they should.


    The HML indicator (accounting price-to-book ratio) are only one facet of determining value stocks. In my opinion, that metric is not only over used but also not very good. I would be careful throwing around narrowly-focused papers like that as evidence for the broad arguments you make.


    2. There are many more such examples. The underlying assertion is true.


    3. Do you work for Morningstar? You belief in and reliance on past performance is impressive.
    20 Nov 2013, 02:51 PM Reply Like
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