Creating A Strategy Index From Long's Law

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Includes: CBOE, CME, EBAY, FDS, GOOG, GOOGL, ICE, MA, MCO, MELI, MORN, MSCI, PYPL, SPGI, TRI, V
by: Harry Long
Summary

We examine a portfolio of oligopoly businesses.

We then borrow an imperfect hedge from our ETP strategy indices.

Then, we achieve much higher Sharpe and Sortino ratios.

Long's Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry.

For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economic "Laws" should best be termed Economic "Tendencies." The rule roughly holds across a vast array of industries.

In August of 2013, I outlined an illustrative portfolio of companies which ranked highly under the criterion of having few competitors.

Here's why this is important. The robber barons understood the long-term competitive advantage of owning oligopoly businesses. You should too. An interesting characteristic that some of the businesses below share is that they are toll bridge-like businesses.

For example, if you want to hedge or to speculate in the futures market, chances are you will be doing so through the futures exchanges.

If you want to pay for goods or services using a credit or debit card, chances are you will be using Visa or MasterCard's payment network. You get the picture.

Here is an illustrative portfolio of companies which rank highly under Long's Law:

Major Payment Networks (Network Effect Businesses)

Visa (NYSE:V)

MasterCard (NYSE:MA)

PayPal (NASDAQ:PYPL), formerly owned by eBay

Major Futures Exchanges (Network Effect Businesses)

CME Group (CME)

Intercontinental Exchange (ICE)

CBOE Holdings (CBOE)

Major Online Auction Marketplaces (Network Effect Businesses)

eBay (NASDAQ:EBAY)

MercadoLibre (MELI)

Major Credit Rating Agencies (De Facto Regulators)

Moody's (MCO)

McGraw-Hill Cos. (MHFI)

Internet Search (Dominant Online Advertising)

Google (NASDAQ:GOOG) (NASDAQ:GOOGL)

Financial Database Firms

FactSet (FDS)

Morningstar (MORN)

Capital IQ (owned by McGraw-Hill Financial)

Thomson Reuters (TRI)

Index Providers

S&P Indices (owned by McGraw-Hill Financial)

MSCI (MSCI)

Morningstar

Here's how this portfolio performs vs. the S&P 500 (please note that EBAY was used in place of PayPal due to its limited trading history since the spinoff). We equally weight the 14 stock portfolio and rebalance annually.

The portfolio does well but is highly correlated to the market. Perhaps we can do better. Perhaps decreasing the correlation of the portfolio to the S&P 500 can increase its returns. We can see that the drawdown profile of this strategy follows that of the broader market. It would be great to get less correlated to broad market drops.

What could we do to further increase the strategy's safety and performance? As I have noted in a variety of ETP-only strategies, the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA:TMF) (a 3X leveraged long duration government bond ETP) has the potential to act as an imperfect hedge of sorts if equity markets crash.

Because the long duration government bond ETP is leveraged 3x, we can dedicate far less capital to the bond portion of a traditional stock/bond mix. The TMF instrument almost acts like a call option on long bonds. Unfortunately, interest rates are artificially low, making the TMF portion of the strategy a very imperfect hedge indeed.

However, unlike a risk-parity portfolio, because the leverage is inherent to the TMF instrument, there is no margin leverage in this strategy index. And even if long bonds get decimated due to a hyper-inflation, the TMF portion of the portfolio can only go to zero in any given year in an extreme scenario.

How do the companies outlined above perform if we equally weight them at 5% each, then add a 30% allocation in the portfolio to TMF?

We can see that the portfolio becomes less correlated to the broader equity market, and also, the Sharpe and Sortino ratios rise sharply.

Let's take a look at the drawdown profile of this strategy.

The drawdown profile of the portfolio is far improved! Of course, the TMF hedge is by no means perfect, but what a difference it makes.

Going forward, we will examine a variety of strategy indices which combine individual stocks with ETPs, as opposed to our usual practice of just creating ETP-only indices.

Consider examining whether the addition of additional asset classes can improve the risk/return profile of your own stock portfolio.

Thanks for reading. As always, our cutting-edge strategy indices are only available to subscribers, but I hope that some of the strategy indices presented here will provide inspiration for readers to create their own methods for dealing with an increasingly difficult investment environment. If this post was useful to you, consider giving our service a try.

Remember, hope is for people who do not use data. Wise investors plan using evidence-based methods.

Thanks for reading.

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.

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. I have no business relationship with any company whose stock is mentioned in this article.