Well, what a few weeks we've had with Britain choosing to exit from just about everything European. Maybe the one major positive we can take is that England were kicked out of the European Championships by Iceland - a non-EU European country. It's a spurious relationship but if our team spirit improves Icelandically outside of the EU then perhaps we can look forwards to our football team winning again, even if we can't afford the tickets. Regardless, Brexit negativity has hammered our savings, and we're all feeling worse off as a result. As we'll see the New Year NAPS portfolio has not been immune with a considerably worse showing in H1 2016 versus H1 2015.
Before we assess the NAPS, let's consider the wider market result. Unless you've been on another planet in the last few weeks you'll probably have heard the following, even from the mainstream news outlets:
- Large caps have risen above the level they were at pre-Brexit (FTSE 100)
- Mid and Small Caps have slumped (FTSE 250, FTSE Small Cap)
- Cyclical, domestic stocks have been hammered - banks, housebuilders, airlines
- Defensive, foreign earning stocks have risen - e.g. Glaxo, Unilever, Miner
In economic upswings, savvy investors know you want to own small cap cyclical stocks, but in a downswing they underperform which is why the recent cull has been so brutal for many. Markets tend to climb a wall of worry, in a calm fashion, lulling investors into a false sense of security. Novice investors who haven't lived through downward or bear markets can sometimes be shocked at how fast things move in the other direction when conditions change.
Good diversification always helps soften the blow of these sector and size specific reversals. The plans we'd put in place have helped the NAPS portfolio minimise its losses in a tough environment, but broader market selection and timing ideas could have put the returns year to date in the black. As we'll be exploring these ideas, this will be a lengthy post - you've been warned!
A NAP Refresher
For those that are newbies to the NAPS portfolio, it's worth a quick refresher. It was designed as a portfolio selection process to avoid discretionary stock picking. Just as pilots and surgeons improve their success rate and reduce catastrophic risk using checklist driven processes, we hoped to do the same. The NAPS put their faith in a rule-based process based around an understanding of the the key factors that pay off in the stock market - company quality, share value and price momentum.
The Stockopedia StockRanks score all the stocks in the market across these three factors, so the original set of 2015 New Year NAPS was selected using them. The process picked the top two, reasonably sized, highest StockRank shares from each of ten sectors to generate a 20 stock diversified portfolio.
This portfolio returned 43% in 2015 with 19 out of 20 stocks being winners - a 95% hit rate. A stellar performance, and far beyond my originally cautious expectations. At the end of year review, I made it very clear that this was a 'lucky set', as the overall population of high StockRank stocks had only a 70% hit rate that year.
But the approach has proved popular, and Stockopedia members started applying their own variants of NAPS style processes to the market. Some mirrored the UK portfolio with skews towards their own favoured sectors and styles, while others took the plunge to apply it across the channel in European markets and beyond using our growing international coverage.
So for the New Year 2016, I felt we should keep the approach going, and see if our luck would continue. But given the 6-year bull market in the USA had started to falter on China wobbles it seemed prudent to put a greater focus on risk management. So for the 2016 portfolio, I tweaked the rules.
The additional rules cut out microcaps completely, and ensured broader diversification both across size groups (large caps, mid caps, and small caps) and industry groups (so that the 2 stocks in each sector were never selected from the same industry group). With hindsight, as we'll see, international diversification would have been a very smart move but given we'd started with a UK only approach and our readership is heavily UK oriented we chose to continue as we'd started. So how have we been doing year to date?
The 2016 NAPS selection have not had a terribly auspicious time, but relatively, it hasn't been that bad. After a storming 2016, it was very likely there would be a setback. We weren't expecting such a vicious start to the year nor the shock of Brexit, so at the half year mark, a 4.5% drawdown in capital terms almost feels like a victory. The portfolio is yielding 3.4%, so 1.7% of the loss would have been recouped in dividends.
Here's the 18 month performance chart that shows a final rise to new highs in May, followed by a recent drawdown as Brexit realities have taken hold.
Vs. some benchmarks
Over the last 18 months the NAPS have consistently crushed the performance of the major UK indices, but in the last six months, and especially the last quarter, there's been something of a reversal. While the 2016 NAPS portfolio has continued to beat the small and mid cap indices, the flight to the safety of foreign-earning, international large caps has caused it to lag the FTSE 100. Here's the performance of the indices at the half year mark:
- Micro-caps: FTSE Fledgling ex Investment Trusts -9%
- Small-caps: FTSE Small Cap ex Investment Trusts = -6.2%
- Mid-caps: FTSE 250 = -6.6%
- Large-caps: FTSE 100 = +4.2%
- All-caps: FTSE All Share = 1.56%
The 2016 NAPS have outperformed the general high StockRank peer group, and the non-rebalanced 2015 NAPS portfolio by 3.7%.
- StockRanks: UK 90+ top decile = -8.2%
- 2015 NAPS - not rebalanced = -8.2%
- 2016 NAPS = -4.5%
Worrying about relative performance versus benchmarks can cause a lot of short-termism and panic in investors. It leads to what the billionaire Value investor Seth Karman calls the 'relative performance derby'.
"There are no winners in the short-term, relative performance derby. Attempting to outperform the market in the short-term is futile. The effort only distracts a money manager from finding and acting on sound long-term opportunities. Clients experience mediocre performance... only brokers benefit from the high level of activity."
There's just no point chasing relative performance. The future is genuinely unknowable and while we can't control our outcomes, we can control our process. A good process should be tested, empirical and stand up to the common-sense test.
Ultimately, as van Tharp repeatedly states in his book Trade your Way to Financial Freedom, we don't trade the market, we trade our beliefs about the market. The NAPS is a process hinged on the belief that good quality, reasonably priced, improving stocks should be better performing investments than their opposite - poor quality, expensive, deteriorating stocks. So if the NAPS suffer significant drawdowns I'll just keep asking myself - "does the philosophy make sense?" My own belief, and continuing conviction is that the process should continue "working" over the longer term until the stock market becomes far more efficient at pricing securities than it is today.
On risk premiums and rebalancing
It's worth re-iterating that the recent three year outperformance from the StockRanks is at least partially due to taking on a greater level of risk. In the same way that insurers earn premiums by insuring against risks, in the stock market we can do the same. One of the reasons value investors earn an additional premium versus the broader stock market is that they are willing to buy cheap stocks with heightened levels of potential distress risk.
Professor Andrew Ang in Asset Allocation - a systematic approach to factor investing explains that the additional returns available to quality, value, momentum and other factors "are rewards for investors enduring losses during bad times". These rewards are accrued during the good times but occasionally need at least partially repaid during bad times. So in stock markets, drawdowns are par for the course and to be expected. We can't avoid them. We can only win if we're willing to occasionally lose. The key is managing the downside.
Andrew Ang also explains how critical regular portfolio rebalancing is in accruing these rewards. Long term buy and hold doesn't work for earning these premiums. So when good, cheap, strong stocks are bought for the NAPS portfolio, we have to understand that they won't remain in that state for long. Over time any stock's exposure to quality, value and momentum drifts. They either become expensive (lower value), deteriorate financially (lower quality) or their price or earnings trends weaken (lower momentum).
Ang explains that "Rebalancing is the simplest, and yet one of the most powerful, ways of buying low and selling high". From this perspective, it's interesting to note that the 2015 NAPS have tumbled by 8.2% since the start of the year, while the 2016 rebalanced NAPS have only fallen 4.5%. The 2015 NAPS ended up heavily exposed to some stocks which have since suffered nasty reversals. The rewards to rebalancing can be further explored in a series of articles by Ben Hobson - notably on rebalancing and volatility pumping.
The distribution of winners and losers
In sharp contrast to 2015, we've seen a majority of stocks in the losing category. Year to date we've seen only 8 winners against 12 losers.
Firstly, amongst the top winners are Drax, Indivior and H&T Group. A utility, a healthcare stock and a financial. All increasingly disliked by the investment community at the end of last year. There were plenty of NAPS following site members who deliberately kept these stocks out of their own portfolios for good reasons. But they've been some of the rare stocks to soar this year. Their performance illustrates one of the key reasons why value investing works - people dislike problem stocks so much that they sell them too cheaply. When things are too cheap, they tend to eventually recover through the power of mean reversion. Sometimes holding your breath and taking the plunge in stocks that you'd normally turn your nose up at can indeed reap rich rewards.
If we look at the stocks from a sector and super-sector perspective, we can see some clear trends:
The winning stocks were mostly in defensive sectors, healthcare, utilities and consumer defensives, while more sensitive and cyclical sectors were crushed. Cyclicals have been the place to be in the last few years as the economic recovery has taken hold, but as Brexit fears have taken over we've seen the market trend radically invert. Anyone caught in a portfolio solely full of cyclicals or industrials may be feeling considerably more pain than those taking a more prudent, and partially defensive approach.
While we did try to manage some risk in the 2016 rule changes, the NAPS process isn't explicitly designed to time sectors or the market. It doesn't care what market we're in, it just aims to be a Forrest Gump style all-weather portfolio. Last year we picked up the premium from a cyclical rally, this year we've found some defensives at least partially holding the fort.
But it's been the large cap defensives which have really saved our bacon - stocks like National Grid (NYSE:NGG) and GlaxoSmithKline (NYSE:GSK), which wouldn't be seen dead in a small cap growth investor's portfolio, have rallied strongly. As we can see from the following breakdown, it's been the small caps that have been badly crushed this year.
With hindsight, our New Year rule changes to cut out sub £50m cap companies completely and diversify more evenly across small cap, mid cap and large cap size groups has helped enormously. In terms of numbers, I'd allocated 6 to large caps, 6 to mid caps and 8 to small caps. Small caps do tend to outperform over the long term, so I'm comfortable with the slight skew to small caps but it could hurt us in a prolonged downturn.
Market selection - winning the war abroad…
Brexit may have come out of the blue, but it's highlighted the massive cost of home bias. Not only have UK stocks fallen, but the sinking pound has magnified the drawdown. Domestic UK investors have paid a seriously high price for not owning international equities.
"To avoid having all your eggs in the wrong basket at the wrong time, every investor should diversify. If you search worldwide, you will find more and better bargains than by studying only one nation." Sir John Templeton
From my discussions with site members, it seems those who have done best have ventured further afield. The US has not been a happy hunting ground this year perhaps as it's been the most expensive of the major western stock markets, but some other markets have done extremely well. It's been just over a quarter since we launched Canadian, Australian, Asian and Indian market coverage and here's some initial high StockRank results from those markets:
- 90+ StockRank Indian shares are up 20% in the last quarter
- 90+ StockRank Australasian shares are up 6% in the last quarter
- 90+ StockRank Canadian shares are up 18% in the last quarter
- 90+ StockRank Singapore shares are up 6.85% in the last quarter
- 90+ StockRank Hong Kong, Japan, Taiwan & Korean shares are largely flat.
In the same time period, the UK StockRanks fell by 8.2%, while the pound fell 10%. In real currency adjusted relative terms, a 25% exposure to foreign markets could have boosted a portfolio by 7.5% more than making up for the fall of the rest.
Market timing - predicting the future
Market timing is notoriously hard to do, and the NAPS portfolio doesn't attempt to do it. But that doesn't mean we shouldn't entertain the thought. The NAPS goal is to aim for market or better returns through a diversified portfolio, but relative performance doesn't count for much if it brings in an absolute loss. As Mike Tyson once said ""Everyone has a plan until they are punched in the face". Markets can and do fall considerably in bad times, so using hedging strategies at high risk moments in the market can minimise losses. While hedging may not improve absolute returns, it will improve risk-adjusted returns.
One of the best market-timing books I've read in recent years is Dual Momentum by Gary Antonacci. He explains a very simple stocks-to-bonds switching approach using a measure called Absolute Momentum - neatly summarised in this blog post.
Absolute momentum is easy to calculate and apply. It is positive if an asset's excess return (return less the Treasury bill rate) over a specified look back period is positive. One then holds that asset until absolute momentum turns negative. If absolute momentum is negative, then one stands aside.
Antonacci found that using this approach over several decades considerably reduced drawdowns and improved returns by several percent annually. So I've been using this simple rule of thumb to keep an eye on the health of the 90+ StockRanks over the last couple of years. Riffing on Antonacci's absolute momentum theory, if the 1 year performance of the top 10% of ranked stocks is below zero, then it's time to play defence. Nearly every segment of the market has been under water by Antonacci's measure for some time which is one of the reasons I've been preaching caution, but the 90+ ranked shares weren't, until Brexit. As you can see from this chart, on a 1 year time frame, the 90+ StockRank set has now fallen by 4% over 12 months.
Given the US is at the end of a 6 year bull market, that macro nerves are abundant, that risk assets have been propped up by quantitative easing and our market timing indicator has turned negative, the major risk this year may not be to the upside.
Playing a good defence
One of the big mistakes that some investors make is treating equity exposure as a binary in/out decision. The equity markets are volatile and possibly manipulated into being overly volatile in order to 'shake out the weak hands' on a regular basis. Volatility and severe short term price falls often lead to people throwing in the towel and liquidating their portfolio right at the worst possible moment. This article I wrote about staying calm when facing the 'beast' of volatility in the market actually marked the precise date of the October 2014 low. Anyone selling on that day would have missed out on considerable 20%+ returns since.
John Maynard Keynes who once said that when it comes to the future: "We simply do not know." So instead of liquidating a portfolio when fearful, a better way to reduce equity exposure is to stay invested but hedge the downside. This can be achieved by taking out insurance, either by shorting the market or shorting individual names. Shorting is very easy to do these days with the tools available - there are short ETFs which can be bought, the indices can be sold short using spread bets or CFDs, or put options can be bought through a broker. It's out of scope for this article to explore this in more detail, but it should help trigger debate.
Another alternative is to employ a trailing and/or protective stop-loss strategy to raise cash as individual names decline. Stop losses do create more transaction costs and don't tend to improve returns but they do reduce the risk of severe loss. A 20% stop loss applied to this year's NAPS would have reduced the maximum drawdown by more than 3.5%. A few weeks ago I wrote an article detailing the likelihood of drawdowns and espoused the virtues of using stop losses.
Most investors focus entirely on finding a good technique for buying, but rarely consider methods for selling. Ultimately, without an exit plan we're at the mercy of the market. My own experience in 2008 taught me never to become emotionally attached to any of my stocks again. While I'd bought really well on the way up, I changed my plan on the way down as I'd fallen in love with my holdings. I gave up on my stop loss rules, and it didn't end pretty. I've noticed a lot of people rationalising their reasons for continuing to hold shares that have fallen considerably. The market will continue to dish out painful lessons to those who refuse to learn…
Half year selections
Once again with the help of some of the fine Stockopedia team (namely Ben Hobson, Alex Naamani and Tom Firth) we've put together a brief synopsis of each of the stocks qualifying for the NAPS 2016 rules at the half year mark. The list appears a particularly contrarian one this time around. Personally, I know nothing about any of these stocks other than the fact they qualify for the rules, so if you are doing your own investing, DYOR.
Camellia (OTC:CLAVF) - StockRank 97, MktCap £218.2m - Camellia is a holdings company with interests spanning agriculture and horticulture, engineering, food storage and distribution, private banking and financial services, and property and investments. Its share price has drifted down over the past year despite rising earnings forecasts from brokers. In April the company said: "The strength and diversity of our operations, the investments we continue to make in Agriculture, the success we have had in bringing in new management, and the ongoing turnaround, sale or closure of our loss making companies, all point to a more successful future. However conditions in many of our markets remain challenging."
McColl's Retail (OTC:MTCRF) - StockRank 95, MktCap £136.1m - Shares in this network of convenience stores and newsagents have had a roller coaster year in 2016 and the stock now has a very high ValueRank. Paul Scott has expressed reservations about the company's balance sheet and its potential as a "cigar butt" business. On the flip-side, McColl's does have a decent record of growing profitability and plans to expand further. In March the company said: "In a challenging market we have grown sales and improved profits, at the same time we continue to deliver on our strategy of evolving our store portfolio. McColl's is a business which can continue to grow and deliver for customers, colleagues and shareholders."
Indivior (OTCPK:INVVY) - StockRank 99, MktCap £1.81bn - Indivior originally joined the SNAPS portfolio in 2015 and still makes the grade. The pharma group was spun-out of Reckitt Benckiser in late 2014 with only one real commercial product, Suboxone. Fears that generic competition might eat into Indivior's market share were partly alleviated in June when the first of a number of litigation cases concerning Suboxone was won. The company noted: "The ruling confirms Indivior's belief in the validity and enforceability of its Suboxone Film patent portfolio and provides the business with substantially greater certainty about the nearer-term outlook."
Lifeline Scientific - StockRank 90, MktCap £56.6m - This is an American medical technology company (reporting in US dollars) which has seen some impressive strength in its shares this year as a result of fast-growing profitability. An ongoing strategic review in looking at possible mergers, acquisitions or a possible sale of the company. In April it reported: "We have seen significant improvements in our full year revenues and profitability, and this performance has advanced across all strategic initiatives. We have seen growth in all of our major markets and continue to maintain a robust cash position."
Drax (OTCPK:DRXGY)(OTC:DRXGF) - StockRank 97, MktCap £1.32bn - Including Drax in the New Year portfolio earlier this year caused a great deal of anguish in the Stockopedia office. It looked beaten up and deteriorating and was on the wrong end of changes to government regulation. But we're not allowed to over-ride the rules, and thank the heavens we didn't as the shares have gained more than 32% since then and the ranking has climbed. In February the company's CEO said: "I am confident we have a strong team, sound business model and robust balance sheet to capitalise on future opportunities for growth should they arise. At the same time, we are prepared for a variety of eventualities in an ever-changing and challenging environment."
National Grid - StockRank 69, MktCap £41.07bn - This electricity and gas utility joined Drax in the 2016 Naps portfolio and finished the half-year with a sharp upwards spike after the EU referendum. That surging momentum has damaged the value appeal of National Grid, which, given the popularity of defensive stocks, was already pricey. In May the company said: "We are well positioned to deliver asset growth in 2016/17 and beyond. We will continue to enhance efficiency across the Group to deliver an outstanding and affordable service to our customers."
SCS - StockRank 100, MktCap £64.8m - Sofa and flooring retailer SCS has reported strong trading conditions this year, with earnings forecasts being ratcheted up accordingly. In June the company said it expects to report profits ahead of current market expectations which have already been significantly upgraded during the current year. The stock currently boasts a whacking forecast yield of 8.4%. Trading Update 09/06/16 - "the Group expects to report profits ahead of current market expectations which have already been significantly upgraded during the current year."
XLMedia, StockRank 98, MktCap £131.5m - XLMedia specialises in the online marketing of gaming companies. This Israeli group is highly profitable and has a strong track of earnings growth. In May it reported that current trading was strong and remained in line with internal expectations. "The Board believes that Group operating profit for the year ending 31 March 2016 will be slightly ahead of current market expectations". Paul Scott has previously raised concerns about the future sustainability of earnings and wrote about it here.
Gem Diamonds (OTC:GMDMY)(OTCPK:GMDMF) - StockRank 99, MktCap £174.3m - Small cap mining stocks have been some of the big beneficiaries of uncertain market conditions in 2016, and this diamond mine operator is no exception. With mines in Lesotho and Botswana, Gem Diamonds boasts a solid track record of high profitability. In May it said it had seen a "strong start to the year with production in line with plan."
Powerflute Oyj (OTC:PWRFF) - StockRank 97, MktCap £204.2m - Powerflute is a paper and packaging company with an operational base in Finland. It has a buy-and-build growth strategy and doubled its size and profitability in 2015 with a major acquisition. It boasts some very strong financial quality characteristics but the share price has drifted over the past year amid signs of softening market conditions. In the annual report the company stated "We currently expect that 2016 will be another successful year for the Group."
H&T - StockRank 99, MktCap £92.9m - Financial stocks took a hammering in the aftermath of the EU referendum but one exception was high street (ex) pawnbroking chain, H&T. Now a veteran of the Naps portfolio (it has been included since the early months of the original portfolio), the shares have performed very well since the spring. A turnaround plan looks to be succeeding, with profits rising well in 2015. H&T recently reported that: "We have built a robust infrastructural platform which, when combined with the development of new products and the solid performance of our core businesses, means we are increasingly well placed in this new environment."
3i Infrastructure (OTC:INFCF) - StockRank 98, MktCap £1.83bn - This is a closed-ended investment company that makes equity and debt investments in infrastructure and greenfield projects in developed markets in the UK and Europe. A combination of price strength and recent broker upgrades give 3i excellent momentum, which combines with strong financial quality. In a trading statement in January, the company said: "Looking ahead, we are confident in our business model and our ability to continue to deliver our objectives."
Somero Enterprises - StockRank 98, MktCap £88.8m - One of Paul Scott's favourite stocks, Somero makes specialised leveling equipment that is used in laying concrete floors. It's based in the US and local sales represent 70% of the total, and are growing the most in absolute terms. This combined with the fact that Somero reports in US dollars ought to be a real plus given the fall in the value of sterling. The company has particularly strong quality and momentum ranks. Trading Update 06/06/16 "Somero is pleased to report that overall business is progressing well in 2016".
Dart (OTC:KESAY) - StockRank 98, MktCap £779.7m - One of the biggest winners for subscribers in recent years, Dart runs a package holiday/ airline business and a road haulage operation. Airlines were among the losers in the fallout of the EU referendum, and it's true that shares in Dart have come under pressure. Even so, the strong long-term momentum and high quality fundamentals mean the stock still looks reasonably priced. In March it reported: "Although it is still early in the leisure travel booking cycle and notwithstanding challenges in the Eastern Mediterranean, given current booking momentum the Board expects operating performance for the year ending 31 March 2017 to be broadly in line with the current year."
John Wood - StockRank 96, MktCap £2.62bn - There has been a sustained upward trend in the price of John Wood shares in 2016 and sentiment has warmed to the oil and gas sector. The engineering group saw profitability slump in 2015 but it's forecast to bounce back strongly over the next two years. The company recently reported: "The current environment remains challenging, however we are encouraged by the recent Upstream awards and feel well positioned for future activity in brownfield maintenance and US onshore. Overall the outlook for the full year has not changed and there is no change to EBITA guidance of around 20% down on 2015 as given in May."
Glencore (OTCPK:GLNCY) - StockRank 77, MktCap £22.0bn - Glencore was a poster child for the dramatic downward trend in fortunes for commodity-focused businesses through 2015. However, the stock has seen an uptick this year as the mining sector begins to attract investor attention. Strong value appeal and improving momentum point to a potential turnaround if commodity prices improve. In March the company said: "Our rigorous focus on debt reduction, supply discipline and cost efficiencies enabled Glencore to record a robust performance in difficult market conditions."
Manx Telecom - StockRank 97, MktCap £223.7m - Manx Telecom was brought into the Naps portfolio earlier this year and until a recent bout of volatility it had delivered a great performance. The quality metrics here are strong, as is the momentum. Profits soared in 2015 and further growth is expected in 2016. In March the company said: "We continue to generate strong cash flow, which enables us to create value for shareholders, while continuing to invest in our infrastructure projects at an average of £10m per year over the last 3 years."
Gamma Communications - StockRank 84, MktCap £351.7m - Gamma sells telecoms services to the business market and has seen strong growth in profitability in recent years. Brokers have been consistently upping the earnings forecasts on the stock over the past year. In some respects the valuation looks stretched, but quality and momentum are both strong. In March the company said: "The Board looks forward enthusiastically to 2016 and beyond. The emerging market for converged fixed and mobile services presents many opportunities, and Gamma is well placed to exploit these with its clear focus on the UK business market and its commitment to new product development."
Computacenter (OTC:CUUCY) - StockRank 96, MktCap £904.8m - IT infrastructure company Computacenter was another stock that made it into the original Naps portfolio in January. Recent volatility and some forecast downgrades have dented otherwise strong momentum but the stock's solid projected EPS trend remains intact. In April the company said: "As we highlighted in our 2015 final results we expect 2016 to be a year of progress and we also expect to end the year with record levels of net funds."
Spirent Communications (OTCPK:SPMYY) - StockRank 91, MktCap £497.0m - Spirent provides technology services for the communications industry. Shares in the company got off to a strong start in 2016 driving the stock's momentum, and complementing some very strong financial characteristics. Profits have been on a downtrend in recent years but forecasts for the next two years suggest some substantial improvement ahead. In February the company said: "The seasonality we saw last year is likely again to be a factor, but the Board's expectations for 2016 are unchanged. We remain confident in our strategy delivering a sustainable and growing business."
Hopefully this has been a thought provoking piece. If you have been using a NAPS process or a variation of it, please do share any successes and failures, warts and all in the comments below… we're all trying to learn and improve here. Hopefully this post will trigger a useful discussion. Safe Investing !
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.