Sunday, May 17, 2009

The Investment Labyrinth?

A few weeks ago, Susan Eng, Vice President Advocacy at the Canadian Association of Retired Persons (CARP), asked me to write an article on investing.

At first I hesitated. I simply do not believe a "once size fits all" approach to investing. Moreover, I am a risk-taker and my risk profile is certainly not the same as most investors out there. I can stomach huge swings in volatility because when I have conviction on a trade, I remain focused and ride out the storm.

I have already written some investment comments like Boy Plunger's Pivotal Point Theory and in January, I wrote an extensive comment on Outlook 2009: Post-Deleveraging Blues?

I want to follow-up here and give you my approach to investing my money. I typically start by looking at the big picture. Last week I wrote comments on the "W" recovery and followed up by asking whether inflation is inevitable.

I like to constantly read on what are the big secular trends and have broken them down to the following key themes:
  • Inflation/ deflation
  • Alternative energy (solar, wind, nuclear)
  • Chindia (China & India)
  • Demographics (healthcare, biotech, etc.)
  • Infrastructure ( see update below)
  • New technologies (nanotech, etc.)
You might ask why I think thematically. When I was investing with the top hedge funds, I noticed the best ones were not only great stock pickers, but they also typically related their stock picks to broader themes. In other words, they combined a bottom-up approach with a top-down approach.

I still like to track what hedge funds are buying and selling because they have strong incentives to outperform. Remember, unlike a mutual fund manager, a hedge fund manager does not get paid if they do not perform.

This does not guarantee they will not make mistakes. Most hedge funds are poor performers in down markets and that's why most got clobbered in 2008. Still, I like to spy on the top hedge funds to gain some insight into what they are buying and selling.

The other investors I like to spy on are people like Bill Miller of Legg Mason. Mr. Miller beat the S&P 500 for many years because he wasn't afraid to take concentrated bets in sectors. He too got clobbered in 2008 but at least he invests with conviction which is more than I can say for the majority of mutual fund managers who charge fees and under-perform index funds.

Importantly, when selecting a fund manager, ask tough questions on fees and do not place too much emphasis on one year performance. Even the best fund managers can have a bad year and conversely, the worst ones can have a good year.

Again, Legg Mason is an excellent example. They got clobbered last year but if you understand their style - taking more concentrated bets to outperform the index - then you understand why they lost money in a year where everything blew up.

In a comment I wrote back in October, looking beyond the 2008 stock market crash, I wrote that I track the following funds from MFFAIS website (data is lagged but fairly recent):

AQR Capital Management

Atticus Capital

Bridgewater Associates

Caxton Associates

Citadel LP

Clarium Capital Management

Farallon Capital Management

Greenlight Capital Inc

Golden Tree Asset Management

Goldman Sachs Group

Hussman Strategic Growth Fund

Legg Mason

Letko Brosseau and Associates

Kingdon Capital Management

Maverick Capital

Quantum Capital Management

Spinnaker Capital LP

Sprott Asset Management

Tiger Global Management

Viking Global Investors LP

[Note: John Hussman of Hussman funds writes an excellent weekly market comment on the web which you should all be reading.]

Another good source of information on what hedge funds are buying and selling is Seeking Alpha's comments on hedge fund activity.

The reason I track what some of the better known hedge funds and mutual funds are buying and selling is that I learned long ago to ignore what most analysts think and to pay attention to what the big funds are buying and selling.

It is important to remember that the stock market is its own beast. One of the most humbling experiences of my life was trading to make a living on my own. I would spend the whole day looking at how prices swung from opening bell to the closing bell.

I learned about gaps and filling the gaps before a stock would move higher. I paid attention to the highs, lows and closing prices of the day and of the week. I also paid attention to unusual swings in volume which could signal accumulation was going on.

For the most part, I keep my technical analysis simple. I like to see stocks moving above their 50 and 200 day moving averages, but I often buy stocks in sectors that got pummeled where I feel there is a long-term secular trend (for example, solar stocks make up most of my long-term holdings. When they got decimated, I doubled down and bought as much as I possibly could).

I also use technicals to see if this is another sucker's rally or the start of a great new bull market. Looking at the 50 day and 200-day moving averages of the Dow Jones, I see that we are at a point where we might break out higher or break down lower. In other words, there might be more follow through after this Q2 rally which I have been calling for or there might be another "sell in May and go away" ending to this latest rally.

I don't know the future, but I am better prepared to deal with it. For those of you who swing trade, there are ways to make money in down markets by buying Proshares ETFs or Direxion ETFs. In Canada, it 's called Horizon Betapro ETFs.

[Note: Hedge funds love to play these leveraged ETFs, but most investors should avoid them because they will lose their shirts. Moreover, these products need tighter standards for disclosure].

So what are the most important things to remember about your personal portfolio? I would tell you that secular trends can last for a long, long time. We have come off a long secular bull market for financials and I believe that it will be followed by a long secular bear market that could last a decade or longer.

I know that banks rallied sharply from the March 9th lows, but I consider this a strong technical rally, not the beginning of a secular upswing. I just do not see what will propel banks higher in the coming years. Leverage has been cut, securitization, private equity and real estate are in the doldrums, trading profits are down and the only thing banks have to survive is the spread they have on borrowing at a low interest rate and lending at prime rate.

There are other sectors of the economy that should do well. Tech inventories have been slashed to bear bones so expect tech companies to come out strong on any signs of a global recovery (just buy Nasdaq index shares like QQQs).

As far as a global recovery goes, keep an eye on shipping stocks like DryShip (DRYS), Eagle Bulk Shipping (EGLE) and Excel Maritime (EXM). A pick-up in global trade will first be seen in these stocks.

If deflation sets in, you need to have a strong allocation to government bonds to weather the storm. Even a low yield is better than a negative yield when dealing with the ravages of deflation.

If inflation picks up, you'll see gold shares being bid up. Keep an eye on spot gold prices over the next few years to see if inflation expectations are shifting.

I end this comment on the investment labyrinth with another article by Luc Vallée that appeared in the Financial Post over the weekend, Broker model needs repair:

There are segments of the financial industry that can be easily and immediately reformed. On the heels of recent investment scandals, it is pressing to review the business model of the retail fund manager.

As it stands today, the model stifles competition, favours large firms and leads to pricing abuse, low-quality information and substandard services. Most people I have talked to are not satisfied with their brokers, nor with their exorbitant fees. Yet, most clients won't switch for lack of a better alternative.

Who can blame them? Switching to a possibly better broker often means transaction fees, headaches due to interrupted service and running a higher risk of being the victim of a fraud. Here are the facts:

-Most money managers do not beat the markets. The median money manager's performance is well below that of an indexed portfolio. In other words, after fees, the average broker loses money when compared with a market index.

-It is more difficult to choose a money manager based on his knowledge and performance than it is to choose a stock portfolio. Indeed, most money managers rely on other people you don't even know and whose performance is unknown in order to manage your money.

-By charging you 1% annually to manage your money, a large portion of your wealth ends up in his or her pocket.

Let me elaborate on the third point: Assume that a balanced portfolio will yield annually a 5% nominal return for the foreseeable future. After 15 years, if you reinvest your 5% return every year, without the help of a broker, the value of your portfolio will have slightly more than doubled. If, instead, you pay your broker 1% of your assets, your annual return will be 4% and it will take you 3½ more years to reach the same performance. And remember you still have to pay your broker even if you lose money.

How do you know if your broker is of the good variety? As the investment process of most brokers is a total black box, its outcome should be considered pure luck.

One way to solve the problem is to force the separation of fund management and "custodian" services. You grant your broker the permission to make the investment decisions in your portfolio but never allow him or her to touch your money sitting at the custodian of your choice.

Granting "custodian" status to a few large institutions and providing a government guarantee against fraud in exchange for regulation of the custodian industry would provide investors with many benefits. First, you would sleep at night knowing that you won't be the victim of the next Bernard Madoff. Second, you could change your broker at will since all ancillary services, such as money transfers to your regular bank account, paying taxes and so on, could be performed by the custodian for a minimal fee.

Competition in the brokerage business would then increase dramatically, which would, in turn, help to lower prices. Fees would probably migrate from a percentage of assets under management to a structure based on a fixed fee for each service that you would purchase. The quality and diversity of services would also improve as tax strategy and estate-planning services would probably be the kind of value-added services that would attract investors to a brokerage firm.

Finally, information about the quality of the brokers would increase and be more widely available.

I couldn't agree more. We need more competition, better disclosure and better enforcement on existing products to protect retail investors from sharks peddling snake oil.

Only then will the investment labyrinth be a little easier to navigate through.


I added infrastructure as a theme after reading Random Roger's comment on thematic investing. I also added Kingdon Capital management's activity from MFFAIS and will add other funds as I see fit.

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