Performance Review
Despite, or more accurately I should say because of, the turmoil in markets the portfolio performed quite adequately during May. While the final performance of +0.36% for the month (putting the YTD at 2.9%) is decent, it understates how well the portfolio coped during May.
Unsurprisingly, the weakest parts of the book were those that were long equities. The Value Equity bucket (-134bps) was the most disappointing of these; THRX remains volatile (giving up all of April’s gains, and more) and the decision to take Earnings-related risk on the initial DRWI proving costly, though the stock’s sharp reaction to the uncertainty provided a good opportunity to add to the name. The Other Equity bucket (-38bps) and Absolute Value/NCAV bucket (-23bps) both fell with the market, which in the latter’s surprise was ahead of relative expectations.
Given the strength of the sell off and market fears, there was a continued bid for instruments perceived to be safe resulting in the Treasury Bucket (+188bps) being, by some distance, the largest contributor. Exposure to Treasuries also benefited the tortoise-like Bond Fund Bucket (+14bps).
While the hedge/put option bucket (+43bps) was a contributor, it did not benefit as fully as one might have expected in part as rumors of a Goldman-SEC settlement helped investors reconsider GS’ “franchise value”. The short China-related thesis (-18bps), which has been discussed almost the entire year but hadn’t yet been added to the book, finally entered the book near the end of the month. As such, around 1/3 of its loss stemmed from costs related to its implementation (commissions, bid-ask spread, etc) – it is a bucket that I’ll be looking to add to, if there’s sufficient market strength.
Portfolio
42.8% - Long Treasury Bonds (20.5% TLT and 22.3% in the Aug-29 Bond)
14.3% - Long Bond Funds (6.7% HSTRX, and 7.7% VBIIX)
4.7% - Value Idea Equities (2.9% THRX, and 1.8% DRWI)
3.4% - Absolute Value/NCAV Equities
3.1% - Other Equities (1.6% NWS, 1.5% CMTL, and 0.0% SOAP)
-0.9% (delta-adjusted) - China-Related Thesis (15bps premium in FCX put, 6bips premium in EWA put)
-7.1% (delta-adjusted) - Hedges/Put Options (61bps premium in S&P put, and 100bps premium in a GS put)
30.0% - Cash
Sunday, May 30
Saturday, May 29
Endowments – Part A: Introduction to Endowment Model
Today, I’m going to disappear off down a strange tangent so apologies in advance for that. The decision to start this blog came as a result of two things. The first was that I started reading blogs in 2006, and felt I learned far more from them (with particular hat-tips to Calculated Risk and the now retired Macro Man) than I did through work. The second was as a couple of non-investments related courses that I took at Business School during 2008, that somewhat bizarrely helped me finder greater comfort in my own investment style.
Since, Our Man is currently among the unemployed and looking at jobs related to his pre-MBA employment, he’s hoping to get some interviews with Endowments. What better time to stab himself in the eye and look back at his final paper from one of those ‘eureka’ classes. The paper was tongue-in-cheek entitled – “A critique of the Endowment Model – preemptively; Why Harvard and Yale generated no investment performance from 2008-2017”.
Most endowments have two minimum objectives:
1. Disburse a sufficient level of assets to the associated institution in order to help meet the institution’s mission. Legally, non-profits are required to disburse c5% of their total each year to the associated institution.
2. To maintain the “real” value of the endowment’s principal in order that the inflation-adjusted level of funding is unchanged going forwards. Recent history shows that this has broadly been in the 2-3% range.
As such, most endowment’s target levels of return, not risk, and the requirement can be seen as:
Minimum Target Return (c7.5%) = Disbursement Requirement (c5%) + Principal Inflation-Adjustment (c2.5%)
The Yale or Endowment Model
If we look at Exhibit A, the performance of Yale and Harvard are noticeable; not only were they amongst the largest endowments (in 1986, as well as 2008) but they both generated amongst the highest compound annual growth rates over the 23-year period. Yale’s phenomenal performance has largely been attributed to David Swenson, who became the University’s Chief Investment Officer in 1985. Following his 2000 book, Swenson's investment style has come to be known as the “Yale Model”.
Exhibit A: From NACUBO Reports
The intuitive philosophy behind the “Yale Model” is as follows: the perpetual nature of University (and/or non-profit) endowments means that their investment horizon should be exceptionally long-term, giving them with the ability to ignore short-term market fluctuations while they maximize long-term returns. As such, endowments should invest a smaller proportion of their assets in traditional investments (bonds and equities) and far greater portion of their assets into alternative and non-traditional investments, as due to their infinite time horizon the endowment could reap the illiquidity premium from investing in these illiquid assets. Furthermore, by investing across numerous asset classes, in a diversified fashion and regularly rebalancing, the belief is that risk could be reduced.
The below graphs, from Yale’s Endowment 2007 and Harvard’s policy portfolio, show Yale’s allocation at FY-2007 and the evolution of Harvard’s endowment which shares a broad philosophy with Yale.
The “Yale Model” has become widespread amongst endowments, with NACUBO's 2008 report suggesting that by mid-2008 $1bn+ endowments, on average, allocated almost 50% of their capital to alternative assets.
Since, Our Man is currently among the unemployed and looking at jobs related to his pre-MBA employment, he’s hoping to get some interviews with Endowments. What better time to stab himself in the eye and look back at his final paper from one of those ‘eureka’ classes. The paper was tongue-in-cheek entitled – “A critique of the Endowment Model – preemptively; Why Harvard and Yale generated no investment performance from 2008-2017”.
Most endowments have two minimum objectives:
1. Disburse a sufficient level of assets to the associated institution in order to help meet the institution’s mission. Legally, non-profits are required to disburse c5% of their total each year to the associated institution.
2. To maintain the “real” value of the endowment’s principal in order that the inflation-adjusted level of funding is unchanged going forwards. Recent history shows that this has broadly been in the 2-3% range.
As such, most endowment’s target levels of return, not risk, and the requirement can be seen as:
Minimum Target Return (c7.5%) = Disbursement Requirement (c5%) + Principal Inflation-Adjustment (c2.5%)
The Yale or Endowment Model
If we look at Exhibit A, the performance of Yale and Harvard are noticeable; not only were they amongst the largest endowments (in 1986, as well as 2008) but they both generated amongst the highest compound annual growth rates over the 23-year period. Yale’s phenomenal performance has largely been attributed to David Swenson, who became the University’s Chief Investment Officer in 1985. Following his 2000 book, Swenson's investment style has come to be known as the “Yale Model”.
Exhibit A: From NACUBO Reports
The intuitive philosophy behind the “Yale Model” is as follows: the perpetual nature of University (and/or non-profit) endowments means that their investment horizon should be exceptionally long-term, giving them with the ability to ignore short-term market fluctuations while they maximize long-term returns. As such, endowments should invest a smaller proportion of their assets in traditional investments (bonds and equities) and far greater portion of their assets into alternative and non-traditional investments, as due to their infinite time horizon the endowment could reap the illiquidity premium from investing in these illiquid assets. Furthermore, by investing across numerous asset classes, in a diversified fashion and regularly rebalancing, the belief is that risk could be reduced.
The below graphs, from Yale’s Endowment 2007 and Harvard’s policy portfolio, show Yale’s allocation at FY-2007 and the evolution of Harvard’s endowment which shares a broad philosophy with Yale.
The “Yale Model” has become widespread amongst endowments, with NACUBO's 2008 report suggesting that by mid-2008 $1bn+ endowments, on average, allocated almost 50% of their capital to alternative assets.
Tuesday, May 25
Portfolio Update
One of the points of this blog is that I’ve always found that writing helps me think, and knowing what I think helps me be more decisive (and hopefully make better decisions).
The small portfolio tweak this afternoon, stems from my ponderings on the portfolio and risk captured in the previous post. I closed one of the general market hedges (SPY put, Dec-10 expiry and $85 strike) and replaced it by finally starting the China-Related bucket (described here and here). This was done through opening 2 out-of-the money puts in FCX (Jan-11 expiry and $40 strike) and EWA (Oct-10 expiry and $16 strike). The overall cost after all commissions, was less than 1 basis point (though both positions suffered a loss today, largely bid-ask spread) with the China bucket now representing 30bps of premium (and -1.0% on a delta adjusted basis).
While the capital at risk is unchanged, it is noticeable that while the time horizons are broadly similar, the strike price of both of the new positions is further out-of-the-money. This reflects both the increased risk in the positions (a crude way of seeing this is that the beta of both FCX and EWA are greater than 1) and my increased belief in the possibility of a China-related unwind.
The small portfolio tweak this afternoon, stems from my ponderings on the portfolio and risk captured in the previous post. I closed one of the general market hedges (SPY put, Dec-10 expiry and $85 strike) and replaced it by finally starting the China-Related bucket (described here and here). This was done through opening 2 out-of-the money puts in FCX (Jan-11 expiry and $40 strike) and EWA (Oct-10 expiry and $16 strike). The overall cost after all commissions, was less than 1 basis point (though both positions suffered a loss today, largely bid-ask spread) with the China bucket now representing 30bps of premium (and -1.0% on a delta adjusted basis).
While the capital at risk is unchanged, it is noticeable that while the time horizons are broadly similar, the strike price of both of the new positions is further out-of-the-money. This reflects both the increased risk in the positions (a crude way of seeing this is that the beta of both FCX and EWA are greater than 1) and my increased belief in the possibility of a China-related unwind.
Saturday, May 22
Portfolio Thoughts and Risks – 05/10
First, more generally, I try to stay away from regular missives on how the portfolio is doing; given my thematic bent, the pace of change is often excruciatingly slow and while writing about it may make it more exciting, it does little to help speed the passage of time. That and as those who know would attest, I’ve never been known to be particularly loquacious on subjects that I have little to talk about.
As such, I’ll spare you all the “post hoc ergo propter hoc” analysis floating around to try and explain the market’s recent decline; bar to state the obvious and say that it’s the market that makes the news (not the other way around) and that fear (though I wouldn’t say panic or capitulation) is back.
Given the general theses that I’ve been espousing and the portfolio’s construction, with its heavy leaning towards flight to quality assets and smattering of equity puts, it shouldn’t be a surprise that the portfolio is bearing up reasonably well and has eked out a small gain in May.
Given that, what do I think and worry about?
The short-term:
I’m relatively sanguine at the moment, with the portfolio remaining set up to perform well on an absolute basis if markets fall and to “hang around” (though this likely entails giving up recent gains first) should the rally resume. The latter situation would represent a disappointing year, though at least capital is unlikely to be noticeably impaired.
Any short-term views I hold tend to be applicable towards position sizing (rather than trading positions), and today clearly the biggest risk to the portfolio is a large shift back towards increased risk appetite. A further bounce (e.g. following new European measures agreed over the weekend) within a continued downtrend isn’t overly concerning. It will doubtless cost the portfolio, but if it was within a broader trend then it’s more likely short-term mark-to-market risk than anything that will have any longer-term impact. Even an aggressive move, while painful for the Treasury position, would be acceptable given the increased size of the NCAV bucket (with its penchant towards micro-small cap names).
The most difficult situation would be a more orderly resumption of the rally coupled with investors putting an increased premium in liquidity (to give themselves flexibility); here, the small-micro cap nature of part of the book would see it suffer, while the puts and Treasuries would offer little protection and would probably suffer too in an unfortunate double whammy. Separately, should the market progress from fear to panic the NCAV bucket would be heavily hit but this is less concerning given the probable performance of the puts and Treasuries.
Finally, you’ll notice that I haven’t talked about Treasuries much; I’ve been a little surprised by their sharp move over the last weeks -- TLT was +8.5% over the last month vs. +<4% Aug-Oct 2008. Clearly, they’ve benefited from being under-owned and being seen as a flight-to-quality instrument, as well as the weak inflation data. These are amongst the reasons that I’ve substantially discounted the probability of the European contagion in sovereign bonds spreading to US Treasuries. Though I view the probability as small, this remains the scenario that would do the most damage to the portfolio.
Longer-term:
Strange at it seems, I’m already looking towards the late 3rd and 4th quarter and the turning of the calendar as being the period likely to be fraught with the most important decisions. With my short exposure expressed through puts and the expirations around year-end, the nightmare scenario is a volatile S&P that falls back into somewhere that could broadly be described as acceptably fair value (850-1,000) and Treasuries finding a 2008-like end-of-year bid as investors seek to represent themselves as prudent. Given the likelihood that I’ll have legged into some longs, and want to reduce the Treasury holdings, it leaves the possibility of going into 2011 in a no-man’s land, with increased but not substantial long exposure and a hoard of cash.
On the other side of the coin, there’s the fear of missing out on potential short names especially those related to the China theme (e.g. FCX, JOYG, etc) and Australia (EWA). Both are down substantially from their peak, and with volatility having increased, they’re harder shorts (psychologically at least). This matters because I worry most about the Euro and trade (and the restrictions on it). I’ve stated before that the Kindleberger spiral of global trade during the Great Depression is one of my favourite graphs/pictures.
I suspect any substantial fall in the Euro is setting the stage for our own modern-day version of the Kindleberger spiral. However, far more troubling than that, in my (seemingly more frequent) darker more bearish moods I can’t help but wonder if the Greek crisis, and Europe’s reaction to it, may be our Franz Ferdinand or Credit Anstalt moments. Seemingly innocuous events, far from the mainstream, that tipped an unstable world into a cascade of crises that spiraled far beyond our control. Now there something that will keep one up at night…
As such, I’ll spare you all the “post hoc ergo propter hoc” analysis floating around to try and explain the market’s recent decline; bar to state the obvious and say that it’s the market that makes the news (not the other way around) and that fear (though I wouldn’t say panic or capitulation) is back.
Given the general theses that I’ve been espousing and the portfolio’s construction, with its heavy leaning towards flight to quality assets and smattering of equity puts, it shouldn’t be a surprise that the portfolio is bearing up reasonably well and has eked out a small gain in May.
Given that, what do I think and worry about?
The short-term:
I’m relatively sanguine at the moment, with the portfolio remaining set up to perform well on an absolute basis if markets fall and to “hang around” (though this likely entails giving up recent gains first) should the rally resume. The latter situation would represent a disappointing year, though at least capital is unlikely to be noticeably impaired.
Any short-term views I hold tend to be applicable towards position sizing (rather than trading positions), and today clearly the biggest risk to the portfolio is a large shift back towards increased risk appetite. A further bounce (e.g. following new European measures agreed over the weekend) within a continued downtrend isn’t overly concerning. It will doubtless cost the portfolio, but if it was within a broader trend then it’s more likely short-term mark-to-market risk than anything that will have any longer-term impact. Even an aggressive move, while painful for the Treasury position, would be acceptable given the increased size of the NCAV bucket (with its penchant towards micro-small cap names).
The most difficult situation would be a more orderly resumption of the rally coupled with investors putting an increased premium in liquidity (to give themselves flexibility); here, the small-micro cap nature of part of the book would see it suffer, while the puts and Treasuries would offer little protection and would probably suffer too in an unfortunate double whammy. Separately, should the market progress from fear to panic the NCAV bucket would be heavily hit but this is less concerning given the probable performance of the puts and Treasuries.
Finally, you’ll notice that I haven’t talked about Treasuries much; I’ve been a little surprised by their sharp move over the last weeks -- TLT was +8.5% over the last month vs. +<4% Aug-Oct 2008. Clearly, they’ve benefited from being under-owned and being seen as a flight-to-quality instrument, as well as the weak inflation data. These are amongst the reasons that I’ve substantially discounted the probability of the European contagion in sovereign bonds spreading to US Treasuries. Though I view the probability as small, this remains the scenario that would do the most damage to the portfolio.
Longer-term:
Strange at it seems, I’m already looking towards the late 3rd and 4th quarter and the turning of the calendar as being the period likely to be fraught with the most important decisions. With my short exposure expressed through puts and the expirations around year-end, the nightmare scenario is a volatile S&P that falls back into somewhere that could broadly be described as acceptably fair value (850-1,000) and Treasuries finding a 2008-like end-of-year bid as investors seek to represent themselves as prudent. Given the likelihood that I’ll have legged into some longs, and want to reduce the Treasury holdings, it leaves the possibility of going into 2011 in a no-man’s land, with increased but not substantial long exposure and a hoard of cash.
On the other side of the coin, there’s the fear of missing out on potential short names especially those related to the China theme (e.g. FCX, JOYG, etc) and Australia (EWA). Both are down substantially from their peak, and with volatility having increased, they’re harder shorts (psychologically at least). This matters because I worry most about the Euro and trade (and the restrictions on it). I’ve stated before that the Kindleberger spiral of global trade during the Great Depression is one of my favourite graphs/pictures.
I suspect any substantial fall in the Euro is setting the stage for our own modern-day version of the Kindleberger spiral. However, far more troubling than that, in my (seemingly more frequent) darker more bearish moods I can’t help but wonder if the Greek crisis, and Europe’s reaction to it, may be our Franz Ferdinand or Credit Anstalt moments. Seemingly innocuous events, far from the mainstream, that tipped an unstable world into a cascade of crises that spiraled far beyond our control. Now there something that will keep one up at night…
Wednesday, May 19
Some Ponderings on Risk
I often describe how I think of my role running this little portfolio as being the Chief Risk Officer, rather than the Chief Investment Officer. That may well sound silly to some (and perhaps rightly so), but the way I think about it is that my job is to take good risks (and the investment returns will fall where they fall) rather than to make good investments (it’s amongst one the many reasons I don’t really think of myself as a deep value or value guy). Paradoxical, I know and a deeper subject for another time.
Risk is one of the topics that I obsess over, as any long-time reader probably realizes, thus what better excuse to scrawl down some ponderings on risk both generally, and with regards to the broad portfolio make-up.
Risk Management vs. Risk Control
During my shortish career I’ve been fortunate to be able to spend a lot of time with a number of investors talking about their strategy. Something I’ve gleaned from these conversations and always found helpful is the subtle difference between what I call risk management and risk control.
Risk management, to me, is everything you do before you put a position into the portfolio including the research on it, the consideration of the risks involved, and the sizing of the position. I’d say it’s the most under-rated part of investing, and it certainly requires the most thought. One of the reasons is because it reflects the difference between having an opinion and how you execute it; too much of the investments business is centered around peoples’ opinions, when in my opinion the ability to execute these opinions efficiently (so that you make lots of money when right, and lose only a little when wrong) plays the key factor in generating returns.
Risk control, on the other hand, is what I think happens after the position is in the book; the readjusting, selling, adding, etc to a position.
I make the distinction because doing a better job of risk management requires a lot of proactive and wide-ranging thought before putting a position on to understand the risks involved. Furthermore, if done well, it should limit the number of occasions when risk control comes into play. I think that’s important because risk control is more likely to come as a reaction to some particular event, and as such is more likely to be a judgment based on emotion rather than rational though – something which I suspect, and much behavioural finance tries to show, leads to worse decisions.
How the NCAV Bucket affects the portfolio
One of my (many) flaws as an investor results from this focus on risk; I’m more comfortable underperforming in bull markets than I am losing money in bear markets. It’s also one of the reasons that I like having the NCAV bucket within the portfolio. The reasoning is simple; the size of the NCAV bucket is likely to be negatively correlated with the portfolio’s exposures. Or more simply, as the market rises one would expect the number of names in the NCAV bucket (and hence the allocation to it) to fall, reducing the portfolio’s equity exposure. Similarly, as the markets falls more names should meet the NCAV criteria and be added to the bucket, meaning the allocation should grow.
Why do I like that?
Simple; I can’t short and thus my short exposure comes from using puts, which means as the market falls, the delta expands and my short exposure increases. The additions to the NCAV portfolio partially offset this, especially early on during larger falls or if the falls in the market turn out to be no more than dips. The downside of course is that the negative performance impact is likely to be reasonably noticeable in a down-market, especially one that sees a noticeable shift away from risky assets (like the micro-small caps that the NCAV screen typically throws up). However, my hope is that as NCAV is a measure of absolute value (comparing a firm’s market cap to its balance sheet) rather than a relative value measure (e.g. P/E, EV/EBITDA, etc) these will merely be mark-to-market losses rather than more permanent impairments of capital (which would most likely be caused by write-offs and a reduction in balance sheet value).
Risk is one of the topics that I obsess over, as any long-time reader probably realizes, thus what better excuse to scrawl down some ponderings on risk both generally, and with regards to the broad portfolio make-up.
Risk Management vs. Risk Control
During my shortish career I’ve been fortunate to be able to spend a lot of time with a number of investors talking about their strategy. Something I’ve gleaned from these conversations and always found helpful is the subtle difference between what I call risk management and risk control.
Risk management, to me, is everything you do before you put a position into the portfolio including the research on it, the consideration of the risks involved, and the sizing of the position. I’d say it’s the most under-rated part of investing, and it certainly requires the most thought. One of the reasons is because it reflects the difference between having an opinion and how you execute it; too much of the investments business is centered around peoples’ opinions, when in my opinion the ability to execute these opinions efficiently (so that you make lots of money when right, and lose only a little when wrong) plays the key factor in generating returns.
Risk control, on the other hand, is what I think happens after the position is in the book; the readjusting, selling, adding, etc to a position.
I make the distinction because doing a better job of risk management requires a lot of proactive and wide-ranging thought before putting a position on to understand the risks involved. Furthermore, if done well, it should limit the number of occasions when risk control comes into play. I think that’s important because risk control is more likely to come as a reaction to some particular event, and as such is more likely to be a judgment based on emotion rather than rational though – something which I suspect, and much behavioural finance tries to show, leads to worse decisions.
How the NCAV Bucket affects the portfolio
One of my (many) flaws as an investor results from this focus on risk; I’m more comfortable underperforming in bull markets than I am losing money in bear markets. It’s also one of the reasons that I like having the NCAV bucket within the portfolio. The reasoning is simple; the size of the NCAV bucket is likely to be negatively correlated with the portfolio’s exposures. Or more simply, as the market rises one would expect the number of names in the NCAV bucket (and hence the allocation to it) to fall, reducing the portfolio’s equity exposure. Similarly, as the markets falls more names should meet the NCAV criteria and be added to the bucket, meaning the allocation should grow.
Why do I like that?
Simple; I can’t short and thus my short exposure comes from using puts, which means as the market falls, the delta expands and my short exposure increases. The additions to the NCAV portfolio partially offset this, especially early on during larger falls or if the falls in the market turn out to be no more than dips. The downside of course is that the negative performance impact is likely to be reasonably noticeable in a down-market, especially one that sees a noticeable shift away from risky assets (like the micro-small caps that the NCAV screen typically throws up). However, my hope is that as NCAV is a measure of absolute value (comparing a firm’s market cap to its balance sheet) rather than a relative value measure (e.g. P/E, EV/EBITDA, etc) these will merely be mark-to-market losses rather than more permanent impairments of capital (which would most likely be caused by write-offs and a reduction in balance sheet value).
Wednesday, May 12
Portfolio Update
Following it's beating since releasing earnings, the DRWI position was increased by 50% today, taking it to a c1.8% position.
While DRWI is still a speculative investment, remember that DRWI has $3.15/share in cash on its Balance Sheet. Additionally, a conservative liquidation value (assumes no value for tax assets, any long-term assets, or DRWI's technology, and a discount to book for receivables/inventory) is c$3.40-3.50.
While the news (or lack-of) on Clearwire and Tier 1 US carriers wasn't great on the conference call, bear in mind that analysts still believe DRWI will earn $0.80+ this year and be profitable next year. That combined with the balance sheet value remains interesting, given the $6.15 stock price.
While DRWI is still a speculative investment, remember that DRWI has $3.15/share in cash on its Balance Sheet. Additionally, a conservative liquidation value (assumes no value for tax assets, any long-term assets, or DRWI's technology, and a discount to book for receivables/inventory) is c$3.40-3.50.
While the news (or lack-of) on Clearwire and Tier 1 US carriers wasn't great on the conference call, bear in mind that analysts still believe DRWI will earn $0.80+ this year and be profitable next year. That combined with the balance sheet value remains interesting, given the $6.15 stock price.
Thursday, May 6
NCAV Q1.5-10
Before discussing the changes to the NCAV Bucket, let’s touch on the “rules” of adding things to the NCAV bucket:
1). Based on a quantitative screen: The stock must have a market cap > $50mn, be listed on a US exchange and its market cap must be <=65% of its NCAV
2). The data the NCAV is based off must be fresh (i.e. from within the last 3-6months)
3). Stocks can be removed from list if they fail a simple eye-ball test/qualitative glance (i.e. the case of NUHC last month, where it has lost its major customer and much of its NCAV was inventory).
4). Every stock that passes the above list of criteria is added at a fixed position size (50bips).
The NCAV bucket is interesting because its size (and hence the capital at risk) is counter-cyclical to the markets. By that I mean, that the more the market falls the greater number of stocks are likely to appear in initial quantitative screen and in the portfolio. However, since the size of the NCAV bucket is fixed by position size (i.e. NOT by allocation of capital to the bucket), the NCAV bucket should grow (in terms of names) as the market falls and shrink (in terms of names) as it rises. The $-allocation is also likely to follow a similar trend (though of course performance of the names will dictate the level of correlation) and the %-allocation should be correlated (but far less well, since it will depend on the rest of the book’s performance).
I think that this, in the fullness of time, will be an interesting feature of the bucket, but a related frustration will be that the initial performance of names added as the bucket expands may well be poor. This is related to the second potentially interesting feature; the information the bucket may provide. Most of the names within it are likely to be micro-small caps, something that along with the fact they pass the screen make them appear risky. As such, the performance of the bucket may be able to offer some broad insights in the willingness of market participants to take risk (though the small number of names may well limit the value of information that is provided).
While I’m generally not a fan of hard and fast investment rules, this is the most quantitative of my investment buckets, and having mentioned the entry rules it would make sense to note here the rules about exiting a position.
1). Do nothing within 30 days (since that’s a requirement for exiting any position)
2). Sell half of the position if the stock is up 65-100% from cost (a wide range, I know, but as we know these are micro-small caps and so volatile).
3). Sell the remainder of the position if the stock is up 150-200% from cost
4). Sell the entire position in 1-year from the date that it dropped off of the screen.
Why bring these rules up now?
I had intended to wait till next month’s NCAV post before mentioning the exit the rules, but the performance of BXG (which was added last month) brought it to the fore. BXG was added at an entry price of $3.26 (including commissions) and was trading over $6.00 when the 30-day period ended. As such, it was a candidate for trimming (done yesterday, c $5.75, including commission) and I thought it’d make sense to explain why.
What was added?
It seems that small cash-rich Chinese companies (with ADRs or primary listings in the US) are popular. Unsurprisingly, the purchase price of almost all would have been a little better if done today rather than yesterday!
What was qualitatively removed?
- NUHC, XING & PCC: for the same reason as last month
-The existing position in QXM also had stale financial statements, thus it’s 1-year clock has started (along with AVTR and BXG, neither of whom passed the screen)
The NCAV Bucket has 7 names (AVTR, BXG, QXM, XIN, CNTF, LTON and TWMC) and represented 3.4% of capital at yesterday’s close.
1). Based on a quantitative screen: The stock must have a market cap > $50mn, be listed on a US exchange and its market cap must be <=65% of its NCAV
2). The data the NCAV is based off must be fresh (i.e. from within the last 3-6months)
3). Stocks can be removed from list if they fail a simple eye-ball test/qualitative glance (i.e. the case of NUHC last month, where it has lost its major customer and much of its NCAV was inventory).
4). Every stock that passes the above list of criteria is added at a fixed position size (50bips).
The NCAV bucket is interesting because its size (and hence the capital at risk) is counter-cyclical to the markets. By that I mean, that the more the market falls the greater number of stocks are likely to appear in initial quantitative screen and in the portfolio. However, since the size of the NCAV bucket is fixed by position size (i.e. NOT by allocation of capital to the bucket), the NCAV bucket should grow (in terms of names) as the market falls and shrink (in terms of names) as it rises. The $-allocation is also likely to follow a similar trend (though of course performance of the names will dictate the level of correlation) and the %-allocation should be correlated (but far less well, since it will depend on the rest of the book’s performance).
I think that this, in the fullness of time, will be an interesting feature of the bucket, but a related frustration will be that the initial performance of names added as the bucket expands may well be poor. This is related to the second potentially interesting feature; the information the bucket may provide. Most of the names within it are likely to be micro-small caps, something that along with the fact they pass the screen make them appear risky. As such, the performance of the bucket may be able to offer some broad insights in the willingness of market participants to take risk (though the small number of names may well limit the value of information that is provided).
While I’m generally not a fan of hard and fast investment rules, this is the most quantitative of my investment buckets, and having mentioned the entry rules it would make sense to note here the rules about exiting a position.
1). Do nothing within 30 days (since that’s a requirement for exiting any position)
2). Sell half of the position if the stock is up 65-100% from cost (a wide range, I know, but as we know these are micro-small caps and so volatile).
3). Sell the remainder of the position if the stock is up 150-200% from cost
4). Sell the entire position in 1-year from the date that it dropped off of the screen.
Why bring these rules up now?
I had intended to wait till next month’s NCAV post before mentioning the exit the rules, but the performance of BXG (which was added last month) brought it to the fore. BXG was added at an entry price of $3.26 (including commissions) and was trading over $6.00 when the 30-day period ended. As such, it was a candidate for trimming (done yesterday, c $5.75, including commission) and I thought it’d make sense to explain why.
What was added?
It seems that small cash-rich Chinese companies (with ADRs or primary listings in the US) are popular. Unsurprisingly, the purchase price of almost all would have been a little better if done today rather than yesterday!
What was qualitatively removed?
- NUHC, XING & PCC: for the same reason as last month
-The existing position in QXM also had stale financial statements, thus it’s 1-year clock has started (along with AVTR and BXG, neither of whom passed the screen)
The NCAV Bucket has 7 names (AVTR, BXG, QXM, XIN, CNTF, LTON and TWMC) and represented 3.4% of capital at yesterday’s close.
Wednesday, May 5
Portfolio Update
A small flurry of trades this morning to update on.
Value Equity Bucket:
DRWI, 1.6% position -- As explained in the write-up, a position was taken in DRWI.
NCAV Bucket:
Four new positions (XIN, CNTF, LTON and TWMC) were added to the NCAV bucket, at c50bps each.
Half of the existing position in BXG was sold, the remaining position represents c45bips
I'll have some additional information up on the NCAV bucket posted tomorrow.
Value Equity Bucket:
DRWI, 1.6% position -- As explained in the write-up, a position was taken in DRWI.
NCAV Bucket:
Four new positions (XIN, CNTF, LTON and TWMC) were added to the NCAV bucket, at c50bps each.
Half of the existing position in BXG was sold, the remaining position represents c45bips
I'll have some additional information up on the NCAV bucket posted tomorrow.
Value Equity Bucket -- DragonWave Inc
The thesis for DragonWave is pretty simple, they do one thing - high-bandwidth wireless links for IP networks. The primary use of this is “backhaul” for 3G and 4G networks; backhaul is the connection from the cell-phone tower to the backbone of the Internet.
Demand-side: Why do we care?
The demand for this type of product to enhance and improve the connection of cell-phones to the Internet should be recognizable to us all. I think it’s clear to anyone who’s had a cellphone (or mobile, as we Brits call them) over recent years, that the amount of Internet data we get using it has increased substantially. After all, connecting to the web (and downloading all those iPhone/Android Apps) requires far more data (i.e. bandwidth) than making a phone-call, texting or sending an email. Furthermore it’s also pretty noticeable, especially for those who live in Manhattan, that the wireless networks are struggling to deal with the amount of data that needs to be downloaded – after all who hasn’t been frustrated by the fact your iPhone (if you can get AT&T Service) or Blackberry are so slow to confirm the Mets’ latest demise!
Supply-side: OK, so we care…but what does that mean?
The supply-side is somewhat more complicated. To help, let’s think of a wireless phone network in 3 parts; a) The backbone, b) The connection between the backbone and the cell-phone towers and c) The connection between the cell-phone towers and us, the end users. DRWI is only involved in part b, and is agnostic about the other parts (i.e. it doesn’t matter to them how your network connects to the tower)
Some fun facts:
- There are c200,000 cell-phone towers in the US (800K in Europe)
- US Connection to Backbone: 75% use T1 lines, 20% use fiber-optic cables and 5% use TDM (a low-bandwidth microwave link)
- In Europe, however, 70% connect using TDM (due to the cost of using T1) and 15% by fiber-optic cables
- In Emerging Markets, almost 100% use microwave (predominantly TDM)
- Both T1 lines and TDM are low-bandwidth solutions (i.e. great for voice, not so much for data), whereas fiber-optic cables are a high-bandwidth solution.
Now, if growth in data continues to grow then the above suggests we’re going to need a lot more bandwidth. Why? Well, only 20% of the towers in the US (15% in Europe, even lower in Emerging markets) are connected using high-bandwidth solutions. This is the potential opportunity for DRWI, though we should remember it isn’t going to happen overnight and will be a multi-year process.
Backhaul Technologies: We need lots of bandwidth, but why’s it good for DRWI?
There are 3-types of backhaul technologies:
1). Copper: This is what’s used for L-1, xDSL, etc. Copper’s problems are scalability and the fixed cost of getting the wire from the tower to the backbone is high, and that wireless carriers (unless they own that connection) have to pay a monthly charge to use it.
2). Fiber-Optic Cable: Fiber-optics are high-bandwidth, but the problem is again co st (e.g. it costs $100/foot in cities; and while this falls in the suburbs/country-side, you also have to run the cables for larger distances!) and again there are recurring charges (if not owned by the wireless company)
3). Microwave Technology: Unlike the other systems, there are no monthly recurring costs.
There are a few types of Microwave technologies:
- TDM: a low-bandwidth (i.e. not able to connect to IP) solution that will remain attractive for 2G expansion (especially in Emerging Markets).
- TDM-hybrid: where TDM (for voice) is used alongside a medium-bandwidth solution (for data), and so is attractive early in the upgrade cycle.
- Pure IP Microwave links: DRWI is the leader in this final solution and adheres to specifications that make it similar to landline IP. Furthermore, its Horizon systems are integrated (i.e. bandwidth increased easily and for low cost) and its Quantum solution delivers 4Gbs (the highest on the market). While I don’t have definite numbers on DRWI’s cost advantage, based on a study by a US Wireless carrier, it appears to be 70%+ cheaper than using fiber and the roll-out is substantially quicker (<6mos vs. 2-years).
Risks
- Customers: A major risk is that while DRWI has over a hundred customers, Clearwire currently represents 80% of DRWI’s business. Though this is not surprising, as Clearwire is the first-mover in 4G, DRWI will clearly have to expand its customer base beyond Clearwire. To this end, the company’s announcement on 24th February that they’ve signed an agreement with a major OEM, is a positive step. However, it also is fair to assume that the stock will be volatile, until there’s definitive news as to whether the company will be getting any business from the US behemoths (Verizon or AT&T).
- Competition: DRWI is the leader in high-bandwidth microwave, but there are other companies involved in the space. These include stand-alone companies Ceragon Networks, Aviat, Cielo, and Trango, as well as major multi-nationals such as Alcatel-Lucent, Ericcson and NEC. Of these, only Ericsson seems to currently offer a product that has capability of 1Gbs+.
- Execution/Production: The thesis implies that DRWI will see increased demand for their business, and a general risk in these cases is that management executes poorly and there are production issues. While the former is certainly a risk (especially from a strategic perspective relating to AT&T and Verizon), I’m less concerned about the latter as DRWI outsources all of its manufacturing to Plexus (a $1.5bn EMS company). In fact Plexus’ conference call comment on the strength of their wireless business gives me some comfort in taking the position before results.
So, it seems like an interesting company, but why does Our Man find it an attractive stock?
While the prospects for growth are certainly attractive to my mind, what makes DRWI an interesting stock is that the stock price does not reflect them (DRWI, on Nasdaq, closed yesterday, at $8.12. The company’s primary listing, is DWI in Toronto, but all figures below are in USD)
Positives
- Balance Sheet: As of 11/09 DRWI had $3+/share of cash, and a NCAV of $3.50+/share
- The current price puts the stock at <10x fiscal 2010 (02/10) and fiscal 2011 (02/11) earnings. This isn’t expensive, and reflects analysts concern about whether DRWI will get any Verizon/AT&T business. While these risks are valid, the price reaction looks extreme given the Balance Sheet value of $3.50+ (predominantly in cash) and 2011 analyst estimates of $1.02/share.
Negatives
- The chart is ugly as uncertainty over whether DRWI will win business (ex-Clearwire). Furthermore, as a small-cap, DRWI has and likely will continue to be volatile
Neither, just an observation
- In March & April, DRWI announced approval to buy back up to 10% of the stock at market. With results on Thursday, I’ll be reading the transcript to get a sense of how business is going but also be looking at how much of their cash they spent defending the stock (or potentially buying it back very cheaply).
So, what does that mean for our position?
DRWI was added to the portfolio, this morning, at about a 1.5% position size. Whilst this is a little undersized, it’s a decent size starter position (meaning I can live with never adding to it, should it run up, up and away) but that it does leave some room to add to the position (potentially to take it up to 2.5%) should the stock fall further.
Demand-side: Why do we care?
The demand for this type of product to enhance and improve the connection of cell-phones to the Internet should be recognizable to us all. I think it’s clear to anyone who’s had a cellphone (or mobile, as we Brits call them) over recent years, that the amount of Internet data we get using it has increased substantially. After all, connecting to the web (and downloading all those iPhone/Android Apps) requires far more data (i.e. bandwidth) than making a phone-call, texting or sending an email. Furthermore it’s also pretty noticeable, especially for those who live in Manhattan, that the wireless networks are struggling to deal with the amount of data that needs to be downloaded – after all who hasn’t been frustrated by the fact your iPhone (if you can get AT&T Service) or Blackberry are so slow to confirm the Mets’ latest demise!
Supply-side: OK, so we care…but what does that mean?
The supply-side is somewhat more complicated. To help, let’s think of a wireless phone network in 3 parts; a) The backbone, b) The connection between the backbone and the cell-phone towers and c) The connection between the cell-phone towers and us, the end users. DRWI is only involved in part b, and is agnostic about the other parts (i.e. it doesn’t matter to them how your network connects to the tower)
Some fun facts:
- There are c200,000 cell-phone towers in the US (800K in Europe)
- US Connection to Backbone: 75% use T1 lines, 20% use fiber-optic cables and 5% use TDM (a low-bandwidth microwave link)
- In Europe, however, 70% connect using TDM (due to the cost of using T1) and 15% by fiber-optic cables
- In Emerging Markets, almost 100% use microwave (predominantly TDM)
- Both T1 lines and TDM are low-bandwidth solutions (i.e. great for voice, not so much for data), whereas fiber-optic cables are a high-bandwidth solution.
Now, if growth in data continues to grow then the above suggests we’re going to need a lot more bandwidth. Why? Well, only 20% of the towers in the US (15% in Europe, even lower in Emerging markets) are connected using high-bandwidth solutions. This is the potential opportunity for DRWI, though we should remember it isn’t going to happen overnight and will be a multi-year process.
Backhaul Technologies: We need lots of bandwidth, but why’s it good for DRWI?
There are 3-types of backhaul technologies:
1). Copper: This is what’s used for L-1, xDSL, etc. Copper’s problems are scalability and the fixed cost of getting the wire from the tower to the backbone is high, and that wireless carriers (unless they own that connection) have to pay a monthly charge to use it.
2). Fiber-Optic Cable: Fiber-optics are high-bandwidth, but the problem is again co st (e.g. it costs $100/foot in cities; and while this falls in the suburbs/country-side, you also have to run the cables for larger distances!) and again there are recurring charges (if not owned by the wireless company)
3). Microwave Technology: Unlike the other systems, there are no monthly recurring costs.
There are a few types of Microwave technologies:
- TDM: a low-bandwidth (i.e. not able to connect to IP) solution that will remain attractive for 2G expansion (especially in Emerging Markets).
- TDM-hybrid: where TDM (for voice) is used alongside a medium-bandwidth solution (for data), and so is attractive early in the upgrade cycle.
- Pure IP Microwave links: DRWI is the leader in this final solution and adheres to specifications that make it similar to landline IP. Furthermore, its Horizon systems are integrated (i.e. bandwidth increased easily and for low cost) and its Quantum solution delivers 4Gbs (the highest on the market). While I don’t have definite numbers on DRWI’s cost advantage, based on a study by a US Wireless carrier, it appears to be 70%+ cheaper than using fiber and the roll-out is substantially quicker (<6mos vs. 2-years).
Risks
- Customers: A major risk is that while DRWI has over a hundred customers, Clearwire currently represents 80% of DRWI’s business. Though this is not surprising, as Clearwire is the first-mover in 4G, DRWI will clearly have to expand its customer base beyond Clearwire. To this end, the company’s announcement on 24th February that they’ve signed an agreement with a major OEM, is a positive step. However, it also is fair to assume that the stock will be volatile, until there’s definitive news as to whether the company will be getting any business from the US behemoths (Verizon or AT&T).
- Competition: DRWI is the leader in high-bandwidth microwave, but there are other companies involved in the space. These include stand-alone companies Ceragon Networks, Aviat, Cielo, and Trango, as well as major multi-nationals such as Alcatel-Lucent, Ericcson and NEC. Of these, only Ericsson seems to currently offer a product that has capability of 1Gbs+.
- Execution/Production: The thesis implies that DRWI will see increased demand for their business, and a general risk in these cases is that management executes poorly and there are production issues. While the former is certainly a risk (especially from a strategic perspective relating to AT&T and Verizon), I’m less concerned about the latter as DRWI outsources all of its manufacturing to Plexus (a $1.5bn EMS company). In fact Plexus’ conference call comment on the strength of their wireless business gives me some comfort in taking the position before results.
So, it seems like an interesting company, but why does Our Man find it an attractive stock?
While the prospects for growth are certainly attractive to my mind, what makes DRWI an interesting stock is that the stock price does not reflect them (DRWI, on Nasdaq, closed yesterday, at $8.12. The company’s primary listing, is DWI in Toronto, but all figures below are in USD)
Positives
- Balance Sheet: As of 11/09 DRWI had $3+/share of cash, and a NCAV of $3.50+/share
- The current price puts the stock at <10x fiscal 2010 (02/10) and fiscal 2011 (02/11) earnings. This isn’t expensive, and reflects analysts concern about whether DRWI will get any Verizon/AT&T business. While these risks are valid, the price reaction looks extreme given the Balance Sheet value of $3.50+ (predominantly in cash) and 2011 analyst estimates of $1.02/share.
Negatives
- The chart is ugly as uncertainty over whether DRWI will win business (ex-Clearwire). Furthermore, as a small-cap, DRWI has and likely will continue to be volatile
Neither, just an observation
- In March & April, DRWI announced approval to buy back up to 10% of the stock at market. With results on Thursday, I’ll be reading the transcript to get a sense of how business is going but also be looking at how much of their cash they spent defending the stock (or potentially buying it back very cheaply).
So, what does that mean for our position?
DRWI was added to the portfolio, this morning, at about a 1.5% position size. Whilst this is a little undersized, it’s a decent size starter position (meaning I can live with never adding to it, should it run up, up and away) but that it does leave some room to add to the position (potentially to take it up to 2.5%) should the stock fall further.
Saturday, May 1
April Review
Performance Review
April was quite a strange month for the portfolio; on the positive side almost every single position made money, leading to a +3.67% month (putting the YTD at +2.5%). However, this level of correlation between the names and the extremely sharp moves in a number of them was quite unexpected, and is a potential cause for concern.
The obvious beneficiary during the month was the put position in GS (+73bps), following news of the SEC’s civil suit. While there was clearly a large amount of good fortune involved in the position’s contribution, I continue to believe that the Financials (in general) remain vulnerable should any further potential struggles in the housing market flow through to the credit markets, and that GS remains at the most risk (primarily due to its own seemingly never-ending desire to heavy-handedly attempt PR) should the public or Congress ever need a scapegoat for excesses of recent years. People tend to forget that the dramatic demise of 2 other financial firms that dominated their markets, Salomon Brothers and Drexel Burnham Lambert, started with SEC actions.
Interestingly, the increase in volatility towards the end of the month meant that the S&P hedges also contributed positively (+3bips) despite the market’s rise. Despite claims from numerous pundits, that the 10-year and 30-year Treasury yields were poised to break-out higher early in the month, Treasuries once again acted as a safe-haven following as events surrounding Goldman Sachs and Greece developed, and as such the Treasury positions were the largest contributor (+126bips). The Bond Funds also benefited (+23bips) from this flight to quality during the month.
Our equity names were surprisingly strong during the month, Theravance rising strong (+82bips) and the small NCAV portfolio (+55bips) rising by over 30% during the month; it would be reasonable to expect neither to continue such rampant performance going forwards. The Other Equity holdings were broadly flat (+5bps).
Overall, there were no changes to the portfolio this month; in part due to “trading time” being slow (in Mandelbrot-speak) for my particular style but largely due to my leeriness over valuation, given the risks I see. While I understand that the most obvious thing about holding cash is that it means a portion of the portfolio generates no meaningful return, it remains my belief that people undervalue the safety cash offers but more importantly the flexibility it provides a portfolio manager (in particular, the option to be able to invest from a stable psychological and NAV level when more attractive opportunities present themselves – or more simply, holding cash allows one to be long-term greedy when others are short-term fearful instead of just saying that). That said, it is likely that Our Man will be a very small size buyer on any dip this month of both a Water Theme ETF and a single stock in the Value Equity bucket that he’s working on. It’s also likely that following last month’s sharp move in the NCAV bucket, there will be some readjusting of positions there.
Portfolio
41.1% - Long Treasury Bonds (19.6% TLT and 21.5% in the Aug-29 Bond)
14.2% - Long Bond Funds (6.6% HSTRX, and 7.6% VBIIX)
3.8% - Value Idea Equities (3.5% THRX)
3.5% - Other Equities (1.8% NWS, 1.7% CMTL, and 0.0% SOAP)
2.0% - Absolute Value/NCAV stocks
-5.5% (delta-adjusted) – Put Options (0.45% of premium in S&P put options and 1.07% in a GS put option)
33.9% - Cash
April was quite a strange month for the portfolio; on the positive side almost every single position made money, leading to a +3.67% month (putting the YTD at +2.5%). However, this level of correlation between the names and the extremely sharp moves in a number of them was quite unexpected, and is a potential cause for concern.
The obvious beneficiary during the month was the put position in GS (+73bps), following news of the SEC’s civil suit. While there was clearly a large amount of good fortune involved in the position’s contribution, I continue to believe that the Financials (in general) remain vulnerable should any further potential struggles in the housing market flow through to the credit markets, and that GS remains at the most risk (primarily due to its own seemingly never-ending desire to heavy-handedly attempt PR) should the public or Congress ever need a scapegoat for excesses of recent years. People tend to forget that the dramatic demise of 2 other financial firms that dominated their markets, Salomon Brothers and Drexel Burnham Lambert, started with SEC actions.
Interestingly, the increase in volatility towards the end of the month meant that the S&P hedges also contributed positively (+3bips) despite the market’s rise. Despite claims from numerous pundits, that the 10-year and 30-year Treasury yields were poised to break-out higher early in the month, Treasuries once again acted as a safe-haven following as events surrounding Goldman Sachs and Greece developed, and as such the Treasury positions were the largest contributor (+126bips). The Bond Funds also benefited (+23bips) from this flight to quality during the month.
Our equity names were surprisingly strong during the month, Theravance rising strong (+82bips) and the small NCAV portfolio (+55bips) rising by over 30% during the month; it would be reasonable to expect neither to continue such rampant performance going forwards. The Other Equity holdings were broadly flat (+5bps).
Overall, there were no changes to the portfolio this month; in part due to “trading time” being slow (in Mandelbrot-speak) for my particular style but largely due to my leeriness over valuation, given the risks I see. While I understand that the most obvious thing about holding cash is that it means a portion of the portfolio generates no meaningful return, it remains my belief that people undervalue the safety cash offers but more importantly the flexibility it provides a portfolio manager (in particular, the option to be able to invest from a stable psychological and NAV level when more attractive opportunities present themselves – or more simply, holding cash allows one to be long-term greedy when others are short-term fearful instead of just saying that). That said, it is likely that Our Man will be a very small size buyer on any dip this month of both a Water Theme ETF and a single stock in the Value Equity bucket that he’s working on. It’s also likely that following last month’s sharp move in the NCAV bucket, there will be some readjusting of positions there.
Portfolio
41.1% - Long Treasury Bonds (19.6% TLT and 21.5% in the Aug-29 Bond)
14.2% - Long Bond Funds (6.6% HSTRX, and 7.6% VBIIX)
3.8% - Value Idea Equities (3.5% THRX)
3.5% - Other Equities (1.8% NWS, 1.7% CMTL, and 0.0% SOAP)
2.0% - Absolute Value/NCAV stocks
-5.5% (delta-adjusted) – Put Options (0.45% of premium in S&P put options and 1.07% in a GS put option)
33.9% - Cash
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