Sunday, April 28, 2013

Picking Winners

The job of a professional investor is simply to pick winners, or is it? Professional investors focus on avoiding  losses (nominal or “real” )
and not appearing to act imprudently.

As regular readers of these posts already know, my two great learning schools were the race track and the US Marine Corps. The first taught me how to analyze and the second how to act. Allow me to share some of what I learned from going to "the track" in my quest to pick investment winners for clients and my family.

What is winning?

My betting objective for each day at the track and each season of visits was to finish with more money than when I started. As a wager of limited means I had to overcome my costs incurred including transportation, food, admission and the portion of winning tickets that went to the track and state/local taxes. For me these amounts could easily add up to a hurdle rate of 25%. Thus when it came to investing in the stock market or through mutual funds the costs seemed like a bargain particularly at long-term capital gains rates. With my objective of producing the first dollar of net profit after paying all incurred expenses dragging on my returns, certain basic strategies evolved:

          1.      Avoid losing by selecting only a limited number of races. (No multi bets or the equivalent of indexing).

          2.      Arbitrage the difference in potential payoffs between the winning payoff on a highly favorite horse versus half of the net pool for second place, if one of the first two horses is highly favorite.  At times such a bet may lead to a better return with some less risk than on betting on a favorite to win.

          3.      Look at current race conditions compared with the past record of the racers. Most often the odds on the horses that recently did well were less than those of horses whose immediate past results were poor. (For investors this is the difference between momentum investing or extrapolating vs. searching for new opportunities amidst almost always changing conditions.)

Applying winning strategies

Most fund selectors follow a disciplined approach to avoid losers;  they seek to avoid having any performers in the bottom performance quintile. If their remaining choices are averaged, they should have a performance record that is better than the average of the overall universe which is the equivalent of earning the first (small) dollar of profit.

The investment manager of a portfolio of funds, like me, constructs a mix of funds that in many, if not most markets should produce a satisfactory result. The way to do this is to diversify into a group of funds which will by direction and magnitude offset periodic losers with winners. The selection process should be guided by the assessing the chances of success over the chances of permanent loss of capital.

In contrast, the individual security analyst is most oriented toward the future, looking for the odds of meaningful changes that are not appropriately recognized in current prices.

The current picture

Market price correlations are widening; the price performance between the best performer and the worst are no longer parallel. This phenomenon could make the use of ETFs less useful. A number of actively managed portfolios are demonstrating that their selectivity is what produced better than average performance in the first quarter. In many cases the weighting of individual issues combined with good selectivity produced meaningful performance increments.

Dividend paying stocks have been leaders for over a year. But the focus is narrowing away from just yield production. JP Morgan is recommending common stocks of companies with high free cashflow production as companies that could increase their dividends among other uses of their cash generation. A number of mutual funds have either publicly espoused or just followed a strategy of selecting stocks of companies with rising dividends. The focus on dividends is part of what appears to be an almost insatiable drive for income to replace the former sources of reasonable interest on government bonds or bank savings accounts. This drive has caused an enormous flow of money into corporate bond funds. But this is beginning to show early signs of change. In 2010 the average trading turnover (the amount of trading vs. the amount of outstanding bonds) of investment grade bonds was 95% and now has dropped to 75%. This may indicate that the objective of trading to add to yield is declining a bit.


We have done a good job for our accounts, but at this point in the cycle I am worried that on a relative basis my accounts could use more future growth-oriented funds as well as highly selective fixed-income funds. If you have any suggestions in terms of techniques, or perhaps a securities analyst-trained person who should join us, please let me know.

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