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Managing Expectations III: Mining Stocks And Respecting The Bear

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Managing Expectations Part III: Picking Mining Stocks in a Bear Market by Frank Holmes

In the first part of this three-part series, I discussed the importance of cycles such as four-year presidential elections and the life of a gold mine, and how they play into our investment strategy here at U.S. Global Investors. Part II dealt with statistical diagnostic tools, in which I strived to simplify the definitions of standard deviation and mean reversion and explain how they’re applied.

The third part of this series on managing expectations is devoted to fundamental resource stock evaluation. I’ll discuss some of the statistical tools we use to pick quality stocks during a treacherous bear market, such as what we’ve seen in gold stocks the last three years.

Let it be known, however, that, though our approach might vary slightly depending on the condition of the market, we fervently seek to pick the best stocks at the best price and execution.

How I Learned to Respect the Bear

The traditional definition of a bear market is when broad stock market indices fall more than 20 percent from a previous high—which sounds like a catastrophe, but is in fact “normal” market behavior. According to self-professed “investing nut” Ryan Barnes, a contributor for Investopedia, “bear markets… are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and combined legislative and regulatory changes in the marketplace.”

Think of bear markets, then, as the gradual transition from warm summers into frozen winters. Trees lose their leaves, snow and ice blanket the ground, many animals—the bear the most notable—hibernate for the season. All life seems to take a breather. But just as you can always count on spring to emerge and, with it, new life, you as an investor can count on the market to rebound with fresh vigor.

As you might have known, the tail end of “winter” is when you want to take part in the inevitable recovery. If the market never had a winter season, if it were perpetually trapped in an endless summer, investors would be hard-pressed to find an ideal entry point.

It’s easy to determine when winter becomes spring. But what about the end of a bear market? How do you know when it’s bottomed and the optimal buying time has been reached?

CLSA consultant Russell Napier, in his now-classic 2009 book Anatomy of the Bear, describes the determinants of the end of a bear market:

The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterized by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices.

Look at the chart below. You’ll see that, in three decades, the PHLX Gold/Silver Sector (INDEXNASDAQ:XAU) has never had a losing streak for more than three years.

Mining Stocks
click to enlarge

Historical precedent suggests that gold stocks were due for a jump in 2014, and just as expected, the XAU has returned close to 20 percent year-to-date (YTD) after an abysmal 2013, the “final slump of prices on low trading volumes.”

The following line graph illustrates just how dramatically gold and silver stock performance has rebounded. As you might remember from our discussion last week, what we see here is an example of mean reversion, which occurs when the price of a security reverts back to its historic average.

Mining Stocks
click to enlarge

These data exemplify the notion that you should remain patient during downturns, avoid getting discouraged and allow the security—in this case, precious metal stocks—to revert back to its long-term mean. When it does, you’ll find that the wind is suddenly at your back instead of in your face.

Spencer Johnson, author of the 2009 book Peaks and Valleys: Making Good And Bad Times Work For You—At Work And In Life, writes, “You cannot always control external events, but you can control your personal peaks and valleys by what you believe and what you do.” Likewise, we might not have any control over how the market behaves, but we can control how we respond to it: with grace, intelligence and levelheadedness.

Value Drivers for Superior Performance

One of the tools we use to navigate around volatility, regulate emotion and focus on facts and fundamentals is an invaluable model we call the portfolio manager’s cube. It helps us separate the weak from the strong, evaluate a company’s attractiveness and pick the best GARP-y stocks. “GARP” stands for “growth at a reasonable price,” which is an investment strategy that aims to identify companies with superior growth and value metrics.

Mining Stocks

The cube allows us to sift, sort and prioritize. It draws attention to the intersections among a resource company’s production, cash flow and reserves (rows) and relative value, momentum and event drivers (columns). Using this model, we compare stocks on a relative basis in production per share to find attractive opportunities and overpriced risks. We also identify events that could increase reserves and/or production per share over the next 12 months.

More than anything else, the cube affords us the framework for conducting relative valuation of a stock. Relative valuation is a method that compares a security’s value to that of others to determine its financial worth.

For example, we evaluate mining stocks in the same way you or I might compare cars on multiple metrics before making a purchase. On this topic, I urge you to check out one of my favorite websites, Dennis Boyko’s GoldMinerPulse, for a look at the type of fundamental analysis and relative evaluation that goes into comparing and contrasting mining stocks.

The following is an example of how we might use the cube. Suppose a young mining company has just discovered a gold deposit. This event might excite potential investors and compel them to enter when the stock is undervalued, expecting it to skyrocket. But it’s important to conduct a cross-sectional analysis of this discovery in terms of production, cash flow and reserves. How much gold does the company expect to produce in relation to others? The average concentration of gold in the earth’s crust is 0.005 parts per million, making a substantial yield very rare. About one in 2,000 companies is lucky enough to stumble across at least a one-million-ounce deposit.

Other questions might include: Does the company have ample cash flow to finance the costly yet necessary infrastructure, equipment, geological analyses and manpower to extract the metal, not to mention pay dividends? Has it kept up with its cash reserves to remain solvent during development of the mine and subsequent excavation? Many years, after all, typically go by before ounce one is plucked from the ground.

Besides using models such as the portfolio manager’s cube to determine a mining company’s or asset’s relative value, we also rely on “boots on the ground” experience. Members of our investment team and I routinely visit domestic and global projects to gain tacit knowledge and ensure that operations are running smoothly and management is knowledgeable and has a firm handle on things.

To see photos of what these visits look like, check out our most recent slideshow, On a Quest for Copper.

The Five Ms

A mine’s lifecycle is the perfect segue into what I call the five Ms to picking the best mines. Most of what follows can be found in the 2008 book I co-wrote with London-based financial writer John Katz, The Goldwatcher: Demystifying Gold Investment.

One of the five Ms is Mine Lifecycle, which I cover at length in Part I of this series along with other cycles such as weather patterns, gold seasonality trends and four-year presidential cycles.

Mining Stocks
click to enlarge

The other four Ms are Market Cap, Management, Money and Minerals, detailed below.

Market Cap

Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors ($2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, “Is this company really worth $10 million?” If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (one million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies—an area of focus for our U.S. Global Investors World Precious Minerals Fund (MUTF:UNWPX)—we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

Management

Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers”—people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

Money

Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn’t come up with the results necessary to get an evaluation—find gold for less than $50 an ounce—investors quickly lose confidence. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

Minerals

Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples.  For example, the current price-to-earnings ratio for Freeport-McMoRan, is 8x-times forward earnings. Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

I must stress once again that these relative valuation techniques apply whether we’re in a bull or bear market. In Peaks and Valleys, Spencer writes, “Have you ever noticed that your life is filled with ups and downs? It is never all ups or downs.”

Similarly, the market is never all ups and downs. As active money managers, we have learned to adapt to an ever-changing climate—from “summer” to “winter”—to select what we believe are the best, most reasonably-priced mining stocks for our investors.

Next week, look out for my discussion on how our investment team trades uses statistical tools to make trades around core positions.

Happy investing!

Further resources on active management of resource stocks:

For more on my unique approach to active management, listen to my interview with Frank Curzio of S&A Investor Radio.

Also be sure to watch the latest edition of Kitco News, in which Daniela Cambone and I chat about what’s in store for gold in the coming weeks.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Past performance does not guarantee future results.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

Gold, precious metals, and precious minerals funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The prices of gold, precious metals, and precious minerals are subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in these sectors.

The Philadelphia Gold and Silver Index (XAU) is a capitalization-weighted index that includes the leading companies involved in the mining of gold and silver.

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Milk Helped Francis Chou Become A Top Value Investor

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Milk, of All Things, Helped Francis Chou Become One of Canada’s Top Value Investors. by Morningstar

Francis Chou is the co-founder of Chou Associates Management, the parent firm of five mutual funds, including Chou Associates, which has returned an annualized 11.5% over the past 27 years. In 2004, Morningstar Canada named him the manager of the decade. Chou has a history of rebating fees to shareholders in years when the funds underperform. 

1. How did you end up becoming a portfolio manager?

I was working at Bell Canada as a technician. I wanted to change that so I was reading a lot, trying to find out what field to go into next. Once I read Security Analysis I knew I wanted to be a portfolio manager.

2. You started your firm with $51,000 from six investors. 
What was harder, convincing those first six to invest or keeping the clients you have now?

It was difficult to get the six investors on board. I was just a technician with no formal education in investing. The initial capital was a lot of money for them. But once they saw how well we did, it was easy to keep them on board.

3. There is a story of you as a child checking milk jugs 
for freshness and price. How do situations like that play a part in your outlook on investing now?

See full Interview with Francis Chou by Morningstar

H/T Dataroma

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Buffett Beyond Value Explains Buffett’s Investing Approach

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New book, Beyond Value by Prem C Jain, explains Warren Buffett approach to investing By Sanjay Kumar Singh, The Economic Times

Many books have analysed Warren Buffett’s investment approach that has led to the maestro amassing a fortune of more than $60 billion over a career spanning more than half a century. Prem C Jain’s book adds to that rich corpus. Contrary to popular perception, says Jain, Buffett is not a pure value investor. He was indeed Benjamin Graham’s favourite pupil and in his early years he did bet on low-priced stocks. Since the results he got were not to his satisfaction, he scouted around for other approaches. His quest led him to Philip Fisher’s approach. What Graham is to value investing, Fisher is to growth investing. The essence of this approach is that you identify a stock that has the potential to increase its earnings for years to come, and hold it for long. Buffett’s investment approach today is a synthesis of value and growth investing. As Jain’s analysis of many of Buffett’s stock purchases reveals, he is willing to pay a valuation that is reasonable, but not high, for stocks with strong growth prospects. He then holds on to them for years, often decades.

The author has explained both value and growth investing in a lucid manner. He urges readers not to limit themselves to either style but to use both. By not buying overvalued stocks, investors will curtail their downside risk. And if the stock is of a high quality, the investor need not necessarily sell it once its price approaches its intrinsic value, as a value investor would. Instead, he can hold it for years and partake of its growth.

See full article by The Economic Times

Buffett Beyond Value – Description

Buffett Beyond Value

Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing by Prem C. Jain

A detailed look at how Warren Buffett really invests

In this engaging new book, author Prem Jain extracts Warren Buffett’s wisdom from his writings, Berkshire Hathaway financial statements, and his letters to shareholders and partners in his partnership firms-thousands of pages written over the last fifty years. Jain uncovers the key elements of Buffett’s approach that every investor should be aware of.

With Buffett Beyond Value, you’ll learn that, contrary to popular belief, Warren Buffett is not a pure value investor, but a unique thinker who combines the principles of both value and growth investing strategies. You’ll also discover why understanding CEOs is more important than studying financial metrics; and why you need an appropriate psychological temperament to be a successful investor.

  • Reveals Buffett’s multifaceted investment principles
  • Discusses how Buffett thinks differently from others about portfolio diversification, market efficiency, and corporate governance
  • Highlights how you can build a diverse and profitable investment portfolio

With Buffett Beyond Value as your guide, you’ll learn how to successfully invest like Warren Buffett.

Buffett Beyond Value -Book Review

From the Inside Flap

While Warren Buffett’s investment ideas are simple to understand, his success can be difficult to duplicate—unless you become familiar with how he really goes about the process of investing.

In this engaging new book, “Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing“, author Prem C. Jain extracts Warren Buffett’s investment wisdom from Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) annual reports, Buffett’s letters to shareholders and partners in his partnership firms, and as many of Buffett’s other writings as he could find—thousands of pages written over the past fifty years. Through this effort, Jain uncovers the key elements of Buffett’s approach and offers an accessible way to apply it to your own investment endeavors.

With Buffett Beyond Value, you’ll quickly learn that, contrary to popular belief, Warren Buffett is not a pure value investor, but a unique thinker who combines the principles of both value and growth investing strategies. You’ll also discover why Buffett emphasizes the importance of high-quality management above many other metrics when evaluating a company he’s interested in.

Written for anyone serious about stock market investing, this unique guide skillfully outlines the proven principles Buffett has followed over the course of his long and successful career and shows you what it takes to make them work for you. Topics include:

  • How to build a diverse and profitable portfolio the Warren Buffett way
  • Why you need an appropriate psychological temperament to be a successful investor
  • Buffett’s thoughts on market efficiency and the ways in which you can incorporate them into your investment decision making
  • How issues related to profitability and accounting can provide you with a perspective that is uncommon in investing circles
  • Why Buffett thinks differently from others about portfolio diversification, corporate governance, and much more

If there’s one person worth listening to when it comes to investing—whether you’re an individual investor, a student, an academic, or a professional portfolio manager—it’s Warren Buffett. And with Buffett Beyond Value as your guide, you’ll gain valuable insights that could enhance your understanding of investing and improve your ability to make more profitable decisions in today’s markets.

From the Back Cover

“Many books about Warren Buffett describe him as simply a ‘value’ investor. Jain gives us a clearer understanding of the techniques of the man known as ‘the world’s greatest investor’ and shows that his investment principles are consistent with many of the precepts of modern financial theory.” —BURTON MALKIEL, Professor, Economics Department, Princeton University; author of A Random Walk Down Wall Street and The Elements of Investing

“This is required reading for all Buffettologists looking for more than just sound bites and folk wisdom in their quest to peer into the mind of one of the greatest investors of all time. Read Buffett Beyond Value slowly and savor every page while sipping a Cherry Coke!” —ANDREW W. LO, Harris & Harris Group Professor, MIT Sloan School of Management

“What better way to become a successful investor than to study the teachings of Warren Buffett? And, what better way to study those teachings than to read Buffett’s forty-year writings contained in his annual reports? Prem C. Jain jump-starts those lessons by culling Buffett’s most salient investment secrets and summarizes them in a wonderful and easy-to-read book.” —HOWARD M. SCHILIT, author of Financial Shenanigans; founder, Financial Shenanigans Detection Group

“Post the 2008-2009 financial crisis, everyone from New York to New Delhi is looking for investment advice. The advice has just arrived! Prem C. Jain’s lucid, accessible encapsulation of Buffett’s investment wisdom is a page-turner—it’s full of investment nuggets and entertaining anecdotes, and yet the write-up is faithful to economic theory. Buffett’s investment thesis is now out in the open, and therefore may a thousand Buffetts bloom!” —S.P. KOTHARI, Managing Director, Blackrock; Gordon Y Billard Professor of Management, Sloan School of Management, Massachusetts Institute of Technology

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Small Is Beautiful: ‘Bond King’ Expected Alpha and Assets Under Management

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Small Is Beautiful: ‘Bond King’ Expected Alpha and Assets Under Management

Claude B. Erb

TR

September 30, 2014

Abstract:

Many fixed income investors allocate assets to funds managed by “bond kings” with the expectation of achieving significant market beating “alpha”. The investment performance of “bond kings” reflects the intersection of 1) those perceived to be skilled at identifying and exploiting mispriced securities and 2) the availability of investment capital. Historically, the value-added, the alpha, of “bond kings” has declined as the availability of capital has increased. As an empirically observed historical rule of thumb, a doubling in “bond king” assets under management has been associated with a 10-20% decline in achieved alpha. As a result, historically a “bond king” with a smaller asset base has outperformed a “bond king” with a larger asset base. For investors seeking the possible beauty of “bond king” alpha, the trade-off between size and alpha suggests that small is beautiful.

Overview

  • A “bond king” is a fixed income portfolio manager perceived to be highly skilled
  • A “bond king” is assumed to have the talent necessary to “beat the market”, to produce “alpha”
  • There are very few “bond kings” at any given time
  • Empirically “bond king” fund alpha has declined as assets under management have increased
  • An abundance of “bond king” skill does not increase the size of the universe of mispriced securities
  • As a result, “bond kings” perform best when they manage a relatively small asset base
  • A “bond king” with a “smaller” asset base may outperform a “bond king” with a “larger” asset base
  • Historically, a doubling in assets under management led to a 10-20% reduction in “alpha”

The Historical Relationship Between “Bond King” Fund Size And Fund “Alpha”

  • There are currently two “bond kings”: Bill Gross and Jeffrey Gundlach
  • Historically, the “alpha” of Gross’ PIMCO Total Return Bond Fund declined as assets rose
  • Historically, the “alpha” of Gundlach’s DoubleLine Total Return Bond Fund declined as assets rose
  • The negative asset size-alpha trade-off may reflect too much capital chasing too few opportunities

Bond King Alpha

Matching Current “Bond King” Fund Size With Possible Future “Alpha”

  • Naïve extrapolation of the historical relationship between fund size and one year “alpha” suggests
  • Bill Gross’ new “unconstrained” bond fund could have an “alpha” of about 10%
  • Jeffrey Gundlach’s fund alpha could be about 3%
  • Bill Gross’ “old fund” might have an alpha of about 90 basis points

Bond King Alpha

Building Blocks: Historical Performance Of The DoubleLine Total Return Bond Fund

  • Since inception, the DoubleLine Total Return Bond Fund has outperformed “the market”
  • The outperformance is widely seen as a reflection of “bond king” portfolio manager skill
  • This performance has caught the attention of many investors

Bond King Alpha

Building Blocks: Historical Assets Under Management Of The DoubleLine Total Return Bond Fund

  • Many investors are aware of the performance of the DoubleLine Total Return Bond Fund
  • This awareness has lead to an increase in fund assets under management
  • At the end of August 2014, assets under management were approximately $35 billion

Bond King Alpha

Building Blocks: Historical Relationship Between Fund Size And Fund “Alpha”

  • Should there be a positive, a negative or no relationship between fund alpha and fund asset size?
  • Historically, the greater the assets under management the lower the “alpha” of DoubleLine Total Return Bond Fund Class I (MUTF:DBLTX)
  • This may be a historical curiosity or a reflection of the scarcity of mispriced assets relative to fund size
  • Historical relationships may not be stable, but there is only one history and one historical relationship

Bond King Alpha

Building Blocks: Historical Relationship Between Fund Size And Fund “Alpha”

  • Historically, the greater the assets under management the lower the “alpha” of PIMCO Total Return Fund Institutional Class (MUTF:PTTRX)
  • This may be a historical curiosity or a reflection of the scarcity of mispriced assets relative to fund size
  • Curiously, investor flight from PTTRX could improve its “alpha” potential

Bond King Alpha

Building Blocks: Historical Assets Under Management Of The PIMCO Total Return Bond Fund

  • Since April 2010, the size of the PIMCO Total Return Bond Fund has declined
  • Reasons for the decline in fund assets are varied including
  • Perceived challenging performance, and
  • An awareness of alternative investment opportunities

Bond King Alpha

See full article here

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Richard Bernstein & David Rosenberg – Redwood Conference [VIDEO]

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Richard Bernstein & David Rosenberg via Redwood Asset Management

On October 30, 2014 Redwood Asset hosted a luncheon for investment advisors in Toronto.  Providing their outlooks were two of the industry’s most well-respected strategists, Richard Bernstein and David Rosenberg.

Richard Bernstein and his firm Richard Bernstein Advisors are the lead portfolio manager of the Redwood Global Equity Strategy Class

The lunch has been broken out into segments below:

  1. Opening Remarks
  2. Richard Bernstein Presentation
  3. David Rosenberg Presentation
  4. Question: What are your key indicators?
  5. Question: What are the side effects of the size of the Fed’s balance sheet?
  6. Question: Outlook for oil?
  7. Question: Views on the improving U.S. economy?
  8. Question: What changes  have you seen in the indicators you use and their effectiveness?
  9. Question: What are the biggest mistakes investors make?
  10. Question: Thoughts on gold?
  11. Question: Thoughts on profit margins?
  12. Question: What major sector themes are you seeing?

1. Opening Remarks by Peter Shippen (2:15)

2. Richard Bernstein Presentation (11:39)

3. David Rosenberg Presentation (14:34)

4. Question: What are your key indicators? (5.06)

5. Question: What are the side effects of the size of the Fed’s balance sheet? (6:54)

6. Question: Outlook for oil? (5:47)

7. Question: Views on the improving U.S. economy? (3:58)

8. Question: What changes have you seen in the indicators you use and their effectiveness? (9:31)

9. Question: What are the biggest mistakes investors make? (5:30)

10. Question: Thoughts on gold? (3:09)

11. Question: Thoughts on profit margins? (3:33)

12. Question: What major sector themes are you seeing? (7:30)

For more information on the Redwood Global Equity Strategy Class, please contact the Redwood Sales Team.

 

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Managed Investment Assets Projected To Reach $6.7 Trillion In 2018: MMI

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The Money Management Institute (MMI), the national association representing the $3.8 trillion managed investment solutions and wealth management industry, today released selected findings from a proprietary survey of industry growth trends published in its 2014-2015 MMI Industry Guide to Managed Investment Solutions – Trends and Statistics.

Among the key findings, assets under management in managed solutions are forecast to reach $6.7 trillion by year-end 2018, representing a five-year compound annual growth rate of 14 percent and an increase of 74 percent over the $3.8 trillion in assets as of September 30, 2014. All segments of the managed solutions industry are projected to continue to post positive asset gains and net flows, sustaining the upward trajectory seen since the end of the 2007-2008 financial crisis and providing evidence that financial advisors and their clients continue to embrace the discipline and objectivity of managed solutions.

Managed Investment Assets

Managed Investment Assets Projected to Reach $6.7 Trillion by the Close of 2018

Money Management Institute Releases Annual Industry Guide with Growth Forecasts

WASHINGTON, D.C., December 18, 2014 – The Money Management Institute (MMI), the national association representing the $3.8 trillion managed investment solutions and wealth management industry, today released selected findings from a proprietary survey of industry growth trends published in its 2014-2015 MMI Industry Guide to Managed Investment Solutions – Trends and Statistics.

 

Each year MMI develops an industry growth forecast that is based on a survey of sponsor firms that are MMI members conducted by Dover Financial Research. Respondents are asked to provide industry trend information and projected growth rates for five managed solutions market segments – Separately Managed Accounts (SMA), Mutual Fund Advisory, Rep as Advisor, Rep as Portfolio Manager and Unified Managed Accounts (UMA). The responses are consolidated into an aggregate industry forecast.

 

Among the key results:

 

Strong Industry Growth Projected through 2018

  • MMI asked sponsor firms to provide a five-year forecast for 2014 to 2018, enabling for the first time projections that take into account 10 years of actual and forecasted data. Assuming no material shifts in the underlying capital markets, survey respondents forecast managed solutions industry assets under management of $6.7 trillion by year-end 2018, representing a five-year compound annual growth rate of 14 percent and an increase of 74 percent over the $3.8 trillion in assets at the close of the third quarter of 2014.

 

  • The market share of wirehouses is projected to continue to slip as their asset growth rate lags that of the total managed solutions market, a trend reflecting heightened competition from other distribution channels.

 

  • Independent broker-dealer (IBD) and third-party service providers are the most optimistic about long-term growth prospects, a result partially driven by the continued success of IBD Mutual Fund Advisory programs, as well as their emphasis on providing a variety of affiliation models which attract advisors and Registered Investment Advisers (RIAs) interested in greater independence.

 

Projected Growth Opportunities by Market Segment

  • With the exception of UMA programs, all of the major segments are forecast to exceed $1.0 trillion by 2018. UMAs, which have the lowest current asset base at $325 billion as of June 30, 2014, have a projected compound growth rate of 24 percent through 2018. UMAs are seen as beginning to look more like Rep as Portfolio Manager programs as the silos between advisory program types break down. Looking ahead, UMAs are projected to either be part of the broader investment management solution or the solution. Either way, market share will continue to increase.
  • Survey responses indicate that Rep as Portfolio Manager programs are poised for the greatest growth over the next several years with assets projected to reach $1.5 trillion by 2018, surpassing Rep as Advisor asset levels. In 2013, 36 percent of sponsor firms indicated that Rep as Portfolio Manager programs would offer the greatest opportunity for growth within the managed solutions sector. A year later, that figure has risen to 50 percent.

 

  • Rep as Advisor programs will continue to experience declining market share as financial advisors opt for advisory solutions that give them greater control and more discretion.

 

  • Given the deep and broad usage of Mutual Fund Advisory programs, it is expected that they will continue to grow at a healthy rate, but will not expand their market share because advisors will increasingly adopt Rep as Portfolio Manager and UMA programs for their mutual fund holdings.

 

  • As platform consolidation creates product neutrality, solutions will be chosen based on merit rather than ease of access, a trend expected to benefit SMA programs. However, the market share of SMAs as a standalone segment is projected to decline as the shift to UMA programs and/or consolidated platforms continues.

 

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Michael Mauboussin: Managing the Man Overboard Moment

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Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

H/T Meb Faber

Summary

  • A key part of successful investing is the ability to keep emotions in check in the face of adversity.
  • A particularly challenging situation is when a stock in your portfolio drops sharply, an event that precipitates what has been called a “man overboard” moment.
  • This report provides analytical guidance if one of your stocks declines 10 percent or more in one day. Such drops tend to evoke strong emotional reactions and make sound decision-making difficult.
  • We provide the base rates for more than 5,400 such events in the past quarter century. We refine the base rates by separating earnings announcements from non-earnings announcements and by introducing factors including momentum, valuation, and quality.
  • We provide a checklist to guide you as you decide whether to buy, hold, or sell the stock.

Michael Mauboussin: Managing the Man Overboard Moment – Introduction

A key part of successful investing is the ability to keep emotions in check in the face of adversity. One example, the focus of this report, is when one of the stocks in your portfolio drops sharply. If you are the portfolio manager, you might feel frustrated, upset about the hit to returns, and worried about the business implications. If you are the analyst, you might feel anger, disappointment, and shame. None of those feelings are conducive to good decision making.

This kind of event precipitates what has been called a “man overboard” moment.1 These moments demand immediate attention, are stressful, and require swift action. In an investment firm it is common for a number of professionals to stop what they are doing in order to discern a suitable course of action.

The use of a checklist is one approach to making good decisions under pressure. In his superb book, The Checklist Manifesto, Dr. Atul Gawande describes two types of checklists.2 The first is called DO-CONFIRM. Here you do your job from memory but pause periodically to make sure that you have done everything you’re supposed to do. The second is called READ-DO. Here, you simply read the checklist and do what it says. READ-DO checklists are particularly helpful in stressful situations because they prevent you from being overcome by emotion as you decide how to act.

You can think of your emotional state and the ability to make good decisions as sitting on opposite sides of a seesaw. If your state of emotional arousal is high, your capacity to decide well is low. A checklist helps take out the emotion and moves you toward a proper choice. It also keeps you from succumbing to decision paralysis. A psychologist studying emergency checklists in aviation said the goal is to “minimize the need for a lot of effortful analysis when time may be limited and workload is high.”

The goal of this report is to provide you with analytical guidance if one of your stocks declines 10 percent or more in one day. More directly, we want to answer the question of whether you should buy, hold, or sell the stock following one of these big down moves.

Exhibit 1 shows the number of such observations from January 1990 through mid-2014. There were more than 5,400 occurrences in all, with clusters around the deflating of the dot-com bubble in the early 2000s and the financial crisis in 2008-2009. The bubble periods contain about 40 percent of the observations. These sharp drops happen frequently enough that they deserve a thoughtful process to deal with them but infrequently enough that few investment firms have developed such a process.

Michael Mauboussin Stock Price Declines 1

Michael Mauboussin: Structure of the Analysis

There are two broad approaches to making a decision. You can rely on the specific circumstances of a particular situation as well as your own experience. This is known as the inside view. Or you can examine a larger reference class to understand the base rates. This is known as the outside view. For example, if you are forecasting the returns for the stock market in the next year you can use the inside view to come up with an estimate based on current valuation, sentiment, and your own gut feel. Or you can use the outside view and examine how the stock market has done over the years. Both the inside and outside view are useful, and there is a specific way to combine the two to allow for an effective forecast.5 But research in decision making suggests that we naturally rely more on the inside view than we should.6 In fact, it is common for investors to be unaware of the base rates that are relevant in their decisions.

We use base rates to show how stocks perform after they have dropped sharply. To do this, we calculate the “cumulative abnormal return” for the 30, 60, and 90 trading days after the time of the decline. An abnormal return is the difference between the total shareholder return and the expected return. A stock’s expected return reflects the change in a broader stock market index, the S&P 500 in our case, adjusted for risk. The cumulative abnormal return, then, is simply the sum of the abnormal returns during the period that we measure.

See full PDF below.

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[Archives] Sigmund Freud The Portfolio Manager

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Sigmund Freud The Portfolio Manager by Wade W. Slome, CFA, CFP®, Investing Caffeine

Posted April 2011

Byron Wien, former investment strategist at Morgan Stanley (MS) and current Vice Chairman at Blackstone Advisory Partners (BX), traveled to Austria 25 years ago and used Sigmund Freud’s success in psychoanalytical theory development as a framework to apply it to the investment management field.

This is how Wien describes Freud’s triumphs in the field of psychology:

“He accomplished much because he successfully anticipated the next step in his developing theories, and he did that by analyzing everything that had gone before carefully. This is the antithesis of the way portfolio managers approach their work.”

Wien attempts to reconcile the historical shortcomings of investment managers by airing out his dirty mistakes for others to view.

“I think most of us have developed patterns of mistake-making, which, if analyzed carefully, would lead to better performance in the future…In an effort to encourage investment professionals to determine their error patterns, I have gathered the data and analyzed my own follies, and I have decided to let at least some of my weaknesses hang out. Perhaps this will inspire you to collect the information on your own decisions over the past several years to see if there aren’t some errors that you could make less frequently in the future.”

Here are the recurring investment mistakes Wien shares in his analysis:

Selling Too Early: Wien argues that “profit-taking” alone is not reason enough to sell. Precious performance points can be lost, especially if trading activity is done for the sole purpose of looking busy.

The Turnaround with the Heart of Gold: Sympathy for laggard groups and stocks is inherent in the contrarian bone that most humans use to root for the underdog. Wien highlights the typical underestimation investors attribute to turnaround situations – reality is usually a much more difficult path than hoped.

Overstaying a Winner: Round-trip stocks – those positions that go for long price appreciation trips but return over time to the same stock price of the initial purchase – were common occurrences for Mr. Wien in the past. Wien blames complacency, neglect, and infatuation with new stock ideas for these overextended stays.

Underestimating the Seriousness of a Problem: More often than not, the first bad quarter is rarely the last. Investors are quick to recall the rare instance of the quick snapback, even if odds would dictate there are more cockroaches lurking after an initial sighting. As Wien says, “If you’re going to stay around for things to really improve, you’d better have plenty of other good stocks and very tolerant clients.”

It may have been 1986 when Byron Wien related the shortcomings in investing with Sigmund Freud’s process of psychoanalysis, but the analysis of common age-old mistakes made back then are just as relevant today, whether looking at a brain or a stock.

See also: Killing Patients to Prosperity

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in MS, BX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

[Archives] Sigmund Freud The Portfolio Manager

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Looking Closer at Morningstar Peer Groups for Fund Analysis

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Looking Closer at Morningstar Peer Groups for Fund Analysis by Royce Funds

Director of Risk Management Gunjan Banati sits down with Co-Chief Investment Officer Francis Gannon to discuss the results of her Morningstar peer group research and suggests ways in which investors can compare funds within peer groups more effectively.

See Gunjan Banati video on Morningstar peer groups here.

Looking Closer at Morningstar Peer Groups for Fund Analysis

Francis Gannon: So tell us about the most recent Royce research article.

Gunjan Banati: Our most recent article is based on peer groups, specifically how the Morningstar peer groups have changed over time.

We get a number of questions through due diligence about which peer groups should our different Royce Funds be compared to and why, sometimes, when we say that it’s a certain kind of small-cap fund that it doesn’t look the same in the Morningstar style box, or the Morningstar category, and also the Morningstar peer groups.

Francis: So Morningstar does have peer groups, the categories, and styles. What’s the difference between them all?

Gunjan: That’s a great question. So the style box is the most common graphic that you see that Morningstar puts up, and what that is is that’s a point-in-time snapshot of where your portfolio’s holdings are aggregating as a centroid onto that particular grid. And when you look at a category, what that is is that’s a three-year look-back at where all those style boxes have been, so they aggregate those then to come up with your category, and your category is what determines your peer group. So your peer group and category will always be the same, but your style box may be different.

Francis: Well, how can there be a disconnect sometimes between where advisors think our Funds should be and where Morningstar places them?

Gunjan: Well, there’s a number of different reasons why there might be a disconnect. Morningstar’s process of putting a fund into a category or style box is completely formulaic. It’s based on your holdings.

Francis: It’s a snapshot.

Gunjan: Correct. They don’t actually ask the portfolio manager, “Where do you think you should reside?” This is based on the holdings. So as a result of that, where you think you should be might be different based on where your portfolio currently is in terms of the evolution of the market cycle, an evolution of an investment thesis, and, also, it’s a comparative computation, so it could also be based on the fact that everybody is doing something else differently.

Francis: So you did a deep dive into the small-cap category. How did you compile that data?

Gunjan: What we did to compile this data is we tried to actually recreate what a Morningstar category looked like 10 years ago. So we were looking at just the small-cap categories for this exercise, and so we looked at all funds that were in the small-cap Blend, or Value, or Growth at year end 10 years ago, adding back in all the liquidated funds and all the merged funds just to create a picture of what that would have been, and we did that for 10 years ago, for five years ago, and for three years ago, then compared it to today.

Francis: And what stood out in the results?

Gunjan: Our results were actually really interesting. We were surprised to see the degree of flux that takes place in Morningstar peer groups. For example, in the small-cap Value category that we looked at, we found that only 33% of funds stayed in the same category over a 10-year period of time.

Francis: Now does that change over shorter periods, three and five years?

Gunjan: So we looked at shorter time periods as well. For example, again, in small-cap Value, we found that over a five-year time frame 48% of funds stayed in the same category and the rest of them had actually moved or had been liquidated out of the category, and over a three-year period, across all three categories, we saw only about 75% of funds stayed in the same place. So that means one in four funds actually moved out of that category over a three-year period.

Francis: So given the amount of flux you saw in your data, how are investment advisors effectively able to compare funds within peer groups?

Gunjan: So one of the ways we’d suggest is instead of looking at just the Morningstar-defined categories of Blend, and Value, and Growth, to create larger categories, and that’s something we do here at Royce. We create a much broader category and compare our Funds to, say, all small-cap funds.

Francis: So could advisors create custom groups as well?

Gunjan: Absolutely. That’s a great example. You can create custom groups in a number of different ways. You can use a combination of holdings-based, style-based analysis. I would suggest asking the portfolio manager where do they think they should be in a peer group, and using that to create custom peer groups.

Francis: Can you give us an example of a custom peer group?

Gunjan: Sure. For example, if you were trying to evaluate a dividend-oriented large-cap strategy, you could compare it to the Morningstar category it’s in, which would probably most likely be large-cap Value, and you’d be subjected to some of the flux issues that we see with creating, with comparing, funds within a category. You could create a custom category of all dividend-oriented large-cap funds and use that instead, and I think you’d find the results would be a lot more accurate.

Read the research article: How Morningstar Category Flux Impacts Peer Group Analysis

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Allan Mecham On His Investment Style; Favorite Books

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Interview with Allan Mecham…. more on this topic here and more here. We also hope to have more (and exclusive info on Allan) to ensure you do not miss coverage sign  up for our free newsletter.

Allan Mecham on his favorite books

Is Allan Mecham The Next Warren Buffett?

One Of The Greatest Track Records In History

: I enjoy all the behavior psychology stuff and would recommend  Predictably Irrational,: The Hidden Forces That Shape Our Decisions [by Dan Ariely], Nudge [by Richard Thaler], How We Decide [by Jonah Lehrer], and Think Twice: Harnessing the Power of Counterintuition [by Michael Mauboussin].

The Big Short: Inside the Doomsday Machine [by Michael Lewis] is a good book and a very entertaining  read.

Roger Lowenstein’s new book, The End of Wall Street, is very good as  well.

I’d also recommend The Relentless Revolution: A History of Capitalism [by Oldham Appleby]. I  like reading history of all sorts and think it’s beneficial to investing.

Arlington Value’s Allan Mecham On Investment Strategy And Finding Stocks To Buy

Allan Mecham On His Investment Style; Favorite Books

Interview continues below…

We recently had the pleasure of interviewing Allan Mecham who heads Arlington Value Management. The firm has established an impressive ten-year record, including a positive return in 2008 despite no reliance on short selling. We are pleased to bring you this interview exclusively in Portfolio Manager’s Review.

The Manual of Ideas: Over the ten years ended December 31st, 2009, the S&P 500 delivered an underwhelming return of negative 9.1%, equaling a 1.0% annual loss. Bruce Berkowitz’s Fairholme Fund achieved a net annualized return of 13.2% during the same period, while your fund returned 15.5% annually net of fees. Berkowitz’s record has made him somewhat of a “rock star” in the investment business. How come you are still flying below the radar?

Allan Mecham: Ha! Good question… I’m eagerly awaiting The Little Book on Becoming a Hedge Fund Rock-Star. In all seriousness, it’s likely a combination of factors (Salt Lake City-based LLC, only $10+ million under management for the first five years with no serious marketing), but certainly my limitations marketing Arlington are partly to blame. Additionally, and probably the biggest reason for our obscurity, stems from our fanaticism about accepting the “right” capital. Maintaining a culture that’s conducive to rational thinking and investment success has been the top priority since inception. We have turned down significant sums of money on many occasions because of this stubborn commitment. As I said in my most recent letter, we get far more satisfaction from producing top returns than from the size of our paycheck… though we’re hopeful this distinction won’t need to be highlighted for much longer!

Many potential investors require monthly transparency into the portfolio and are overly focused on short-term results. Accepting “hot” money would endanger the culture and my ability to perform. My partner Ben [Raybould] considers it his most critical job to cultivate and maintain a culture that minimizes emotional noise and short-term performance pressures, to which I must say he has done a fantastic job. We believe patience and discipline are critically important to investment success. Taking emotion out of the equation, or at least minimizing it as much as possible, is vitally important and difficult to do if you have investors peering over your shoulder in real time, questioning ideas. That’s like telling someone what’s wrong with their golf game in the middle of their backswing — it’s the last thing you need when you’re trying to concentrate and execute a shot.

MOI: We could conduct this entire interview simply by revisiting quotes from your past letters, which are a tour de force. You recently didn’t hold back on your view of certain types of institutional investors: “Many times these gate-keepers of capital have expressed admiration for our results. Yet for them to invest we would need to not only continue to find undervalued stocks, we’d need to find more of them; additionally, we would need to identify overvalued stocks – and short them – as well as find ideas across the globe in both large and obscure markets. Such comments are flattering, yet we see nothing but wild-eyed hubris attempting to outsmart people, more often, in more ways, and in more markets, as opposed to sticking with what produced top-tier results in the first place.” Clearly, the proliferation of investment vehicles whose partners’ interests are at odds with those of the ultimate owners of capital has resulted in misallocation of capital. Do you see owners waking up to this inherent conflict and demanding a more sensible approach to investment? Is it feasible for a fund like yours to bypass the agents and go directly to the owners of capital?

Allan Mecham: I think it’s possible to gain traction but I’m not optimistic about change on a large scale as there are multiple factors at play. Bypassing the agents is a laborious process that’s difficult for a two-man shop like ours. The fees throughout the financial system are crazy and make no sense when thinking about the industry as a whole. A lot of financial intermediaries and hedge funds operate using a form of the “Veblen” principle — where status is attached to the high cost and exclusivity of the product. The financial middlemen satisfy the clients’ emotional needs more than the financial needs. The comfort of crowds is strongly at play throughout the system. At the end of the day I think managers are giving clients what they want — peace of mind and smoother returns, albeit at the expense of long-term results.

………………………….

Arlington Value Wishes For “Moody” Market Volatility, Gets It One Day Later

 

See full Exclusive Interview with Allan Mecham in PDF format here.

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