Category: Industry Rotation

Current Industry Model

Current Industry Model

Posted on by David Merkel

Here are my current industry ratings. Unfortunately, the current list does not diversify me much. I might look at trucking, shoes, coal, restaurants, or specialty retail, but nothing much grabs me on the list. Most industries don’t feel trashed at this point.

When I find my model to be thin in what it is offering me, I sometimes run another model that looks at bad relative price performance by industry. If I’m still uninspired at the next portfolio reshaping, due for late June (or so), I’ll run that model to see if it gives me any fresh ideas.

Another Boon from RealMoney.com

Another Boon from RealMoney.com

Posted on by David Merkel

Well, my RealMoney column from April 9th got republished on the free site, and got syndicated out to Yahoo! as well. When I write a piece where I mention a company, like Assurant, it’s fun to see the piece appear on the Yahoo! news. But when I don’t mention a ticker, I know that if they put it on the free site, I know they also syndicate it out to Yahoo!, and a number of other places as well. I get amazed at times where my stuff ends up. Well, I hope it makes money for them, and most of all, I hope it benefits those who read it.

That’s particularly true for this piece, because it focuses on risk control in a very direct way. Too many market players don’t realize that risk control is a way to make more money on average over the long term. How does that work?

  1. It keeps you in the game. Absent war on your home soil and aggressive socialism, being an owner in society is a winning strategy over the long haul.
  2. Rebalancing allows you to pick up an incremental 2-3% annually on average. It forces you to buy low and sell high.
  3. There will be drawdowns. You will get drawn down less, and if you stay with strong companies in industries that have previously underperformed, when the bottom arrives, you will outperform the market.

I view risk differently than most market players, and than almost all academics. Risk means trying to avoid loss on every name in my portfolio, not avoiding loss on the portfolio as a whole, and certainly not standard deviation of returns, or even worse, beta.

“Don’t keep all your eggs in one basket.” True enough. “Keep all your eggs in one basket, and watch that basket carefully.” Also true. “Watch every egg.” That’s what I try to do. I’m a singles hitter, not a home-run hitter with attendant strikeouts. I try to make money on every company, by following my eight rules. That doesn’t guarantee success, but my losers over the last 6.5 years have been less than 10% of the names that I invested in. And, in each case where I lost, the error of judgment came from neglecting one of the eight rules.

All that said, I encourage you to focus on risk control. It’s a lot easier to make money if you don’t lose it.

 

Full disclosure: long AIZ

What I Have Been Doing Lately

What I Have Been Doing Lately

Posted on by David Merkel

Recently I have had rebalancing trades, selling a little Dorel Indsutries and Sappi. Also, I swapped Sonic Automotive for Group 1 Automotive early on Tuesday. I was able to enjoy two unexpected sell-side upgrades. It’s not supposed to work this well, but it is nice when it does.

On another note, from a piece by Lloyd Byrne of Morgan Stanley, in 2006 only 73% of oil production was replaced by new reserves for companies that they follow. This is just another reason why I am overweight energy. The replacement ratio has fallen for the last four years.

Finally, if you subscribe to RealMoney, be sure to read Jim Griffin’s post, Fed-Watchers Have Blinders On. I have been contending that the housing lending crisis is serious but will not derail the economy on is own. With the decline in the dollar, it is no surprise that our exporters are seeing some growth. Funny that few notice that. I guess we are used to being importers only….

Full disclosure: long GPI DIIB SPP

The Kelly Criterion

The Kelly Criterion

Posted on by David Merkel

In an upcoming article at RealMoney, I will be writing an article on optimal position sizing. To do that, I use the Kelly Criterion, which says that a position size should be equal to (edge/odds). There is added complexity in applying this to stocks, because in gambling, each game is uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another, particularly for me, because I concentrate sectors.

The Kelly criterion applied to stock investing would recommend a fixed weight portfolio. Optimally, you would rebalance daily to those fixed weights, but there are two factors that interfere: first, there are costs to trading, and second, momentum tends to persist in the short-run. To me that implies that one has fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, like maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. How much are each of the rules worth? Well, that I will describe in the article at RealMoney, and that hopefully will explain why holding 35 or so positions is proper for me in running my strategy.

One more thing, I appreciate the work done at the CASTrader Blog on the Kelly criterion. We manage money very differently, but we both appreciate the value of the Kelly Criterion.

PS — As an aside, I get ribbed by some at RealMoney, whether contributors or readers about holding 35 positions as hyperdiversified. In general I agree with portfolio concentration, but given that I concentrate sectors and industies, that makes 35 a lot more like 20 in terms of total volatility. On the other hand, compared to most mutual fund managers, 35 names would be a tighter ship than 95% of them run.

Final Step and My Portfolio Decisions

Final Step and My Portfolio Decisions

Posted on by David Merkel

Here?s the final list that I worked with in making my trades. Working up from the bottom of my list, I decide on what to sell. If I?m not selling something that rates low on my quantitative screen, I have to have an explanation as to why I am keeping it.

What I Am Not Selling

 

St. Joe ? This doesn?t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee ? These are still in turnaround mode. Metrics don?t look good now, but should improve.

Sappi ? Value of underlying assets not reflected in the metrics. South Africa is also out of favor.

Dow Chemical ? it?s still cheap, and there are probably transactions that can unlock value.

DTE Energy ? My one US utility. Would benefit from a sell-off of their energy production arm. I might be close to selling, but am not there yet.

Premium Standard ? The merger with Smithfield will go through, and Smithfield will be able to take out costs. They might also gain a wee bit of pricing power. I think cost pressures have reached their maximum here, and profits will improve more than street estimates.

What I Am Selling

ABN AMRO ? Barclays may do the deal or not. ABN Amro is fully valued here, and then some.

Devon Energy and Apache ? I like them both, but their valuations have risen, and I have other places to deploy money.

What I am not Buying

After this, I look from the top down, and look for replacement candidates from the list. If I reject a highly rated name, I have to have a reason:

Group 1 Automotive ? I already have Lithia Motors and Sonic Automotive. It?s in less desirable areas of the country, so I will pass on it for now, but will revisit it at a later date.

Georgia Gulf ? It?s cheap, but I worry about the balance sheet, and I already own Dow and Lyondell.

Thornburg Mortgage ? Would give me conflicts of interest with my employer.

Optimal Group ? This is the most interesting of the ones that I did not buy. They have some interesting payments technologies, but the earnings estimate momentum was negative, and I could not really discern what competitive advantages they had.

Encore Wire ? A bit of a cult stock. I just don?t like the business that they are in.

Arkansas Best, P.A.M. Transportation ? I own YRC Worldwide, and these are not appreciably cheaper.

Foot Locker ? Too many earnings disappointments.

Spectrum Brands ? Lousy set of brands, and a poor earnings history.

Stolt Neilsen ? I own Tsakos, and I think it has better growth prospects.

National Coal ? Too small.

Home Solutions of America ? I don?t like their business, given my view of the housing market.

What I am Buying

Bronco Drilling ? Seems to be a cheap land driller, and replaces some of the exposure I lost selling Apache and Devon.

Komag, Nam Tai Electronics, Vishay Intertechnology ? Cheap technology stocks that are near the beginning of the technology food chain. The businesses are more stable than those who buy their products.

Full Disclosure: long VSH KOMG NTE BRNC BCS LAD SAH DOW LYO JOE SPP SPX SLE DTE PORK YRCW TNP

On Maintaining an Even Keel, Without Getting Wishy-Washy

On Maintaining an Even Keel, Without Getting Wishy-Washy

Posted on by David Merkel

The Broad Market Portfolio was up a little less than 50 basis points today.? Leading the charge were Dow Chemical and Sappi.? Trailing the pack were? Grupo Casa Saba, Industrias Bachoco, and Deerfield Triarc Capital.

One of the things that I debate about as I write for RealMoney is how public to be when I disagree with Cramer.? I’ve had a very good call on the FOMC for the past four years, with very few mistakes, and Cramer, in his view that the FOMC will loosen because of the present weakness in the stock market, because of subprime lending, seems misguided to me.? I differentiate between what I would do if I were the Fed Chairman, and what I think the current Fed Chairman will do.? My use of a political pain avoidance model has worked well for me over the last six years.? I no longer assume that the FOMC will want to do the right thing; they do what leads to the least political risk.

Also, I want to avoid becoming so bullish or bearish that I don’t listen to reason.? This is a pit for those that write about the markets, particularly if one is sensitive about being wrong.? Well, I will be wrong, hopefully just every now and then.

The course of action that is the most intellectually lazy is becoming a perma-bull or perma-bear.? It makes life simple because you can dismiss a large amount of the data.? It’s easier to write when you can focus on the same likely future difficulties/successes again and again.


I choose the hard route, trying to be fair about likely outcomes, and not overstating the case.? It doesn’t make for good journalism, but it makes for good investing!

PS — I will post on the last phase of my portfolio reshaping tomorrow.

Full Disclosure: long DOW SPP SAB IBA DFR

Second to Last Step

Second to Last Step

Posted on by David Merkel

Here’s the file for my progress on the portfolio change so far. Because of the data license that I have from Bloomberg, no numeric data fields from Bloomberg are listed here; only fields that I have calculated.

The grand rank is a weighted average of the ranks of the other variables, where a low number indicates desirability. Rsi Px 52week rank is a measure of price level. 0 means a 52-week low, and 100 means a 52-week high. NOA is net operating accruals; 0 means a low level of accruals on the balance sheet. 100 means there are a lot of accruals on the balance sheet.

Rsi Px 52week rank, NOA, Price-to-Sales, and Price-to-Book get a double weight. Everything else gets a single weight. I vary the weights each period based on what concerns me. When I am more bearish, I overweight the things that I am overweighting now.

Tomorrow I should have my portfolio changes. I choose 2-4 companies in the top half of my portfolio to replace 2-4 companies in the bottom half. Why do I do it this way? It forces me to make trade-offs, tossing out appreciated positions, and adding in promising names.

A Good End to a Good Week

A Good End to a Good Week

Posted on by David Merkel

The Broad Market portfolio was up a little more than 2% this week. The economic sensitivity of the portfolio helped, as did the Latin American names in the portfolio: SABESP, Cemex, Industrias Bachoco, and Grupo Casa Saba.

The week was characterized by a retreat from perceived systemic risk As the week went on risk went from general to localized. The true offenders in the subprime lending world were taken out and executed, and the rest of the market recovered.

I have been sounding bullish of late, but I want to caution you regarding the dangers of this present market. Though this panic did not spread to the market on the whole, it is possible that a future crisis might be more virulent. Remember, the current market prosperity relies on free trade in goods and services; any interruption of that could lead to a major decline. Bad FOMC policy is another risk here as well. Profit growth has slowed significantly as well. There are reasons to be concerned, but if you are concerned, tweak your portfolio toward less risk. Don’t leave the party entirely, but choose stocks with strong balance sheets and cheap valuations, and raise a little cash.

Full disclosure: SAB IBA CX SBS

My Main Industry Rotation Model

My Main Industry Rotation Model

Posted on by David Merkel

I have several industry rotation models.? Some are short-term, others are longer term.? My main one is in the back of my head as I analyze where the pain is growing, and nearing maximum intensity.? (If anyone wants me to share shorter term models, I can do that.? I don’t use them much though.)

For me, the idea in industry rotation is to find stocks that fit one of two paradigms: 1) strong companies in troubled industries, and 2) well-run, cheap companies in industries where favorable trends are over-discounted.? My main model attempts to address the former.

My model has 6 1/2 years of Value Line industry rank data.? It asks the following questions:

  1. What is the industry’s current rank?
  2. Relative to your rank history, where is your current rank compared to the maximum and minimum ranks?
  3. How many standard deviations are you above or below your average rank? and
  4. Compared to past history, what percentile is your Value Line rank compared to prior dates in history.

The results from these questions are weighted and turned into a grand rank. From highest to lowest, the weights go 1, 4, 3, 2 for the questions listed above.? This spreadsheet lists the final results.?? Now the new ranks can be used in two ways, in value mode, or momentum mode.

Value Line ranks are a product of three factors: price momentum, earnings momentum, and analyst surprise.? They are momentum driven.? My model attempts to refine that, and give investors two ways to play the market.? If you like fast momentum-style trading, buy the companies in the red zone near the bottom of the list.? If you’re like me, buy the companies in dead industries in the green zone at the top of the list.

So what did I do here?? The list of industries entitled “dig through” I deemed interesting from the “green zone.”? I ran a screen on them to get a few more names for this current portfolio reshaping.? Here are the tickers:

HERO ADM SMG SE ABFS CMC CVX ESV GMRK GSF HES MRTN NAT NE NX OXY PDE PTSI RADN RDC SHOO TSO

Okay, so now I have two things ready to go: I have the full list of tickers that I will compare against my current portfolio.? I also have what my main industry rotation model recommends.? I call my methods “quantitative assisted,” because I use my intellect to overrule them when I think it is needed.?? The next step is lining up all of the candidates against my current portfolio to help decide who to add in , and who to kick out.? More on that on Monday.

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