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Stocks

New Constructs - Featured Stock in March's Exec Comp & ROIC Model Portfolio


Eight new stocks make March’s Exec Comp Aligned with ROIC Model Portfolio, available to members as of March 15, 2019.

The success of this Model Portfolio highlights the value of our Robo-Analyst technology [1], which scales our forensic accounting expertise (featured in Barron’s) across thousands of stocks.

This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating and align executive compensation with improving ROIC. We think this combination provides a uniquely well-screened list of long ideas because return on invested capital (ROIC) is the primary driver of shareholder value creation. [2]

New Stock Feature for March: Insight Enterprises (NSIT: $56/share)

Insight Enterprises (NSIT) is the featured stock in March’s Exec Comp Aligned with ROIC Model Portfolio. We highlighted NSIT as a Long Idea in August 2018, and since then it has outperformed (+2% vs. S&P -1%). Despite this outperformance, the stock remains undervalued.

Since 2015, NSIT has grown after-tax profit (NOPAT) by 25% compounded annually. This profit growth has helped NSIT improve its return on invested capital (ROIC) from 7% in 2015 to 10% in 2018. As Figure 1 shows, NSIT’s ROIC has grown faster than its weighted average cost of capital (WACC) over the past four years, which drives growth in economic earnings, the true cash flows of the business.

Figure 1: NSIT’s ROIC and WACC Since 2015

Sources: New Constructs, LLC and company filings

Executive Compensation Plan Helps Drive Shareholder Value Creation

NSIT executives receive long-term equity compensation in the form of performance and time-based restricted stock units (RSU’s). The performance-based RSU’s account for 60% of long-term executive compensation and are tied to non-GAAP ROIC performance goals. RSU’s made up 43% of the CEO’s pay in 2017 (the most recent year for which we have data), so it is no coincidence that NSIT has improved ROIC in recent years - executives’ bonuses depend on it.

The focus on improving ROIC aligns the interests of executives and shareholders, helps to ensure prudent stewardship of capital, and lowers the risk of investing in the business.

NSIT Remains Undervalued

At its current price of $56/share, NSIT has a price-to-economic book value (PEBV) ratio of 1.1. This ratio means the market expects NSIT’s NOPAT will grow by no more than 10% for the remainder of its corporate life. This expectation seems pessimistic given NSIT has grown NOPAT by 12% compounded annually over the past two decades.

If NSIT can maintain 2018 NOPAT margins (2%) and grow NOPAT by just 3% compounded annually over the next decade, the stock is worth $69/share today – a 21% upside. 

Critical Details Found in Financial Filings by Our Robo-Analyst Technology

As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings. Below are specifics on the adjustments we make based on Robo-Analyst findings in Insight Enterprises’ 2018 10-K:

Income Statement: we made $61 million of adjustments, with a net effect of removing $7 million in non-operating expenses (1% of revenue).

Balance Sheet: we made $602 million of adjustments to calculate invested capital with a net increase of $494 million. One of the largest adjustments was $432 million in accumulated asset write-downs. This adjustment represented 35% of reported net assets.

Valuation: we made one adjustment with a net effect of decreasing shareholder value by $260 million. There were no adjustments that increased shareholder value. Despite the net decrease in shareholder value, NSIT remains undervalued.

 

[1] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

[2] Ernst & Young’s recent white paper “Getting ROIC Right” demonstrates the superiority of our stock research and analytics.

Click here to download a PDF of this report.

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This article originally published on March 22, 2019.

Disclosure: David Trainer, Kyle Guske II, Sam McBride and Andrew Gallagher receive no compensation to write about any specific stock, style, or theme.

Follow us on TwitterFacebookLinkedIn, and StockTwits for real-time alerts on all our research. 

 

About New Constructs

Our stock rating methodology instantly informs you of the quality of the business and the fairness of the stock’s valuation. We do the diligence on earnings quality and valuation so you don’t have to.

In-depth risk/reward analysis underpins our stock rating. Our stock rating methodology grades every stock according to what we believe are the 5 most important criteria for assessing the quality of a stock. Each grade reflects the balance of potential risk and reward of buying that stock. Our analysis results in the 5 ratings described below. Very Attractive and Attractive correspond to a "Buy" rating, Very Unattractive and Unattractive correspond to a "Sell" rating, while Neutral corresponds to a "Hold" rating.

Cutting-edge technology, featured by Harvard Business School, enables us to scale our unconflicted & comprehensive fundamental research across 10,000+ stocks, ETFs, and mutual funds. Learn more about New Constructs. Get a free trial. See what Barron’s has to say about our research.

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from New Constructs, LLC and is being posted with New Constructs, LLC’s permission. The views expressed in this material are solely those of the author and/or New Constructs, LLC and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.


23305




Fixed Income

Invesco - The Fed Delivers A Dovish Message - By Noelle Corum


The FOMC projects zero rate hikes this year, says economic fundamentals are still strong

Going into the Federal Reserve’s (Fed) March 19-20 policy meeting, markets were focused on three main themes: economic sentiment, the so-called “dot plot” and guidance on balance sheet runoff. The outcomes were considered to be dovish by markets. In addition to leaving its policy rate unchanged, the Fed revised down its US growth outlook and announced plans to end its balance sheet runoff. Initial market moves pointed to easier financial conditions, with real rates trading lower, risk assets higher and the US dollar weaker. Overall, Invesco Fixed Income expects these developments to be positive for credit risk assets.

 

Economic sentiment revised down

The Fed’s statement acknowledged a strong labor market but slowing growth. During Chairman Jay Powell’s press conference, he noted that underlying fundamentals remain strong and that the Fed’s outlook is positive, overall. Comments on inflation were somewhat downbeat, but largely unchanged.

 

Dot plot now indicates zero hikes in 2019

Federal Open Market Committee (FOMC) members now see zero interest rate hikes in 2019, as indicated by the median dot on the FOMC’s rate hike outlook (or “dot plot”). This is down from two in December’s outlook. The downward revision to growth expectations and an anticipated rise in unemployment  likely contributed to this move. Core inflation estimates were unchanged.

 

Balance sheet runoff to end in September

The Fed plans to slow the runoff of Treasuries from its balance sheet starting in May of this year and ending by the end of September. In October, maturing mortgage securities will be reinvested back into Treasuries up to a cap of $20 billion per month. Anything beyond this cap will continue to be invested in mortgage-backed securities. Their goal to primarily hold Treasuries in the long run remains unchanged.

 

Invesco Fixed Income outlook

Relative to the Fed’s median outlook for growth and inflation, our expectations are slightly more constructive. We expect growth of 2.3% and core inflation to run at 2.1% in 2019, versus Fed expectations of 2.1% and 2.0%, respectively. While building inflation and a solid growth outlook could bring challenges in the latter part of the year, we do not expect this to be a concern for the Fed over the next two quarters. Therefore, we believe the Fed will remain on hold for the medium term.

We believe that a dovish Fed — along with our favorable growth and benign inflation view — will likely be positive for credit risk assets. Additionally, we expect a patient Fed — combined with building inflation expectations — may steepen the yield curve and support inflation-linked bonds. Lastly, we expect the US dollar to continue to weaken. Specifically, as we see a stabilizing global growth picture and little in the way of US monetary policy, we expect the US dollar to weaken as investors look elsewhere for investment opportunities.

 

Important information

The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

A risk asset is any asset that carries a degree of risk, such as credit bonds and equities.

Real interest rates are adjusted to remove the effects of inflation.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

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Originally Posted on March 21, 2019

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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

NOT FDIC INSURED

 MAY LOSE VALUE

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All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco Ltd., used by the investment adviser, Invesco PowerShares Capital Management LLC (PowerShares) under license. PowerShares and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.

©2019 Invesco Ltd. All rights reserved.

Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. 

The Fed Delivers A Dovish Message by Invesco US

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Invesco and is being posted with Invesco’s permission. The views expressed in this material are solely those of the author and/or Invesco and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.


23306




Stocks

Singapore Exchange - Highlights of SGX's 10 Largest OSV Plays


Singapore Exchange lists 35 Offshore Supply Vessel (OSV) players. These companies provide support services to offshore drilling rigs, pipe laying and oil-producing assets – including production platforms, as well as floating production, storage and offloading (FPSO) units – used in the exploration and production (E&P) of oil and gas (O&G). 

OSV stocks are heavily dependent on the fortunes of the crude market. They are widely viewed as one of the key beneficiaries of a rebound in oil prices. A robust demand for oil leads to an increase in planned E&P activities, resulting in higher demand for rigs, platforms and FPSOs, which in turn boosts the OSV market.

Crude Hit 4M Highs Last Week

Since the start of 2019, WTI crude has gained over 30%, supported by production cuts from the Organization of Petroleum Exporting Countries (OPEC) and its partners – known as OPEC+, in addition to supply disruptions in Iran and Venezuela following US sanctions. After hitting a four-month high of US$60 a barrel last week, oil prices have since retreated, as risk-off sentiment increased on continued uncertainty over the US-China trade war and disappointing economic data from US and Europe. Saudi Arabia signaled earlier in March that producers may need to extend their 1.2 million barrels per day of supply curbs past June into the second half of the year, as OPEC’s job of rebalancing the oil market was far from done.

 

 

Price Recovery From 12M Troughs

The 10 largest OSV stocks on SGX have a combined market capitalization of more than S$1 billion. These 10 largest players have also averaged a 30.9% price rebound from their 52-week lows, in line with recent crude gains. Among the 10, five that posted the strongest price rebounds from their 12-month troughs were: Amos Group (160.9%), Sinwa Ltd (57.9%), Vallianz Holdings (30.0%), Dyna-Mac Holdings (23.0%), and Baker Technology (9.2%).

The table below details the current and 52-week low prices for the 10 largest OSV stocks, sorted by market capitalization.

 

Recent Performances

In the 2019 year-to-date, the 10 largest OSV stocks have averaged a total return of +9.8%, bringing their one-year and three-year total returns to -26.0% and -22.4%, respectively. The three best-performing OSV players in the YTD were: Amos Group (+160.9%), Sinwa (+15.4%), and PACC Offshore Services (+0.6%).

The table below details the year-to-date, one-year and three-year total returns for the 10 largest OSV stocks, sorted by YTD returns.

 

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Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC Risk Disclosure. A copy and additional information are available at ibkr.com.

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Singapore Exchange and is being posted with Singapore Exchange’s permission. The views expressed in this material are solely those of the author and/or Singapore Exchange and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.


23307




Macro

State Street Global Advisors - Cautious on Emerging Markets Until Fundamentals Pick Up


By Ramu Thiagarajan, Chris Laine, Aaron R. Hurd, Laura Ann Ostrander

 

Emerging markets (EMs) have had a better start to the year following a dismal 2018 marred by the US-China trade dispute, a stronger US dollar, a hiking Federal Reserve (Fed) and slower growth exacerbated by deleveraging. However, it remains to be seen whether the factors behind the rebound are transitory or herald the start of an upward trend.

So far, the rally has been relatively superficial, driven more by expanding multiples than by earnings increases, on the back of the Fed’s rate-hiking pause and more positive trade talks. Global investors need to be cautious, therefore, as the hot money flows into EMs could just as easily switch direction if more robust EM GDP and earnings growth fails to materialize. While there are hints of stabilization, especially in China, investors should be prepared for a more fundamental EM recovery to take time.

Against this backdrop, we remain cautious and selective on EMs. The universe is highly heterogeneous and the prospects for earnings and GDP growth differ markedly between countries and sectors. Moreover, given structural changes in inflation expectations for EMs, certain countries could provide more developed market (DM)-like returns over the next five to ten years, so yield-sensitive investors may need to consider higher allocations to active EM strategies to capture the same levels of return in the future.

Fundamentals Begin to Stabilize, But At Lower Level

While EM equities have risen 8.5% year-to-date[1] and continue to trade at a discount to DMs, they have underperformed the S&P 500 Index and are still down 4% on a 12-month basis. A more visible measure of improving global liquidity has been the compression of EM debt spreads over US Treasuries. But while monetary and geopolitical conditions have improved, and some fundamentals such as return on equity and profit margins are showings signs of stabilizing, they are doing so at a lower level. Trade volumes have also yet to recover.

Earnings estimates continue on a downward trend as shown in Figure 1, with the majority of downgrades hitting the important tech sector. Until these flatten out or start to rise, it is hard to see how stocks could make further progress; much of the gains from likely trade reconciliation and a more lenient policy response appear to be priced in.

 

However, it is worth noting that while EM earnings revisions have continued to be mostly downward, the ratio of upward to downward revisions has been on an improving trend over the last few months, particularly in Asia ex-Japan. Further, much of the negative estimate revisions have been in the Information Technology (IT) sector—an area more afflicted by global cyclical factors than EM-specific factors. Meanwhile, countries with lower forward price-to-earnings multiples have benefited most from the recent stock rally, including Russia, Turkey and China.

China Stimulus Provides Some Support

From a short-term cyclical standpoint, we would expect China’s latest fiscal and monetary stimulus to provide some support at home and across the region. Total social financing for January saw a sharp increase as this stimulus started to come through, although February’s figure was lower than expected. Overall financing for the first two months of 2019 has been RMB 1 trillion higher than the same period in 2018. Much of 2019’s financing has gone into short-term loans for companies, so the stimulus is unlikely to be prolonged (see Figure 2) given the already high levels of corporate leverage.

Recent comments by the Chinese premier also suggest this latest stimulus is very different from that in 2015/2016; it is designed to cushion the effects of slower growth on highly levered businesses and to preserve jobs rather than to boost overall economic growth. China recently lowered its expected growth rate for 2019 to 6.0%-6.5%, and so we would not expect further aggressive stimulus from the authorities unless they have to defend the lower end of this range.


So, while we could see improvement in China – certain purchasing managers’ indices (PMIs) look more promising – we remain cautious on the prospects for companies not exposed to long-term secular trends such as rising consumption. In the IT sector, DRAM (computer memory hardware) prices continue to fall even as firms such as Samsung have seen a rise in share prices year-to-date. Normally, the two correlate closely, suggesting the market believes the semi-conductor cycle will turn in the second half of this year. If it does not, then EMs may struggle to make headway as big tech companies constitute a significant proportion of the MSCI EM index. 

EM Inflation Trends Lower

In addition, we have noticed a downward trend in EM inflation, which raises the question of whether nominal interest rates and risk premia will be lower over the next five years. We have already seen China adjusting to new growth expectations, but there are structural reasons why EMs, while continuing to offer opportunities arising from their development, might produce more DM-like returns in the future.


Inflation across EMs has been trending downwards since 2011 thanks to inflation-targeting, more credible central bank policy and lower energy prices. However, the component drivers of inflation have also changed. Figure 3 shows that the proportion of inflation driven by country-specific components has fallen since 2016 compared to an increase in common inflation components that affect all EM countries. The common component is driven by oil price inflation, while idiosyncratic inflation is falling as economies open up and FX volatility declines.

At present, it is hard to determine if these changes in inflation composition are permanent or not. If they are, this will have implications for long-term expected returns. So far, nominal yields seem to have contracted more than real yields, but the reduced inflation risk premium appears not yet to be fully priced in.

Even if overall inflation volatility may be coming down as EMs globalize, many countries remain exposed to national policy choices. So, we are likely to continue to see interest rates vary across the asset class. Finally, we recognize that this change in the component drivers of inflation may be a function of where we are in the cycle, rather than an indicator of future returns, and requires further research to determine its significance.

Reasons to Go Active

Any reduction in the inflation risk premium will affect not only rates, but also equity risk premia. EM-type returns should continue to be available given the high level of idiosyncratic risks across the EM universe e.g., around elections, sanctions, policy moves and product cycles. However, returns are likely to be more disparate than before – EMs remain highly heterogeneous in growth terms as evidenced by the manufacturing PMIs in Figure 4 – and require an active approach to achieve them. 


If inflation volatility does continue to fall in EMs, currencies should benefit. In the short term, we are seeing attractive currency yields available in places such as South Africa and Mexico. Investors need to be able to assume the higher idiosyncratic risk these markets bear, but in our view a lot of macroeconomic risk is already priced in and the short-term cyclical outlook is positive compared to last year. That said, it can be useful to gain exposure to these areas in an active manner to be able to manage risk dynamically as conditions change.

Conclusion

With the Fed on pause and the US-China trade dispute inching toward resolution, the improving liquidity picture is strengthening our case to be constructive on EMs, while remaining aware of both macro and country-specific risks such as forthcoming elections in India. The US economic expansion is now the longest ever, at 117 months, so the Fed may take its time before it moves on rates, whether up or down, though the US consumption story appears intact for now. More accommodative policy should be positive for EM foreign exchange against the dollar unless EM growth weakens substantially from here. However, EM currencies are generally near fair value, and the carry over the dollar is not huge given that dollar yields are relatively high.

In summary, EM headwinds may have faded but tailwinds such as favorable currency conditions have yet to appear. Earnings expectations still need to stabilize, and underlying growth fundamentals remain relatively weak. In such a climate, it can be helpful to take active positions and avoid stocks that could suffer the most from macroeconomic and policy shifts.

1As of 28th February 2019

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Originally Posted on March 22, 2019

Disclosures

The views expressed in this material are the views of through the period ended 03/21/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Investing involves risk including the risk of loss of principal.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.

There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.

The information provided does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.  You should consult your tax and financial advisor.

The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.

For four decades, State Street Global Advisors has served the world’s governments, institutions and financial advisors. With a rigorous, risk-aware approach built on research, analysis and market-tested experience, we build from a breadth of active and index strategies to create cost-effective solutions. As stewards, we help portfolio companies see that what is fair for people and sustainable for the planet can deliver long-term performance. And, as pioneers in index, ETF, and ESG investing, we are always inventing new ways to invest. As a result, we have become the world’s third largest asset manager with US $2.51 trillion* under our care.

 

*AUM reflects approximately $32.45 billion (as of December 31, 2018), with respect to which State Street Global Advisors Funds Distributors, LLC (SSGA FD) serves as marketing agent; SSGA FD and State Street Global Advisors are affiliated.

Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC Risk Disclosure. A copy and additional information are available at ibkr.com

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from State Street Global Advisors and is being posted with State Street Global Advisors permission. The views expressed in this material are solely those of the author and/or State Street Global Advisors and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.


23308




Macro

Validea - The Balance Between Simple and Complex in Investing


Successful investing can be complicated. And our natural inclination as human beings is to want to address complicated problems with complicated solutions. But that can be to our detriment at times. Jim O’Shaughnessy recently wrote an excellent tweetstorm on Twitter on the benefits of simplicity, and it got me thinking about how difficult the balance between simple and complex can be in investing.

From what I have seen in my career running factor-based models, simple is usually best. Our tendency as human beings to make things more complex than they need to be tends to do more harm than good, and it leads us to seek complex solutions when simple ones would do just fine. But investing is a complex game and just using the simplest solution to any problem can also be problematic.

So, what is the answer? As is the case with many decisions in investing, it isn’t completely clear cut. My goal has always been to try to find the simplest solution possible to any given problem, understanding that sometimes that solution will be more complex than I would like it to be.

The best way to see how this balance plays out in the real world might be to look at some examples.

Is Simple Value Investing Dead?

If you look at the academic research that provides long-term support for value investing, it is actually very simple. When Fama and French defined value in their 3-factor and 5-factor models, they only used one variable. They found that using the Price/Book ratio to identify value stocks resulted in excess return over long periods of time. Significant academic research since then has verified that conclusion.

So, if I wanted to use the simplest approach to value possible, I might just use a one variable strategy, where I select a basket of stocks that are cheapest using the Price/Book. Or I could replace the Price/Book with a different simple value variable like the PE ratio or the Price/Sales.

But is that very simple approach the best way to build a value-based portfolio? A look at the historical base rates would say that the odds of that simple system beating a market cap weighted index over long periods of time are actually quite good. Some basic adjustments to it can make it significantly better, though. The first issue with that strategy is that it is very hard to pick the one value metric that will work best going forward. The Price/Book ratio has been the most maligned ratio is recent years (and rightfully so since intangible assets comprise the majority of assets these days but are not included in the Price/Book), however all the individual ratios have their own unique issues. It might be better to just use a composite of all of them. That way I eliminate the risk of picking the wrong ratio, and my return will be the average of all the major value metrics.

Another issue that I might want to address with my basic value strategy is the fact that many cheap stocks are cheap for a reason. I wrote an article a while back where I proposed one method that might help to do that, so I won’t discuss all the detail here. But in general, I think the evidence supports the conclusion that you can improve the returns of a value strategy by eliminating low quality stocks.

With these two changes I have made to my value strategy, I have now improved the likelihood of its success. But I also have added complexity. I could easily use these same types of arguments over and over to continue to add complexity to my strategy, and the whole process could quickly get out of control. That is why the battle between simple and complex is so difficult. On one hand, my original simple strategy with one variable was not optimal. But on the other I need to be careful not to add complexity just for the sake of doing so without actually improving the strategy. I think my two proposed changes above struck a good balance between the two fairly well, but the right answer can be very difficult to find.

Simple vs Complex in Trend Following

Trend following is another good example of the battle between simple and complex in investing. At its core, trend following is very simple. Pick something like the 200-day moving average, stay invested when the market is above it, and sell your stocks or hedge when it is below. It doesn’t get much simpler than that.

But like many things in investing, the devil is in the details. There are two major decisions you need to make with trend following. The first is which trend indicator you use. The second is how often you apply it. Many funds use a simple 200-day moving average system like I described above and make adjustments once per month. If the market is below the 200-day moving average at the end of the month, they will remain in cash or hedged for the following month. Over the long-term, that simple system works out just fine, but in individual instances, it can get things very wrong. All trend following systems will have false signals, so that isn’t uncommon, but by only using one indicator and only applying it once a month, that type of strategy ends up taking a good amount of unnecessary risk. If the market ends up slightly below the 200-day moving average at the end of any given month and then sharply reverses, this type of simple system will have to wait a month to get back in, which can lead to major negative deviations from the market’s return. What has happened this year is a good example of how using month-end indicators can hurt you as many simple trend systems stayed out of the market from the beginning of the year until the end of February and missed most of the market rally.

A more complex trend following system can address this problem in two ways. First, it can use multiple signals and couple the 200-day moving average with other indicators. That way if the 200-day moving average ends up being the worst indicator in a specific decline, the other indicators can pick it up. The second is applying the signal more than once a month. A system applied weekly or even daily is less prone to bad timing luck.

Over really long periods of time, the simple and more complex system will likely have close to the same performance. But the more complex one is less likely to have a major negative event due to bad luck, which means investors are much more likely to stick with it.

Simple, But Not Too Simple

Simple often beats complex in investing for good reason. Our overconfidence as investors leads us to want to continue adding layers of complexity to our portfolios, and that often leads to an inferior result compared to what a much simpler system would have generated. Even with the modifications I made, the trend following and value strategies I discussed are still fairly simple. But they do add some complexity relative to the simplest option.

In the end, finding the perfect balance between simple and complex is very difficult, and the right answer may vary for each person. But if you can err on the side of simple and make sure any complexities you add beyond that are clearly superior to the simple option, you will likely end up with a strategy that strikes the right balance and gives you the best chance of achieving your investing goals.

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Originally Posted on March 19, 2019

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