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otm-pham0914

Peter Pham
Peter Pham

The document discusses an investment strategy that focuses on companies in countries with low price-to-sales ratios and high real interest rates. The strategy screens for large, liquid companies trading above their previous year's high with high free cash flow. Applying this strategy from 2009-2014 to countries like South Korea, Japan, the US and Thailand outperformed the market by 50%. Ongoing rebalancing is key to maintain outperformance. Risks include increased volatility if central bank policies change.

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continued on p. 8 BY PETER PHAM TRADING Strategies 6 www.activetradermag.com September 2014 ACTIVE TRADER Global growth and income A fund manager discusses the macroeconomic concerns and fundamental criteria driving portfolio development. On The MARKET E quity returns follow a natural cycle from growth to income. A successful startup company often needs external financing from both debt and equity markets to build operations and capture or expand market share. Once operations become successful, a firm generates free cash flows that can be used for dividends, acquisitions, or share repurchases. Investors should seek and indeed, expect higher-risk re- turns in the form of capital appreciation during a firms relatively short growth stage and seek lower-risk returns in the form of higher dividends and repurchases during a firms indefinitely long mature phase. These simple observations form the basis for a professional portfolio-development and alpha-capturing regimen. This article will examine investment selection and stock-evaluation criteria, along with a historical back-test of the approach. Investment thesis The funds approach begins with the idea that the stabilization of global economies and financial markets after the financial crisis left the world with an overhang of growth-impeding sovereign debt. The impairment of the financial system and slack capacity created disinflationary and deflationary pressures. Central banks have (and continue to) offset these pressures with low interest rates and de facto monetization of sovereign debt. These measures have combined to push yields and credit spreads lower, and also divert investment from real plant and equipment to the financial representation of corporate assets equity prices. In this environment, many public corporations have found share repurchases, the ownership of their own existing assets and their future cash flows, to be more attractive and less risky than new plant and equipment. Their ability to finance these share repurchases with historically low debt makes them doubly attrac- tive. Moreover, corporate managers who are paid on shareholder returns have an absolute incentive to push their stock prices higher. This cycle will continue until and unless major central banks reverse the easing cycle. As of July 2014, however, this does not appear to be an imminent possibility for the Federal Reserve, the Bank of Japan, or the European Central Bank. All these central banks fear raising the cost of public debt service and the macro- economic consequences of financial market volatility that higher short-term interest rates would induce. Given this economic backdrop, lets look at the equity evalua- tion component of the investment approach. Stock evaluation criteria Large tactical opportunities remain within this broad strategic environment. The best criterion for evaluating firms relative valu- ation is the price-to-sales (P/S) ratio because, unlike both price- to-earnings (P/E) and price-to-book (P/B) ratios, this measure
On The Market 8 www.activetradermag.com September 2014 ACTIVE TRADER is comparable across global accounting standards. Next, because a fund must maintain liquidity to pay returns to shareholders, each holding in its portfolio must be liquid. As a result, each stock must meet a minimum market capitalization to give the manager leeway to enter and exit positions quickly. Finally, the fund respects the markets assessment of each firms performance, and thus seeks investments trading above the previous years high. Now lets see how these criteria can trans- late into strategy. The strategy 1. Screen the top economies in the world with an equity index. Calculate the aver- age P/S ratio for each country along with the average real interest rate, which will be defined as the difference between the lending rate and the Consumer Price Index (CPI) for the past year. 2. Select the top five to seven countries with the best combination of low P/S ratios and high real interest rates. These countries have the greatest potential for uncover- ing high growth over the next credit cycle (three to five years). 3. Identify companies with the following criteria: a. A ratio of Free Cash Flow (FCF)/Share- holder Return (dividends and stock repurchases) greater than 1 and less than 5. b. A market capitalization greater than $1 billion. c. Trading above the previous years high. FIGURE 2: RELATIONSHIP BETWEEN REAL INTEREST RATE AND AVERAGE TAR, 2009-2014 Data source: Bloomberg, World Bank FIGURE 1: P/S AND AVERAGE TOTAL ANNUAL RETURN (TAR) RELATIONSHIP, 2009-2014 Data source: Bloomberg
continued on p. 10 d. Primarily consumer discretionary and consumer staple stocks with high eco- nomic goodwill. 4. Finally, employ precise, quantitative trading methods to time entry and exit points in each stock, buy efficient hedges, and maximize the time efficiency of each investment. Testing the approach This investment thesis and strategy criteria were back-tested over a five-year period. The first test analyzed the relationship between P/S ratio and annual return. A country group was created for this study by screening for countries with the highest real interest rates and the cheapest overall stock market. Then the constituent stocks of each countrys equity index were collected. These results are summarized in Figure 1, which clearly indicates a P/S ratio less than or equal to 1 produced the highest returns over a five-year period from 2009 to 2014. World Bank data from the studys country group was used to determine each coun- trys real interest rate. This data was then compared to the annual returns for each of the countries equity indexes, as shown in Figure 2. There is a clear inverse relationship between real interest rates and total annual- ized return. Both of these results confirm the thesis that the highest returns are possible after real interest rates peak and begin to fall. Interest rates above 13% may indicate extreme investor fear and high local deflation because of extreme monetary tightening by local central banks. ACTIVE TRADER September 2014 www.activetradermag.com 9 TABLE 1: COUNTRIES WITH AVAILABLE P/S AND REAL INTEREST RATE IN 2009 Country Ticker P/S 2009 Real Int. rate 2009 TAR from 2009-2014 Pakistan MXPK INDEX 0.51 -5.1 30.81 United Kingdom UKX Index 0.90 -1.6 14.04 Australia AS51 Index 1.35 1.0 12.80 Singapore FSSTI Index 1.21 1.8 10.06 Netherlands AEX Index 0.52 1.9 13.84 South Korea KOSPI Index 0.70 2.0 8.97 Japan NKY Index 0.62 2.2 10.80 United States SPX Index 1.00 2.5 18.81 Italy FTSEMIB Index 0.63 2.6 6.00 Switzerland SMI Index 1.58 3.2 12.30 Chile IPSA Index 1.32 3.3 4.63 Vietnam VNINDEX Index 1.22 3.6 9.17 Thailand SET Index 0.71 3.9 24.54 Canada SPTSX Index 1.43 4.6 10.99 Argentina MERVAL Index 0.96 5.3 40.63 Hong Kong HSI Index 2.46 5.4 8.33 Philippines PCOMP Index 1.80 5.6 26.73 Indonesia JCI Index 1.38 5.7 21.96 India NIFTY Index 2.11 5.8 13.74 China MXCN Index 1.90 6.0 5.22 Belgium MXBE Index 0.90 8.2 18.88 Colombia COLCAP Index 2.68 9.3 12.10 Norway MXNO Index 0.85 10.2 16.26 Malaysia FBMKLCI Index 1.41 11.8 15.65 Russia RTSI$ Index 0.77 13.1 10.01 Peru MXPE Index 4.67 19.0 10.82 Brazil IBOV Index 1.20 35.0 0.65 Source: Bloomberg, World Bank
On The Market Real interest rates below 1% have the highest returns, likely indicating the creation of hyper credit expansion and a high probability of a reversal. Based on these results, the criteria with the best overlap for choosing countries with the highest annualized return are: P/S ratio less than 1.2 and real interest rates between 2% and 6%. In 2009 the top-five countries that fit those criteria were South Korea, Japan, the U.S., Thailand, and Argentina (Table 1, p. 9). We took that list of countries and found the stocks that met the criteria; a list of 20 was initially identified (Table 2). The portfolio is rebalanced monthly using the same criteria, meaning stocks would be included and excluded on an equal-weight basis. Back-test performance This strategy was back-tested against the MSCI index over the same five-year period from 2009 to 2014, starting with the stocks in Table 2. It outperformed the MSCI index by roughly 50%, with a 156% portfolio return vs. 106% for the MSCI index during that time. A total of 58 stocks would have had a position taken during this time. Winners outnumbered losers nearly three to one, with 43 stocks up and 15 down. Winners gained an aver- age of 3.3% per month vs. an average -2.76% loss for the losers. Uptrends periods were longer than downtrends, 3.3 months vs. 1.2 months. 10 www.activetradermag.com September 2014 ACTIVE TRADER FIGURE 3: PORTFOLIO RETURN VS. MSCI Source: Bloomberg Book detailing quantitative trading techniques: The Big Trade: Simple Strategies for Maximum Market Returns By Peter Pham (Wiley, 2012) Articles by Peter Pham: Searching for organic growth, old-school With equity valuations approaching the stratosphere, investors looking for real value may want to look closer to the terra firma. Active Trader, August 2014 Geopolitics, the EU and the Trade of the Century How to position yourself for a realignment of the global financial paradigm. Active Trader, July 2014 Related reading
Note: The 20 initial stocks gained only 20% compared to 106% for the MSCI index. If the portfolio is not rebalanced every period to ensure the stocks included are meeting the proposed criteria, underperformance will result. Other considerations This portfolio management approach is in tune with both global credit and capital flow cycles. An analysis to back-test this strat- egy was done through Bloomberg to create a model of behavior. It strongly suggests the strategy can be implemented with automatic rebalancing. However, timing can be further refined with precise entry and exit points using quantitative techniques, such as those referenced in Related reading. In addition, core portfolio returns can be augmented through options strategies, such as writing covered calls or selling naked puts. Risks are inherent in a global environment where competitive currency devaluations dominate central bank policy. There is a limit to those policies which threaten the stability of all capital markets when it is reached. In that case, volatility in equities will increase and downside risks emerge quickly. Hedging is therefore a strong requirement, as is adequate liquidity maintenance. Emerging markets are especially vulnerable to capital flight under those conditions. This means weighing those risks vs. the selection criteria and constructing the portfolio accordingly. Disclosure: The approach outlined here is the portfolio-development method of the Prestige Global Growth and Income Fund, an open- end global fund established in 2007 and designed to outperform the MSCI-Barra World Free index with a mix of young high-growth and mature high-income vehicles. Phoenix Capital (headed by the author of this article, Peter Pham) and AM Capital took over management of the fund at the end of May 2014. ACTIVE TRADER September 2014 www.activetradermag.com 11 TABLE 2: COMPANIES MEETING THE SCREENING CRITERIA IN 2009 Ticker Name FCF/(dividend + share repurchase) Price: D-1 High Px:Y-1 Market Cap ($ mln.) 2685 JP Equity ADASTRIA HOLDING 4.17 5,300 3,340 1,435 4967 JP Equity KOBAYASHI PHARM 4.61 3,670 3,460 1,626 021240 KS Equity COWAY CO LTD 2.02 31,100 31,000 1,823 7532 JP Equity DON QUIJOTE HOLD 1.76 1,934 1,808 1,451 DRI US Equity DARDEN RESTAURANT 1.73 33 33 4,533 9843 JP Equity NITORI HOLDINGS 4.74 6,830 5,540 4,072 CPF TB Equity CHAROEN POK FOOD 3.57 5 4 1,054 5947 JP Equity RINNAI CORP 2.17 4,100 4,020 2,316 2809 JP Equity KEWPIE 4.96 980 934 1,587 TRI CN Equity THOMSON REUTERS 2.05 34 33 18,834 LANC US Equity LANCASTER COLONY 3.20 45 31 1,249 CASY US Equity CASEYS GENERAL 1.47 25 23 1,276 AAN US Equity AARONS INC 2.36 30 22 1,545 HRL US Equity HORMEL FOODS CRP 3.26 35 34 4,634 HSY US Equity HERSHEY CO 1.19 36 33 8,009 FDO US Equity FAMILY DOLLAR ST 4.88 28 23 3,919 CL US Equity COLGATE-PALM 2.04 72 70 36,008 CLX US Equity CLOROX CO 2.08 56 53 7,783 6460 JP Equity SEGA SAMMY HOLD 2.34 1,187 914 3,503 CPALL TB Equity CP ALL PCL 3.22 16 11 2,082 Source: Back-testing result from Bloomberg

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  • 1. continued on p. 8 BY PETER PHAM TRADING Strategies 6 www.activetradermag.com September 2014 ACTIVE TRADER Global growth and income A fund manager discusses the macroeconomic concerns and fundamental criteria driving portfolio development. On The MARKET E quity returns follow a natural cycle from growth to income. A successful startup company often needs external financing from both debt and equity markets to build operations and capture or expand market share. Once operations become successful, a firm generates free cash flows that can be used for dividends, acquisitions, or share repurchases. Investors should seek and indeed, expect higher-risk re- turns in the form of capital appreciation during a firms relatively short growth stage and seek lower-risk returns in the form of higher dividends and repurchases during a firms indefinitely long mature phase. These simple observations form the basis for a professional portfolio-development and alpha-capturing regimen. This article will examine investment selection and stock-evaluation criteria, along with a historical back-test of the approach. Investment thesis The funds approach begins with the idea that the stabilization of global economies and financial markets after the financial crisis left the world with an overhang of growth-impeding sovereign debt. The impairment of the financial system and slack capacity created disinflationary and deflationary pressures. Central banks have (and continue to) offset these pressures with low interest rates and de facto monetization of sovereign debt. These measures have combined to push yields and credit spreads lower, and also divert investment from real plant and equipment to the financial representation of corporate assets equity prices. In this environment, many public corporations have found share repurchases, the ownership of their own existing assets and their future cash flows, to be more attractive and less risky than new plant and equipment. Their ability to finance these share repurchases with historically low debt makes them doubly attrac- tive. Moreover, corporate managers who are paid on shareholder returns have an absolute incentive to push their stock prices higher. This cycle will continue until and unless major central banks reverse the easing cycle. As of July 2014, however, this does not appear to be an imminent possibility for the Federal Reserve, the Bank of Japan, or the European Central Bank. All these central banks fear raising the cost of public debt service and the macro- economic consequences of financial market volatility that higher short-term interest rates would induce. Given this economic backdrop, lets look at the equity evalua- tion component of the investment approach. Stock evaluation criteria Large tactical opportunities remain within this broad strategic environment. The best criterion for evaluating firms relative valu- ation is the price-to-sales (P/S) ratio because, unlike both price- to-earnings (P/E) and price-to-book (P/B) ratios, this measure
  • 2. On The Market 8 www.activetradermag.com September 2014 ACTIVE TRADER is comparable across global accounting standards. Next, because a fund must maintain liquidity to pay returns to shareholders, each holding in its portfolio must be liquid. As a result, each stock must meet a minimum market capitalization to give the manager leeway to enter and exit positions quickly. Finally, the fund respects the markets assessment of each firms performance, and thus seeks investments trading above the previous years high. Now lets see how these criteria can trans- late into strategy. The strategy 1. Screen the top economies in the world with an equity index. Calculate the aver- age P/S ratio for each country along with the average real interest rate, which will be defined as the difference between the lending rate and the Consumer Price Index (CPI) for the past year. 2. Select the top five to seven countries with the best combination of low P/S ratios and high real interest rates. These countries have the greatest potential for uncover- ing high growth over the next credit cycle (three to five years). 3. Identify companies with the following criteria: a. A ratio of Free Cash Flow (FCF)/Share- holder Return (dividends and stock repurchases) greater than 1 and less than 5. b. A market capitalization greater than $1 billion. c. Trading above the previous years high. FIGURE 2: RELATIONSHIP BETWEEN REAL INTEREST RATE AND AVERAGE TAR, 2009-2014 Data source: Bloomberg, World Bank FIGURE 1: P/S AND AVERAGE TOTAL ANNUAL RETURN (TAR) RELATIONSHIP, 2009-2014 Data source: Bloomberg
  • 3. continued on p. 10 d. Primarily consumer discretionary and consumer staple stocks with high eco- nomic goodwill. 4. Finally, employ precise, quantitative trading methods to time entry and exit points in each stock, buy efficient hedges, and maximize the time efficiency of each investment. Testing the approach This investment thesis and strategy criteria were back-tested over a five-year period. The first test analyzed the relationship between P/S ratio and annual return. A country group was created for this study by screening for countries with the highest real interest rates and the cheapest overall stock market. Then the constituent stocks of each countrys equity index were collected. These results are summarized in Figure 1, which clearly indicates a P/S ratio less than or equal to 1 produced the highest returns over a five-year period from 2009 to 2014. World Bank data from the studys country group was used to determine each coun- trys real interest rate. This data was then compared to the annual returns for each of the countries equity indexes, as shown in Figure 2. There is a clear inverse relationship between real interest rates and total annual- ized return. Both of these results confirm the thesis that the highest returns are possible after real interest rates peak and begin to fall. Interest rates above 13% may indicate extreme investor fear and high local deflation because of extreme monetary tightening by local central banks. ACTIVE TRADER September 2014 www.activetradermag.com 9 TABLE 1: COUNTRIES WITH AVAILABLE P/S AND REAL INTEREST RATE IN 2009 Country Ticker P/S 2009 Real Int. rate 2009 TAR from 2009-2014 Pakistan MXPK INDEX 0.51 -5.1 30.81 United Kingdom UKX Index 0.90 -1.6 14.04 Australia AS51 Index 1.35 1.0 12.80 Singapore FSSTI Index 1.21 1.8 10.06 Netherlands AEX Index 0.52 1.9 13.84 South Korea KOSPI Index 0.70 2.0 8.97 Japan NKY Index 0.62 2.2 10.80 United States SPX Index 1.00 2.5 18.81 Italy FTSEMIB Index 0.63 2.6 6.00 Switzerland SMI Index 1.58 3.2 12.30 Chile IPSA Index 1.32 3.3 4.63 Vietnam VNINDEX Index 1.22 3.6 9.17 Thailand SET Index 0.71 3.9 24.54 Canada SPTSX Index 1.43 4.6 10.99 Argentina MERVAL Index 0.96 5.3 40.63 Hong Kong HSI Index 2.46 5.4 8.33 Philippines PCOMP Index 1.80 5.6 26.73 Indonesia JCI Index 1.38 5.7 21.96 India NIFTY Index 2.11 5.8 13.74 China MXCN Index 1.90 6.0 5.22 Belgium MXBE Index 0.90 8.2 18.88 Colombia COLCAP Index 2.68 9.3 12.10 Norway MXNO Index 0.85 10.2 16.26 Malaysia FBMKLCI Index 1.41 11.8 15.65 Russia RTSI$ Index 0.77 13.1 10.01 Peru MXPE Index 4.67 19.0 10.82 Brazil IBOV Index 1.20 35.0 0.65 Source: Bloomberg, World Bank
  • 4. On The Market Real interest rates below 1% have the highest returns, likely indicating the creation of hyper credit expansion and a high probability of a reversal. Based on these results, the criteria with the best overlap for choosing countries with the highest annualized return are: P/S ratio less than 1.2 and real interest rates between 2% and 6%. In 2009 the top-five countries that fit those criteria were South Korea, Japan, the U.S., Thailand, and Argentina (Table 1, p. 9). We took that list of countries and found the stocks that met the criteria; a list of 20 was initially identified (Table 2). The portfolio is rebalanced monthly using the same criteria, meaning stocks would be included and excluded on an equal-weight basis. Back-test performance This strategy was back-tested against the MSCI index over the same five-year period from 2009 to 2014, starting with the stocks in Table 2. It outperformed the MSCI index by roughly 50%, with a 156% portfolio return vs. 106% for the MSCI index during that time. A total of 58 stocks would have had a position taken during this time. Winners outnumbered losers nearly three to one, with 43 stocks up and 15 down. Winners gained an aver- age of 3.3% per month vs. an average -2.76% loss for the losers. Uptrends periods were longer than downtrends, 3.3 months vs. 1.2 months. 10 www.activetradermag.com September 2014 ACTIVE TRADER FIGURE 3: PORTFOLIO RETURN VS. MSCI Source: Bloomberg Book detailing quantitative trading techniques: The Big Trade: Simple Strategies for Maximum Market Returns By Peter Pham (Wiley, 2012) Articles by Peter Pham: Searching for organic growth, old-school With equity valuations approaching the stratosphere, investors looking for real value may want to look closer to the terra firma. Active Trader, August 2014 Geopolitics, the EU and the Trade of the Century How to position yourself for a realignment of the global financial paradigm. Active Trader, July 2014 Related reading
  • 5. Note: The 20 initial stocks gained only 20% compared to 106% for the MSCI index. If the portfolio is not rebalanced every period to ensure the stocks included are meeting the proposed criteria, underperformance will result. Other considerations This portfolio management approach is in tune with both global credit and capital flow cycles. An analysis to back-test this strat- egy was done through Bloomberg to create a model of behavior. It strongly suggests the strategy can be implemented with automatic rebalancing. However, timing can be further refined with precise entry and exit points using quantitative techniques, such as those referenced in Related reading. In addition, core portfolio returns can be augmented through options strategies, such as writing covered calls or selling naked puts. Risks are inherent in a global environment where competitive currency devaluations dominate central bank policy. There is a limit to those policies which threaten the stability of all capital markets when it is reached. In that case, volatility in equities will increase and downside risks emerge quickly. Hedging is therefore a strong requirement, as is adequate liquidity maintenance. Emerging markets are especially vulnerable to capital flight under those conditions. This means weighing those risks vs. the selection criteria and constructing the portfolio accordingly. Disclosure: The approach outlined here is the portfolio-development method of the Prestige Global Growth and Income Fund, an open- end global fund established in 2007 and designed to outperform the MSCI-Barra World Free index with a mix of young high-growth and mature high-income vehicles. Phoenix Capital (headed by the author of this article, Peter Pham) and AM Capital took over management of the fund at the end of May 2014. ACTIVE TRADER September 2014 www.activetradermag.com 11 TABLE 2: COMPANIES MEETING THE SCREENING CRITERIA IN 2009 Ticker Name FCF/(dividend + share repurchase) Price: D-1 High Px:Y-1 Market Cap ($ mln.) 2685 JP Equity ADASTRIA HOLDING 4.17 5,300 3,340 1,435 4967 JP Equity KOBAYASHI PHARM 4.61 3,670 3,460 1,626 021240 KS Equity COWAY CO LTD 2.02 31,100 31,000 1,823 7532 JP Equity DON QUIJOTE HOLD 1.76 1,934 1,808 1,451 DRI US Equity DARDEN RESTAURANT 1.73 33 33 4,533 9843 JP Equity NITORI HOLDINGS 4.74 6,830 5,540 4,072 CPF TB Equity CHAROEN POK FOOD 3.57 5 4 1,054 5947 JP Equity RINNAI CORP 2.17 4,100 4,020 2,316 2809 JP Equity KEWPIE 4.96 980 934 1,587 TRI CN Equity THOMSON REUTERS 2.05 34 33 18,834 LANC US Equity LANCASTER COLONY 3.20 45 31 1,249 CASY US Equity CASEYS GENERAL 1.47 25 23 1,276 AAN US Equity AARONS INC 2.36 30 22 1,545 HRL US Equity HORMEL FOODS CRP 3.26 35 34 4,634 HSY US Equity HERSHEY CO 1.19 36 33 8,009 FDO US Equity FAMILY DOLLAR ST 4.88 28 23 3,919 CL US Equity COLGATE-PALM 2.04 72 70 36,008 CLX US Equity CLOROX CO 2.08 56 53 7,783 6460 JP Equity SEGA SAMMY HOLD 2.34 1,187 914 3,503 CPALL TB Equity CP ALL PCL 3.22 16 11 2,082 Source: Back-testing result from Bloomberg