23.4.2012 Ernst Grönblom

Positive Returns Regardless of Economic Cycle

FAQ: HCP Asset Management
Investing in a few superstar companies provides the highest returns

John Pierpont (“JP) Morgan (1837 – 1913) was the most influential American investor of his time. When asked what the stock market will do, he replied: “It will fluctuate”. We think this is a correct answer – the only correct answer.

It is widely believed that in order to be a successful investor, one has to be able to predict the short-term movements of the market. An investing strategy, which is based on efforts to predict the short-term market movements, is called market-timing. Several investors have built their entire strategies based on the assumption that they have the ability to predict where the market is moving next. Unfortunately, we have to be realistic; there is no proof that anybody can systematically predict the highs and lows of the market with adequate precision. Instead, there are several reasons to believe that predicting the market is impossible, both in theory and in practice.

Why is it impossible? We would have to dig deeper into the world of chaos theory, and this is not the right forum for it. Predicting the market can be compared to predicting the weather, which is extremely difficult to do for several days ahead, despite the available computing power. The fundamentals of the market are chaotic, there are numerous unclear cause – effect relationships, and even the slightest changes can have extensive cumulative effects. While the weather is based on physical phenomena, which can be modeled, the markets are created by humans, you, I, and other investors, who all have free will and the ability to influence the system. The human factor makes modeling of the markets very difficult.

Why do people think they can time the market, and disregard the evidence shown against it? The answer lies in psychology; people tend to overestimate their own abilities and to be overly optimistic. The markets can only move two ways; up or down. When a coin is flipped, the result can be heads or tails: the probability for heads is 50% and the probability for tails is 50%. According to probability theory, if hundred people flip a coin four times in a row, approximately six people will guess all four of the flips right (100 x 50% x 50% x 50% x 50% = 6.25). Only few successful coin flippers will be so naïve to believe that they have a special gift and it has nothing to do with luck. Still, the world is full of “investing geniuses” who have been able to predict the market right a few times in a row, and therefore think they have a magical skill. The human mind is programmed to remember success and to forget failures, which distorts reality even more.

At this point, several readers might ask themselves, so what? It might be impossible to successfully predict the stock market, but does it hurt to try? Unfortunately, we have to be realistic again. Efforts to time the market are foolish for several reasons: a) the long-term trend of the stock market is upward sloping, (and because every effort to time the market is a shot in the dark) so, in order for a timing strategy to be successful, half of the efforts to time the market should be successful, because results are random this is impossible in the long run. Therefore every effort to time the market has a negative profit expectation, which means that in the long run this strategy loses. (The situation resembles roulette; in which the short-term result is random, but in the long-run, the house always wins. Another applicable example would be a coin flipping game, in which heads wins a euro and tails loses two euros – no rational person would agree to play); b) efforts to time the market result in extra expenses, which further exacerbates the short comings of the timing strategy.

How should we address the stock market, if we accept the claim that the short-term movements of the market cannot be predicted, and therefore timing should not be attempted. There are three complementing strategies.

The first one is an alternative investment strategy. Alternative investments are meant to work as the portfolio’s buffer, because traditional investment instruments are often highly positively correlated, meaning that the prices move in the same direction at the same time. For example, during the financial crisis stocks, bonds and real estate prices plummeted. The price movements of alternative investments are not as highly correlated with traditional investment instruments. Some alternative investments are not correlated at all with traditional investments, in which case, the price fluctuations are completely unrelated. Some, on the other hand, have negative correlation (but still producing on average yars a positive return), meaning that the prices move in opposite directions. A portfolio, which has both traditional and alternative investments, will typically perform better during crisis (for example recessions), than a portfolio full of only traditional investments.

Another strategy is the lengthening of the investing period. A practical example enlightens this strategy: the S&P 500 index had 56 positive years and 24 negative years between 1929 and 2009. On average 30% (every third) of the years were negative during that time period. When the same time period is divided into ten-year periods, the ratio changes dramatically. Between 1929 and 2009, there were 71 positive ten-year periods and only two negative ten-year periods. On average, under 3% of the ten-year periods were negative (the first negative period was in the 1930s, during the great depression and the other one during the financial crisis started in 2007)

A third way to invest successfully in fluctuating markets is active stock picking. In this strategy, specific stocks are picked, which are expected to have great potential upside and are seen as undervalued.

Bear (downward) and bull (upward) market trends are often used to describe the direction the market is moving, but there is a third market trend, which is sometimes called sideways market. The term sideways market is used when the market moves up and down, but its long-term trend is flat. Investing in a sideways market is similar to riding a roller-coaster: the market moves up and down, but always returns to the initial level. Several experts have predicted that due to the euro-crisis and high levels of debt etc., it is highly likely that the next ten years the world’s stock markets will be moving sideways. Even though the market itself doesn’t move significantly in any direction, it doesn’t mean that the prices of individual companies’ stocks cannot change drastically (e.g. Apple / Nokia) and everything indicates that this trend will continue. The best way to make money in a sideways stock market is (successful) stock picking.

HCP offers two strategies based on stock picking: HCP Focus equity strategy and HCP Market Neutral equity strategy.

HCP Focus follows a classic (long only) stock picking strategy based on the value investing principles, in which undervalued stocks, which benefit from the major global economic trends and have a long-term competitive advantage, are bought. The strategy follows a focused investing philosophy, in which funds are allocated to 8 to 15 thoroughly analyzed companies. This enables the maximization of the benefits of active stock picking. The strategy has a very long investing horizon, which, through “time-arbitrage”, aims to benefit from the market’s shortsightednessBetween the years 2009 and 2011, the strategy returned over 90%, when the HEX25 returned a little shy of 30%.

The HCP Market Neutral equity strategy (long-short) buys undervalued stocks aiming for an upside movement and sells short overvalued stocks to profit from the expected downside movement of the stocks. The strategy has returned approximately 10% annually since 2000. Those who think this is a modest return, shall be reminded that during the same period HEX25 didn’t basically return anything. Another benefit of the Market Neutral strategy is relatively consistent returns. The strategy’s only negative year was 2008, when the strategy ended the year 16% in the red, while the HEX25 was down almost 50% (Since the beginning of the year, the strategy has returned +9%).

We are strong advocates of thorough company analysis based on value investing principles an alternative investing based on a broad securities analysis and we believe that by utilizing these methods, we are able to make profit during sideways market or any other market type. Hard work and bold views are rewarded, especially when the market is saturated with index- and ETF-funds, closet index funds, five-year fixed structured notes and other passive investments. There is plenty of room for genuin active management.

FAQ: HCP Asset Management
Investing in a few superstar companies provides the highest returns
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