By Serge-Paul Carrasco on October 15, 2007

Investing for Dummies

(E) Barron’s in its October 1, 2007 edition has ranked the top 50 hedge funds based on their average returns over the last three years (The article is available online only through a paid subscription but here is the ranking for you: BA_HedgeFund50_071001). Like probably everyone else, I was surprised not to see two famous hedge funds which made a lot of headlines last year namely: Renaissance Technologies and Citadel. You have to read the article to understand why those two funds did not make it into the rankings.

So after having read this article and many books about investment theory and practice, I decided to elaborate for fun on five ways to invest based from well-known scholars and investment professional masters. This is not a tutorial just some food for thoughts. Here, we go…

The “David Swensen Way”

As the head of the Yale University endowment, instead of investing classically in US stocks, bonds, and cash, David Swensen pushed the limit of diversification to a broad class of assets that are not correlated but whose contributions to the total portfolio are actively managed and constrained. The result of that new strategy produced quite good returns with less volatility for long-term investments. As of June 2004, the Yale endowment fund was $15.3 billion and had a ten-year investment return annualized of 17.4%! Not bad for such a large fund! David Swensen wrote a book: “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment”.

Until his departure from Harvard University in 2005, David Swensen’s portfolio strategy was as well executed by Jack Meyer for the endowment fund of Harvard University.

Fortune Magazine and Business Weeks have both written interesting articles about David Swensen and Jack Meyer’s investment techniques for large funds:
. Fortune: The Money Game
. Business Week: How to Invest like Harward
And, the Business Week’s article gives the asset allocation of the Harvard endowment fund in 2004:

. US Equities: 15%
. Commodities: 13%
. Private Equity: 13%
. Hedge Funds: 12%
. US Bonds: 11%
. Foreign Equities: 10%
. Real Estate: 10%
. Inflation-indexed Bonds: 6%
. Emerging Markets: 5%
. High-Yield Bonds: 5%
. Foreign Bonds: 5%
. Borrowed Money: – 5%

A slight change to Swensen’s strategy that seems to get some word and some traction is to have more a global sector-based approach than a geographical diversification since global economies are making geographical diversification irrelevant.

Although Swensen’s strategy works quite well for large funds and for long-term investors, the same strategy can be applied to much smaller multi-million dollars funds. Even small funds that can be as low as $500K, $100K or $50K and obviously cannot afford to invest in a hedge or private equity funds can be built using a simple but efficient combination of index funds, mutual funds, stocks and bonds following Swensen’s investment principles.

The “Jim Cramer Way”

The host of CNBC’s Mad Money and co-founder of TheStreet.com, Jim Cramer is certainly one of the most entertaining public investors. Cramer’s techniques and analysis can be learned as well through his two books: “Real Money” and “Mad Money”.

Over and over, Jim Cramer always emphasizes a few investment techniques that relentless works:

. Homework, homework, and homework:
Investing is about homework about companies’ businesses, products, customers, competitions, and financial. Never invest without having done some significant homework.

. Buy and homework:
The game is not about buying and holding. It is about buying and still studying how the investment is doing. Jim Cramer likes to say: “If you can’t spend an hour a week researching each of your stocks, then you should hand off your portfolio to a mutual fund”.

. Always have a core portfolio that is diversified:
Jim Cramer has a section of his show that is devoted entirely to diversification. A portfolio needs always to start with good diversification.

. Buy broken stocks not broken companies:
Investing is about owning a share of a company that will grow its earnings. Investing is finding those companies at a discounted price.

. Buy the best of breed:
This is very important. When you are considering multiple choices, always go for the stronger player even if (and that the way it should be) the price is higher. That is exactly how David Swensen invested in each class of assets.

A slightly different variant to this technique that I like to implement is for each market segment to find the market leader and the new challenger and as a rule invest 75% of your total investment in the leader and 25% of your investment in the challenger and rebalanced it periodically. For instance, invest 75% in Microsoft and 25% in Google and increase your Google contribution as Google takes market leadership over Microsoft. New opportunities and values should be created by the leader but in most cases, those are obviously created by new challengers, and value is always migrating. For more on that simply read: “Value Migration” from Andrian Slywotzky or “Built to Last” from Collins & Porras.

. Speculate to add juice to your portfolio:
But no more than 5% to 10% of the total portfolio for the long-term investor. The way that I like to put it is to consider yourself as a venture capital investor. Basically, you have 5% to 10% of your portfolio to find the next Google. But the next Google must have a successful business model, good products, good customers and be a competitive winner. You have to investigate a lot of promising opportunities, be ready to lose some money but hopefully, a good bet will reward nicely that effort.

. There is always a bull market somewhere:
Finding it is not easy but that what you need to learn to do if you are a trader or a short-term investor.

Watching Jim Cramer is certainly a good time spent for any investor to build his or her portfolio. Listen and learn from his techniques. Research and analyze his stock recommendations.

The “Professor Siegel Way”

Jeremy Siegel, Professor at the Wharton School, has written two best sellers that are a must to read: “Stocks for the Long Run” and “The Future for Investors”.

In his second book, Professor Siegel has articulated a number of investment findings that he analyzed from extensive research.

. For the short term trader:
Chasing the next hot sector is the strategy since returns and market values are highly correlated in the short term. Traders need to understand quite well any catalyst that will move the market or a stock up or down and quickly take profit from it. But always remember, a trade is not an investment.

. For the long-term investor:
Chasing hot sectors will lead to poor returns over a long time. Valuations always matter. And, hot sectors that dictate high bubble valuations will always damage a good portfolio in the long term after the bubble burst. Remember when the Nasdaq was over 5,000!

. Over the long run, less than one-third of sector returns can be attributed to the expansion or contraction of that sector:
In other words over two-thirds of the return for a given sector can be attributed to other factors such as changes in valuations, the reinvestments of company dividends, and the entry of new companies into that sector.

This last research finding is not so obvious but nevertheless needs to be clearly understood. Easier to understand are the following two conclusions:

. Dividends are the best way to know that earnings are real. And, dividend-paying stocks deliver generally the best returns.

. Almost half if not more than half of the world’s equity is headquartered outside the US. So any portfolio should be structured with a global approach.

Following is Professor Siegel’s allocation of equity funds given in his book that can work well in particular for a small fund that can be as low as $500K, $100K or $50K:

. Worldwide based stock index funds: 50%
. US-based stock index: 30%
. Non-US based stock index: 20%
. Return enhancing strategies: 50% (10% to 15% each)
. High-dividends companies:
. Highest-yielding dividend-paying stocks
. Dow 10, S&P 10
. Real estate investment trusts
. Global companies:
. S&P Global 100
. Dow Jones Global Titans
. Diversified multinational equity firms
. Sector strategies:
. Oil and natural resources
. Pharmaceuticals
. Brand-name consumer staples
. Low price relative to growth:
. Lowest price-to-earnings ratio
. Top survivors/best of breed
. Berkshire Hathaway

The “Hedge Fund Way”

Hedge funds develop in-house many proprietary techniques but the following are some of their most well-known techniques. If you do not invest in a hedge fund or do not want to build yourself a hedge fund, it is still important to understand how they work since they are trading so much volume on every exchange.

. Arbitrage-driven:
Arbitrage is an exploitation of a market price inefficiency. For instance, a stock trading at $10 when its option is at $12. Or buying the convertible bonds but selling short the common stock. Unfortunately, price inefficiencies never last for very long so arbitrage opportunities are somewhat challenging to find or require significant leverage to be fully exploited.

. Event-driven:
Event-driven funds take advantage of inefficient pricing of transaction announcements and corporate events. For instance in Mergers and Acquisitions when the price of the buying company declines whereas the acquired company stock price generally increases.

. Global:
Global funds invest “top-down” in macro trends such as currencies, interest rates, commodities or foreign economies. For instance, shorting the dollar but buying the euro.

. Focus:
. Long and short:
Those funds combine long market positions with short market sales. For instance being long on a number of growth stocks while shorting a few value stocks.
. Market neutral:
Those funds combine long and short by being market neutral. For instance, buying long Lowe’s but shorting Home Depot.
. Dedicated short:
Those funds trade short sales of over-valued securities at a peak of a bubble. This technique works well only at the peak (plus on a time scale value destruction happens much faster than value creation so returns can be very high). For instance shorting the dot.com stocks in 1999 would have led to significant losses whereas shorting them in 2000 would have led to significant profits.

. Quants (itative)
Quant funds trade and invest automatically with software that implements knowledge and rule-based algorithms with inputs from large datasets. They can implement both proprietary and well-known techniques.

Your “Own Way”

Finally, the best way to invest shall be your “Own Way”. You need to find out what kind of investor you are and what kind of techniques work well for you.

If you are a short-term investor who likes to anticipate and take advantage of short-term market inefficiencies and rapid market, sector or company moves. Or if you are a long-term investor that wants to build a bullet-proof portfolio like David Swensen’s. In that case, you need a portfolio structure whose assets and sector allocations are perfect and highly tuned. And, you need to work hard to find the best stocks and funds for each asset class and sector.

In the end, you need to design your own formula and re-engineer it from mistakes that you have learned until it gives the returns that you feel comfortable.

My basic formula to invest integrates all methods described previously. Plus, I always try to never break my own rules…

. Understand the cash flows:
Never invest in a company if you do not understand why and how the company is making money. There is only one game: valuations and free cash flows that must translate in cleaned growing earnings and dividends.

. Never trade the quality of an asset:
Diversification is good to reduce risks and necessary for long-term investment. But diversification does not imply a decrease in asset quality. It is OK to have cash in your portfolio. It is not OK to invest in companies whose management and board are weak.

. Index funds are your friends:
Your ability as an investor is limited by your expertise and your time. You usually only do well where you spend the time and have the expertise to make the right decisions. For everything else, do not be shy to use index funds and to mix them with other best of breed active managed funds and stocks.

. It is all about risk management:
Always assess and monitor your risk exposure. Establish how much you are ready to lose and hedge your positions with options if you have doubts about your bets.

. Money needs sun and water:
Never forget that money is like any plant and tree of my garden: it will stay where it can grow.

. Have fun looking at new opportunities:
Many math students fail because they use old techniques for a new class of problems. So have fun analyzing new opportunities in their entire contexts with a fresh look. And if investing is not fun for you, like anything else in life, just switch to another channel rather than staying watching CNBC.

Categories: Investing