continued on p. 8

BY PETER PHAM

TRADING Strategies

6 www.activetradermag.com•September2014•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 firm’s relatively short growth stage and seek lower-risk returns in the form of higher dividends and repurchases during a firm’s 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 thesisThe fund’s 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, let’s look at the equity evalua-tion component of the investment approach.

Stock evaluation criteriaLarge 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•September2014•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 market’s assessment of each firm’s performance, and thus seeks investments trading above the previous year’s high.

Now let’s see how these criteria can trans-late into strategy.

The strategy1. 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 year’s high.

FIGURE 2: RELATIONSHIP BETWEEN REAL INTEREST RATE AND AVERAGE TAR, 2009-2014

Datasource:Bloomberg,WorldBank

FIGURE 1: P/S AND AVERAGE TOTAL ANNUAL RETURN (TAR) RELATIONSHIP, 2009-2014

Datasource:Bloomberg

continuedonp.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 approachThis 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 country’s 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 study’s country group was used to determine each coun-try’s 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 •September2014•www.activetradermag.com 9

TABLE 1: COUNTRIES WITH AVAILABLE P/S AND REAL INTEREST RATE IN 2009

Country Ticker P/S 2009Real Int.

rate 2009TAR from

2009-2014

Pakistan MXPK INDEX 0.51 -5.1 30.81

United Kingdom

UKX Index 0.90 -1.6 14.04

Australia AS51Index 1.35 1.0 12.80

Singapore FSSTIIndex 1.21 1.8 10.06

Netherlands AEX Index 0.52 1.9 13.84

SouthKorea KOSPIIndex 0.70 2.0 8.97

Japan NKY Index 0.62 2.2 10.80

UnitedStates SPXIndex 1.00 2.5 18.81

Italy FTSEMIBIndex 0.63 2.6 6.00

Switzerland SMIIndex 1.58 3.2 12.30

Chile IPSAIndex 1.32 3.3 4.63

Vietnam VNINDEX Index 1.22 3.6 9.17

Thailand SETIndex 0.71 3.9 24.54

Canada SPTSXIndex 1.43 4.6 10.99

Argentina MERVAL Index 0.96 5.3 40.63

Hong Kong HSIIndex 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 NIFTYIndex 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,WorldBank

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 performanceThis 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•September2014•ACTIVE TRADER

FIGURE 3: PORTFOLIO RETURN VS. MSCI

Source:Bloomberg

Book detailing quantitative trading techniques:

The Big Trade: Simple Strategies for Maximum Market Returns ByPeterPham(Wiley,2012)

Articles by Peter Pham:

Searching for organic growth, old-schoolWithequityvaluationsapproachingthestratosphere,investorslookingforrealvaluemaywanttolookcloser to the terra firma.ActiveTrader,August2014

Geopolitics, the EU and the Trade of the CenturyHow to position yourself for a realignment oftheglobalfinancialparadigm.ActiveTrader,July2014

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 considerationsThis 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:Theapproachoutlinedhereistheportfolio-development

methodofthePrestigeGlobalGrowthandIncomeFund,anopen-

endglobalfundestablishedin2007anddesignedtooutperformthe

MSCI-BarraWorldFreeindexwithamixofyounghigh-growthand

maturehigh-incomevehicles.PhoenixCapital(headedbytheauthor

ofthisarticle,PeterPham)andAMCapitaltookovermanagementof

thefundattheendofMay2014.

ACTIVE TRADER •September2014•www.activetradermag.com 11

TABLE 2: COMPANIES MEETING THE SCREENING CRITERIA IN 2009

Ticker NameFCF/(dividend +

share repurchase)Price: D-1 High Px:Y-1

Market Cap ($ mln.)

2685JPEquity ADASTRIAHOLDING 4.17 5,300 3,340 1,435

4967JPEquity KOBAYASHIPHARM 4.61 3,670 3,460 1,626

021240KSEquity COWAYCOLTD 2.02 31,100 31,000 1,823

7532JPEquity DONQUIJOTEHOLD 1.76 1,934 1,808 1,451

DRIUSEquity DARDENRESTAURANT 1.73 33 33 4,533

9843JPEquity NITORIHOLDINGS 4.74 6,830 5,540 4,072

CPFTBEquity CHAROEN POK FOOD 3.57 5 4 1,054

5947JPEquity RINNAI CORP 2.17 4,100 4,020 2,316

2809JPEquity KEWPIE 4.96 980 934 1,587

TRICNEquity THOMSONREUTERS 2.05 34 33 18,834

LANCUSEquity LANCASTERCOLONY 3.20 45 31 1,249

CASYUSEquity CASEY’SGENERAL 1.47 25 23 1,276

AANUSEquity AARON’SINC 2.36 30 22 1,545

HRLUSEquity HORMELFOODSCRP 3.26 35 34 4,634

HSYUSEquity HERSHEYCO 1.19 36 33 8,009

FDOUSEquity FAMILYDOLLARST 4.88 28 23 3,919

CLUSEquity COLGATE-PALM 2.04 72 70 36,008

CLXUSEquity CLOROX CO 2.08 56 53 7,783

6460JPEquity SEGASAMMYHOLD 2.34 1,187 914 3,503

CPALLTBEquity CP ALL PCL 3.22 16 11 2,082

Source:Back-testingresultfromBloomberg