Who Doesn’t Love a 3-D Graph?

Potential Returns and an Alternative Approach

After last weeks fairly lengthy newsletter I have decided to keep this one short and sweet – well the first part at least – it also includes a 3-D graph! Now let’s face it who doesn’t like a graph when it comes to investment, and if you can add an extra dimension well that’s even better!

Using twenty-five “bellwether” shares as a proxy for the FTSE-100 I have looked at the relationship between their average Price to Book (PBV), average Price to Sales (PS) ratios and subsequent annualised five year returns.

Linear Regression tells us that based on a PBV of “x” and a PS of “y”, historically these have produced an annualised return over the next five years of “z”; the statistics function of excel also tells us that this is pretty accurate at just over 75%.

3d

As you can see the best outcomes are situated at low price to sales and average price to book values – price to sales appears to have greater importance as even at very low price to book values if price to sales is high then returns are negative.

Alternative Strategies

As you know for some time I have been very negative on market conditions; being negative and subsequently not invested can be a pretty miserable place as it can take years for conditions to be perfect for either bullish or bearishness. With this in mind over the next few weeks in the absence of finding anything spectacular in terms of value I will have a short look at some alternative approaches or strategies that I have been thinking of.

This one is nice and simple if you have concerns about the broader market

  • Buy quality stocks – large cap, financially strong, dividend payers
  • Buy an inverse ETF that is “short” the FTSE-100

Here’s an example of how it could work; in Jan 2015 you are worried about the overall UK market but like three high quality dividend paying shares (British American Tobacco, GlaxoSmithKline and Unilever).

Now rather than defer investment you buy the three quality shares and buy an inverse tracker ETF (there are lots available) and to make this less expensive leverage is introduced by using a 3x daily short version.

Here are the returns of these holdings and the FTSE-100 since Jan 2015

returns graph

Now if we put all this together how much would it have made in monetary terms?

Current Value of £1000 invested on Jan 2015
FTSE 100

£893

Three quality shares equally

£1092

Three quality shares and an inverse tracker ETF equally

£1072

Now the question is why bother with the ETF? Without wishing to answer the question with a question why buy car insurance? In case there is a disaster…..rewind to 2007/2008.

Say you invested £1000 in one of the three following portfolios using the investments above in 2007 and held them over the next year the graph shows what the portfolios would have been worth by mid 2008 as the FTSE and the shares reached multi-year lows.

  • FTSE-100 Tracker
  • The high quality shares equally (£330 in each)
  • The high quality shares and 3x Daily Short FTSE-100 ETF equally (£250 in each)

returns graph

Option three allowed the shares that you like to be held and protection was provided by the inverse ETF – particularly as it is leveraged at 3x (this is where leverage can be employed effectively and with relatively low risk). I would of course make the following points about all this

  • Conditions in 2007/2008 were perfect for the strategy, it would not have worked so spectacularly in other periods – you need to be fairly strong on your views of under or overvaluation.
  • Leverage can work both ways if the FTSE-100 had rallied strongly losses on the ETF would certainly reduce or in the worst case wipe out the share returns – that said the ETF is daily tradeable and you can buy and sell as you wish so if you bought for protection and the market started moving the other way its easy to sell. If leverage is not for you then there ETFS that simply offer an inverse return x1 instead of x3.
  • ETFS – particularly synthetic ones have risks, including counterparty risk and the possibility they may close. I spent 2014 loading up on an ETF linked to the US VIX index (volatility) only for the fund to shrink to such a small size it was closed in 2015; subsequently the VIX is up from around 12.5 to 22.9 (it was at 40 in late 2015 and I have missed out on what I feel was an obvious value buy because of the ETF closure). Even the best ideas don’t always work.
  • This is not for everyone – we all have our own risk tolerances and time frames.

My view is this is an interesting strategy that can be used in conditions to protect existing quality share holdings or allow you to invest in these shares even if you think overall market conditions are high risk.

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