adaptive portfolio theory

8/14/2019 Adaptive Portfolio Theory

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ADAPTIVE PORTFOLIO THEORYTHE ASTUTE INVESTORS GUIDE TO SUCCESSFUL PORTFOLIO MANAGEMENT

Fundamental Technical Economic Diversification

System Control Asset Allocation Risk Long/Short Exposure

A presentation by:

Registered Investment Adviserwww.libertyanalytics.co.cc/mws/Welcome.html


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ADAPTIVE PORTFOLIO THEORYWhy should investors manage portfolios with adaptive

outlooks and strategies?

Markets themselves are not linear and go through secular andcyclical bull and bear phases.

A brief look at stock market history can reasonably explain:


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The Case For Adapting StrategiesThe previous two charts display how decade+ long time

frames can produce little return for investors whosimply buy and hold.

These long consolidation periods do present opportunitiesfor investors with enough flexibility and openmindedness

Determining the degree and type of trend is critical in the

adaptive investors strategies for investment allocationand time-preference


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Tools Of The Trade In Portfolio

Management Fundamental Analysis

Technical Analysis

Austrian Economic Theory, Wave TheoryEconomic, Social, Market & Political HistoryRisk Management Of Trading, Exposure, Losses &

EmotionsManaging Long/Short Portfolios


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The Objective of Fundamental

AnalysisFundamental analysis has its most comfortable use in finding

attractive long-term securities for investment.

The fundamentalist builds a quality investment framework:

Price to value relationships Competitive advantages and growth catalysts Quality of financials and management Expectations of return i.e. dividends and earningsQualifying investments will satisfy all points of the framework


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Fundamental Analysis


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Disciplined Guidelines For

Attractive Common Stocks


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Determining Value For

Individual StocksAbnormal Earnings Growth Model (AEG)

Present Value (PV) of discounted earnings forecasts n years into the futureand capitalized to arrive at value.

Value =Step 1 (AEG): [Earn1 Earn-1*(1+WACC)] + [Earn2 Earn-2*(1+WACC)] +

+ [Earnn Earnn-1*(1+WACC)]

Step 2 (PV of AEG): sum of AEGn discounted by 1+ WACCn

Step 3 (capitalization): M * [Sum of Earn1 + PV of AEG]

M = Capitalization factor i.e. 10x or 12x Earnn = Earnings in year 1,2,3n WACC = Weighted Average Cost of Capital


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Dividends The Tangible Return

On InvestmentDividends are an important source of returns, especially in range

bound markets. Forecasting dividends vs. assumed capital lossscenarios can help determine risk / reward during marketdownturns (absolute returns).

Estimated Return:

= Initial Investment + (D1 + D2 +D3 +D4 +D5)

Assumed Capital Loss = Total Return

The assumed capital loss tests different loss severity scenarios (10%,

20%, etc.), a break even point would prove insightful. Positivetotal returns in the face of capital losses make attractive longterm investments.

Dn should be discounted by expected inflation rates.


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Quality Framework Example:

TD Ameritrade (AMTD)Growth Catalysts:

2007 20?? Fallout/dislocation from top Wall Street investment banks Industry transition from commission based representatives to fee

based RIAs

Growing need for private retirement planning as the trust in socialsecurity dwindles as a source of retirement asset gathering model

Increased availability of the internet, growing independence andknowledge of retail investors, and increased availability ofinformation

Transaction revenues increase during volatile markets; asset basedrevenues increase during bull markets


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TD Ameritrade (AMTD)Competitive Advantages:

History of successful industry specific M&A activity

TD Waterhouse, Fiserv, Think or Swim, Datek, MyDiscount Broker, Brokerage America & JB Oxford

Niche in the active trader and mass-affluent investormarket with easy to find research and plentiful tradingtools1 2008 Smart Money Survey

Recent trend indicating growth is more organic based thanM&A based. ROCA highest among competitors.


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TD Ameritrade (AMTD)Forecasts (next slide):

Forecast Scenario 1 -

Future 4 yr EPV assuming $60bln NNA (Net New Assets), 0.25% FFR(Fed Funds Rate), 850 S&P 500 and a 40bps ROCA (Return on ClientAssets)

Forecast Scenario 2

Future 4 yr EPV assuming $60bln NNA, 2% FFR and 1,000 S&P 500, anda 45bps ROCA


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TD Ameritrade (AMTD)Less optimistic forecast of earnings: Forecast 1


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TD Ameritrade (AMTD)More optimistic forecast of earnings: Forecast 2


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TD Ameritrade (AMTD)Key Metrics:

Net New Assets (NNA) annualized 11% growth in NNA, 77% of NNAare organic (not a result of dislocation on Wall Street)

Trades Per Day (TPD) - #1 in trades per day measured againstE*Trade, Charles Schwab, Fidelity Investments & Options Express

Total Client Assets & Return on Client Assets (ROCA):

- A pro-cyclical measure, capturing added profitability from NNA,

Dividend and interest inflows & Multiple expansion/contraction.

Spread Based Assets Interest differential earned in securitiesborrowing and lending. Impaired when FFR are too high or low.


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TD Ameritrade (AMTD)

Relative Valuation to Competitors:


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TD Ameritrade (AMTD)Relative Value to Broader Markets:


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TD Ameritrade (AMTD)TD Ameritrade Summary: Quality growth, growing business model, competitive position &

strong balance sheet

Relative value between $10 - $12; Absolute value considerably higherwhen economic conditions improve.

Strong future earning potential, no indication of paying dividendsFinal Conclusion:

Bull Market Buy: - Good earning & multiple expansion potential

Range Bound Market Buy: - No tangible return for holding throughcyclical bulls & bears I.e. dividends

Range Bound Market Trade: - Consistent earning power should berewarded during cyclical upturns; trade with the primary trend


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Technical Analysis Elliott Wave Theory Primary & Alternative Counts Long Term View of Large Degree

Trend Lines, Support & Resistance


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Elliott Wave Theory Long Term

Chart Of Large Degree


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Elliott Wave Theory

Primary Count


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Elliott Wave The Bearish

Alternative Count


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Elliott Wave The Bullish

Alternative Count


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Other Technical Measures


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Other Technical Measures


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Humana Inc The Case For Bonds$500,000,000 Initial principal @ 6.45% interest (semi-annual) senior notes due 6/01/2016.

The notes are unsecured and rank equal with other senior unsecured notes (including futurenotes). They rank junior only to the senior secured outstanding notes (or future) of theoperating subsidiaries. As of 3/31/2006, there were only $3,500,000 of senior secured notes.

The proceeds were used to pay down $200,000,000 of the outstanding balance of credit facility @5.60% and to be used towards the 8/2006 maturity of 7.25% senior notes due.

Optional Redemption:

The notes may be redeemed at any time in whole or in part at a price equal to the greater of100% of the principal amount to be redeemed and the sum of the present values of theremaining scheduled payments on the notes to be redeemed consisting of principal andinterest, exclusive of interest accrued to the date of redemption, discounted to the date ofredemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-daymonths) at the applicable Treasury Yield plus 30 basis points plus accrued interest to the dateof redemption.

All issues of covenants, liens, and voting matters will not be discussed here in depth. However,the company may not change principal amounts, interest rates or payment dates, legal rightsor senior status without vote of the note holders.

The above information was taken from the prospectus and prospectus supplement dated3/31/2006.


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Humana Inc The Case For Bonds


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Humana Inc The Case For BondsOf most significance to interested bondholders are three items:1. EBIT / Interest Expense is very high, currently 13.37 and in past record 11.73 (2005).

2. Working Capital / Debt is 1.10. The company has adequate resource to pay off debt withoutincurring any fixed asset sales and with high liquidity.

3. The 3 year average performance of the common stock has been poor at -14.6% (as is thecase in this major bear market with most common issues). Yet the common market valuetrades at a multiple of 1.77x that of the debt, a reassuring sense of confidence in the healthof the company.

Given the fact working capital has adequate coverage of total debt, in depth analysis ofexpected real market value of tangible assets is not significantly important. Duration isintermediate with low probability (in this author's opinion) of significant increases in interestrates within the time frame of maturity. Looming are massive health care reforms at thenational level that could materially impact Humana's top and bottom lines. The probability ofthis occurring remains unknown as well as specific details of a plan.

Investors should view these intermediate term Humana bonds as attractive investment gradesecurities with a wide EBIT/interest expense margin of safety.

As of 7/7/2009 the bonds traded at around 90 cents on the dollar. All three nationally recognizedrating agencies have rated the bonds at the lowest tier of investment grade.


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Economics The Dismal Science Kondratieff Wave Cycle Theory Austrian Economic Theory


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Kondratieff CycleAn economic cycle theory outlining four distinct phases of

production and consumption

During periods of relatively cheap prices, assets accumulate. As prices increase, the consumptionof assets are necessary to maintain a standard of living. When new production fails to keep up with

consumption, due to relatively high prices, the economy begins to decline to another period ofcheap prices, and a new growth cycle begins.

Spring Beneficial Inflationary Growth Phase Summer Stagflation (recession) Autumn Disinflationary Growth Phase (plateau) Winter Deflationary Depression


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Kondratieff Cycle


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Kondratieff Waves in the US


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Austrian Economics: The Monetary or

Circulation Credit Theory of the Trade Cycle

The wavelike movement affecting the economic system,the recurrence of periods of boom which are followedby periods of depression, is the unavoidable outcome ofthe attempts, repeated again and again, to lower thegross market rate of interest by means of creditexpansion. There is no means of avoiding the finalcollapse of a boom brought about by credit expansion.The alternative is only whether the crisis should comesooner as the result of a voluntary abandonment offurther credit expansion, or later as a final and totalcatastrophe of the currency system involved.

Mises, Ludwig Von. Human Action pg. 572


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Austrian Economics: Inflation vs. Credit Inflation

Money Proper Inflation:

Let us assume that a government of an isolated country issues additional papermoney in order to pay doles to the citizens of moderate income. there will beno tendency of the monetary units purchasing power to return to the state of thepre-inflation period. The structure of prices will be lastingly affected by theinflationary venture if the government does not withdraw from the market theadditional quantity of paper money it has injected in the shape of subsidies.

Credit Inflation:

Conditions are different under a credit expansion which first affects the loan market.In this case the inflationary effects are multiplied by the consequences of capital

malinvestment and overconsumption. Overbidding one another in the struggle fora greater share in the limited supply of capital goods and labor, the entrepreneurspush prices to a height at which they can remain only as long as the creditexpansion goes on at an accelerated pace. a sharp drop in the prices of allcommodities and services is unavoidable as soon as the further inflow of additionalfiduciary media stops.


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Austrian Economics: Deflation & Credit Contraction

1. A government aiming at deflation floats a loan and destroys the paper money borrowed. Such aprocedure has been, in the last two hundred years, adopted again and again. The idea was toraise, after a prolonged period of inflationary policy, the national monetary unit to its previousmetallic parity. (under a gold standard, exchange or fixed regime currency)

2. Banks, frightened by their adverse experience in the crisis brought about by credit expansion, areintent upon increasing the reserves held against their liabilities and therefore restrict the amountof circulation credit.

3. The crisis has resulted in the bankruptcy of banks which granted circulation credit and that theannihilation of the fiduciary media issued by these banks reduces the supply of credit on the loanmarket.

Now, it is true that even with no restrictions in the supply of money proper and fiduciary mediaavailable, the depression brings about a cash-induced tendency toward an increase in thepurchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, andthese endeavors affect the ratio between the supply of money (in the broader sense) and the

demand for money (in the broader sense) for cash holding. This may be properly called deflation.

Prices of the factors of production both material and humanhave reached an excessive height inthe boom period. They must come down before business can become profitable again. Theentrepreneurs enlarge their cash holding because they abstain from buying goods and hiringworkers as long as the structure of prices and wages is not adjusted to the real state of the marketdata. Thus any attempt of the government or the labor unions to prevent or to delay thisadjustment merely prolongs the stagnation.


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Portfolio Management Trade & Risk Management Asset Allocation & Diversification Long/Short Exposure


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Trade ManagementTrailing Stop Loss

To be implemented once a position is considered to begreatly overvalued and downside momentumpossibility becomes a greater risk than to the upside orlong term fundamentals no longer warrant investment .

Frees the decision from pesky emotions and locks inprofits where made

The percentage adjustment to lock in profits should bedetermined by analysis of the overall market trend,prevailing sentiment, and expectations for the future


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Trade ManagementBuy Limit Orders

Removes emotions from the buy process, allowinginvestors to enter at comfortable prices

Though disciplined, can fall victim to the value trap More useful in bull markets during corrections than in

bear markets


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A Note On Risk TakingThere Lies Five Main Forms of Risk For Investors:

1. The Risk Of Loss2. The Risk Of Missing Out3. Sector/Industry Risk4. Market Risk5. Fundamental Risk

Balance is the key to managing these risks, since chasing higherreturns or not missing out can increase the risk of loss.


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Asset Allocation & DiversificationGuided by:

Flation expectations

Price to value relationships of individual securities &across broad sectors

Technical trend patterns and sentiment Individual positions & portfolio correlation to

benchmarks & SPY should be kept low for truediversification. Example: 10 Yr Treasury vs S&P 500


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Investing & Inflation


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Managing Net ExposureTo control the risk of loss from market and sector risks, a long/

short portfolio should be maintained on a net dollar basis

Long Neutral Short

A pairs trade can be created using an attractive undervaluedstock with a comparable sector/industry ETF that is indicatedas relatively overvalued. A neutral pair would have equal

dollar amounts on both the long stock and short ETF.

General market trend/valuation expectations and economicoutlooks should guide net exposure (of net long/neutral ornet short)


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Advisors for Advisors

Michael Mish Shedlock SitkaPacific Capital

David Rosenberg Gluskin Sheff& Associates

Bob Hoye Institutional Advisors Tim Wood Cycles News & Views David Einhorn Greenlight Capital Robert Prechter Elliott Wave

International

John Mauldin Outside The Box Hugh Hendry Eclectica Asset

Management

Vitaly Katselnelson InvestmentManagement Associates, Inc.

Barry Ritholtz Fusion IQ Tyler Durden Zero Hedge Joe Saluzzi Themis Trading Bill King The King Report Steve Keen - Economist

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