Capital Ideas has two successful models with Covestor—the Macro Plus Income model and the recently launched ETF Only model. Both have succeeded in beating the S&P 500 in recent months, so we thought we’d sit down with one of the founding principals to get some insight into their success.
Covestor Live: Your ETF Only model has beaten the S&P since its inception in May. What trends are you currently watching to help you maintain this performance?
CJ Brott: The model was originally designed as an aggressive growth equity portfolio with an allocation of 50% US stocks and 50% foreign equities. In the US the idea was to invest in the in primarily smaller and mid cap ETF’s which historically outperform the large cap S&P 500 when emerging from a recession. Even our large cap exposure is to the equal weighted 500 which also gives smaller cap emphasis. Outside the US we decided to invest in emerging markets. Our primary focus was to countries with emerging middle classes. Our belief is that this demographic is one of the most dependable and strongest engines o f long term economic growth. Therefore in the portfolio there is a high emphasis on Brazil and China. We believe a “Virtuous Circle” “exists between the two economies with Brazil as producer and China as consumer of raw materials. The short term trends we are watching in Brazil are the advent of energy independence, the emergence of a developing retail credit market, including mortgages, and the upcoming election which we believe will continue the trend toward moderate social and fiscal policies. In China we are watching the central bank as it tries to gently apply anti inflationary policies while striving to provide credit to the developing economy. We think the most important trend there is the development of Western China from an agricultural to a consumer oriented industrialized economy. The Chinese retooling of export industries to production for internal consumption remains a primary focus of Chinese leadership. We see this effort as the continuing development of a consuming middle class. This is a middle class which is five times the size of the US work force and thus a critical lever to our thesis. To help us monitor the growth rate of China we will watch indicators such as the Baltic Dry Index or the price of container ships for clues to the relative strength of the Chinese Brazilian economic health. Other macro indicators are base metal prices, the Yuan exchange rate and the strength of Pacific basin supplier economies such as Korea or Australia.
CL: You recently added iShares FTSE Xinhua China 25 Index Fund (FXI) to your ETF Only model. What economic or other factors went in to your decision to add this position?
CB: We are watching all of the economic indicators listed in the previous question. In addition we have traded the FXI some years ago and were lucky enough to sell it before the Chinese market corrected almost 30%. Our belief is that the decline in large Chinese stocks has more than compensated us for the economic risk that the Chinese central bank will over tighten loans and cause a further fall in Chinese equity prices. We are interested in adding the HAO Chinese small cap ETF when we become more certain of our judgment.
CL: Your Macro plus Income model’s return has beaten the S&P since April and is designed for retirement within five years. How do you balance the need for return with the importance of conserving assets as retirement nears, especially in an economy like this?
CB: Actually the model is designed for investors who are five years either side of retirement. That is we try to invest in securities suitable for income reinvestment before retirement. However after retirement the investor can choose to take the dividends and interest in cash rather than reinvesting them. Thus, the investor gets compounding growth pre-retirement and high income post retirement all from the same portfolio.
As for portfolio protection we use limited diversification. We never invest more that 10% in any one investment. And that percent is cut to 5% for more volatile or non income-producing investments. Normally we will hold between 12 to 20 securities some in fixed income and some in equities. Although this level of portfolio concentration can produce volatility we believe in the long run it will produce superior investing results. Although this is a concentrated approach it is a buy and hold but not a buy and forget investment strategy. We believe strongly in the investment rules first promulgated by Gerald Loeb the most important of which is the ruling reason for ownership. Using a methodical process of investment review and valuation, underperforming securities are regularly liquidated and the cash redeployed only when suitable investments are identified. Combining this with a GARP (growth at a reasonable price) approach we are willing to cut losses and let winners run while simultaneously limiting exposure to any one idea.
CL: You recently added ipath S&P 500 VIX Short-Term Futures ETN (VXX) to the Macro plus Income model. How does this position help an account focused on retirement within 5 years, and what are the potential risks?
CB: As we explained in the previous question, regular portfolio review will sometimes produce a lot of position liquidations with no offsetting reinvestment of the cash. We have found that in overpriced or rotational markets, such as we are in now, new leadership is developing. As a result we are slow to find suitable new investments and our portfolios end up with large cash positions. In addition we have noted that at these times the market is most prone to higher levels of variation in its levels of volatility. Using a portion of the cash to participate in a higher level of market volatility becomes a short term insurance policy for the positions we still hold. We look at this as a non-directional bet on the market as the S&P VIX will trend higher during these times of market stress. More importantly should market anxiety lead to a quick decline in prices, the iPath VXX will follow the VIX higher and the iPath investment acts as an even higher payoff hedge. Obviously this is a temporary position intended to be held until such time as market conditions allow us to either repurchase previously liquidated positions at substantial discounts or invest in new ideas with even more promise.
CL: You recently sold Maiden form Brands, Inc. (MFB). What was your reason behind the sell?
CB: Although we believe Maidenform Brands will eventually trade at higher prices we believed that the current price reflected most of the short term value able to be derived by its current high level of earnings growth. At the time of purchase the short term price target was $28. We sold because the stock had achieved most of that gain and to us the risk of a price correction was high. (CL Note: MFB was sold from the model on August 19th for $27.25. The stock had a closing price of $25.76 on August 26th.) We believed this because of a suspicion that new channels such as Victoria’s Secret might be getting saturated, and the stock market in general might be getting weak. Therefore we decided to liquidate the position in hopes of reacquiring it later at a reduced price.