Trading Portfolio; Momentum Houston we have an agency problem

Two years ago now this real money portfolio was started in order to beat the S&P 500 index using a proprietary equal weight momentum method.

In this blog it is time for a relative return evaluation and secondly also some ranting and observations on the state of the stock market.

This blog is for information and entertainment purposes. If the reader uses information in this blog for investment decisions, the reader will lose money. Holland Park Capital London ltd is in no way, shape or form liable for what the reader decides to do after reading this blog.

First things first; on the 1st of July 2020 Q3 the Trading Portfolio; Momentum strategy started with $50000 in investments in S&P 500 index companies. Now on the close of the 30th of June 2022 the portfolio is worth $ 63453. Cash in the portfolio had been mostly taken out earlier this week. Still some cash from dividends had come in again to the tune of almost $7. If we adjust the portfolio value downwards for that cash the value was around $63443 on the 30th of June.

The absolute return in Q2 2022 was a disaster, but of course that is not what is being measured here.

The MSCI World Index has tumbled more than 20% in the first 6 months of 2022 and that is the worst first-half decline since the index was set up around half a century ago according to Hugo Duncan writing for the Daily Mail. Yahoo Finance has an article today that “Stocks slide to close worst first half in 52 years: S&P 500 plunges 20.6% YTD, 8.4% in June”.

The Dow Jones DJIA did best in the US and was only down 15.28% YTD.

The Nasdaq 100 index was one of the worst and is down now 29.55% YTD.

Momentum MTUM Factor for the US is down 25% YTD according to the Seeking Alpha website. So the momentum factor did even worse than the S&P 500 in 2022 so far.

The US Equal Weight Factor was down 17.52%.

The US Value Factor was one of the best with down 12.39% YTD but the US High Dividend Yield Factor was the best at only down 9.29% YTD.

The Trading Portfolio; Momentum is down 17.21% YTD.

The proprietary Trading Portfolio; Momentum investment strategy once again seems closer related to the US Equal Weight Factor than the US Momentum Factor by the way.

How has the relative return versus the S&P 500 index fared?

Because if the relative return underperforms, it would have been better to just put the $50000 in an S&P 500 ETF and sit back and relax. An S&P 500 ETF can be expected to modestly underperform the real S&P 500 index returns, because of the drag of the management costs of the ETF (the expense ratio etc.). The VOO Vanguard 500 index fund ETF was put in a paper portfolio with two portfolio tracking websites on the 1st of July 2020 with $50000 as well. On the SigFig website the paper VOO holding would be worth $61398 after the first six months of 2022. In the Stockrover website the paper VOO ETF holding shows as worth $61230 at the end of Q2 2022.

Above; A picture of the Stockrover website performance tracking of the paper holding in the Vanguard S&P 500 ETF VOO.

So the Trading Portfolio; Momentum outperformed the VOO Vanguard S&P 500 ETF by about 3.3% after two years excluding dividends. The calculation is (63443/61398) and then into a percentage.

Two years is still way too short to be able to draw any conclusions with some amount of conviction; time horizons of between five to seven years are needed for that. Still the early conclusion can be that so far the Trading Portfolio; Momentum was a waste of time and effort. For Holland Park Capital London for the Trading Portfolio; Momentum to be worth it long term the outperformance needs to be closer to 2% a year. The current outperformance of about 1.65% a year falls short of that.

It is time to move on to the second part of this blog post.

Houston we have an agency problem.

“Only when the tide goes out do you discover who has been swimming naked”

Warren Buffett quote

The tide is certainly going out in 2022 so far and nudeness seems to have been the flavour of the day recently.

Special Purpose Acquisition Companies (SPAC) were very popular in the beginning of 2021. Performance of SPAC’s in 2022 has been so bad one can question who’s interests the SPAC’s served; the shareholders or the SPAC founders. There are plenty of SPAC’s that are down 90% or more from the highs now.

Another example of naked ambition to fill one’s own pockets can be found in the tech company space where insiders working for a listed tech company have been very busy giving themselves newly created shares and options every year and massively diluting existing shareholders. Management’s that use the stock listing as an ATM to get filthy rich fast themselves are bad for the other stakeholders. This practice is very bad for existing shareholders since the earnings have to be divided over an ever growing number of shares. It is also very bad for employees that are not part of the inner circle and are likely the target of all kind of cost cutting measures to pump out short term profits and the short term share price while the inner management circle is having an extravagant party at everyone else’s expanse (and management is busy selling the shares they get as quick as they are allowed to sell them).

Never be fooled by an announcement of a listed company that they launch a share buyback program as positive news.

Very often the left arm of the company buys back shares on the stock exchange while the right arm is even busier granting new shares and options programs to management employees as part of the “remuneration” program.

There is absolutely no point for shareholders buying back 5 million shares of the shares outstanding of company X if company X issues 25 million new shares to management in the same time. This is only a generous scam to enrich management.

The net buyback activity matters not the gross buyback activity.

This can be easily followed by comparing the number of outstanding shares now with the number of outstanding shares this time last year.

A basic economy lesson that people seem to have forgotten is that if the supply of something is scarce and the demand does not go down the price is likely to go higher.

That goes for the number of outstanding shares of a listed stock company as well.

For example;

there are be 2 identical companies (A & B) and they start both with a share price of $100 and 10 million outstanding shares. The profit growth is identical at 10% a year but company A buys back 10% of the shares every year and reduces the number of outstanding shares by 10% a year whilst company B doesn’t. Company B issues 10% extra shares to management for “remuneration” every year and then buys back these shares every year in the stock market. Both companies start with a P/E of 15 and finish at a P/E of 15 after 5 years. The Earnings per Share at the beginning for both companies is 6.67. At the start the GAAP profit for both companies is 66.7 million dollar. At the end the GAAP profit for both companies is 107 million dollar.

Company A is likely to have a higher share price after 5 years than company B.

Company A has around 5.9 million shares outstanding after 5 years. Company B still has 10 million shares outstanding. The Earnings per Share for company B after 5 years is 10.7. Fifteen times 10.7 makes a share price of $160.5. The Earnings per Share for Company A however is around 18.3 after 5 years. Fifteen times 18.3 makes a share price of $274.5. Company A trades almost 71% higher after only 5 years!!

Management of every company is in charge of asset allocation.

Basically the question is what to do with the profits every year (or free cash flow that does not necessarily need to be reinvested in the business to keep the lights on).

If management spends profits every year on options and shares for management and the inner circle itself and camouflages these practises with stock “buybacks” the above example can easily become reality. The Company B’s of this world are not acting in the best interest of their shareholders. Incentives for management and shareholders should be aligned, but some managers have been running circles around shareholders lately at their expense.

In the same mode Switzerland did not increase the money supply during the recent lockdowns by 30% a year. Swiss June inflation was 3.4% in June 2022. UK inflation was 9.1% in May. The Netherlands inflation was 9.9% in June according to the European method. In Sweden the May 2022 inflation was 7.2%. The United States had an 8.6% inflation rate in May 2022. The central bankers will testify that the high inflation is not their fault. Perhaps though the central bankers conveniently forgot (whilst they were funding their governments with excessive money printing) that sound fiat money needs a money supply that does not grow faster than the rate of the GDP growth. If you print too much money of course the price of money is likely to go down.

The Western world had about 2 years of lockdowns and those lockdowns killed capacity for businesses and now we are out of everything. Businesses will demand higher profit margins in order to have an incentive to build back this destroyed capacity. Capacity supply is scarce. Demand after the lockdowns is picking up. So the prices have to go up. Voila there is your inflation a la cart. In the beginning of this year we still had lockdowns in Europe (Omnicom wave). On and off Europe has had lockdowns for about two years. It is likely capacity of businesses in Europe will take two years to recover (somewhere in 2024 things can go back to normal). In those two years we will have had inflation of at least 10 percent. It is only now that in the court of public opinion it is acceptable to talk about the negative side effects of lockdowns. How about we all are becoming at least 10 percent poorer thanks to Lockdowns? Also the UK SATS exams for the children that leave primary school this year show lower results than in 2019. On top of that polio is back in London after having been eradicated for about 20 years. “117000 die on waiting lists for NHS” was the headline of the Evening Standard newspaper yesterday. That is double the number of deaths from before the pandemic.

Maybe the current recession will not be that bad and a force for the good if it washes away the above dodgy practices in the financial world and kills of the zombie companies and makes some room for companies that have healthy business plans, take all stakeholders interests into account and have management with good characters. The current recession will also slow down demand and give businesses the time and chance to invest in their capacity issues in the meantime.

Talking about character Fred Kiel wrote a book in 2015 called “Return on Character; The Real Reason Leaders and Their Companies Win”. There have long been people that think that listed companies with better ratings on websites like Glassdoor will make for better investments going forward. Fred Kiel has done research in his book which shows that Self-Focused CEOs achieve a Return on Assets (ROA) of 1.93% while Virtuoso CEOs achieve a Return on Assets of 9.35%. The assumption is that a higher Return on Assets also means a higher stock market return for investors.

Above; the book cover of Return on Character. Please buy the book!

Anyway Holland Park Capital London has looked into the concept of shareholder yield lately. This could potentially be used to see how friendly the management of a stock listed company is towards the shareholders of that company that are the actual owners of that company. It is a classic agency problem.

Management may say they are doing their best for shareholders but are they really or are they too busy filling their own pockets at the expense of everyone else?

A higher shareholder yield is seen as desirable and captures cash dividends, net stock repurchases and debt reduction.

In this age of financial repression Holland Park Capital London finds the debt reduction part of shareholder yield misleading. For a company with pricing power why would a shareholder want debt reduction when it is likely the interest rates the company pays are lower than inflation? Basically the debt is being inflated away anyway.

Shareholders would be much better off if management buys back and reduces the number of shares more while continuing to grow total GAAP earnings year in year out.

Apple under Tim Cook is one of the poster boys for buying back its own shares.

The finbox.com website allows you to create a chart with the share price of a company which you want to see go from low in the left to high in the right part of the chart while including the number of shares outstanding. In the chart you want to see the number of shares go from high in the left of the chart to low in the right of the chart.

Above; Apple price and number of shares outstanding over time

Steve jobs in his second term at Apple managed to create Apple shareholders returns of about 34% annually.

Tim Cook so far has managed to create Apple shareholder returns of almost 26% annually.

The financial engineering of the number of outstanding Apple shares must have helped Tim doing such an outstanding job.

Holland Park Capital London Ltd did some research for an investor that had 131 single stock holdings. Of those 131 companies 33 had doubled or more in the past. The assumption is that doubling also means a higher stock market return for investors.

Of the 14 companies out of the 131companies group that had reduced their number of shares by 18% or more over the last 10 years 50% had doubled or more in the past allowing this investor to take out the initial investment while letting the profits run for the remaining holding. The number of companies that had doubled in the past for the 131 holdings group was around 25%.

So the hypothesis is that companies that have reduced the number of shares outstanding by 18% or more in the past 10 years will show better returns as a group than a different group of other listed companies.

Holland Park Capital London Ltd might need to do another real money experiment one day to test this hypothesis.

Hopefully more management teams will start acting like good Return on Character leaders as this recession goes on and less and less managers will get away with enriching themselves with plundering the number of outstanding shares like a never ending ATM machine. Let’s vote down some remuneration proposals at the Annual General Meetings (AGM’s) of listed companies in the coming years fellow shareholders.

Anyway thanks for reading and good luck! May the force be with you!

The blog is not advice on what you should do with your money and was written for information and entertainment purposes only. When you invest in the stock markets it is possible to lose money. Please do your own research. If in any doubt what is best in your individual situation, please hire a licensed financial advisor. Good luck on your investment journey.

Holland Park Capital London hopes you enjoyed the information in the blog. Holland Park Capital London Ltd is not receiving any compensation from anyone to write this blog. Holland Park Capital London is long most of the stocks in the S&P 500 index and is also long the S&P 500 index ETF. Holland Park Capital London has no business relationship with any company whose stock is mentioned in this blog. Holland Park Capital London expressed its own opinions. This is not advice. Make your own decisions please. Please go and see an authorized financial advisor before making any investment decisions. What works for Holland Park Capital London may well not work for you and your personal situation is unknown to Holland Park Capital London. Stocks go up as well as down and you may get back less than you invest. Any information in this blog should be considered general information and not relied on as a formal investment recommendation. This blog is for information purposes only and helps Holland Park Capital London expand on the book “Beat the Stock Market Casino” and brings extra discipline in the investment process. Holland Park Capital London is not liable for any mistakes in this blog. This blog cannot be a substitute for comprehensive investment analysis. Any analysis presented in this blog is illustrative in nature, limited in scope, based on an incomplete set of information and has limitations to its accuracy. The information upon which this blog is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore the accuracy cannot be guaranteed. Any opinions are as of the date of publication and are subject to change without notice.