I am a top down investor. That means I find big picture themes and apply the appropriate trading instruments to them. Things weren’t always this way, but after a few years of investing I realized that picking stocks was much like swimming with the tide. It’s a lot easier as long as you get the direction of the tide correct (or the direction of the bigger trend as it applies to the market). For stock picking, as long as you picked the correct market direction you can almost choose any stock in the market and as long as that sector is going up the odds of your stock going up improved substantially. This is a gross oversimplification, but you get the point.
Most investors are fooled into thinking that the stocks they choose generate alpha, but in reality most of the alpha in your portfolio is generated by your ability to invest in the direction of the market at the correct time. This is the main reason why most mutual funds can’t outperform a simple index – the stocks they invest in essentially are the index (to some degree depending on the fund) and they tend to have a long directional bias meaning they are always fully invested. But that’s a topic for another day….
The other trend I tended to notice when I started investing was that combining the directional bias with the beta of an underlying asset would generate outsized returns. For instance, riding the recent rally and picking a bank (a very high beta sector in these times) has been an incredibly high performance strategy – and it almost didn’t matter which bank you chose. If I had handed you a bag with 100 bank names inside and asked you to pick 25 names out of the bag with your eyes closed I can almost guarantee you that you would have performed more or less in-line with the overall index of 100 or any mutual fund that specializes in banks. Basically, choosing a high beta name and the market direction during this rally provided substantially better returns than the S&P 500 – not because you are a stock picking genius, but because you swim with the tide using a swift instrument.
With that said, it’s useful to formulate strategies using various top down themes. Regular readers know that I have often referred to the food theme as one of my favorite long-term global macro themes. In “the next great bubble” I highlighted the strategy and how to play it. My “bond trade of the year” is a similar example where I applied the overall theme of increasing inflation fears to the bond market. Most global macro hedge funds do some form of the same strategy by creating macro themes and applying instruments to them. In a recent research note, Goldman Sachs, the hedge fund of all hedge funds, highlighted a number of macro strategies geared towards global macro themes. I’ve highlighted 2 of them below. Both are sound fundamental global macro themes and should spark some good ideas for readers:
1) Investing in international companies with high sales .
This is one of my favorite strategies. Sales can’t be faked. Revenues provide the most accurate view of corporate health. They can’t be fudged like EPS and they only grow when there is strong underlying organic growth. This approach finds the 50 stocks with the highest leverage to international revenues. The companies derive 68% of all revenues from outside the U.S. Key criteria and performance:
• Key Criteria: S&P 500 stocks with highest international sales across ten sectors.
• Performance: -3.3% since inception vs. -15.9% for
S&P 500 and +27.8% YTD vs. +13.0% for S&P 500.
2) The BRIC’s sales portfolio
Similar to the international basket, but focused solely on the BRIC nations (Brazil, Russia, India & China). Think of this as the international portfolio on steroids. It will have a little higher beta and will perform better (or worse) depending on market direction. Key criteria and performance:
• Key Criteria: Russell 1000 stocks with highest revenue exposure to the BRIC regions across ten sectors.
• Performance: +27.7% since inception vs. +7.7% for S&P 500 and +37.9% YTD vs. +13.0% for S&P 500.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.