Smart Investing Approach (SIA) explained

Smart Investing Approach (SIA) – it’s a philosophy of my thinking about investing. I have been conciously trying to develop it for at least 10 years now and I possibly tried to do it unconciously before during all the years that I have tried to survive all the ups and downs on capital markets, both professionally and in private investing. The reason why I searched for a different approach than most widely accepted ones was that I was not able to accept the cons of the usual ways on investing. The more I tried what the financial world and its professionals offered me and the bigger experience I personally gained working as a professional in capital markets, the more reluctant I was to following the usual path in finance and investing. With every other failure (and there has been many of them on my way, believe me) I felt that finding something different in how I behave, what and when I sell or buy and how I think about markets and economy, is a must. I will try to explain it below.

I pretty much had the “pleasure” to go through every single part of getting to know financial markets from the outside and from the inside. Starting with buying certificates of open-ended investment funds when I was in my early twenties and started some student jobs, which gave me first (small) disposable savings (usual thinking: you’re young and/or don’t know much about investing, so you give some of your savings to the professionals). I noticed pretty fast though that this has clear disadvantages:
(a) I’m effectively buying an option on a person managing the fund without any guarrantees this person (or team) will do the right job for me;
(b) such form of investing puts my money at risk of the portfolio manager falling under the hoarding spell (or crowd thinking), i.e. say an equity fund has minimum level of equities exposure of 60% and max 100%: although this fund should have closer to 60% in equities as market booms, it’s very often the other way round (allocations close to 100% into a cycle peak);
(c) structures of such products are very stiff – no matter what an equity fund has to have minimum 60% in equities or a corporate debt fund has to have close to 100% (minus liquidity cash buffer) in debt of corporates – why!? (some say “you can choose a mix of two or three diffrent funds with different profiles”, but the truth is that even if I do it, all the other risks in points (a) and (b) still persist for each of the chosen funds);
(d) actively managed mutual funds hardly ever beat their benchmarks, so why buy them and not the benchmark (especially now when it’s easier and more accessible to buy a benchmark than ever)?!;
(e) in most countries (especially from the emerging markets) the management fees are still extremely high compared to the quality of management; as an effect the fees can eat all your potential profits over the long run;
(f) investing in mutual funds certificates very often has assymetric tax profile, meaning profit or loss on them cannot be netted out with opposite return on an investment account (that might not be the case in some countries, but definitely is here in Poland, where I live): so say I make a profit on stocks and a loss of half that on certificates, I won’t be able to decrease my capital gains tax, will still pay 19% of the gain on stocks (if I had no losses to net out from previous years).

That got me done with investment fund certificates pretty quickly, I think around year 2006. I then considered giving some of my savings to some closed-end funds (they only collect money once and are then listed on the stock exchange, small amounts of money are accepted at inception) or hedge-funds (usually minimum amounts paid into such vehicles are substantial, so these are not really accessible to small retail investors, plus they’re less regulated and less liquid usually) employing different investment strategies (benchmarked or total return ones). The problem was, I figured, that these vehicles, although to a substantial degree different than open-ended funds, still carry most of their risks from points (a), (b), (d) and often (e) listed above, plus they often carry other risks like very limited liqudity (no possibility of getting out of an investment when an investor decides or without impact on price), often excess leverage (especially in case of hedge-funds), much smaller financial markets watchdog supervision (giving disadvantage to a holder of certificates against the issuing entity). This was not the way for me.

I then concentrated on investing by myself and in myself. Throughout my higher education in finance and banking and after I chose to pursue a career in capital markets. This decision had two major opposite implications – on one hand it pushed me into making understanding investing and how capital markets work my everyday job, but on the other hand it kind of attached me to the constant noise of information in the financial world, which can be very overwhelming in the longer run and also makes it very hard to concentrate on the so called “big picture”. As an effect of this I very often had much worse effects and returns than I could or should have, had I stayed aside and didn’t let the market crowds influence me that much. My perspective was becoming short, dependant on the noise and views of others and also very technical (in a sense that I concentrated on the current price of assets I put money into rather than their long-term value and risks). IT also constantly pushed me into using more risky instruments in managing my portfolio of assets. I am talking going from bank deposits and government bonds through bluechip dividend stocks, then mid- and small-caps, unleveraged ETFs to index derivatives, leveraged ETFs and FX trading. As I try to sit back and look at things from perspective now, the wider the portfolio of instruments was, the more the following things were happening:
(a) my investing was more and more becoming just speculation,
(b) involvment from my side (both mental and physical through time spent on controlling everything that impacts the positions 24 hours a day) was growing geometrically,
(c) my feeling of control over what I was doing was falling substantially,
(d) returns volatility was growing (especially after inception of FX and leveraged instruments) often leading to both big short-term gains as well as big short-term losses,
(e) on average there was a negative correlation between my returns and the complexity of methods and instruments used.

As an effect of the above I found that instead of getting better, I was actually getting worse at things I was supposed to constantly improve in, given I am considered a professional. Instead of making things simplier and more effective, I was making myself a slave of my money, my profits and my losses. I absolutely felt a growing need for more control and less time consuming way of investing (that’s the “maximize effects while minimizing efforts” part of what i later called SIA). Needed a system that would protect me from as many points listed above as possible. First I noticed that the instruments that are most addictive and time-consuming are the leveraged ones. If you have a position in futures or FX margin account, you are pretty much bound to watching them trade all the time, as the fact that you trade them with involvement of a margin account substantially increases the aggregate risk to your portfolio (in unfavourable circumstances or with excess leverage ratio you can quickly lose much or even all the money in your account). Besides FX markets trade practically 24 hours a day making you a slave. The conclusion was that while derivatives are obviously a must for institutional investors (for hedging and similar reasons) who have extremely easy access to funding from their prime broker-dealers and custodians, it’s not the case for a retail investor. A single person trying to run a responsible portfolio of assets does not have the capacity and has limited time to take care of such instruments in a proper way. Derivatives including margin trading must go out of the spectrum of potential instuments then (leveraged ETFs, although also risky via compounding effect, are a better choice, if someone looks to hedge, because effectively they behave more like equities, but just with higher Beta and the cost of carry is smaller compared to margin account derivatives like futures or FX, etc; it’s a topic for a different discussion really).

The Birth of SIA

Slowly but steadily the idea of a top-down adjustment of allocations in riskiest assets of my (or any other) portfolio led by a macro model was rooting in my mind. As I was reading through different macroeconomic reasearch notes and studied macroecnomic trends, I was becoming more and more convinced that eventualy it is some kind of a macro model with strong forecasting power that will give me the protection from all the above points I mentioned in the former paragraph that caused unnecessary frustration. That’s when the foundation of SIA came to life. I think it was around year 2013, although back then it was nothing concrete, but rather a blur idea of how long-term returns could be smoothed and how the relation between achieving resonable returns and minimising (or eliminating) the inefficiencies mentioned above could look.

Over the years I also noticed the following tendencies (this is my personal perspective, others can have different views and thoughts here of course and have full right to have them):
-> The financial industry (part of which I am too) is constantly making the atmosphere of fear of missing out (they call it MOFO i think – Missing Out FObia). You’re hearing sentences like this all the time: “the train is gone and you didn’t step in”, “index is up and fund X is better than the index, but fund Y is worse, so buy fund X!”, “this is the best Portfolio Manager, because he had a gain of 3% last quarter, whilst his competitors had smaller gains on average”, “our analysts recommend being overweight construction sector, because its high financial leverage will let boost its profits in a low rates and real estate boom environment”, “this is the last moment for investors to buy into emerging markets, chief investment officer of X Group AM says”, “value stocks have never been so cheap in history, you must not miss the opportunity!”, etc, etc). Many of these sentences are just facts OK, but very often they are aimed at creating certain kind of atmoshpere on the market convenient for those already positioned in a certain way and influencing others to behave in a certain way, which someone thinks is right at that specific point in time. That’s how capital markets are, that’s the nature of stock exchanges and capitalism, BUT the clue is not to be drawn into all this noise. There’s one thing certain in markets and investing, noone is infallable. So the worst thing you can do is let others tell you that something is good or bad for you without you actually having your own judgement in a certain matter. That’s how the „I don’t have to, I can” part of my future Smart Investing Approach (SIA) was born.
-> Benchmarks don’t really make much sense. They are maybe good to measure the efficiency of PMs for the typical stiff-status portfolios I wrote above at the beginning of this post, but not for the type of investing SIA represents. Why would I compare myself to any index (be it a benhcmark for equities, bonds, treasury notes or a mixture of them)? Looking to manage a portfolio’s risk mainly by adjusting allocations in riskiest assets to the economic cycle makes it uncomparable to any index. Removing an index benchmark also removes the constant pressure of trying to be better or at least not wose than the external benchmark. SIA is supposed to make things easier and working for a person who follows it. At the end of day all that matters is that a portfolio delivers expected nominally positive returns at a certain level of risk and protects the purchasing power of money invested. So inflation and protection of long-term positive returns are the real absolute benchmarks. No external benchmarks in SIA.
-> The longer I tried investing in different stocks, the more it was clear to me that it does not make sense to be a shareholder of companies that do not provide value that is really changing everyday life of the shareholder and everyone aroud him. I am talking making a real difference, not just being another company that does what other companies do. A perfect candidate for a company to become a part of a SIA-style portfolio is the one that:
(a) Operates in a growing sector that has a clear bright future ahead (think of IT, SaaS, internet or green energy sectors over hard coal miners now as I write this post in 2020 – which sectors have bright and which a dark future ahead, if you think of them with a 10 year perspective? the answer is pretty clear right);
(b) Is an incumbent or prospective global leader of growth in its own sector – leading companies usually attract the best managers, best specialists and widest range of investors (both institutional and retail) who all complement each other in maximising shareholder’s value in the long run (think of Yahoo! and Google at the break of centuries and now: both were positioned to become the world’s number one search engine, but eventually Google made it, whilst Yahoo! didn’t, because Google was able to maximise the efficiency of its search engine);
(c) Operates on growing or stable wide margins (40%+ gross). This gives a clear advantage over other (usually older) more fixed assets or regulation heavy industries (take Miscrosoft (68% gross margin) vs. Boeing (19% gross margin) vs. Dow (15% gross margin)); usually fulfilling requirements (a) and (b) automatically matches this point as well;
(d) Does not carry excessive debt or is ideally debt-free. Financial leverage (use of debt to finance growth) makes sense in some cases, when cost of debt is substantially lower than cost of equity, but as a rule companies who depend too much on debt financing become hostages of their obligations (debt must be rolled, whilst interest rates fluctuate over time constituting risk to the price of debt; liquidity management becomes crutial and any mistakes can cause a default; high levels of debt compared to generated earnings (measured usually by Net Debt/EBITDA ratio where Net Debt=Total Debt-Cash) massively increase the company’s risk, if unexpected deterioration of business conditions arise; debt holders’ claims on company’s assets have priority over equity holders in case of a default, so being a shareholder in such a company automatically puts you in a disadvantaged position),
(e) Generates regular stream of above-average cash flows to the shareholders (measured by Free Cash Flow Yield= FCF/Market Capitalisation). Ideally a candidate’s FCF yield is above both the S&P500 average dividend yield or risk free rate (measured by the current yield of US 10-year treasuries) or its respective local benchmarks, should the company be from outside USA).

Slowly, but steadily all these little points of what I now call SIA were adding up into one more complex thinking about how effective investing should look like. Most of the conclusions I came to above, let’s be frank, were an effect of my own wrongdoing, misjudgment and mismanagement that often costed quite a bit of money and nerves. At least the conclusions were constructive and the process got me learning on mistakes. This old saying is very true I think: “a man learns his whole life and still dies stupid”.

In a search for a macro model that could constitute a base for my thinking of a cycle-adjusted portfolio I have tried diggin into whatever the street’s wisest guys had to offer. I have read through the research papers of the world’s biggest investment banks whenever I had the opportunity to do it. Merrill Lynch (currently part of Bank of America), JP Morgan, Morgan Stanley, Credit Suisse, HSBC, UBS and last but not least Citi (my own employer for the last 14 years until I quit to run this blog) – they all have dozens of analysts creating sophisticated macroeconomic models trying to assess the probability of a recession coming. I personally followed the most (also because it was easiest accessible for me, given I was an employee) Citigroup’s Tobias Levkovich’s model, which includes a wide mixture (close to 20) of both US macroeconomic (including yield curve, high yield credit spreads, industrial production, banks credit accessibility, etc) and microeconomic (P/E trailing, ROE, earnings revisions, net debt, etc) and sentiment indicators trying to predict whether the equities market is prone to enter a bear market. All of these models are obviously a great value added for professionals. But, however complicated they often are, they still carry the same risk of not being infallable. Besides they are just too complicated for most people in the world to read through and understand, assumed this person ever gets to reach such a report given they are mostly distributed to institutional investors only. The clue for me was to find a model that carries the following characteristics:
(a) maximises the readability of the model’s outcomes by attaching its forecasting signals to as few indicators as possible (ideally just one),
(b) is simple enough to be understood and followed by somone, who’s not necessarily a professional in macroeconomics or capital markets (making it useful for wide public),
(c) has a long confirmed history of successful cycle phase change signals (especially calling peaks and throughs) ahead of them actually happening.

After a long search I finally ran into Dr.Robert Dieli’s Enhanced Aggregate Spread model (or Mr.Model), which forecasts economic cycles in a way that fulfills all the 3 elements I just mentioned above in a beautiful simple manner. Maximum readability of forecasting signals from just one easy-to-compute spread indicator that covers both the financial conditions and real economy conditions, supported buy 3 additional coincident indicators. Maximum simplicity that does not need endless amounts of different factors, spreads and indices to be covered, watched upon and updated. Accessibility to everyone, also non-professionals in the tough matter of macroeconomic forecasting. Way over half a century of data to which the model can be implemented. 80%+ forecasting success confirmed by historical data, making the model very trustworthy. A model based on “pure facts, not conjecture, thus “no spin”” as the author himself calls it. That’s exactly what I was looking for! A perfect match for my concept of cycle-adjusted investment portfolios. Dr.Dieli presents his extremely valuable work via his website under www.nospinforecast.com. I sincerely advise anyone planning to implement SIA methodology to own investing procedures to visit his website and thoroughly study his work and the EAS model. Optionally you can also read my post about how EAS works and what value it gives here.

It all started adding up.

I did actually feel more and more convinced that this kind of model can be a base for a bigger philosophy of asset allocation style, in which exposure to the riskiest part (equities) would be managed accordingly to the phase of the economic cycle. This would do a great work of smoothing out long-term returns. During the usually long periods of expansion a wise long-term portfolio should be exposed to equities, because there’s no doubt they offer the highest possible returns in the long run (on average between 8-10% annually). As long as a trustworthy forecasting model confirms the rationality of being allocated in equities with a meaningful part of a portfolio, I do not need to worry about short-term noise and corrections (which usually happen every once in a while and are no deeper than 5-15% from tops). On the other hand, when a trustworthy model is telling me something is wrong and a phase change is due, it gives me a signal early enough to prepare myself and my portfolio for what with high probability waits around the corner. When the bad (meant by recession or bear market which usually comes alongside) eventually comes I want to have as little exposure to equities as possible. It’s close to running on an autopilot, only you need to be sure the autopilot can be trusted and will bring you where you want to go without any surprises. I have later developed this way of thinking in the portolfios I now run on my blog. First to start is an allocation-only Pension Portfolio I describe and update regularly in my monthly updates. Please take a moment to read through my 1st inception post about the Pension Portfolio to understand the major assumptions of how it’s run and managed. The other portfolio is called Global Leaders Portfolio. This one does include stock picking (unlike the Pension Porfolio) in a manner compliant with the rules described above (equity part of is portfolio allocated in stocks which fulfill the following characteristics: growing sector, incumbent or prospective global leader of growth in its own sector, growing or stable wide margins, no excessive debt or is ideally debt-free, generates above-average FCF yield). It also accepts higher equities exposure,so effectively a higher-risk portfolio, not suitable for someone with low risk acceptance (please read my post on how imporant it is to measure and understand your own risk acceptance before starting to invest here.) Still the general rule is the same for all current and future SIA portfolios:
(1) a macro forecasting model is the basic determinant of equity allocations,
(2) equity allocations determine allocations in other assets and cash,
(3) portfolios need to capture both worldwide growth opportunities (via equities exposure) and safety (via long term high grade sovereign debt exposure and inflation hedges and value holders like gold); this gives the porfolios an important factor of self-balancing -> given the fact that gold has practically zero correlation with S&P500 and long term treasuries have a negative correlation with equities, being allocated in all these 3 different types of assets always buffers your returns in the long run; when equities plunge, usually bonds and gold outperform, etc.),
(4) their basic target is to smooth out long-term returns and avoid big one-time drawdowns.

This is SIA then:
* „I don’t have to, I can” attitude
* no benchmarks
* cycle-adjusted portfolio allocations helping risk control
* concentration on the world’s best assets
* avoidance of debt overload
* maximization of effects with minimalization of efforts
* each stock must undergo a so called SIA Score process before qualifying into the portfolio:
SIA Score:
S1: growing sector 1pts/0pts,
S2: incumbent or prospective global leader 1pts/0pts,
S3: growing or stable wide margins (40%+ gross; 3yr avg) 2pts/0pts,
S4: Net Debt/EBITDA <1.5 (last 3 ended FYs) 2pts/0pts,
S5: above-average cash flows (last 3 ended FYs) (FCF/MktCap > S&P500 Dividend Yield or US 10yr Treasry Yield (higher of the values)) 2pts/0pts;
MAX TOTAL SCORE: 8pts/MIN TOTAL SCORE: 0pts/MIN SCORE TO QUALIFY: 4pts

This is because I think Your money cannot control you and your time, but the other way round.  Join me!

Yours,
PC