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INVESTMENT INSIGHTS ARCHIVE
Originally posted in April 2016

Subscribers will have received our closing trade recommendations for Sainsbury’s and Admiral during the month. SBRY was in the HindeSight Dividend Portfolio from 10th December 2014, a holding period of 467 days. During that time, it collected 12.2p worth of dividends and captured a total return of 30.14% (absolute) and 34.99% (relative). Admiral entered the portfolio on 7th October 2015 and was held for 166 days. Although it collected no dividends, its price appreciation was 26.30% (absolute) and 28.54% (relative).

Rarely a month goes by without reading some type of article about a fund manager who believes in holding his chosen stocks for the long term. Whether or not it all started with Warren Buffett’s belief in his ‘forever’ holding period – and everything since is just a variant of that – the generally accepted belief is that you have to hold stocks for the long term to have any chance of success. After doing some incredible amounts of research, you find stocks at attractive prices that you can hold through thick and thin, feeling confident that they will bring growth, earnings and dividends. At least that’s the plan. Personally, I have never adhered to that plan. Maybe this is because my background is more of a trading nature, or maybe I just don’t believe that’s the best style.

The Hinde Dividend Value Strategy focuses on the cyclical nature of large, well-capitalised stocks. While small growth stocks might be the most exciting and offer the largest potential for gains (and losses), they play no part in our strategy. Our model is to identify and invest in stocks that are undervalued, often as a result of overreaction to current earnings. We believe that by investing in these stocks at that time, we have an excellent risk/reward horizon over the following 12 month-period. Every aspect of the return is important to us, including the amount of dividends collected, the absolute return, especially the total relative return, and the holding period of the investment. Even the great Warren Buffett would agree that it is better to make 30% on holding a stock in 30 days, rather than 30% in 5 years. A simple way to look at this is to compare non-compounded annualised returns. In the case of Sainsbury’s and Admiral, a return of 30.14% in 467 days and 26.30% in 166 days might be reflected as annualised returns of 23.55% and 57.8% respectively.

Clearly, Admiral has been the better investment for us. We have made roughly the same amount of return, but our money was at risk for a much shorter period. Moreover, we have been able to straight away reinvest the profit we made in the next undervalued company. Our sales at this time in SBRY and ADM are no reflection of a belief that either of them are good or bad stocks. We purely believe that they are no longer cheap enough at these prices to offer us the risk reward horizon, which is the bedrock of our strategy, and hence we rotate and move on, hopefully to continue compounding.

The ability to compound returns is merely a function of the age old mathematics of compound interest where:

F= P ( 1+ i/n) ^nt (to the power of nt)

Where F= future value, P= present value, i= nominal interest rate, n= compounding frequency and t=time

In the case of compounding investment returns, you do not need to have the best risk/reward outcome if you have the ability to compound at a greater frequency. This is, in fact, the essence of high frequency trading.

If you have developed a systematic methodology by using a historical time series of data that produces investment picks with a 70% chance of success to make 10% and 30% chance of failure to lose 10%, then your expected return outcome would be:

E = (70x10)-(30x10) = 400% profit if 100 investments were made, so each investment THEORETICALLY will return an average of 4%.

So your model for your potential investment returns would be:

= (1+0.04)^T where T is the number of trades made, assuming that you apply any new profit to the next investment. The problem comes if the model does not correspond too well with the actual results in the short term. You might have 5 losers in row in a real life scenario!

In a high frequency trading programme – where the time of trades is measured in micro seconds, rather than days, although the size of the percentage returns is much smaller – the ability to compound is far greater.

HFT model returns might be = (1+0.00001)^10000 where the expected return is much less, but the ability to compound 10,000 times in a much shorter time frame.

There are two reasons why this is important. Firstly, the actual investment risk/reward probability can be substantially less and secondly, by compounding faster it helps the actual outcome to track the theoretical outcome much quicker.

An integral part of the success of the Hinde Dividend Value Strategy is how we focus on the ability to compound returns over shorter time frames that many investors hold stocks for, which is done within a rotational methodology based on the inherent cyclicality of large capitalised stocks.

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