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Daniel Figueroa
Pepperdine University
December 3, 2009
Individual Term Paper: Systematic Value Investing Strategy
Table of Contents
Introduction..........................................................................................................................4
Market Outlook....................................................................................................................4
Forecasting Method.........................................................................................................5
Analyze Stock....................................................................................................................10
Positions Sizing.................................................................................................................16
In Summary.......................................................................................................................19
Table of Figures & Tables:
Figure 1 (Chart: VEU)........................................................................................................6
Figure 2 (Chart: VTI)...........................................................................................................7
Figure 3 (Advisory Sentiment Chart)..................................................................................8
Figure 4 (U.S. Industry Bell Curve)....................................................................................9
Figure 5 (Chart: XLV).........................................................................................................9
Figure 6 (Chart: EMS - Eyeballing)..................................................................................10
Figure 7 (Chart: EMS – Regression Trend Line)..............................................................11
Figure 8 (Chart: EMS – 10m EMA)..................................................................................11
Figure 9 (Probability Chart: EMS)....................................................................................14
Figure 10 (Probability Chart: EMS)..................................................................................15
Table 1 (Markets)................................................................................................................5
Table 2 (Intrinsic Value: EMS).........................................................................................12
Table 3 (Risk Tolerance – Beta Weight)...........................................................................17
Table 4 (Existing Portfolio)...............................................................................................18
Table 5 (New Portfolio).....................................................................................................19
Table of Appendix:
Appendix A (Correlation between VTI & VEU)..............................................................20
Appendix B (EMS’ Bearish Break-out)............................................................................21
Appendix C (Correlation between EMS & XLV).............................................................22
Appendix D (NPV of EPS)................................................................................................23
Appendix E (NPV of FFCF)..............................................................................................24
Appendix F (Key Fundamental Ratios for EMS)..............................................................25
Appendix G (Portfolio Betas)............................................................................................26
Executive Summary
The objective of this paper is to illustrate the process of opening a new stock
position within an existing portfolio, utilizing a systematic value investing strategy. This
strategy is unique in so that it was designed to utilize many of the quant analysis methods
learned throughout the trimester. The investment strategy is broken down into four main
tasks as illustrated below:
Market Outlook Identify Sector Analyze Stock Position Sizing
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Individual Term Paper: Systematic Value Investing Strategy
The market outlook identifies where the market is as in relation to where it has
been over the past months. Looking at both the global and U.S. equity markets with the
use of exponential moving averages, a bullish trend emerges. From there the healthcare
sector was chosen using technical analysis. Of all the stocks in the healthcare sector,
Emergency Medical Services Corp (NYSE: EMS) was chosen due to its bullish technical
indicators and its strong key fundamentals. Some of the tools utilized in the analysis
consisted of forecasts: moving averages and regression lines, simple regression, factor
analysis and net present value.
Once the stock was chosen, stop-losses and a target were determined using
standard deviations for probabilities. The next step in the process was to determine the
desired portfolio beta and identify the position size for EMS. The last step performed
was to calculate how many share of EMS were to be purchased.
Using this strategy the value investor, with conservative growth tolerance, would
purchase 167 shares of EMS. The investor would expect less volatility than the stock
market as a whole and would be proactive in managing risk. The investor should expect
to lose a maximum of $1,250.83 if the position goes completely against him. This would
be an expected portfolio drawdown of 1%.
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Individual Term Paper: Systematic Value Investing Strategy
Introduction
The objective of this paper is to illustrate the process of opening a new stock
position within an existing portfolio, utilizing a systematic value investing strategy. This
strategy is unique in so that it was designed to utilize many of the quant analysis methods
learned throughout the trimester. Explanations of the formulas for the tools used are not
within the scope of this paper, identifying how to use quant tools is of most importance.
The investment strategy to open a new position is broken down into four main tasks as
illustrated below:
Market Outlook Identify Sector Analyze Stock Position Sizing
Each main task will include its own underline assumptions. However, the overall
strategy has its own main assumptions. This paper assumes:
• That the investor is interested in opening a new long, unlevered, position.
• It assumes that the investor will only be watching the market on a monthly basis.
• Desires to minimize draw-downs.
• It assumes that no traditional sector diversification is desired.
• Lastly, that the objective is to use a safe systematic strategy, not create the “holy
grail” of investment strategies.
Because this paper focuses on entering a new position it will not include portfolio
performance. This paper also does not provide expected returns because CAPM is not
utilized. Nor does this paper provide back-testing because doing so tends to shape a
strategy towards unpredictable capital gains and away from risk management. This paper
does use the portfolio’s beta to match the investor’s known risk tolerance. It will focus
on being proactive in managing risk and reactive to responding to market conditions.
Market Outlook
This paper uses a liberal top-down analysis. A top-down analysis is described as:
An investment approach that involves looking at the "big
picture" in the economy and financial world and then
breaking those components down into finer details. After
looking at the big picture conditions around the world, the
different industrial sectors are analyzed in order to select
those that are forecasted to outperform the market. From
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Individual Term Paper: Systematic Value Investing Strategy
The use of the word liberal in the earlier statement is used because this paper will
factor in some underline market assumptions. Due to the accessibility and liquidity with
exchanges for stock market indices, the paper assumes weak-form market efficiency.
This means that all known economic fundamental factors are priced into the market
indices. The technical analysis used in this section is not to beat the market, but simply
identify where the market is as in relation to where it has been i.e. a map. The trend
identification takes into consideration Newton’s First Law of Motion that an object in
motion will remain in motion unless acted upon by another force.
Normally an investor should look at a minimum of the five markets, as listed in
the table below:
Market Ticker Description
Bonds IEF iShares Barclays 7-10 Year Treasury
Commodities DBC PowerShares DB Commodity Index Tracking
Real Estate VNQ Vanguard REIT Index ETF
Total US Stock Market VTI Vanguard Total Stock Market ETF
Total World Stock Market VEU Vanguard FTSE All-World excluding - US ETF
Table 1 (Markets)
For brevity and purposes of this paper we will only analyze the Total World Stock
Market, which excludes the U.S., and the Total U.S. Stock Market. The main “market
outlook” task is broken down into three subtasks as illustrated below:
Forecasting Method Analyze Markets Sector Selection
Forecasting Method
Since the paper assumes all known economic fundamental data is incorporated
into the indices’ prices, it then only has to determine if the stock market is in a bullish or
bearish trend. To do so this strategy will utilize technical analysis with a 10 month
exponential moving average as the forecasting tool.
The 10 month (m) exponential moving average1 (EMA) is represented on the
charts as a green line. To establish whether the market is bearish or bullish, this paper
uses an end-of-month close, moving average crossover. If the monthly close is above the
1
The exponential moving average is based off industry standards and not optimized for mean absolute
deviation.
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Individual Term Paper: Systematic Value Investing Strategy
10m EMA, it is assumed the market is in a bullish trend. If the monthly close is below
the 10m EMA it is assumed the market is in a bearish trend.
The charts are setup to display 5 years worth of monthly data. Each month is
represented by 1 bar. This setup will help reduce noise, being that the objective is to
perform investment analysis on a monthly basis using a systematic strategy.
Analyze Markets
As stated prior, this paper will only analyze two markets the Total World Stock
Market (VEU), which excludes the U.S., and the Total U.S. Stock Market (VTI). Since
there is a high correlation between VTI and VEU, VTI will only be analyzed if VEU is
found to be in a bullish trend.
Running a simple regression on VTI and VEU, with VEU being the independent
variable, VTI has a coefficient of 0.76. Of that correlation, 85% of the volatility can be
explained by the relationship between the two. (Appendix “A”)
Analyze VEU
Below is the chart for Total World Stock Market (VEU):
1
"Total World Stock Market (VEU)." Chart. Total World Stock Market (VEU). Thinkorswim. Web. Nov.
2009. https://www.thinkorswim.com/tos/client/index.jsp
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Individual Term Paper: Systematic Value Investing Strategy
The last monthly bar clearly closed above the 10m EMA. This means it is
forecasted that the international stock market will likely continue in a bullish direction.
As a result it may be safe to enter new positions given further research.
Analyze VTI
Below is the chart for the Total U.S. Stock Market (VTI):
1
" Total U.S. Stock Market (VTI)." Chart. Total U.S. Stock Market (VTI). Thinkorswim. Web. Nov. 2009.
https://www.thinkorswim.com/tos/client/index.jsp
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Individual Term Paper: Systematic Value Investing Strategy
Sector Selection
To select a sector this paper uses the U.S. Industry Bell Curve. The criteria for
this strategy will be to find an industry that is not bearish or over-bought. Preferably it
would be between the 40% and 70% range.
1
"Advisor Sentiment Chart." Advisor Sentiment Chart. Investors Intelligence. Web. Nov. 2009.
http://www.investorsintelligence.com/x/default.html
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Individual Term Paper: Systematic Value Investing Strategy
1
" U.S. Industry Bell Curve." U.S. Industry Bell Curve. Investors Intelligence. Web. Nov. 2009.
http://www.investorsintelligence.com/x/default.html
2
" Healthcare SPDR ETF (XLV)." Chart. Healthcare SPDR ETF (XLV). Thinkorswim. Web. Nov. 2009.
https://www.thinkorswim.com/tos/client/index.jsp
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Individual Term Paper: Systematic Value Investing Strategy
Analyze Stock
Our objective in this section is to select a stock within the healthcare industry so a
position may be opened. The main “analyze stock” task is broken down into five
subtasks as illustrated below:
Scan Stocks Stock: Technical Analysis Stock: Fundamental Analysis
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Individual Term Paper: Systematic Value Investing Strategy
Using the eyeballing method the stock appears to be in an upward trend. This
means it would be advisable to continue analyzing with a regression trend line.
The next forecasting tool is the regression trend line. While regression trend lines
are typically performed on scatter plots, it is performed on this bar chart using end-of-
month data.
1
" Emergency Medical Services Corp (NYSE: EMS)." Chart. Emergency Medical Services Corp (NYSE:
EMS). Thinkorswim. Web. Nov. 2009. https://www.thinkorswim.com/tos/client/index.jsp
2
" Emergency Medical Services Corp (NYSE: EMS)." Chart. Emergency Medical Services Corp (NYSE:
EMS). Thinkorswim. Web. Nov. 2009. https://www.thinkorswim.com/tos/client/index.jsp
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Individual Term Paper: Systematic Value Investing Strategy
As predicted prior via the eyeballing and regression trend line methods, EMS is
verified as being in an upward bullish trend by using a 10m EMA since it did close above
the moving average3. This means it would be advisable to move into analyzing the stocks
fundamentals.
3
Note that the bearish trend which ended in July due to the close above the 10m EMA was not confirmed
until August when the move exceeded 1 trailing standard deviation. See Appendix “B”
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Individual Term Paper: Systematic Value Investing Strategy
EMS is currently selling at a discount to both its EPS and FFCF. Table 1
indicates that there may be a potential return between 34% based off EPS and 120%
based of FFCF. This is not to be interpreted as a guaranteed return, but instead akin to a
moving magnet, where current price should gravitate slowly towards that direction.
Being that EMS is selling at a discount, this means it would be advisable to analyze the
company’s key fundament ratios.
The company’s key fundamental ratios can be analyzed using multifactor
analysis. We will analyze EMS’ ratios against its industry’s ratios. The key ratios used
in this strategy as the factors are: P/E, P/S, P/B, P/CF, ROE, D/E and CR. These ratios
along with 3 red flag indicators will be used as the factors. The 3 red flag indicators look
for incongruence with revenues, operating incomes and receivables on an annual basis.
See Appendix “F” for data.
In order to analyze the data the key ratios and red flags are converted to points.
The points are given based on its performance against constraints1 for the factors. A 1 is
given if it beats the constraint, a 0 if it matches the constraint, and a -1 if it does not meet
the constraints. For example, the factor P/S has a constraint of being less than 2.5. EMS
beats the constraint since it is 0.82, thus given a 1. The industry does not beat the
constraint since it is 8.9, thus given a -1. The factors are then given weights2 based on the
relevance to value investing.
A multifactor analysis is performed to identify whether the chosen company is
stronger than its represented industry. If the industry was to be stronger than the
company, then the company would not be a reasonable investment. Another constraint
used to ensure strong fundamentals is that the outcome must be greater than 100. In
EMS’ case it is both stronger than its sector and greater than 100. This would mean that
an investment in EMS would be reasonable.
1
For brevity of the paper the constraints are not listed.
2
Weights are subjectively chosen using a judgmental system.
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Individual Term Paper: Systematic Value Investing Strategy
Determine Stop-losses
There will be two stop-losses implemented with this strategy. One is intraday,
used for preservation of initial capital. The other is end-of-month, used for capital gains
preservation and change in trend direction.
The intraday stop-loss is a point at which the stock has decisively moved against
the position on an intraday basis and actions for preservation of capital should be
implemented. The first task for determining an intraday stop-loss is to set a time horizon.
The time horizon chosen for this model is 2 months1. This keeps volatility within a
predictable timeframe.
The intraday stop-loss for EMS is going to be set on a probability of it touching 1
standard deviation away from it current price. This would mean that there would only be
a 16% chance that the downward move to $40.32 is due to monthly noise fluctuation.
This is illustrated using a probability analysis chart as shown below:
With the intraday stop-loss being a standing order, a second stop loss used for
trend direction and capital gains preservation is also to be determined. This is not a
standing order. Instead it should be reviewed on an end-of-month basis.
This end-of-month stop order is a trailing stop that shall be placed on a monthly
basis if the price closes below the 10m EMA. This will preserve capital gains if a change
in trend occurs.
Determine Target
1
This timeframe also matches the price target timeframe.
2
" Emergency Medical Services Corp (NYSE: EMS)." Probability Chart. Emergency Medical Services
Corp (NYSE: EMS). Thinkorswim. Web. Nov. 2009. https://www.thinkorswim.com/tos/client/index.jsp
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Individual Term Paper: Systematic Value Investing Strategy
The target is not to be considered an expected return, but instead a point at which
new decisions must me made. The target is a point at which the stock has decisively
moved into a favorable position and not determined to be noise fluctuation. Once the
target is hit, the stop should then be moved to a risk free position. The first task for
determining a target is to set a time horizon. The time horizon chosen for this model is 2
months. As stated prior, this keeps volatility within a predictable timeframe.
The target for EMS is going to be set on a probability of it touching 1 standard
deviation away from it current price. This would mean that there would only be a 16%
chance that the move to $58.40 is due to daily noise fluctuation. This is illustrated using
a probability analysis chart as shown below:
While a buy and hold strategy could be implemented since fundamental analysis
was used in determining an appropriate stock, our objective is to minimize draw-downs
and match risk to the investor’s risk profile. In doing so, once the target of $58.40 is hit,
a standing post-trade2 stop-loss order should be placed at the trade order price of $47.81.
This preserves initial capital and creates a pseudo risk-free trade.
Like the initial trailing stop, the end-of-month stop order shall be placed on a
monthly basis if the price closes below the 10m EMA. This will preserve capital gains if
a change in trend occurs.
1
" Emergency Medical Services Corp (NYSE: EMS)." Probability Chart. Emergency Medical Services
Corp (NYSE: EMS). Thinkorswim. Web. Nov. 2009. https://www.thinkorswim.com/tos/client/index.jsp
2
This is not to be confused with the stop-loss orders set during the initial position opening. This position
voids those orders, as the target has been met.
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Individual Term Paper: Systematic Value Investing Strategy
Positions Sizing
Our objective in this section is to open a new long position in EMS. The main
“position sizing” task is broken down into three subtasks as illustrated below:
Determine Risk Tolerance Determine Portfolio Beta Determine Position Size
When devising the position size certain assumptions are made. This paper
assumes the following:
• That the portfolio performance will not be benchmarked1; instead it will adhere to
the investors risk tolerance profile.
• The investor is adding to a current portfolio.
• To preserve capital the investor will not place an initial position with a size
greater than 10% of the total portfolio.
• Available cash for investment equals $10,000.
• Once a position is opened, no rebalancing of the position shall take place to
maintain weights.
• The portfolio consists only of equities.
• Non-round lot sizes are acceptable
• The portfolio is not required to be fully invested.
• It will not use the Capital Asset Pricing Model (CAPM) to project expected
returns due to the unreliability of predicting expected market returns one year out.
1
The total U.S. stock market is used as a benchmark against risk, but not performance.
2
Betas are subjectively chosen using a judgmental system.
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Individual Term Paper: Systematic Value Investing Strategy
Desired Beta
Risk Tolerance Weighted Portfolio
Cash Only 0
Conservative 0.25
Moderate Conservative 0.50
Conservative Growth 0.80
Moderate Growth 1.00
Aggressive Growth 1.30
Table 3 (Risk Tolerance – Beta Weight)
Being that the objective of this paper is to add a position into an existing portfolio,
it will be assumed that such questionnaire has been assessed. The resulting assessment
will be that the investor is conservative growth with a desired beta of 0.80. This means
the investor wishes to be correlated with the market, but slightly less volatile.
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Individual Term Paper: Systematic Value Investing Strategy
By plugging this formula into the excel table and leaving EMS’ position at zero it
forces WEMS to be zero. This gives an initial portfolio beta of 0.86. Then the max
position size of $10,000 is entered for EMS’ size, which yields a portfolio beta of 0.78.
EMS’ size is then decreased in $1,000 increments to force the desired portfolio beta of
0.80. The resultant size for EMS is $8,000 with a weighted beta of 0.03. This also
1
See Appendix “G” for betas
2
($108,000 + $10,000) x 10% = $18,000
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Individual Term Paper: Systematic Value Investing Strategy
changes the weighted beta for each of the existing holdings since the portfolio size is now
$116,000.
Once a position size is determined, the required stock shares needed may be
calculated. This is performed by dividing the position size by the price per share. For
EMS it is as follows: $9,000 / $47.81 = 167.33 ≈ 167 shares.
In Summary
Using this strategy the value investor, with conservative growth tolerance, would
purchase 167 shares of Emergency Medical Services Corp (NYSE: EMS). The investor
would expect less volatility than the stock market as a whole and would be proactive in
managing risk. The investor should expect to lose a maximum of $1,250.831 if the
position goes completely against him. This would be an expected portfolio drawdown of
1%2.
1
$1,250.83 = ($47.81 - $40.32) x 167
2
1% = $1,250 / $116,000
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Individual Term Paper: Systematic Value Investing Strategy
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