ADAPTIVE PORTFOLIO THEORY

THE ASTUTE INVESTOR’S GUIDE TO SUCCESSFUL PORTFOLIO MANAGEMENT Fundamental  Technical  Economic  Diversification  System Control Asset Allocation  Risk  Long/Short Exposure A presentation by:

Registered Investment Adviser www.libertyanalytics.co.cc/mws/Welcome.html

ADAPTIVE PORTFOLIO THEORY
Why should investors manage portfolios with adaptive outlooks and strategies? Markets themselves are not linear and go through secular and cyclical bull and bear phases. A brief look at stock market history can reasonably explain:

The Case For Adapting Strategies
The previous two charts display how decade+ long time frames can produce little return for investors who simply buy and hold. These long consolidation periods do present opportunities for investors with enough flexibility and open mindedness Determining the degree and type of trend is critical in the adaptive investor’s strategies for investment allocation and time-preference

Tools Of The Trade In Portfolio Management
 Fundamental Analysis  Technical Analysis   Austrian Economic Theory, Wave Theory   Economic, Social, Market & Political History   Risk Management Of Trading, Exposure, Losses & Emotions   Managing Long/Short Portfolios

The Objective of Fundamental Analysis
Fundamental analysis has its most comfortable use in finding attractive long-term securities for investment. The fundamentalist builds a quality investment framework:   Price to value relationships   Competitive advantages and growth catalysts   Quality of financials and management   Expectations of return i.e. dividends and earnings Qualifying investments will satisfy all points of the framework

Fundamental Analysis

Disciplined “Guidelines” For Attractive Common Stocks

Determining Value For Individual Stocks
Abnormal Earnings Growth Model (AEG) Present Value (PV) of discounted earnings forecasts n years into the future and capitalized to arrive at value. Value = Step 1 (AEG): [Earn1 – Earn-1*(1+WACC)] + [Earn2 – Earn-2*(1+WACC)] + … … + [Earnn – Earnn-1*(1+WACC)] Step 2 (PV of AEG): sum of AEGn discounted by 1+ WACCn Step 3 (capitalization): M * [Sum of Earn1 + PV of AEG]   M = Capitalization factor i.e. 10x or 12x   Earnn = Earnings in year 1,2,3…n   WACC = Weighted Average Cost of Capital

Dividends – The Tangible Return On Investment
Dividends are an important source of returns, especially in range bound markets. Forecasting dividends vs. assumed capital loss scenarios can help determine risk / reward during market downturns (absolute returns). Estimated Return: = Initial Investment + (D1 + D2 +D3 +D4 +D5) – Assumed Capital Loss = Total Return The assumed capital loss tests different loss severity scenarios (10%, 20%, etc.), a break even point would prove insightful. Positive total returns in the face of capital losses make attractive long term investments. “Dn” should be discounted by expected inflation rates.

Quality Framework Example: TD Ameritrade (AMTD)
Growth Catalysts:   2007 – 20?? Fallout/dislocation from top Wall Street investment banks   Industry transition from commission based representatives to fee based RIA’s   Growing need for private retirement planning as the trust in social security dwindles as a source of retirement – asset gathering model   Increased availability of the internet, growing independence and knowledge of retail investors, and increased availability of information   Transaction revenues increase during volatile markets; asset based revenues increase during bull markets

Quality Framework Example: TD Ameritrade (AMTD)
Competitive Advantages: History of successful industry specific M&A activity – TD Waterhouse, Fiserv, Think or Swim, Datek, My Discount Broker, Brokerage America & JB Oxford Niche in the “active trader” and “mass-affluent investor” market with easy to find research and plentiful trading tools1 2008 Smart Money Survey Recent trend indicating growth is more organic based than M&A based. ROCA highest among competitors.

Quality Framework Example: TD Ameritrade (AMTD)
Forecasts (next slide):
Forecast Scenario 1 Future 4 yr EPV assuming $60bln NNA (Net New Assets), 0.25% FFR (Fed Funds Rate), 850 S&P 500 and a 40bps ROCA (Return on Client Assets)

Forecast Scenario 2 – Future 4 yr EPV assuming $60bln NNA, 2% FFR and 1,000 S&P 500, and a 45bps ROCA

Quality Framework Example: TD Ameritrade (AMTD)
Less optimistic forecast of earnings: Forecast 1

More optimistic forecast of earnings: Forecast 2

Quality Framework Example: TD Ameritrade (AMTD)

Quality Framework Example: TD Ameritrade (AMTD)
Key Metrics: Net New Assets (NNA) – annualized 11% growth in NNA, 77% of NNA are organic (not a result of dislocation on Wall Street) Trades Per Day (TPD) - #1 in trades per day measured against E*Trade, Charles Schwab, Fidelity Investments & Options Express Total Client Assets & Return on Client Assets (ROCA): - A pro-cyclical measure, capturing added profitability from NNA, Dividend and interest inflows & Multiple expansion/contraction. Spread Based Assets – Interest differential earned in securities borrowing and lending. Impaired when FFR are too high or low.

Quality Framework Example: TD Ameritrade (AMTD)
Relative Valuation to Competitors:

Quality Framework Example: TD Ameritrade (AMTD)
Relative Value to Broader Markets:

Quality Framework Example: TD Ameritrade (AMTD)
TD Ameritrade Summary:   Quality growth, growing business model, competitive position & strong balance sheet   Relative value between $10 - $12; Absolute value considerably higher when economic conditions improve.   Strong future earning potential, no indication of paying dividends Final Conclusion: Bull Market Buy:  - Good earning & multiple expansion potential Range Bound Market Buy:  - No tangible return for holding through cyclical bulls & bears I.e. dividends% Range Bound Market Trade:  - Consistent earning power should be rewarded during cyclical upturns; trade with the primary trend %

Technical Analysis
  Elliott Wave Theory
  Primary & Alternative Counts   Long Term View of Large Degree

  Trend Lines, Support & Resistance

Elliott Wave Theory – Long Term Chart Of Large Degree

Elliott Wave Theory – Primary Count

Elliott Wave – The Bearish Alternative Count

Elliott Wave – The Bullish Alternative Count

Other Technical Measures

Other Technical Measures

Humana Inc – The Case For Bonds
$500,000,000 Initial principal @ 6.45% interest (semi-annual) senior notes due 6/01/2016. The notes are unsecured and rank equal with other senior unsecured notes (including future notes). They rank junior only to the senior secured outstanding notes (or future) of the operating subsidiaries. As of 3/31/2006, there were only $3,500,000 of senior secured notes. The proceeds were used to pay down $200,000,000 of the outstanding balance of credit facility @ 5.60% and to be used towards the 8/2006 maturity of 7.25% senior notes due. Optional Redemption: The notes may be redeemed at any time in whole or in part at a price equal to the greater of 100% of the principal amount to be redeemed and the sum of the present values of the remaining scheduled payments on the notes to be redeemed consisting of principal and interest, exclusive of interest accrued to the date of redemption, discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the applicable Treasury Yield plus 30 basis points plus accrued interest to the date of redemption. All issues of covenants, liens, and voting matters will not be discussed here in depth. However, the company may not change principal amounts, interest rates or payment dates, legal rights or senior status without vote of the note holders. The above information was taken from the prospectus and prospectus supplement dated 3/31/2006.

Humana Inc – The Case For Bonds

Humana Inc – The Case For Bonds
Of most significance to interested bondholders are three items: 1. EBIT / Interest Expense is very high, currently 13.37 and in past record 11.73 (2005). 2. Working Capital / Debt is 1.10. The company has adequate resource to pay off debt without incurring any fixed asset sales and with high liquidity. 3. The 3 year average performance of the common stock has been poor at -14.6% (as is the case in this major bear market with most common issues). Yet the common market value trades at a multiple of 1.77x that of the debt, a reassuring sense of confidence in the health of the company. Given the fact working capital has adequate coverage of total debt, in depth analysis of expected real market value of tangible assets is not significantly important. Duration is intermediate with low probability (in this author's opinion) of significant increases in interest rates within the time frame of maturity. Looming are massive health care reforms at the national level that could materially impact Humana's top and bottom lines. The probability of this occurring remains unknown as well as specific details of a plan. Investors should view these intermediate term Humana bonds as attractive investment grade securities with a wide EBIT/interest expense margin of safety. As of 7/7/2009 the bonds traded at around 90 cents on the dollar. All three nationally recognized rating agencies have rated the bonds at the lowest tier of investment grade.

Economics – The Dismal Science
  Kondratieff Wave Cycle Theory   Austrian Economic Theory

Kondratieff Cycle
An economic cycle theory outlining four distinct phases of production and consumption –
“During periods of relatively cheap prices, assets accumulate. As prices increase, the consumption of assets are necessary to maintain a standard of living. When new production fails to keep up with consumption, due to relatively high prices, the economy begins to decline to another period of cheap prices, and a new growth cycle begins.”

•  Spring – Beneficial Inflationary Growth Phase •  Summer – Stagflation (recession) •  Autumn – Disinflationary Growth Phase (plateau) •  Winter – Deflationary Depression

Kondratieff Cycle

Kondratieff Waves in the US

Austrian Economics: The Monetary or Circulation Credit Theory of the Trade Cycle
The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. Mises, Ludwig Von. “Human Action” pg. 572

Austrian Economics:
Money Proper Inflation:

Inflation vs. Credit Inflation

Let us assume that a government of an isolated country issues additional paper money in order to pay doles to the citizens of moderate income. … there will be no tendency of the monetary unit’s purchasing power to return to the state of the pre-inflation period. The structure of prices will be lastingly affected by the inflationary venture if the government does not withdraw from the market the additional quantity of paper money it has injected in the shape of subsidies.

Credit Inflation:
Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion goes on at an accelerated pace. a sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

Austrian Economics:

Deflation & Credit Contraction

1.  A government aiming at deflation floats a loan and destroys the paper money borrowed. Such a procedure has been, in the last two hundred years, adopted again and again. The idea was to raise, after a prolonged period of inflationary policy, the national monetary unit to its previous metallic parity. (under a gold standard, exchange or fixed regime currency) 2.  Banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit. 3.  The crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.   Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation.   Prices of the factors of production— both material and human—have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.

Portfolio Management
  Trade & Risk Management   Asset Allocation & Diversification   Long/Short Exposure

Trade Management
Trailing Stop Loss   To be implemented once a position is considered to be “greatly overvalued” and downside momentum possibility becomes a greater risk than to the upside or long term fundamentals no longer warrant investment .   Frees the decision from pesky emotions and locks in profits where made   The percentage adjustment to lock in profits should be determined by analysis of the overall market trend, prevailing sentiment, and expectations for the future

Trade Management
Buy Limit Orders   Removes emotions from the buy process, allowing investors to enter at “comfortable” prices   Though disciplined, can fall victim to the value trap   More useful in bull markets during corrections than in bear markets

A Note On Risk Taking
There Lies Five Main Forms of Risk For Investors:

1.  The Risk Of Loss 2.  The Risk Of “Missing Out” 3.  Sector/Industry Risk 4.  Market Risk 5.  Fundamental Risk

Balance is the key to managing these risks, since chasing higher returns or not “missing out” can increase the risk of loss.

Asset Allocation & Diversification
Guided by:   “Flation” expectations   Price to value relationships of individual securities & across broad sectors   Technical trend patterns and sentiment   Individual positions & portfolio correlation to benchmarks & SPY should be kept low for true diversification. Example: 10 Yr Treasury vs S&P 500

Investing & Inflation

Managing Net Exposure
To control the risk of loss from market and sector risks, a long/ short portfolio should be maintained on a net dollar basis
  Long   Neutral   Short

A pairs trade can be created using an attractive “undervalued” stock with a comparable sector/industry ETF that is indicated as relatively “overvalued”. A neutral pair would have equal dollar amounts on both the long stock and short ETF. General market trend/valuation expectations and economic outlooks should guide net exposure (of net long/neutral or net short)

Advisors for Advisors
  Michael “Mish” Shedlock – Sitka Pacific Capital   David Rosenberg – Gluskin Sheff & Associates   Bob Hoye – Institutional Advisors   Tim Wood – Cycles News & Views   David Einhorn – Greenlight Capital   Robert Prechter – Elliott Wave International   John Mauldin – Outside The Box   Hugh Hendry – Eclectica Asset Management   Vitaly Katselnelson – Investment Management Associates, Inc.   Barry Ritholtz – Fusion IQ   Tyler Durden – Zero Hedge   Joe Saluzzi – Themis Trading   Bill King – The King Report   Steve Keen - Economist

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