By Minyi Chen and Charles Biderman
TrimTabs Asset Management
Portfolio Managers of AdvisorShares TrimTabs Float Shrink ETF (TTFS)
PREFACE
More than 1,000 exchange-traded funds are available in the market today. So why did we create another one? TrimTabs Investment Research has been providing research on stock market liquidity to professional investors for more than 20 years. We have been asked many times for a product available to all investors, not just professionals. The TrimTabs Float Shrink ETF (TTFS) is our response to these appeals.
The fund offers a unique approach to gaining exposure to the broad U.S. stock market. It invests in stocks with liquidity and fundamental characteristics that are historically associated with superior long-term performance. Stock selection for the fund is based on extensive historical research by TrimTabs.
Most fundamental investment approaches, such as the discounted cash flow method, attempt to calculate a company’s intrinsic value. Investors attempt to exploit discrepancies between intrinsic value and the market value. The problem with these approaches is that it is impossible to know exactly what intrinsic value is.
Instead of guessing about intrinsic value, we contend that the prices of stocks, like the prices of other tradable goods, are set by the underlying conditions of supply and demand. This study introduces investors and advisors to our strategy. This paper provides:
- An overview of our liquidity-based investment approach.
- The metrics we use to seek excess returns in an environment in which investors suffer from long-term dilution and low dividend yields.
- The reasons we use an equal-weighted strategy rather than a market-cap weighted strategy.
OVERVIEW OF LIQUIDITY THEORY
Liquidity theory offers an alternative to traditional fundamental stock-selection strategies. Taking its cue from basic supply and demand, it holds that if the same amount of money is chasing a smaller amount of shares, the share price should increase, all else being equal.
As shown in Chart 1, L1 is Liquidity Indicator 1 (supply indicator), and L2 is Liquidity Indicator 2 (demand indicator). TrimTabs developed these indicators to measure supply and demand in the equity market. If demand (flows) stays the same and the supply (float) shrinks, the stock price should rise.
Top insiders at a firm know more about its fundamentals than the general public, and these insiders can influence the price of their employers’ shares by timing equity issuance and stock buybacks to their advantage. But focusing solely on stock buybacks can be problematic. Companies can always borrow money to repurchase shares or issue new shares after completing share repurchases. Our liquidity-based strategy uses three criteria to increase the robustness of our approach:
- Float shrink: We want to invest in companies that reduce their float over time. Most companies shrink the float through stock buybacks, but companies can also reduce the float by taking other actions, such as reverse stock splits or spin-offs.
- Free cash flow: We want to invest in companies that shrink the float because their underlying business is profitable, not because they are divesting assets.
- Leverage: We do not want to invest in companies that simply swap equity for debt. Such exchanges do not add real value because the risk of equity capital rises when the proportion of debt capital grows.
We combine the three criteria—float shrink, free cash flow growth, and change in leverage—into a single liquidity score that we assign to members of the Russell 3000 Index, a benchmark representing approximately 98% of the investable U.S. equity market.
MERITS OF FLOAT SHRINK-FOCUSED STRATEGY
There are many instances when companies do not dilute shareholders but benefit shareholders by shrinking the float through share repurchases. Our actively managed strategy seeks to exploit such situations by investing in companies that are shrinking the float without increasing their leverage. We seek to generate excess returns over long periods while providing investors with constant exposure to the equity market.
There are two fundamental trends in the U.S. equity market that make a float shrink-based strategy attractive. First, public offerings of shares and options that convert to shares dilute shareholders over time. According to research by Research Affiliates in April 2011, half of today’s shares did not exist 50 years ago. Entrepreneurial capitalism dilutes shareholders by about 2% per year over long periods as new enterprises are created. Since the Great Depression, the average annual real Gross Domestic Product (GDP) growth rate exceeded 3.2% in the six decades from the 1940s through the 1990s, and the S&P 500 Index had positive returns in all six decades. Only in the 1930s and 2000s—when average annual real GDP growth fell to 1.3% and 1.7%, respectively—did the S&P 500 Index have a negative return. This data suggests that secular bull markets occur when the economy expands faster than the float and a secular bear markets occur when the float expands faster than the economy.
Second, U.S. companies are spending more on stock repurchases than on dividends. As Chart 2 shows, spending on buybacks grew from about $30 billion per quarter in 1998 to about $120 billion per quarter in 2011. In this period, buybacks rose an average of 17.4% per year, while dividends rose an average of just 4.4% per year. As Chart 3 shows, from 1998 through 2004, S&P 500 companies spent about $1 trillion each on dividends and buybacks. From 2005 through September 30, 2011, they spent $1.5 trillion on dividends and $2.5 trillion on buybacks.
Finally, free cash flow is growing much more rapidly than dividends. As Chart 4 shows, the dividend yield of the S&P 500 is 2.1%, which is almost the same as it was at the beginning of 2008. Yet the free cash flow yield tripled from 2.4% in 1998 to 7.6% in 2011. What did companies do with their growing free cash flow? They used much of it to repurchase shares. Announced buybacks rose to $485 billion in 2011, up from $130 billion in 2009 and $357 billion in 2010.
We publish various metrics of our portfolio—including float shrink and free cash flow yield—and compare them to those of the Russell 3000 Index on a monthly basis (See http://ttfs.advisorshares.com.)
LIQUIDITY-BASED EQUAL-WEIGHTED INVESTING
We gather all the information necessary to compute the three liquidity criteria for members of the Russell 3000 Index on a daily basis. We exclude stocks that lack sufficient data to calculate the criteria. For instance, we cannot calculate float shrink or free cash flow growth for newly listed companies.
Once we convert the criteria into a combined liquidity score, we rank all Russell 3000 Index members from the highest score to the lowest. Then we remove stocks with low trading volumes or high bid/ask spreads. Finally, we allocate our capital equally to each of the 100 companies that we select from the ones in the top 5% of Russell 3000 Index companies by combined liquidity score.
We use an equal-weighted portfolio because we believe it will enable us to deliver excess returns over the Russell 3000 Index. A small number of very large companies often dominate a market cap-weighted portfolio. For example, just 15% of the companies in the Russell 3000 Index account for 80% of the market capitalization of the Russell 3000 Index. A market-cap weighted portfolio tends to overweight overvalued components and underweight undervalued components. By contrast, an equal-weighted portfolio takes profits on outperforming components and reinvests in underperforming components as the portfolio manager regularly rebalances back to equal weight. According to research by Standard & Poor’s in July 2010, the S&P Equal Weight Indices have outperformed their market cap-weighted equivalents in the long run, as the differing weighting and rebalancing processes being the major source of outperformance.
Relative to market cap-weighted indices, equal-weighted indices will be underweight a few larger stocks and overweight a large number of smaller stocks. To control the risk of overweighting small cap securities, we strive to maintain the portfolio beta as close to 1 possible through active stock selection.
CONCLUSION
Our liquidity-based strategy provides an alternative for investors who believe that market cap-weighted index strategies and strictly fundamental strategies are sub-optimal. By investing in companies that shrink the float while growing free cash flow at a healthy pace and not increasing their leverage, investors are essentially investing along with the people who possess the best knowledge of their companies. They are also minimizing their exposure to stock market dilution, which will probably continue as entrepreneurial capitalism leads to the formation of new companies. Our approach, which aims to exploit the advantageous disequilibrium of supply and demand, offers potential benefits to investors.
EXPLANATORY NOTES
The Russell 3000 Index measures the performance (including the returns from reinvested dividends) of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held com¬mon stocks. One cannot invest directly in an index. Beta is measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Before investing, you should carefully consider the Fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.advisorshares.com. Please read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.
There is no guarantee that the Fund will achieve its investment objective. An investment in the Fund is subject to risk, including the possible loss of principal amount invested. Other Fund risks include market risk, equity risk, large-, mid-, and small-cap risk, liquidity risk, and trading risk. Newly organized, the Fund has a brief trading history, and there can be no assur¬ance that active trading markets will be developed or maintained.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.