Flying under the Radar investing. 4 of 5

Executive Summary Page:

“Flying under the Radar” – The sinking of the German ship Bismarck seventy years ago illustrates how low technology action can sometimes triumph over state-of-the-art technology that conventional wisdom believed to be “unsinkable”

Investment managers of 2010 trade millions of shares of stock in milliseconds many using state-of-the-art technology to predict how human thinking will react based on past trading experience.

As investment managers hire more smart people to quicken their programs to add profit, an undeniable change in the investment markets has befallen us since 2008.

Computer-driven trading applications, such as High Frequency Trading (HFT) render unprofitable a breathtaking number of investment strategies that had been profitable in the past.

While investors’ fear of such technology-based changes in the investment markets has led to their inaction, we exploit the notion that perhaps the physics-trained PhD’s may be misguided in their technological hubris.  We suggest while they are basking in the brilliance of their complex calculations imbedded in their algorithms they may be neglecting one item: focus improving risk-adjusted portfolio return.

A Eureka moment?

So as institutional money managers employing state-of-the-art trading programs and dark pools are contesting each other for multi-continental bragging rights, is it possible we could make money for our clients by sidestepping the maelstrom?  Only time will tell.  In the meantime, we use a 3-step approach.

First, out of sight out of mind

We sought investments with low trading volume.  If a security trades 100,000 trades per day, it is less likely to be traded by an institution’s algorithm’s appetite that requires, say, 1 million shares to be traded per second.

Second, try to stay safe by demonstrating uselessness to those that may do you harm.

We scouted for investments that performed horribly using standard mathematically-based timing systems.  Institutional investors should find these investments undesirable.  For example, we smiled upon finding an all-weather investment which performed better as a buy-and-hold versus being traded according to market timing system.

Third, cut them off at the pass.

Acknowledging investors are presently enamored with dividend stocks, we searched for investments that dividend-paying companies might eventually purchase to strengthen and/or boost their dividend paying potential: buying a company to use their cash flow as an immediate boost to its dividend-paying potential.

Drawbacks?  The cost of regular trading activity used in a “Flying under the radar” portfolio to minimize tax liability is negligible on larger portfolios.  However the trading costs can become punitive on smaller-sized portfolios.

Result: During the very unique market path from 2005 to 2010, the “Flying under the Radar” growth portfolio outperforms all major indexes over the timeframe tested; though the post-tax returns are somewhat less.    

This chart is not meant to suggest similar outperformance is guaranteed in the future.  Instead, it is a road-test of a portfolio during severe market turbulence measured against major market indexes (and with the benefit of hindsight’s 20/20 vision) the top-performing index over that timeframe – emerging markets.

One can almost gauge their appetite for risk from this illustration; more specifically the “Flying under the Radar” growth portfolio suffers a 34% setback during the 2007-2008 peak-to-trough.  Allocate accordingly.

 

Expanded Commentary:

“Sink the Bismarck” was a term coined seventy years ago after the German battleship Bismarck was unleashed against British vessels in the Atlantic Ocean.  The world watched in fear as the Bismarck, only five days into its voyage, needed only five shots to sink the 41,000 ton British flagship H.M.S. Hood in three minutes.

A fortnight later with nearly the entire British navy in pursuit, the Bismarck prepared for its next fight, a fight it was prepared to win using state-of-the-art science and technology incorporated into the ship by German designers and scientists; technology more advanced than anything any navy had ever possessed.

Still jubilant over the sinking the British Hood is it any wonder that as German naval officers anxiously prepared their war machine to send the rest of the British navy to the bottom of the Atlantic Ocean.  Yet the German designers’ forecasts were doomed.  The Bismarck design was prepared based on forecasts to fight British aircraft flying at 400 miles per hour at 5,000 feet in the air; only the fastest aircraft would dare attack the Bismarck.  The German designers obedient to the planning forecasts dutifully protected the Bismarck with weapons to obliterate such an aerial foe.

Conventional wisdom proves inaccurate

Bismarck’s advanced design allowed for it to make quick work of destroying the best British aircraft during an attack.  But the German did not expect to fight the “worst” British aircraft.  For the aircraft attacking the Bismarck on that fateful day flew too slow to be destroyed by the German guns which fired at a rate to hit enemy planes flying at 400 mph.  Moreover, the Bismarck’s guns were unable to depress to fire on planes flying at wave-top levels, the forecasts assumed the attacking aircraft would descend from several thousand feet.

So it was.  One torpedo dropped from a slow, low-flying British “Swordfish” aircraft paralyzed the mighty Bismarck by disabling its rudder and thus sealing Bismarck’s fate.

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