This week we will cover an important topic that is not well understood by many subscribers: the important role of the Market Trend in the StockPointer® Canadian Equity Model Portfolio Strategy. You can access the Market Trend by clicking on the left menu of the Inovestor Platform. In a nutshell, the Market Trend is our in-house sector allocation based on the top 100 economic profit performers from the performance index. This ratio is calculated as the Return on Capital divided by the Cost of Capital (ROC/COC). When this ratio is above 1, it means the company is generating wealth for its shareholders.
The best way to understand the construction of the Market Trend is with an example. As of July 2018, the Market Trend recommends investing 19% in the Consumer Discretionary sector. Why 19%? Because literally 19 companies out of the best 100 EVA companies are in that sector. With that in mind, if we need 19% in Consumer Discretionary and we have a portfolio of 25 stocks with a theoretical weight of 4% in each, this means we should own approximately 5 stocks in that sector. That’s exactly what we have in the portfolio right now as we are holding these stocks: CTC.A, DOL, GIL, LNR and MG.
The graph below shows how the sector allocation changed over the last 3 years. What’s interesting is the largest sectors differ significantly from the S&P/TSX. By calculating a median on the sector weights for the last decade, we discover the Market Trend tends to favor Financial (24%), Discretionary (19%) and Industrials (13%) while the S&P/TSX’s largest sectors are Financials (34%), Energy (25%) and Materials (14%). Those last two are among the lowest weights in the Market Trend because the high capital expenditures often translate to low economic profit in a low-priced commodities environment.
A neat feature of the Market Trend is that you can click each of the sectors in the chart legend and it will show you an individual graph for the sector. Please note the Market Trend still includes Real Estate in Financials. When we rebalance the strategy on a quarterly basis, we only consider the values shown on the pie chart, which are the current recommended weights by the Market Trend. For example, as we are writing this article the current weight in Industrials is 16%. Some subscribers make the mistake of taking the last bar of the Market Trend graph, which is 14% for Industrials, but that is last month’s data.
Why is the Market Trend so important? Since we launched the Strategy in April 2008, we determined the sector allocation is responsible for half of the Strategy’s outperformance. As seen in the graph below, the Strategy generated an annualized return of 12.1% vs 4.8% for its benchmark. If we invested in the broad sectors recommended by the Market Trend without picking any stocks, it would have made an annualized return of 8.4%. In other words, 3.6% alpha is created by the sector allocation (8.4%-4.8%) while 3.7% alpha is created by the stock picking (12.1%-8.4%).
In conclusion, by including the Market Trend in the investment process, we added a statistically significant amount of alpha over the S&P/TSX TR. This sometimes comes at a price of slightly higher portfolio turnover. For example, we bought Enghouse (ENGH) on Q1 2018 based on a Market Trend change and we sold the same stock three months later because the Market Trend favored another sector allocation. Fortunately, in this case, ENGH appreciated as much as 13% in a short time span and we were able to sell high. ENGH is still a good stock with a high SPscore but we had to seize a better opportunity in another sector. After all, history proved us that the Market Trend is your friend.