Saturday, February 17, 2018

Paranoid Android: Artificial Intelligence in your Portfolio

In the 2014 Sci-Fi mystery movie "Ex Machina", Stanley Kubrick's film"A.I.Artificial Intelligence", and the HBO television series "Westworld", humans are having sex with robots. Although we haven't quite reached that juncture in evolution, the proliferation of Artificial Intelligence is everywhere including your stock portfolio. It's so pervasive now that saying you have A.I. in your investments is like saying you've got corn in your Cornflakes. Digirarti guru Mark Cuban believes technological advancement in the next ten years will be swifter than the last thirty years with A.I. being one of the main catalysts.

(click to enlarge)

Since late 2017, financial Websites have been inundated with articles about Artificial Intelligence pureplays, suggesting single stock selections to goose your investment portfolios. Although you will occasionally find a semiconductor equity such as Nvidia (NVDA) included, business writers primarily suggest the FANG stocks. FANG is an acronym CNBC's Jim Cramer coined in the past two years that stands for Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google (GOOG) (now known at Alphabet). The term recently morphed into FAAANG to include Apple (AAPL) and Alibaba (BABA). With the exception of Apple, all are Internet stocks.

I've written ad nauseam about my personal preference of investing in plain vanilla S&P 500 or Total Market index ETFs, but sector ETFs are an option for investors wanting to generate alpha in their portfolios. Even with elevated expense ratios, these niche ETFs can boost your overall returns if, and only if, you catch them at the right time. They primarily come in two flavors, passively managed Internet ETFs issued by mid tier ETF companies and A.I. specific funds from boutique financial firms.

Internet ETFs

Liquidity and longevity are two critical ingredients when selecting subsector ETFs. In the Internet space, First Trust Dow Jones Internet Index Fund (FDN) and PowerShares NASDAQ Internet Portfolio (PNQI) are the two largest with track records going back at least a decade. In fact, since the market crash of 2008-2009, they are two of the best performing ETFs in the financial universe. Domestically focused FDN is the preferred investment vehicle for traders because of its liquidity, but PNQI has performed equally as well with an international leaning. FDN has 9 times the daily volume as PNQI. Expense ratios for both are steep, 0.54% for FDN and 0.60% for PNQI.

Nevertheless, with market-cap-weighted holdings greatly exposed to the FANG stocks, both ETFs have kicked in the afterburners where performance is concerned. Average gains are roughly 23% per year the past five years outpacing the S&P 500. Besides the liquidity, the big difference between the two funds are geographic allocation and number of holdings. PNQI includes overseas equities with a significant exposure to Chinese Internet companies with the exception of Alibaba. The exclusion of Alibaba continues to perplex me, but organizations like Baidu (BIDU) and JD.com (JD) are under its umbrella. Another heavy hitter in the fold is British travel company Priceline Group (PCLN). PNQI holds 88 securities, over double the amount as FDN.

A.I. ETFs

  • Global X Robotics & Artificial Intelligence ETF (BOTZ): News travels fast in the financial world. BOTZ had its inception date on 9/12/16, and in a short period of time, it became one of the best non-leveraged ETFs of 2017 gaining 49%. Some of this performance may have to do with an overweight position in Nvidia which constitutes almost 10% of holdings. With only 28 stocks, it's a concentrated portfolio, but that hasn't stopped speculators from bidding it up. Like all of these specialty ETFs, the expense ratio is high, 0.68%. No FANG stocks in its top 10 holdings, so you're getting more of a robotics story here.
  • ROBO Global Robotics and Automation Index ETF (ROBO): ROBO has been trading three years longer than BOTZ, but has a much higher expense ratio of 0.95%. You expect some alpha generation with those fees, and although it gained 36% last year, it pales compared to the performance of BOTZ. ROBO holds 89 equities which gives you some global diversification. Like its brother BOTZ, there is not a lot of liquidity with this fund, so you are best suited to use limit orders. The top holding only constitutes 2% of the portfolio.
  • ARK Industrial Innovation ETF (ARKQ): ARKQ is another high flyer from 2017 gaining approximately 45%. It's also another low volume, lofty expense ratio ETF charging 0.75% annually. International in scope and actively managed, I found it interesting that Tesla (TSLA) comprised almost 10% of the portfolio of 43 equities. Inception date was 9/30/14, so it's got some history behind it, but don't confuse brains with a bull market. There are thousands of ETFs issued worldwide and any significant downturn in the market could put any of these thematic ETFs in jeopardy.

Conclusion

An oligopoly has formed in the A.I. arena. The same Internet companies we've come to depend on for our everyday technology needs devour smaller startups. The Google and Amazon of 15 years ago are no longer mom and pop shops. They are the IBM and AT&T of the 1950's, if not the Standard Oil of New Jersey in 1900. The Gilded Age redux. That is why if I were to purchase an Artificial Intelligence ETF, I would select either PNQI or FDN with heavier leanings toward the Internet. Unless the European Union or the United States Government breaks them up, there is plenty of room to run.

FDN receives my most favored nation status only because of its relatively high volume. In an up-to-the-second connected world, PNQI, BOTZ, ROBO and ARKQ may frustrate investors or traders with quotes delayed as much as 5-10 minutes. Sometimes as much as a half an hour. That is why I can't stress enough the importance of using limit orders. Although your broker can probably provide you with CFRA reports powered by S&P Global on these smaller exchange traded funds, I find ETF.com is the best source for statistical analytics. It's free. Just go to their Website and register.

Thursday, February 15, 2018

I Was Born at Night, But Not Last Night

Last week while surfing Seeking Alpha, I came across Bill Ackman's Pershing Square London Investor Meeting slide deck. What caught my attention wasn't the securities the renown hedge fund was buying or shorting, but the recent performance history of the company as compared the the S&P 500.

Year Pershing Square S&P 500
2013 9.6% 32.4%
2014 40.4% 13.7%
2015 (20.5%) 1.4%
2016 (13.5%) 11.9%
2017 (4.0%) 21.8%

Although Pershing Square trounced the S&P 500 by approximately 27% in 2014, the remaining years aren't even close with the S&P 500 shellacking the hedge fund. In fact, while 2013 and 2014 are a wash if you compare the index to Pershing Square, 2015-2017 shows the S&P 500 gaining roughly 35% compared to Bill Ackman's investments losing 38%. It's a 73% difference in performance for those three years. Small sample size? Yes, but we're in a bull market and these are the times when investors make money.

I don't mean to single Pershing Square out, but Bill Ackman puts himself in this position by making frequent television appearances on high profile business networks such as CNBC. His dust up with activist investor Carl Icahn on CNBC's Fast Money over Herbalife (HLF) was all the rage in the business press over a year ago. Mr. Icahn was buying shares of Herbalife while Mr. Ackman took a significant short position, calling the company a pyramid-scheme. The big story here wasn't the overall success or failures of their portfolios, but the pissing match they created on national television.

In a recent CNBC Fast Money segment, money manager Mario Gabelli of GAMCO Investors, defended Bill Ackman's poor performance stating that Ackman's company would be back after a rough patch. Gabelli also stated his own firm has 600 securities under management. That's closet indexing. Being the highest paid money manager on Wall Street, he has a vested interest to promote active management. These guys are thick as thieves.

In reality, when you're dealing with investments, the bottom line should always be performance. The majority of hedge funds have underperformed the market the past decade. Icahn Enterprises (IEP) may be an outlier only because it gained a whopping 154.83% in 2013. However, for the most part, the returns have been lackluster to negative for the past decade. If you put your money in Icahn Enterprises beginning in 2014, you're behind the eightball. According to multiple reports, hedge funds in total gained 8.5% in 2017 as opposed to 21.8% for the S&P 500, and that was the best performance year since 2013.

Anecdotally, in 2007 Warren Buffett bet one million dollars with asset managers Protégé Partners LLC that over a 10 year period, an index fund would outperform a basket of hedge funds, otherwise known as a fund of funds. Over the decade, the S&P 500 returned 7.1% compounded annually while Protégé Partners selections averaged 2.2%. Protégé Partners ponied up. Although the wager was for charity, you get my point. Mr. Buffett has long promoted the use of index funds for individual investors. In his 2013 annual Letter to Shareholders, he stated that he would allocate 90% of his fortune bestowed to his wife in S&P 500 index investments. That's a big time endorsement.

I expect more from the high costs associated with these well heeled money managers. Hedge Fund Research reports the average hedge fund management fee is 1.45% of assets. Pershing Square charges clients 1.5%. I'd rather be in an S&P 500 index fund such as the iShares Core S&P 500 ETF (IVV) which charges 0.04%. That's $4 for every $10,000 invested. SPDR S&P 500 ETF Trust (SPY) has an expense ratio 5 basis points higher than the lowest priced S&P 500 index trackers, but you're paying for liquidity and it's still much less expensive than an actively managed fund.

With the expense wars heating up between ETF providers, you can find ETFs with smaller expense ratios than iShares Core S&P 500 ETF. The SPDR Portfolio Total Market ETF (SPTM), which includes over 3,000 domestic equities, has an expense ratio of 0.03%. Many sources in the business press have reported about the ongoing ETF expense ratio reductions. Some are speculating that some index funds holding fees will drop to zero within the next few years to enable management firms such as Vanguard, Blackrock and State Street Global Investors to commandeer your assets.

Standing in the Shadows of Love

Damon Runyon once said: "The race is not always to the swift, nor the battle to the strong, but that's the way to bet.". That pearl of wisdom may have been true in an era before the proliferation of high frequency trading and computer algorithms, but now that we are in the age of artificial intelligence, the turtle, not the hare appears to be the smarter way to wager - at least in the long run. Don't take my word for it, just examine the statistics. Sabermetrics is not only confined to baseball. Big Data in the investing industry is current and prevalent. There are many excellent books up-to-date and available that prove this thesis.

In the mid 1970's, Charles Ellis wrote a research paper that later morphed into his pioneering passive investing book "Winning the Loser's Game". I read it years ago and recommend the most recent edition as a starting point. However, during the past six months there are two books I've read that are fresher in my memory. The first is "The Incredible Shrinking Alpha" by Larry Swedroe and Larry Berkin. It's like a pamphlet, but well worth the price of admission. The second is the 10th anniversary edition on John Bogle's "The Little Book of Common Sense Investing". If you are new to investing, they are eye openers.

Although the debate over active vs. passive investing rages on, it's passive indexing that trounces active managers once you remove fees and expenses from the equation. That is the overarching theme in the three books I have just recommended. This is especially true in a computerized stock market. Trust me, you're not faster than a bot. "Everyone is entitled to his own opinion, but not his own facts.". That old political chestnut by Daniel P. Moynihan was prescient in a time before being inundated by artificial intelligence from Google, Facebook, Amazon and Apple. Ego has no amigo in the investing world. Just follow the facts.

Sunday, October 18, 2015

Kicking the Tires on GoPro

For the past year and a half, the financial blogosphere has been inundated with posts touting the pros and cons of GoPro (GPRO). There's never been too much of an argument as to the quality of their high definition camcorders - very popular with millennial daredevils and outdoor enthusiasts. However, the perception that GoPro is more than a one-trick pony was greatly distorted in its first few months as a public company which caused it to accelerate to the upside.

Originally, traders bid the stock up with the expectation GoPro would build a media company with original content created with GoPro camcorders. You probably remember the catch phrase "content is king" back in the late 90's. Unfortunately, it couldn't supplant the 800 pound gorilla in the space, Alphabet's (GOOG) YouTube. Although GoPro has a very successful channel on YouTube, it doesn't generate enough revenues to command the lofty valuation it once did.

The stock got as high as $100 during its first few months of trading, only to come crashing down to $28, roughly $4 above the IPO price of $24. Almost a round trip ticket.

Examine the chart below:

Source: Stock Charts

The extreme decline in share value may be a tantalizing entry point for some investors, especially if they're familiar with GoPro's products. However, there's a 30% short float on the equity, so many traders believe the stock has more room to go to the downside.

I've read arguments that there is potential for quick profits for GoPro bulls with the advent of a short squeeze, and this may be true, but not at this juncture in my opinion. I tend to side with the shorts and think that although there is a future for this company, whether as a stand alone entity or part of a larger conglomerate, the next quarter will be tepid. The next earnings call is scheduled for October 28th, and I'm waiting for company results at this time before I put any money to work, if at all.

Short Term Bear Thesis

  • High Definition semiconductor manufacturer Ambarella (AMBA) warned that Q3 would be flat in their last conference call. Ambarella is GoPro's primary chip supplier. Although this news caused GoPro to sell off significantly, the damage may not be done.
  • No wide moat. Although GoPro has great brand recognition in the United States and is doing well internationally, in China it's rival Xiaomi that may have a leg up. Not only are Xiaomi camcorders significantly less expensive than GoPro's products, but there's that old adage "charity begins at home". There's no guarantee GoPro's Hero series of action cameras will supplant Xiaomi products in Asia.
  • Oversaturation. GoPro has been around for years. Those that want the cameras probably already own them. Although they make for great stocking stuffers, that's a Q4 phenomenon.
  • Smartphone cameras are improving. Although you don't want to take your iPhone or Android device scuba diving, the quality of still and motion pictures on smartphones is improving which may temper sales to mainstream buyers. As an example, the recently released Session model aimed at mainstream users was met with tepid reception, resulting in GoPro reducing the price by $100.
  • Government regulation. Quadcopter is GoPro's foray into the drone market, and is scheduled to be released in the first half of 2016. Wall Street is a forward looking mechanism and potential sales of Quadcopter may be buoying current share price of $28. I think the drone market will be regulated in the near term, and may put pressure on sales, which in turn will decrease earnings.
  • Virtual reality is an evolution, not a revolution. Odyssey, GoPro's 16 camera array that captures action in 360 degrees will surely be a hit, but not until VR technology becomes more suitable for the mass market. As is, we're still in the pioneering phase of VR rollout. Odyssey will not contribute meaningfully to the top or bottom lines for a few years.
  • Analyst downgrades. Piper Jaffray recently cut GoPro's price target from $54 to $25. More brokerage firms may follow suit as the company's financial niche transitions from entertainment entity to hardware manufacturer. Valuation metrics should be in the same ballpark as a Garmin (GRMN) or an Apple (AAPL).

Long Term Bull Thesis

  • Quality. GoPro cameras are the best products on the market. The editing software is improving, too.
  • Brand recognition. GoPro cameras are synonymous with "must have" with the Millennials. This is true both domestically and in Europe. If they command a certain cachet in Asia, this could propel revenues to the upside.
  • Expanding markets. If drone technology doesn't get regulated to extreme levels, and Virtual Reality becomes more user friendly, GoPro will have additional revenue streams to build on.
  • Great distribution. Over 40,000 retail outlets sell GoPro camera. If you want to buy one, there shouldn't be a problem.
  • Well run company. GoPro is profitable and has very little debt.

Valuation

The sentiment on Wall Street has soured on GoPro because it is no longer considered a media company. Analysts are valuing it as a hardware stock now. Let's compare some statistics between GoPro and Apple, another hardware company and see how it stacks up.

GoPro Apple
Price/Sales 2.23 2.84
Price/Book 4.84 5.08
Return on Equity 41.58% 41.15%
Estimated earnings growth this year 28.80% 41.60%
Trailing P/E 25.53 12.84
Estimated earnings growth next year 15.30% 7.30%
Forward P/E 14.55 11.33
Dividend 0% 1.86%

Source: Yahoo! Finance

The two stocks appear to be evenly matched in Price/Sales, Price/Book and Return on Equity. It's when we get to earnings growth and forward P/E Ratios that GoPro seems to be slightly overvalued compared to Apple. Plus, Apple pays a healthy dividend for a Silicon Valley corporation. I believe Q3 will be a tough one for GoPro, and analyst estimates may come down, especially impacting the forward P/E Ratio.

Strategy

I'm a value investor by principal and prefer to purchase my stocks at discounted rates. GoPro doesn't meet that criteria yet. All bets will be off if they report a killer quarter on October 28th, but I'm positioning my bid as a price in the low $20 range, below the original IPO price of $24. I will not chase a stock like GoPro. If I do happen to catch my price, I wouldn't hold my position much past Q4 which is traditionally a strong quarter because of the holidays.