wildcat investors research newsletter: december 2012

7/29/2019 Wildcat Investors Research Newsletter: December 2012

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INSIDE THIS ISSUE:

Capturing the Carbon

Trade

2

Commodities Rolling

Over Investors

2-3

The Effect of BP‟s

Criminal Settlement

3

Building an Optimal

Portfolio

4

Is Market Efficiency a

Paradox?

4

Mathematical De-

pendence of Returns

5

Art, the Newest Hard

Asset

5-6

Cons. Discretionary vs

Cons. Staples

6

In our experience as Investment Club managers, the largest challenge in seeking excess returns

with a medium-term investment horizon was our capital constraints. With just a few thousand

dollars in student investments, it is difficult to balance diversification and transaction costs.

Because of this, WI decided to launch a paper-fund that seeks to minimize equity index tracking

error but targeting alpha through a sector allocation strategy. Using a top-down approach with

macroeconomic indicators, we are in process of rebalancing sector weightings within a typical S&P

500 allocation, DWRRF (“dwarf”).

Thus far, there have been three rebalances. Energy, Consumer Discretionary, and Health Care arecurrently overweight. Technology, Consumer Staples, and Telecommunications are currently un-

derweight.

WI presents sector analysis that recommends adding to the allocation of a sector ETF in the port-

folio and selling from another

to create a position-cost neu-

tral transaction. These presen-

tations use a combination of

fundamental / technical eco-

nomic indicators and industry

analysis to make a case for

(against) leading (lagging) sec-

tors that comprise the S&P

500.

Our portfolio‟s gross perfor-

mance is outperforming the

S&P 500 Index by 38 basis

points. We plan on maintain-

ing this allocation throughout the rest of the year and will revisit our weightings when the club

reconvenes in January. A synopsis of the analysis of the Consumer Discretionary and Consumer

Staples trade can be seen on page 5.

Commodities retain value either by providing utility in someway or because of their scarcity. Oil and gold are two quintes-

sential commodities that fit into this mold. Oil is valuable for

its high energy content, while gold holds value simply because

it is scarce and has been sought for millennia. In light of recent

equity volatility, low government security rates, and extreme

monetary intervention, art seems to be acting much like gold,

providing a safe haven for investors leery of other asset classes.

However, unlike gold, there is very little chance of previously

unknown works being discovered; there is a limited supply of

truly unique works...

Continued on page 5.

Performance Updates(Since Inception 10/25):

DWRRF Portfolio [Gross]

+0.66%

S&P 500 Index

+0.28%

Current Holdings (P/L):

GTU (+0.99%)EWBC (-7.45%)

F (+9.55%)

DAR (+2.60%)

Art, the Newest Hard Asset

BY WILLIAM SPENCE

WILDCAT INVESTORS CLUB

WI Research Newsletter

December 03, 2012

ISSUE I

17.2%

14.9%

15.0%

13.5%

13.6%

8.9%

10.0%

3.4%

3.4%

0.0%

0% 5% 10% 15% 20%

Technology (XLK)Financial (XLF)

Healthcare (XLV)

Cons. Disc. (XLY)

Energy (XLE)

Cons. Staples (XLP)

Industrial (XLI)

Materials (XLB)

Utilities (XLU)

Telecom(IYZ)

SP-500*

DWRRF

*https://www.spdrs.com/product/fund.seam?ticker=spy

The Scream By Edvard Munch. (courtesyofwww.edvard-munch.com)

The Dynamic Weight Relative-Return Fund (DWRRF)

Using Sector ETFs to beat the S&P 500

ASTeCC 123

[email protected]

Wednesdays 5:00 B&E 309

www.wildcatinvestors.com

Alternative

Assets

Equities

IntheMeetings...

http://www.wildcatinvestors.com/





states.

There are skeptics and proponents of the

cap and trade system, between which the

effectiveness of the system thus far is de-

bated. Emissions have fallen, more than

expected,

during

Phase II,

which was

due in large

part to the

economic

crisis. The

EU has al-

ready begun

selling

Phase III

permits, which sold at a discount to the

prevailing spot market price. It is evident

that there is still an excess supply of car-bon allowances in the EU while the demand

has yet to pick up. Heading into Phase III,

EUAs are hitting all-time lows at €6/metric

ton of CO2. According to Bloomberg's pre-

dicted aggregation of trading volume, the

total carbon market value will fall in 2012

to 85 billion euros, 8% below last year's

level.

However, the allowances will slowly be-

come more scarce as the third phase gets

in motion and the cap begins to shrink.

Bloomberg predicts demand to increase

as economic conditions improve, power

generation (and therefore carbon emis-

sions) increase, and "free" allowances die

out. This means thatthere could be value

found in the Carbon

Trade in coming years.

On November 14, 2012

California, the world‟s

eighth largest econo-

my, held its first auc-

tion of greenhouse gas

emissions, initiating

the cap-and-trade

system in the United States. The pro-

gram, though, does not currently have

national support and won‟t be mandated

federally in the near future. Perhaps the

rest of the country is still getting over the

last time California tried to create its

own market (see Enron). Nonetheless

the carbon trade is gaining momentum

globally, and may present a unique op-

portunity for trade. Both the California

allowances and the EU allowances are

tradable with futures on the Interconti-

nental Exchange (ICE).

In an effort to

curtail greenhouse

gas emissions,

specifically carbon

dioxide, European

Union launched its

Emission TradingSystem (ETS) in 2005 as a part of the Kyoto

Protocol. The system includes three phases

of development in which a cap and trade

infrastructure will be built throughout the

EU. The first two phases (Phase I: 2005-

2007, Phase II: 2008-2012) were character-

ized by National Allocation Programs

(NAPs). The NAPs are decided by the EU

countries to allocate fixed allowances to

individual emitters on the basis of historical

emissions, subject to approval by the Euro-

pean Commission.

For Phase I, each country is allowed toauction up to 5% of their total allowances,

which was raised to 10% in Phase II. Start-

ing in 2013, as the emission cap becomes

more stringent, auctions will amount to

nearly 50% of the total European Union

Allowances (EUAs) in an effort to reduce

emissions by 20% of the 1990 levels. In ad-

dition, the total cap will be determined by

the European Commission, and the auctions

will be held by the individual member

WI RESEARCH NEWSLETTER

Ac co rd in g to an ar ti cl e on red Or -

bit.com, global carbon emissions are

expected to set record highs in 2012.

Al th ou gh de ve lo pe d co un tri es su ch

as the US and those in the EU are

reducing emissions, the emerging

e co no mie s o f Indi a and Chi na co nt i n-

ue to drive emissions higher.

Exploring Trading Opportunities Across Multiple Markets

Alternative Assets

Capturing the Carbon Trade

BY DANIEL NALL

Commodities Rolling Over Passive Investors

BY TAYLOR MALUEG

In a year that some have termed the fundamental "trifecta" (corn, wheat, and soybeans), 2012 market pressures in

agricultural commodities have been unprecedentedly bullish. While an historic drought throughout United States

has dominated the headlines of mainstream agricultural news, a determined push by the financial industry over

the last few years to make commodity index products a widely-held investment has gone largely unnoticed.

Whether because of appealing stories of coming commodity market tightness or search of further portfolio diversi-

fication, …

(Continued on next page)

Since June, CME’s

Front Month Corn

Futures contract has

returned over 15%

more than the CORN

ETF.



an astronomical

amount, it still

was less than

expected caus-

ing an increase

in share price

from $40.30 to

42.02, or ap-

prox. 4.3%,

from the news

release on No-vember 15th to

November 23rd.

However, there is still continuing uncertainty in relation to the

oil spill because of the outstanding civil penalties BP faces under

the Clean Water Act. Fines could range from $1100 to $4300 per

barrel spilled making the possible price tag between $5.4 billion

and $21 billion. So, when news breaks of the settlement of these

penalties remember that it‟s not a matter of BP having a cash

outflow, but whether or not it is more than expected that will

predict the effect on its share price.

Captivated by the discussion in Dr. Clifford‟s

FIN300 class, I decided to share the infor-

mation I learned from an article regarding

the Criminal Action Lawsuit against British

Petroleum:

On November 15th BP agreed to pay $4.5

billion in a criminal settlement with the US

Government in regards to the 2010 oil spill.

BP plead guilty to a total of 14 criminal

charges including the deaths of 11 rig work-

ers, and intentionally misleading congress

and investors about the severity of the spill.

Release of this news definitely had a drain

on BP‟s stock price right? Wrong. As pointed

out by Dr. Clifford, the stock price of a

company is based on the discounted ex-

pected future cash flows of a company.

Investors became aware that there was

going to be criminal and civil settlements

directly after the spill happened and the

market adjusted accordingly two year prior

in 2010. Even though $4.5 billion dollars is

ISSUE I

Thoughts and Investigations in the US Equities Market

Equity Analysis

The Effect of BP‟s Criminal Settlement

BY CORY LAAKER

Chart courtesy of Yahoo! Finance

It had been awhile, so I

flipped through a fewpages in The Intelligent

Investor and found a quote

in the appendix:

“The Washington Post

company in 1973 was

selling for $80 million in

the market. at that time,

that day, you could have

sold the assets to any one

of ten buyers for not less

than $400 million. The

company owned The Post,

Newsweek, plus other TVstations. Those same

properties are worth $2

billion now, so the person

who would have paid $400

million would not have

been crazy.

Now if the stock had

declined even further to a

price that made the

valuation $40 million

instead of $80 million, its

beta would have been

greater. And to people whothink beta measures risk,

the cheaper price would

have made it look riskier.

This is truly Alice and

Wonderland.”

Buffet discusses the claim

that EMH fans call investors

that beat the index lucky.

Buffet admits that there is

some truth to this

statement. He gives an

analogy of coin-flipping.

But the fact that theworkers from Graham and

Newman had such

incredible track records

speaks also to statistics.

Graham and Doddsville

Christian Sgrignoli

Commodities Rolling Over Passive Investors (cont.)

recent history, prices for front month corn gained

59.3% during June and July while the commonly trad-

ed Teucrium Corn Fund (Symbol:

CORN) only gained 43.6% during the

same period. This phenomenon is not

only witnessed in agriculture index

products, but in almost every com-

modity fund. Imagine the passive

investor that bought the United States

Natural Gas Fund at the start of the

2012. The fund at one point was down

nearly 20% while the front month fu-

tures actually gained a stunning 24%.

This problem gets more exaggerated as

these negative roll yields slowly com-

pound over time. Over the last five

years, the United States Natural Gas

Fund has lost close to 90% of its value.Commodities will probably continue to roll over in-

vestors for years to come. As the Wall Street Journal

reminds us, “It is good to remember, even when

commodities win, investors can still lose.”

… buy and hold investors have made products tracking

commodity baskets increasingly popular.

The problem with index funds thatare backed by commodity futures is

that at some point the future that

the fund holds will expire. In order

to have constant exposure to the

commodity of choice, a fund must

"roll" its commodity exposure to

another future with a different

contract month. Usually longer

dated futures cost more than the

upfront ones; as funds roll their

positions into more costly futures,

they usually incur what is called a

negative roll yield. These negative

yields slowly eat away at the indexfund's profits, causing a stark disconnect in performance

relative to the commodity market(s) they track.

For example through the worst drought and corn crop of



Math Economics Seniors taking

Principals of Operations Re-

search (MA416) with Dr. Mol-

zon had to conduct

an efficient frontier

for a group of di-verse asset classes.

Using linear pro-

gramming tech-

niques with the use

of Excel and R, I

analyzed returns of

11 different ETFs to determine the optimal portfolio during a

strong bull

market, from

2009 to 2012.

In order to use the linear

programming solver, mean

absolute deviation of the

returns was used as therisk measure instead of

standard deviation.

In order to pick an opti-

mum portfolio, either the

return or risk would need

to be fixed. For this model, the risk parameter was capped for a maximum

return output. A program in R was developed to run loop through risk

caps, thus creating an efficient frontier.

However this was not enough information to determine an optimal

portfolio. Given a specific investor‟s risk tolerance, the efficient

frontier would be enough to pick out a specific allocation. But

without this infor-

mation, there are a

few ways of rankingportfolios to determine

which is optimal. In

this analysis two

measures were used to

create optimal portfo-

lios: the Sharpe Ratio

and Jensen‟s Alpha.

Looking at the effi-

cient frontier, it is

clear that an equally weighted portfolio, the S&P 500, and most of

the individual assets were dominated by the efficient frontier.

However, high yield bonds (JNK), the Nasdaq Index (QQQ), and the

Vanguard REIT ETF (VNQ) all lie on the efficient frontier. This was

somewhat expected after taking into account the strength of thebull market during the time period analyzed, which was character-

ized by high returns with low variance (which can be seen in the

total return chart). Using the portfolio ranking methods, both

optimal portfolios were characterized by low risk on the efficient

frontier, and both consisted of allocations to just three assets: 3-7

Year Treasury Bond Fund (IEI: 48-67%), High Yield Bond Fund

(JNK: 26-43%), and Large Cap Growth Equities (QQQ: 7-8%).

Building the Optimal Portfolio (2009-2012)

BY DANIEL NALL

Agriculture COW iPath Dow Jones UBS Livestock TotalReturn Sub-Index ETN

Energy UHN United States Diesel-Heating Oil

Fund LP

Junk Bonds JNK SPDR Barclays Capital High Yield

Bnd ETF

Large CapGrowth QQQ PowerShares QQQ Trust

Real Estate VNQ Vanguard REIT ETF

Healthcare IHI iShares Dow Jones US Medical Dev.(ETF)

Currency FXS

CurrencyShares Swedish Krona

Trust

Financial PSP PowerShares Listed Private Eq.

(ETF)

Government Bonds IEI

iShares Barclays 3-7 Year TreasryBnd Fd

Metals DBB Powershares DB Base Metals Fund(ETF)

Mid Cap

Growth SPHQ PowerShares S&P 500 Hgh Qlty Prtfl

(ETF)

of this efficiency. At the core, market efficiency claims that theequilibrium of buyers and sellers provide an optimal level of dis-counting future events.

If markets are efficient, and all actors optimally discount infor-mation, security analysis is a waste of time. The proper thing to dois to diversify into different asset classes and minimize firm specif-ic risk. After a while other people conclude the same thing. Butwhat happens when many, or the majority believe and invest ac-cordingly?

What will happen is a dispersion from true value; resulting in aparadox. As more investors believe the market is efficient, the lessefficient it gets. These investors will use indexing strategies andvague qualities such as growth vs. value to satisfy their diversifica-tion needs. These generalities do not provide the true value of anequity security-the discounted residual value available to theshareholder.

There has been an invest-ment philosophy that has gained muchtraction in the past few decades. Themomentum for this strategy can betraced back to Harry Markowitz“portfolio selection” paper in theMarch 1952 issue of the Journal ofFinance. At the time, Markowitz was a

graduate student at the University of Chicago. Up until this time, therehad not been much study on the subject; which can be noticed in thelack of sources in Markowitz‟s paper. Markowitz was interested in therelationship of risk/reward. He recognized that most investors, evenprofessionals, had tunnel vision on reward. His answer to this problemwas covariance.

The technical name of this investment philosophy is modern portfoliotheory (MPT). It is taught heavily in finance courses. It proposes thatthe market is efficient. There is a weak, semi strong, and strong form

Is Market Efficiency a Paradox?

BY CHRISTIAN SGRIGNOLI




we can begin comparing numbers. First off

are the equations, which I will addressmore in Part 2.

Second are the

probability distri-

butions which

aren‟t as easy to

calculate as you

may first think.

The single varia-

ble probability

distribution func-

tion (PDF) is sim-

ple though; all

one must do is

partition the

values into equidistant bins and then count

the number which fall in each bin, as you

would do for a histogram. For the bivariate

distribution however you can‟t use a frequency

method. Instead, we must use an algorithm tointelligently partition

the space, for some

examples please see

the figures. The

algorithm I find easi-

est to understand is

the Fraser-Swinney

algorithm.

The Fraser Swinneyalgorithm partitionsthe 2 dimensionalspace into what arecalled equi-probablerectangles where a

rectangle will require no further sub divisionsonce the product of the marginal equals that ofthe rectangle, i.e. Px * Py = Pxy . Once this isdone we can then compute the entropy, H(x),and joint-entropy, H(X,Y) such as to computethe mutual information. Once done we caneasily see that the mutual information valuesfollow an expected pattern similar to that ofcorrelation. The difference in the numbersgoes beyond the scope of my reasoning, by thatI mean finding trading strategies which usethese relationships has proved harder than I atfirst thought. The goal however going forwardis to address this next time around. So look

forward to next month‟s issue! (If anyonewould like more information on the topicplease contact John Eversvia [email protected].)

Ask any person what they think of the stock

market andmost will

equate it to

something

along the lines

of “Vegas for

the rich.” By

that, people

see the market

as a game of

probabilities

and uncertain-

ties not suited

for the aver-

age Joe. Of

course, who the markets are suited for isn‟t

really important to the „game,‟ but under-

standing the uncertainty and its probabilities

is. Thus, in order to uncover these relations

one could use correlation. This measure how-

ever fails to decipher non-linear relation-

ships. That is, let Y be a random variable and

let X = Y ^2, then the correlation of the two

would be 0. The informational approach of

entropy and associated mutual information

however do not. The theory behind entropy

and mutual information has been well re-

searched, as has the comparison of correla-tion to mutual information.

In order to calculate the entropy version of

dependence we will need a few things before

What goes on in 309 B&E each week

In the Meetings...

ISSUE I

Mathematical Dependence of Stock Returns (Part 1)

BY JOHN EVERS

X=Y=25 uniformly distributed points on the interval [0,1] X and Y are different but both uniformly distributed on [0,1]

X and Y normally distributed on [0,1]

sold. In May of this year, The Scream by Edvard

Munch shattered all records by selling privately

for just shy of $120 million. ,,,

(continued on next page)

Art, the Newest Hard Asset (continued from cover)

BY WILLIAM SPENCE

As shown in the chart, global art auction revenues have

been increasing since 2004, with the exception of the

recent financial crisis. In fact, 2011 was a record-setting

year with $11.57 billion of art sold. This trend seems to

be solidifying as more and more works of art begin re-

placing others on the list of most expensive works of art

Fine Art Auction

Revenues have

increased by over

4.5x in the past

decade.

mailto:[email protected]






Despite the stagnant economic

conditions, the Consumer Confi-

dence Index (CCI) continues to

grow. According to the monthly

survey conducted by The Confer-

ence Board, the CCI has again

increased from

73.10

(October) to

73.70. This is

the highest

the index hasbeen since

February 2008.

The 4th Quar-

ter of 2012 has

been charac-

terized by

stabilized

business con-

ditions and sentiment regarding

employment opportunities contin-

ues to improve, even as the mar-

ket has seen a decline.

In a relative strength comparison in

the 4th and 1st quarters since 2006,

the XLY has outperformed the XLP 67%

of the time. And when the S&P 500

has shown a positive return, the XLY

outperformed 100% of the time. The

seasonality of these sectors seemed to

play a role.

Because the club was not overly bull-

ish in the mid-term on the market,

the allocation to this

rebalance was rela-

tively small. Given

the XLY is a risker

asset than is the XLP,

the trade was a Beta+(adding beta to our

portfolio). We decid-

ed to add 2% to our

XLY allocation while

trimming 2% from out

XLP allocation.

Thus far we have seen

an outperformance of 1.8% of XLY

over XLP since we initiated the posi-

tion on 10/31.

Consumer Discretionary (XLY) vs. Consumer Staples (XLP)

BY DANIEL NALL & CORY LAAKER

Consumer sentiment (blue histogram) has had a high correlation

with Discretionary outperformance. As it continues to make new

highs, we look for the uptrend in the XLY/XLP to strengthen.

Chartcourtesy of Bloomberg.

Consumer Sentiment vs. XLY/XLP

Performance since 10/31 (courtesy Freestockcharts.com)

“However, unlike gold,

there is very little

chance of previously

unknown works being discovered; there is a

limited supply of truly

unique works.”

by‟s profits on both ends of the transaction.

Additionally, the company offers a multitude of

secondary services such as

valuation, storage, estateplanning, and many more.

By focusing on its core com-

petency and exploiting its

resources, it has become

the industry leading art

auctioneer. In FY2011, it

sold art totaling over $5.8

billion (including The

Scream). With a PE of 15

and 2011 operating and

profit margins of 34.8% and

20.6%, respectively, Sothe-

by‟s maintains strong pricing

power while trading for a relatively price. Itremains on watch for the Wildcat Investors.

An investor wishing capitalize on this trend can do

so in a handful of ways, depending on the capital

employable. One way is

to seek out works that areexpected to appreciate in

value—a costly venture.

Another—more cost effec-

tive—method would be to

look for proxy invest-

ments that profit from art

transactions. The clear

frontrunner in this cate-

gory is Sotheby‟s Interna-

tional (NYSE: BID). Spe-

cializing in art auctions,

Sotheby‟s has been in

business for over 250

years. By taking a commission from the seller andcharging a premium to the winning bidder, Sothe-

Art, the Newest Hard Asset (fini.)



ISSUE I

On-Campus Office:

ASTeCC 123

E-mail:

[email protected]

Meetings Fall 2012:

Wednesdays 5:00 B&E 309

The Wildcat Investors Club is open to new membership of all experi-

ence levels at anytime during Fall and Spring semesters. It is student-

run organization designed to foster an environment of learning cen-

tered around the financial markets. This includes investment and

trading strategies, diversification techniques, retirement account

preparation, and any other investment decisions.

W I L D C A TI N V E S T O R S

Each year the Chartered Financial AnalystInstitute sponsors a global investment analysis

competition amongst university students.

This year, the University of Kentucky‟s team

includes two Board Members, John Evers and Daniel Nall. The other members of the team

are finance seniors Paul Gerwe, Brad Harris, and Thomas Napier. Finance professor, Dr.

Chris Clifford will act as a faculty sponsor to guide the team.

As a group, each team is required to complete a detailed, sell-side analyst report to be sub-

mitted first at a regional level. For the 2013 Competition the universities in the CFA Socie-

ty of Louisville Region will analyze Humana Inc. (HUM), one of the big 5 national health in-

surance providers , which is headquartered in Louisville, KY.

Over 3,000 students from over 650 universities competed in the 2011-2012 Competition.

Last year‟s winner of the Louisville Region was Butler University. And the team that went onto win the Americas division was Illinois Institute of Technology from the Chicago Region.

“The market can stay irrational

longer than you can stay

solvent.” -John Maynard Keynes

For more information on our organization or full

presentations, visit our website: www.wildcatinvestors.com.

Wildcat Investor Officers Join the University of Kentucky CFA

Research Challenge

Sources:

Denning, Liam. "For Passive Investors, Rolling Commodities Gather a Loss." Wall Street Journal Online. 11 Nov.2012.

"EU Carbon Auction Clears at Biggest Discount to Spot Price." Bloomberg. N.p., n.d. Web. <http://www.bloomberg.com/news/2012-11-16/eu-carbon-auction-clears-at-biggest-discount-to-spot-

price.html>. "Europe's CO2 Trading Scheme: Is It Time for a Major Overhaul?" Europe's CO2 Trading Scheme: Is It Time for a

Major Overhaul? by Ben Schiller: Yale Environment 360. <http://e360.yale.edu/mobile/ feature.msp?id=2396>.

Graham, Benjamin, and Jason Zweig. The Intelligent Investor. New York: HarperBusiness Essentials, 2003.Print.

"Investor Relations." Sotheby's. N.p., n.d. Web. <http://investor.shareholder.com/bid/index.cfm>. Markowitz, Harry. “Portfolio Selection” Mar. 1952. <http://www.math.ust.hk/~maykwok/courses/

ma362/07F/markowitz_JF.pdf>

Disclaimer: The contents of this

newsletter are for educational and

informational purposes only. The

views and opinions expressed

throughout are not necessarily re-

flective of those of the Gatton Col-

lege of Business at the University of

Kentucky.

wildcat investors research newsletter: december 2012

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