Q: What are the main themes in your fund?
A : There are two themes that drive our investment decisions. First, a stock, or the stock market as a whole, is just a claim on a future stream of cash flows. For the market the price investors pay for these cash flows has been much more volatile than the actual future stream of cash flows (not just one particular year). Given that the future stream of cash flows is quite stable, we look at this as investors’ risk tolerance changing over time.
For a specific company’s stock cash flows can be much less stable. Even with this, individual stock prices are still much more volatile than the future stream of cash flows. But because both components matter a great deal we see changes in the price investors pay for individual firm cash flows as essentially measuring changing investor expectations for a company (sometimes deservedly so).
In both cases, if you want to understand the market or an individual stock, you have to be able to gauge investors’ expectations and risk tolerance as they exists at the time and what direction they are currently heading.
The other theme is based on our perception that markets can be looked at as an ecosystem where you have different investment styles competing against each other. When a particular style becomes popular with investors it lowers the future returns from that style while increasing the future returns of the styles that become neglected or out of favor.
Once the additional return or alpha is seen as having gone down, then people may gradually change over to other styles of investment. So, with the market behaving in a dynamic fashion the reward to risk for the market or for a specific stock will keep changing over time, which is what makes us look for an adaptive growth strategy as the name suggests.
Q: Would you give us an overview of the company’s history?
A : Wegener, LLC was started in 2003 with this investment philosophy in mind. In 2006 we launched the Wegener Adaptive Growth Fund to cater to this concept. Through this fund we look at all stocks that are traded on an exchange in the U.S., which includes foreign companies that trade as American Depository Receipts, with no limitation on the market cap.
Q: What is the basic objective of the fund?
A : The basic investment objective of the fund is to seek long-term capital appreciation while attempting to protect capital during negative market conditions with the aid of hedging strategies.
Q: How do you execute your investment strategy to achieve these objectives?
A : We seek to achieve this objective by investing in a portfolio of common stocks that we believe have superior prospects for appreciation. Based on market conditions we may invest in options to increase the market exposure of the fund or alternatively use hedging to reduce market exposure. We believe that there are three main groups of factors that affect the stock market as well as individual stocks. These are Long-Term Reversal Factors, Intermediate-Term Trend Factors, and Short-Term Reversal Factors.
Q: Could you elaborate on these factors in more detail?
A : The Long-Term Reversal Factors are what we arrive at when we compare the current price of a stock to our estimate of its present value of future cash flows. We also may use other factors like stock price to current sales and stock price to current earnings. We believe that these factors are invaluable in measuring investors’ expectations for individual stocks, and their risk tolerance for the stock market. When risk tolerance is low, we believe there is a significant potential for the stock market to go up and vice versa. The same applies to expectations for individual stocks.
The Intermediate-Term Trend Factors are different for individual stocks and the whole stock market. While in individual stocks the factors affecting the stock price are their trends and the earnings estimates arrived at by the analysts, in the stock market it depends on sector indexes, movement of small capitalization stocks and large capitalization stocks, corporate bonds and government bonds. These factors will give us an idea of the current direction of change in investors’ expectations for individual stocks and in investors’ risk tolerance for the stock market as a whole.
The short-term reversal factors are related to individual stock prices in the case of individual stocks and a wide variety of price variations for the whole market. These factors give us the tool to measure the overreactions that are of short duration and get corrected accordingly.
Q: Once these factors are estimated, what does the manager do?
A : We select individual stocks to be placed in the portfolio that we believe give the portfolio the best combination of factors. Over time we will then sell those holdings that have become less attractive and replace them with higher ranked stocks. When the combined factors of the stock market as a whole cause us to expect a poor reward for the risk taken we will then reduce the fund’s market risk by hedging the portfolio. And if the combined factors of the stock market lead us to expect a strongly positive reward for the risk taken we may increase the fund’s stock market exposure by leveraging the portfolio.
Q: Is there any hedging strategy involved in this process?
A : To hedge, we typically purchase put options on market indexes and simultaneously write call options on those same market indexes. To achieve leverage, we purchase call options on individual stocks or market indexes.
Q: Do you have any limit to these option positions?
A : The fund’s maximum stock position either directly or through option positions is limited to 150% of the net assets. This means the option positions will not exceed 50% of the fund’s net assets at any given point.
Q: What is your benchmark index?
A : Our holdings are most closely correlated to the Russell 2000. We do hold some larger companies and in the past we have used the S&P 500 to hedge up to 20% of the portfolio. We feel both indices can be used as a benchmark longer term.
Q: What is the range of positions that you can hold? [
A : There is no set range. We’ve held between 75 and 120 stocks and have usually been at the lower end of that range. We have some flexibility there and it is a bottom-up process based on how individual stocks are being ranked and are performing at that time.
Q: What is your research process in selecting a stock?
A : As discussed before, we have a general framework that describes our thinking. We then try to put that into quantitative form as much as possible. This leads to historical testing of our ideas and the ability to refine our thinking through further research. It also produces a list of top ranked stocks from which we invest.
When we go to purchase a new stock we take a top ranked stock we aren’t holding and review our data for accuracy and determine whether it is reflective of the company’s situation. We will then look for current news that may not be reflected in the data. If the stock is still highly ranked we will then purchase that stock on short-term relative price weakness and replace a current holding that is lower ranked on short-term relative price strength.
Q: Do you look at sector performance before looking at individual stocks?
A : We primarily stay focused at the company level. Sector concentrations can then bubble up from that. For the past three years the big driver of returns has not been the movement of individual sectors, but the overall market. Back in 2000 investors were in the process of switching from large caps to small caps, from growth to value strategies, and away from the technology sector. At that time sector analysis was very helpful in understanding why a portfolio had done well or poorly, but it has not be as helpful the past three years.
Q: Do you look at current macro-economic factors while analyzing the market?
A : We feel that macro economic factors are important. However, it isn’t because of their impact on long term cash flows for the market as a whole, which is modest. It is due to two reasons: 1) investors care about them and it influences investor risk tolerance, both positively and negatively, and 2) consumers and business people are also investors, so how they are adjusting their consumption and business decisions may impact their investing decisions.
For example, when consumers are feeling good they may be willing to buy a car and have a higher stock allocation. When a businessperson has poor earnings and cuts back on hiring there may be a need to sell stocks raise cash. In both instances the stock market is being impacted by something that is transitory, but when done by consumers and businesspeople as a whole it can have an impact on the market.
We try to make the market more efficient, and hence be rewarded for it by earning abnormal returns, by being a willing buyer when risk tolerance is low and the market has likely fallen, helping keep the market closer to fair value than it otherwise would be. Then as risk tolerance increases, and the market rises, we become a willing seller.
Using the intermediate trend side of what we do allows us to be more patient buying initially and more patient selling initially. However, we are essentially helping keep the market efficient and closer to fair value. When we provide this service it is usually scarce and valuable. So like any business that provides such a service we expect to be rewarded for it over time.
Q: What is the turnover in the portfolio?
A : It is around 100% since we are constantly making adjustments as our top ranked stocks change. We are constantly looking to add to top ranked stocks and then sell lower ranked holdings.
Q: Do you hold any cash positions?
A : We are fully invested at all times in a portfolio of common stocks, because we can always reduce our market risk by hedging.
Q: What are the risks that you perceive in the portfolio and how do you control them?
A : To the extent that we take risks we expect to be rewarded for those risks. We always feel our stock selection will add value and so we are always fully invested in stocks and willing to take that risk. However, the market may not always have a good reward to risk ratio. So we will reduce our market exposure using options when warranted and therefore reduce our risk level.
Many people require bonds and cash in their portfolio in order to mute their stock market risk. When used as a stock exposure replacement our approach reduces the risk in the portfolio, which also allows investors to take greater risk elsewhere in their portfolio. So the value added from the risk side can be just as important as the value added from the return side.