Personal Insights from a Global Hedge Fund Trader

Capitalist Exploits's picture

By: Brad Thomas and Chris Tell

This week Brad discusses his view on short and long term trading ideas, and outlines the criteria he uses to screen the companies.

If you have any questions, thoughts or comments for Brad feel free to drop them here. Brad is a trading veteran with 20+ years of experience under his belt. His specialty is hunting for deep value asymmetric payoffs in the equity markets.

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The following is an email exchange I had with a subscriber:

Brad, you have started to post up weekly short term trade ideas along with long term ideas - what is the essential difference between short and long term trades?


Well, if I could sum it up in a one liner - it's momentum vs. value.

 

Specifically, the short term strategy has a "look out window" of about 3 months. I look for stocks that have gone sideways for at least three months but appear to be breaking to the upside out of their trading range. Generally, when a stock breaks out of its trading range it does so in an explosive fashion and this momentum carries it higher for the following 3-4 months. But there is more to it than the behaviour of a chart. There needs to be a solid underlying reason as to why a stock is breaking higher.

 

I also employ earnings momentum into the criteria. I want to see positive earnings for the last 12 months and earnings estimate upgrades. Using both price and earnings momentum produces a powerful combination. But there is one more aspect to my short term trading strategy criteria. I don’t look at valuation multiples. I believe that what happens to a stock over the short term has little to do with its valuation.

 

The long term strategy is very different from the short term. This is a classic contrarian strategy where I look for large cap stocks that are offering "deep value". The typical candidate would be a stock that has the following traits:

  1. Over the preceding 5 years, the price has gone down or at best nowhere such that anyone who bought it "on average" during that time would not have made money (or at best very little). If few have made money in a trade over the preceding 5 years then it is highly likely that the stock isn't widely held by the investment community (i.e. it's not a crowded trade).
  2. Over the last 12 months the stock has outperformed the general market. One wants to be reasonably sure that the long term under performance has been arrested and that one isn't catching a "falling knife".
  3. There is little in the way of bullish commentary about the stock - if a stock is moving higher or is out performing the market and there is little accompanying bullish commentary surrounding it then it is highly suggestive that the stock isn't widely held.
  4. Low price multiples. I pay attention to the P/Book and P/Sales multiples. I have a strong bias to buying stocks below P/Sales of 1x or below a P/Book of 1.5x. I won’t touch anything if it has a debt/equity level above above 50%.

So that is the difference between the criteria you look for in the short and long term strategies, but that is only "half" of your overall strategy. It's really the application of your strategy that makes you very different from the "average" short term trader or value investor.


Yes, you are right. I express my views via options. Options give me a non-linear or exponential return, which means I don't have to be so reliant on a high win/loss ratio to be profitable in both trading strategies. It isn't difficult to achieve 1000% returns in trades and just one of these trades can make up for 10 other losing trades.

 

It seems simple but what is the catch?


There is no catch... but it isn't that simple. On selecting short and long term candidates there is a final filtering process. For all the candidates I need to select only those that have cheap options. The cheaper the option, the more exponential the payoff of the trade. It is one thing to find a favourable earnings and price momentum (with respect to short term trades) or to find value (for long term trades) and it is another to find cheap options.

 

However, generally if a stock has gone sideways in the preceding for a lengthy period then options tend to be underpriced as people have an innate tendency to transpose the behaviour of the recent past into the future. So, if a stock hasn't been volatile in the last 3-6 months then option writers tend to price this in for options expiring 3-6 months out. The same applies to long term trades.

 

Do you keep your short and long term trades in separate accounts or lump them all together in one account?


It is imperative to keep them in separate accounts due to the differing levels of cash associated with each strategy. The short term strategy only engages about 20% of the portfolios capital at any point in time whereas the long term portfolio can be up to 80% engaged.

Next question is about the trade idea on Treasuries that I mentioned last week.

Brad, loved your trade idea on Treasuries in your recent alert. Timing worries me, though. There seems no end to the ability of central banks to keep rates low.


Trading the markets now for over 20 years, I've learned there's always money to be made in any and all market conditions, but always the biggest returns, which tend to make for life-changing trades, are to be found in asymmetric trades. Present day bond markets provide us with such a setup.

 

What I've found works is to ensure that you don't over commit on any trade of this nature while ensuring that you can live to fight another day. You don't want to be out of bullets when your ship comes in. Remember, everything was fine in Greece, too... until it wasn't. Don't believe the herd. Trees don't grow to the moon, and when everyone thinks that this is the way things will be forever is often the maximum point of the bubble.

 

The government bond markets right now present one of the most one sided trades I've ever seen in my professional life. Sure, this particular strange set of circumstances can continue for a few more years. As a trader I have to view things dispassionately and looking at the market fundamentals you're silly not to have a small position.

- Brad

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Thank you for joining us. As mentioned earlier, feel free to pick Brad's brains about trading and his macro views here.

Additionally, you can access Brad's trading ideas here.

Have a good weekend!

- Chris

 

"If you want to have a better performance than the crowd, you must do things differently from the crowd." - Sir John Templeton