Lyons Tactical Allocation Portfolio A Different Approach to Tactical Investing
A Different Approach to Tactical Investing The tactical investment style is a broadly defined category in which asset management techniques vary amongst managers. Generally speaking, tactical managers attempt to miss equity market declines by rotating through asset classes or market sectors, while others short stocks in an effort to hedge. Allocations may be shifted as often as monthly or weekly. The majority of these managers use ETFs as their exposure to the stock market, and primarily rely on systematic signals to make their decisions, also known as algorithms. At Lyons, we believe in the power of long-term equity value investing, but recognize that a buy-and-hold approach is subject to harmful losses during periods of sustained market declines. In our view, the prudent use of tactical allocation is to maximize the opportunity for investment compounding for as long as possible, and attempt to minimize the impact of only the larger market declines that harm cumulative returns. 2
Not All Market Declines are Equal On average, the deeper the market decline, the longer it takes to recover. The market frequently endures small declines that are brief and quickly retrace to breakeven. For example, a 5% decline historically averages just 47 days in length when measured from peak to trough.¹ Additionally, the greater the loss, the larger the gain needed to recover and break even. While a 10% loss requires an 11% gain to break even, a 50% loss requires a 100% gain to recover. Bear market declines occur less frequently, yet are far more severe and potentially damaging to investor portfolios. The two bear markets of the 2000s averaged a decline of 52% and took 3 ½ years to recover.³ Eleven bear markets have occurred since 1950 an average occurrence of once every six years. Such multi-year market declines stop investment compounding. The years spent holding equities during decline and recovery periods can have a devastating impact on cumulative investment performance. 0% -10% -20% S&P 500 Drawdowns (Declines & Recoveries) January 1990 December 2013 1998 Decline -30% -40% -50% Frequent, short-term losses Sustained losses 2000-2003 Bear Market 2007-2009 Bear Market -60% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Graph of hypothetical investment in the S&P 500 Total Return Index from 1/1/1990 12/31/2013 and assumes reinvestment of dividends. The referenced indices are shown for general market comparisons and are not meant to represent the Fund. Investors cannot directly invest in an index. Source: Graph created by Lyons Wealth Management with Zephyr StyleADVISOR using data from www.standardandpoors.com 3
Sustained Declines Matter Most We observe that frequent, small market declines have little impact on a long-term, buy-and-hold investor. Reacting to each one increases the likelihood of being on the wrong side of the market when a reversal occurs. This whipsaw effect is magnified substantially by leverage, and impacts many tactical portfolios that shift frequently in and out of the market, or between stocks and bonds. Most tactical managers trade in this fashion. Like a ship at sea that navigates turbulent waters and changes course only to avoid severe weather, we believe we should stay the course and sail through choppy markets, seeking to steer around extreme conditions only. A defensive strategy that focuses on large, painful market drawdowns may reduce the whipsaw effect and offer a better risk/reward profile. Potential Whipsaw Buy & Sell Signals Hypothetical One Year Period Market Price BUY BUY BUY SELL BUY SELL BUY SELL SELL SELL 1 2 3 4 5 6 7 8 9 10 11 12 Month Source: Graph created by Lyons Wealth Management Buy and sell signals shown above are purely hypothetical and do not represent actual trading by Lyons Wealth or any other manager. The hypothetical index and buy/sell signals are shown for general information purposes and are not meant to represent the Portfolio. 4
The Lyons Approach The Lyons Tactical Allocation Portfolio is based on our belief that equities offer a favorable risk/ reward trade-off over time, and that minor market gyrations and disruptions do not warrant frequent defensive shifts. Our value investing philosophy is that we can outperform by investing in the stocks of strong companies available at good prices, and seeking the relative safety of a defensive allocation only when we perceive market risk to outweigh the reward. Our Approach: Offense First, Defense Next During most normal market cycles, we strive to outperform the market averages. Most tactical portfolios focus so heavily on defense that they underperform the S&P 500 during normal market conditions. We focus on offense first, building a portfolio of individual, dividend-paying stocks. Then we look at defense, seeking to navigate only sustained market drawdowns. Our goal is to participate in long-term equity market growth by being fully invested, yet offer the potential to avoid sustained declines. 5
Stock Selection We seek to buy high-performing companies at what we believe are bargain prices. We are interested in those companies who most efficiently generate cash on the resources they put to work, and who are undervalued relative to peers. We are looking for strong performers priced below their intrinsic value due to short-term market fluctuations. In our view, a company should be evaluated as to how efficiently it can generate cash, the reliability of its returns, and most importantly on how much it costs. We focus our performance analysis on cash flow rather than earnings, which are often manipulated by company management to distort true performance. We invest in large dividend-paying companies, as they tend to be more stable during periods of market volatility. Only stocks that meet minimum requirements for market cap and dividend yield are included in our universe. We evaluate companies on a relative basis using a series of rank orders, seeking to highlight those companies offering the best relative combination of high performance and low price. Separate performance and valuation rankings are combined and used to build our equal-weight equity portfolio. 6
Downside Protection Quantitative Risk Indicator (QRI) We ve constructed a systematic approach intended to capitalize on the fundamental market price shifts that often precede bear markets. We call this the Quantitative Risk Indicator (QRI). The QRI focuses on minimizing the impact of equity bear markets. It assesses market conditions on a monthly basis and drives our allocation between equities and Treasuries or cash. Based on such measures as market trend, momentum, and consumer sentiment, the QRI helps us establish which direction the market is moving, how quickly, and if the movement bears conviction. We measure all data sets over multiple time intervals. For the QRI signal to change, all data sets must collectively turn either positive or negative across all time intervals. The QRI is a relatively slow-moving signal designed to react only to extreme risk sentiment. We want to avoid the potential for the whipsaw that may result from a short-term dip. QRI Signals QRI Positive Signal Equities Treasuries or Cash QRI Defensive Signal To reiterate, we are concerned only with the more rare, prolonged periods of extreme decline. With this in mind, we anticipate shifting defensive only a few times per decade, allowing us to focus on offense and achieving the long-term benefits of compounding returns. 7
Building the Portfolio We begin with a universe of stocks that meet minimum dividend yield and market capitalization parameters. Stocks meeting our criteria are then ranked using a variety of performance and valuation measures. From the top two deciles, we select 25 stocks offering the best relative combination of performance and value to build an equal-weight portfolio. Once our offense is in place, we evaluate the QRI each month to determine portfolio allocation. We remain fully invested in our equity portfolio unless the QRI provides a defensive signal. When this happens, we will allocate fully to U.S. Treasuries and/or cash. An allocation shift may occur at the beginning of any month. We rebalance our equity portfolio quarterly when the QRI remains positive. By repeating our equity selection process, we retain any holdings that still represent a good value according to the model, and replace others even well-performing companies with new and better opportunities. The rebalanced portfolio is set to equal-weight. 1. Construct Equity Portfolio Screen for stocks that meet minimum dividend yield and market cap criteria Select top 25 stocks that offer best prospects for performance at a reasonable price Build equal weight portfolio 2. Evaluate Market Risk Evaluate market risk each month using the QRI If QRI signal remains positive, maintain equity portfolio If QRI turns negative, shift to defensive portfolio 3. Rebalance Portfolio When QRI remains positive, rebalance equity portfolio quarterly by repeating systematic equity selection process 8
How We are Different Individual Stocks We believe a portfolio of individual stocks chosen for value and performance can outperform index ETF portfolios. Tactical portfolios that use index ETFs to track the return of an asset class or market sector are essentially active indexing strategies, bound to perform no better than the market sectors they invest in. Dividend Focused Dividends have historically accounted for a significant portion of S&P 500 returns, even in bull markets. By investing only in stocks that meet our minimum dividend yield criteria, we seek to enhance the power of compounding on cumulative returns. Lower Internal Expenses By investing in individual stocks, we eliminate the layers of internal expenses embedded in portfolios of ETFs. From 1990-2013, dividends accounted for nearly 40% of the annual returns of the S&P 500 Total Return in non-bear market years. 4 No Leverage or Shorting We avoid the use of leverage and shorting, both which can create an unfavorable risk/reward profile and lead to significant underperformance, particularly when combined with frequent allocation shifts. Whipsaw is exaggerated by leverage. Defense Focused on Sustained Declines Only With the QRI intended to react only to large market declines rather than short-term pullbacks, we believe we can reduce the likelihood of the whipsaw effect that often results from more frequent allocation shifts. Potential for Relative Tax Efficiency We anticipate rare defensive shifts, allowing us to maintain our equity allocation over multi-year periods. This creates the opportunity for long-term capital gains if we hold a stock longer than one year. By contrast, frequent allocation shifts ensure short -term capital gains. 9
Lyons Tactical Allocation Index The Lyons Tactical Allocation Portfolio seeks to track the performance of the Lyons Tactical Allocation Index (ticker: LTAX), calculated and distributed in real time by NASDAQ OMX since July 2012. The Index, based on the same tactical model used in our portfolio, was created to show historical model performance prior to strategy inception, while also serving as a tracking index for current strategy performance. Applying our model back to January 2000, we find the QRI generated a defensive signal only twice. Both instances occurred as a result of market price shifts that preceded the two painful bear markets of the 2000s. As a slow-moving signal that seeks to navigate bear markets rather than short-term corrections, our research shows the QRI signaled a defensive shift in the early stages of the last two bear markets. 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 S&P 500 Market Cycles and Historical QRI Signals January 2000 - December 2013 QRI Defensive Signal QRI Defensive Signal Bull markets Bear markets Short-term corrections 400 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Graph of S&P 500 Index from 1/1/2000 4/30/2012. QRI defensive periods are hypothetical and are based on the back-tested application of a model. Please see disclosures on following page for important information regarding back-tested data and the Lyons Tactical Allocation Index. Source: Graph created by Lyons Wealth Management using data from www.standardandpoors.com The graph above depicts the price level of the S&P 500 Index and the time periods for which the QRI provided a defensive signal, according to our research. These defensive periods are reflected in the historical performance of the Lyons Tactical Allocation Index. 10
Lyons Wealth Management, LLC Forward Thinking. Proactive Management. Lyons Wealth Management, LLC is a registered investment advisor based in Winter Park, Florida that serves as an asset manager and sub-advisor to a broad range of clients and investment professionals. Our mission is to create unique investment solutions that help our clients meet their longterm goals. We take pride in complementing our investment programs with quality service and support. Conventional buy-and-hold investment strategies can fail to keep pace with rapid globalization of economies and financial markets. We seek to innovate forward-thinking investment strategies that address the needs of the evolving investment landscape. Accordingly, Lyons Wealth applies a proactive investment management philosophy to navigate diverse market conditions. Important Disclosures The Lyons Tactical Allocation Index ( the Index ) is the exclusive property of Lyons Wealth Management LLC ( Lyons Wealth ). Lyons Wealth has contracted with The NASDAQ OMX Group, Inc. (collectively, with its subsidiaries and affiliates, NASDAQ OMX ) to calculate and maintain the Index. NASDAQ OMX shall have no liability for any errors or omissions in calculating the Index. You cannot invest directly in an Index. The Index inception date is January 1, 2000, and commenced daily calculation and dissemination by NASDAQ OMX with a base value of 1,000.00 on July 18, 2012. Any information related to the Index prior to its calculation commencement date is hypothetical and derived from a back-tested model. The Index inception date of January 1, 2000 was selected by Lyons Wealth because it captures at least 10 years of performance that includes multiple bear and bull market cycles, which creates a robust data set while maintaining a frame-able and modern reporting period. Lyons Wealth registered as an investment adviser in July of 2009, and was not managing money for the entire time period shown. The index does not represent actual trading, but was achieved by the application of a model. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the methodology or system discussed in this presentation will generate profits or ensure freedom from losses. Hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risks associated with actual trading. 11
Lyons Wealth Management, LLC 807 W Morse Blvd #105 Winter Park, FL 32789 www.lyonswealth.com 1 (877) 951-8710 Information Sources: ¹ Capital Research and Management Company ² JP Morgan Asset Management: Guide to the Markets 1Q 2014 ³ Fund Evaluation Group, Standard & Poor s, and Lyons Wealth Management using data from Zephyr StyleADVISOR. Recovery periods are stated as the time needed for the S&P 500 Index to reach its previous high water mark. 4 Standard & Poor s 05.22.2014-LWM-02