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FAQsCan you summarize your investment methodology? What does SweetSpot’s track record look like? How did SweetSpot hold up during the recent market turmoil? How do you know when a sector’s sweet spot has been reached? Besides SweetSpot’s track record, are there studies that support this approach? Why doesn’t conventional investment methodology work as well as your approach? How risky is SweetSpot compared with the broader market? Is SweetSpot a value approach a la Warren Buffett? How long have you been trading SweetSpot? How liquid are SweetSpot holdings? What is the typical turnover rate of the SweetSpot Portfolio? What are your fees and account minimums? Do you also offer other investment advisory services such as a newsletter? Please tell us a little bit about your background. How does a new SweetSpot investor get started?
Q: Can you summarize your investment methodology? A: I invest in the stock market’s most unpopular sectors — the ones that investors have essentially abandoned. I work with a universe of about 500 sector mutual funds and ETFs, organized into about 85 industry sectors or international regions. I apply a formula that ranks sectors according to how popular they are with investors, looking at things like net assets, price performance, and cash flows. Each year I buy several of the highest-ranked sectors — or lowest-ranked by the investing public — in a three-year hold. I call this strategy “SweetSpot® investing.” The SweetSpot Portfolio currently holds 17 positions bought over the last three years. A: In stock investing, the term “sweet spot” refers to that point in a market cycle where a downward trend begins to level off, and potential rewards now outweigh potential risks. At the sweet spot, the market is saying something like, “Things can’t get any worse and they’ll never get any better” – which is kind of silly if you think about it. Even if more bad news does come out, the worst has already been factored into the price so nothing much happens. But if the news is unexpectedly good, the trend reverses upward and a new market cycle is born. With respect to our past trades, unexpected good news has come just about every time.  Click On Image to Enlarge Q: What does SweetSpot’s track record look like? A: As of Q3 2009, a dollar invested in the SweetSpot Portfolio since its inception in 1999 would have grown to $3.81, while that same dollar invested in the S&P 500 would have actually shrunk to 98 cents. On average, SweetSpot returned 14 points better per year than the S&P 500. In SweetSpot’s 10-year history, we have completed 20 round-trip trades, with holding periods ranging from one to five years. Of those 20 trades, 19 have been profitable and 17 have outperformed the S&P 500. Perhaps most significantly, positions bought each year have always collectively outperformed the S&P 500 during the period they were held.
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The only calendar year that SweetSpot has underperformed its benchmark was 2006. But there is no stock-investment strategy that beats the market every year. If anything, 2006 demonstrated that year-over-year returns are not relevant to our long-term prospects: At the end of that “subpar” year we completed the most successful three-year trade in SweetSpot’s history.
Q: How did SweetSpot hold up during the recent market turmoil? A: In 2008 we suffered big losses like everyone else who held stocks. But SweetSpot had gone global in 2007, and we beat our global benchmark by a wide margin in 2007, 2008, and so far in 2009 as well. It was hard to feel victorious about anything last year, but in the end our test is how we perform compared to a representative benchmark, and SweetSpot has aced that test. Moreover, as discussed below, SweetSpot recently converted to a “long/short” approach. We expect to be much better protected from major market declines, without sacrificing performance. Q: You invest in sectors — why? A: Sectors are uniquely well suited to an approach that relies on market cycles. When we break down the investment universe into its component parts, we find that each sector is moving within its own market cycle – going strong, going bust, or going nowhere. This gives us a sizable universe to work with. There are always sectors that are out of favor with investors and, of those, some are likely to be nearing a market bottom.
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With a sector approach we end up with a nicely diversified basket of funds that spreads the risk around. We also sidestep the company-specific risks associated with individual stocks. It’s odd that so many investors who would not consider investing in supposedly risky sectors won’t hesitate to buy an individual stock if they like its “story.” Stocks are much riskier than sectors.
 Q: How do you know when a sector’s sweet spot has been reached? A: Well, I can’t say we know when the sweet spot is reached – wouldn’t that be great? In fact, the sweet spot can only be identified conclusively in hindsight. But SweetSpot is about probabilities. The SweetSpot formula looks at sector-specific data – that is, numbers – but what it really measures is human behavior. The best evidence of investor sentiment is the movement of capital into some sectors and out of others. But we have to be careful — while market bottoms are usually characterized by extreme capital outflows, it does not follow that such outflows only occur at market bottoms. Still, on the rare occasions when we have bought a sector that was far from its bottom, we actually benefited from the opportunity to add cheaper shares. That’s why I usually keep a certain percentage of assets in cash. Even without averaging down our cost basis, however, SweetSpot’s track record shows that a three-year holding period has been enough time for our investments to recover their value and ultimately show market-beating profits. Q: Besides SweetSpot’s track record, are there studies that support this approach?
A: Several studies by different investment research firms provide support for SweetSpot’s specific methodology, and countless others over the years support SweetSpot’s basic premise – that contrarian investing works. It’s an age-old truism: “When everyone thinks alike, everyone is likely to be wrong.” But for most investors, being a contrarian is easier said than done. As Warren Buffett has said, “It’s simple but it’s not easy.” One of SweetSpot’s big advantages is that it essentially forces us to take a contrary position. Mr. Buffet’s mentor Benjamin Graham once said that in order to be a successful investor, “People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” SweetSpot gives us simple rules that are worth adopting and sticking to. In 2006, after SweetSpot had registered seven straight years of solid performance, I ran a back test to see how the strategy would have performed historically. I found market-beating returns going back to 1989,* which is the earliest it would have been possible to trade this type of strategy. I have also found plenty of support for SweetSpot in behavioral finance, which has shown that our brains react the same way to certain stimuli. When everyone is selling, our irrational “caveman” brain tends to take over. Investment opportunities must be present when just about everyone is taking the same action based on emotion and not objective analysis. Q: Why doesn’t conventional investment methodology work as well as your approach? A: It all comes down to price. Most investors buy stock in companies that are known to have good growth prospects. If the growth comes, fine – maybe the stock will continue to appreciate. But there’s no margin for error – if bad news comes, the price will suffer and investors will sell. So the conventional approach perpetuates the “buy-high, sell-low” cycle that plagues most investors. SweetSpot investors, in contrast, buy sectors that have a negative story attached to them, so at least we know we’re buying low (even if not at the low). And so far, we have been able to complete almost every trade by selling high. Q: How risky is SweetSpot compared with the broader market? A: SweetSpot’s historic risk-adjusted returns have been outstanding, but so what? The fact remains that few of us are willing to leave ourselves vulnerable to the kind of wealth destruction we saw last year and could see again. An adjustment is needed, and I have found the one I want to make. SweetSpot’s risk profile has been transformed this year with the adoption of a “long/short” program. The long side of the program will remain the same; we will continue to buy beat-up sectors each year and hold them for at least three years. The short side will consist of selling the broad stock market whenever it shows signs of topping out, according to a backtested strategy that looks at some of the same measures we use to inform our SweetSpot trades. This approach can be expected to protect us from major market declines while preserving our ability to reap what SweetSpot sows versus the market. A recent backtest found that SweetSpot’s short strategy would have anticipated every extended market decline going back to 1971.* In SweetSpot’s 10+ years of real-time trading, there would have been five sell signals: Trade dates and returns for short S&P 500 positions, 1999-2009:
Notice that our short strategy would have enabled us to sidestep both of the severe bear markets that have occurred in the last decade. What if we had been smart enough to trade it alongside SweetSpot from the beginning? No surprise: Our risks would have been dramatically lower, and our returns would have been dramatically higher. Ain’t hindsight great?
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Performance figures relate to hypothetical trades that would have resulted from trading a short strategy alongside SweetSpot’s real-time long program. It is assumed that short trades were entered in an amount equal to the long portfolio as of the trade date, and earned the inverse of the S&P 500 Index. The SweetSpot Hedge SweetSpot sectors tend to exhibit a distinct profile just before we buy them. Their asset base has shrunk and they have seen ever-lower prices over an extended period. Now both trends show signs of leveling off or even reversing. That’s when we buy. But what if the broad stock market starts showing the opposite traits? Suppose the market has seen an extended period of growing assets at ever-higher prices, but the trend is now leveling off or showing signs of reversal. Shouldn’t we sell? Yes, according to the kind of numbers that inform our SweetSpot trades each year. The same principles we rely on to find sectors that are likely to be at or near a bottom can also tell us when the broad stock market may be at or near a top. By regularly performing the equivalent of an inverse SweetSpot analysis, we should be able to take timely action to protect ourselves. Risks and trade-offs
How to Implement When the time comes to sell the market, choices will include: 1) Sell short shares of market-index exchange-traded funds (ETFs); 2) Buy leveraged or unleveraged inverse-index ETFs or mutual funds (whose prices move in the opposite direction of the underlying index by a factor of one, two, or three); 3) Sell market-index futures; and/or 4) Raise cash. The Long Side Further protecting us from downside risk is the profile our long side will keep. SweetSpot is a “deep-value” approach to investing, meaning that much of the downside risk we would otherwise face was already suffered by whoever held our positions before we acquired them. Moreover, investors who have sold out of the oversold sectors we’re about to buy cannot then sell them after we buy. Selling pressure is what drives stock prices lower, so it’s comforting to know that the pool of prospective sellers who could move prices against us is thinly populated. It is true that individual sectors can be more volatile, or “riskier” than the market as a whole. But what if you hold a basket of a dozen or more sector funds, spread across a broad range of industry sectors and international regions? The day-to-day gyrations of any individual fund in that basket become irrelevant. The changes in value of the whole basket are what we care about. And those changes tend to resemble the market’s movements, the only difference being a noticeable tendency to appreciate a bit more on up days and lose a bit less (or even gain) on down days. SweetSpot investing is similar to buy-and-hold but with a twist: Every year we sell the positions that have had ample time to realize their full value, and then we “refresh” our holdings with new positions that have years of value recovery ahead of them. Conservative investors want to limit unnecessary trading; SweetSpot has shown that frequent trading, whether long or short, is not necessary to achieve solid returns. Q: Is SweetSpot a value approach a la Warren Buffett? A: SweetSpot actually reflects more closely the way Warren Buffett used to invest, by looking for solid companies whose stock was priced below their break-up value. SweetSpot sectors tend to include many of the stocks that come closest to meeting this standard. Mr. Buffett learned this approach from Benjamin Graham, who developed it during the depression era when dirt-cheap companies were plentiful. When that changed, Mr. Buffett went from trying to buy good companies at a great price, to buying great companies at a good price. Obviously, that has worked phenomenally well for him over the years. If you’re Warren Buffett, I like your chances with that approach. Q: How long have you been trading SweetSpot? A: Eleven full years. Q: How liquid are SweetSpot holdings? A: Very – mutual funds can be sold any day the market is open, and the trades usually settle the next day. ETFs trade like stocks, so they can be sold throughout the trading day. The proceeds can be used for some purposes immediately upon execution of a trade, and settlement occurs three days later. Q: What is the typical turnover rate of the SweetSpot Portfolio? A: Average annual turnover is about 25%, and all SweetSpot trades qualify for long-term capital-gains tax treatment. Normally, entering three-year trades once a year would give us a 33% turnover rate, but every now and then a position we already hold becomes a repeat trade and we restart the three-year clock at that point. This effectively lowers overall turnover. Q: Is your approach proprietary? A: The SweetSpot formula is proprietary, and as far as I know no one else makes available the information one would need to trade this approach. There is also no single mutual fund or ETF I know of that offers anything resembling SweetSpot. Indeed, you’re unlikely to hear about this style of investing from money managers who feel they have to justify their fees by showing that they are actively managing your investments. Similarly, few brokers would refer you to SweetSpot because it won’t generate the commissions they seek from frequent trading. I guess they’re all hoping investors won’t notice that trading for its own sake is counter-productive and investor-unfriendly. Q: What are your fees and account minimums? A: The current account minimum is $100,000. Annual fees, paid quarterly, are 1.5% of assets under management. Q: Where are accounts domiciled?
A: Accounts can be at any firm that offers investors access to markets for mutual funds, exchange-traded funds, or both. Q: Do you also offer other investment advisory services such as a newsletter?
A: Yes, I publish an annual newsletter, The SweetSpot Investment Letter, with updates quarterly and at other times as warranted by events. Q: Please tell us a little bit about your background? A: I am a registered investment adviser and a former federal attorney, and I have been a student of investing for over 25 years. A few years into my legal career, after I had paid off my student loans and actually accumulated some capital, I realized we are all responsible for our own financial well being. Yet in all my years of schooling, I was never taught how to invest. It took lots of hard work and trial and error to learn for myself what works and what doesn’t in the investment arena. SweetSpot brought it all together, and the decision to base a business on it essentially made itself. Q: How does a new SweetSpot investor get started? A: New SweetSpot investors should take the following steps:
For assistance, or to receive periodic updates on performance, call 248-254-6648 or email info@sweetspotinvestments.com. *Backtesting suffers from certain inherent limitations. In particular, the backtested results for SweetSpot’s short strategy do not represent actual trading; they may not reflect the impact that material economic and market factors may have had on an adviser’s decision-making if the adviser were actually managing clients’ money. Maybe that’s why so many strategies fall short when investors attempt to duplicate backtested results. Contrast the short backtest, however, with the 2006 backtest of SweetSpot’s long strategy. While that backtest showed a clear advantage over the market, SweetSpot’s real-time results far exceeded what the backtest would have predicted. The backtest merely confirmed that the strategy would have worked over a longer time horizon than the period in which it has been actively traded. Still, no representation is made that investors will see profits similar to either actual or hypothetical past results. Disclaimer: SweetSpot Investments LLC is a registered investment adviser in the State of Michigan, USA, and is authorized to do business under various exemptions in other States and foreign Nations. The firm will not solicit or accept business in any jurisdiction in which it is not properly qualified to conduct business.
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