SweetSpot® Investments LLC

Frequently Asked Questions

 

Q: What is SweetSpot’s investment approach?

A: In a word, contrarian. We invest in the stock market’s most unpopular areas — the ones that investors have essentially abandoned. Although this may seem counter-intuitive, the reality is that investors tend to bid down the prices of out-of-favor stocks to levels that reflect a greater discount than would be justified by even the most pessimistic view. This approach has worked well over time, generating significantly higher average annual returns than a market buy-and-hold strategy.

Methodology

“SweetSpot® investing” relies on a formula to calculate annual cash flows into and out of the 500+ mutual funds and exchange-traded funds that make up our global investment universe. The funds are sorted into approximately 100 industry sectors and international regions (or “sectors”). Each January, end-of-year fund data are collected, analyzed, and aggregated by sector, and the sectors are ranked. New positions are entered in several of the highest-ranked sectors (or lowest-ranked, according to the investing public), financed by the sale of positions entered years earlier. The result is a well-diversified, self-perpetuating portfolio that gives us an ownership interest in roughly 2,000 companies, both foreign and domestic.

Q: Why the name “SweetSpot”?

A: In stock investing, the term “sweet spot” refers to that point in a market cycle when a downward trend begins to level off, and potential rewards now outweigh potential risks. At the sweet spot, typically the market is saying something like, “Things can’t get any worse and they’ll never get any better.” Even if more bad news emerges, the worst has already been factored into the price so further declines are less likely to be severe. But if the news is unexpectedly good, the trend may reverse upward, giving rise to a new market cycle.

Q: What does SweetSpot’s track record look like?

A: Since SweetSpot’s inception in December 1998, average annual gross returns of +13.1 percent have outpaced the strategy’s market benchmark (+4.6 percent) by 8.4 percentage points. In the shorter term, returns have been more sedate. Such periods are inevitable for any strategy that seeks to outperform the market — even the best long-term performers. Research performed in 2014 showed that SweetSpot’s edge is alive and well. The program’s complete real-time trading record can be found here.

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. We work with a sizable universe; there are always sectors that are out of favor with investors and, of those, some are likely to be at or near a bottom.

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 a stock if they like its “story.” Individual stocks are much riskier than sectors.

ETFs vs. Mutual Funds

While ETFs are available for almost every sector in SSI’s investment universe, historically we have tended to favor Fidelity funds when given a choice. (The 2017 model portfolio is invested 70 percent in ETFs and 30 percent in Fidelity funds.) The reason for this preference is simple: As a group, nondiversified Fidelity funds have consistently outperformed their ETF counterparts over time.*

Fidelity’s advantage may be explained by the sector-specific expertise of the firm’s fund managers. (See Are Sector Fund Managers Superior Stock Selectors?) If so, this would be an exception to the historical, collective inability of active equity-fund managers to outperform a passive market index.

Still, we have no assurance that Fidelity’s advantage will persist, whereas we can rely upon what ETFs have to offer: transparency, tax-efficiency, low fees, and liquidity. New SweetSpot investors need not wait for us to phase out Fidelity funds; with rare exceptions, a complete SweetSpot portfolio can be constructed today using only ETFs. Regardless of which vehicle an investor chooses, however: SSI has found that, in the end, it is more important to invest in the right sectors than it is to hold the “best” funds in those sectors.

(Note: SSI receives no compensation of any kind from Fidelity or any other fund sponsors for recommending their products or services.)

Q: How do you know when a sector’s sweet spot is reached?

A: Well, we can’t know when the sweet spot is reached – wouldn’t it be great if we could? In fact, only in hindsight can the sweet spot be identified conclusively. But SweetSpot is about probabilities. SweetSpot’s 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, when we have bought a sector that proved to be far from its bottom, we were able to lower our average per-share cost by adding cheaper shares.

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 many others support SweetSpot’s basic premise – that contrarian investing works. It’s an age-old truism: “When everybody 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 advantages is that our formula essentially forces us to take a contrary position. Mr. Buffett’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.

Backtests

In 2006, after SweetSpot had registered seven straight years of excess returns, SSI ran a backtest to see how the strategy would have performed historically. We found market-beating returns going back to 1989,* which is the earliest it would have been possible to trade the strategy using sector funds. This research was updated in 2014, and the findings were encouraging.

Behavioral Finance

We also find plenty of support for SweetSpot in the field of behavioral finance. BF research has shown that virtually all of us react the same way to certain stimuli. When everyone around us is selling, our irrational “caveman” brain tends to take over. Investment opportunities must exist if just about everyone is taking the same action based on emotion instead of objective analysis. Being aware of this dynamic makes it a bit easier for us, as SweetSpot investors, to override our self-defeating, instinctual response.

Q: Why doesn’t conventional investment methodology work as well as your approach?

A: Price has a lot to do with it. Most investors buy stock in pricey companies that are believed to have good growth prospects. If the growth comes, fine – maybe the stock will continue to appreciate. But there’s little margin for error – if bad news comes, the price will suffer and investors will sell.

This dynamic serves to perpetuate 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, most of the time we have sold high, both in absolute terms and relative to our market benchmark.

Fund Flows are Key

But price alone does not explain SweetSpot’s long-term returns. In fact, we don’t invest in poorly performing sectors as such.  We buy sectors from which investors have fled. Sometimes they are not the worst performers, which can attract bottom-fishers and nonbelievers — that is, people are sticking around. In contrast, investors have given up on the sectors we buy. SweetSpot’s formula focuses on fund flows — investors voting with their feet. Actions really do speak louder than words. Yet annual fund flows are not a commonly used metric, nor one that is even known to most of the investing public.

Most value strategies seek to identify what is fundamentally cheap. SweetSpot identifies what has been abandoned. Cheap can get much cheaper before bottoming, whereas cheap that’s been abandoned is more likely to be at or near a bottom. It’s physics at work: Those who have sold cannot then sell, and if everyone has sold, the next person who wants to buy will have to pay a higher price. That’s how bottoms are formed.

Q: How risky is SweetSpot compared with the broader market?

A: SweetSpot’s historical risk-adjusted returns have been solid. From 1999 until 2009, every completed SweetSpot trade was profitable, usually beating the market by a wide margin. Through January 2017, 45 of 49 closed trades were profitable. SweetSpot’s market benchmark was profitable in only 33 of 49 corresponding periods. As for the “reward” side of the risk-reward ratio, 41 of 49 SweetSpot trades outperformed their market benchmark.

SweetSpot is a “deep-value” approach to investing; much of the risk we would otherwise face was already suffered by previous holders. Those who 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, making it reassuring that the number of prospective sellers who could move prices against us is depleted.

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 sector funds, spread across a broad range of industries and international regions? The day-to-day gyrations of any individual fund in that basket become irrelevant. What matters is the basket as a whole, and its movements have tended to be no more volatile than the market’s movements.

SweetSpot investing is similar to buy-and-hold but with a critical 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 we expect to have years of value recovery ahead of them. Conservative investors want to limit unnecessary trading; SweetSpot’s “buy-low-and-hold” approach has shown that frequent trading is not required to achieve solid long-term 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 priced below their break-up value. Many stocks that meet this standard — or come close — have been found in SweetSpot sectors. Mr. Buffett learned this approach from his mentor Benjamin Graham, who applied 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.”

Q: Has SweetSpot’s long-term track record been verified by an independent third party?

A: Yes. Completed trades through 2011 have been verified by an independent third-party auditor here.

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 bought and sold throughout the trading day. Sale proceeds can be reinvested 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 has been about 25 percent. SweetSpot trades qualify for long-term capital-gains tax treatment.

Q: Is your approach proprietary?

A: SweetSpot’s formula is proprietary, and we’re aware of no other practitioner of SSI’s specific methodology, nor any single mutual fund or ETF that offers anything resembling SweetSpot. Indeed, you’re unlikely to hear about this style of investing from other money managers, who feel that they have to justify their fees by actively managing your investments. Yet trading for its own sake is counter-productive and investor-unfriendly. Quoting Vanguard founder John Bogle: “Don’t just do something, stand there!”

Q: Can you tell us a bit about yourself?

A: I am a Phi Beta Kappa graduate of Michigan State University, and I earned a law degree from George Washington University Law School. That was followed by a successful legal career in both the public and private sectors. I specialized in environmental law, having authored two books on the subject. For over 30 years I have also been a student of investing.

A few years into my legal career, after I had paid off my student loans and actually accumulated some capital to invest, I realized that I was responsible for my own financial well being. Yet in all my years of schooling, I was never taught how to invest. It took a lot 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 the method essentially made itself. In 2007, I founded SweetSpot Investments LLC and then registered the firm as an investment adviser in the State of Michigan. In 2016 I decided not to renew SSI’s registration, instead opting to offer SweetSpot on a subscription basis exclusively.

Disciplinary History

Neither SweetSpot Investments nor its owner and Editor-in-Chief was ever the subject of any complaint, criminal or civil action, administrative enforcement proceeding, or proceeding initiated by a self-regulatory organization that would impugn the integrity of the firm or its owner/manager.

Q: Where are accounts domiciled?

A: Accounts can be held at any firm that offers investors access to markets for mutual funds, exchange-traded funds, or both.

Similarly, in most cases foreign (i.e., non-U.S.) investors can subscribe to and act on SweetSpot’s annual trades if they are resident in countries that allow the free flow of information. Although SSI’s investment universe consists of funds that are available to U.S. investors, many foreign brokerages offer their customers access to funds that serve as reasonable analogs to holdings in the model SweetSpot portfolio. Foreign investors would need to do some sleuthing, but most brokerages are only too happy to assist their clients in identifying funds that can be bought locally.

Q: How does a new SweetSpot investor get started?

A: SSI publishes a quarterly newsletter, The SweetSpot Report, on a subscription basis. The Report supplies the information needed to trade SweetSpot in a self-managed account. Prospective subscribers are advised as follows:

SSI is a publisher of investment data and research, and is not a registered investment adviser. Subscribers are responsible for their own investment decisions. Information that SSI provides to subscribers does not constitute a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent that any such information may be deemed to be investment advice, it is impersonal and not tailored to the investment needs of any individual. See additional disclosures and disclaimers here.

The annual fee for SSI’s subscription service is $495. To subscribe, send a check to:

Neil Stoloff
The SweetSpot Report
221 West Gorgas Lane
Philadelphia, PA 19119-2510
USA
*Backtesting suffers from certain inherent limitations. In particular, backtested results 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. While the 2006 backtest showed a clear advantage over the market, SweetSpot’s real-time results since 1999 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 results similar to either actual or hypothetical past results.
Additional disclosures:  The SweetSpot Portfolio’s past performance is not an assurance of similar future results. It should not be presumed that current or future trades will be profitable or will equal or exceed the returns of past trades. Money invested in the stock market is risk capital that can be lost. SweetSpot’s reported track record relates to trades that were entered and exited in real time on the dates indicated. All reported returns, both gross and net, assume the reinvestment of dividends and other fund distributions. Gross returns show SweetSpot’s record in identifying investment candidates compared with buying and holding a representative market-index fund. Net returns show what an investor would have earned after SSI’s advisory fee and trading costs are deducted. SweetSpot investing is about the method and not the manager. Reported returns do not reflect the effects, if any, of material market or economic conditions on trade sizing or intra-trade activity that might have affected actual returns for better or worse. See more-detailed disclosures and disclaimers here.
Sketches from behaviorgap.com are reproduced here with the permission of the artist, Carl Richards.