4 ways to defend your stock portfolio that have helped this fund manager beat the market

By Michael Brush

If recent stock-market weakness has you on edge, this might be your problem

Sometimes in stock investing, the best offense is a good defense. Except, according to mutual-fund manager David Miller, "most investors don't know how to play defense."

Miller runs the Catalyst/Millburn Hedge Strategy Fund MBXIX, which tops its Morningstar Direct benchmark by always playing a bit of each - defense and offense.

The fund goes long stocks by owning a mix of exchange-traded funds (ETFs) for diversification - such as SPDR S&P 500 Trust SPY, Vanguard Emerging Markets Stock Index Fund VWO, and Vanguard Real Estate Index Fund VNQ, among others.

Trend following

For defense, Miller bets against asset classes in downtrends. This trend-following side of his portfolio often does best when stocks do their worst. "You get better total return when you add the two strategies," he says. "You get a tiny fraction of the drawdowns."

Catalyst/Millburn Hedge Strategy Fund has beaten both its Morningstar fund category and benchmark index by three to seven percentage points annualized over the past three to five years, according to Morningstar Direct. "We are playing against all these teams that don't play any defense," Miller says. "We can put up a better return by losing less."

On the trend-following side, Miller focuses on four asset classes: equities; commodities; bonds and currencies. He bets against them when their trends look negative - below their 200-day moving average. Likewise, he goes long in these asset classes when they appear to be in an uptrend because they are above this long-term average.

For example, the fund outperformed in 2022 (up 7.7% compared to a 19.6% decline for the S&P 500 SPX) due to Miller's negative bet against bonds, which fell sharply that year as interest rates rose. He didn't need to agonize over an economic forecast to get this right. "I had no way to predict that," he says. "But we didn't have to predict it for it to work in our favor. Our goal is not to predict what will happen, but to be on the right side of the trend."

For trend-following positions, Miller turns to the futures markets. They offer more targeted exposure to parts of the market such as commodities, bonds and currencies. A futures contract is an agreement between two parties to buy or sell an asset at a set price in the future.

Currently, on the trend-following side, Miller is long equities, long commodities, and short bonds. He is short currencies from countries with low interest rates such as Japan, and long currencies in economies with relatively high interest rates like Australia and New Zealand.

Here are four tips from Miller to use in your own investing:

1. Don't be long only: Consider betting against asset classes that appear to be in downtrends because they are below their 200-day moving averages.

2. Follow the insiders: Miller favors companies where insiders are buying stock. Their purchases are a bullish signal because they probably know more about their companies than anyone. Miller uses this age-old strategy with a nice twist, though: He buys the debt of companies where insiders are purchasing company stock. "No executives in their right mind will buy their stock if they think they are going to default on their debt," says Miller. "You get dramatically fewer defaults in bonds where executives are buying the stock. It is one-sixth the overall default rate."

He favors bonds maturing in three years or less. He checks to make sure the company has adequate current assets to pay off the bonds that mature ahead of the debt he buys, since those debts get paid off first. Companies that recently passed his test include Sherwin-Williams (SHW), Ares Capital (ARCC), VeriSign (VRSN), and AbbVie (ABBV).

3. Follow the buybacks: I use insider analysis extensively in my stock letter, but I mainly consider purchases by actual insiders, namely executives and directors. Miller takes a different approach. To broaden the pool of potential stocks, Miller considers stock buybacks as a form of insider buying. This makes sense. Management often has a grasp on when their stock is cheap. And shrinking the share count improves key metrics like revenue and earnings per share.

The car parts retailer AutoZone (AZO) is a good example. The company had 42 million shares outstanding in 2011, and it reduced that to under 18 million last year. Over the same time, revenue grew to $17.4 billion from $8 billion in 2011. "If the share count drops by a half and revenue doubles, that is quadruple," Miller says. AutoZone stock has advanced to $68 from $12.50 back then.

4. Invest in oligopolies: Miller says he prefers to invest in companies that are near-monopolies or part of an oligopoly. The airplane-parts seller TransDigm Group (TDG) , for instance, dominates its market. TransDigm also offers a way to invest in the rebound in air travel. It benefits from the demand trend, but suffers less than airlines in travel downturns during recessions.

"TransDigm is a good example of a monopolistic business," Miller says. "It is hard to displace them because airlines are not going to buy second-rate parts. They have a real lock on the customer." Like car owners, airlines really need parts when they need them, which gives Transdigm pricing power. This brings rich margins. The gross profit margin here is 56%.

In the brokerage business, no single company has the presence that Transdigm has in airplane parts. But large, household-name brokerages such as Morgan Stanley (MS) and Merrill Lynch effectively act as an oligopoly because they don't compete much on fees. "They locked into concept of charging 1% of assets," Miller says. In this space, Miller has invested in Ameriprise Financial (AMP), which is aggressively reducing its share count via buybacks.

Miller also singles out Mastercard (MA), which is part of an oligopoly in payments systems for credit and debit cards. Limited competition supports high profit margins. The fund manager points out that revenue will continue to grow because people worldwide are switching to cards from cash, and because of inflation. And the company continues to buy back stock. That's a winning combination, Miller says. "Those just seem to work."

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested ARCC, ABBV, AZO, TDG, MS and MA in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks

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-Michael Brush

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04-22-24 1502ET

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