Sunday, January 9, 2011

Investing PART 9: One version of the “Unfinished symphony”

The widows’ and orphans’ stock portfolio

The buy and hold strategy referenced in PART 1 uses mutual funds. I don’t like mutual funds because of their expense, and I consider bond funds a “fool’s game.” Almost all mutual funds are precluded from addressing the most important question which is asset class mix (i.e., rebalancing).

Thus, when a friend asked me, “What’s a good mutual fund to buy and hold?” I ducked the question with a flip response. All the previous postings on investing provide the context I would have had to discuss before giving any serious investment advice. I also would have wanted to discuss leverage.

So my flip response was to note J&J and Pepsi as buy and hold alternatives. (All links relevant to stocks referenced are at the end of this posting). He knew it was a flip comment. For most people it would be too risky to own just two stocks. For younger people, say his kids or his nephews, I wouldn’t worry about their just owning J&J and Pepsi, assuming they would add other positions over time. Diversification is a real risk-reducing factor for long term investors. But, you don’t need a mutual fund to achieve it.

To illustrate, before I knew my grandmother as Grandma, she was the classic widow with children. They lived exclusively off of her investments. This was back before Social Security. She was a self-taught investor and a good one. The types of stocks mentioned here are either the same stocks she held or the same type of stocks, thus the name, widows’ and orphans’ stock portfolio. These stocks also constitute a darn good selection for a major portion of a retirement portfolio especially in an IRA where the dividends would be shelters from our ever-greedy tax man. The object is make money and these companies do.

Within large cap stocks, about 80% of the benefit of diversification can be achieved with as few as 5 or 6 names. About 90% can be had with 10 and 98-99% with 20. But, the logic of the entire buy and hold strategy is, “I don’t want to worry about it.” So, the selection has to meet the 10, 20, or 30 year test and provide diversification. But, that’s just stocks, and, you’ll see, it’s only large cap at that. I’ll discuss other assets in future postings.

“Why start with large cap US stocks?” you ask. We’ve changed musical genre again so we can set Katy Perry’s “Don’t look back” aside. In PART 7 I promised to update the Compound Average Rate of Growth (CARG) table for the S & P. As it turned out, I was also asked to show it adjusted for inflation. The data are available in “S & P CARG through 2010.”

Basically it shows that US large cap stock have a fairly stable return over long periods when dividends are allowed to compound. That’s a pretty big hint. It is particularly important to note how little a year or two between start dates matters to the rate of return over a long period. Is it really worth giving up the return on a diversified portfolio for a year or two to try to get a better entry point? Well, not if you’re planning for 10, 20 or 30 years out.

Add to that the simple truth that most people know more about these companies than they think. People know whether the products are good. They know how the products fit into their budget. They may know whether employees generally seem happy. People let confusing the stock with the company intimidate them. Sure stocks can get overpriced, and buying at market tops will cost you money. However, if you’re talking about a portfolio, generally, not all the stocks will be overpriced at the same time. Large cap US companies are a good place for an individual investor to start.

What you’ll notice about this posting is that it discusses a totally different set of assets from ones mentioned when talking about trading. The most important consideration in investing is your time frame. You depend upon my investments for short-term cash generation and long-term investments. Thus, you should think about short-term trades (although maybe not as short-term as the reader I refer to as the trader) and long-term investments (essentially holding where hopefully the holding is 10 plus years). I’m much more comfortable with holdings (and more successful).

The approach of clearly deciding whether you are buying as a long-term investment or trading reflects some basic truths about forecasting. The WALL STREET JOURNAL, Weekend Investor, January 8, 2011, had an interesting article on the topic entitled “Making Sense of Market ForecastsBy Jason Zweig. While the article missed a few points and misinterpreted some others, it’s a good read.

Points it missed included errors in the measurement of what’s being forecast and, even more importantly, whether the statistic being forecast represents anything other than noise. Also, when talking about forecast error, he overlooks an important characteristic of forecast techniques. Forecasters refer to the trumpet in forecast error. Error doesn’t increase linearly with time. Confidence bans that reflect the model’s statistical characteristics increase at an increasing rate. Thus, while he accurately describes the characteristics of most forecasts, he misses some of the causes. The missed points are no big thing.

However, when he gets down to what to do about it, he reaches some conclusions that should be viewed with the same skeptical eye you should apply to forecasts. The first relates directly to the short-run and long-run issue. He states, "If you are a long-term investor, you should accept that short-term market moves aren't predictable, and there is little point in adjusting your portfolio in response. In most cases, long-term averages of past returns—while far from perfect predictors—are probably a better guide than long-term forecasts of future returns." That's a conclusion about the long-run that underlies much of this posting.

The problem comes in the setup for this statement. He contradicts himself. He talks about a phenomena economists know as persistence, the tendency for things moving up to continue moving up and visa versa. He concludes "this kind of momentum surfing is best left to traders." That's his basis for stating "you should accept that short-term market moves aren't predictable." Well, trading and investing aren’t incompatible as long as you’re always clear about which you’re doing.

In the section entitled "Average many different forecasts," things get down right dangerous. He states, "Forecasts from different sources tend to draw on varying information and divergent methods, so their errors will frequently offset one another." There is a very dangerous assumption built into that statement. While often true, there is no reason to believe the forecasters errors will be randomly distributed. That same assumption, that forecast errors would be normally distributed, had a lot to do with why the experts underestimated the housing crisis. Always understand the assumptions the forecaster is making. Further, always, always, always look hard for reasons why errors wouldn't be independent of each other. It is when errors compound that catastrophic errors occur.

The approach here is to buy with a ten year horizon and hopefully to leave the selection alone for ten years. This portfolio is designed for a ten year -plus time frame. Thus, the reason for holding these assets is important. Selling them would only be due to a fairly important change in the company or the world.

Academic studies indicate that ten stocks get you in the neighborhood of 90% of the benefits of stock diversification within large cap stocks. The diversification reduces company risk (management screw ups) and industry risks (buggy whips to autos). Country risk can be reduced by owning companies with global franchises (Brazil verses US economic performance is a good example because Brazil has collapsed at a time the US was booming and it grew right through some US financial crises). You’ll hear people talk about currency risk in global companies, but you want currency exposure unless you think the dollar has some divine right not to fluctuate.

Also, dividends that grow are important. They mitigate inflation risk and reduce the risk from overall stock market fluctuations (a form of liquidity risk). If the market goes down when the dividends go up, who cares – you’re not selling for ten years. You can use the dividends to buy more shares. Or, if you live on the dividends and one company cuts its dividend, the growth in the other nine helps to protect your cash flow. Whenever anyone talks about buy and hold, listen closely to what assumptions they make about dividends. Some of the critics of buy and hold ignore dividend growth or ignore dividends totally. I think they are pimping for the brokers and trying to generate trading commissions. An unbiased look at the data is pretty supportive of the viability of buy and hold.

That said, here’s a list with some comments.

1) J&J - I can’t figure out a single stock that can substitute for J&J’s combination of consumer non-durable, drug, and medical devise exposure. J&J is well-run, conservatively financed with a strong balance sheet, their brand management is exemplary (some of their brand names have become product categories), and they pay a nice dividend.
2) Pepsi – Beverage and snack food exposure. It gave me fast food exposure also when I bought it. They hadn’t spun off YUM yet. But, I didn’t immediately replace the fast food exposure when they spun off YUM which was unfortunate since both YUM and McDonald’s have done well. (They would have been the logical holdings). Later I purchased a little McD on the side for the portfolio.
3) Exxon – Chevron is an alternative with a bigger dividend. If you believe oil is the fuel of the past, buy one of these companies anyway. They are hydrocarbon processors as well as miners/drillers.
4) 3M – no one can figure out what 3M is. So the company has decided they need a good ROI and dividend to get investor attention; it works and it is a great company strategy from a shareholder’s perspective.
5) Bank of NY Mellon - or Berkshire Hathaway – Both are weird financial service companies for sure, but the financial service industry is tricky. I wish Mellon still had a retail bank, but Mellon is the firm purely in the financial services space that I feel most comfortable with for an intended ten year holding period. Berkshire isn’t a pure financial service play, but under the hype, it has a big financial service component. Even in troubled times you need to include at least one financial firm. Mellon has a dividend which they cut during the financial crisis. Berkshire doesn’t have a dividend and thus didn’t make this portfolio.
6) Boeing – Unfortunately it has headline risk. But as a stock and as a company, it belongs. It has a business cycle that is totally out of synchronization with everything else.
7) Verizon – Is it a telephone utility, a cell phone, an internet delivery, or a cable company competitor? Don’t care what it is: it is well-run and well-positioned. It also has a nice dividend. While Boeing has its own cycle, Verizon tends the follow the inverse of the cycle for many of the other stocks on this list. Because of the dividend, it is sensitive to interest rate cycles over short-to-intermediate time horizons.
8) P&G or Colgate – One could cycle between Procter and Gamble, Clorox, Kimberly Clark and Colgate Palmolive and probably make a profit. But, that’s a lot of work for the marginal return over any one of the individual stocks. They tend to move together so if you don’t like P & G, pick one of the others.
9) PPG – It is a conservatively-run chemical company. The chemical industry is a tough business, but their staying power is illustrated by the little story at the end of this posting.
10) GE or United Technology – For the long-term you want companies that can survive bad managers. GE is doing that right now. The alternative United Technologies is better run right now and more of a pure industrial play, but GE will survive Immelt. Some day United Tech will be run by someone like Immelt who can’t admit he is in over his head.

There are two or three others you could substitute to suit your style. McD as mentioned, Sysco, Abbott Lab, and Wells Fargo come to mind, but it doesn’t matter too much. You might throw in a tech company to update the list, but in tech I’m not a good source for ideas. I got Microsoft and Intel at good prices, but I haven’t a clue as to how long I’ll hold them.

I think how I learned about PPG is funny because it illustrates just how easy it is to overlook an opportunity if you aren’t looking for it. It is also indicative of why PPG is on this list.
My grandmother use to talk about PPG. That should have been enough, but it took more to get my attention.
Grandma gave some of her stocks to each daughter (sort of a dowry). My mom got some PPG. Well, along the way my parents ended up selling all their stocks, or so they thought. My mom had a habit of “putting things in a safe place”.
Well, PPG occasionally paid a stock dividend. My mom dutifully put in a safe place. However, as she often did, she forgot where the safe place was. With time she forgot she had the shares. (After all it was only 20 shares and who knew where it traded back then). So, when everything was sold, these shares were overlooked.
When she died, knowing her habit of forgetting things she put in one of her safe places, we went through everything. Inside the cover of an old book were these 20 shares. (We also found a few thousand dollars in other books, some in silver certificates and some evidently printed in the 40’s and 50”s. Growing up during the depression, she used inside of books as her version of stuffing it in a mattress).
Well, we called the PPG’s trustee to inquire about the 20 shares. We wanted to determine whether they had actually been replaced or sold by book entry. The trustee asked why we had never responded to their letters. Since mom didn’t know she owned the shares, she never told them where she lived. Except for the initial dividend right after she moved, the dividend checks were never mailed since they kept coming back to the trustee. Eventually the checks were cancelled. But, the stock had split two-for-one three times. The 20 shares she lost were now 160 shares paying a 3 or 4% dividend, I forget which.
If you want a case for buy and hold and an illustration of the power of compounding, do the math on that. Since then, I studied the company and followed its performance. I’m embarrassed to admit that it took an accident to wake me up to what has been a strong and stable performer.

Now, you might ask, “Why is this posting an unfinished symphony?” Well, this is only relevant to one objective and only covers one narrowly-defined asset type. So, there’s more to come. Perhaps it should be called “A Bridge Over Troubled Water.” It sure felt like one at various times.

Stock references in the order mentioned:
J&J (JNJ), Pepsi (PEP), YUM (YUM), McDonalds (MCD), Exxon (XOM), Chevron (CVX), 3M (MMM), Bank of NY Mellon (BK), Berkshire Hathaway (BRK-B), Boeing (BA), Verizon (VZ), Procter and Gamble (PG), Clorox (CLX), Kimberly Clark (KMB) , Colgate Palmolive (CL), PPG (PPG), GE (GE), United Technology (UTX), Sysco (SYY), Abbott Lab (ABT), Wells Fargo (WFC), Microsoft (MSFT), Intel (INTC)

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