Saturday, April 6, 2013

It's Hard To Believe.

Well, at least I'm not the only one to notice grandmother's portfolio.

The last posting (“In the Eye of the Beholder”) mentioned a widows’ and orphans’ portfolio.  When first I introduced the portfolio in “Investing PART 9: One versionof the ‘Unfinished symphony,” I described how my grandmother, who was a widow with children to support, first introduced me to some of the stocks.  So, when I saw an article on Yahoo finance entitled “Why Your Grandmother’s Portfolio Is Beating the Pros’,” naturally, I was curious.  Alas, it was not about my grandmother, but it certainly was about her investment style.
Sure enough, it made the same point as the last posting.  Some very conservative, high-quality stocks have been leading the market.  Or, to quote from the Yahoo article, “A scan of the stocks leading the rally to new index highs in 2013 reveals a pantry full of household-name, blue-chips of the sort that might have entered a conservative investment account 30 or more years ago.”

The interesting question at this point is what that leadership implies for future gains.  The WALL STREET JOURNAL article that mistakenly attributed leadership to low-quality stocks argued that it was time to rotate into the high-quality stocks.  However, as discussed in the last posting, much of the performance of the high-quality portfolio results from its lower volatility, especially in down markets. 
At some point the market will correct, which is market speak for go down.  At that point, it will be interesting to watch whether it is the market leaders (i.e., high-quality stocks) that decline the most.  That would be extremely atypical, but then the market likes to do things that are atypical.  More than likely, and therefore a good forecast, is that some of the stocks in the widows’ and orphans’ portfolio will go down more than the market and some of them will defy the market decline.  Overall, the portfolio will probably outperform the market during the next correction. 

An excellent illustration of the point of the posting right before the last.

The posting, “A KISS for Financial Education,”concluded with the statement:
“Financial management can be boiled down to a few simple principles. Interest rate compounding, inflation, and risk and diversification are important, but one suspects that often the failure of financial management education results from the fact that stating simple truths is sometimes painful. No one likes to accept the fact that there are limits. As a consequence, financial management education often focuses on how to try to avoid the limits rather than on what those limits are. The limits are unavoidable.”

As if on cue, the day following the posting, the WALL STREET JOURNAL ran an article entitled “12 Debt Myths That Trip Up Consumers.” The subtitle was “Borrowers too often fall prey to the conventional wisdom. And it can cost them.” The article was a perfect illustration of the concluding paragraph of the posting.
It started with the simple statement: “Avoid debt if you can. If you can't, borrow carefully and conservatively.” The article could have been very educational, if at that point it had explained why and pointed out the unavoidable limitations associated with consumer borrowing. Instead, the article provides an excellent example of using information to obfuscate. It goes on to state: “So the conventional wisdom goes. But if you follow it blindly, you may miss out on key nuances of dealing with debt.”
The information the article presents is interesting and accurate, but the deficiency is that the only potential use of the information is to try to avoid the limitations inherent in consumer debt. One can go through each of the 12 points and use it to illustrate the theme of the previous days posting. But in the interest of brevity, only the introductory examples are discussed in this posting.
The article starts with the statement: “For instance, consider store-brand credit cards. They often offer no-interest financing and rewards on store-bought products. Sounds great. But did you know those attractive financing terms can come back to bite if you carry a balance after a promotional period?” One has to wonder why the author thinks it “Sounds great.” It's equally reasonable to assume that having a bunch of merchandise in your possession that you don't own does NOT sound great.
This statement only makes sense if one assumes that it is legitimate to apply the logic of present value calculations to consumer goods. But, as has been argued on this blog in a previous posting entitled “Truth In Lending:”
“…present value relationships are appropriate for investing. They do not apply to consumption. A dollar today can be invested with the result that it’s worth more than a dollar paid a year from now. However, there is no guarantee that a dollar spent today will result in more satisfaction, happiness, benefit, or whatever you chose to call it, than the dollar spent a year from now. If a year from now it’s a medical treatment for a potentially life-threatening condition that is in question, the treatment has a pretty big benefit to most people. It would be rare to have whatever was bought be worth more than the treatment.”

Even the inducement of the rewards may not justify accumulating a bunch of junk that isn't yours. The statement is deficient in that it treats the absence of an interest charge during some specific period of time as the absence of a cost. Using any consumer credit involves giving up a very valuable asset: your control of your future income and the optionality implied by controlling your future income.
That critique should not be misinterpreted. In the body of the article, it does present the way in which using those interest free loans implies risk. It stresses the risk associated with not servicing the debt in a timely manner, but it overlooks the relationship between the surrender of optionality and that risk. Consequently, it misses an important concept. It completely ignores the fact that all leverage, even interest-free leverage, creates risk.

The second introductory example in the article is as follows: “Then there's mortgage debt. A big down payment may be a great way to steer clear of a huge home loan. But if you get the money for the down payment from relatives, lenders may scrutinize your financials closely.” It would seem to me as a casual observer that whether the debt is to a financial institution or a relative is quite irrelevant. If I isn’t a gift, it is still debt.
Perhaps if the article had gone into issues related to interest rate costs, or something else relevant, it would have made sense. But the whole focus of bringing up the point seems to be on preserving the ability to borrow more money by not affecting your credit rating and the mortgage review process.

Why should anyone in a position of taking on a major debt worry if an independent party wants to look closely at their financials? A more rational approach would be to welcome an independent party evaluating whether the loan makes sense. Further, the lending organization should have an incentive to want to be sure that the borrower is not taking on more debt than they should. One of the critiques of the behavior of financial institutions before the current financial crisis is that they weren't doing just that. So, the article seems to be trying to present ways one can develop the same sort of over-leveraged position that many people got into during the buildup to the financial crisis.
The posting included the comment: “We seem more intent upon making it possible for people to borrow rather than to educate them about the risks associated with borrowing.” That same focus seems to apply the WALL STREET JOURNAL article. As stated in the posting, “That is unfortunate because nothing is more destructive of prosperity, both for the individual and for society, than the US public's attitude toward borrowing. It is a system-wide problem.”

Monday, April 1, 2013

In the Eye of the Beholder

It's not beauty; it’s an interpretation.

The WALL STREET JOURNAL on March 22, 2013, had an interesting article entitled “Low-Quality Stocks Have Zoomed.  Time to Shift Gears?”  Some may legitimately object to my use of asset appreciation as analogous to beauty, but please, give me a pass.  Instead, focus on the theme of the article, which was that "junk" continues to beat "quality" on Wall Street because it’s a fiction.
To support that interpretation, one has to very carefully pick the time over which the analysis is applied.  If one uses the first quarter of 2013 during which time the market gained 11%, market leadership by sector has been healthcare, followed by consumer staples, followed by utilities.  Those sectors generally aren't associated with “junk.” One can undoubtedly pick junk from the sectors, but they hardly support the argument the author makes.

The author identifies his time frame with the statement: “Nearly four years after the end of the recession of 2007-09, it should be the other way around.”  As an economist, I don't object to the use of the business cycle, but as an investor, the business cycle is an inappropriate time horizon.  As an investor, the appropriate timeframe is ones holding period.  At a minimum the appropriate holding period would be through the entire cycle, not just since the low point of the recession.  
Further, as is appropriate for a journalist, the author focuses on what is changing the most, but that may not constitute the best investment.  To illustrate the point, the author uses two example stocks.  But as we all know, picking two examples may be an appropriate technique for illustration, but it hardly constitutes a reason to accept the hypothesis.  It would be equally possible pick two examples that support the opposite argument.

Better support for the author's hypothesis comes when one considers groups of stocks.  So, quote from “Low-Quality Stocks Have Zoomed. Time to Shift Gears?,” again:  “Consider two groups of stocks that were constructed according to financial-quality ratings from Ford Equity Research of San Diego. These ratings are based on factors such as debt, balance-sheet health, earnings consistency and industry stability. The first group contained the 20% of the firm's universe of more than 4,000 U.S. stocks with the firm's highest financial-quality ratings, while the other group contained those with the lowest ratings—junk, in other words.”
“Since March 2009, according to Ford, the average junk stock has gained 273%, versus 171% for the typical high-quality stock. And there is no recent evidence that this trend has reversed: Over the past three months, for example, junk has increased its lead, gaining 12.1% versus 9.6% for quality.”    

While the broader focus seems to present a more relevant data set, it suffers from the same flaw of only focusing on the recovery.  Further, and more seriously, it ignores dividends.  The same “quality” that the author points out as underperforming is strongly associated with superior dividend maintenance and growth.  Those dividends need to be added in, and compounded.
Some relevant information about dividends is pointed out a week later in BARONS in a column appropriately entitled “Speaking of Dividends,Payouts Outpace Price Gains in S&P” (March 30, 2013).  As it points out, “From 2007 through the end of 2012, dividends grew 14%, according to data from Howard Silverblatt, senior index analyst with S&P Dow Jones Indices. A dollar in 2007 is worth about $1.12 now, a jump of some 12% from 2007, according to data from the Bureau of Labor Statistics. So the rise in corporate cash distributions has outpaced inflation.”

“Dividend-paying stocks have seen healthy share-price gains, as well. A selection of S&P 500 stocks that have consistently increased their dividend payouts for at least 25 consecutive years -- the so-called Dividend Aristocrats -- actually exceeded their precrisis price highs two weeks before the broader index, marking a 144% recovery from the financial-crisis lows.”
But in terms of market commentary the BARONS column entitled “Don't Worry, Be Bullish” (March 30, 2013), probably presents the most accurate summary.  As it points out “WHATEVER ELSE IS SAID about the quarter, the winners have been a curious bunch…”
It notes that some of the leaders were “some companies all but left for dead last year” [the “junk”].  After providing some examples, it then goes on to note that “…exuberance of a most curious sort has put the staidest of sectors in the lead, consumer staples.”  It then notes some examples that are clearly from the “quality” group.

All this commentary is interesting, but only marginally relevant as investment advice.  It's news.  No doubt.  Ultimately, when viewed objectively, it does nothing more than highlight an old Wall Street saying: “it's not a stock market; it’s a market of stocks.”  It's individual stocks that matter.
In terms of direct investment advice the BARONS column, “The Striking Price,” on March 30, 2013, is probably most on target.  It's curious that the advice should appear in the “The Striking Price” column since that column usually addresses shorter-run option trades.  But the article entitled “Investing, the Rudyard Kipling Way,” advances almost the opposite approach from options trading.

Further, the column presents a good illustration of why the relevant holding period should be through the entire market cycle rather than just the recovery.  It points out that “one of the great riddles of our time is why so many people are such bad investors. After all, good investing isn't terribly difficult.”
“All you really need to do to be successful is pick a reasonably well-run company like IBM (ticker: IBM), or Johnson & Johnson (JNJ), or even a low-cost mutual fund or exchange-traded fund that tracks the Standard & Poor's 500, and forget about it. Dividends and inflation account for about half of investment returns, and the rest is largely attributed to time, perhaps a little luck, and an ability to remain graceful under pressure.”

“But few people, as demonstrated yet again by Dalbar's recently released annual ‘Qualitative Analysis of Investor Behavior,’ can do what Kipling extolled—keep their heads when all about them are losing theirs. Because of this, most investors fail to match the annual returns of the market. In short, they greed in to Wall Street's latest craze and panic out when the party suddenly ends.”
Clearly, for many people the advice to develop “an ability to remain graceful under pressure” and keep one’s head when many other people are losing theirs is a tall order.  But it need not be.  In a posting on January 9, 2011, this blog introduced what it referred to as “The widows’and orphans’ stock portfolio.”  The posting presented 10 stocks as a core portfolio as well as a number of alternatives that can be substituted.  It (“Investing PART 9: One version of the ‘Unfinished symphony”) referred to them as a widows’ and orphans’ stock portfolio because of the very low beta of the overall portfolio.  It's the type of portfolio a widow can hold through the entire business cycle.  It certainly isn’t unreasonable to assume that the average investor could do the same.

Of those 10 stocks, four recently made all-time highs, and three others have made 52 week highs.  Many of the potential substitute stocks have also made all-time and 52-week highs.  But the real secret of the widows’ and orphans’ portfolio isn't how it performs during upswings.  One of the quotes in the BARONS column entitled “Don't Worry, Be Bullish” (March 30, 2013), hints at the advantage of the widows’ and orphans’ portfolio.  Specifically, “Société Générale strategist Andrew Lapthorne attributes consumer-staples stocks' outperformance to their ability to cushion losses during times of market turmoil.” 
A major shortcoming of the average investor is a tendency to time the market wrong, buying when the market is in its peaks and selling when it's at its lowest.   “Qualitative Analysis of Investor Behavior” isn't the first study to uncover the phenomena.  The existence of the phenomena has implications.  A portfolio that reduces the impact of market swings on the individual mitigates one of the causes of the tendency that lead to investor underperformance.  Essentially by mitigating the impact of market swings on an individual's portfolio, the widows’ and orphans’ portfolio reduces the incentive to try to time the market.

If the market goes down 50%, as it did in the recent downturn, it's hard to see how the market upswing is going to provide 100% return required to get even.  By contrast, if one’s portfolio goes down 20%, it's a lot easier to believe that the portfolio will be able to gain the 25% needed to break even.  That's especially the case when each year the portfolio is generating two or 3% of that return in the form of dividends that can be reinvested.  Further, during the accumulation stage of one's life, it's fairly easy to set up a simple scheme to ensure that one’s purchases do benefit, at least a little, from market timing.  Automatic dividend reinvestment guarantees that one purchases more shares during down markets.
There's another saying on Wall Street about good investment.  It goes something like: Sucessful investors make their money during down markets not bull markets.  The Hedged Economist feels obligated to add something to Wall Street's inventory of sayings.  So, I would add that it isn't just at theme parks that “a roller coaster may be more fun but boring monorail ride is more likely to get you where you want to go.”  It works in the stock market, too.