Friday, January 24, 2014

What is to be learned about stock acquisition?

The market for individual stocks can be more profitable than the stock market.

This blog posted a discussion of a model large cap stock portfolio.  The posting on Sunday, January 9, 2011 was entitled “Investing PART 9: One version of the ‘Unfinished symphony.”  As it made clear from the subtitle, “The widows’ and orphans’ stock portfolio,” the portfolio was designed to be a boring (stable, low beta) and profitable equity portfolio.  Also, as implied by references to it as a “core” portfolio, the design was for it to be a boring and profitable portfolio when held year-in-and-year-out, not just in 2013.  Perhaps a better name for the portfolio would be the retirement portfolio.  However, it was introduced as a widows’ and orphans’ portfolio.  So, widows’ and orphans’ it stays.

There are advantages to targeting such a portfolio beyond just the boring profitability of the holdings.  Specifically, the portfolio is designed to require minimal maintenance. Just the act of holding a core set of assets generates familiarity.  Anyone who invests in a particular company will want to monitor its activities and learn about it.  Thus, over time, without a huge concentrated effort, the investor will become familiar with the companies.  At the same time, minimal maintenance implies that whatever effort is expended should be easy.  Furthermore, it is best if it does not require huge technical skills.

A low beta portfolio like the widows’ and orphans’ portfolio could easily underperform in a year like 2013.  Another posting about the same portfolio identifies how to avoid that trap.  As noted in the posting on Wednesday, January 12, 2011, “Investing PART 10: Know when to hold ‘em, know when to fold‘em,” one still has to decide when to purchase the core holdings.  The timing issue is much easier when it is being applied to a limited range of stocks, all acquired with the intention of a long-term holding period.

Again, 2013 provides a lot of guidance.  In fact, 2013 was a bit atypical in that it presented numerous illustrations of how to manage portfolio acquisition timing.  A January 11, 2014 BARRON'S article entitled “Stocks Hold Steady Despite Weak Jobs Data” cited relevant data from Bespoke Investors’ Group's year-end report: …“the S&P 500 stocks that went up the most were the smallest; those with the lowest dividend yields; the highest short interest, and the worst analyst ratings. In other words, the lowest-quality stocks rocked the house.”  That is not the type of year that would benefit a large-cap widows’ and orphans’ portfolio.

The article goes on to point out, “From time to time, however, relatively cheap stocks pop up—even high-quality companies, and often for short-term reasons. In times like these, a quick 10% drop in the shares of a well-known company with a solid business and a promising future could represent a nice entry point for investors with a two- to three-year outlook.”  Therein lies the guidance appropriate for any investor, especially one with a long-term horizon, and 2013 provided an excellent illustration of how the investor could easily take advantage of such opportunities.  A key word in the statement above is “easily.” Monitoring analysts’ ratings of a large number of stocks, having a judgment about the relative performance of large verses small companies in the S&P 500, and foregoing dividends are not easily incorporated into the philosophy of the widows’ and orphans’ portfolio. 

Noticing a 10% drop in one of the portfolio holdings is a bit easier, and 2013 provided ample opportunities to capitalize on such events.  Such opportunities will be discussed subsequently, but first, 2013 provided an even easier opportunity.  Again, it simply involves applying the same rule to the media as was discussed above in connection with portfolio strategy.

The need to analyze the motives of commentators does not just apply to general market commentary and discussions of portfolio structure.  It is equally true of discussions of individual stocks or bonds.  Here, however, an investor is justified if, occasionally, he or she suspects that there is maliciousness involved.  After all, nothing forbids short-sellers from commenting or duping the media into commenting for them.  Occasionally, the Hedged Economist has commented when short-sellers seem to be generating media coverage.  But, from an investor's perspective, the best strategy is to avoid any involvement in situations where that seems to be the case.

Malicious intent is hard to identify.  There are, however, easier opportunities to profit from focusing on the motives of commentators.  One should always keep in mind that the media is perpetually looking for scandals and bad news.  The saying, “if it bleeds, it leads” may be an exaggeration when applied to the business media, but a close approximation is nevertheless very true.  Even more to the point, when general media focuses on a business story, there is no doubt that the intent of the commentator is to find scandal and bad news.  What could be easier than just following the news and using the information to increase the return on a portfolio?  A little judgment is all that is required.

A review of 2013 provides an excellent example of just such an opportunity.  Boeing experienced difficulty in the launch of its new airliner.  It had experienced delays that held the stock down for a number of years.  Remember, Boeing is in the widows’ and orphans’ portfolio specifically because it moves according to its own development cycle.  However, in January, battery fires on Boeing's new airplane hit the news big-time.  

The launch of the new airplane is going to involve the identification of necessary enhancements to the original design.  Consequently, battery failures and other needed enhancements will undoubtedly be in the media again from time to time.  However, when general media starts second-guessing a premier, world-class aerospace firm on the development of airplanes, it is an opportunity far greater than trying to time a development cycle.  During January, and even into February, there were some excellent opportunities to purchase Boeing at a discount.

The opportunity was so great as to literally eliminate any long-term downside risk to the purchase.  It justified attracting any dividend reinvestment from Boeing or other stocks, as well as providing a strong argument for targeting Boeing with any new capital.  Boeing did much more than just recover from the temporary bad news associated with batteries.  In some respects, the bad news associated with batteries heralded the end of the development cycle for the new aircraft.  It was a cue that Boeing was about to transition from heavy investment in aircraft development into the launch of a major new aircraft.  Boeing went on to almost double by the end of the year and raised its dividend.  It does not take many stocks performing like Boeing to ensure the portfolio does not lag the general market. 

Opportunities like the Boeing situation are rare.  One such opportunity each year would be enough to keep an investor happy with the portfolio.  However, during 2013 other opportunities to enhance performance of a portfolio like the widows’ and orphans’ portfolio provided enough positive reinforcement (in the form of profits) to be sure that the lessons from 2013 would be remembered. 

The situation with Boeing only required paying attention to the general media.  The other opportunities required a little more attention.  But the widows’ and orphans’ portfolio is not intended as a buy it and forget it portfolio.  One has to pay attention to how the companies and their stocks are performing.  But it does not require detailed financial analysis or sophisticated technical analysis tools.

A perfect illustration is developments with PPG.  PPG is not as much of a household name as most of the other holdings in the widows’ and orphans’ portfolio.  So, it is not surprising that the opportunity in PPG results from monitoring the performance of the stock and the company. 

In 2012 PPG stock began to advance as the economy improved and the cost of its inputs fell.  A full year of advancing prices provided ample opportunity to notice the result and hopefully tweak an owner's interest as to what was going on.  All that was required to understand the advance was an understanding of the importance of natural gas as an input for PPG and an awareness of the impact that fracking was having on natural gas prices.

Checking the price of the stock periodically revealed that early in 2013 the stock’s price began to lag behind overall market performance.  Much of the underperformance was due to uncertainty associated with PPG’s decision to spinoff one of its business lines.  However, the overall profile of the corporation and its management remained much the same.  Further, the advantage PPG gains globally from its reliance on cheap US petroleum product (natural gas derivatives) remained in place.

The price was off 5% in mid-February and again in mid-March and April.  By the end of March and into April, the stock, which had outperformed the S&P during 2012, had underperformed the S&P by 10% in 2013.  Yet, the basic business story remained the same.  Stock market technicians have all sorts of complicated sounding names or what was happening like resting during a bull run or retracing.  They can also create all sorts of complicated mathematical or chart monitoring techniques for identifying such events.  However, no such complicated analysis was required.  All one had to do was notice that something funny was happening to the price of PPG stock.

It is important to note that excellent timing was not required to benefit from PPG’s performance.  There was a full year of appreciation of the stock to call attention to the performance of the company.  When the opportunity arose to get the stock at a discount, it lasted a couple of months.  If that opportunity was missed, a similar but less compelling opportunity arose again in June.  The price earnings multiple was continually indicating a discounted price.  Further, timing the total market was totally irrelevant. 

The principal complication associated with PPG was that it followed so shortly after Boeing had presented an opportunity that justified spending all available cash.  Some dividends would have accumulated in the interim.  Yet, the attractiveness of the PPG opportunity so soon after Boeing made it instructive in another way. 

PPG’s stock performance justified looking for an opportunity for a portfolio adjustment within the widows’ and orphans’ portfolio.  Just as the stock of good companies can be selling at a discount, some stocks in the portfolio can be performing better than justified by the company's outlook.  During February, March, April, if one owned GE stock, it was such a stock.  It was outperforming the S&P 500 with no justification other than hype.  Selling some GE stock with the intention of replacing it with dividend proceeds over time presented an opportunity to capitalize on the anomaly in the price of PPG.

The opportunities in Boeing and PPG are instructive because one did not have to be constantly analyzing stocks to become aware of the opportunities.  Simply monitoring the price of the stocks and knowing something about the companies was all that was required.  Additional analysis just confirmed the legitimacy of the apparent opportunity.   

Shifting some capital from GE to PPG may have required a little closer monitoring.  However, there were many indications that such a shift might be desirable, not the least of which was the relative performance of the stock prices and the relative P/Es of the stocks.  Looking at relative P/Es and the trends in relative P/Es is not required for the widows’ and orphans’ portfolio.  However, an opportunity like PPG justifies the additional effort.

The opportunities in Boeing and PPG were similar in two ways.  First, they were not fleeting.  One did not have to be monitoring the market every day in order to see the opportunities and have time to capitalize on them.  In both instances, the casual stock market investor had enough time to act and still look like an expert market timer.  Second, trying to time the total market was totally irrelevant to both opportunities.  If 2013 teaches investors nothing else, it made it infinitely clear that the key to success is individual stocks not the total market.  Boeing and PPG illustrate another important point.  One does not have to invest in highly speculative stocks in order to achieve portfolio performance.

One would not normally expect any single year to present two opportunities for acquisition that are as exceptional as Boeing and PPG.  In fact, in many years there may not be even one such opportunity.  Fortunately, the rest of the widows’ and orphans’ portfolio provided other opportunities of a much more common variety.  They are worth discussing simply because similar opportunities always exist.

A portfolio like the widows’ and orphans’ portfolio is going to generate dividends on an ongoing basis.  In all likelihood, for widows, orphans, and older retirees the dividends would be a source of income for living expenses.  For younger retirees, those accumulating for retirement, and those who only use investment earnings as discretionary income, whether and how to invest the dividends are issues. The balance of this posting is best viewed in that context. 

When discussing dividends, the first thing to address is automatic dividend reinvestment.  Investing the dividends in the same stock has a certain simplicity about it, as well as low-cost.  Its simplicity appeals to many investors during the accumulation phase.  Some advantages are:  First, for many people, not having dividends available makes it much easier to accumulate.  Second, reinvesting the dividends makes it much easier to calculate the total return being realized on each stock.  It makes calculating relative total returns extremely easy.  Third, it automates a process very similar to “dollar cost averaging.” (Dollar cost averaging involves periodically investing a fixed dollar amount in a stock regardless of how many shares result from the dollar amount).  Dollar cost averaging results in a lower average cost per share for the end position.  Fourth, it eliminates the necessity of having enough cash initially to acquire the entire position in the stock that one would like to eventually have.

Other investors find dividend reinvesting unattractive.  First, it involves giving up control of the timing, and thus price, of acquisitions of additional positions.  Put differently, the disadvantage of dollar cost averaging across an entire portfolio is that it eliminates the opportunity to take advantage of situations, such as Boeing and PPG and those described below.  Second, because different stocks will perform differently at different times, it necessitates rebalancing periodically within the equity portfolio.  Third, some investors legitimately place upper bounds on the size of any individual position.  Once they have acquired their dollar target or number of shares target, they want to stop accumulating shares in that company.

Clearly, there is no right or wrong about automatic dividend reinvestment versus accumulation of dividends for directed reinvestment.  It should be equally obvious it does not have to be an all or none proposition.  Automatic dividend reinvestment may be appropriate for some stocks but not for others.  Further, it may be desirable to have automatic reinvestment of a particular stock’s dividend during some periods and not during others.

With that general background regarding the reinvestment of dividends, is now appropriate to turn to specific issues within the widows’ and orphans’ portfolio.  First, however, is necessary to provide some background and a reminder that the purpose of the widows and orphans portfolio is long-term investment, not short-term speculation.  So, for example, during 2013, there were opportunities to trade within the portfolio that would look advantageous if one only looked at 2013.  For example, Verizon got off to a very good start in the year as investors chased yield and Johnson and Johnson became expensive about mid-year.  One could easily have traded from them into other stocks, or even between them.  Such trades would look good if one looked only at 2013.  But that sort of short-term trading is not what the widows’ and orphans’ portfolio is about.  The objective is to establish positions that can be maintained in the long-term.

Opportunities like those discussed above in connection with Boeing and PPG are the time to bring holdings in those stocks to the level one would anticipate holding for the long term (barring some unforeseen development).  Thus, using Boeing and PPG as examples, there would be no further need for dividend reinvestment.  Both Verizon and Johnson & Johnson had previously been in similar positions.  Stock in Johnson & Johnson represented a similar opportunity as it emerged from its difficulties with recalls of over-the-counter drugs and changed top level management.  Verizon presented a number of opportunities to increase holdings when the market was in decline.  That was especially true during the recent financial crisis.  While Verizon declined, it was reasonable to expect it to decline less than other stocks and to provide dividends that could be used to purchase the other stocks at reduced prices.  Pepsi presented a similar opportunity years before.  With these five stocks at the desired holding level since early in 2013, their dividends could be invested in other opportunities.

For most of the year Exxon presented an excellent opportunity to buy a first-rate company’s stock at a discounted value.  Reinvesting Exxon dividends in that type environment made infinite sense.  If on the other hand, one held Chevron, the other integrated oil mentioned as a candidate for the widows’ and orphans’ portfolio, dividend reinvestment was not as appealing.

Another stock where dividend reinvestment made sense was 3M.  It was a logical strategy going into the year, as 3M stock was reasonably priced.  About midyear, 3M stock began to outperform the S&P 500.  As it did, another behavior of its stock became apparent.  Normally, 3M's stock price fluctuations are not much more extreme than the overall market.  (3M has a five year beta only slightly greater than one).  Yet, during the second half of 2013, whenever the stock market turned down even slightly, 3M stock dropped more dramatically. 

Since the widows’ and orphans’ portfolio is an equity portfolio, those drops represented an opportunity to invest dividends accumulated from other stocks into 3M.  Investing the dividends earned by other stocks into 3M when it dipped was an easy way to add to total portfolio performance.

The net effects of all of these purchases (Boeing, PPG, 3M and Exxon) during 2013 was to increase holdings in the widows’ and orphans’ portfolio at prices closer to the 2013 low of the stocks than either the high or the 52 week average.  As a result, the widows’ and orphans’ portfolio easily outperformed the bull market run in either the S&P or the Dow.  However, it would be foolish to adopt either the S&P or the Dow as a benchmark.  There is ample evidence that if the S&P or the Dow is the appropriate benchmark, an index funds is the effective tool. The more important accomplishment is that the portfolio has acquired stocks at prices that create a margin of safety.  When the market turns down, as it inevitably will, the acquisitions should remain profitable.  In the meantime, they will generate continuing dividend streams.  Thus, the risk associated with the portfolio has been reduced without sacrificing return.


1 comment:

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