The buy part of
buy-and-hold is the trickiest, but if done right, it makes the hold part easy.
Good
judgment comes from experience, and experience comes from bad judgment.
Experience
should result in some principles to guide behavior.
Introduction
This
posting and the ones that will follow discuss buying criteria as they apply to a
universe of stocks that should be a good investment over a very long period of
time, forever unless something changes fundamentally in the business. The
portfolio criteria are:
1-Generates
a reliable dividend stream that will grow over time
2-Displays
less volatility than the market in general
3-Provides
returns that do not lag the overall market over a full market cycle
4-Contains
core stock holdings in a diversified portfolio of assets
5-Requires very few changes over a long period of time
In previous postings, the portfolio has been
referred to as the Widows’ and Orphans’ Portfolio. Hopefully, that conveys the
fact that it is neither the only investment option nor even the best investment
option for some investors. It is, however, designed to be real life portfolio
that accomplishes the stated objectives. The focus in this posting is on when
to buy stocks that are appropriate for the portfolio.
Anyone reading these postings thinking that the
buying criteria will be along the lines of load up on stock X at $42.50 should
look for a different source of information on stock purchasing. Establishing a
target price is always advisable, but one’s investment success should never
totally depend upon that target price being right. That leaves no room for the
inevitable errors that will occur in such analyses. Rather, buying criteria as
discussed in this posting are hopefully timeless examples of the type of
situations that are opportunities to buy.
This posting describes some general tools that allow
the construction of the portfolio that meets the criteria. The following postings
discuss each individual stock in the portfolio. For each individual stock the
following postings identify examples of buying opportunities and how they fit
into the construction of the portfolio. Reviewing the stocks individually can
give a false impression that there is a lot of trading involved in managing the
portfolio. That is not the case.
Minor adjustments may be required occasionally to
rebalance, and stocks may be added to the portfolio. However, for most of the
stocks in the portfolio, trading has consisted of deciding that the stock
belonged in the portfolio and the initial decision to buy. After that, it was a
matter of turning on the dividend reinvestment and watching for opportunities.
In general, for most of the stocks there weren’t more than one or two times in a
20 or 30 year period when an additional major purchase seemed appropriate.
Major purchases will be referred to as a statement buy or conviction buy. In
order to provide additional guidance on buying, the postings will also discuss
some minor purchase opportunities that will be referred to as opportunistic
purchases. The best way to look at opportunistic purchases is that for some
other reason like portfolio fit or rebalancing there was a need to find a
purchasing opportunity. The stock wasn’t bought because of the opportunity
rather the opportunity was uncovered because of a desire to buy the stock.
Background
This is an update to an original article that
introduced the concept of the “Widows’ and Orphans’ Portfolio” (JANUARY 9,2011, Investing PART 9: One version of the “Unfinished symphony”). It's
not the first update; previous updates tended to focus on reporting changes. These
posting take a totally different approach.
These postings discuss buying criteria for each stock. So, they are actually
more an extension on the previous postings than an update. They also discuss
expanding the portfolio beyond 10 stocks, an artificial limit that clearly
becomes increasingly unnecessary as the value of the portfolio increases.
The only comprehensive attempt to address buying
criteria was from the perspective of the total portfolio (e.g., JANUARY 12,2011, Investing PART 10: “Know when to hold ‘em, know when to fold ‘em.”). It
only dealt with buying from the perspective of the appropriateness of dividend
reinvestment during the accumulation phase and overall portfolio considerations
such as rebalancing and risk management. The considerations discussed in that
posting still apply.
There have been postings that addressed individual
stocks. Focusing on individual stock can be easily misinterpreted. Any comment
on an individual stock can be misleading if viewed in isolation rather than
from the perspective of portfolio fit. There have been references to taking a
position in stages rather than all at once. But generally, other than the
discussion of individual stocks, the only other reference to the buying criteria
was a suggestion that, if starting from scratch, equal dollar weighting of the
10 stock portfolio made sense.
Disclosure: I recommend equal dollar amounts in all
10 stocks, but that wasn't how the portfolio was built. It was built one or two
stocks a time because that's all I could afford at that time. It is still
possible to build the portfolio that way, but it's no longer necessary given the
elimination of odd lot charges, lower brokerage commissions, and the plethora
of mutual funds and ETF's that an investor can use while accumulating funds. I
would not fully invest in the 10 stocks all at once. Rather, I would make
purchases in stages at fixed intervals over at least a full year or more.
A recent article constructed a portfolio with
objectives similar to the Widows’ and Orphans’ Portfolio by examining the
holdings of certain ETFs (20 Top Stocks For A Monthly Dividend Portfolio,SeekingAlpha.com, 7/26/2017). It identified a good starting point for anyone
looking for a universe of stocks to consider for a portfolio sharing the
objectives of the Widows’ and Orphans’ Portfolio. However, it is only a
starting point because the ETFs do not include some types of companies that are
appropriate for a portfolio with the stated objectives. Like many discussions
of portfolios, including the discussion of the Widows’ and Orphans’ Portfolio, the
article didn't discuss buying criteria. It described the objective but not the
means of achieving it.
Examining ETFs is a different approach from that
taken by postings on the Hedgedeconomist.com where the emphasis was on a firm-by-firm
selection to build a portfolio with broad industry coverage. A firm-by-firm
approach to building the portfolio allows ample opportunity to avoid overly
concentrating in any specific industry or group of firms whose stocks tend to
behave similarly over stock market and economic cycles. Further, the firm-by-firm
approach forces an investor to think about differences in cyclical behavior. Thinking
about how the stock will behave over the business cycle makes the hold part of
buy-and-hold easier. Finally, the firm-by-firm approach can yield buying
criteria in the form of portfolio fit. What
one considers buying should always reflect what one already owns.
The discussion of the Widows’ and Orphans’ Portfolio
made a point of fact that there are alternatives for many of the stocks in the
portfolio. Those other stocks might be added to expand the coverage of the
portfolio. As the number of firms to be considered for inclusion in the
portfolio increases, the overlap between the two approaches (firm-by-firm
analysis and examination of ETFs) becomes quite extensive. Interestingly, the article on ETF holdings was
the second in a series and also represented an expansion of an initial
portfolio of 10 stocks to include a larger universe. So, perhaps before
addressing individual stocks, it would be appropriate to discuss the general
approach to expanding the portfolio.
Why
stocks have to be added to the portfolio
It seems appropriate upfront to indicate that the
criteria used in the ETF articles to expand from 10 to 20 holdings isn't one of
the criteria used in these postings. The articles expanded the portfolio to 20
stocks in order to manage the monthly dividend flow. The assumption in these
postings is that anyone who can build a portfolio of dividend growth stocks is
sufficiently financially sophisticated to manage the cash flow over each year
and quarter. That makes monthly dividend flow irrelevant.
Risk
management is often a potential justification for expanding the portfolio.
Since it is the stock portfolio, it's always going to be 100% invested in
stocks by definition. Consequently, if one stock becomes overweight, a
potential response is to acquire an additional stock. If it's done as part of expanding
the portfolio with new funds, the original position can be retained with the
proper weighting restored by the acquisition of the addition.
For example, if during the accumulation phase
dividend reinvestment is being used, one stock may become an unacceptably large
portion of the portfolio. If that occurs, a decision has to be made whether to
sell some of the stock, use additional funds to add a new stock, or turn off
the dividend reinvestment in some stocks and use the dividends from those
stocks to restore the proper weighting.
During the distribution phase, the dividends from
one of the stocks may become too large a portion of the total dividend stream.
It's a different form of concentration risk. If dividends are being accumulated
with a view toward spending them, consideration might have to be given to
postponing the spending in order to acquire a new stock for the portfolio.
If risk is managed using the percent of the
portfolio and/or the percent of the total dividend flow, the need to add
additional stocks is less urgent; the rebalancing can be done within the
initial portfolio holdings. In rare cases, that may be the correct approach.
However, if dollar values are used as limits for the amount of concentration in
any single stock or the amount of the dividend flow, adding an additional stock
can end up being the only solution. For example, it's reasonable to establish a
rule that no individual stock can be worth more than X percent of one’s annual
income, or during the distribution phase, no individual stock can generate more
than Y percent of one’s monthly income needs. Both are legitimate risk
management approaches. Using dollar limits for portfolio concentration to
provide additional perspective beyond that gained from percentage limits has
been advocated on the Hedgedeconomist.com website.
Finally, although the intent is to hold the stocks
indefinitely, things change and some stocks will have to be sold and replaced.
One might have fixed selling criteria, such as, selling a stock whenever a
dividend is cut. Also, changes in the environment or the structure of the
business may negate the reasons that the stock originally fit in the portfolio.
However, there are two types of
selling strategies that seem inappropriate for a widow’s and orphan’s
portfolio. Selling based on the achievement of a price target or percent gain
is inappropriate. Such activities belong in a trading account. Second, one
wants to build a portfolio of companies that are not dependent upon stellar
management. To paraphrase Warren Buffett, try to invest in companies that will
prosper even if run by an idiot because sooner or later they will be.
Consequently, temporary displeasure with the current management is not a reason
to sell in and of itself. In fact, in some cases it may provide a buying
opportunity.
Finally, as discussed throughout these posting,
there are times when individual potential candidates for the portfolio are
particularly appealing. It's not always possible to buy high-quality stocks at
bargain prices, but when the opportunity arises, it's the perfect opportunity
to add it to the portfolio.
An
approach to building and expanding the portfolio
Obviously, any stock purchase begins with an
analysis of the company. The result should be a two or three sentence
investment thesis. There are examples from the original article on the Widows’
and Orphans’ Portfolio quoted in subsequent postings. They are examples that
held up through the subsequent analysis that would precede any purchase. In
some cases, they include aspects of the company's business that were
particularly relevant to a portfolio that would consist of only 10 stocks.
However, they are still representative of the type of thesis that should be
developed.
That initial two or three sentence investment thesis
can result from rigorous screens of various financial characteristics of the
firms. The Widows’ and Orphans’ Portfolio was not constructed that way. Many of
the screening tools available currently were not available when the initial
investments were made. Further, an important component of that initial analysis
is a subjective assessment of the market position and brand strength of the
company’s products. It also should include an understanding of the company's
long-run strategy. Strategy and brand strengths are something that can’t easily
be screened with existing tools. So, some familiarity with the industry and the
company are prerequisite to formulating an investment thesis. Also, a screening
isn't going to automatically establish a portfolio fit. Starting with market position and brand strength, strategy, and
portfolio fit seems far more reasonable than starting with financial
characteristics. The financial characteristics of the individual company
can be checked at any point.
Once a group of companies has been identified as
potential investments, gaining additional familiarity with how the stock
performs and the company behaves is the next step. In previous postings, I
referred to that as putting the stock on a watch list. Commenters have
sometimes reacted as if putting a stock on a watch list is the equivalent of a
buy recommendation. It's far from it, although I have a preference for taking a
small position well before the final decision about a serious investment has to
be made.
The
advantages of the small initial position are many.
First, if it is a good, well-run company with strong brands, it may require a
long wait until a really good buying opportunity arises. In the meantime, that
initial position can be used for dividend reinvestment to slowly build up the
position while waiting for an opportunity to make a “statement” buy. Similarly,
if the stock takes off, the investor has a position, participates in the run,
and can focus on other opportunities that may represent better entry points.
Although taking an initial position while further
assessing the company can result in small losses, the losses are small and draw
attention to errors in the investment thesis which could have cost much more. At
the same time, if the investor feels that the loss on that initial position is
unjustified, the price decline presents an opportunity to purchase additional
shares at an even lower price. In most instances, monitoring the initial
position sharpens the investors understanding of the stock's performance, and
consequently, results in an average lower cost for the total acquisition.
Although as stated, it may also involve a long wait for the opportunity to take
advantage of that sharpened understanding of the company and the stock.
Small initial positions also allow the investor to
diversify more quickly. If managed properly, they can also eliminate the
necessity of taking a position on the overall direction of the market. They
allow portfolio additions to come into the portfolio in a manner analogous to
dollar cost averaging. Further, unless the investor has just experienced some
windfall, small initial investments allow the investor to grow the portfolio in
a way that is consistent with their ability to add funds to the portfolio.
The only time small initial positions become awkward
is when the investor has just liquidated a large position and needs to reinvest
the proceeds. Keep in mind this is a fully invested 100% stock portfolio by
definition. When a large position is liquidated, multiple small positions may
be appropriate. That can be particularly appropriate if the liquidation
eliminated a desirable industry exposure and the investor hasn't identified a
single replacement were a conviction buy would be appropriate. In other
circumstances, it may be appropriate to initiate one small position while
making a statement buy on one of the stocks that was being accumulated.
It is also a good idea to have a “parking lot”
equity investment. One can use an index fund or ETF as a place to park funds if
no other option seems advisable. The parking lot approach is particularly appropriate
if rolling a significant amount of funds from a 401(k) into a self-directed IRA
where you want to purchase individual stocks.
Why
principles not rules
For many investors, the Holy Grail is a rule for
buying and selling stocks. Most efforts to develop rule-based trading are
totally inappropriate for a portfolio with the objectives of the Widows’ and
Orphans’ Portfolio. They're more appropriate for a trading account. Many of
them seem to have been developed with a view toward encouraging portfolio churn.
That's especially true of many of the systems marketed by the brokerage
industry. There's nothing wrong with a trading account. If one enjoys the
thrill of trading stocks, a trading account is totally appropriate. It also can
be appropriate for a speculative account that supplements core holdings.
However, those objectives are very different from the objectives being
discussed in this posting. The purpose of the portfolio being discussed is to
make money over the long run with a high degree of reliability and consistency.
As an aside, it shouldn't require a lot of work, and it should be something
that anyone could do.
There's no point in debating different approaches to
the stock market. If everybody agreed, it wouldn't be a market. However, some
justification for the approach being discussed is warranted. The catchy way to
describe the difference between a rule-based system and this description of
actual experience based upon certain principles is as follows: a rule-based system assumes knowledge,
while a principle-based system assumes judgment. Since investing involves
predicting the future, it seems reasonable to believe that the investor can't
know the future but can make a judgment about its implications.
Now, if one wants to get technical, any rule-based
system has to be based upon analysis of historical behavior. One of the
variables in the analysis is time. So, the rule is always going to be applied
to circumstances that are technically referred to as “out of sample.” That does
not mean that the analysis is irrelevant. Not surprisingly, as a hedge
economist, my comments aren't designed to denigrate such analysis. I have done
them, explained them, analyzed them, and am an avid consumer of the research.
Understanding the findings, the data reliability, the estimation errors, and
the forecast errors is useful as an input. It may be a good input into the
judgment. But, if one acts on the implications of the analysis, one is making a
judgment using only the limited set of information about history that was used
in the analysis. All the techniques that people use to back test are good
refinements to the analysis, but they don't overcome the fact that a judgment
is being made about whether the analysis applies out of sample.
It also seems highly likely that any rule developed
to be applicable to all stocks at all times is going to fail. There is just too
much diversity in the nature of the companies the stocks represent, the
composition of the potential buyers and sellers of different securities, and
the environment in which the decision has to be made. Knowing various rules for
trading is useful, but the trick is to know which rule to apply in which
circumstance.
Start
small and grow
This posting talked about how to expand the
portfolio, and the ones that follow will discuss a large number of individual
stocks. That can make the process seem complicated and time consuming. It's
not.
Keep in mind that the current portfolio was
developed over many years. Also, because of when it was developed and the
limited range of investment tools available at that time, it was built stock by
stock. It started with the purchase of three stocks. The next year one of those
stocks was replaced and a couple of stocks were added. After that, one stock
was added each year until the number of stocks reached 10.
It is realistic to think that despite the demands of
career and family, it is possible to identify one good investment opportunity
per year. It's also probably a good discipline. It forces the investor to pick
their very best investment idea. One doesn't need to do extensive analysis to
identify one potential investment opportunity a year. Just in the course of
living life and being attentive one can identify a good opportunity each year.
It's totally anecdotal, but that has been my
experience. In the stock-by-stock discussion that follows, I will mention some
bloopers. Almost invariably they were the second or third stock I tried to pick
in any given year. Initially they tended to be the ones furthest from my
firsthand experience. Put differently, it sometimes took two or three tries to
get industry exposure to areas where I lacked firsthand experience that I could
use to judge the companies brand strength and marketing skill.
The bloopers occurred at the beginning of the effort
to build this portfolio when I wanted to get some industry diversity fairly
quickly. They also occurred much later when I added more money to the portfolio
due to 401(k) rollovers or made a contribution that I thought justified more
than one purchase.
Once the portfolio reached 10 stocks, portfolio
management consisted of turning on the automatic dividend reinvestment and
reviewing quarterly reports (they were hard copy and only available quarterly).
Because I owned stock in the 10 companies, I naturally noted any news coverage
of the companies. Once a year I read the annual reports of the companies. In
one instance I actually sold the company because reading the annual report was
extremely time-consuming and required a lot of analysis. Even after reading all
the footnotes and examining the financials, it was hard to determine the health
of the company. If a company makes
understanding their business complicated and time-consuming, get out of the
business. That was the situation for
many years, and the portfolio stayed at 10 stocks.
In previous postings on Hedgedeconomist.com there have
been references to research on how many stocks are needed in a portfolio in
order to manage stock-specific risk. It's also been discussed by many
experienced investors. The Widows’ and Orphans’ Portfolio included 10 stocks.
However, it is easy to argue that six is enough or that it requires 30 or 40.
The right answer depends upon the industry coverage of the stocks selected, the
investor’s willingness to accept volatility, and the amount of time the investor
is willing to put into constructing the portfolio. That final point about the “time
the investor is willing to put into constructing the portfolio” is crucial. A
portfolio of stocks should be rewarding in many ways, not just financially. Put
differently, if it isn't fun, don't do it. One can always hire someone else to
do it, but don't be naïve; it's going to be costly to hire someone.
No comments:
Post a Comment