What is to be learned for 2014 planning?

It is good to have a plan.

Going into 2014, situations like Boeing, PPG and 3M create a tremendous temptation to chase their performance.  All three are excellent companies, and there are many reasons to believe that the conditions that led to the superior performance of Boeing's and PPG's stock are still in place.  3M on the other hand appears to be fully priced, although the stock has historically been able to maintain a premium for a number of years. 

Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.

Consequently, dividend flows are a consideration in planning for 2014.  Managing dividend flows involves three considerations.  First, one obviously cares about the total dollars the portfolio generates.  Second, the investor is risking capital to secure those dividends.  How much capital is at risk matters.  Consequently, the yield (rate of return the dividend represents) is also a concern.  Third, if one only cared about the total dollars and the rate of return, there would be a tremendous temptation to chase yield and to invest only in the highest yielding stock.  That would introduce considerable risk in two ways: the high-yield stock would become an inordinately large portion of the portfolio and that high-yield stock would probably embody considerable interest rate risk (risk of the decline in price if interest rates rise).  Therefore, the amount or portion of the dividend flow due to each individual stock is a consideration.  It is desirable to have the dividend flow originate from a variety of different stocks.

By purchasing additional shares of Boeing and PPG, the dividend yield (percentage rate of return) of the portfolio decreased.  Both have dividend yields lower than the average of the portfolio.  Further, selling GE shares in order to purchase PPG involved selling higher-yield shares to purchase ones with a lower yield.  Fortunately, dividend increases across a portfolio supported the dollar value of the dividends, but at a lower yield.  The total dividend flow from the entire portfolio is obviously a concern.  Nevertheless, a legitimate objective for 2014 is to restore the yield on the portfolio.

One of the considerations in making the purchases of Boeing and PPG shares was the dollar value of their dividends.  The total dollar value of the dividends from each individual component of the portfolio is managed in order to control risk.  The dividend flow is diversified so that no single firm’s dividend represents too much of a risk to the cash flow.  In fact, references to bringing holdings of Boeing and PPG up to desired levels involved a dollar dividend flow objective.  Thus, during 2014, one should consider investing dividends in those stocks that are not at the desired dollar payout.  At the same time, one would want to also increase the average yield of the portfolio.  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.

When one acquires a stock, one hopes that sales, profit, and/or dividends per share will increase.  It is of course best if all three increase.  During 2013, Boeing's launch of a new airplane indicates that sales and profits should increase going forward.  That should increase potential for higher dividends.  As it turned out, during 2013 Boeing met all three objectives when it raised its dividend.  PPG, by contrast, has done exceedingly well on maintaining profitability, and whether they increase their dividend significantly will be an important indicator of whether management retains their traditional shareholder-friendly posture.  By contrast, 3M increased their dividend, but it needs to confirm that they can generate profits to support future dividend increases.

A multiyear run up in value of stock, such as occurred with PPG, or one year near doubling, as occurred with Boeing, can disrupt the desired portfolio weightings of different stocks.  In fact, it was the performance of PPG and Boeing that justified the continued dividend reinvestment in Exxon and 3M during 2013.  In order to maintain a reasonable exposure to energy, it makes sense to plan to continue the dividend reinvestment in Exxon into 2014.  Adding exposure to Chevron is an equally viable approach.  Although 3M appears to be fully or overvalued, planning to continue dividend reinvestment for 3M also makes sense from the portfolio perspective.  Further, if it pulls back it will be a candidate for investment of dividends generated by other stocks.

As was mentioned, GE shares were sold in order to take advantage of the opportunity in PPG.  It may be appropriate to begin dividend reinvestment in GE during 2014.  If one held United Technology, an alternative to GE mentioned in connection with the widows’ and orphans’ portfolio, the situation is different.  GE is, in many respects, a unique industrial firm because of the substantial holdings in the financial sector.  Its management also creates some unique issues that will be discussed in a future posting.

Similarly, the Bank of New York Mellon is a candidate for dividend reinvestment.  Both the Bank of New York Mellon and GE fell substantially during the financial crisis.  As a consequence, they are below an appropriate portfolio weighting unless one purchased them at some point in the interim.  But there were no compelling reasons to purchase them previously.  However, the Bank of New York Mellon is particularly well situated going into 2014.  It is a potential candidate for reinvestment of dividends from other stocks.  However, it has one of the lower yields of the portfolio holdings.  Therefore, one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.

The other portfolio adjustment to consider is in the area of consumer non-durables.  Consumer non-durables play an important role in stabilizing the portfolio during market downturns.  However, the bull market since the financial crisis will have shifted the portfolio weighting of consumer non-durables to a lower level.  That was particularly true in 2013.  Consequently, Pepsi and Procter & Gamble (or Kimberly-Clark, Clorox or Colgate Palmolive mentioned as alternatives to Procter & Gamble) are candidates for dividend reinvestment or additional purchases.

It is important to keep in mind that the plan for 2014 is not about trying to pick the stock that will appreciate the most.  If that were the case, further investment in PPG would definitely be a candidate for consideration.  There are multiple rules for establishing limits on the weighting of an individual stock in a portfolio.  Some people use 5%, 10%, or 20% of the portfolio’s value.  An equally valid approach is to set a limit to the portion of total dividend flow that any individual stock should contribute.  There is a more subtle rationale for establishing a total dollar value to any individual holding (e.g., that limit could be determined by the relationship of the stock’s value to one's income needs over some period of time). But given PPG’S multiyear run it should have achieved close to the maximum weight one desires for an individual stock regardless of what technique is used for setting that maximum portfolio weighting.

If the plan were simply about picking the stock that has the potential to appreciate the most, the entire focus might be on a single stock.  A good guess is that Bank of New York Mellon or PPG would be that stock.  But such a focus is totally at odds with the objectives of the widows’ and orphans’ portfolio.  The objective is performance over a long-term horizon, not just over the next year.

Even with a multiyear time horizon for investments, 2013 illustrated that one can benefit substantially from simply monitoring what is going on a portfolio and adjusting purchases accordingly.  So, although there is a plan for 2014, that plan explicitly provides for using developments during the year to maximize the benefits of dividend reinvestments and new purchases.

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.

 

What is to be learned about portfolio strategy?

Always keep the objectives of the portfolio in mind.

On December 30, the WALL STREET JOURNAL had a summary of 2013 stock performance.  Unlike some summaries in other media that focus on the biggest gainer or the biggest loser, the WALL STREET JOURNAL's summary was more oriented toward what is relevant to individual investors.  The title, “Winners of 2013: Boring Investors” pretty much summarized why much of the financial press chose to talk about other topics at the end of 2013.  Boring just does not sell to the media.  They want excitement.  Further, the subtitle “Buying and Holding U.S. Stocks Paid Off Big This Year,” indicates why 2013 results would not appeal to the financial service industry.  The financial service industry is oriented toward transactions.

The authors, Tomi Kilgore and Tom Lauricella, point out that: “So-called dumb-money strategies, which involve buying and holding a plain-vanilla portfolio of U.S. stocks, did much better than the more complex approaches employed by hedge funds and other professional investors.”  They go on to point out that: “…the Dow Jones Industrial Average goes into the final day of 2013 with a gain of 29% once dividends are included, while the S&P 500 index has climbed 32% with dividends.” That is the type of year that will make any equity strategy look smart.  As the saying goes, “There's nothing like the bull market to make an investor look smart." 

To the authors’ credit, they compare a buy-and-hold strategy to a number of alternative strategies often touted by financial service industry representatives and the media.  They also point out a number of aspects of this year's performance that were quite unique, and how the uniqueness of 2013 can be misleading.  In particular, they point out how the uniqueness of this year could be misleading if taken to be indicative of how to manage one's total portfolio. 

Another refreshing aspect of the article is that it focuses on actual performance.  Far too much of the media's coverage is just backward looking.  It is always possible, in hindsight, to identify trades and trading strategies that would have been profitable.  It is worth noting that it is equally possible to identify trading strategies and trades that would have been laughable.  What an investor needs to focus on is what investments and trades make sense and profit when applied in a forward-looking situation.  Contrary to popular belief, over the long-run, buy-and-hold stacks up quite well against any alternative.  The only exception is that rebalancing makes sense when applied in the context of the time horizon for the investor.

When focusing just on equities, their article is very telling.  It is particularly timely given the infatuation with tactical market timing among the financial service industry and media.  One does not have to be a rocket scientist to realize that tactical market timing would appeal to the financial service industry because it involves more frequent trading.  For the media, which has to find something to write or talk about, it is equally appealing.  But, in neither case is the focus on how investors make money.  Their agendas are quite different from helping you make money.

At the aggregate level, in terms of market strategy, nothing more is required than understanding that the media is an entertainment business, not an investment advisory service.  Further, every investor needs to understand the financial service industry makes its living from fees on transactions, trades, activity within accounts, and media coverage that facilitates gathering assets, not necessarily from the profitability of the account.  There is no maliciousness involved.  It is just a difference between the service being provided, and the service that the investor needs in order to profit.

So, last year provided ample evidence that the individual investor needs to think hard about the motives of anyone who discusses investments.  It also highlights a point often made by investment counselors.  Nothing is more important than understanding why one is investing.  If excitement is the objective, tactical market timing and constant monitoring of every potential influence on the market is warranted.  It is entertaining, but if profit is the objective, boring is the most reliable approach.  One does not need to look for a moonshot in order to make money investing.

 

 

2013 Was a Very Educational Year.

Bull markets can be just as informative as bear markets.

Behavioral economists and market observers have long noted that people respond differently to losses and gains.  The generalization is that people feel losses twice as intensively as gains.  In fact, from neuroscience we know that comparisons between the two are inappropriate.  They are actually felt quite differently by different parts of the brain.  Nevertheless, the generalization that losses are felt more intensively creates the risk that people will retain what they learn from things like the financial crisis and the associated market meltdown, but not things learned from the bull market recovery that has been going on since then.

Thus, it is appropriate to point out and stress the lessons to be learned from a bull market.  Last year’s performance provides an excellent opportunity to do that.  The next few postings will focus on what 2013 teaches about portfolio management with particular emphasis on management of the equity portion of one's portfolio.

There will be a series of postings that will address related topics:

First, what is to be learned about portfolio strategy?

The uniqueness of a bull market run like 2013 can be misleading.  It would be misleading if taken to be indicative of how to manage one's total portfolio.  Yet, it is appropriate to use the experience of 2013 as an opportunity to learn how to manage an equity portfolio. 

Real opportunities to time the market are rare.  Neither the media nor the financial service industry has any interest in pointing out that buy-and-hold stacks up quite well against any alternative.  While that's true within the equity portion of a portfolio, it does not eliminate the fact that rebalancing makes sense when applied within the context of the time horizon for the investor.

No discussion of any investment approach makes any sense without reference to the investment objective.  Nothing is more important than understanding why one is investing.  If excitement is the objective, tactical market timing and constant monitoring of every potential influence on the market is warranted.  It is entertaining, but if profit is the objective, boring is the most reliable approach.  One does not need to look for a moonshot in order to make money investing.

Second, what is to be learned about stock acquisition?

2013 provided some excellent examples of the fact that a quick 10% drop in the shares of a well-known company with a solid business and a promising future represent a nice entry point for investors with a long run outlook.  No portfolio should be thought of 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.

If it is a long-term holding, the opportunities that arises it will not be fleeting.  One does not have to be monitoring the market every day in order to see the opportunities and have time to capitalize on them.  If the opportunities are real long-run opportunities, the average stock market investor should have enough time to act and still look like an expert market timer. 

If 2013 teaches investors nothing else, it made it infinitely clear that the key to success is individual stocks not the total market.  Trying to time the total market is totally irrelevant to the best opportunities. One does not have to invest in highly speculative stocks in order to achieve portfolio performance.

Third, what is to be learned for 2014 planning?

Bull markets created tremendous temptation to chase the performance of the winners.  However, the fact that they were winners argues against that approach.  Their portfolio weights are already out of portion.  It is also likely, that the best performers are not necessarily the most stable stocks. (High beta stocks may have appreciated the most).  In other words, a bull market can introduce additional risk into a portfolio.

The appropriate response is to readjust portfolio weights in an opportunistic fashion.  One step that may work is to change which stocks are set up for automatic dividend reinvestment.  Nevertheless, the portfolio will generate cash that should be invested as opportunities arise.  One can plan for those expected opportunities.  But it would be developments during 2014 that will actually determine when those opportunities exist.  So, it is possible the plan to 2014 as long as one realizes that the plan may have to be adjusted during the year.

“It's a Wonderful Life”: How to

It's That Time of Year

In “It’s a Wonderful Life,” George Bailey makes it a regular practice to wish he had $1 million.  Instead, he gets a wonderful life, a life not without trials, but a wonderful life.  In current dollar terms, he may be a millionaire, too, but the point of the movie is that a wonderful life is not a material thing. 

The picture below is the first hint at the secret to his success.  As he wishes for $1 million, he is not on the way to buying a lottery ticket.  He is going to work; not in a job that will pay him $1 million, but he is working toward his goal, not just wishing for it.

 

So, we have in the picture above one simple hint about the road to the wonderful life.   Wishing is not a waste of time if it is accompanied by working to realize the wish.  Therefore, it is a working toward the goal, not the wishing for it, that matters.

Although money is mentioned at a number of points in the movie, there is never a reference to how much money George is making working in the drugstore.  That is significant.  What is important is that he is working toward an objective.  What he is doing and what he is paid are quite irrelevant.  It could have been homework, extracurricular activities, volunteer work, or just about anything else.  What is important is that it was his objective that determined his activity.  He was not just killing time or following a trend.

As the movie unfolds, we learned that he does not take his earnings from his job lightly.  Rather than buying himself sundaes at the soda fountain where he works, he later tells his father that he has been saving whatever he can.  So, not spending every cent he has is another aspect of his approach.  It is amazing how many people nowadays do not comprehend that if one spends everything one can, the result is always being broke.

But it would be a mistake to assume that George just saves.  We know what he does beyond just saving. He is also investing in his business.  His investment timing is not bad either.  Keep in mind that when he is on his way to leave for his honeymoon he turns around.  He takes all the money he had saved for his honeymoon and invests it in saving Bailey Building and Loan.  What precipitates this change of heart?  A panic.  Buying when everyone else is selling is something he takes the time to explain to the customers of Bailey Building and Loan.

Although his timing of his investment in Bailey Building and Loan is excellent, it is clear from the balance of the movie that his investment is not a get-rich-quick, short-term scheme.  He is truly investing, not speculating.  The same can be said for his purchase of a home.  He purchases a true fixer-upper, not with the intent of flipping it, but with the intent of fixing it up and living in it.  Fixing it up is simply a way to build equity in his home. It is worth remembering that he is putting money into education.  We know that since he discusses putting his brother through college. 

So let's take inventory: hard work, saving, education, investing for the long run, and building home equity.  It is unfortunate that so many people today consider those values quaint while at the same time bemoaning the fact that they are not experiencing a wonderful life.  While the connection between those values and the good life should be obvious to people, that often is not the case.  What is even more tragic is that many people never realize what George finally comes to realize at the end of the movie.  A wonderful life is not a material phenomenon.  Those values in-and-of-themselves contribute to a wonderful life, whether or not it is one of material plenty.

The movie provides more subtle hints at other keys to a wonderful life.   Some, like the role of community and family, have social implications, but this posting will stick to those that have financial implications for individuals.  Nevertheless, it would be neglectful not to mention that George's service to his community and his commitment to his family play an important role in his achievement of the wonderful life.

For individuals, it is well worth noting that liquidity, the amount of money George can get his hands on at any point in time, is not what George seeks.  One of the major themes of the movie is the dire straits.  George finds himself in when he needs to get his hands on liquid assets.  When he needs money to address problems at Bailey Building and Loan, he finds that the cash value of his life insurance policy is his only source of liquidity, and it is far from adequate for his needs.

This predicament is telling.  His investments (his home, the building and loan, his life insurance policy) are all directed toward achieving objectives other than a large mark-to-market positive balance sheet.  The movie provides many hints at why that is the case.  George forgoes a number of trips or vacations (from his honeymoon to trips to New York to a trip to Florida with a friend); he drives an old car that at times frustrates him, and his “drafty old house” provides numerous ways he could consume (from the banister knob to the kitchen appliances).  George is just not motivated by current consumption ability.  He is not measuring his success by how much he can consume.  So, why would he need a large amount of liquidity? 

Not measuring oneself by what one can consume almost defines George Bailey's life.  One senses that George Bailey knows that happiness is not a function of how much one consumes.  George's prosperity has a lot to do with the fact that material consumption is not his primary objective. It does not take a rocket scientist or deep philosophical thinker to realize that confusing consumption and happiness keeps many people from achieving either. 

In the end, George's salvation, the liquidity he needs, is there.  It is easy to overlook the implications of that source of liquidity for financial planning.  From a macroeconomic perspective, it is the general public.  One often wonders why people are surprised that in our recent liquidity crisis it was the general public that had to "bailout” illiquid institutions.  It never dawns on people that there is no source of liquidity, other than the general public.  The general public can mobilize itself as occurs in “Its Wonderful Life,” or it can occur through an institution like the Federal Reserve.  It does not matter the form it takes, it is always going to be the general public.

From a personal perspective, it is the trust that George has built up among the residents of Bedford Falls that results in the availability of liquidity to George.  It is not surprising that when there is trust, the liquidity is provided without conditions.  One can imagine that if it were Potter who required the liquidity, it probably would have come in a form similar to the loans made to banks during the recent financial crisis. 

But here's the subtle point that is terribly relevant to personal finance.  It concerns how George has built that tremendous reservoir of trust among the people of Bedford Falls.  It is easy to overlook the fact that George has repeatedly borrowed from the residence of Bedford Falls.  It could be overlooked because it is done through the Bailey Building and Loan.  Each resident’s deposit at the Bailey Building and Loan is a loan to the Bailey Building and Loan.  The residents have all been paid back with interest when requested by the depositors.  Furthermore, the residents are aware that in some instances, like during the panic, they were paid back out of George Bailey's own money.  That sort of record of managing debts naturally leads to trust.  If one doubts it, simply look at how credit ratings are affected by a history of timely repayments of all debts.

 

 

 

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.”

 

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.