Market Tremors Series - Market Exposure

Market Exposure

This is the final installment, #6, in the Market Tremors series.

In prior postings, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.

I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Market Exposure, through the lens of my own recent portfolio reconstitution. Here’s how I define Market Exposure:

Am I comfortable with the levels of equities I hold?

This is one of those questions that many investors spend a great deal of time on, as the market is cresting or crashing, with the idea of then repositioning the portfolio to better take advantage of whatever has already occured and is now in the rear view mirror.

There are basically only two types of investments: debt and equity. There are many sectors against which your debt or equity might be backstopped, but really, you only have two real underlying investment choices. It’s worthwhile thinking about that.

Equity is always the most volatile portion of any asset holding. As Warren Buffett once said “the company’s assets were questionable, but its liabilities were rock solid”.

So, with this in mind, you can be an owner, or a loaner.

Owners often borrow money, are subject to business and financial risk, strategy failure, management miscues, and so forth.

Loaners try to protect themselves against these risk factors by securing against assets valued at more than the debt. The price of debt (the interest rate, generally) is very clear. It’s relatively easy to make a decision on whether or not it appears attractive to you, relative to its risk profile.

Ownership, on the other hand, whether complete or partial (as in stock ownership) is more complicated. In addition to all those aforementioned factors, one has to judge whether the offering is at an attractive price. While there are lots of objective criteria upon which a purchase can be judged, the subjective portion is, and will always remain, large. Dr. W. Edwards Deming, the statistical expert who is perceived to be the father of the Japanese quality miracle, stated that “The most important things are unknown or unknowable” and “The most important things cannot be measured”– and he was talking to the insiders who could both measure and effect corporate change!

Given all these attributes that equities have, it’s not surprising that their pricing is volatile. During buoyant markets, the subjective portion will be perceived favourably, and priced accordingly. During bear markets, all those subjectives take on a negative hue, and are thus “properly” discounted off the price.

Its also worthwhile thinking about debt too – over the long term, it just barely matches inflation. If you are an extraordinarily strong saver, with a very low risk tolerance, then this might be a good match for you.

On the other hand, if that isn’t you, then you’ll likely want some equities exposure. However, you have to be mentally and emotionally prepared for market declines, and how much of your portfolio you will accept as being subject to those types of risk. For instance, as Barry Ritholtz has pointed out, the market had numerous large downward moves during the period between 1966 and 1982 – three times of around -25%, and twice between -36% and -45%. These types of moves are always possible in a weakened business and consumer environment.

While it’s always attractive to believe you can get rid of the downside risk, the reality is that you usually will miss having some real portfolio growth if you try to eliminate it all.

Where you stand on the amount of market exposure you are willing to accept depends upon many things: your risk tolerance in general, your emotional readiness to handle market and portfolio declines, the amount of time you can realistically be in the market (i.e. are you 25 or 75?) and your willingness to see your portfolio lag your friends during nice bull markets.

Nevertheless, its useful to model a couple of different equity exposures and think about how that might support your portfolio during bear markets, but possibly hold it back during bulls. There are no pat answers, and formulaic answers fail to account for investment strategies and investor differences. It is something you have to think about and model in your head at a minimum.

Finally, it’s unusually beneficial to think about these things well before the cresting of the bull market when greed is in full force, and before the nasty bear is clawing at your portfolio.

This concludes the Market Tremors series – I hope you enjoyed it, and I welcome any feedback you’d like to give.

Disclosure: Significantly invested, long, equities.


JW

The Confused Capitalist

Market Tremors Series - Holdings

Holdings

This is #5 in the Market Tremors series.

In prior postings, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.

I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Holdings, through the lens of my own recent portfolio reconstitution. Here’s how I define Holdings:

What are my specific holdings – what is their orientation, what is their risk profile? How much am I counting on “the future” (potential growth of earnings etc.), rather than “the past” (historical earnings, etc.)?

This is one portion of these questions that many investors spend a great deal of time on, as the market is cresting or crashing, with the idea of then repositioning the portfolio. However, if you have properly considered these prior three questions, then the actual holdings become much simpler to select, and to hold onto during active market phases.

As I have mentioned, I have a concentrated portfolio, something I have always done, and feel comfortable with. In fact, just five stocks account for 50% of my equities. The other 50% of equities is held by five ETFs, with significant thematic overlap on two of those positions.

While just ten positions (5 stocks, 5 ETFs) sounds like relatively few, research has shown that diversification benefits begin dropping dramatically after just five holdings. That’s not to say that risk doesn’t continue to decline relative to market averages, just that the risk decline quickly tapers down.

According to Morningstar, three of my stock holdings have a wide moat, and two a narrow moat. Just 10% of Morningstar’s ranked stocks get “wide” moat status, and 45% get narrow moat (the remaining 45% have no moat). Moreover, these selections were recently selling at an average of just 69% of Morningstar’s Fair Value estimate. The average dividend yield is greater than 5%, and all of the stocks have had recent dividend growth. Additionally, all have had sufficiently long periods of decent or good earnings growth and good to very good returns on equity and capital. Furthermore, all except for one had a four or five star Morningstar ranking.

One note worth thinking about: several of my holdings were former “superstar” stocks or in superstar sectors – ones that never disappointed the markets, and became extremely pricey. In most cases, while the revenues and net income continued to grow at solid rates, it was at rates that the market eventually came to be disappointed with. As I write this, the market (S&P 500) has dropped by 19% against its high over the past five years, while three of my stocks declined between 40-70%, and one by 22% within that time period.

It’s worth considering in terms of your own holdings that I don’t believe for a minute they are attractive BECAUSE they’ve fallen (a trap many investors fall into), only that high PE ratios HAVE finally fallen back to earth. This has provided me attractive entry points relative to their existing earnings, dividends payments, and future potential. If you held one of these superstars through a decline, you must contextualize your thinking to see if it holds good value, AS OF TODAY. The fact you’ve suffered through the decline – too bad, so sad - but don’t bail now just because of that. It might just be your most attractive holding today. Really think about that.

As previously mentioned, my stocks were selected by screening for above average attributes (in fact, far above average) and generally in areas/sectors that are attractive for business on a long-term basis. Overall, I have achieved relative diversification here – none of the selections look like the others, as I have one industrial conglomerate, one bank (a UK bank), a teleco, a spirits (liquor) maker and distributor, as well as a hard asset owner/manager. There is very little or no thematic overlap.

In terms of the ETFs, I have oriented to growth possibilities. Here, my five ETF holdings consist of two emerging market selections (large/mid cap & a small cap; both with a dividend selection orientation), two alt/clean energy holdings (again, one that focuses mainly on large companies, while the other has a mid/small cap orientation), an agricultural ETF.

Each of these three ETF themes account for between 14% and 20% of my total portfolio. I’ve considered the relative valuation measures, and believe they are attractive for the emerging markets (PE ratios of below 11 in both of these ETFs). Furthermore, I have a stabilizing and relatively high dividend yield (5-7%) to go along with my two selections there. While many people would consider this a growth position, I also hold the opinion that it’s really a value position as well (although a volatile one currently).

The alt/clean energy ETF valuations, while not crazy, are definitely on what I consider to be the high side (PE ratios of 30 on average). Nevertheless, its worth considering that the ratio is elevated by the fact that some of the underlying companies aren’t yet profitable in this sector (making the “E” understated in “PE), something I expect will change as societal demand increases for this energy source.

Finally, agriculture is being affected by many of the trends that have previously affected oil prices: emerging economy changes (diet preferences in this instance), and a limited amount of the resource (arable land in this case). Add to this mix 70 million new babies every year and climate change, and it’s not difficult to think that this business sector will be larger ten years out as agriculture becomes more intensive.

In the case of all of these ETFs, I simply close my eyes and try and envision the future, ten years out. I simply cannot imagine that these market sectors are not much more significant than they exist today.

These emerging market economies will be much larger is a given I feel. I consider alt/clean energy to be a global imperative that is becoming more and more recognized. In terms of agriculture, there are numerous value drivers as mentioned.

So I believe am paying a reasonable price for most of these themes, although perhaps on the pricier side for the alt/clean energy. That is likely to be a more volatile holding than many of my other holdings.

In summary, in relation to my holdings, I personally feel more comfortable worrying about those ten holdings – which I think have above average characteristics – than I would be worrying about the whole market. Other investors – perhaps such as you - would of course having different comfort levels about this type and style of holdings.

Having said that, there’s also some tie in between emotions and holdings. It’s much easier to hold junk during market escalations, than during declines. For instance, during the NASDAQ go-go days, I personally owned a lot of junky stocks – no earnings, but lots of “prospects”. It ended up around the top (March 2000 or so) that I owned enough of this crap that I couldn’t sleep well at night. I eventually liquidated my holdings, which was luckily before the taking the 80% beating as the NASDAQ eventually tanked to. Still, the sting hurt, but it did teach me a valuable lesson about both quality, earnings, and value.

Finally, there’s one other thing to think about. As Geoff Gannon once wrote, there’s no reason that cheap stocks can’t get cheaper, and this could happen with each and every one of my picks or to the market in general.

As an example, South Korean stocks declined to a PE ratio of just two (as I recall reading it) following the 1998 Asian contagion. So the question to ask yourself is, “Would I be a buyer or seller at those prices?” and “How solid are my holdings, relative to market averages?”

While it’s seductive to think that you’d hang on to your positions in the face of such a deluge, obviously a great many investors weren’t or that pricing would never have arrived.

If you can come to terms with those questions in relation to being satisfied with your holdings over an entire market cycle, then you probably have a better than average chance at outperformance.

The final installment in this series will be “Market Exposure”, which will be published on Monday.



JW

The Confused Capitalist

Is Buffett's purchase into Goldmans really just insurance?

Much has been said and made about Warren Buffett's $5 Billion purchase into Goldman Sachs.

There's no doubt that Mr. Buffett is a very cagey investor, having waited until Goldman was (effectively) permitted to turn itself into a commercial bank. This lowered the risk of Goldman Sachs measurably, since they can now step up to the Fed and secure further funding, making the risk of failure fade considerably.

That he bought into an investment now that competitive forces have been considerably reduced should surprise no one, given Mr. Buffett's oft-stated opinion that he likes businesses with "pricing power". If a passel full of your competitors just bit the dust, or found themselves in the arms of a much more conservative commercial lending culture this, as an owner, can only have you rubbing your hands with pleasure.

Of course, you can't ignore the fact that he invested in what amounts to convertible preferreds (at WB's option effectively), happily collecting his 10% interest along the way. He's, as always, limiting his downside, while maximizing his upside.

But my final thought about this purchase is this: Mr. Buffett would happily see lower prices for some indeterminate period of time, but a financial melt-down wouldn't be in his interest, no matter how low the prices got.

Aside from his strong humanist streak (making him well aware of the human suffering that would cause), he's well aware of how long markets can potentially take to recover lost ground. In the case of the US and the Great Depression, the Dow Jones did not surpass the 1929 heights until 1954. Yes, 1954. One can only look at Japan today to see a similar market (if not Main Street) phenomenon in play.

So, I wonder whether, knowing that a more orderly decline of the stock market can play just as well - and probably better - into his hands, he stepped up with this purchase. A purchase, with his reputation, large enough to salve the panic-stricken, and yet with many of his classic down-side protection hallmarks. As a percentage of his total portfolio, and even of his cash holdings, $5 billion represents a small fraction of Berkshire's total assets.

I wonder if, in effect, Warren Buffett wrote a very large, very public, insurance policy against a disorderly market decline? An insurance policy that effectively rests upon his reputation, more than anything else?


JW

The Confused Capitalist

Market Tremors Series - Emotions

Emotions

This is #4 in the Market Tremors series.

Previously, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance.

I suggest that all investors need to ask and answer these five questions, in order to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Emotions, through the lens of my own recent portfolio reconstitution. Here’s how I define Emotions:

What is my emotional readiness to handle declines or lags in my portfolio, without changing strategies?

Of all the questions, this is the one that is most problematic for retail investors in particular, especially self-directed ones. That’s because there are so many sources for emotions to arise from, and everyone has a different risk tolerance and also because so few people work through questions like these. With rationale thought, chosen at a time of low stress, comes a better ability to handle the inevitable marketplace ups and downs.

Having said that, there are some sources of emotional distress that you can actively “turn off”. Firstly, we are bombarded today by news – including business news. The anchors and talking heads act as if its’ all meaningful to your portfolio.

Most of it isn’t. It’s mental plaque that’s tough to get rid of. Here are a few suggestions for doing so:

Unless you are actively seeking to reposition your portfolio, shut off or restrict your business news intake. You have to view it like an addition – one that’s likely harming your financial health. If you are repositioning your portfolio, fine, intake that news, collect information for awhile, then shut if off again, and STUDY and THINK about what this means.

As a corollary to that, you also need to stop checking your portfolio every day, or even every week. Generations ago, the saying was “A watched pot never boils” and this still speaks to the impatience of people, when their expectation of the speed of the anticipated change is unreasonable. Just like in the movie “Hitch”, your equities portfolio needs time to percolate.

“Hang on”, you say – “How will I know what’s going on with my stocks/portfolio?”

That’s the point – you won’t – AND you’ll stop thinking that each day or week is meaningful in the life cycle of a business or the stock market. It’s not.

If you’re worried you’ll miss some opportunities to buy, sell or reposition your portfolio, then do this instead: set up email “alerts” when your current or desired stock or ETF hits a certain price (buy or sell signals), and/or for earnings announcements. You really don’t need to be more in the loop than that.

If you don’t believe that, then think about this: with all the changes and gyrations in the Dow Jones Industrial Index in the past 50 years, an investor would have been better off to simply have held those stocks in the Dow of 50 years ago, including all spin-offs and buy-outs, than to have followed the Dow in its reconstituted form. And if that’s the case for a relatively slow changing index, then what do you think the odds are that you can outperform the market with all your shifty moves and break-dances?

In order to break the “watched pot” habit, buy yourself some sort of treat as a reward if you limit yourself to checking your portfolio and stocks just once a month, or better yet, just once a quarter. I can almost guarantee you that treat will easily pay for itself, and the addiction will have been broken!

One other antidote to emotions is to think about how much time you’ll be actively “in the market”. If you perceive that as less than ten years, it’s understandable you worry with every belch and burp of the market. Maybe you shouldn’t be in market at all. You need to consider this.

However, if your time frame is more reasonable, like 10 to 20 years, then print yourself up one of those long-term stock charts and eyeball it every time you’re tempted to trade because the markets’ aren’t moving your way.

The other thing you need to consider is the rationale and holdings within your portfolio; how those stylist leanings might affect your returns in a bear and bull market. For instance, if you invest exclusively in micro-cap stocks, and portfolio is down 45% when the market is “only” down 27% (and all your friends are complaining about that), how will you react? Can you really be at peace with this? Are you prepared to hold those positions (or similar) long enough to capture the returns available as an asset class over the business cycle? Or will you bail at the bottom?

Similarly, whenever the next bull starts, there’ll inevitably be one sector or stylist leaning that’ll crush returns in other asset styles. If you see yourself as a value investor, will you long to be part of that crowd, and inevitably give in, just as the sector is screaming towards its pinnacle? You really need to truly face your mental and emotional aptitude to handle a particular portfolio style. You must adapt that style if necessary to reflect something you can handle over an entire business and market cycle.

Finally, going through a process like this (all five steps), including providing a clear and cogent synopsis of your rationale and the key attributes of your holdings anywhere near your computer, should help stop you from trading indiscriminately. In other words, it will help you to control your emotions at tough times in the market – when the market is falling, or when your portfolio is lagging market averages.

The next installment in this series will be “Holdings”, which will be published on Thursday.


JW

The Confused Capitalist

Morgan Stanley and Goldman Sachs Saved

Breaking news: Morgan Stanley, Goldman Sachs, bailout.

Morgan Stanley (MS) and Goldman Sachs (GS) saved, read here.

Can you say "ka-ching" to the bailout price? ... just keeps rising.

Just like Morgan Stanley's and Goldman Sachs stocks will on Monday.

In more news involving prudent bankers, Wells Fargo (WFC) seeks small bolt-on acquisitions, story here.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!


JW

The Confused Capitalist

Market Tremors Series - Rationale

Rationale

This is #3 in the Market Tremors series.

I previously stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance.

I suggest that all investors need to ask and answer these five questions, in order to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Rationale, through the lens of my own recent portfolio reconstitution. Here’s how I define Rationale:

What was my thought process for assembling this particular portfolio, and how well will this rationale hold up if market conditions are reversed?

In terms of my own portfolio, my first item to mention is holdings concentration amongst my equities. I hold a concentrated portfolio, with relatively few positions. It’s my belief that concentrating your holdings concentrates your mind, and you become willing to take larger positions, as your margin of safety grows. Many studies have shown that equity managers who run concentrated portfolios do better than those who have more traditional numbers of holdings. My rationale is that if I’m looking to outperform the market, if I’ve found something cheap enough with the growth I like, then I’m willing to concentrate my holdings.

In fact, five stocks account for 50% of my equities. The other 50% of equities is held by five ETFs, with significant thematic overlap on two of those positions.

While just ten positions (5 stocks, 5 ETFs) sounds like relatively few, research has shown that diversification benefits begin dropping dramatically after just five holdings. That’s not to say that risk doesn’t continue to decline relative to market averages, just that the risk decline quickly tapers down.

I demand numerous margins of safety with my stock purchases. First, a “moat” (barriers to competition). Second, a stock price at purchase that reflects a healthy discount to fair value. Third, a decent dividend yield (with recent dividend growth) – this indicates the possibility that the market is currently mispricing the stock. Fourth, decent earnings growth over a period of time (although I’ll accept “stalled” earnings growth for a short period, in order to buy a good stock at an attractive price).

A major rationale with my portfolio construction is that I’m seeking at least a moderate level of diversification – none of the selections look like the others. For instance, I have one industrial conglomerate, one bank (a UK bank), a teleco, a spirits (liquor) maker and distributor, as well as a hard asset owner/manager. There is very little or no thematic overlap. This contrasts with the way I used to construct my portfolio, with extremely heavy weightings in just two or three areas.

In terms of the ETFs, I have concentrated my holdings thematically. Some investors use ETFs as a “portfolio gyroscope” providing leanings and risk profiles towards market averages (i.e. SPY or VT as examples). On the other hand, I use mine to provide a ten year growth tilt. If juicy dividends and low PE ratios are available, then so much the better, these but not totally necessary, as I want a moderate to high growth profile.

Accordingly, I think about where the world will be in ten years, what the demand cycle might look like, and try to buy specialty ETFs that capitalize on those long term opportunities. Just like you couldn’t give away oil and mining stocks in 1998, and yet investors have been crazy for them in the last five years, I’m trying to envision the longer-term.

Overall, I have a clear preference to value positions, yet even then I seek growth profiles within those positions. In my portfolio, value accounts for about 65% of the portfolio, with a clear growth tilt to the balance. However, even on the individual stock purchases (which are generally the value orientations), three of them have clear exposure to emerging markets, so despite their conservative valuations, they are also growth profile selections. I have further underpinned, I believe, the safety of this portfolio with a predominant dividend selection process – affecting some 65% of the portfolio.

In summary, I believe that the intrinsic value of the portfolio is much more stable than the market average, given all the attributes I have attempted to capture.

However, I also recognize that market gyrations on the ETFs may be above market averages, but that, in my opinion, these wouldn’t represent permanent impairments of capital. Overall, given the relative valuation measures on both the stocks and ETFs, it also appears there’s considerable opportunity for price growth, should recent market conditions begin reversing in the few years. If not, I get to collect a fat dividend cheque on much of my portfolio, while I await that turnaround.

Finally, it’s my long-stated belief that the US will continue its currency decline over the longer haul (next five to ten years), and I have therefore limited my purchases to reflect that belief. That’s not to say that I don’t have exposure, just that it’s considerably less than the 44% world-stock-market-capitalization held by US companies.

So, summarizing my own rationale, bullet-style, might look like this:

- Titled to diversification – eight different sectors, many different markets.
- Titled to value on most of the portfolio – many relatively low PE selections
- Titled to growth on significant portions of the portfolio
- Titled to dividend downside protection
- Titled away from revenues that are primarily received in US currency
- Overall rationale is “If I left this portfolio untouched for 10 years, would it still be successful?”

In the final analysis, the only thing you can control on your portfolio is your risk profile – the market determines the returns. In my case, I feel that no matter the markets short-term orientation, I have built a portfolio inclined towards relative long-term safety and yet with growth opportunity.

The next installment in this series will be “Emotions”, which will be published on Monday.


JW

The Confused Capitalist

Market Tremors Series - Process

1. Process
   
   This is #2 in the Market Tremors series.
   
   In the last posting, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.
   
   I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:
   
   1. Process;
   2. Rationale;
   3. Emotions;
   4. Holdings;
   5. Market Exposure
   
   Today, we are looking at Process, through the lens of my own recent portfolio reconstitution. Here’s how I define Process:
   
   What process and tools did I use to construct this portfolio?
   Have I given myself an edge in some way?
   
   Firstly, it’s rare that any long term market outperformance is possible without a decent process. If you’ve been outperforming the market without a specific process, then you better chalk it up to luck – and just like in the casino, it’s not likely to last. If you’ve luckily lurched from stock tip and suggestion and back to the same, better quit now and put your winnings in your pocket. Stop now, build and define your process.
   
   While I don’t suggest my process will fit everyone, it fits me. Here’s mine.
   
   First, I admit with my time constraints, I just don’t have the time to delve deep into the annual report of every corporation in the areas I have chosen. I used to do that when I bought just small and micro cap stocks, but have neither the time nor the desire to orient my portfolio that way anymore.
   
   Instead, I use quality “buy side” analysts who have my interests at heart (unlike the conflicted investment banks and their ADHD analysts). Therefore, I extensively use the Morningstar database to find stocks that might interest me.
   
   Using their database, I screen for stocks based on both “moat” (barriers to competition) and largest discount to fair market value.
   
   Second, I require all of the stocks I select to have a moat, and preferably a wide moat. I want that implicit margin of safety. I also require that all of the stocks I buy to have some margin of safety in terms of the pricing – the lower the stock price relative to their fair value estimate, the better. Also, I generally want to buy a four or five star rated equity, which, according to Morningstar’s data, have on average significantly outperformed the market over a relatively long period.
   
   I also check this rating with the S&P report (another buy side rating agency), to see if it’s roughly similar. Again, they report that their four and five star rated equities have significantly outperformed the market on average.
   
   Third, I also require that the equity be paying a dividend. I am looking for both an above average dividend yield, and recent history of dividend growth (or the possibility that is about to occur). Given the long-term outperformance of dividend-paying stocks, as further boosted by those providing dividend growth, I consider this one of the edges I use in the market.
   
   Fourth, when looking at the truncated financials, I look for above market average returns on equity and capital (assets), as both are long term drivers of stock price growth. I look for decent earnings per share growth. I also look at overall financial health of the company, accepting a “C” Morningstar rating at the lowest, but looking for better if possible. I also look at the PE ratio to see if that is a relative bargain.
   
   In terms of my ETF selection, I use a much more “gestalt” process – I usually pick specialty ETFs in areas I think there’ll be considerable growth into the future. Here, I use my general reading, and just plain thinking about the future, to orient towards those ETF buys. I also try to envision those ETF buys ten years out, because that’s my projected holding period in that instance. I look at the valuation ratios but, given I perceive these as the growth portion of my portfolio, are somewhat less concerning than in the stock selection (which I perceive as the value oriented portion of my portfolio). However, I also check relative value measures, like the PE ratio, to ensure I’m not buying the NASDAQ index circa 1999, with a PE of 100.
   
   Now, the final piece of the process is to print up all these materials I’ve compiled, together with any handwritten notes on the reports. I then do a very brief summary on the equities selection, such as dividend yield, Morningstar ratings and percentage of fair market value the equity is selling at, and a brief narrative overview, including PE ratios, value drivers, exposure to the US market, and/or other odds and sods. I do the same for my ETFs.
   
   Next we’ll look at “Rationale”, which will be published on Thursday.
   

JW

The Confused Capitalist

Market Tremors

Image: Portland Oregon skyline, Mt Hood in background.

In my family of origin, reading something you thought interesting to a sibling, parent or child was a sign of love and affection, as well as a way to stay connected and to expand your world. Receiving one of those readings was taken similarly.

So, on a recent multiple-family shopping expedition to Portland, I asked my wife to read to me, as I ground it out for the fifth hour on the freeway on our way there.

“Read what?”, she asked.

“Globe & Mail – business pages, please.”, I replied.

But then I glanced down at the paper and saw the front page headline – “Markets Pounded – TSX/S&P drops 7% over past three days”. Knowing my wife’s market nervousness, I told her to skip the reading. Instead of it being an enjoyable pastime for us both, I know she’d be pounding me with questions about our holdings, feeling sick if we lost anywhere near the average and dismal if it was more.

Which brings me to the point of this exercise: she reacted just like many people do. At a sign of market decline, they seriously question the market in general, and their holdings in particular.

Unfortunately, it is usually only at times of market extremes like these that people begin ask these questions, and it is usually in this order:

1. Market Exposure – Am I comfortable with the levels of equities I hold?

2. Holdings – What are my specific holdings – what is their orientation, what is their risk profile? How much am I counting on “the future” (potential growth of earnings etc.), rather than “the past” (historical earnings, etc.)?

3. Emotions – What is my emotional readiness to handle declines or lags in my portfolio, without changing strategies?

4. Rationale – What was my thought process for assembling this particular portfolio, and how well will this rationale hold up if market conditions are reversed?

5. Process – What process and tools did I use to construct this portfolio? Have I given myself an edge in some way?

In a bear market, the predictable answers to #1 and #2 are “I have too much equities – I need to lighten up”, and “I have too risky holdings, I need to sell”. In a bull market the answers are of course reversed. Typically, whether in a bull or bear market, few bother to get around to questions #3, #4, and #5.


If you want to outperform the market, aside from being willing to assemble a portfolio that looks unlike the market – and all the perceived and real risk that can entail - you need to spend considerable time on questions #3, #4 and #5.

In fact, I believe you need to reverse the order of asking these questions. That’s because they form the long-term framework for sticking with your ideas. And retail investors are notorious for dumping both their strategies and equities, just as market conditions begin to favor those very equities and strategies.

So, over the course of the next few postings, we’ll look more deeply at all these questions, in what I regard as the proper order (1. Process; 2. Rationale; 3. Emotions; 4. Holdings; 5. Market Exposure), through the lens of my own recent portfolio reconstitution.

(This series will be published every Monday and Thursday until complete)



JW

The Confused Capitalist