Thursday, September 25, 2008

Market Tremors Series - 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.


The Confused Capitalist

1 comment:

Dividends Anonymous said...

Great post focusing on investor psychology!