Thinking ahead - planning your investment game

The last time I wrote, it seemed like the global economy generally, and the American economy in particular, was in for a serious bout of greacession.

However, the coordinated global attack on the economic slowdown and banking sector crisis appears to have had some effect with, most importantly of all, confidence being restored. That's not to say there won't be some washouts in the road ahead, but most commentators seem to agree that "The Great Depression, Redux" just won't happen at this time. Opinions on the severity and remaining length of the recession in front of us, and the inflation to follow (or not!) now seems to be the subject of debate, rather than the collapse of the economic system itself.

With all that in mind (or not) and remembering that the most important aspect of investment is the right temperament, here is an investment clock that can suggest various investment timing to be had in the cycle in front of us. Whereas it can often be quite difficult to tell exactly where in the cycle we are, at this time it is unusually clear, at least to the extent of knowing that we aren't in the boom phase, nor have we really reached recovery yet. We appear to be, undeniably, in the recession phase at this time.

Therefore, if you like sector rotation and feel you can use it to your advantage, then this Merrill Lynch clock should be very handy at this time.

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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

Investment Cycle clock

I thought that this graphic, by Merrill Lynch, was worth looking at in terms of where they see the economy in the cycle, and the type of investments they generally see as outperforming during any particular part of the cycle.

The other thing I thought I might try taking a stab at is how long each portion of the cycle typically lasts. Based only on my observation over time, I might suggest that the cycle has roughly 3,4,2,1 counts. My (un)educated guess is that the recovery portion usually is 3 helpings of time, the boom is 4 portions of time, the slowdown is 2 portions and the recession is 1 portion of time.

Using something like this clock may help you to time your type of investments a little better.

Hat tip to the Big Picture for this worthwhile graphic and also to his continuing coverage of the housing situation. Unlike many analysts, Barry Ritholtz has figured out where that particular train is headed (and it's not to the "Happy Days Are Here Again" station, just yet).



JW

The Confused Capitalist

Single Best Investment - some of the rules

I recently reviewed the book, The Single Best Investment, which provided a framework for investing in stocks likely to outperform the market over lengthy periods of time.

I am going to provide a synposis of some of the rules that the author suggests to find suitable candidates using this dividend-and-value-oriented approach:

1. Company has to be financially strong, minimum B+ Value Line rating, or BBB+ S&P credit rank;
2. Dividend yield at 150% of the S&P500, but hopefully at 200%+;
3. Yield has to be expected, and shown to have grown over 5-10 years, at at least 5% annually (twice the expected inflation rate);
4. Dividend payout ratio less than 50% (except for utilities and REITs);
5. Company should have at least moderate earnings growth of 5-10% annually (both historically and going forward);
6. Price/Sales ratio below 1.5, and hopefully less than 1.0;
7. Price/Earnings ratios lower than the market, AND must less than the reciprocal of the long-term bond rate;
8. Book value ratios should be lower than the market, and;
9. Growth of cash on the balance sheet is a big positive.

There are, of course, other rules and suggestions, but I'd suggest to you that these encompass the heart of the book and suggested technique.

Since almost all of these rules as stand-alone situations have been shown by various academic studies to produce some level of market outperformance, combining them is obviously going to provide a platform for outstanding results with enhanced safety of capital.





JW

The Confused Capitalist

Book Review: The Single Best Investment

I recently completed reading The Single Best Investment: Creating Wealth with Dividend Growth, by investment manager Lowell Miller. The dust cover additionally describes the book as "The Classic/Revised & Updated".

The subtitle describes how the wealth is to be created: by finding reasonably-priced (perhaps even so-called "cheap" stocks), reasonably-yielding dividend-paying stocks, that have a history of raising their dividends over time.

As readers to this blog know, I am a fan of both buying stocks with below average PE ratios, and with good (and rising) dividend yields as a way to outperform the market (which is the essense of the approach recommended in this book). This is also something I've written about here, here, and here. So this is an approach that I personally recommend as suitable for practically any type of stock-market investor.

This book is useful for both beginning investors and those with more experience, particularly experienced investors weary of the "next great stock" approach. Mr. Miller does teach the keys to finding the right kind of stocks, that will allow an investor to "sleep easy", knowing that the stocks chosen using this approach are likely to be far less volatile than the market in general, and to have great staying power over the longer term. All with the likelihood of achieving achieving above-market-average rates of return. What more could most investors want?

Of course, this also provides the opportunity to hold these stocks outside of tax-sheltered accounts for long periods of time, thereby reducing both transaction costs, and capital gains. Another wonderful benefit.

Finally, the book isn't filled with lots of technical jargon and is a nice easy read.

However, having sung the praises of this book I also have to note a few a warts with the book. Although it's stated as an "updated" version, there are places in the book where it's not clear what time frame is being talked about: now, or examples which were current when the orginal version was published (about 10 years ago). Also, some of the examples are also dated, and it could have been very useful for the author to show how, for instance, five or ten stocks recently purchased in the portfolio he manages, fits into this approach. A few changes to the book could have resulted in a great book showing a a great approach, rather than just a good book with a great approach. Overall though, these warts aren't enough to really detract from the overall content and message of the book.

In the end, this is a book I definitely recommend this as a good addition to any investors library, with a very solid approach, and with very high off-the-shelf usefulness. I'll definitely be lending this book to my teenagers to read and for them hopefully to practice the approach!

Finally, I would like to thank and acknowledge the publicist (Jo Treggiari of The Print Project) for providing me with a complementary copy of the book.


JW

The Confused Capitalist

Insider Ownership & Long Management Tenure

When management and insiders have significant economic ownership and management has longer tenure ... (see illustration, left).

I recently recieved one of those ubiquitous The Motley Fool ads in my hotmail box recently, and I found the message they conveyed worth contemplating ...

10-Bagger Tenures
By Tim Hanson (TMF Mmbop)

More than 700 CEOs have already resigned this year, putting 2006 well ahead of pace to break the record (set in 2005) of 1,322 CEO exits in one year. That statistic, published in Fortune, should be worrisome for investors. Why? Because companies that do not have steady leadership at the top get lapped by companies who do.

Seriously. It's true ...
Need evidence? I found that of the 100 top-performing small caps from 1996 to 2005, 84 of them had either a founder at the helm or a CEO with more than five years of experience at the company -- far greater than the market average.

And the trend continues across the best-performing stocks of any size. Fully 164 of the 308 stocks that returned more than 20% annually, from June 1996 through June 2006, continue to have insider ownership of more than 5% today. That's 53% frequency. Now let's compare that to the broader market. According to Capital IQ, there are 21,959 companies trading on U.S. exchanges. Of that enormous number, just 3,550 have insider ownership of 5% or more -- a measly 16%.

Clearly, then, there's correlation between long-term shareholder rewards and insider commitment to the company they're running.

While I sometimes find the frequency of these ads irritating, it's worth thinking about this.

In fact, this is one of the things that I look at, when I analyze a stock in my small and microcap blog: a consideration of insider ownership. Perhaps I'll start considering the tenure of the CEO hereafter too ...


JW

The Confused Capitalist