Still beating the S&P 500 with a simple portfolio

Back in early 2006, The Confused Capitalist suggested a low maintenance model portfolio that I felt would outperform the S&P500 over the next five years or so. The portfolio was based on certain themes, some of which are ones which have generally proven to outperform over longer periods of time, such as buying value positions and small companies.

Additionally, I felt that commodities and emerging markets would continue to benefit from the world situation, and that the US dollar would continue to be under pressure - thereby adding to investments denominated in something other than US$. I suggested positions in a total of six ETFs, at values of 7.5% to 25% of the portfolio, with most around the 20% range.

When we reviewed this portfolio on June 17 2007, we found it had outpaced SPY by 5.4% over the 14 months since inception. It's now been 14 months or so since that review, and the market has changed notably over that time frame; let's check in with our model portfolio to see how it has performed.

Since then, SPY has dropped by 15.5% and is now priced at $129.37. Let's see how our own simple ETF-based portfolio, which looks like this, performed:

• 20% weighting to a broad-based international ETF - EFV - $78.92 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This ETF closed at $58.96 on Friday August 8, 2008, for a 25.3% loss.

• 18.6% weighting to small company - IWN - $85.11- ishares product tracks the Russell 2000 Value Index (US small cap). This ETF closed at $68.84 on August 8 2008, for a 19.1% loss.

• 25.7% weighting to emerging markets - EEM - $44.14 (adjusted for a 3 for 1 split) - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. This ETF closed at $41.16 on August 8 2008, for a 6.7% loss.

• 19.4% weighting to the value portion of the S&P 500 - IVE - $83.78 - an ishares product tracking the value portion of the S&P500. This ETF closed at $65.90 on August 8 2008, for a 21.3% loss.

• Commodity-oriented countries: The Canadian ETF (EWC; 7.6% weighting) - $30.58- and a Brazilian ETF (EWZ; 9.1% weighting) - $62.66. The EWC closed at $29.35, for a 4.0% loss, and EWZ closed at $74.61, for a 19.1% gain.

Overall, this portfolio lost 13.1% of its value compared to our last review in June 2007.

Last year, both this portfolio and the SPY were up, although this portfolio beat the SPY by 5.4%.

So this year, both SPY and this portfolio are down, although this portfolio did beat the SPY by 2.4% which is still pretty significant outperformance.

The relative gains and losses on the portfolio aren't sufficient enough to warrant a re-balancing yet, so here are the relative portfolio balances going forward:

• EFV -19.5%
• IWN - 18.5%
• EEM - 26.0%
• IVE - 19.1%
• EWC - 7.8%
• EWZ - 9.1%

JW

The Confused Capitalist

Portfolio Construction - As easy as 1,2,3 - A,B,C

The other day I talked about portfolio outperformance, suggesting one method to outperform the broader market. This method, a "focused portfolio", has plenty of academic support for its effectiveness and rationale. Yet, it doesn't suit every investor. It's time intensive and requires at least average investing skills (i.e. the ability to read a balance sheet, earnings and cash-flow statements). So it's definitely not for everyone.

But the great thing about investing is that there is more than one way to "skin a cat", as the saying goes. That means you can outperform the broader market (which I define as the S&P 500), by doing other things well. One way is through asset allocation and the use of low-cost ETFs to build a portfolio.

A way to enhance these returns is by investing with history on your side - in other words, finding the type of investments that have historically produced above average returns. Of course, also investing with an eye to what the world might be like in ten to twenty years, is another way to boost your returns.

So, having said that, what are some practical ways to build a low-maintenance outperforming stock-market based ETF portfolio for the next ten to twenty years?

Firstly, to acknowledge that so-called "value" stocks and "value indices" produce better market returns - on average - than so called "growth" stocks and "growth indices".

Secondly, to consider that small company stocks traditionally produce better returns than large company stocks.

Thirdly, to see the rapid rise of the emerging markets, and to acknowledge they are likely to be far larger in twenty years than today (they are producing about 20% of global goods today, yet their stock markets only hold about 5% of the capitalized value of stocks in the global economy).

Fourthly, that these advantages should also be stabilized with some large company stocks and broad-based market exposure, that will produce relatively reliable returns over a longer period.

Fifthly, to consider that the US trade and fiscal deficits are likely to continue impairing the currency for a while longer, and therefore willingly have greater than average exposure to other markets.

Finally, to consider your particular own thoughts and ideas, and to add these into the mix somewhat. This might be the idea that health-care stocks will prosper into the future, or perhaps that technology stocks now appear reasonably priced, or that commodities appear to have a bright future for the next five to ten years. Whatever - the point is is to add one or two of those themes into your overall investing mix, if you feel comfortable doing that.

Now, here is a sample portfolio I've constructed that I think would be suitable for an investor with a twenty year horizon (this is the all-stock market portion of the portfolio), and with a willingness to overload promising positions, as discussed recently. For the twenty year investor, this is the type of portfolio that probably needs only to be re-visited and re-balanced every five years or so. So remembering our themes of:

1. Value orientation;
   
2. Small companies orientation;
3. Emerging Markets exposure;
4. Some Broad-based;
   
5. Consideration of currency implications (ie more exposure to international);
   
6. Your own ideas (in this case, mine);

here's the low-maintenance ETF portfolio I'd construct with an eye to the next twenty years:

1. 20% Broad-based international - EFV - $64.91 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This index has outperformed the broader (non-value) index MSCI EAFE index by about 2% annually over the past five year. Five year return on the index is 11.7% annually.
2. 20% Small company - IWN - $74.99 - ishares product tracks the Russell 2000 Value Index (US small cap). It has outperformed the broader (non-value) Russell 2000 Index by about 3.4% annually over the past five years. Five year return on the index is 16.2% annually.
   
3. 25% Emerging markets - EEM - $105.45 - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. Five year return on the index is 23.2% annually.
4. 20% S&P 500 - IVE - $70.62 - an ishares product tracking the value portion of the S&P500. Produced a 5.0% annual return over the past five years, beating the broader based S&P500 by 1.0% annually.
5. 15% Own Ideas (in this case, my belief that commodity-oriented countries will do well for the next five to ten years). I'd equally weight a Canadian ETF (EWC) - $24.86 - and a Brazilian ETF (EWZ) - $44.25 - or Australian ETF (EWA) - $21.94. Five year returns on these indices have ranged from a low of 18.2% to 27.9% annually.
   

Now, you lose a little bit due to the management expense ratios but, over a decade or so, this looks to me like a portfolio that should significantly outperform the S&P500. By comparison, SPY is trading at $131.47.

Of course, you can always tinker with this, but this is a simple, pretty well-balanced stock portfolio, constructed with the aforementioned moderately overweighting themes in mind. I personally would sleep very easy with this portfolio. We'll check back in with this model portfolio in six months to a year.



JW

The Confused Capitalist

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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

Distill Your Investment Choices

A recent story from the excellent Avner Mandelman of Giraffe Capital reminded me, once again, of one of the reasons I became a "focus" investor.

Mr. Mandelman relates a story of a old classmate asking for Giraffe's top ten stocks in 2003. Although Giraffe already ran a focussed portfolio of just 25 stocks, Mr. Mandelman agreed. One year later, the former classmate sent back the results of just those 10 stocks: those ten stocks actually doubled the overall performance of the already focussed portfolio (see link for overall 2003 performance).

Mr. Mandelmans point is to dive into your own stocks to both cull the weaker positions, and to add to those positions holding the best promise.

In fact, I also had a virtually identical experience when I ran the Global Walkers Investment Newsletter in the mid-to-late 1990s. I had two model portfolios, one of which ("The Top Ten"), which was a subset of a moderately larger (typically 20-25 stocks) portfolio. While both portfolios trashed the TSX index (its benchmark) over the two year period I ran them, the Top Ten, like Mr. Mandelmans experience, also doubled the broader model portfolio.

So I concur with Mr. Mandelman: don't be afraid to look in your own backyard for some of the best stock ideas out there. After all, there's already been considerable distilling (hopefully) of your ideas to arrive at those. Just a little further distillation can yield fabulous results!

A foolish diversification is the hobgoblin of little minds, adored by mutual fund managers, brokers and fitful investors alike.

(With all due apologies to Ralph Waldo Emerson)

JW

The Confused Capitalist

Beating the S&P 500

Back in early 2006, The Confused Capitalist suggested a low maintenance model portfolio that I felt would outperform the S&P500 over the next five years or so. The portfolio was based on certain themes, some of which are ones which have generally proven to outperform over longer periods of time, such as buying value positions and small companies.

Additionally, I felt that commodities and emerging markets would continue to benefit from the world situation, and that the US dollar would continue to be under pressure - thereby adding to investments denominated in something other than US$. I suggested positions in a total of six ETFs, at values of 7.5% to 25% of the portfolio, with most around the 20% range.

To compare, we suggested a suitable tracking comparison would be the S&P500, as represented by the "SPY" ETF which was then priced at $131.47. It closed Friday June 15, 2007 at $153.07, a gain of 16.4%, which is pretty good. Add in dividends of roughly 2% or so, and the total gain is about 18.4%. If you'd gotten this, you would have beaten about 80% of the mutual funds out there, using traditional five year horizons as a guide (only 1 in 5 mutual funds beats the index, when the period is five years or so).

Sidebar 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!

Let's see how our own simple ETF-based portfolio, which looks like this, performed:

• 20% weighting to a broad-based international ETF - EFV - $64.91 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This ETF closed at $78.92 on Friday June 15, 2007, for a 21.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 20% weighting to small company - IWN - $74.99 - ishares product tracks the Russell 2000 Value Index (US small cap). This ETF closed at $85.11 on Friday June 15, 2007, for a 13.5% gain, plus dividends. Advantage: The S&P500.

• 25% weighting to emerging markets - EEM - $105.45 - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. This ETF closed at $132.42 on Friday June 15, 2007, for a 25.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 20% weighting to the value portion of the S&P 500 - IVE - $70.62 - an ishares product tracking the value portion of the S&P500. This ETF closed at $83.78 on Friday June 15, 2007, for an 18.6% gain, plus dividends. Advantage: The Confused Capitalist.

• 15% Own Ideas (in this case, my belief that commodity-oriented countries will do well for the next five to ten years). I'd equally weight a Canadian ETF (EWC) - $24.86 - and a Brazilian ETF (EWZ) - $44.25. The EWC closed at $30.58, for a 23.0% gain, while the EWZ closed at $62.66, for a 41.6% gain. Advantage both: The Confused Capitalist.

These weightings result in a total gain of 22.0%, plus dividends which, in this case, would add about another 1.5%, so the total would be about 23.5%, versus the 18.4% all in of the SPY ETF.

So not only did the Confused Capitalist beat the S&P500 ETF by five percentage points in just over a year, it did so in 5 of the 6 ETFs selected, showing broadly-based outperformance. The Confused Capitalist feels comfortable continuing to hold these same positions and original weightings going forward over the next year or so, and will check back in 2008 to compare relative performance.

I hope to continue to show that a low-maintenance portfolio, with modest thought given to what the future might look like, will continue to be able to outperform static indices. Those wishing to view some similar simple portfolios felt to have an excellent change to outperform the S&P500, should go here, here and here.

With these increases in value, the weightings have changed slightly going forward, but not enough to warrant a re-balancing. These weightings are now:

• EFV - 20.0%
• IWN - 18.6%
• EEM - 25.7%
• IVE - 19.4%
• EWC - 7.6%
• EWZ - 8.7%

June 18 2007. 12:10PM Pacific time. Correction made to the EEM discussion bullet, which misstated (understated) the current price and percentage increase. Ah, the dangers of using the "cut and paste" function!



JW

The Confused Capitalist

To the Moon Alice, to the Moon ...

We recently profiled a potential portfolio over here, that analysts state is slated to underperform. On the basis of aggregate analyst opinion being a contra-indicator of actual performance, it was suggested that portfolio may well be slated for above-average performance.

At the opposite end of the scale, we have a potential portfolio that analysts just love - in fact, they love them so much, some way had to be found to limit the size of the lists (unlike the underperform portfolio). The base selection criteria were similar in that they had to have an aggregate "strong buy" from the analysts, with the additional proviso that if it was a NASDAQ-listed stock, it had to be covered by at least seven analysts (because there were so many "strong buys" among that wildly enthusiastic crowd).

So, just like in "The Honeymooners" where Ralph was always threatening to send Alice "to the moon", the analysts claim that these stocks are going "to the moon". Their name, trading symbol and March 16th 06 closing price are as follows:

1. AC Moore Arts - ACMR - $16.44
2. BE Aerospace - BEAV - $24.57
3. Cognex - CGNX - $28.30
4. Comcast - CMCSA - $27.17
5. DepMed - DEPO - $5.80
6. DOV Pharmacuetical - DOVP - $17.05
7. Petrohawk Energy - HAWK - $13.10
8. Jupitermedia - JUPM - $16.99
9. Ness Technologies - NSTC - $11.31
10. Open Solutions - $26.46
11. Pinnacle Financial Partners - PNFP - $27.90
12. RC2 - RCRC - $38.71
13. Signature Bank - SBNY - $33.50
14. Select Comfort - SCSS - $36.50
15. Stage Stores - SSI - $28.77
16. Banc Corp. - TBNC - $11.79
17. UTI Worldwide - UTIW - $101.19
18. Xyratex - XRTX - $25.84

With the exception of Stage Stores (#15 on the hit parade), they ALL trade on the NASDAQ. (Perhaps the analysts there are subject to wild boosterism, I guess we'll find out).

Anyway, they say that these stocks are all slated to outperform - we'll check in later and find out if analysts are as useful as their employers think they are....

JW

The Confused Capitalist

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The Tortoise and Hare Portfolios

Back in mid-March, I profiled two model portfolios, based on aggregate analyst recommendations. One, nicknamed "The Tortoise" portfolio, was designated by analysts as an "avoid" situation, while analysts were universally effusive in their praise of "The Hare" portfolio.

At the time, I suggested that those rankings could well be reversed in the real world: that is, the Tortoise Portfolio could well outperform the Hare Portfolio.

I recently checked in on them, and as of May 24, here's how they've been doing:

• The US Tortoise portfolio: -5.5% (Benchmark S&P500 [via SPY] -3.7%).

• The US Hare portfolio: -10.9% (Benchmark Nasdaq Index [via QQQQ] -6.1%)

I guess I'd have to give this one to the Tortoise to date; although both lost against their respective benchmarks, because while the Tortoise lost 48% more than the benchmark, the Hare lost 78% more than it's respective benchmark.

• The Canadian Tortoise portfolio lost 1.1% over the same time frame, compared to it's benchmark, the TSX/SP60 index (via XIU) which had a loss of 6.2%.

So, to date, the Tortoise portfolios are beating the Hare portfolio. We'll check in again later to see how they're all doing.


JW

The Confused Capitalist

Would Morningstar like this portfolio?

Recently, I profiled a portfolio that looks like it could do well to help fund a financially secure retirement, based on borrowing against your home, and using dividends to make the payment.

Today I joined Morningstar, and looked up the rankings for all of those stocks. Some of their key rankings involve their assessment of overall business risk, the moat of the company, the overall rating (out of five stars), and their estimate of fair value. Now, due to their business model, I consider Morningstar ratings to be of higher quality than that churned out by the average investment house.

Of the eight stocks in the portfolio, only three of them have an overall "three star" (average) rating (Progress, Reynolds and Verizon), with GE having a four, and the rest at five stars. This suggests an above-average portfolio, overall.

The average ratio of current stock price to their indicated fair value is just 80%, with only Verizon over 100% (109%), and all the rest are at 92% or below. This suggests that, as a group, there is room for significant capital growth going forward. The best buy of the group on this ranking is Bank of America, which they estimate is trading at just 55% of their fair value estimate.

All of the businesses exhibit "average" business risk, except for Reynolds (above average) and US Bancorp (below average).

Five of the businesses are defined as having a "wide" moat, while the same three stocks that got an overall three star (average) rating had their moat defined as "narrow". According to information Morningstar publishes, only about 10% of their coverage universe achieves a "wide moat" definition, with about 45% achieving the next highest "narrow moat" ranking, and the balance defined as "no moat". This suggests that this portfolio is far more secure than average in this criteria.

In summary, I'd say that the portfolio is above-average quality in three of these four important categories, while still no lower than average in any category (average in overall business risk).

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

Will this high dividend, low PE stock portfolio outperform?

I have used the Globe Investor stock screen to come up with a group of TSX-listed common stocks that have both a high dividend yield, above 4% and a a relatively low PE (15 or lower). To make sure I'm not getting ones that have dubious cash-flow/earnings issues or accounting practices, I've also added a cash-flow filter, ensuring that the price/cash-flow is also 15 or lower.

Of the 1,075 common stocks that this screen picks up without any defined parameters (except for common stocks), the aforementioned screening yields some 15 securities, meaning this screen is picking up well under 2% of those common stocks. I'm going to track over the next while, so see if they outperform the broader index, the S&P/TSX60 index, which is currently at 12,044.83. We'll track the performance of this model portfolio, over time.

Here is the list of the 15 stocks, name, followed by symbol, and latest price (market close August 18, 2006):

• Amerigo Resources, ARG, $2.26
• BCE Inc., BCE, $27.48
• Circa Enterprises, CTO, $1.30
• Destiny Resource Services, DSC, $9.90
• Goodfellow Inc., GDL $26.50
• MCAP, MKP, $10.05
• Norbord, NBD, $9.09
• Pacific Northern Gas, PNG, $17.44
• Revenure Properties Company, RPC, $14.00
• Rothmans, ROC, $20.10
• Russell Metals, RUS, $27.88
• Seamark Asset Management, SM, $6.50
• Taiga Building Products, TBL, $2.03
• Viceroy Homes, VLH.A, $5.17
• Weyerhaeuser, WYL, $65.63

We'll check back in anywhere from a month or longer, to see how they're all doing ..


JW

The Confused Capitalist

Book Review - The Ultimate Dividend Playbook

Any investor worth his or her salt, who doesn't want to rely on the vagaries of capital appreciation to grow their net worth, and who would readily lean on the best shortcut in the world to wealth creation, dividends, simply must seek to understand them. Numerous studies have shown that dividend paying stocks outperform all other stock classes, and usually by a wide margin of 2% or more annually.

This book, by Josh Peters of Morningstar, helps the investor understand the case for dividends, and how to select individual stocks for a modestly diversified portfolio. While many investors may think dividends are suitable for income investors only, the fact is that dividend paying stocks should be a or the major stock holding style in most investors' portfolios.

Why? Well, as Josh points out, it's very simply because they outperform most other stocks, and generally with reduced volatility. So, it's a more stable, higher-returning investment. What could be better than that?

As Josh points out, dividends are a sign of many things investors like to see:

• An alignment of managements and the investors interest (return of, and return on, cash);
• Corporate self-discipline (have to keep grinding out the cash to pay and grow the dividend);
• Financial strength;
• And a Valuation basis (dividends can show when a stock is overpriced, and underpriced).

Josh covers economic moats, which he likes all his dividend-paying stocks to have, as well as return on equity (see his book, or mine, on why this is important). He suggests looking at the trend of the dividend (the trend is your friend, in terms of projecting the future), so see how the dividend might grow into the future.

He covers handy items like payout ratios, high yielding stocks (generally, be careful) and high payout ratios (look out if ratio has been continuing to rise).

In the book, Josh covers especially two items that make the book an entirely worthwhile addition to any investors bookshelf: the dividend drill, and the dividend drill return model.

The dividend drill focuses on three items;

1. Is the dividend safe;
2. Will the dividend grow;
3. What does the dividend stream tell me the stock is likely to return to me as a shareholder?

Attempting to answer these questions will help you decide whether or not a prospective stock investment is one that you can or should add to your portfolio.

In relation to #3 above (the total return from the stock), he also introduces one very handy shortcut (and investing is full of them, from PE ratios, to inventory turns, to PEG ratios). Think about the potential of the total return of the stock as the sum of the actual dividend yield, plus the likely growth rate of dividend over the next while, say ten years.

A couple of simple examples showing how the total return might be different for two stocks, is that one might be yielding a 5% return, and has recently been increasing the dividend by about 4% annually. If you think that increase would continue over the next decade or so, then the likely total return on that stock would be about 9% annually (5%+4%). In the case of a stock which has a lower initial yield, but is increasing the dividend more rapidly, the projected return might look like this; a 3% dividend yield, plus expected future dividend increase at 8% annually, suggests an 11% (3%+8%) total return.  The book is full of handy advice like this, written in a straightforward and uncomplicated style.

The book also details the more complicated (but not complex) Dividend Drill Return Model, which encourages you to think more deeply about the company and its prospects. Yes, it's more work, but relies only on elementary/grammar school arithmetic, so it's within the reach of virtually any investor.

I highly recommend this book, and thank Josh Peters for writing it. The information is handy, practical, simple, and timeless.

The Confused Capitalist

Analysts "Hot Buys" falling way, way behind their "Dump It" stocks

Back in March, here and here, I detailed two model portfolios, one of which analysts said was going to underperform, while the other portfolio was the subject of numerous "strong buy" analyst recommendations.

As originally suggested, these look like they have turned into valid contra-indicators, with the "strong buy" portfolio, now displaying an average loss of -20.0% (similar median loss), and with only 4 of the stocks having any type of positive return. (Prices measured at market close on Friday Aug 11, 2006)

On the other side of the coin, the underperform portfolios, both in the Canadian and US versions, have both produced a positive average return. This has amounted to an average gain of +5.6% (median of +5.7%) for the Canadian stocks, and +3.7% average (+7.5% median), for the US stocks.

This again suggests that "value" stocks remain consistently underestimated, even (especially?) by professional analysts. (Follow link contained here and here to see possible reasons why).

Makes one wonder why they'd have any money in almost any conventional mutual fund, (with a few notable exceptions [Bill Miller, Marty Whitman, etc.])? Next time your broker trots out the "strong buy" recommendation, it's OK to leave the room screaming,

No, you'll never take me alive ... or my money ...

JW

The Confused Capitalist

Morningstar ... Hello, hello .... HELLO?

Long-time readers here know that I am a bit of a Morningstar fan, appreciating their truly independent coverage, and an unconflicted (eg investment banking activities) viewpoint, that so tainted any so-called independent research that emanated from the so-called major institutions.

Nevertheless, I have to call them out today. Came across a residential apartment owner, Equity Residential (EQR), to whom they assign a "three-star" rating (average). They estimate the fair value of the shares at just $35 (last traded at one-third OVER than level, at $45). They also say the business has no moat, and say their valuation is subject to high uncertainty (two factors that usually lower their star rating). Furthermore, they estimate the forward PE as 64, and the current price/cash flow as 19.

They also add...

In the near term, Equity Residential's main geographies are suffering from high unemployment, and a deteriorated housing market. All else equal, high unemployment and consequential lower job mobility lowers housing demand, and makes it difficult for landlords to increase rents. Equity Residential's ownership share of a given metropolitan area is, by and large, less than 3%, so it can't readily affect the sector's pricing discipline.

On the positive side, they note that EQR has above-average balance sheet strength, leading to the potential for future residential "trophy" acquisitions. However, they also say ...

While we think this environment will present the firm with more attractive acquisition opportunities, we do not bake unannounced acquisitions into our valuation model ...

The final kick is the closing statement that they think EQR can earn 7% on its capital over the next ten years, LOWER than their estimated cost of capital at 7.9%.

So, let's see if I have this all correctly: overvalued, no moat, trading at high income/cash-flow metrics, weak "same-store" price increase income prospects going forward from existing portfolio, no pricing pricing power in the market, and can't earn its cost of capital.

Jack ... JACK ... assign this one an "average" rating, on the account of the "magic beans" that the CEO has in his pocket.

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

Emerging Markets

I was recently forwarded a paper written by Goldman Sachs reseachers in October 2003 relating to the potential of the BRIC emerging economies. I have written on emerging market potential outperformance many times (and here, and here too) before.

The paper projects that, given favorable growth regimes in those countries, that these economies will be one-half the size of the G6 by 2025, and larger than them, as measured in USD, by 2040. In fact, the world's largest economy in 2041 is predicted to be China.

The paper has obvious implications for any forward-looking investor. They also suggest that one expectation is that average currency appreciation for BRIC nations will be by about 2.5% annually for these currencies over the next 45 years. That's a pretty good tailwind alone, for investment results.

As the paper points out, things could obviously go wrong over that time period, but these results have reasonable potential to occur. Under the assumptions laid out in the paper (and with their model checked against history in other nations), it suggest that the largest economies in 2050 will be as follows:

1. China
2. US
3. India
4. Japan
5. Brazil
6. Russia

In other words, BRICs will have four of the top six spots. I think long-term investors should pay attention here, and try to understand why your particular investment advisor might be suggesting emerging market investment ratios of below 15% or 20% of your portfolio (which is actually below their current world GDP share in US$, at roughly 25%).

What also brought this issue into sharp relief for me, again, was a recent Economist magazine special on the world economy, that focussed on the emerging economies of the world. To an investor that wants growth at a reasonable price, these economies are growing their GDPs over the past five years at 5.6% annually, versus 1.9% for the developed world.

A forward-looking investor can't afford to ignore these reasonably-priced markets, and excellent growth prospects going forward. Are you such an investor?


JW

The Confused Capitalist

Long division? * 20 / 10 / 5 * A useful analogy.

Every once in a while, you come across a useful analogy that can help you in your own life, in your own particular situation, that helps you better yourself, or break out of a tired old mental model that no longer works for you.

Whatever it is, you strive to remember it, and use it to your advantage.

I've been reading some of the Robert Kiyosaki books (of Rich Dad, Poor Dad fame). Now I've read some disparaging reviews of his books and the like, but frankly, I like them. I think he brings some good information down to a level that almost anyone can understand, and I always admire people like that. The fact that he's overcome his own learning disability to become very successful, makes me admire him all the more.

Anyway, in one of his books, his "Rich Dad" gave him a piece of advice about the markets that can both help one prepare for profit and be mentally ready for diaster.

His rich dad told him that the markets run in a 20 /10 /5 cycle.

For twenty years, the stock market is popular, and produces good returns. For ten years, commodities rule (we're in the middle of this now). And every five years, there's some type of crisis.

His "rich dad" cautioned him that the timing wasn't exactly precise, but was a rough guide that seemed to recur with regular frequency.

This is a useful analogy in my view, because it allows you to be prepared for the next crisis which, according to the guideline, might be arriving very soon. In 1997 we had the "Asian contagion" and shortly thereafter the Long-Term Capital near crisis, and then in 2001 the terrorist attacks. According to the timing of this formula, some crisis may be arriving on our doorstep soon.

What it is, obviously is somewhat unknown. There's been a lot of talk about "global imbalances" with relatively little talk about how that might play out or trigger a crisis. Perhaps it would be in form of a rapid movement away from the US currency. Or perhaps the rising of interest rates and slow drain of liquidity from the markets will trigger some type of crisis in the real estate market that will spill over in some unforeseen way to the broader markets. Or perhaps it'll be something that sideswipes from "out of nowhere". The point is, is that some preparation might be warranted at this point.

This would include, in my opinion, careful review to ensure that your portfolio isn't excessively exposed to any one over-valued or speculative sector, and that it generally appears robust and reasonably valued. And of course, a review to ensure that you can handle any leverage you're using, should one or two factors about it turn negative.

Analogies - use them, or lose them!


JW

The Confused Capitalist

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