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

The Weird Answer to Excess Liquidity

The loose lending standards and the low rates of the past few years are collectively known as "excess liquidity". In traditional central bank fashion, this is to be generally avoided since the tail end of a long period of this brings nasty consequences.

The severity of these consequences is partially dependent upon the length of time the excess liquidity was available, plus the corresponding reaction of both the central banks, commercial banks, investors and the public reaction itself as the liquidity is drained off.

In the 1970s, the drain of excess liquidity meant markedly higher lending rates, as inflation began to soar in response to the excess liquidity. Lending rates, in most industialized countries, continued to rise, until inflation was defeated in one last hurrah, as the earliest part of the 1980s dawned. A decade long battle that ultimately required lending rates in the 15-20% range to defeat.

Now, it appears, the answer to excess liquidity is this: raise rates to something beginning to resemble normal long-term banking averages - and watch the banking system begin to wobble, wobble, wobble. When the time is ripe (or some critics argue, over-ripe), introduce the forebearer of excess liquidity (low central bank rates) to deal with the number of weakened banks. This will allow some of the (less) reckless banks to repair their balance sheets, the strong to get stronger (and thus buy out some weak competitors) and for, more generally, faith to be restored in the system.

So the answer to the 2000s excess liquidity situation is - more liquidity.

Weird, right?

Further explanation, here.

JW

The Confused Capitalist

Housing Market to Contine Its Wobble

Having been around the real estate industry in one capacity or another for nearly 30 years, reading just one story like this wherein Barclay's Capital estimates that over $300 Billion of US option ARM (adjustable rate mortgages) mortgages are still due to re-set, makes me aware that the housing market won't be out of its slump any time soon.

The "homeowner" (air quotes as they have no equity) will finally realize they can't afford a payment due to re-set typically 60-80% higher than currently. This will drive an unbelievable volume of homes onto the market.

Given the majority of these option ARMs don't re-set until 2010-2011, don't count on this housing market slump subsiding anytime soon.

Every housing rally for the next few years will inevitably prove to be a suckers rally, as more houses continue to pour onto the market under foreclosure - as the most financially desperate find the American Dream has collapsed on them.

I'll make one more wild-ass prediction - the housing market losses to date (around 18% nationally) will be roughly matched by a further loss of between 12% to 20% more. The roller-coaster hasn't reached the bottom yet folks - hang on - it'll likely take at least another 18 months before calls of "this is the market bottom" are likely to be close to being true.

Greenspan's legacy continues to be written.


JW

The Confused Capitalist

Monoline vehicle insurer profits to turn up

I expect that monoline auto insurers profits will turn up over the next year or two, as two significant factors in accidents come into play:

1. The amount of driving done - the media is reporting that as gasoline prices have risen, the American consumer is driving less than last year - about 5% less.


2. Various anecdotal reports are that drivers becoming aware that speed is a factor in gas mileage and are slowing down.

These two factors together may well provide for a significant drop to the bottom line over the year or two, as accidents fall due to less driving, and driving at lower speeds.

It may further very well be that as all staples and non-discretionary inflationary costs hit home more, your typical "drinking driver" won't be able to afford to drink as often, thereby dramatically lowering accident rates for those insurers specializing in the high-risk driver category.

Something to consider if you invest in insurance companies.

JW

The Confused Capitalist

Bank Writedowns - Who has the money?

A recent posting over The Big Picture talked about the global bank writedowns being, to date, in excess of $500 Billion, and either half-way ($1 Trillion) or just one-quarter ($2 Trillion) finished.

My question to all you readers is simple: since the writedowns represent real dollars that have left the bank balance sheets and ended up elsewhere, where do you think most of it went?

• Effectively free or reduced rent by unqualified home buyers?
• Consumer goods purchases?
• Home flippers with excessive profits?
• Realtors (too many sales)?
• Home builders?
• Other?

What do you say?

JW

The Confused Capitalist

Executive Pay: Confusing "Doing Great" with a "Rising Tide"

Image: Not great surfer still managing to "ride the tide".

That executive pay, particularly for the top 5-10 corporate jobs in most large companies, needs reform, is no secret to any informed shareholder in a public company, especially with the recent implosions in the financial sector. With stock compensation schemes that can balloon the leaders pay in excess of $10, $50 and $100 million annually, without materially benefiting the corporation over the long haul, things have gotten totally out of control.

Executives should be well-paid, but in keeping with the idea that they are "employees" of the shareholders rather than corporate owners (what a quaint notion!). Further, their management expertise and acumen should be valued in comparison to a competitive peer group, rather than the stock market in general (stock options). What must happen is for compensation schemes to measure a competitive group of managers, rather than thinking they are great because the tide in that particular sector is rising.

In other words, former Home Depot CEO Bob Nardelli (quarter-billion dollar Bob) shouldn't be compensated for Alan Greenspan's decision to inflate housing prices, and all the subsequent housing market activity that renovation and home-building retailers benefited from. His contribution to Home Depot's fortunes should be measured and paid against a competitive market sub-set (like home building/renovation retailers & home-building companies, for instance). Shareholders should pay a great manager very well for doing great against his/her competitors, rather than rewarding (penalizing) for the rising (falling) tide of the sector they operate in.

With this idea in mind, here's my top 10 list for executive pay reform structure:

1. Stock options are completely and forever ceased to be granted, and instead low-interest loans are offered to the executive team to BUY stock in the company;


2. Corporate boards become far more activist in protecting shareholders from egregious pay structures based on results that are later re-stated, by dispensing employment contracts that call for the return of incentive pay based on erroneous original measurements;


3. Measuring and paying for (incentive pay) performance against a proper set of five to ten market competitors - in the Olympics, the swimmers aren't measured against the rowers, and this needs to stop in the economic marketplace;


4. Measurement should include benchmarks like: changes in return on invested capital (ROIC) compared to the competitor subset;


5. Inventory turns, compared to the competitor subset;


6. Debt ratios, again compared to the subset;


7. Changes in market share against the subset;


8. Changes in profit and free cashflow (or profit/cashflow ratios) against the subset;


9. Changes on all of the above, 2 and 5 years after the executive has left their position, so that the "long-tail" of their decisions, for good or ill, are properly rewarded or penalized;


10. A "hold-back" on a certain percentage of all of the above incentive pay, so that the Board doesn't have to go "cap in hand", begging the CEO for a return of some improperly rewarded gains.

Reforms like this would provide the proper and necessary alignment of shareholder's interests, with management's desire to achieve maximum pay - all the while, keeping both the risk and reward of any potential action clearly in mind.

Executive pay reform: an idea whose time must come.

JW

The Confused Capitalist

Value Investors - The Pendulum will swing back in favour

A recent blog posting over at Morningstar sniped at Professor Jeremy Seigel of Wisdom Tree, indicating that his firm's stock selection methodology and retention of assets depended on his call that a market bottom had been hit.

The post compared the performance of several Wisdom Tree ETFs to various total market benchmarks, showing relative YTD performance is lagging for Wisdom Tree dividend selection process. While true, it ignores the beating that all value benchmarks have taken since the credit crisis began in the summer of 2007.

As most value investors know, they aren't going to beat the benchmark every year - but it's going to happen often enough to outpace "growth" funds by about 2% annually over the long haul.

What's been unusual about this bear market is that it's the so-called value stocks leading the slump, whereas value stocks almost always outperform in weak markets.

Obviously, in this case, that's because the fact is that so many stocks that are usually labelled as value stocks, due to either low PE ratios, or relatively high dividend yields, have found themselves trashed and tarnished by the credit problems. That's because financial firms (whether retail or investment banks, stockbrokers and insurers), which usually have relatively low PE ratios and relatively high dividend yields - putting them squarely in the value camp - have been the epicenter of the credit and economic problems. Wisdom Tree's dividend selection process obviously weights orients a portfolio towards a value selection.

Comparing other value ETFs against growth ETFs show that this phenomenon isn't restricted to Wisdom Tree selections.

For instance, since just before the credit crisis began (I am using June 1 2007 as the date), the Barclays iShares products tracking growth or value indices show the following divergences:

- For international stocks, the MSCI EAFE (Europe, Australia, Far East)iShares index-tracking products shows that the growth product (EFG) has lost -13.2% of its value, compared to much larger -25.3% loss for the value product (EFV). In that context, Wisdom Tree's International Dividend Top 100 EFT (DOO) loss of -16.6% is pretty good.

- For large cap domestic stocks, the iShares growth product (IVW) has lost just -9.0%, while the value product (IVE) has lost -20.8% of it's value. Again, in that context, the Wisdom Tree Large Cap Domestic ETF (DLN) loss of -19.8% is understandable.

- Finally, for domestic small cap, the iShares growth product (IWO) lost 6.5%, while the value ETF (IWN) lost -17.2%. Here, the Wisdom Tree loss is larger at -23.2%.

Given that growth rarely outperforms value for any stretch of time, I believe that the relative outperformance of value must be just around the corner.

In summary, I'd suggest to all value investors in general, and Wisdom Tree ETF holders in particular, to hang on. Retail investors are notorious for dumping underperforming funds, not long before the corner is turned. Don't be one of those fools.



JW

The Confused Capitalist

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

Three Excellent Emerging Market ETF's

The other day, I posted about two popular emerging market ETF (EEM, VWO) choices. While you aren't likely to go too wrong adding one of these two major ETFs to your portfolio, I believe you can do better.

The three choices I examine here are all fundamental analysis ETFs, rather than based on old-fashioned market weighted capitalization like the prior two choices. What this means is the underlying stock choices are chosen on a rules-based entry system rather than how fat (or skinny) the valuations have gotten. I have written about fundamental analysis systems before, including here and here.

Wisdom Tree has used a dividend-rating system to select stocks most likely to outperform. This is based on back-testing that has shown that, firstly, dividend-paying stocks outperform their non-paying brethren, and secondly, that higher yields more often than not indicate relative undervaluation. Finally, Wisdom Tree's research shows that a basket of these stocks also have lower volatility than a comparable market-cap index.

The FTSE RAFI indexes, used in many Claymore and PowerShares products, uses four factors to weight stocks. These factors aren't related to the markets enthusiasm (or lack thereof) for the company itself, and extensive back-testing has shown these type of indexes outperform old-fashioned market cap indexes, such as the S&P 500, MSCI EAFE, and Dow Jones Industrial Averages. The factors are dividends, cash-flow, book value and sales.

The three choices we are looking at are Wisdom Tree and PowerShares products. They are the PowerShares FTSE RAFI Emerging Markets ETF (PXH), the WisdomTree Emerging Markets High-Yielding Equity ETF (DEM), and the WisdomTree Emerging Markets Small Cap Dividend ETF (DGS).

Let's take a look under the hood of these choices. Firstly, cost and turnover. On cost, none of them has a significant cost advantage, with DEM and DGS are 0.63%, and PXH at 0.85%. Turnover in PXH is 8% annually, with DEM at a remarkable 3% annual turnover. DGS does not have a reported turnover, but given that this is a small cap ETF, you can expect it to be relatively high, certainly higher than any of the choices I've discussed to date.

Let's look at the average company size and some of the top sectors in each product. In terms of average company size, these are all distinctly different products. DGS defines 92% of their portfolio as small cap, with the remainder as mid-cap. DEM is relatively agnostic for cap size, with 39% defined as large cap, 41% as mid-cap and 20% small cap. PXH, on the other hand, is primarily a large cap ETF, with 88% so defined, plus another 8% as mid-cap and a smattering of small cap.

In terms of the top four sectors, finance holds first or second place in all of them, and ranges from 26% in DEM to 19% in both DGS and PXH. Energy achieves one of the top four spots only in PXH, and there it holds first place with 26%. Information Technology holds down fourth spot in all the portfolios and range from 10-16%. Materials, at 14% is unique to DEM, while telecomm at 15% is unique to PXH. DGS has consumer discretionary in top spot at 19% (a unique top four holding) and industrials in third spot at 17% - again a unique top four holding.

Stock concentration is quite different among the three choices, with DGS holding around 400 stocks, and with the top four stocks holding 4.3% of the total portfolio value, and the top 20 companies accounting for 16% of the portfolio.

DEM holds around 300 stocks, with the top four stocks comprising 11% of the portfolio value, and the top 20, some 38%.

PXH is heavily concentrated by comparison to all of the choices reviewed so far: it holds around 160 stocks, the top four stocks account for a heavy 26% of the portfolio value while the top 20 stocks hold 60% of portfolio value. Essentially, this portfolio lives and dies with the top 20-30 stock choices.

Let's turn to country selection. In the Wisdom Tree ETFs, the top two countries represented in these ETF's are the same, with Taiwan holding top spot in both between 26-29%, and South Africa coming second at 11-15%. Brazil, Turkey, Malaysia, and Thailand fill out third and fourth spots at between 8-9% with the Asian choices in the DGS ETF.

The PXH ETF has China in top spot with 19%, South Korea with 18%, Brazil with 15% and Taiwan with 14%.

Finally, we turn to relative value measures of the portfolio. Dividends, as can be expected, rate high in the Wisdom Tree products, with recently reported yields of 7.92% (DEM) and 6.17% (DGS). The yield is not reported for PXH, but I'd say a reasonable guess, given portfolio size, and that consideration is given to firm size including dividends, would be in the 3-4% range.

PE ratios are attractive across the board, with DGS unexpectedly at the low of 9.3, DEM at 9.8 and PXH at 10.2. The price-to-book ratio varies from DGS, again at the low of 1.1, to 1.9 for DEM, and PXH at 2.7. Finally, the price-to-sales ratio is given only for DGS and DEM, at 0.71 and 1.21 respectively, which are both attractive, particularly the DGS.

Finally, let's look at the performance of these products year-to-date (note: DGS and PXH are less than one year old, hence the YTD comparison), compared to the iShares MSCI product EEM.

(Click to expand in size)



While PXH looks alot like EEM on the above chart, I believe that this is coincidental to some extent and the differences in the products will reveal themselves over time.

Looking at the products, DEM certainly appears to have low volatility, making it an easy choice for investors who prefer low volatility. Furthermore, the process for inclusion into the ETF also makes significant outperformance a reasonable possibility going forward.

DGS has relatively low volatility given its small cap orientation. I think of it as having just large cap volatility, but with the promise of small cap returns and a better selection process.

PXH is the large-cap ETF of the three. Offsetting to this usually comforting factor are the rather large bets on a relatively few number of firms, something you have to be comfortable with in order to be comfortable holding this ETF. On the other hand, the selection process is likely the most robust over the long haul for outperformance.

I lean slightly more toward the dividend approach in this instance, rather than other relative valuation measures, since other measures are more likely to be manipulated by accounting shenanigans, or simply poor disclosure practices. As the saying goes, "Dividends don't lie" ... and "Dividend investors sleep better". So for my money, I prefer the two Wisdom Tree products in this instance, although I have enormous belief that the PowerShares product will also prove itself over time.

In conclusion, I don't think the relatively low expense ratio of VWO is superior to the relatively low portfolio valuations offered by these three products and the superior selection process they employ, compared to both EEM and VWO. I believe the returns on all three of these products will outpace EEM and VWO over time.

Disclosure: Long positions in DEM, DGS.



JW

The Confused Capitalist

Emerging Markets Choices

Recently, some members of the investment business have suggested that emerging markets offer unusually good value.

This, of course, offers me the opportunity to once again explore one of my favorite topics.

According to one recent article, despite the growth of emerging markets to currently represent 13% of the world stock market capitalization, British investors have only 1.6% of assets in those markets. Presumably, American and Canadian investors are in the same boat.

This is all the more alarming given that these markets are widely forecast to achieve 50% of the world economy in 20-30 years time. That means that most investors aren't playing the largest visible theme of our times.

Given the growth in ETF's and mutual funds catering to this segment, there's no excuse for most stock investors with a 10-15 time horizon not to be in this market. This is a growth component that simply must not be ignored.

Having said that, I'd like to take a look at two of the most popular emerging market ETF market-capitalization choices, plus three ETF choices from purveyors who use a rules-based fundamental analysis to choose an emerging market basket.

The first two are choices from Barclay's iShares (EEM) and Vanguard (VWO). They are based on selecting on tracking broad-based market-capitalization based indexes. Market capitalization indexes (such as the S&P 500, MSCI EAFE, etc.) select the largest companies by market capitalization for inclusion into the index.

Critics argue that these type of indexes over represent over-valued companies, and under represent undervalued companies, and investors therefore leave some potential alpha on the table, while attracting unwanted volatility. On the other hand, supporters of these indexes argue that, despite these flaws, owning such an index proxy is still a reasonable way to participate in most of the stock markets gains, in a tax and cost efficient manner.

Let's take a look under the hood of both of these choices.

Firstly, cost and turnover. On cost, Vanguard (VWO) has it's legendary cost structure sliced to the bone, with just a 0.25% cost, while the Barclay's product (EEM) has a 0.74% cost. A 0.49% point advantage isn't to be sniffed at, but it't not the only item of consideration. Turnover for VWO is 9% annually, the second highest rate amongst the five products we'll look at. The iShares EEM has a turnover of just 5% annually. In a non tax-deferred account, these two cost and turnover factors are offsetting, with no clear winner. In a tax deferred account, the VWO is the better choice, if these were the only two factors under consideration.

Let's look at the average company size and some of the top sectors in each product. and company size. country choices. In terms of average company size, both are similar with Morningstar defining between 77-80% of the companies held therein as large or giant, and between 18-22% as mid-size. That means either fund has virtually no exposure to small cap stocks, and both can be thought of as large cap ETF's.

In terms of the top four sector allocations, both have financial firms (banks etc.) at between 18-22% of the fund, energy at between 16-20%, and materials between 18-21%. The only difference is for the fourth choice, which for iShares EEM is information technology at 14%, while for Vanguard VWO it is telecommunications at 12%.

In terms of individual stock concentration, the top four choices of EEM comprise some 16.2% of the portfolio value, while for VWO it is 12.2%. The top 20 choices comprise some 40% of the value of EEM, while for VWO it is 27%. EEM holds about 350 securities in total, while it's nearly 900 for VWO.

On these three later factors of market size, sector choice and stock concentration, there isn't that much to choose between these. So let's turn to country selection.

In both ETFs, the top four countries represented in these ETF's are pretty similar, with Brazil in first place representing 16-18%, and either China or South Korea in second or third place between 11-13%. The difference is in fourth place, where Russia represent 11% of EEM, while fourth is held by Taiwan in VWO, again with 11%. Overall, once again, very little to choose from between the two.

Finally, we turn to relative value measures of the portfolio. However, I have to complain about "the people's choice", Vanguard, long a champion of the individual investor. Their disclosure of valuation of the portfolio, in a word, sucks! The only valuation measure they offer is price-to-book (PB) ratio, wherein all of the other choices we'll look at provide at least the price-earnings (PE) ratio and the dividend yield of the portfolio, with some others also providing the price-to-sales (PS) ratio.

Having said that, the PB ratio of VWO is 2.8, compared to 3.7 for EEM. Morningstar calculates the dividend yield at 2.22% for VWO and 2.70% for EEM. Combining these two measures of relative valuation, suggest these portfolios offer relatively similar attractiveness from a valuation standpoint.

Yahoo calculates the PE of EEM at 11.9 (versus iShares own calculation at 18.0), and VWO at 13.0. Given the differences in PE calculations I've seen between Yahoo and ETF providers themselves, I don't think the Yahoo calculations are particularly reliable. On the other hand, Morningstar calculates the cash-flow ratio of both portfolios to be between 8.5 (EEM) to 8.9 (VWO). Therefore, there's little to choose from here, except to say that both portfolios appear relatively expensive, given the valuation characteristics of the three other product choices that I'll cover in a future posting later this week.

And, although no one looks at historical charts - given that we're all aware that past performance is no guarantee of future performance, let's see how the two products have performed against each other and the S&P 500 ETF (SPY) over the past year.



Given the similarity between the products, I'd say it's hard to pick a clear winner. Perhaps if Vanguard would get into the modern era, and provide its investors better information, as well as it's outstanding cost structure, it would be easier to make a choice between these two.

Later this week, I'll look at three fundamental analysis ETF choices.

Disclosure: No positions held.


JW

The Confused Capitalist

Best of the Rest? Dow Jones Industrial Average

A few days ago, I profiled an eight stock selection of the Dow Jones Industrial Average (DJIA) that I felt would outperform the DJIA over the next couple of years.

The selection was based on using a strategy similar to the Dogs of the Dow, wherein I used high yields to favourably indicate the potential for mispriced stocks in the Dow. I chose eight out of the 16 highest yielding stocks, names that included drug and health care companies, telecommunicators, as well as Coca-Cola, Procter & Gamble, and General Electric. I felt these stocks in the aggregate, would produce a total return greater than the DJIA over the next few years.

Generally, drug companies (Pfizer, Merck) selected have had a long cold winter in relation to any positive changes in share prices, despite numerous predictions and suggestions that these offered good value, relative to their moat and prices. Also, payouts are generally at the high end of the earnings range, indicating limited ability for further upward payouts, itself a negative signalling factor about the intermediate future prospects of earnings growth. While Johnson & Johnson doesn't strictly fit into the same criteria, it's greatest revenues are from it's pharmaceutical division, and therefore the share price growth might be stifled by association.

To some extent, the telecommunications companies have had limited payout increases over the past few years, and this can indicate that their earnings growth isn't as robust as it once was.

This leaves, in my mind, three candidates as offering the best combination of safety, dividend yield and potential growth, and potential share price appreciation.

Procter & Gamble has the lowest dividend yield of the remainders (and in fact was in the bottom half of the Dow 30), and also one of the highest PE's of this group. Therefore, it is felt to be more susceptible to share price pull-backs than some others in the group.

This leaves Coca-Cola (KO), and General Electric GE).

Over the past twenty years, Coke (KO) has been one of the most attractive businesses on the planet. It has proven its long-term sustainable competitive advantage, has enormous brand recognition, and achieved very, very, high returns on equity (30-33% over the past five years) over very long periods of time, with minimal use of leverage. Further, earnings growth, while rarely dramatic, is highly visible going forward.

It currently provides a yield in the upper end of the Dow with, in my opinion, far, far, lower than DJIA average business risk. Wall Street consensus estimates suggest that the earnings in 2009 will be $3.36, versus $2.57 in 2007. The business derives 27% of its net income from the US, with 26% from investments in bottling operations likely adding to that figure marginally - suggesting that somewhere in the order of 2/3 of net income is derived from elsewhere on the planet - a nice hedge if you are concerned about the long term stability of the USD.

The dividend payout ratio has varied over the past five years between 50-57%, with 2007 clocking in at 53%.

All-in-all, Coca-Cola has fallen (earnings risen) to become a relative value proposition, and a potential cornerstone building block for a portfolio.

At a different end of the investment spectrum, we have General Electric (GE). It has been priced by the market as if it is a regional bank employing bank-style leverage and with all the attendant troubled homeowner loans. One only needs to look at the current/forward PE ratio at around 13 in either instance, and the yield of 4.5%, to suggest that the market is pricing it like a bank. I suggest that this diversified giant has been egregiously mispriced by the market.

While the company does have a finance division, the retail finance portion (mortgages, credit cards, etc) comprised only 15% of revenue/net income in 2007, and there is a commercial finance division accounting for 20% of revenue/net income in 2007. In total, only 35% of the company looks like or smells like a bank of any sort and certainly the commercial division can't be considered like a retail bank.

Of the remaining revenues and net income, some 35% of the revenue/net income of GE comes from its infrastructure division - hello market, I thought the world infrastructure market still has a "long-tail" of growth?!

Ten percent of revenues relates to health care, also a growth industry, considering the rapid aging of the Western World in particular, but really, now much more of the world since population growth rates are decelerating world-wide.

Finally, the Industrial division (appliances, industrial equipment) at 10% of revenues, and NBC Universal (10%) make up the balance.

Furthermore, 50% of its revenues are derived outside of the United States.

Sorry, tell me again why this is priced and is yielding like a regional bank?

In seriousness though, earnings have continued to rise nicely over the past five years, from $1.55 per share to $2.20 in 2007, with 2008 consensus estimates at $2.21 and $2.34 for 2009.

Dividend payout ratios have ranged tightly from 50-53% in the past five years and, when measured against cash-flow, even tighter from 34.3% to 35.9%. Dividends have risen nicely over that five year period, with substantial raises every year; five years ago they were $0.77 and in 2007, $1.15. Today, they're at $1.24. Returns on equity are very good, ranging between 17-22% over the past five years.

Overall, this isn't a bank, and it's not a highly cyclical stock warranting a low PE. Two different CEO's have proven it's a pretty good business over the past couple of decades.

In summary, I believe that the GE stock is the most obviously undervalued of the two, but that the business dynamics of Coke provide exceptional long-term peace of mind.

In either case, a dealer's choice of outperformance for the next few years, I believe.

Disclosure: Long GE.

JW

The Confused Capitalist

DJIA - Diving in Deeper

I recently profiled an eight stock basket chosen from the 30 stock Dow Jones Industrial Average (DJIA) that I felt would, over the next 2-3 years, outperform the DJIA.

It was essentially chosen using a Dogs of Dow strategy, wherein I used the dividend yield to provide clues to potential mispricings. With one exception (Procter & Gamble), all had yields in the top half of the DJIA.

Certainly, you can't view all of these stocks as a monolithic pick. Generally, the stocks with payouts at high ratio relative to their earnings, had dividend yields at the high end of the range, suggesting that the market considers that either the dividend is at risk itself, or the prospect is for limited dividend increases over the next while.

Having said that however, six of the eight stocks have had meaningful (excluding special dividends) dividend increases in virtually every one of the past five years. The two stocks that don't meet that criteria are Merck and Verizon, with a total dividend increase of under 7% each over the entire five years.

In my view, the dividend payments generally appear safe over the next year or two, given that the lowest yielders have comfortable payment ratios, generally not above 55% of earnings.

For the ones above that, such as Verizon and AT&T, these telecomm's spin out plenty of cash, with cash-flows running at a 2:1 or better ratios compared to earnings over the past five years. This suggests that, even while payout ratios may appear high against earnings, there's plenty of cash spinning off the business to support the current dividends.

In terms of Pfizer and Merck, there's lots of cash on the balance sheet, together with reasonable cash-flow to easily support dividend payments for some time. Nevertheless, given the long winter in drug firm valuations and share price growth, I think you've got to be willing to take a bit of a flyer that the drug pipelines will provide additional earnings growth five years out, if you want to be comfortable with those particular purchases over the longer haul.

Tomorrow, I'll cover the two of these eight stocks that I think comprise the best combination of safety, dividend yield (and dividend growth), and potential share price growth over the next two to three years.

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

Hated: Just about everything!

I took a quick trip over to the StockScouter, which is also a link on my sidebar.

According to the algorithm, there are no stock types liked right now.

Those in the "out of favor" category include VALUE & GROWTH (the only two styles they measure) as well as every stock size, ranging from micro cap to large cap. Virtually every sector is also out of favor, with only Health Care and Consumer Non-Durables managing to make the "Neutral" category.

What's "in favor" in terms of Style, Size or Sector?

Nada, Nil, Nothing, Zero, Zilch ... Yada, yada, yada.

Which, folks, is generally the cue to rummage through the so-called trash, looking for those stock bargains.

Happy hunting!

JW

The Confused Capitalist