Tag Archives: faith

What’s In Your Wallet: The Case For Cash

Strong returns to risk assets have largely precluded the consideration of cash in a portfolio. In times of uncertainty and low expected returns, however, holding cash entails little opportunity cost. Further, holding cash provides a valuable option to take advantage of opportunities as they arise in the future. Following a period of high inflation in the 1970s and early 1980s, and then a period of 33 years of declining interest rates that boosted asset returns, it’s no wonder that cash has fallen out of the lexicon of useful investment options. In addition to this experience, some of the core tenets of investment theory have also helped to relegate cash to an afterthought as an investment option. Regardless, the lesson taken by many investors has been to remain fully invested and let risk assets to do what they do – appreciate over time. Not surprisingly, this has largely obviated the utility of cash. We don’t live in a static world though, and sometimes things change in ways that challenge underlying assumptions and change the endeavor in a fundamental way. In times of ever-increasing asset appreciation, investors just need exposure and cash serves as a drag. In leaner times characterized by lower expected returns, however, the opportunity cost of cash is far lower. More importantly, it also provides a valuable option to take advantage of future opportunities as they arise. Several factors have contributed to the lowly status of cash. An important one has been a core tenet of investment theory that indicates higher returns accrue from assets with higher levels of risk. Money managers and asset allocators such as investment consultants and wealth managers have run with this partly out of desire to help clients earn better returns, but also to out of desire to increase their own asset management fees. Many of these fiduciaries, however, take a shortcut by basing allocation decisions on past records rather than by making determinations of future expectations. This practice has two important consequences for investors. One is that it almost permanently consigns cash allocations to only the most extremely risk averse investors. Another is that it structurally avoids addressing situations in which risk asset opportunities deviate materially from their historical average. And deviate they do from time to time. Stocks, for example, hit exceptionally high valuations in 2000 and 2007. Identifying such instances is not a matter of using Ouija boards and engaging in occult activities either; straightforward analytical techniques are widely available (see John Hussman’s work [ here ] for an excellent analysis). These instances create significant opportunities to avoid low expected future returns by temporarily holding cash instead. To skeptics leery of making any changes, such a dynamic response falls far short of market timing. It merely involves adapting one’s exposure to be consistent with longer term risk/reward characteristics as they go through cycles over time. This really just involves a common sense approach of only taking what is given and not overreaching, but it is also completely consistent with the Kelly criterion prescription for wealth maximization that we discussed [ here ]. The problem is that at the current time, it’s not just stocks that look expensive. With rates near zero, and below zero in many countries, fixed income also looks unattractive. As James Montier of GMO complained [ here ], “Central bank policies have distorted markets to such a degree that investors are devoid of any buy-and-hold asset classes.” And that was in 2013 when the S&P 500 was 400 points lower! He followed up by expanding on his position [ here ], “When we look at the world today, what we see is a hideous opportunity set. And that’s a reflection of the central bank policies around the world. They drive the returns on all assets down to zero, pushing everybody out on the risk curve. So today, nothing is cheap anymore in absolute terms.” In other words, we seem to be experiencing a rare global phenomenon in which virtually all assets are overpriced. For a generation (and more) that grew up on strong asset returns, this may seem surreal and hard to believe. Some things move in bigger cycles than our personal experience, though, and the history of asset returns certainly bears this out. On this score, Daniel Kahneman highlighted in his book, Thinking, Fast and Slow , exactly the types of situations in which we should not trust experience. In his chapter “Expert intuition: When can we trust it?”, he notes that a necessary condition for acquiring a skill is, “an environment that is sufficiently regular to be predictable.” Given our current environment of unprecedented levels of debt on a global basis and central banks intentionally trying to increase asset prices by lowering interest rates, in many cases below zero, it is doubtful that anyone can claim that this environment is “sufficiently regular to be predictable.” Indeed, this environment more closely resembles a more extreme condition identified by Kahneman: “Some environments are worse than irregular. Robin Hogarth described ‘wicked’ environments, in which professionals are likely to learn the wrong lessons from experience.” For those who are anchored to the notion that risk assets are utilities that reliably generate attractive returns, and for investors who are making decisions based on the last thirty years of performance, Kahneman’s work raises a warning flag: This is likely to be a situation in which your natural, intuitive, “system 1” way of thinking may lead you astray. This is a good time to engage the more thoughtful and analytical “system 2” to figure things out. If indeed we must contend with a “hideous opportunity set”, what options do investors have? The answer many receive from their investment consultants and wealth managers is to diversify. The practice of diversification works on the principle that there are a lot of distinct asset classes which implicitly suggests that there is almost always an attractive asset somewhere to overweight. This response creates two challenges for investors. One, as mentioned in the last Areté Blog post [ here ], is that, “The utility of diversification, the tool by which most investors try to manage risk, has been vastly diminished over the last eight years.” This is corroborated by Montier who notes, “Investors shouldn’t overrate the diversifying value of bonds … When measured over a time horizon of longer than seven years, Treasury bonds have actually been positively correlated to equities.” A second issue is that diversification does not really address the problem. As Ben Hunt notes [ here ], “investors are asking for de-risking, similar in some respects to diversification but different in crucial ways.” As he describes, “There’s a massive disconnect between advisors and investors today, and it’s reflected in … a general fatigue with the advisor-investor conversation.” The source of the disconnect is that “Advisors continue to preach the faith of diversification,” which is just a rote response to concerns about risk, while “Investors continue to express their nervousness with the market and dissatisfaction with their portfolio performance.” In short, “Investors aren’t asking for diversification;” they are asking for de-risking. And one of the best answers for de-risking is cash. In an environment of low expected returns wrought by aggressive monetary policy, James Montier makes a powerful case for cash [ here ]. He describes, “If the opportunity set remains as it currently appears and our forecasts are correct (and I’m using the mean-reversion based fixed income forecast), then a standard 60% equity/40% fixed income strategy is likely to generate somewhere around a paltry 70 bps real p.a. over the next 7 years!” In other words, we are stuck in an investment “purgatory” of extremely low expected returns. He suggests some ideas for exceeding the baseline expectation of paltry returns, but his favorite approach is to “be patient”, i.e., to retain cash and wait for better opportunities. As he duly notes though, “Given the massive uncertainty surrounding the duration of financial repression, it is always worth considering what happens if you are wrong,” and purgatory is not the only possibility. Montier’s colleague, Ben Inker, followed up with exactly this possibility [ here ]: “He [Montier] called it Purgatory on the grounds that we assume it is a temporary state and higher returns will be available at some point in the future. But as we look out the windshield ahead of us today, it is becoming clearer that Purgatory is only one of the roads ahead of us. The other one offers less short-term pain, but no prospect of meaningful improvement as far as the eye can see.” Inker’s recommendation is, “if we are in Hell (defined as permanently low returns), the traditional 65% stock/35% bond portfolio actually makes a good deal of sense today, although that portfolio should be expected to make several percentage points less than we have all been conditioned to expect. If we are in Purgatory, neither stocks nor bonds are attractive enough to justify those weights, and depending on the breadth of your opportunity set, now is a time to look for some more targeted and/or obscure ways to get paid for taking risk or, failing that, to reduce allocations to both stocks and bonds and raise cash.” Once again, cash figures prominently as an option. An unfortunate consequence of these two possible paths is that the appropriate portfolio constructions for each are almost completely mutually exclusive of one another. If you believe we are in investment purgatory and that low returns are temporary, you wait it out in cash until better returns are available. If you believe we are in investment hell and that low returns are the new and permanent way of life, something like the traditional 65% stock/35% bond portfolio “still makes a good deal of sense.” The catch is that the future path is unknowable and this uncertainty has implications as well. In regards to this uncertainty Montier’s observation is apt: “One of the most useful things I’ve learnt over the years is to remember that if you don’t know what is going to happen, don’t structure your portfolio as though you do!” That being the case, most investors should prepare for at least some chance that either path could become a reality. And that means having at least some exposure to cash. In conclusion, managing an investment portfolio is difficult in the best of times, but is far harder in times of uncertainty and change. When valuations are high, uncertainty is high, and diversification offers little protection, there are few good options and it makes sense to focus more on defense than on offense. In times like this, there are few better places to seek refuge than in cash. The degree to which one should move to cash depends heavily on one’s particular situation and investment needs. If you are a sovereign wealth fund or a large endowment with low draws for operating costs, your time horizon is essentially infinite so it may well make sense to stay pretty much fully invested. In most other situations, it probably makes sense to have some cash. If your spending horizon is shorter than the average 50 year duration of equities, if you may have liquidity needs that exceed your current cash level, or if you are trying to maximize your accumulation of wealth (and minimize drawdowns), cash can be a useful asset. Finally, the current investment environment has highlighted a growing divide between many investors and their advisers. Investors who are well aware of the risks pervading the market are seeking to manage the situation but all too often receive only rote directives to “diversify” in response. They may even be chided for shying away from risk as if risk is an inherently good thing. Such investors should take comfort in the knowledge that it only makes sense to take on risk insofar as you get well compensated for doing so. Further, identifying assets as expensive is in many ways a fundamentally optimist view – it implies that they will become cheap again someday and will provide much better opportunities to those who can wait. (click to enlarge)

The Benchmarks Lie, Here’s How

Many investors, new and experienced alike, are intent upon “beating the Dow” or “beating the S&P.”. A laudable goal except that… …those indices are always moving targets! The benchmarks lie. Many investors, new and experienced alike, are intent upon “beating the Dow” or “beating the S&P” rather than seeing their capital increase over time. It isn’t that difficult to beat the benchmarks. We’ve done it over 15 years from 1999-2014 and this year the markets, so far, are down 6% to our 1% so we hope to keep that trend alive. On the other hand, for investors who place their faith in buying only companies that are in the benchmarks often find it is difficult to beat the indexes. That’s because “the benchmarks lie.” Every time a company disappoints the keeper of these benchmarks, S&P Dow Jones Indices (a McGraw Hill Financial subsidiary) they boot it out of the index and replace it with something they consider more “representative.” I don’t believe it is a coincidence, however, that “representative” usually equates to rising relative momentum, making the index performance look considerably more attractive — although that index may have a completely different composition than the one you bought before all their changes. As for the companies booted out, they are still in business but, if you bought a mirrored portfolio of those 30 stocks, you own the same 30, but the index and its ETF clones own a very different index — and not because the component companies went out of business or failed to meet regulatory requirements. Assuming S&P Dow Jones Indices are correct in their momentum assessment, the results are regularly skewed upward. So if you obsess over, “why didn’t the 30 Dow stocks in my portfolio keep up with the Dow Jones Index?” well, in Nov 1999, did you toss Chevron (NYSE: CVX ), Goodyear (NASDAQ: GT ), Sears (NASDAQ: SHLD ), and Union Carbide out of your portfolio and replace them with Home Depot (NYSE: HD ), Intel (NASDAQ: INTC ), Microsoft (NASDAQ: MSFT ), and SBC Communications (which a few years later acquired/became AT&T?) S&P Dow Jones Indices did. In April 2004, did you sell AT&T (NYSE: T ) (after just 5 years in the index,) Eastman Kodak (out of bankruptcy now and again trading on the NYSE) and International Paper (NYSE: IP ) and instead buy AIG , Pfizer (NYSE: PFE ), and Verizon (NYSE: VZ )? Or in Sep 2008 sell Altria Group (NYSE: MO ) and Honeywell (NYSE: HON ) in order to buy Bank of America (NYSE: BAC ) and Chevron (which I suppose the indices gurus decided was worthy once again?) In 2009, when Citigroup (NYSE: C ) and General Motors (NYSE: GM ) stocks were plunging, did you switch to Cisco (NASDAQ: CSCO ) and Travelers (NYSE: TRV )? Or did you exchange AT&T for Apple (NASDAQ: AAPL ) this year? There are many other examples but you get the idea. “Representative” seems to mean “on its way up” — though it doesn’t always work out that way. A recent anomaly in the last couple years indicates some boot-ees do better than the new inductees, though it remains to be seen if this will continue. That brings us to an interesting example just today of how trying to read too much into a benchmark can confuse or backfire. The S&P closed down 0.35% and the Nasdaq closed down 0.7% — but the Dow is up .08%. How come? Well, the Dow has only 30 components so if one of them soars or plunges on one day it can affect the index out of proportion to its long-term trend. Today it was DuPont that sent the Dow ahead (which will no doubt lead some feckless commentator to claim that, since the Dow means Blue Chips, that the “leadership of the Dow today proves” that the markets will rise.) But the reason the Dow rose as DuPont rose 10% today? The CEO said she would retire, giving rise to speculation the company may be broken up, hardly an event likely to be repeated every day. The bottom line is that I continue to believe that intelligent stock (and preferred, bond, ETF, CEF and mutual fund) selection remains key to market success, that indexes can be beaten by this approach, and that markets go up and down, meaning there are times to enter trailing stops, adjust your portfolio percentages to include more cash, bonds or hedges. In my next article, I will give some current examples. Disclaimer: As Registered Investment Advisors, we believe it is essential to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as “personalized” investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year. We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about. Best regards, Joseph L. Shaefer

How I Created My Portfolio Over A Lifetime – Part VI

Summary Introduction and series overview. When and why I might trim a position or two from my portfolio. The methods I use to liquidate a position. Back to Part V Introduction and Series Overview This series is meant to be an explanation of how I constructed my own portfolio. More importantly, I hope to explain how I learned to invest over time, mostly through trial and error, learning from successes and failures. Each individual investor has different needs and a different level of risk tolerance. At 66, my tolerance is pretty low. The purpose of writing this series is to provide others with an example from which each one could, if they so choose, use as a guide to develop their own approach to investing. You may not choose to follow my methods but you may be able to understand how I developed mine and proceed from there. The first article in this series is worth the time to read based upon some of the many comments made by readers, as it provides what many would consider an overview of a unique approach to investing. Part II introduced readers to the questions that should be answered before determining assets to buy. I spent a good deal of that article explaining investing horizons, including an explanation of my own, to hopefully provoke readers to consider how they would answer those same questions. Once an individual or couple has determined the future needs for which they want to provide, he/she can quantify their goals. If the goals seem unreachable, then either the retirement age needs to be pushed further into the future or the goals need to become attainable. I then explained my approach to allocating between different asset classes and summarized by listing my approximate percentage allocations as they currently stand in Parts III and III a. Part IV was an explanation of why I shy away from using ETFs and something akin to an anatomy of a flash crash. In Part V I did my best to explain why holding cash, especially when assets valuations are relatively high, may be better than being fully invested at all times. In this article I will explain when, why and how I remove positions from my portfolio. I will provide two examples, one for each of the two methods I use. When and why I might trim a position or two from my portfolio There are two reasons that I might want to sell a stock position from my portfolio. The first is when the company management changes direction or the business model in a way that does not appear to be sustainable to me. This one should be obvious, but I do not want to exclude anything that could be useful to those just starting out. If the fundamental reason I bought the stock has changed, such as the moat has been washed away by technological advances creating easy entrance by competitors, I must reassess whether holding the position still makes sense. Usually, in such a case, the answer is no. Thus, I will want to sell the stock and look for another investment with a more sustainable growth/income business model still intact. The second reason is when I sense, for many reasons, that the market and by extension some of my positions, have reached overly high valuations. I will discuss the many reasons in a moment. But, for now, suffice it to say that when I feel that I could find a better investment for my money in terms of total return potential, I consider selling the position. The method, in this case, is to sell calls. In the first case I will sell the position outright on a day when the stock is exhibiting some price strength (usually when the broader market is up and lifting most stocks higher). In the second case, I will sell the calls when the stock is over its fair value by 20 percent or more and do so while the stock is still near its 52-week high. The methods I use to liquidate a position I want to provide two examples, one to explain each situation in which I decide to sell a position. The first example is Best Buy (NYSE: BBY ) which I first recommended in this article back on October 7, 2011. But I did not buy the stock at that point because my recommendation was to sell put options in hopes of either collecting a 20 percent annualized return on cash or to buy the stock at a discount. I ended up collecting the cash and the option expired worthless. The next time I made a similar recommendation came in my December 23, 2011 article . This time I was successful, having sold two put options, collecting $2.39 per share, with a strike price of $20 while the price at the time stood at $23.28. I did not expect to get put the shares but, as it turned out, the stock fell all the way down to near $11 per share in November of 2012. I ended up owning 200 shares of BBY with a cost basis of $17.61 in mid-January 2013 with the price at $15. I had originally wanted the shares because of BBY’s position as the leading electronics retailer after a consolidation in the space and because of my personal experiences while shopping at three different BBY locations. I received some negative feedback after my original article that customer service in some areas had become less than desirable. I considered that to be more of a localized situation as my recent experiences had been superior. Then something changed. All of the highly knowledgeable employees that I had previously made my shopping experience enjoyable suddenly disappeared. The employees that replaced them barely spoke English and were not as interested in helping find what I needed but totally focused on selling me something along with some other things that I did not need. They were highly trained in selling but knew little about the products they were charged with selling. Fortunately for me this happened in September, 2013 with the price trading near $38 per share. I dumped my 200 shares on September 16th at $38.50. One of the major reasons why I had bought stock in the company, excellent customer service, had changed dramatically. I was lucky to be shopping and having the experience when I did. Sure the stock went up to over $43 per share in November of that year, two months after I had sold. But I felt no regret at the time. My decision was based upon the assumption that the company had decided to lower labor costs and try to increase dollars per sale at the expense of customer service. Management probably did not think it would be sacrificing so much in the customer experience, but, in the end, the result was horrific. Results disappointed and the stock price fell back to a low of $22.15 on January 2014. I was not tempted to add back shares at that price. While I would have profited nicely if I had, the company had broken my faith and I will not look back. Of course, the bigger future problem for BBY will be competing over the Internet with the likes of Amazon and some smaller electronics specialty sites. The stock now stands at $37.78. I believe it is over valued at that price relative to its future prospects. The second example is a company than I have held in my tax-deferred IRA account since 2006 with a cost basis of just over $30 per share. McCormick (NYSE: MKC ) is one of my all-time favorite companies but the stock has, like many quality stocks in the current environment, has become over valued by my estimates. The current share price is $79.62 (as of market close on Friday, October 2, 2015). I really do not want to sell these shares because the company is still doing everything right and the future remains bright. However, when the price of a stock gets to be over valued by 20 percent or more I like to sell calls above the current price. If the stock rallies and remains above my strike price I end up having to sell the stock for 25 percent or more above what I consider to be fair value. My estimate of fair value for MKC is $66. I get to that price base by using the dividend discount model [DDM] with a discount (or my hurdle rate) of nine percent. Dividends have increased handsomely over the past five and ten years, at nine and 9.1 percent, respectively. However, I believe that the growth prospects going forward will be lower, not only for MKC but for most multi-national corporations, as growth in emerging markets is slowing and not likely to regain the levels of the past decade in the foreseeable future. My estimated compound annual growth rate for MKC dividends is 6.6 percent. Plug in the numbers and we end up with a fair value of $66.01 per share. As I mentioned before, I do not want to lose this position but it will not break my heart if these shares get called away at $85 before year end. Since the position is in my IRA account I am not worried about a tax consequence. I would not sell calls so close to the current price if it were in a taxable account. I figure that if the position gets called away I will probably look for a better yield in another quality stock that has been beaten down more. Of course, if it does not get called away I am happy because the stock is not likely to fall much below fair value. It seems to hold up very well even during the worst recessions. Everyone has to eat and we like to season our food to taste. That goes for all seven billion of us; or at least those can afford to be choosy. That number has grown and will continue to growth but I suspect the rate of growth to slow considerably for at least the next five years. Summary I intend to get more into some of the common mistakes investors make when not paying attention to tax consequences in the next article. After that I want to get back to the basic concepts of saving and investing goals and methods, primarily for those just starting out, but also applicable to those who are nearing retirement and not quite comfortable with where they are at this stage of life in terms of having enough to last through their remaining years in comfort. There are always a few tough decisions to make but they are generally well worth considering. As always I welcome comments and questions and will do my best to provide details and answers. This is one of the best aspects of the SA community. We can learn from each other and share our perspectives so that other readers can benefit from the comprehensive knowledge and experience represented here.