Tag Archives: opinion

Why I Sold Berkshire Hathaway And Added Quality To My Portfolio

Summary Berkshire Hathaway may be a model for a quality company and merits a place in one’s portfolio on that basis. Berkshire Hathaway’s recent performance has been disappointing. Can an ETF focused on the quality factor replace it and improve returns as well as portfolio quality? I continue to review my holdings with an eye to what I want to keep and what’s not earning its keep. After a hard look, I decided Berkshire Hathaway (NYSE: BRK.B ) just wasn’t getting it done. Take a look at some stats for BRK.B and the ETFs tracking the S&P 500 and the NASDAQ 100. Annualized Volatility Beta Daily Value at Risk Max Drawdown Total Return (1 year) BRK.B 14.2% 0.91 2.1% -6.3% 4.4% SPDR S&P 500 Trust ETF ( SPY) 12.7% 1.00 1.9% -4.9% 9.5% PowerShares QQQ Trust ETF ( QQQ) 13.7% 0.99 2.0% -5.7% 11.8% Looking at these numbers, I asked myself “Why?” Why do I need something that I think of as high-quality but ultraconservative yet has greater volatility than the NASDAQ 100. And with that volatility comes barely a third QQQ’s return. It has greater volatility than the S&P 500 as well, and half of SPY’s return. Sure, the stock has had great years in the past, but when I ask what it’s done for me lately, I’m not getting an answer that tells me to hold onto it, especially since it’s a large holding for me. The question was, what do I replace it with? In looking for the answer, I asked myself why I was holding BRK.B. What came immediately to mind? Quality. When I bought the stock it was because I viewed it as the model for quality. So, while I was deciding to part ways with BRK, I had to decide how to fill the gap it would leave. I might have begun by considering other stocks, of course. But, another factor that entered into my thinking is that I have been moving away from individual stock holdings in favor of funds. That decision is the subject of another discussion altogether, but especially for places where a stock is occupying a structural role in my portfolio, I think it can make more sense to fill that slot with an ETF that does the same job. So, what I wanted was a fund that emphasized high-quality. What Asness et al., following the Fama-French factor terminology, called Quality Minus Junk in their 2013 paper on the subject. In that paper they define quality stocks as being “safe, profitable, growing, and well managed” and showed how the quality factor has outperformed. After BRK.B had a nice pop on Thursday and Friday, I decided it was time. I could have gone with one of AQR’s mutual funds, which are built on Asness’s rigorous research. But, even if the door was open to me, I’m not in a position to fork out the cost of entry. These funds have a nominal minimum purchase of $1-5 Million depending on share type. I have a large holding in BRK.B but not remotely that large. In addition there are fees that approach 2%, and the funds are generally available only through advisors. I’m sure you can get in for less than that nominal seven-figure requirement if your timing and brokerage are right. In fact I do hold an AQR mutual fund purchased this way despite its nominal $1M minimum. But most of them are closed to new or even current investors. A smart move by the funds’ management, keeping the funds something halfway between an open-end and closed-end mutual fund. I won’t argue the desirability of AQR mutual funds, but as I go through them, I don’t see enough to justify those barriers to me. What I went for was the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ), which does what it says on the label: Emphasizes the quality factor. QUAL: Top Ten Holdings and Sector Distribution When I start to look at an ETF almost the first thing I do is look at the portfolio. (click to enlarge) I found that the top six positions in QUAL were also in my own portfolio: Microsoft (NASDAQ: MSFT ), Johnson & Johnson (NYSE: JNJ ), Apple (NASDAQ: AAPL ), Gilead (NASDAQ: GILD ), Berkshire Hathaway and Costco (NASDAQ: COST ). Four more of my stocks were in the top 20: Celgene (NASDAQ: CELG ), AT&T (NYSE: T ), Chevron (NYSE: CVX ) and Qualcom (NASDAQ: QCOM ). I hold a total of 14 individual stocks, and I look primarily for quality in my choices. So, I was struck by the convergence of my opinion and that of QUAL’s passive algorithm. I’m not sure I’ve ever looked at an ETF portfolio and found 70% of my portfolio’s stocks in the ETF’s top 20. And I’m certain I’ve never hit all of the first 6. I felt the algorithm validated decisions I’ve made over a period of several years, and this fund was a fit for my own approach to investing. Sector weighting also aligned with my own portfolio strategies. (click to enlarge) I have a modest allocation to a dual-momentum sector-switching strategy. For the past year and a half or so it’s been in information tech, healthcare, consumer discretionary most of the time it hasn’t been in the out-of-market position. The QUAL index has loaded the portfolio with 70% allocation to those sectors. Again, I felt I was moving along the same path. So, with the validation that my investment strategies and QUAL’s index algorithm were generating similar choices, it seemed clear that I had to look more closely. QUAL’s Strategy and Implementation Quality can be a nebulous concept. The most important question was: How does the fund define quality? According to the fund’s factsheet they use “three fundamental variables: high return on equity, stable year-over-year earnings growth and low financial leverage.” Not unreasonable indicators of Asness’s “safe, profitable, growing, and well managed” definition of quality. The MSCI index description expands this with the quantitative details: A quality score… is calculated by combining Z scores of three winsorized fundamental variables-Return on Equity, Debt to Equity and Earnings Variability. MSCI then averages the Z scores of each of the three fundamental variables to calculate a composite quality Z score… then ranks all constituents of the parent index based on their quality scores. Weighting is determined by the product of market cap weight in the index and quality score. Weights are capped at 5%. As an aside to stock-pickers, think about how high MSFT and JNJ must score on the quality scale to overcome AAPL’s market cap advantage in rising above it in the weighting here. It’s an approach that should lead to emphases on both fundamental value and momentum. I liked what I saw, and feel most would agree that these indicators do indeed reflect a concept of a quality company. They are clearly necessary components of quality, although perhaps not sufficient. I’m sure all of us could add metrics we’d like to see included. But I was satisfied with it at this level. QUAL’s History The fund has 27 months of history (July 16, 2013) and net assets of $1.2B. The total portfolio is set at 125 holdings. SEC 30-day yield as of September 30 is 1.94%. Its beta is 0.92. And its fee is only 0.15%. Returns since the fund’s inception are about a third better than SPY and twice what BRK.B has turned in. (click to enlarge) For longer term evaluation we have to go to the index. It’s always problematic to base decisions on a fund using the historical performance of its index, but it’s what we have. Here we have MSCI’s 15 year chart of the index vs. its USA index of domestic stocks. (click to enlarge) Morningstar’s Samuel Lee looked at the fund and its index about a month after it was introduced ( here ). He called it a “Buffett in a Box,” and ran up this analysis where he divides the MSCI Quality Index by the MSCI USA Index. On this chart positive numbers represent outperformance of the quality index relative to the domestic market index. For the 30 years prior to QUAL’s inception the index outperformed by 60%. What you really want to see in this chart, however, is the changes in slope because the positive slopes represent periods of QUAL’s outperfomance. During bull markets, quality lags, but during downturns it shows its breeding. (click to enlarge) Lee compared QUAL to the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) noting the he’ll be watching it in comparison to VIG with an eye toward moving his VIG position to QUAL if the fund evolved as he anticipated it should. Here’s what he would have seen when he followed through: (click to enlarge) Trading for Quality So, near the close on Friday I sold my entire position in BRK.B and put the proceeds into QUAL. I started my project to replace individual stocks with funds by focusing on BRK.B for two reasons. First, it has been turning in disappointing returns recently, and second I have a large allocation to the stock, larger than I feel appropriate. There are two other stocks I’m holding at much lower allocations that I have been looking to trade out of as well: JNJ and T. I like having both of them for the same reasons I like BRK.B: stability and quality. But, like BRK.B there underperformance comes with opportunity costs. How do those opportunity costs stack up against what QUAL has been returning? (click to enlarge) What this is telling me is that I can jack up my returns with little, if any, sacrifice in portfolio quality by moving these allocations to QUAL as well. The biggest problem I have with QUAL is one of the things that attracted me to it in the first place. That is the extent to which it duplicates what I’m already holding. I’m not prepared to trade out of GILD, COST or CELG at this time. I think each of those has excellent prospects to outperform the market and their sectors. I also hold a large (my largest, in fact) position in AAPL that I’d like to cut back. I’ll probably do so after earnings this week if, as I expect, we get another positive report. But my other duplications I’m more ambivalent about. I like MSFT and it is certainly not underperforming (75% total return vs. QUAL’s 33.5% on the scale of the above charts) but if I had a quality substitute, I would not miss it. The other I replicate is CVX where I’m underwater but am willing to wait for the oil cycle to turn before I do anything there. Of course, most funds I own replicate some part of my portfolio, especially with AAPL and GILD among the top holdings of nearly every fund I find interesting. Bottom line on this exercise for me: I like QUAL, perhaps as much as any ETF I’ve looked at recently. For my purposes, it can serve the same role in my portfolio as individual stocks of quality that have been, and likely will continue to be, underperforming the market.

IFGL: International REIT Exposure Could Include More Countries

Summary The ETF offers investors a fairly unique risk exposure. The fund has heavier allocations to individual countries than I would prefer. The ETF has more concentration to individual company weights than I would want to see. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds I am researching is the iShares FTSE EPRA/NAREIT Global Real Estate Ex-U.S. Index ETF (NASDAQ: IFGL ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio IFGL sports an expense ratio of .48%. Not impressive, in my opinion. Yield The ETF offers a fairly nice distribution yield 3.66%. While there are some things I don’t like, that is a fairly respectable yield. If investors are going to buy an ETF where the individual holdings are largely unfamiliar to them, then I’d prefer to see the ETF have a strong yield to encourage the shareholders to maintain their positions during periods of volatility. Some investors will focus on wanting to see the value of their portfolio increase with every statement, but I think they should also keep an eye on the amount of income the portfolio is generating. Country Allocations I grabbed the following chart from the iShares website: (click to enlarge) I understand that international equity REIT ETFs have a tendency to overweight Japan. No big deal, we can work around that. On the other hand, they are also going fairly heavy on Hong Kong. The top 4 country weights represent around 65% of the portfolio. I find that a little disappointing since I believe international REIT exposure should be designed to improve diversity in small allocations and lead to a lower risk portfolio rather than believing that investors should use the allocation to pump up returns. Since I like this niche for only small allocations to reduce risk rather than drive returns, a heavy allocation to individual countries is a negative factor for me. What I would like to see is the top allocations reduced and increase in the allocations to other parts of Europe (such as Sweden and Switzerland). I wouldn’t mind seeing some fairly light allocations to more exotic locations either to get a little REIT exposure to the emerging markets. Missing Allocations If you’re trying to build a thoroughly diversified international position for the portfolio, it would be wise to consider including ETFs in Latin America and Africa. I’m not a fan of putting huge weights on emerging markets, but a very small weight is reasonable since the goal is diversification of risk factors. Investors may also notice that this ETF went heavy on Hong Kong rather than including an allocation directly to China. I don’t have a problem with that strategy. The markets are correlated but I’d feel more comfortable with the exposure to Hong Kong. REITs The other thing investors should remember is that this international allocation is investing in REITs. In the domestic market REITs and regular equity markets can diverge quite substantially over years so investors would be wise to consider including allocations to the normal corporate international market. Holdings I built the following chart to represent the top 10 holdings. (click to enlarge) These allocations are a little heavy in my opinion. Just like the allocations to individual countries were heavy, I’d rather see the ETF limiting positions to around 2% to 3% of the portfolio as the cap for a single allocation. The positions should not have a hard cap that would force immediately sales and expose the ETF to losses from rapidly liquidating positions, but a soft cap that encourages them to reallocate capital would be favorable. Conclusion The expense ratio is too high for my liking, but the ETF still offers some diversification benefits as long as the weight is low. I’d really prefer to see the ETF offering a more thorough diversification across both individual holdings and weights for countries. If investors are confident these markets will outperform over the next several years, than there is no problem with the concentrated allocation. If the investors, like me, see international REIT ETFs as a diversification play then it doesn’t make sense to have the positions concentrated.

What I Bought And Sold In October

Summary I’m sharing my personal portfolio moves with investors. Over the last few days, I picked up a huge position in CYS Investments and funded it by liquidating my position in VNQI. I left my position in Renesola to grab the tax loss. Aside from buying CYS Investments, my investments were very late in September when I kept sending in new cash to buy up equity ETFs. I’m holding some cash outside the portfolio. If prices fall again, I’ll buy equity. If they don’t, I’ll pay down the mortgage. October has been a fairly easy month for generating positive returns. If an investor’s portfolio isn’t up relative to the start of the month, they should really be contemplating their investment strategy. With about a week left in the month, I thought it would be a good time to go over the changes I recently made in my portfolio. Most Recent Acquisition: CYS Investments (NYSE: CYS ) The most recent purchase for my portfolio was a large chunk of CYS Investments. This is a great mREIT and I’ve been looking for it to go on sale. I wish I had picked these shares up even earlier, but it took me quite a while to build the model I was using to establish movements in book value. If the model had been completed by the end of September, I think I would have tossed more cash into my portfolio and started grabbing up the shares. Avoiding Hindsight Bias Of course, it is easy to establish a hindsight bias and think we would have bought when the market was bottoming out. I try to watch for that kind of bias as I evaluate my own choices. When it came to buying with the market down, I transferred new cash in multiple times to buy up shares of some ETFs in late September. My major acquisitions late in September were the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) and the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ). When prices were falling hard and speculation about another recession was getting stronger, these were the ETFs I felt confident tossing more capital into. My Other mREIT The other mREIT in my portfolio is Dynex Capital (NYSE: DX ). Prior to their latest dividend, the low price on shares was about $6.41. On one day I put the floor in for the market with an order at $6.42. That order came back only partially filled, but the shares I got were a great bargain. I didn’t have the capital available to support the price again when it dipped down to $6.41. It did fall below $6.40 following the dividend, but it had just paid out a $.24 dividend so I still see the $6.41 and $6.42 opportunities as the best buys. Since I had the conviction to double down on my bet there, I feel confident I would have been able to pull the trigger on CYS Investments if I had the data available. Selling the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ) This isn’t a bad fund. It offers a fairly unique exposure with a low expense ratio compared to other international equity REIT funds. Unfortunately it has a fairly high correlation with other international equity investments so I didn’t feel compelled to keep it. When I bring my international exposure back up, I’ll probably do it with acquisitions of SCHC and the Schwab International Equity ETF (NYSEARCA: SCHF ). I’m already long both of those securities and expect to buy more during the next 12 months. I am not remotely bearish on VNQI, but when I completed the analysis on CYS there was no way to make a big move without liquidating an existing position. I looked at my existing positions and decided which one I was most willing to sacrifice so I could make the play on CYS. VNQI came up as the top choice for me. It was a large enough position to give me the kind of capital I wanted for the trade and I had no problem with using SCHC and SCHF to get my international exposure back. If I had enough cash on hand to establish my position without selling VNQI, I would have kept the shares. Selling Renesola (NYSE: SOL ) Renesola is the crowning achievement in wealth destruction for my personal investments. It was a remarkably effective tool for destroying net worth and generating a tax loss shield. There is one thing about this investment that I absolutely love: It was in a taxable account. Most of my investing is done through tax advantaged accounts. When I started buying up more investments, I made it a priority to learn what account types would be available to me. Personal financial planners would be giddy at seeing the volume of options I was able to access. It isn’t just IRA accounts. I’ve added a solo 401K for myself and my wife was able to get a 401A, 403B, and 457B. I held onto the position in Renesola for years because I recognized that the value of the tax loss was more important than the value of the individual shares. That’s a pretty nasty gut punch huh? Since the value of the position was in the tax loss, I wanted to ensure that I could time the loss for a year when the benefits would be optimized. I’ll be reaping this tax loss for a while. Increased Cash I sold the VNQI and spent it all on CYS, but I’ve also got some dividend income in my accounts. That money is currently sitting idle. I’ll need to put that money to work. Since each account has a fairly small amount of cash the most likely way to invest it will be using the ETFs that are free to trade. Since my income substantially exceeds my expenses, I’ve also got more cash on hand outside of my investment accounts. I’m planning to use that cash to pay down the mortgage, but I’m hesitating for a bit because I want to maintain flexibility. If shares go back on sale like they were in late September, I’d feel compelled to put that cash into my investments accounts and buy up more ETFs. In addition to SCHC and SCHF, I’d look to buy up more SCHD if it went under $35 again or buy up some Schwab U.S. REIT ETF (NYSEARCA: SCHH ) if it was dipping back down around $37 again. Even though I already own positions in each of those ETFs, I’m happy to increase the positions if the values are highly compelling. My cash position in the investment portfolio is still fairly small, but it was only slightly above 0% at the end of September so it didn’t take much to increase it. I generally don’t consider cash in a “checking” or “savings” account as part of the portfolio. Interest Rate Expectations Some investors don’t like equity REITs in the current market because they know an increase in interest rates would push prices on equity REITs down. I agree with half of that assessment. A substantial increase in interest rates would probably push equity REIT prices down. However, I don’t foresee that happening. I don’t believe the Federal Reserve has the power it pretends to hold. Yes, they can push up short term rates and I think there could be a temporary increase in long term rates, but I’d be buying hard on the price drop. Europe has already seen quite a bit of negative interest rates. I don’t know if we are going there or not, but I do think the Federal Reserve will be completely unable to follow their target path for raising rates. Since I’m not buying into the increasing of rates, I’m happy to hold a heavy allocation to equity REITs and happy to buy more if the Federal Reserve attempts to raise rates. For the same rationale, I love the mREITs that are holding high quality assets that are substantially less susceptible to prepayments. That means either a portfolio of Agency RMBS with lower coupons (that is CYS) or AAA rated CMBS like Dynex Capital. Conclusion My best pickup of the last 30 days or so was shares of SCHD at $34.60. Those shares are now $39.30. When I pulled the trigger on putting in that limit order, I certainly felt some stress. I’m not big on selling shares in any investment unless I believe it is materially over-valued, so selling off the VNQI was a little painful but I wasn’t willing to miss out on the opportunity in CYS. Now you know which securities I’ve been buying and selling. What have you picked up over the last month?