Tag Archives: portfolio

Building The Ultimate Bank Basket

Summary Building a basket is like creating a custom-made ETF. Simple strategies work better than complex systems. The nuts and bolts of building a custom bank basket explained. Investors like to act like art collectors. They spend years hunting for a specific Monet (or a rare investment holding) and are willing to spend anything to prevent it from slipping through their fingers. On the surface this behavior makes sense, good companies supposedly only come along rarely, and investors are rewarded for taking advantage of opportunity. Where the analogy breaks down is that art is supply constrained, there is a limited set of outstanding Monet paintings and no new paintings. There are thousands of traded companies, and tens of thousands of companies are being started every week. If an investor misses one opportunity another comes along quickly. In the world of bank investing, there are over 1,200 banks with tickers that are in theory tradable. Many of these banks are very small and illiquid and only appropriate for experienced and patient investors. But even if one eliminates all non-SEC filing banks from their pool of investments, there are still over 500 SEC filing traded banks. The question becomes: “How does one find bank investments with so many options?” I’ve made a mistake many investors do when faced with finding the best companies in a pile of potential opportunities. I’ve spent far too much time looking at inconsequential details trying to find the absolute best idea. I’ve come to the conclusion that this is a waste of time. Let me explain. Back in 2011 and 2012, I started to look at Japanese net-net stocks. These are stocks trading for 2/3 of net current assets (current assets – all liabilities). Through screening, I identified hundreds of Japanese companies trading as net-nets. The problem was there were more companies than my portfolio had room to buy, so I needed to narrow down the list. Keep in mind that every single company on the list was cheap, the market was valuing all of these companies for less than their liquidation value. What I ended up doing was spending a lot of time comparing companies against each other with metrics that had no predictive value for investment success. I ended up selecting a handful of what I thought were the best companies on my list. My companies did well, but I could have done just as well picking blindly from the initial pool of undervalued companies. As investors we fool ourselves into thinking we’re smarter than we are, and that we can identify the best performing stock from a pool of very cheap stocks ahead of time. There might be a few super-genius investors who can do such a thing, but for the rest of us mere mortals, our best bet to outperformance is by fishing in a very small pond loaded with fish. In the world of bank investing, there are plenty of companies selling at discounts to intrinsic value no matter how you define intrinsic value. For example, I ran a simple screen on CompleteBankData.com looking for banks trading below 1x TBV with a 7% or higher ROE and low non-performing assets and my search returned 10 banks. This might not seem like stringent criteria, but this search finds banks with an above average ROE at less than book value. If I drop my ROE requirement to greater than 4%, more than 30 banks match my criteria. If one were to look for banks earning an above average ROE at less than 1.5x TBV, which is the median TBV value, they’d have 96 banks to analyze. The point is that one can hunt through that list of 10 banks, or 30 banks, or 96 banks and try to identify the top one or two banks to add to a portfolio. Or an investor can take a simpler approach. In the aggregate, these banks are likely to outperform. They are all undervalued, and all have quality assets. It’s far easier to build a basket of banks and gain exposure to an area of the market not covered by ETFs rather than find the best. The second advantage to building a basket of bank stocks is that you don’t need to be an expert on bank investing to gain exposure to a segment of the market. Building your own basket is akin to buying a custom ETF. How to Build a Bank Basket? It’s easy to agree with the concept of building a basket of banking stocks, but sometimes the actual execution is difficult. “What stocks do I buy?” “How long do I hold them?” “How many should I own?” are some of the questions you might be asking about this. Let’s break down how to build an actual basket of bank stocks. Identify an investment criteria The first step is to identify the criteria you’ll use to select an investment. My advice is to keep it simple, simple criteria is better than complex criteria. For example, look for profitable banks selling below TBV with good assets. A screen for this might be: P/TBV < 1, ROE > 1%, NPA/Assets < 3%. Once you have a criteria you're satisfied with run the screen on your preferred screening platform. Sifting for investment candidates I don't recommend buying every company that matches the screen blindly. I put in the bare minimum amount of effort validating data and criteria matches. Sometimes a bank will report a high ROE as a result of a onetime gain. Or a bank might have quality assets in one or two recent quarters but struggled with significant issues in the past. Or sometimes a bank will match a screen but is in the middle of a merger or another transformative transaction. I quickly go through my matches and remove these companies. Buying and holding Once you've identified your basket candidates, it's time to buy them. If you like a clean separation of basket holdings versus non-basket holdings, I'd recommend opening a new brokerage account for these banks. Buy them as you would any stock, use limit orders and be patient in getting your trades filled. The hardest part of owning a basket of banks is holding them. I recommend at least a one-year holding period if not a three-year holding period for each name in the basket. As some banks are merged or sell, recycle those funds into new names that match the strategy. The hardest part of owning a basket of bank stocks is simply staying still and resisting the urge to tinker with the basket. Best of luck!

How Much Allocation To CEFs Is Too Much For An Income Investor?

CEFs provide a great income source for retirees and income investors. A past performance screen with 10, 20 and 40% allocation of 4 CEFs in combination with VTI is presented. The portfolio with a 40% allocation to CEFs had the highest return for the given period. It has been become a ritual for me when rebalancing my portfolio to make sure that I am not over-allocated to high yield asset classes. However, I have been adding more Closed End Funds to the portfolio due to the attractive discounts especially last month. Adding high yield CEFs in a rising interest rate environment is generally not considered very safe. I therefore set out to see how three portfolios with 40%, 20% and 10% allocations to a set of 4 CEFs would have performed since January 2008. Investing in CEFs is certainly not appropriate for everybody, but it can be a great vehicle for investors in or near retirement who would like to have a higher income from dividends. It is important to keep a sizable portion of a portfolio in stocks or ETFs like the Vanguard Total Stock Market ETF (NYSEARCA: VTI ) for growth especially for long retirement time horizons. This analysis tried to shed light on the performance impact of a larger allocation to CEFs. There are certainly plenty of CEFs to choose from for this analysis and the selection chosen is solely based on the fact that I own each of them (with the exception of MGF) in my personal portfolio. I included MGF since it is a taxable bond CEFs with a long history of data available. I hold the PIMCO Dynamic Income Fund (NYSE: PDI ) in my personal portfolio for taxable bond CEF investment exposure. However, since the inception date for PDI was May 2012 vs May 1987 for MGF, I included MGF in the analysis. My aim was to get a representative set of CEFs with investments in preferred securities, equity and bonds. Overview of CEFs included: The Flaherty & Crumrine Preferred Securities Income Fund (NYSE: FFC ): Invests in preferred securities. At least 80% of the preferred securities are investment grade quality. Leverage ratio 34.6%. I consider this one of the best available Preferred CEF funds. It currently trades at a premium of 5%. The Nuveen Tax-Advantaged Dividend Growth Fund (NYSE: JTD ): Equity CEF using 31.6% leverage. This CEF has historic data going back to June 2007 and currently trades at a 11% discount The Eaton Vance Tax-Managed Global Diversified Equity Income Fund (NYSE: EXG ): International Equity CEF using an option income strategy. I included EXG for its international equity exposure. EXG currently trades at 7.9% discount. The MFS Government Markets Income Trust (NYSE: MGF ): A taxable Bond CEF that invests at least 65% of its assets in US Government securities and may invest up to 35% of its total assets in foreign government securities. MGF trades currently at 5.7% discount. Here are the hypothetical portfolio allocations: Portfolio 1 2 3 VTI 60% 80% 90% FFC 10% 5% 2.5% JTD 10% 5% 2.5% EXG 10% 5% 2.5% MGF 10% 5% 2.5% I used VTI as the non CEF part of the portfolio since it is a largely diversified ETF. So here are the results as analyzed using portfoliovisualizer.com . I included the SPDR S&P 500 Trust ETF ( SPY) for reference: # Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown 1 $100,000 $185,521 8.21% 15.45% 38.14% -31.16% -42.42% 2 $100,000 $178,894 7.71% 16.13% 33.52% -34.07% -45.19% 3 $100,000 $175,342 7.43% 16.66% 31.21% -35.52% -46.68% SPY $100,000 $167,266 6.79% 16.77% 32.31% -36.81% -48.23% The individual returns for the selected funds are listed below: Year VTI FFC JTD EXG MGF Total Return 2008 -36.98% -44.86% -40.22% -30.87% 26.22% -31.16% 2009 28.89% 108.42% 49.32% 49.11% 1.24% 38.14% 2010 17.42% 27.46% 22.61% -1.98% -2.05% 15.06% 2011 0.97% 18.52% 2.78% -11.59% 10.51% 2.60% 2012 16.45% 22.77% 27.14% 19.95% 5.76% 17.43% 2013 33.45% -2.21% 16.22% 25.60% -9.62% 23.07% 2014 12.54% 18.31% 11.37% 4.44% 6.95% 11.63% 2015 (until Oct) 1.90% 10.26% -3.66% 4.78% 1.45% 2.42% Conclusions: The allocation to a set of CEFs seems to have helped the portfolio return for the selected time period. FFC had the biggest positive impact on the portfolio performance. This is by no means a guarantee that the future results will be similar. However, I personally feel a bit more comfortable that a set of equity, preferred and bond CEFs can enhance the overall portfolio returns while providing nice income.

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)