Tag Archives: portfolio

Newest Additions To Our Friedrich Charts

In 1989 I was four years into working on building what would later be called Friedrich and back then I read a book called “The Money Masters” by John Train, which changed my life . In that book, one of the chapters was about the portfolio manager of Source Capital = Mr. George Michaelis, whom I consider one of the greatest investors in history. In the Appendix of that book, is part of the Source Capital annual report to investors for December 31, 1985. Here is what George wrote then. The ratio that you see in the first paragraph is actually one of the foundation stones of Friedrich and plays a major part in my creation of the final algorithm. The reason that ratio is so powerful is because it allows one to determine a company’s actual rate of growth on Main Street by incorporating its return on equity along with the company’s dividend payout policy, which both speak volumes about how well managed a company is. What I look for in using what I call the “Michaelis Ratio” is a return of at least 15% or higher. Here for example is our Friedrich chart for Accenture (NYSE: ACN ) that includes the Michaelis Ratio listed for the first time. As you can see Accenture’s Michaelis Ratio came in at 30%, which is twice what I look for as the ideal for this ratio. When you factor in my other original ratios like FROIC and CAPFLOW, you have quite impressive results for the company. But in that chart you will also see the Watson Ratio and the Sherlock Debt Divisor. Obviously, I am a big fan of Sir Arthur Conan Doyle’s work and have named these two powerful ratios after his greatest creations. Having said that, what is the Watson Ratio? The Watson Ratio is one of 30 original abstract ratios that I have created, which along with many others make up Friedrich. This particular ratio deals with the relationship between a company’s free cash flow and its diluted earnings per share. It uses the free cash flow methodology that Arnold Bernhard (the founder of Value Line) created, which is basically cash flow – capital spending and divides that result by the company’s diluted earnings per share. In theory most companies should have (what I call a Bernhard Free Cash Flow) result equal to its diluted earnings per share, so an average result should be 100%. When a company is well managed you will see a result greater than 100%, like Accenture’s result above of 110%, which obviously tells us that Accenture’s Bernhard Free Cash Flow is 10% better than then Accenture’s diluted earnings per share. Thus we end up with bonus points. A major concern that I have these days in analyzing companies is the amount of debt each company takes on relative to its operations and whether management is abusing our current Fed inspired low interest rate policy. Debt as anyone knows, when used wisely, allows for what is called leverage and leverage can be extremely beneficial within means. On the other side of the coin, the use of debt can also be excessive and put a company’s future in jeopardy. So what I have done to determine if a company’s debt policy is beneficial or abusive is create the Sherlock Debt Divisor, which allows us to investigate debt in a different abstract way. What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well I take a company’s working capital and subtract its long term debt. I then divide that result by the company’s diluted shares outstanding, then multiply that result by (-1). So if a company like Accenture has a lot more working capital than long term debt, I reward it and punish others whose long term debt exceeds its working capital. The final result for Accenture came in at $100.13 but the closing stock price was $104.78, so I am rewarding Accenture’s management for doing a great job using leverage. How do I reward them? Well I do so by using $100.13 as my numerator and not $104.78 in all my ratio calculations performed by Friedrich. So since the valuation in the Numerator is less, each ratio naturally generates a much more favorable result than it would have had I used $104.78. What does a company that is not doing very well look like? Well here is the Friedrich chart for Chevron (NYSE: CVX ). First of all, Chevron pays about a 5.09% dividend yield, so the growth for the company on a Main Street is only 1.91% on a Michaelis scale (7%-5.09%). It’s Watson Ratio ratio tells us to avoid it as its free cash flow is a disaster relative to its reported diluted earnings per share. Finally the large debt that Chevron has on its books punishes the company by adding $8.84 to the numerator in all ratio calculations performed by our Friedrich Algorithm. The Max Value you see below uses a different methodology to come up with its result and sometimes that result is skewed as it relies exclusively on what is called the “discounted owners earnings using a two stage dividend discount model’ found in Hagstrom’s great book “The Warren Buffett Way”. The final “Market Value of the Company” you see in the table below is what I call the Max Value. My work also incorporates different free cash flows than Mr. Hagstrom uses as I use the MFCF = Mycroft Free Cash Flow and since my Mycroft Free Cash Flow for Chevron comes in at $-785 million, you are obviously going to end up with a negative result for Max Value. My True Value and Buy Prices are based exclusively on my own ratios and that is why they are positive as they incorporate many more things than free cash flow in the analysis. As you can see if you used the Max Value in 2014 for Chevron you would have sold it then and avoided watching its stock price go down to $69.58, which is the 52 week low for this year. So when operating with abstract ratios sometimes you get such results where the buy price is higher than the Max Value, but what we are trying to do with Friedrich is find companies that are consistent year in and year out, so we do not need to sell. We are looking for just 50 stocks to put two percent in to become fully invested out of 3000 stocks that we analyze as part of our research. There is no such thing as a perfect system as perfection is an illusion that can only be found as a word in a dictionary. Once an investor understands that, she or he automatically matures and becomes a more seasoned investor. Plato once said “Experience is what man calls his mistakes”. Therefore, Friedrich is the culmination of what I have learned over the last 30 years in creating the Friedrich Algorithm, through trial and error and through my personal experiences in the stock market as a Professional Analyst.

Considerations For Building A Currency Hedged Strategy

By Jane Leung It’s been nearly impossible to ignore the news about the dollar, especially for those of us who are taking advantage of the upcoming vacation season to travel overseas. The greenback’s movement also has implications for investors. One of the things I’m hearing most from colleagues and clients is that investors know they need to have a view on the dollar – whether it will go up or down – and also be very aware of their investing time horizon. Unfortunately, they’re still unsure of how to implement a currency hedged strategy in their portfolio. Of course, predicting exact currency movements is impossible, especially in today’s environment. On one hand, you have the Federal Reserve angling to boost interest rates, while on the other, central banks in Europe and Japan continue efforts to lower rates, thus weakening their respective currencies. So let’s focus on the variable that’s easier to measure: time horizon. Why Time Matters Investors seeking to limit the effects of currency risk on their portfolios have a number of hedging strategies to consider, but what to do depends on the investment horizon. A quick review of the numbers shows that there is a big difference in the risk/return ratio of hedged and unhedged strategies depending on how long you remain invested. The chart below shows developed market return/risk ratios and reveals that results vary significantly over time. Of course, it’s important to remember that currency returns are generally viewed, over the long term, as a zero-sum game. And, as we can see, over a 15-year period, hedged and unhedged strategies, as measured by MSCI (daily index returns from April 1, 2005 to March 31, 2015) produced nearly the same results. However, applying some form of currency hedged strategy may help reduce volatility. In the example below, at 10 years, there was a higher return/risk ratio for a hedged v. unhedged index. The differences keep becoming more pronounced as you look at shorter time periods. Over a 1-year time period, a 100 percent hedged portfolio would have resulted in a 0.8 risk/return ratio while 100 percent unhedged would have resulted in a -0.6 risk/return ratio. EAFE HEDGING How to Build a Hedged Strategy When deciding how much of your portfolio should be hedged for currency risk, a good rule of thumb is to think about developing an asset allocation and hedging “policy” at the same time. To clarify my point, I’m including a simple risk-and-return illustration. Low risk/low return investments such as cash and U.S. bonds reside in the left corner and the potentially high risk/high return investments such as unhedged international equities in the upper right corner. The orange dot is where a hypothetical investor may indicate her risk tolerance. HYPOTHETICAL RISK TOLERANCE Considerations for Investing Overseas When you think about international investing, it is also important to recognize the distinct characteristics of each country that makes up a foreign region. Some of these features may or may not be correlated with the U.S., and this can affect the decision of whether or not to hedge and, if so, how much. Take a look at the annualized volatility over 10 years for a variety of single countries and international regions, as represented by MSCI: ANNUALIZED VOLATILITY: 10 YEARS We can see from the graph above that the annualized volatility over 10 years was consistently higher for unhedged positions than hedged positions and that different countries and regions had different levels of volatility relative to each other. In short, your asset allocation should depend on how much risk you’re willing to take on any given investment. If you have a portfolio that is heavily weighted toward international investments, has high currency volatility or high correlation between the currency and the underlying assets, a higher proportion of currency hedged investments might be appropriate. If you are more risk averse, and your portfolio is more heavily weighted towards U.S.-based investments, has lower currency volatility, or low correlation between the currency and the underlying asset return, you may consider having a lower proportion of currency hedged investments. Whatever your risk tolerance, you may want to consider a currency hedge as a way to help minimize the effects of volatility over the long term, regardless of short-term dollar movement. This post originally appeared on the BlackRock Blog.

EFA: How Do You Make A Mediocre ETF Sound Exciting?

Summary EFA is a mediocre ETF. The sector allocation is mediocre, the geographic diversification is mediocre and the expense ratio is mediocre. The top holdings make sense, but they don’t reflect the total portfolio. Despite having a heavy portfolio weight towards financials, there is only one in the top ten. There is nothing bad about the ETF to warrant taking a capital gains tax on sale, but if a loss could be taken with proceeds reallocated… that would be nice. There isn’t much to say to make this ETF sound exciting. There are so many international ETFs it can be difficult for investors to choose one. Hopefully I can help with that problem by highlighting some of them and shining a light inside their portfolio. One of the funds that I’m considering is the iShares MSCI EAFE ETF (NYSEARCA: EFA ). 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 The expense ratio on the iShares MSCI EAFE ETF is .33%. I’d really prefer to see lower, but that isn’t high enough to remove the ETF from being worthy of further consideration. Geography The map above shows the top 10 countries by the market value of their allocations. This is certainly an international ETF, but the holdings seem more diversified from the list on the left side than from the list on the right side. I’d like to see even more diversification, but at least they have not assigned any single country a weighting higher than 25%. Sector Looking at the sector allocation is fairly interesting. Fortunately this is a fairly diversified group of sectors, but I think I would prefer a smaller allocation to financials. Perhaps I’m being too picky, but I’d rather see more consumer staples and foreign utilities mixed into the portfolio. I’d like to have the benefits of international diversification while overweighting the sectors that I expect to be less volatile. Largest Holdings (click to enlarge) Looking at the individual holdings, you wouldn’t expect that “Financials” would be so overweight. Only one financial company is in the top 10. The concern for me is that a heavy focus on financials in the lower parts of the portfolio suggests to me that the ETF may have a heavier weight on the companies that are easier to research or buy if markets are not sufficiently liquid in some countries. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion EFA certainly has some volatility, but the correlation over longer time periods has been significantly lower than the correlation levels created by measuring on a daily basis. All around, this is a decent but not spectacular ETF. The ETF has a respectable but not incredible diversification among countries. The holdings are concentrated on the financial sector, but only one financial firm was able to warrant a large enough allocation to end up in the top 10. When it comes down to the sheer volume of holdings, there are 934 companies in the portfolio. Of course, that could change at any point. I love having extreme levels of diversification like that in international equity allocations, but such high diversification indicates a passive indexing strategy. As you might imagine, I’d rather not pay the .33% expense ratio for a passive index fund. The problems within the ETF aren’t bad enough for investors to have any cause to sell it and incur a capital gains tax, but I’d rather place international equity allocations in other ETFs. If an investor is able to harvest a tax loss on selling, that would be a very solid reason to reallocate to a more appealing ETF. If you’re looking for more appealing options, I put together an article with three of them .