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Retail investor, long/short equity, dividend investing, medium-term horizon
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Performance for the year was nothing to be ashamed of: an IRR (internal rate of return) of 28% beat the S&P 500 index by 12.5%. However, concerns that the risk involved has been excessive compared to the actual returns, together with a reassessment of my discretionary portfolio objectives, leads me to undertake a shift in emphasis from a Deep (or high beta) Value investing approach toward a Dividend Growth strategy.

A Granular Analysis

Here's a spreadsheet, providing basic performance statistics and a listing of the larger winning and losing trades:


(Click to enlarge)

Starting with the winners, it should be noted that most of them had CCC credentials: they appear on the list of Dividend Champions, Contenders and Challengers as maintained by David Fish. The performance of the diagonal spread options positions is startling, relative to the underlying: I went back and rechecked my spreadsheet for all of them, and that's what they did.

The winning trade on the S&P 500 index ETF (NYSEARCA:SPY) was a hedge, long deep in the money puts, well timed and executed.

The losers were few, 6 of 32, but the average loss was $3,643, compared to an average gain of $2,158 for the winning trades. Hewlett-Packard (NYSE:HPQ) and MBIA (NYSE:MBI) stand out like sore thumbs. Both are Deep and/or Speculative Value plays. Neither has CCC credentials.

The big losing trades are still open, as are substantial positions in 3M (NYSE:MMM), MetLife (NYSE:MET) and Prudential Financial (NYSE:PRU). The others listed in the spreadsheet have been closed.

An Objective View of Investment Performance

Ego distorts the analysis of self-directed investment performance. We want bragging rights, multi-baggers, timely tips, a track record of picking winners. Stepping away from this way of thinking, an investor can compare his performance to what can rationally be expected from his strategy or basic investment style. That's the objective point of view.

James O'Shaugnessy, in his 1997 book "What Works on Wall Street," did considerable work on value strategies, finding that simply buying the cheapest stocks by any common metric generates outperformance. The problem is, that performance of this type of strategy is too erratic for any but the most case-hardened volatility junkies. The drawdowns are too big: risk averse investors will invariably bail on the strategy at the worst time.

Without further ado, here are two charts:


(Click to enlarge)


(Click to enlarge)

What we have here are 10 year comparisons of the performance of a generic Deep Value strategy with a Dividend Growth strategy. The data were developed using the backtest utility in StockScreen123. The Dividend Growth Screen was discussed in my article about backtesting the strategy: the Deep Value is the 30 cheapest (by a combination of book value and cash flow) S&P 500 stocks with beta above 1.20.

Outperformance was computed by comparing either TTM or accumulated performance of the strategies to the index. If the index was up 10%, and the strategy was up 20%, outperformance would be 10%.

My natural investment style is value oriented, ranging from blue chips at a discount on out to speculative value. Results have been gratifying at times. In point of fact, the generic backtest of a Deep Value strategy is a fairly accurate depiction of my self-directed discretionary portfolio over the period covered. That would be pattern, not so much level.

The bottom line is, that Deep Value always performs differently from the index, sometimes far better, sometimes far worse. The logical conclusion is, in order to profit from these high volatility strategies, the investor has to be an adroit market timer. Otherwise, it's just a roller coaster ride, with a nasty outcome if you lose your nerve and sell at the bottom.

I don't think it's realistic to expect Dividend Growth to continue its outperformance from a total return perspective. However, I do expect that the resulting stream of income will increase faster than inflation.

Diagonal Call Spread Performance

The portfolio under discussion here is experimental in nature, a reality test of the theoretical advantages that may be achieved by a synthetic approach. Almost all positions are taken by means of Diagonal Call Spreads: long deep in the money, distant expiration calls, preferably LEAPS, against which out of the money, shorter expiration covered calls have been sold.

Basically, it's a covered call strategy on steroids. The use of options provides considerable leverage, as well as volatility and risk. It performs very well in a sideways to moderately upward market, at the expense of giving away substantial upside and accepting substantial downside. It works well as long as the market doesn't make extreme moves in either direction. On the tails, it does poorly.

Looking back at the outcomes here, when the inherently volatile options strategy is combined with a volatile style, such as Deep/Speculative Value, the weakness of both is exacerbated.

On the other hand, the low volatility associated with Dividend Growth Investing seems to mitigate the volatility of the options strategy. The performance of the underlying on the winning trades wasn't that spectacular, but when done with options the results were gratifying.

The options positions are adjusted by rolling according to methods developed over several years of experimentation. Trading costs were approximately 2.6% of portfolio, a substantial reduction from prior years.

The Achilles heel of the diagonal spread as used here is that it magnifies large losses from blow-ups or implosions. Dividend Growth stocks have substantially less risk for those outcomes. They don't have that much tail risk, either to the downside or upside.

A Strategy Change

This formal review confirms a recent decision: I'm dropping Deep Value and adopting Dividend Growth as my primary investment style, for my discretionary portfolio. The experiment with Diagonal Call Spreads will continue, on the grounds that a more conservative selection of underlying stocks overcomes the most serious disadvantage of this options strategy.

An article on the Synthetic Dividend Growth Portfolio is forthcoming.

I remind readers that I'm a self-directed retail investor, and not an adviser of any kind. I present my opinions and discuss my trades for critical review and comment, since I enjoy talking shop and frequently benefit from interacting with readers while taking part in the comment stream.

Dividend Growth Investing in its purest form does not concern itself with capital appreciation, but focuses on growing a permanent (or at least long-lived) income stream. The options strategy presented here relies on capturing part of any capital appreciation by the underlying, and does not create a permanent income stream. The ability to sell calls for premium may be constrained by low volatility. Options are risky, and the leverage employed will serve to magnify losses.

There was a very good discussion of Dividend Growth Investing in the comment stream of David Van Knapp's contribution to the Positioning for 2013 Series. Options came up, diagonal call spreads as well as a strategy of selling out of the money puts on Dividend Growth stocks, with the option premium serving as a substitute for the dividend income. I've done some analytical work on the puts idea, and I think it's workable. I've never done it on a systematic basis.

Outlook for 2013 to 2017

On a five year basis, I'm investing on the basis that nominal returns from owning the index will be around 7% annualized.

For 2013, I see an economy poised to lift off in real recovery, and a dysfunctional band of politicians in Washington. I'm investing on the basis that the fiscal cliff will be resolved to the extent necessary to avoid hamstringing the economy.

In the event we go over the cliff, my five year outlook is the same. The economy is not as fragile as Bernanke and his colleagues say. The public and business leaders will welcome the prospect of sustainable fiscal policy, by whatever means that is achieved.

Discretionary Portfolio in Context

The portfolio I actively manage (and write about here) represents about 20% of liquid assets for my wife and myself. The remainder is in the Vanguard S&P 500 index fund, core type mutual funds, or cash and CDs. Twelve years ago, when I first started investing in meaningful amounts, the strategy selected was to use a mixture of index and conventional mutual funds in an effort to match the S&P 500 over the long term for a large part my investment assets.

The remainder was to be deployed in a discretionary portfolio, with myself as the stock picker. Here the effort was to beat the market by large amounts, relying on value strategies. The risk of underperformance was acknowledged and accepted.

Following the financial crisis, our assets weren't sufficient to support our normal standard of living without selling some of our holdings at large losses.

To avoid selling assets, the strategy from there was, to invest very aggressively with the discretionary portfolio, in an effort to generate income and give the rest of our holdings time to recover. After generating IRRs of 61%, 50%, -30% and 28% for 2009 through 2012, the discretionary portfolio has met the objective of buying time, since we were able to draw what we needed from it without tapping other resources.

Starting in 2009, very low market valuations created a situation where the application of leverage to a value portfolio made outsize returns possible. From where things are now, the risk and outsize returns aren't necessary or appropriate.

Giving Jack Bogle his Due

I'm grateful that I elected to devote a lot of resources to passive investing. Vanguard did exactly what was expected, and there was a point where simply matching the index beat the alternatives.

Various mutual funds such as were available in our 401k plans more or less tracked the index, in the aggregate and allowing for high expenses, and have now been consolidated into IRAs with Vanguard.

I like U.S. equities compared to BRIC's, emerging markets, etc. primarily because I can be more confident that as the owner of a business I will receive the benefit of any profits it makes. In retrospect, I was wrong to go all equities all the time: however, now is not a good time to start investing in bonds.

Transitional Considerations

Getting back to the chart, if the fiscal cliff issue is resolved or papered over, I anticipate that Deep Value will outperform, leading to a natural quitting point. Smart money will rotate out of defensive names into more aggressive picks.

With that in mind, in December last year I bought back any covered calls that were in place over my value candidates, and plan to scale out of the positions as the situation develops.

New positions will be selected by applying Dividend Growth criteria. A beginning was made late last year, with opening trades in Occidental Petroleum (NYSE:OXY), Johnson & Johnson (NYSE:JNJ), Norfolk Southern (NYSE:NSC) and Abbot (NYSE:ABT) (NYSE:ABBV).

Over the course of the coming year, I also plan to reduce my index and mutual fund positions in favor of dividend growth holdings, operating along conventional lines: long the stock, buy and hold while monitoring.

Source: 2012 Performance Review: A Good Year, Followed By A Strategy Change