Use Conservative Growth to Conquer the Current Market

Last summer, I launched my second model portfolio, the Conservative Growth/Balanced Model Portfolio. At the time, I thanked Seeking Alpha readers for their very thoughtful responses to several of my articles indicating to me that there was great interest in "conservative stocks" and shared a "kick-off" preview, "Investing for Conservative Growth". I followed that piece up with very detailed analysis of all of the stocks I was including in that initial portfolio (Energy, Industrials, Consumer Discretionary, Consumer Staples & Health, Financials and Technology). 41 long and harrowing weeks later, I am very proud to share that the model portfolio, which is measured against the S&P 500 (60%) and the Barclay's Aggregate Bond Index (40%), has returned over 1%, besting its benchmark by almost 15%.

How did I do it? It wasn't buy and hold, as here is the initial portfolio and its members' returns:

AGG	99.32	100.96	1.7%
ASF	26.85	30.49	13.6%
BBBY	29.10	29.99	3.1%
CFR	52.21	50.69	-2.9%
COLM	38.35	31.32	-18.3%
CSCO	22.38	19.50	-12.9%
CSL	26.88	24.10	-10.3%
CVX	86.22	66.87	-22.4%
FII	33.58	23.40	-30.3%
ITW	46.55	34.30	-26.3%
JNJ	67.49	53.85	-20.2%
LOW	19.86	21.02	5.8%
NATI	27.97	22.14	-20.8%
WAG	33.97	31.56	-7.1%
			-11.5%

The iShares Barclays Bond Index Fund (AGG) is a big chunk of the portfolio, and it has increased slightly. The stock holdings, though, have declined about 11.5% since the inception. A blend of 40% bonds and 60% stocks has declined almost 15%, but 40% of AGG and 60% of the average of our initial stocks would have declined about 6.2%. Not too bad, but I stated that we are actually up over 1%.

Again, how did we do it?

1. Conservative Growth stocks did better than the market
2. We traded aggressively

Allow me to elaborate. I already showed that our average stock did better than the market. With respect to the bonds, we have generally been underweight the 40% benchmark, but we took it way up when the ETF was mispriced in October. I actually shared this extreme opportunity. My back-of-the-envelope calculation is that trading around the bond ETF exposure may have added as much as 4%. The balance came from trading around the stocks. Allow me to elaborate.

As you are probably painfully aware, we have had one of the greatest rallies ever (now) as well as a very strong one in November and two of the worst bear markets ever (9/08-11/08 and 1/09 to 3/09). The model portfolio allows me to vary exposure to stocks by neutral +/-25%. In other words, our 60% neutral exposure can be as low as 45% or as high as 75%. On balance, I believe I had those exposures relatively helpful to the model, though I confess to having been underweight since late March. I keep a running blog, and you can get a feel for it by visiting. So, some of the return was pure beta. But, that's only a partial explanation. We have also sold several securities and added others. We sold, for instance, Cullen/Frost (CFR) and Lowe's (LOW) at higher prices than they currently trade. We recently sold National Instruments (NATI) and Cisco (CSCO), and we sold Administaff (ASF) in April (well below today's quote!), Federated Investors (FII) in March, Illinois Tool Works (ITW) in January and Bed Bath and Beyond (BBBY) in December. We have added CR Bard (BCR) very recently, CARBO Ceramics (CRR) at 30 in April, Hormel (HRL) at 27.24 in November, Met-Pro (MPR) at 6.33 in March (hard to believe), Raven Industries (RAVN) at a much higher price, Sysco (SYY) at 22.23 in April and Tidewater (TDW) at 33.23 in March. We also used the volatility to add to our original positions at much lower prices.

The bottom line is that we have focused exclusively on companies with strong balance sheets and reasonable valuations. Some of our excess performance can be attributed to good timing, but a great deal is simply being in the right stocks relative to the market.

We have written on many occasions that trading is essential in this volatile market. One can't buy and hold one's way to success in a bear market. Whether it is at the security level or the sector level, one must allow the poor liquidity in the market to be one's friend.

Here is how we are currently positioned:

• Bonds 33.5% vs 40% benchmark (all in AGG)
• Stocks 46% (above the 45% minimum but well below the 60% neutral weight)
• Cash 20.5%

Our stocks by sector:

• Energy: CRR 5.1%, Chevron (CVX) 5.6%, TDW 2.5% (total of 14.2% or 23.7% of 60% equity benchmark compared to 12.8% in S&P 500)
• Materials: 0% compared to 3% in S&P 500
• Industrials: Carlisle (CSL) 1.5%, MPR 1.6%, RAVN 3.9% (total of 7% or 11.7% of 60% equity benchmark compared to 10% in S&P 500)
• Consumer Discretionary: Columbia Sportswear (COLM) 4.4% (compared to 9% or 7.3% of equity benchmark compared to 9% in S&P 500)
• Consumer Staples: HRL 6.3%, SYY 4.1% and Walgreen (WAG) 1.9% (total 12.2% or 20.3% of equity benchmark compared to 12% in S&P 500)
• Health: BCR 2.1% and Johnson & Johnson (JNJ) 7.5% (total 9.6% or 16% of equity benchmark compared to 14% in S&P 500)
• Financials: 0% compared to 13% in S&P 500
• Tech: 0% compared to 18% in S&P 500
• Telecomm: 0% compared to 4% in S&P 500
• Utilities: 0% compared to 4% in S&P 500

Thus, we are currently very overweight Energy and Staples and underweight Financials and Tech, with about 25% of our potential equity exposure in cash. The overall portfolio has a forward PE of about 13.7X and a 2.8X Px/Tangible book value. The median and average net cash is slightly positive. The equities have a weighted dividend yield of 2.65%, which is slightly higher than the S&P 500 despite the superior balance sheet profile.

I expect this type of portfolio, which is focused on strong balance sheets and modest valuations, to continue to do well in this economic environment. The model is up over 7% YTD. While my outlook is for falling stock prices in the back half of the year, I am hopeful that we can stay green.

Disclosure: Long COLM, CRR, CVX, HRL, JNJ, SYY

Comments

[Emerald:]

The fundamentals of this market are negative with narrow trading breath and volume. Earnings are down. Credit spreads ae wide on corporate debt, so I agree AGG is a good bet as are Ginnie Mae bond funds. Common stocks are risky with an impemding correction due to the rapid growth over the last month. Note: Long the above.

May 05 11:01 AM