Portfolio Strategy: Forget About Low Turnover

Includes: IVV
by: Bram de Haas

Ever since research has shown that portfolios with low turnover do better, it is increasingly recommended to make this a part of portfolio strategy.

I recognize the advantage of lower trading costs that a low turnover portfolio has, over one with higher turnover. But it doesn't mean you can apply this newfound knowledge to your current investment strategy and expect to have better results. Focus on beating the market, not lowering turnover.

Stock Picking to Outperform

If you are selecting stocks you are doing so in an attempt to outperform the market. Every investor has a different approach but usually their methods include selecting the stock of a company, whose future cash flow, or assets, the market undervalues.

Whether you are a Value, Growth, GARP or special situation investor, you want to buy a security that is mispriced by the market.

If it is no longer mispriced, fairly valued or even overvalued, you want to sell immediately, unless you have no better use of cash than holding a fairly valued asset. There is not really an excuse for holding an overvalued asset.

When you start messing with your strategy by extending your holding period to lower trading costs, you are giving up a portion of active share. You are now holding on during a timeframe that you previously identified as a suboptimal holding period. If your default strategy is one that outperforms, this isn't going to do you a lot of good.

If you are extending your holding period in a manner that also increases your outperformance, then that is a no-brainer. But you should have modified your strategy to increase your outperformance in the first place.

Conceding to Lower Turnover

If your strategy is underperforming the market, then extending your holding periods will help. However in that case you should work on improving your stock picking skill or alternatively, stop stock picking. Decreasing your active share to decrease trading costs means you are throwing the towel in the ring. You are saying I don't think I can do it. Let's limit the losses.

There is no shame in that, but I think the best thing in that case is to just buy a broad market ETF, Index Fund or Mutual Fund and forget about stock picking or portfolio turnover. For example the iShares S&P 500 ETF (NYSEARCA:IVV), The Vanguard Total Stock Mkt Idx Adm (MUTF:VTSAX) or the Weitz Partners Value fund (MUTF:WPVLX) are solid options.

If you want to pick stocks and manage your portfolio, focus on improving your buying and selling criteria to increase returns over those of the market. By increasing your holding period to improve returns, you are decreasing your outperformance. Increasing your holding period 'just because' only works in your favor if you are underperforming to begin with.

Lower Turnover as a Strategy Result

If you insist on increasing your average holding period you should try to find a strategy where the tactic will work to your advantage. Special situations are not a great match for example. It's not going to help your track record a lot to hold onto that asset play after the market fairly valued it, or stick with the post-bankruptcy play for years and years.

Your best shot of increasing your holding periods profitably is if you start to pay more attention to durable competitive advantages and stocks that pay high dividends.

Durable competitive advantages will allow the company to generate above market returns for as long as they last. If you become more skilled at identifying them, you can outperform over longer periods while holding on. Selling when the market recognizes the competitive advantages as well, and values them accordingly, is still preferred. But this type of strategy could work with above average holding periods.

High dividend stocks are an option too. High dividend payers return cash to you on a regular basis. Cash you can invest in stocks that are actually significantly mispriced instead of having it in a fairly valued company. This gives you a chance to let your above average stock picking skills go to work. It's no coincidence that advice to buy and hold is often accompanied by advice to look for dividend paying stocks.

If you can identify companies that have both durable competitive advantages and pay large dividends, you are on the right track to creating a strategy that has a shot at beating the market while not requiring as much buying and selling.

Sample Portfolio

This is a sample portfolio of companies with strong competitive advantages that pay solid dividends. This is not guaranteed to beat the market but just serves for illustration purposes.

The dividends would have been higher if I selected more pipeline companies. I chose to show a more diversified set of companies across many industries.

I've written about some of these companies before: On August 20 I broke down why I like Intel and on October 1 I discussed the competitive advantages of Exelon.

Company Competitive Advantage Dividend
Kinder Morgan Energy Partners LP (NYSE:KMP) Regulatory approval required for pipelines and they are like railroads, no one wants to build the second one. 6.16%
Exelon Corp (NYSE:EXC) Unique assets: low cost production 5.84%
AstraZeneca PLC ADR (NYSE:AZN) Patents protecting drugs 5.46%
Westpac Banking Corp ADR (NYSE:WBK) Big efficient bank in a market with few competitors of size 5.28%
Altria Group Inc, (NYSE:MO) Addictive product and customer preference 5.0%
Intel Corp (NASDAQ:INTC) Economy of scale 3.73%
Potash Corporation of Saskatchewan, Inc (NYSE:POT) Unique assets: low cost production 3.71%
Sysco Corporation (NYSE:SYY) Economy of scale 3.48%

The Gist:

Outperformance should be the goal. Low turnover may be a result.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.