I did a post Big Dogs, Small Dogs & Spy Dogs late December. That got me thinking about how people spend much time on stock selection, while neglecting capital allocation and risk measurement, both equally important aspects of return generation.
When people select stocks, an individual investor stock selection style bias will creep in. Some will invest using a value investing strategy, some will think quality and governance, others will focus on growth, and many will elect an income strategy, while others target a momentum strategy and yet others will adopt a style agnostic strategy. And this is not all. We can select stocks at a sector level, or an industry level, or be sector and industry agnostic. Or we can select stocks based on market capitalization of the company. There are innumerable stock selection styles which people employ, and once the stock selection is done an investment decision is made. Often will little thought to capital allocation.
Capital allocation is a very important generator of long-term returns. The first allocation decision involves deciding how much capital to allocate to separate asset classes like commodities, bonds, equity and real estate. Once that decision has been made, and we know how much capital is to be deployed in equity, we need to think about how to spread that money across different stocks selected. Should we equal weight across the selection? Or should we allocate based on a stocks free float market capitalization? How about a price weighted allocation? And that's not all, we can consider how much capital to allocate at sector level, or indeed across small versus large capitalization stocks too. There are innumerable capital allocation strategies. But the point I seek to make is that little or no time is spent on the decision.
Below you will see the Dogs of the Dow at the end of 12/31/2012 together with performance of SPDR Dow Jones Industrial Average (NYSEARCA:DIA), SPDR S&P 500 (NYSEARCA:SPY), iShares Russell 2000 (NYSEARCA:IWM) and Guggenheim S&P 500 Equal Weight (NYSEARCA:RSP).
The top ten yielding Dow stocks at end of 2012, equal weighted, delivered a total return (capital appreciation plus dividend, assuming no re-investment) of 34.46%, and this outperformed the SPDR Dow Jones Industrial Average. The smaller selection of the top five yielding Dow stocks, equal weighted, provided a return of 22.13%, significantly underperforming the SPDR Dow Jones Industrial Average.
A tweak to the capital allocation methodology employed, to one where we allocated capital based on the dividend yield, changes the picture. The Dividend Weighted capital allocation essentially deploys the initial capital as Total Capital Deployed Multiplied by Dividend Yield for the Stock Divided by Sum of Dividend Yield of all Stocks in the List. The dividend weighted Big Dogs returned 32.99%, outperforming the Dow, but underperforming the Big Dogs equal weighted strategy. This illustrates the importance of the capital allocation decision: the equal weight strategy outperformed the dividend weight strategy.
Using a more robust value weight allocation system (compared with using dividend as the sole indicator of value allocation) such as allocating capital by trailing twelve months diluted earnings yield (an exception being HPQ where I used non GAAP EPS instead), would have resulted in Big Dogs returning an astounding 54.45% while the Small Dogs would have risen to 25.33%. This too illustrates what capital allocation can do for returns.
Look at the total return on the SPDR S&P 500. It underperformed the Guggenheim S&P 500 Equal Weight significantly. The stock selection is identical, the only difference is that the Guggenheim S&P 500 Equal Weight equal weights stocks in the S&P 500 while the SPDR S&P 500 weights by free float market capitalization. This too illustrates the importance of the capital allocation decision.
The iShares Russell 2000 which generated a total return of 38.49% outperformed SPDR Dow Jones Industrial Average, SPDR S&P 500, Guggenheim S&P 500 Equal Weight and all the Dog strategies. The outperformance comes from stock selection, because iShares Russell 2000 invests in smaller size companies. But not thinking through capital allocation could have cost some folks because they failed to consider allocating capital to smaller size companies. This also illustrates the importance of the capital allocation decision.
And then there is risk measurement. What I love about the Dogs strategies is that they deliver superior total returns with a lower beta. The iShares Russell 2000 runs with a beta of 1.22. You got your 645 basis points of outperformance over SPDR S&P 500, by adding risk. Assuming a risk free rate as measured by the ten-year bond of 1.8% over 2012, to fully price beta, iShares Russell 2000 should have delivered a total return of 38.7%: it didn't. The Guggenheim S&P 500 Equal Weight runs with a beta of 1.17. You got your 329 basis points of outperformance over SPDR S&P 500, by adding risk. Assuming a risk free rate as measured by the ten-year bond of 1.8% over 2012, to fully price beta, Guggenheim S&P 500 Equal Weight should have delivered a total return of 37.2%: it didn't.
Ultimately, stock selection and capital allocation strategies are used to create tentative portfolios, with the latter being largely ignored by many. And once a tentative portfolio is created, there is risk measurement - another area ignored by many. I believe a focus on all three areas will add to long term performance.
I have used perfect hindsight to illustrate my point of view on the importance of capital allocation and risk measurement. Going ahead, time permitting, I plan to run posts to track performance of the Big Dogs from my post on Christmas 2013, using an equal weight, dividend yield weight and an equal weight adjusted for value strategy. You can read more about the equal weight adjusted for value strategy here.
And to keep myself honest, here is what I intend to track. On a total return basis, I'd hope for the best long-term return from the equal weight adjusted for value strategy.
Disclosure: I am long INTC, MRK, PFE, GE, JNJ. 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.